Contract of Adhesion: definition changing?

The classic definition of a "contract of adhesion" may be changing.

The definition remains in wide use, though now often improperly conflated with unconscionability:

1. Standardized form contract
2. Prepared by stronger party
3. Signed by weaker party
4. No opportunity for purchaser to negotiate terms.
5. An odd addition is the Colorado court which held that a contract is not adhesory where the desired services could be obtained elsewhere, a problematic distinction reminiscent of the "tying" argument, and which would make most franchise contracts non-adhesory, Jones v. Dressel, 582 P.2d 1057 [1978]

To say that a contract is adhesory should be descriptive, not perjorative.

One might argue that an adhesory contract requires a heightened level of scrutiny when judicial enforcement of its terms are sought against the weaker party. Nevertheless, an adhesory contract is simply a type of contract which has become common in modern commerce, and there is an economic efficiency argument which may be made in favor of adhesory contracts.

In recent years however, courts have often used the term "adhesory" as a synonym for "unconscionable." In addition, we have seen plaintiffs bringing suit on the grounds that their Franchise Agreement is (gasp!) a contract of adhesion.

The Second Circuit is particularly influential in the area of commercial litigation. Now, jurists of the 2d Circuit have begun to imply that "adhesory" is a dirty word. An early example which suggests that adhesion may occur when there is unequal bargaining power but that there is a further step to render it "unenforceable" is Aviall v. Ryder (1996):

A court will find adhesion only when the party seeking to rescind the contract establishes that the other party has used “high pressure tactics” or “deceptive language” or that the contract was the product of a gross inequality of bargaining power...

Typical contracts of adhesion are standard-form contracts offered by large, economically powerful corporations to unrepresented, uneducated, and needy individuals on a take-it-or-leave-it basis, with no opportunity to change any of the contract's terms....

To be considered an unenforceable contract of adhesion, the contract also must inflict substantive unfairness on the weaker party, because its terms are not within the reasonable expectations of that party, or because its terms are unduly oppressive, unconscionable, or contrary to public policy...

A court may refuse to enforce an agreement only if the contract is the product of procedural unfairness and suffers from one of the enumerated substantive defects. If either feature is absent, the court will enforce the contract, and even if both features are present the court's only remedy is non-enforcement, not reformation. [internal cites omitted, emphasis added]

Note that the elements which render the contract "unenforceable" are ones which would be generally applicable regardless of the adhesory nature of the contract.

By 2004, the SDNY ruling in G&R Moojestic Treats v. Maggiemoo's Internl. made this statement regarding the MaggieMoo franchise agreement:

The Franchisee Plaintiffs' arguments that the forum selection clause is unconscionable and that it is a contract of adhesion may be taken together.

"An unconscionable bargain is one which no man in his senses and not under delusion would make on the one hand, and ... no honest and fair man would accept on the other." [cite omitted]

The fact that the Franchise Agreement was presented on a take it or leave it basis and was not subject to negotiation renders it neither a contract of adhesion nor unconscionable.

"Taken together" ??!!

No, the concepts are distinct. It may or may not be "unconscionable", but it is certainly a "contract of adhesion" if the term is to be useful in conducting a legal analysis, or a new term will have to be invented to take the place of this heretofore perfectly neutral word.

One court succinctly captured the new conflation which has eviscerated "adhesion" as a useful concept:

In order to establish adhesion, a plaintiff must show fundamental unfairness in the process by which the contract was formed, as well as in the substantive terms of the contract, Kopple v. Stonebrook Fund Mgmt, 2004 WL 5653914 (NY County Supreme)

There was a time when "contract of adhesion" meant something reasonably specific. Virtually all Franchise Agreements are contracts of adhesion, but few of them would be deemed to meet the legal standard of unconscionability.

Franchisees should not assume that all jurists are so addled; zees seeking to have the Franchise Agreement voided would be well advised to base their claim on principles such as procedural and substantive unconscionability.

Conversely, franchisors should not waste a lot of effort denying that the FA is adhesory, but rather properly note that contracts are not void merely by virtue of any allegedly adhesory nature.

High Arbitral Expense May Void Contractual Provision

Are high arbitral fees grounds for voiding a fee-splitting provision? A divided NY appellate court reviews US Supreme Court decisions and answers "Yes".

A frequent complaint of franchisee counsel (and others) is that the arbitration process is significantly more expensive than litigation, and may render the arbitral remedy an illusory one (franchisor trade lobbyists disagree).

In Brady v. Williams Capital Group (April 30, 2009), the Appellate Division First Department analyzes current federal and state case law in holding that a fee-splitting provision may be violative of public policy.

In a lengthy split decision, the majority and dissent spar over the standard for making such a decision and how much proof must be tendered by the party seeking to avoid paying the arbitration fee.

Lorraine Brady was a bond saleswoman fired by her employer Williams Capital after a 5-year employment during which her commission-based compensation varied between $100K to $400K. After making $204,691 during the year prior to her termination, she objected to a bill from the AAA demanding that she pay her portion ($21,150 as being one half of the $42,300 total) of the AAA fees before the AAA would proceed with the arbitration.

The majority began with Gilmer v. Interstate/Johnson Lane Corp standing for the proposition that "The Supreme Court has made clear that arbitration agreements are only enforceable 'so long as the prospective litigant effectively may vindicate...statutory cause of action in the arbitral forum'" and proceeds to note that in Green Tree v. Randolph the US Supreme Court noted that "the existence of large arbitration costs could preclude a litigant...from effectively vindicating her statutory rights in the arbitration forum."

The majority is dismissive of the dissent's uncertainty as to the higher costs of arbitration (as opposed to litigation):

The dissent attempts to minimize the effect of such high cost by making us believe that the alternative litigation cost would be much higher. We cannot agree. It is common knowledge that an employee filing an employment discrimination claim in the federal courts must pay a minimal filing fee, generally only a few hundred dollars. Also, the costs of maintaining and operating the court system, including the salaries of judges and other employees, are borne by the taxpayers, not the litigants themselves...her attorneys may be likely to take the case on a contingency fee basis...if the employee's suit is successful, the remedies available under federal...legislation include the award of attorney's fees. Thus, in general, it cannot be disputed that the out-of-pocket expenses for an employee filing a legal suit are minimal. [emphasis added]

The dissent cited Bradford v. Rockwell Semiconductor (4Cir. 2001) as noting that arbitration may be less expensive due to shorter proceedings and limited ability to appeal the arbitral decision; the dissent also says:

I have no idea whether the alternative litigation costs would be higher, let alone much higher...the majority's assertion of the ostensible 'fact' that [the employee] would incur a 'substantial arbitration cost relative to litigation' is pure ipse dixit.

This 3-2 decision is one which may give guarded optimism to franchisees. Although it takes place in the employment context and not a B-to-B context such as a franchise agreement, the employee in this case was a sophisticated and well-paid bond trader who had earned significant sums for the 5-year period preceeding her termination.

At the present time, it is not known whether the decision will go up to the NY Court of Appeals.

Non-Compete Does Not Extend to Son, Court Holds

Can a husband & wife franchisee avoid a non-compete by "selling" their locations to their son & daughter-in-law? A Michigan court gives victory to the franchisees.

Robert & Jean Rooyakker were franchisees of Little Caesar's. The Rooyakkers were well known to the franchisor, since Robert (a former lawyer) had been one of the 2 franchisees that had negotiated a settlement in 2001 after a class-action lawsuit brought by franchisees.

Little Caesar Enterprises Inc v. Robert Rooyakker et al ( 7 July 2009) originated in a decision by Robert & his wife Jean to use their own spice mix on the pizza pies. In February 2005, the franchisor initiated litigation to terminate the franchises. The parties settled prior to trial.

The Rooyakkers owned 7 restaurants. The settlement provided that their restaurants in Gaylord and Grayling would be de-identified and the other 5 restaurants would be sold.

The Franchise Agreement contained a post-term non-compete:

Franchisee shall not, during the time frame and in the geographic area described below, without Little Caesar's prior written consent, either directly or indirectly, for itself or through, on behalf of, or in conjunction with any person, persons. or legal entity, own, maintain, advise, operate, engage in, be employed by, make loans to, or have any interest in or relationship or association with a business which is a quick or fast service restaurant primarily engaged in the sale of pizza, pasta, sandwiches, and/or related products. The prohibitions...shall apply.. for a continuous uninterrupted two year period with respect to the Designated Market Area...

The Settlement Agreement provided:

The Rooyakker Parties...shall comply with all post-termination obligations of the franchise agreements. A restaurant which sells and advertises (offsite and onsite, including the menu), steaks, salads, pastries and desserts does not violate the post-termination non-competition provision...if it also offers pizza, pasta and sandwiches, as long as pizza, pasta, and sandwiches are not advertised or marketed as the primary or dominant items, and do not comprise the primary or dominant items, and as long as "pizza" is not in the store name, logo, or service mark.

Robert & Jean Rooyakker continued to operate the Grayling and Gaylord sites, and sold the other 5 restaurants to a company named "A & R Hospitality."

The only problem was that all 7 restaurants were operated under the single name "Spicy Bob's Italian Express" and...

...well, make that two problems: the owners of "A & R Hospitality" were Matthew Rooyakker, his wife, and another person. (Matthew was no stranger to disputes about non-compete clauses).

Needless to say, Little Caesars objected that there might be just a wee bit of coincidence in the last name of the parties involved in A & R Hospitality; the franchisor opposed the trial court's granting of summary judgment on the grounds that a material question of fact existed as to whether the "sale" was a sham.

In reviewing the grant of summary judgement in favor of the Rooyakker, the trial court said:

The court does not find a violation of any agreement. Granted it was a sale to a family member and included favorable terms. There is no prohibition against that. Robert Rooyakker did guarantee the down payment to the bank. The agreements do not prohibit that....

The appellate court didn't agree with the trial court about whether there had been a loan in violation of the Settlement Agreement, but with regard to the son's company the appellate court stated:

The express terms of the settlement agreement provide that it is binding on a successor, but that a 'buyer of assets' is not a successor... Little Caesar has not established anything about the transaction... that gives rise to a reasonable inference that their separate corporate identities should be disregarded for purposes of imposing an affirmative duty on A & R Hospitality to comply with the noncompetition covenant in the settlement agreement... In general, separate corporate entities are respected in Michigan, unless doing so subverts the ends of justice... there was nothing unlawful about A & R Hospitality being formed by Robert and Jean Rooyakker's son Matthew Rooyakker, in conjunction with his wife and Nicholas Aune, to purchase assets from A & T Holdings and operate them as Spicy Bob's restaurants.

The court remanded the case due to issues of fact raised by Little Caesar still requiring resolution, and interested BMM readers can read the case for further information. While the Rooyakkers may be held liable for breach in making a loan to their son's company, the assets are now in the son's company and the son is not bound by the non-compete but is able to benefit from the business goodwill.

Normally it is the franchisees who are the losers when contracts are strictly enforced according to their written terms.

The lesson for franchisors is to carefully draft your Settlement Agreements, and the lesson for franchisees is that courts are willing to find for franchisees who can find a way to comply with the letter --if not the spirit-- of their contract.

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Pretextual Termination of A Franchise

The general rule was set forth by Judge Posner in Tuf Racing Products v. American Suzuki [223 F.3d 585 (2000)]:

If a party has a legal right to terminate the contract, its motive for exercising that right is irrelevant. The party can seize on a ground for termination given it by the contract to terminate the contract for an unrelated reason.

Most courts perform a three-step analysis in reviewing the franchise termination:

1. Where the franchisor states a factually-accurate lawful basis for termination,
2. and that basis is either non-curable or the cure time has expired,
3. the franchisor may terminate the franchise on the ostensible basis even where there is an ulterior motive which would not be a proper basis for termination.

No discussion of franchisor pretext would be complete without mentioning Vylene v. Naugles [105 B.R. 42 (1989)], where the franchisee Debra Green had an affair with franchisor chairman Harold Butler, a married man old enough to be Debra's father. The trial court noted:

Apparently Vylene's relationship with Naugles ran rather smoothly so long as the affair lasted. Vylene's difficulties with Naugles began shortly after the termination of the affair.

The Vylene court found that the franchisee got the short end of the stick, but this is a rare instance where hard facts made the law.

Majority jurisprudence is in agreement with Judge Posner of the 7th Circuit, who snapped at the Great American franchisees:

The law generally...does not provide remedies for spiteful conduct or refuse enforcement of contractual provisions invoked out of personal nastiness.

Shortly after that, the 3rd Circuit followed in finding that a McDonalds franchisee's sanitary violations

constituted a material breach of the franchise agreement sufficient to justify termination, and thus, it does not matter whether McDonald's also posessed an ulterior, improper motive for terminating the...franchise agreement McDonald's v. Robertson [147 F.3d 1301 (1998)].

Other courts have agreed with Robertson:

• McDonald's v. Underdown [2005 WL 1745654 (M.D. Pa. 2005]

• Shred-It America v. Haley Sales [2001 WL 209906 (W.D.N.Y. 2001)]

• Zeidler v. A&W Restaurants [ 2001 WL 62571 (N.D. Ill. 2001)], on appeal here

• Midas v. T&M Unlimited [ 2000 WL 1737946 (W.D.N.Y. 2000)]

Maturing franchisors often seek to get rid of "Mom & Pop" operators, but when John Deere franchisees alleged that the ulterior motive of the zor was a long-standing plan to push out small zees, the 8th Circuit found even the alleged ulterior motive to be a "legitimate business reason" Taylor Equipment v. John Deere, [98 F.3d 1028 (1996)]

In the face of a similar "Mom & Pop" claim, the court found no claim stated under the NY Franchised Motor Vehicle Dealer Act, Prestige Harley-Davidson v. Harley-Davidson [ 2008 WL 216987 (S.D.N.Y. 2008)], and another court in Brooklyn NY was skeptical of the claims of Dunkin' franchisees who alleged they were being pushed aside in favor of a mega-franchisee.

Application of the implied covenant of good faith and fair dealing has been unsuccessful in overriding express contractual terms permitting the franchisor decision:

• GNC Franchising v. O'Brien [443 F.Supp.2d 737 (W.D.Pa, 2006)]

• Popeyes Inc. v. Tokita [ 1993 WL 386260 (E.D.La. 1993)]

Allegations of ulterior/pretextual motive are commonly raised by franchisee defendants, and as one of the most litigious franchisors, the Dunkin' Donuts system has dealt with this issue of ulterior motive on numerous occasions, including:

1. Dunkin' Donuts v. 1700 Church Ave. [ 2008 WL 1840760 (E.D.N.Y. 2008)]
2. Dunkin' Donuts Franchised Restaurants LLC v. Grand Central Donuts Inc [E.D.N.Y. 2007-4027]
3. Elkhatib v. Dunkin' Donuts [ 2007 WL 1976126 (7th Circuit 2007)]
4. Nazareth's v. Dunkin' Donuts [ S.D. Fla. # 2004CV20678]
5. Dunkin' Donuts v. Liu [79 Fed.Appx.543 (3d Circuit 2003)]
6. Dunkin' Donuts v. National Donut Rests. of NY [E.D.N.Y. # 2002 CV 6302]
7. Dunkin' Donuts v. Patel [174 F.Supp.2d 202 (D.N.J. 2001)]
8. Dunkin' Donuts v. Donuts [ 2000 WL 1808517 (N.D. Ill. 2000)]

____________________________________________________

Auto dealers are covered by special federal franchise legislation which may restrain franchisors who posess "an ulterior motive for its action" General Motors v. New A.C. Chevrolet, (3d Cir. 2001).

Petroleum dealers are also covered by special federal law, and since many dealers have short-term franchises of only a few years the matter of renewal is important, and the PMPA is designed to balance the legitimate needs of the franchisor with those of the franchisee, PDV Midwest Refining LLC v. Armada Oil, (6th Cir. 2002). As a result, the most frequent claim of "ulterior motive" seems to be under the PMPA, but those cases should not be relied on by non-petroleum franchisees.

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Franchise Regulation History

Regulation History

Franchise legislation per se does not appear until around 50 years ago, but it is rooted in a shift in American jurisprudence dating back around the turn of the last century.

In the aftermath of the Civil War, expansion of the railroads and urban manufacturing led to a shift in US law. There were quite a number of injuries and deaths caused by the new economy, coupled with concern over the ability of powerful individuals and corporations to affect the economy. This led to the development of such things as antitrust laws, labor laws, and other examples of remedial and prophylactic regulation which are relevant to a discussion of modern franchise law, and the legal framework within which the franchise industry operates.

As discussed previously, the early 1900's saw the development of a more urban society which necessarily freed opportunistic actors from the constraints of pre-industrial societies where everyone knew each other and where social pressure made reputational risk a serious factor pressuring people (and companies) to behave. People change gradually, and so even today much behavior that served us well is not compatible with modern law and economics; this has been referred to as "time-shifted rationality " and is closely related to such concepts as "heuristics" (our internal paradigm for quickly processing complex information; the science behind your 'gut reaction') "bounded rationality" (which says that human heuristics limit the "rational economic actor" model which underlies much modern American law) and "kin selection" as a formerly adaptive behavior now exploited by modern franchise salespeople.

For many years, franchisors were not concerned about reputational damage, because in our mobile modern society, there was always a new (often immigrant) franchisee who had not heard of the f'zors reputation. The very idea of the Internet as a "community" is part of what has enabled f'zees to begin to make reputational damage a constraint on abusive f'zors; there are several Internet discussion boards about franchising .

Automobile sales was one of the first areas in which franchising was used. Auto dealers tended to be upper income and influential members of their communities, and so when the franchisors got aggressive, the auto dealers were able to get the first federal franchise legislation passed in 1956. That law remains on the books today, and it is worth reading the law's definition of 'good faith' .

Three years later, franchisors led by Dunkin' Donuts founder Rosenberg formed the IFA in Chicago (it subsequently moved to D.C.) and despite significant abuses in the franchise industry, f'zors were successful in forestalling federal legislation until the Franchise Rule took effect in 1979 (plain-language overview of Rule here ). The notable exception was petroleum franchisors: those of you old enough to remember the 70's know how unpopular Big Oil was, and in 1978 the Congress passed legislation protecting gas station franchisees .

The Auto and the Gas legislation regulates the franchise relationship, but the Franchise Rule regulates only disclosure. Franchisee advocates maintain that simply requiring disclosure does not work since the franchise relationship lasts for many years and f'zee advocates say that it is necessary to have relationship legislation covering matters such as encroachment and termination. Franchisors respond that relationship legislation would result in courts becoming involved in operational matters. A famous example of relationship legislation is the Iowa statute , in particular the provisions relating to encroachment and termination/renewal.

Two Authorities

There are 2 sources of authority for the FTC to regulate franchises: the Franchise Rule and Section 5 of the FTC Act. While Section 5 would potentially cover aspects of the franchise relationship, the FTC takes the position that it lacks a Congressional mandate to use Section 5 to effectively get into the operational decisions of a franchisor, particularly since the law provides (15 USC 45(n)) a three-pronged test: (1) substantial injury (2) not reasonably avoided by the affected party and (3) not outweighed by countervailing benefit. Additionally, the contract between zor and zee is a commercial one and not a consumer. Since there is no private right of action to enforce the Franchise Rule, only the government (and not franchisees) may bring an action in federal court if a franchisor does not comply with the Rule. While f'zee groups maintain that a private right of action is necessary given the perceived lack of FTC enforcement, such a right is unlikely to be granted soon.

Most states do not have franchise-specific legislation, although they may have law of more general applicability and if you have a complaint you can contact your state regulator ; however you should be aware that most regulators regard franchise contracts as being between sophisticated business parties and although the same office normally regulates complaints about other investments such as stocks, the law is quite more protective in the latter case than for f'zees.

In the 1960's the negative media attention caused many prospects to not buy a franchise, and many f'zees of the 70's and 80's were immigrants; this is especially true in segments such as roadside hotels and QSRs. By the 90's, the franchise industry began to look to retirees, laid-off middle-management (who have 401K money to buy a franchise ), and in recent years to young people and to persons leaving the military .

Although the LaFalce and Coble-Conyers legislation failed to pass Congress in the 1990's, as the franchise industry becomes a more central part of the economy there has been concern as to negative externalities caused by the industry: at root, franchising is a method of purchasing capital and labor. As early as the 1990's, analogies were being drawn to regulation of labor and capital markets, and those analogies have continued to be made. That, and the increasing number of franchisees who are middle-class voters, has led to recent interest in regulation of the franchise industry at the state level and some commentators have wondered if the industry's lobbying group can adequately address state legislation since the interests of franchisors may be different from franchisees.

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PMPA Does Not Pre-Empt All State Law Claims

Can a franchisee avoid the PMPA and sue his franchisor in state court? Yes, says the 5th Circuit in reversing the Southern District of Texas.

In Bellfort Enterprises v. Petrotex Fuels (30 July 09) the US Court of Appeals addressed the question. Franchisee (Belfort) and franchisor (Petrotex) entered into a franchise agreement covered by the Petroleum Marketing Practices Act (PMPA).

When Bellfort sued the franchisor, the complaint alleged various claims under Texas law but did not claim PMPA violations.This was important because the PMPA is a federal statute, and therefore any litigation under the PMPA would raise a "federal question" which would have to be resolved in federal (not state) court.

The franchisor moved the suit to federal district court, and the franchisee moved to return the matter to state court. The district court initially agreed with the franchisee, but then changed its mind and held that the PMPA preempted the state law claims.

On appeal, a 3-member panel of the Court of Appeals reversed the district court. The panel distinguished between "ordinary" preemption and "complete" preemption; holding that PMPA was not complete preemption of state law.

In analyzing the applicability of PMPA to the specific case, the court noted that a plaintiff is "master of its complaint" and the plaintiff had chosen to only raise claims under Texas (and not federal) law.

The court distinguished between a "well-pleaded complaint" where the attorney had properly set forth state law claims only, and the "artful pleading doctrine" where the facial causes of action might be state law claims but in reality the claims implicated federal law. Where a court finds "artful pleading" it may hold that there is a federal question even though one is not explicitly stated (Rivet v. Regions Bank of Louisiana).

Often the most important claim a franchisee can make is one regarding improper termination or non-renewal, and such claims have been held to be completely preempted by the PMPA (C.A.L.L. v. ExxonMobil, D. NH, memorandum of Aug 14, 2009). In such a case the most significant element of damages would therefore necessitate a federal venue.

The lesson for franchisees is to plead carefully; it may be in the interests of the franchisee to be in a particular forum (in this case, state court) and so the franchisee might chose to forego legally-supportable causes of action which would result in being sent to a less-desirable forum.