MEDIA

How arbitration provisions impact the world of franchising in N.J., when state and federal law conflict regarding forum selection clauses

New Jersey Law Journal May 20, 2014

Forty-four years ago this month, the Wall Street Journal ran an article entitled "Many Franchise Firms Fall on Hard Times After 15-Year Boom." Although formal franchising has existed in this country since the mid-1800s, when Albert Singer began to sell his famous sewing machine through franchisees, it was not until the 1950s and 1960s that franchising, largely aided by President Eisenhower's interstate highway system, began to explode in popularity. During that time, hundreds of new franchising systems were developed as our country began to recognize the value of identifiable brands being used nationwide. However, the franchising bubble of the 1950s and '60s, once seen as the savior of the small businessman, had essentially popped as the 1970s rolled in. As one franchise system after another began to collapse, the clear disparity between the bargaining power of franchisors and franchisees became readily apparent. Indeed, while the corporate franchisors would take the franchise fees reaped from their failed ventures and move on to the next investment, the individual franchisees were often left with nothing, having invested a lifetime of savings for the failed opportunity.

Not surprisingly, Congress was unable to enact legislation to address many of the perceived issues with franchising, leaving the process of franchise regulation to the states to work out. In 1971, New Jersey became one of the first states to enact comprehensive franchise practices legislation with the adoption of the New Jersey Franchise Practices Act (NJFPA), N.J.S.A. 56:10-1 et seq. The NJFPA reflects the New Jersey Legislature's strong intent to shield franchisees against abuses at the hands of franchisors with superior bargaining power by prohibiting the arbitrary and capricious cancellation of franchises. Case law interpreting the NJFPA has almost uniformly done so with an eye toward the protection of franchisees.

In light of the strong legislative policy reflected in the NJFPA, it was not at all surprising when the New Jersey Supreme Court, in 1996, held that "forum-selection clauses in franchise agreements are presumptively invalid, and should not be enforced unless the franchisor can satisfy the burden of proving that such a clause was not imposed on the franchisee unfairly on the basis of its superior bargaining position." Kubis & Perszyk Assoc. v. Sun Microsystems, 146 N.J. 176, 195 (1996). To rule otherwise, the court noted, would "fundamentally conflict with the basic legislative objectives [of the NJFPA] of protecting franchisees from the superior bargaining power of franchisors and providing swift and efficient judicial relief against franchisors that violate the [NJFPA]." Thus, pursuant to the NJFPA, a franchisee cannot be forced to litigate in a foreign court against its will. That, however, is not the end of the story.

At the same time Albert Singer was putting a sewing machine in every home in America, another phenomenon was also rapidly expanding in this country: the use of arbitration as a means of resolving disputes. As the Civil War came to an end, for example, disputes between former slaves and their once-"owners" became commonplace and were often resolved in arbitration. Similarly, claims between the United States and Great Britain arising from Britain's assistance of the Confederate States were resolved by submission to an arbitration panel.

Driven by the litigation difficulties that are all too familiar to today's lawyer—court congestion, cost, lengthy trial process, etc.—businesses also began to capitalize on arbitration. In the latter half of the 1800s, for example, the New Orleans Cotton Exchange adopted arbitration as a means of dispute resolution, Maryland adopted voluntary binding arbitration of labor disputes, and the New York Stock Exchange adopted arbitration for disputes between members and their customers. See Steven A. Certilman, "Throw Down Muskets, Seek out the Town Elders," New York Dispute Resolution Lawyer, Vol. 3, No. 1 (Spring 2010).

Business' pro-arbitration view grew even stronger at the turn of the 20th century, when strong lobbying occurred for federal legislation to validate and enforce arbitration agreements. This lobbying ultimately led to the adoption of the Federal Arbitration Act (FAA), which was signed by President Calvin Coolidge on Feb. 12, 1925. Among other things, the FAA makes agreements to arbitrate "valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract." 9 U.S.C. § 2. Despite the FAA's broad and sweeping language, which has not been significantly amended since its adoption, at the time of its adoption the FAA was not thought to have the preemptive power that it wields today.

In fact, for decades after its enactment, the FAA was generally regarded as not applying to the states at all. As late as 1967, there was no definitive authority to suggest that the FAA should apply in federal courts in diversity cases. Thus, during most of the 20th century, state law governed challenges to arbitration provisions, with mixed results. It was not until the Supreme Court's sweeping decision in Moses H. Cone v. Mercury Constr. Corp., 460 U.S. 1 (1983), that the court's view of the FAA began to change. In Moses H. Cone, the court held that the FAA is "a congressional declaration of a liberal federal policy favoring arbitration agreements, notwithstanding any state substantive or procedural policies to the contrary." Further, the court held that "as a matter of federal law, any doubts concerning the scope of arbitrable issues should be resolved in favor of arbitration, whether the problem at hand is the construction of the contract language itself or an allegation of waiver, delay, or a like defense to arbitrability."

The next year, the Supreme Court continued its strengthening of the FAA in Southland Corp. v. Keating, 465 U.S. 1 (1984). In that case, the Supreme Court observed that Congress, in enacting the FAA, established "a national policy favoring arbitration and withdrew the power of the states to require a judicial forum for the resolution of claims which the contracting parties agreed to resolve by arbitration." In that regard, the court declared that the FAA preempts any state law that attempts to burden arbitration agreements.

In New Jersey today, franchisees live in a world governed by both the NJFPA and the FAA, which clearly conflict when it comes to forum selection clauses. On the one hand, the NJFPA strongly disfavors such clauses. On the other, the FAA preempts any state law that overrules the selection of arbitration as the forum of choice.

This conflict came to a head a year after Kubis, in Central Jersey Freightliner v. Freightliner Corp., 987 F. Supp. 289 (D.N.J. 1997). In Freightliner, the District of New Jersey was faced with a contractual provision requiring the arbitration of disputes between the franchisor and the franchisee. After considering the aforementioned history of both the NJFPA and the FAA, the court acknowledged the clear conflict between the two laws. Specifically, the court noted:

While the New Jersey statute does not operate as a wholesale proscription of arbitration clauses in franchise agreements and creates only a presumption of invalidity, the statute clearly limits the enforceability of arbitration clauses by requiring, at the very least, that a franchisor prove that the franchisee was offered an identical agreement without the arbitration provision….

Thus, the court concluded, "[b]ecause the FAA was intended to foreclose state legislative attempts to limit the enforceability of arbitration agreements, and because the [NJPFA] is just such an attempt, the court holds that [that aspect of the NJFPA] violates the Supremacy Clause and is preempted by the FAA."

Subsequent case law has reiterated the decision in Freightliner, including the Appellate Division's decision in Allen v. World Inspection Network International,389 N.J. Super. 115 (App. Div. 2006),cert. denied, 194 N.J. 267. In Allen, the Appellate Division made clear that an entire arbitration clause, including that portion of the provision that "dictates where the arbitration shall take place…must be enforced."

Although the doctrines espoused in Central Jersey and Allen reflect the accepted state of the law in New Jersey today, a truly aggrieved franchisee is not wholly without recourse. In B&S Limited v. Elephant & Castle International, 388 N.J. Super. 160 (2006), for example, although the Chancery Division recognized that an arbitral forum selection clause was enforceable, it noted that the provision "may still be challenged under basic contract principles." Thus, a franchisee that has truly been wronged by the inclusion of a forum selection clause in a franchise agreement may be able to utilize state contract law to try and avoid an arbitral forum. This, of course, is no easy task.

What, then, is to be done for today's franchisees, which can be forced into a costly arbitration in a foreign state? On the one hand, perhaps nothing need be done, as it can certainly be argued that today's franchisee is far more sophisticated than his or her 1970s counterpart. Today, franchisees have access to far more information than franchisees in the past, substantially alleviating much of the historic difficulties in negotiating franchise agreements. On the other hand, the disparities in bargaining power remain, with franchisors often being large national or multinational corporations, and franchisees generally being sole proprietors looking to start a new business venture. Of course, only time will be the judge of how arbitration provisions impact the world of franchising. Until then, however, the only thing that we can be certain of is that we should not hold our breath waiting for congressional action.

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Yellin is an associate in the litigation and intellectual property departments of Cole, Schotz, Meisel, Forman & Leonard in Hackensack. He focuses his practice on commercial litigation and franchise law.