I. Introduction.

The legal community holds mixed views on the relative merits of litigation vs. arbitration. But for parties who favor arbitration, it may be distressing to learn that there are gaps in even the best-drafted arbitration clauses in franchise agreements. One such gap occurs where the dispute involves the franchisor’s refusal to grant a franchise, which may give rise to Section 1981 race discrimination claims or other claims. In this scenario, the prospect never signs the franchise agreement, so the accompanying arbitration clause is of no use.

To guard against this risk, franchisors may consider requiring prospects to submit a franchise application, containing a binding arbitration clause, as a condition to entering into negotiations for the sale of the franchise. That is precisely what happened in Doctor’s Associates, Inc. v. Alemayehu, 934 F.3d 245 (2d Cir. 2019), where the franchisor (Subway) moved to compel arbitration of a Section 1981 claim based on such an application.

But this approach is not fail-safe. To be an enforceable agreement, the application must be supported by valid consideration. Furthermore, to comply with the Federal Trade Commission’s (FTC) Franchise Rule and state franchise laws, the application cannot be provided too early in the process—instead, the prospect must receive a Franchise Disclosure Document (FDD) (and the franchisor must be registered in the relevant state) before the applicant signs the application.

While there is no perfect solution, when done properly, franchisors can use applications to narrow the gap in arbitration coverage and increase the likelihood that they can resolve prefranchise agreement disputes in arbitration.

II. Despite the Inclusion of Mandatory Arbitration Provisions, Franchisors May Still Be Forced to Litigate Section 1981 Claims in Court.

a. Background on Section 1981.

Congress passed Section 1981 in the aftermath of the Civil War. It states that “[a]ll persons . . . shall have the same right . . . to make and enforce contracts . . . as is enjoyed by white citizens.” 42 U.S.C. § 1981(a). The statute defines “make and enforce contracts” broadly to include “the making, performance, modification, and termination of contracts, and the enjoyment of all benefits, privileges, terms, and conditions of the contractual relationship.” Id. § 1981(b). It prohibits discrimination on the basis of race, which may include ancestry or ethnicity, See St. Francis Coll. v. Al-Khazraji, 481 U.S. 604, 613 (1987).

Every franchise agreement is a contract, and Section 1981 therefore governs the making of the franchise agreement. While franchisors may have legitimate business reasons for awarding franchises to some but not others, race discrimination has no place in the franchise industry. Yet Section 1981 cases are prevalent. See Iris Figueroa Rosario, Section 1981: A Risk Still Alive and Kicking in Franchising, The Franchise Lawyer, Fall 2015, at 5. Prospective franchisees have turned to Section 1981 to seek relief when a franchisor refuses to grant a franchise for discriminatory reasons.

For example, in Harper v. BP Exploration & Oil Co., 896 F. Supp. 743, 746 (M.D. Tenn. 1995), aff’d in part, reversed in part on other grounds, 134 F.3d 371 (6th Cir. 1998), a black applicant who already owned a franchise brought a Section 1981 claim against the franchisor. The applicant alleged that the franchisor awarded two additional locations to white applicants, rather than him, on account of his race. Id. At a bench trial, the applicant successfully proved discrimination by showing that he consistently received higher performance evaluations than the white applicant who received the first additional location, while the white applicant who received the second additional location had never worked in the petroleum industry before. Id. at 750. The franchisor’s purported non-discriminatory reason—that the franchisee was not a “quality dealer”—was pretext given that the franchisee had complied with the terms of his contract, had consistently received good performance reviews, and had not been terminated like other franchisees who were not “quality dealers.” Id. The franchisee was awarded $350,000 in punitive damages and $280,287 (reduced to $97,888 on appeal) in compensatory damages. 134 F.3d 371, 1988 WL 45487, at *1, *4.

b. Lack of Enforceable Arbitration Agreements Expose Franchisors to Litigating Section 1981 Claims in Court

When a dispute arises out of the failed negotiation of a franchise sale—for example, out of the refusal to grant a franchise—the franchise agreement’s arbitration clause does not apply because the parties never signed the franchise agreement. Absent a legally enforceable agreement, the franchisor cannot require the applicant to arbitrate. See Will-Drill Res., Inc. v. Samson Res. Co., 352 F.3d 211, 215 (5th Cir. 2003) (“Where no contract exists, there is no agreement on anything, including an agreement to arbitrate”).

To mitigate the risk of litigating Section 1981 or other pre-franchise agreement disputes in court, some franchisors may require prospects to agree to arbitration prior to entering into negotiations. But for these agreements to be effective, they must meet the essential requirements of a legally enforceable contract: offer, acceptance, and consideration. The Alemayehu case examined these issues and provided a road map for franchisors who wish to resolve pre-franchise agreement cases in arbitration.

In Alemayehu, the plaintiff, who owned no other franchises, submitted a written application to purchase a Subway franchise. Doctor's Assocs., Inc. v. Alemayehu, 934 F3d 245, 248 (2d Cir. 2019). After his application was denied, he sued the franchisor in the United States District Court for the District of Colorado, bringing a Section 1981 claim (among others) and alleging the franchisor denied his application on account of his race. Id. at 249. Although the prospect never signed the franchise agreement, his written application required binding arbitration of “any and all previously unasserted claims, disputes, or controversies arising out of or relating to [the prospect’s] application or candidacy for the grant of a SUBWAY franchise.” Id. at 248. The application further delegated to the arbitrators, and not the court, the authority to determine the validity and scope of the arbitration clause. Id. Subway therefore filed an action in the United States District Court for the District of Connecticut asking the court to compel arbitration. Id. at 249.

The District of Connecticut, applying Colorado law, concluded the arbitration clause in the franchise application was unenforceable for lack of consideration. Doctor’s Assocs., Inc. v. Alemayehu, 321 F. Supp. 3d 305, 310 (D. Conn. 2018). The court observed that in return for the applicant’s agreement to arbitrate, Subway had not (i) promised to consider the application, (ii) promised to give the applicant any additional information, or (iii) promised to respond. Id. Subway did not even sign the application. Id. at 312. According to the court, even assuming “that a promise to consider an application is sufficient consideration, that does not dictate the outcome in this case where no promise to review the Franchise Application was made.” Id. at 310. Subway then tried to argue that the promise to arbitrate was mutual, and that the mutual promises created consideration. Id. at 311. The district court rejected that argument upon concluding that the agreement was “not mutual: it is a unilateral promise to arbitrate by the applicant.” Id.

Subway appealed the District of Connecticut’s decision to the United States Court of Appeals for the Second Circuit. Subway argued that the district court ruling “effectively invalidated thousands of arbitration agreements between [Subway] and anyone who completed one of its applications to become a Subway® franchisee.” Brief of Plaintiff-Appellant, Doctor's Associates, Inc., v. Alemayehu, No. 18-1865, 2018 WL 4862558, at *1–2 (2d Cir. Oct. 4, 2018). Subway also argued that the threshold arbitrability question should be decided by the arbitrator, and not the court. Id. at *22–31. Subway also disputed the trial court’s substantive decision on consideration, arguing that both its agreement to consider the applicant for an award of the franchise and its agreement to arbitrate provide sufficient consideration to arbitration. Id. at *33–45.

The Second Circuit reversed. It first held that a court, not the arbitrator, should decide the threshold question of arbitrability. 934 F.3d at 251-52. This was because the issue of consideration goes to the “fundamental question of whether [the parties] formed the agreement to arbitrate in the first place,” and to allow the arbitrator to resolve that question “would essentially force parties into arbitration when the parties dispute whether they ever consented to arbitrate anything in the first place.” Id. at 251. Next, the Second Circuit held that the arbitration clause in the franchise application was supported by sufficient consideration. It reasoned that consideration may take the form of a return promise or actual performance. Id. at 252. There was enough evidence in the record that in return for the promise to arbitrate, Subway gave the performance the prospect sought: it reviewed his application and considered him for the franchise. Id. The Second Circuit remanded the case so the district court could address other challenges to the arbitration clause. Id. at 254.

III. Best Steps Moving Forward.

a. Provide Consideration

Alemayehu provides franchisors with a potential path to send Section 1981 or other pre-litigation disputes to arbitration: the franchisor can require prospects to submit franchise applications with binding arbitration agreements. But Alemayehu also highlights the need for these applications to be supported by consideration. In Alemayehu, Subway established consideration by presenting evidence of performance; specifically, Subway actually reviewed the prospect’s application and considered him for a franchise. An alternative and less fact-intensive method of establishing consideration would be for the franchisor to make a return promise in exchange for the applicant’s agreement to arbitrate. For example, the franchisor could expressly make the arbitration obligation mutual. Or the franchisor could promise that in exchange for the agreement to arbitrate, it will consider the application, provide additional information, or merely respond to the application. The franchisor could implement a policy that in exchange for the agreement to arbitrate, it will deem applicants eligible to apply for the purchase of a franchise. Finally, because consideration is a matter of state law, franchisors and prospects should be well-versed in the consideration jurisprudence of the state whose law governs.

b. Comply with the FTC Franchise Rule and State Franchise Laws

Requiring prospects to submit a franchise application or agree to some other preliminary agreement is not without risk. For instance, adding an additional step into the process of selling a could take extra time, could deter prospects, and could slow the closing of the sale.

Moreover, the District of Connecticut did not address whether requiring the prospect to sign a binding arbitration agreement prior to providing an FDD runs afoul of the FTC’s Franchise Rule or state franchise laws. The FTC Franchise Rule requires franchisors to provide an FDD to the prospective franchisee “at least 14 calendar-days before the prospective franchisee signs a binding agreement with . . . the franchisor or an affiliate in connection with the proposed franchise sale.” 16 C.F.R. § 436.2. Several states require registration prior to offering to sell a franchise. See, e.g., Minn. Stat. §§ 80C.01(16)–80C.02 (requiring a franchisor to submit “an effective registration statement” prior to “every attempt to offer to dispose of, and every solicitation of an offer to buy, a franchise”).

These laws raise the question of whether a franchisor can require the prospect to sign a binding arbitration agreement prior to providing an FDD and filing registration documents in the required states. Although the statutes and regulations are ambiguous, one can make a good case that under the plain language of the FTC’s Franchise Rule, a franchisor must provide an FDD prior to requiring the prospect to sign an application. First, the application requiring arbitration must be a “binding agreement,” or else there is no point in asking the prospect to sign it. Second, the application likely is “in connection with the proposed franchise sale.” In this scenario, the application is a necessary step towards eventually consummating the franchise sale. For these reasons, the safest course of action is for the franchisor to provide the FDD and submit all required registrations prior to allowing the prospect to submit an application constituting a binding arbitration agreement.

Franchisors should recognize that absent a franchise application or other preliminary agreement with a binding arbitration agreement, they may be required to resolve Section 1981 or other pre-franchise agreement claims in court. In light of the Second Circuit’s opinion in Alemayehu, franchisors may elect to mitigate this risk by requiring that prospects sign franchise applications that require arbitration of all disputes arising out of or relating to the parties’ dealings with respect to potential franchise sales. Like all contracts, these preliminary agreements must be supported by consideration. And franchisors should take care that in implementing these preliminary agreements, they do not run afoul of the FTC Franchise Rule.

The original article, "Feeling Exposed? How to Use Franchise Applications to Close Gaps in Arbitration Coverage for Section 1981 Cases," first appeared in The Franchise Lawyer, Volume 22 No. 4 in Fall 2019.