Successful franchisors have long faced the threat that a few disgruntled franchisees, organized and led by a plaintiff’s contingent fee law firm, will commence a class action based on some  perceived grievance common among all franchisees. In a class action scenario, damages allegedly owed by the franchisor to potentially all of the franchisees throughout a franchisor’s entire system are aggregated and decided at once. Even a small chance of a devastating loss frequently drives the franchisor to incur enormous legal fees and costs to defend the class claim. When the stakes are so high, the risk of an error by a jury or court will often become unacceptable and pressures the franchisor to settle questionable claims by paying large sums and agreeing to other business concessions that the franchisor would normally reject.

A recent U.S. Supreme Court decision provides an extraordinary opportunity for franchisors to minimize risks of a class action by its franchisees and customers though use of mandatory arbitration in franchise relationship agreements. In April, 2011, the Supreme Court published its decision in AT&T Mobility LLC v. Concepcion et ux. , finding that an arbitration clause in AT&T’s cellular service contract that precluded classwide arbitrations was valid and enforceable.

The AT&T decision involved a consumer contract for a cellular telephone between Concepcion and AT&T which required arbitration of all disputes but forbade classwide arbitration.   Concepcion was chaged sales tax on the retail value of phones provided free under a standard form of service contract that Concepcion signed with AT&T. Concepcion sued AT&T in Federal Court in California. The Concepcion suit became a class action on behalf of all AT&T customers similarly situated, alleging, among other things, that AT&T had engaged in false advertising and fraud by its practice of charging sales tax on free phones. Both the Federal Court in which the case was brought and the Ninth Circuit Court of Appeals found that the limitation against class actions in the AT&T arbitration agreement was unenforceable.  The Supreme Court reversed the lower courts in its landmark decision.

Arbitration is the private resolution of a dispute involving a procedure established by a contract between the parties. In franchising relationships, “arbitration clauses” can be inserted in the franchise agreement. Such clauses commonly specify that in any dispute arising out of the franchise agreement or relating to the franchise relationship, the parties must resolve such disputes before a privately chosen neutral decision maker called an arbitrator, who acts like a judge and has similar powers to a judge The arbitration clause is, in effect, a contract between the parties that specifies the methods of selecting the arbitrator and the procedures and limitations of the arbitration proceeding. The arbitrator’s decision is just as binding and enforceable as a judge’s or jury’s decision. Unlike a judge’s or jury’s decision, however, there are very limited rights of appeal and the arbitrator’s decision is normally final.

There has long been a debate among lawyers regarding the pros and cons of arbitration in general and in the franchise context in particular. The principal advantages of arbitration include informality, lower costs, greater efficiency and speed, and the ability to choose expert arbitrators to resolve specialized disputes. The principal disadvantage of arbitration is the absence of the availability of multi-layered appeal which can normally be filed to rectify erroneous court decisions, but not arbitration awards. In other words, in arbitration, the principal tradeoff against the many advantages is the inability of the losing party to correct erroneous decisions by the arbitrator.

In the opinion of this author, the AT&T decision ends this debate, at least for franchisors and companies that provide contractual services to consumers, since it is now clear that a franchisor may both mandate arbitration of franchisor-franchisee disputes and preclude classwide arbitrations. This can effectively eliminate the risk of a class action by franchisees against a franchisor. The AT&T decision now makes a well-drafted arbitration clause an essential feature of every franchise agreement.