Dispute resolution clauses in franchise agreements are constructed to provide advantages to franchisors. Often, the clauses provide the franchisor with flexible options as disputes arise and require the franchisees to exhaust certain remedies before filing litigation or arbitration. In the case of Waldron v. SVHB Marketing, No. 2:23-cv-03485-MSG (E.D. Pa. March 20, 2024), franchisees’ RICO case was dismissed on summary judgment for failure to exhaust the mediation prerequisite to filing a lawsuit against the franchisor and its personnel.

The Rationale for Stepped Dispute Resolution

The Federal Trade Commission (FTC) regulates the offer and sale of franchises as do some 17 states. Part of the regulation is the requirement that all franchise prospects receive a franchise disclosure document (an FDD) that discloses the material claims franchisees has brought against the franchisor and their disposition. This information is essential to franchisees who consider purchasing a franchise as litigation history and judgments against the franchisor may provide fair warning of issues with the franchise opportunity.

Disputes in any long-term commercial relationship are to be expected, and not all of the disputes require formal litigation or arbitration. Many can be resolved less formally by the parties talking it out or by guide mediation of their issues. Franchisors that must disclose formal dispute resolution which is material often will require an escalation process to short-circuit mandated disclosure of franchisee disputes in the FDD. The usual prerequisites are first, a meet and confer obligation, and second, formal mediation with a third-party mediator, with the hope that franchise system disputes can be resolved before public disclosure in the FDD. For franchisees, these prerequisites seem like stumbling blocks thrown in the path of quick and clear justice. The reality is that many disputes are resolved through this step process and avoid the costly and public outcomes of formal arbitration or litigation. On the other hand, the FDD does not hint of disruption in the franchise system if the disputes are resolved informally.

The Dispute Resolution Clause in This Case

Each franchise agreement contained this dispute resolution paragraph:

18.3 Mediation; Arbitration. At franchisor’s option, all claims or disputes between franchisee and franchisor or its affiliates arising out of, or in any way relating to, this agreement or any other agreement by and between franchisee and franchisor or its affiliates, or any of the parties’ respective rights and obligations arising from such agreement, which are not first resolved through the internal dispute resolution procedure set forth in Section 18.2 above, must be submitted first to mediation, … in accordance with AAA’s commercial mediation rules then in effect. Before commencing any legal action against franchisor or its affiliates with respect to any such claim or dispute, franchisee must submit a notice to franchisor, which specifies, in detail, the precise nature and grounds of such claim or dispute. Franchisor will have a period of 30 days following receipt of such notice within which to notify franchisee as to whether franchisor or its affiliates elects to exercise its option to submit such claim or dispute to mediation. Franchisee may not commence any action against franchisor or its affiliates with respect to any such claim or dispute in any court unless franchisor fails to exercise its option to submit such claim or dispute to mediation, or such mediation proceedings have been terminated either: as the result of a written declaration of the mediator(s) that further mediation efforts are not worthwhile; or as a result of a written declaration by franchisor.

This mediation clause is finely tailored to require mediation only at the option of the franchisor and requires exhaustion of the mediation, in the opinion of the mediator or the franchisor, before allowing commencement of arbitration or litigation.

Why Did the Case Reach Summary Judgment Before Dismissal?

The plaintiffs’ basic dispute alleged that the defendants misled them about the services the defendants could provide to franchisees. The plaintiffs asserted claims for fraud, breach of contract, violation of various state consumer protection statutes, and violation of the Racketeer Influenced and Corrupted Organizations Act (RICO). The defendants made several demands for mediation before the AAA, but no actual mediations occurred. Instead, the defendants advised the AAA that the mediations had been stayed pending informal exchanges of offers. The parties entered into a tolling agreement and agreed to stay mediation, but the plaintiffs eventually concluded that the defendants were not negotiating in good faith and commenced this lawsuit.

The defendants moved to dismiss the lawsuit, but plaintiffs defended on the basis of waiver claiming the tolling agreement and the conduct of the defendants eliminated the defendants’ contractual rights to mediation. In briefing the issue, the parties included materials outside of the pleadings, which converted a motion to dismiss under Federal Rule of Civil Procedure 12 (b)(6) into a motion for summary judgment under Rule 56. With the case fully in view, the district court felt confident that dismissal was the appropriate disposition.

Additional Issues of Counsel Fees, Third-Party Claims and Stay Requests

The court had the discretion to stay the case, however, the procedural history of the case and the parties’ difficulty in mediating the issues probably influenced the court to dismiss rather than stay the case. Not only was the franchisor sued, but also its executives. Helpful language in the franchise agreement allowed the executives to be considered third-party beneficiaries of the dispute resolution clause but it seemed impracticable to keep the case alive while all of these issues and parties were sorted in mediation.

The Federal Arbitration Act, Title 9 U.S. Code, which allows parties to compel arbitration does not explicitly allow a court to compel mediation but the contractual language certainly supported this decision. With respect to the attorney fee request of the defendants, the court similarly could not find strong support for an award of counsel fees based on any statute, and concluded that the failure to mediate was not a material breach of the contract, and for that reason denied counsel fees.

What If?

Suppose the dispute resolution provision had explicitly allowed counsel fees for failure to mediate. Would the plaintiffs have proceeded directly to mediation? Suppose when confronted with the mediation motion, the plaintiffs agreed to mediate during the pendency of the case? Would the district court have punished the plaintiffs with dismissal for staking a claim for venue and jurisdiction while mediating? After all, the defendant executives were not obligated to mediate. The case provides valuable lessons on drafting and strategy.

Reprinted with permission from the April 22, 2024 issue of The Legal Intelligencer© 2024 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.”