Arbitration of Distribution and Franchise Disputes Gerald Saltarelli Abstract: Manufacturers and other sellers of goods and services reach their markets through a variety of means, including distributor agreements, contracts with sales representatives, and franchise relationships. Disputes between the manufacturer/seller/franchisor, on the one hand, and the distributor/sales representative/franchisee, on the other, are frequently subject to arbitration under the relevant contracts. The stakes in these disputes are high, as they often involve the survival of the distributor or franchisee as a going concern. This article describes common characteristics of distribution controversies, remedies that may be available, advantages of using arbitration, and relevant considerations in drafting the arbitration clause. I. Introduction: Manufacturers and other sellers of goods and services reach their markets through a variety of means, including distributor agreements, contracts with sales representatives, and franchise relationships. Although these methods are legally distinct, they typically entail detailed, written agreements that regulate the sale of product and services from one level of the distribution chain to another. Disputes between the manufacturer/seller/franchisor, on the one hand, and the distributor/sales representative/franchisee, on the other, are frequently subject to arbitration under the relevant contracts. Many jurisdictions have enacted substantive laws that are applicable to these disputes. This article describes the many common characteristics of such relationships, remedies that may be available, advantages of using arbitration, and relevant considerations in drafting the arbitration clause. For simplicity, the provider or seller of the product or service shall be referred to as the manufacturer or franchisor; the downstream buyer shall be referred to as the distributor or franchisee. II. Nature of Claims Typically Asserted A. Termination. Disputes over the right of the manufacturer or franchisor to terminate the distribution arrangement account for a substantial number of matters that are arbitrated. Depending on the specific contract terms, grounds for termination typically asserted by the manufacturer or franchisor include (i) the right to terminate upon advance written notice, without cause; (ii) lack of performance by the distributor or franchisee; (iii) failure to comply with business standards imposed by the agreement; (iv) breach of the relevant agreement; and (v) violation of the distributor s or franchisee s obligation of exclusivity.
In addition to disputing facts about performance and/or breach of the agreement, distributors and franchisees often defend on grounds that the duty of good faith and fair dealing constrains the rights of the manufacturer or franchisor, or that related oral or written agreements preclude termination on the grounds asserted by the manufacturer or franchisor. Further, distributors and franchisees often invoke protections afforded by state equipment dealer and franchise statutes, which typically require good cause for termination as well as prior written notice specifying the grounds for termination, and allow an opportunity for the distributor or franchisee to cure the perceived deficiencies. Whether a distributor is entitled to invoke an equipment dealer statute, and whether a putative franchisee is, in fact, covered by a franchise law, are questions that require a searching factual examination of the relationship between the parties. Critically, the examination must assess the degree to which the distributor or franchisee has become dependent on the business represented by the manufacturer s or franchisor s products and services. Even without those statutes, distributors and franchisees that derive a significant portion of their business from the products and services of the manufacturer or franchisor can use the fact of such dependence to tip the equities in their favor. B. Fraudulent Inducement and Statutory Misrepresentation Claims. Disputes arising out of distribution and franchise agreements often entail claims by the distributor or franchisee that the manufacturer or franchisor deceptively or negligently misrepresented the viability of the business, the degree of support that the distributor or franchisee would enjoy, or the sales or earning potential of the business contemplated by the parties. These claims frequently are based on forecasts or projections provided by the manufacturer or franchisor at the time of contracting. Such claims can be cast as common law fraud claims or as violations of state and federal franchise rules. In addition to denying that the forecasts or projections were false or misleading, manufacturers and franchisors typically respond by arguing that those claims are barred by the terms of the relevant agreements, that the distributor or franchisee conducted or should have conducted its own investigation of the business, and/or the distributor or franchisee cannot show reasonable reliance on the allegedly misleading projections. C. Unconscionability and Contracts of Adhesion. As one moves down the distribution chain, disputes between sellers and buyers often reflect fights between big companies and small businesses. In this setting, the distributor or franchisee may seek to avoid the preclusive effect of unfavorable contract terms by asserting that the relevant agreements are unconscionable or the product of such unequal bargaining power that unfavorable terms should not be given effect. Whether these kinds of claims can succeed will depend on the law applicable in the jurisdiction and a thorough factual inquiry into the status of the parties and the history of their negotiations. D. Disputes about Non-Compete Obligations, Ownership of Customer Information, and Trade Secrets. Distribution and franchise agreements typically obligate the distributor or franchisee not to compete with the manufacturer or franchisor after termination of the business relationship. 2
Consequently, the validity, scope, and effect of such non-competition agreements is part and parcel of litigated disputes. Closely related to non-competition disputes are disagreements as to the ownership of customer information and other trade secrets. If the parties are to go their separate ways, they need resolution of issues raised regarding the ownership of intellectual property created during the course of the parties relationship. III. Issues With Regard to Remedies A. Injuctive Relief. Distributors and franchisees who have received notice of termination may seek to prevent or forestall termination by seeking emergency injunctive relief. Although the relevant agreements may allow the aggrieved party to seek such relief in court, injunctive relief can be effectively obtained in arbitration. The rules of most dispute resolution providers now authorize the appointment of an arbitrator on an expedited basis for the specific purpose of resolving requests for emergency relief. Proceedings before such an emergency arbitrator are fast-tracked so that the arbitrator may determine, in short order, whether emergency relief is justified. B. Claims for Damages Distributors and franchisees who have been terminated typically seek recovery of lost profits that would have been earned but for the alleged unlawful termination. Such claims often present large potential exposures and their resolution requires a thorough understanding of the nature and history of the relevant business. Expert testimony is customarily offered to establish both the fact of lost profits and the likely amount. Manufacturers and franchisors may seek damages for amounts owed by the distributor or franchisee for product purchased or for franchisee fees or royalties owed prior to termination. In addition, manufacturers and franchisors may assert claims for liquidated damages if the relevant agreements so provide. Liquidated damages are generally allowable under state law as long as they represent a reasonable approximation of damages that would be incurred in the event of a breach. IV. Advantages of Arbitrating Distributor and Franchise Disputes Arbitration has many advantages over dispute resolution in court. Several are particularly important in the realm of distribution and franchise litigation. A. Expertise of the Fact finder Perhaps the most important question for parties contemplating litigation is what kind of fact finder would be best for the dispute a court or an arbitrator. In the realm of distribution litigation, arbitrators are particularly well-suited to resolve the dispute. Unlike judges who must deal with many different kinds of disputes, often without time to address complex commercial problems, arbitrators can and do develop expertise in resolving distribution disputes. That expertise is important because distribution and franchise disputes typically require knowledge of, and experience with, equipment dealer statutes, state and federal franchise laws, state law 3
contract doctrines, and the kinds of contract terms and clauses frequently employed in distribution and franchise agreements. The multiple statutes that have been enacted to protect franchisees are complex and varied, differing across state lines and from county to county. Moreover, knowledgeable franchise arbitrators may have significant experience in particular industries, whether through their arbitration work or as result of matters handled as an advocate. The ability to select arbitrators with industry experience and expertise with the legal framework governing distribution disputes makes arbitration an effective way to resolve distribution and franchise controversies. B. Availability of injunctive relief. When the continued existence of a distributor s or franchisee s business is at stake, which often is the situation in this kind of litigation, the availability of prompt injunctive relief is essential. The rules of the arbitration providers generally grant arbitrators broad powers, including the power to grant injunctive relief, a power that courts have recognized and enforced. The availability of injunctive relief, coupled with the expedition characteristic of arbitration, ensures that the parties will have a fast and fair hearing on any claims to enjoin termination of the relationship between them. C. Confidentiality. Arbitration can effectively preserve the confidentiality of sensitive data. In the context of disputes along the distribution chain, sensitive information often includes customer information and trade secrets. Whereas courts must grapple with the extent to which proceedings and information revealed must be open or available to the public, parties to arbitrations, as well as arbitrators, have more flexibility to fashion confidentiality and protective orders that protect the parties legitimate interests in the secrecy of their information. Moreover, depending on the disclosure obligations of public companies or regulated franchisors, the very fact of the arbitration, and the identities of the parties, may be maintained in confidence, thereby protecting the reputational interests of the parties. D. Costs of Litigation. Litigation is expensive. When disputes involve small businesses, the costs of litigation may impede the ability of that small business to have its claims determined on the merits. Arbitrators have the flexibility, perhaps greater than that of many courts, to fashion the proceedings and discovery so as to reduce litigation expense to what is absolutely essential for fair resolution of the dispute. This increases the likelihood that a party s ability to present its claims is not cut short by the costs of litigation. E. Possibility of continued business relationship. Litigation does not necessarily end the business relationship between the parties. Many distribution disputes involve claimed violations of the relevant agreements but do not entail an effort to sever the relationship between the parties. In these instances, the litigation must be conducted with view to enabling the parties to continue in business together when the litigation 4
is over. Because arbitration is flexible, parties in this situation have the ability to design the process including the identification of issues, extent of discovery, manner of trial, and scope of allowable relief so as to minimize hostility and expense, and maximize the likelihood of continued cooperation after the award is rendered. V. Critical Terms in the ArbitrationAgreement A. Limitation of remedies The terms of distribution and franchise agreements usually favor the manufacturer or franchisor, as they generally have superior bargaining power. Consequently, distribution and franchise agreements often preclude the recovery of consequential damages, including lost future profits. This is an important protection for manufacturers and franchisors because termination of the relationship between the parties may destroy the distributor s or franchisee s business. Given that, lost profits and punitive damage claims can be significant. Conversely, the inability to recover lost profits may leave an unlawfully terminated distributor or franchisee without a full remedy. To redress the balance of power between the parties, distributors and franchises who have bargaining power at the drafting stage should seek to eliminate any limitation on consequential damages. B. Non-Reliance Provisions An important defense that is often asserted by manufacturers and franchisors is that the distributor or franchisee could not and should not have relied on any projections or forecasts provided during contract negotiations. To facilitate that defense, manufacturers and franchisors seek to include in the contract, either in the arbitration clause or in a separate provision or required document, unambiguous language that negates the right of the distributor or franchisee to rely on such projections and obligates them to independently investigate the business and determine its profitability. C. Fee Shifting. Both sides of the distribution relationship should carefully consider whether their interests are served by a provision awarding the prevailing party its attorneys fees and other costs of the arbitration. Although fee shifting will make a party essentially whole in the event it prevails, the availability of fee-shifting may serve as an incentive to litigate. At the same time, however, depending on circumstances and the relative financial strength of the parties, fee-shifting may significantly deter the possibility of litigation. D. Discovery. Discovery in arbitration generally is more limited than discovery in court. To counter this, parties sometimes provide in arbitration agreements that the parties shall be entitled to the same discovery as if the case were to proceed in court. At the drafting stage, however, it is usually impossible to know whether parties will need or benefit from extensive discovery. This is certainly true of distribution disputes. The nature of the relationship between the parties does 5
not, by itself, appear to dictate that one or the other will desire extensive discovery in the event of a dispute. Accordingly, parties drafting arbitration clauses in the distribution context should be cautious about expanding discovery rights from those normally found in arbitration. If the need for expanded discovery arises, arbitrators have the authority to allow discovery that is commensurate with the claims asserted by the parties. E. Mandated Time to Resolution. In an apparent effort to force the arbitration process to be quick and inexpensive, parties sometimes specify in their arbitration clause that an award must be rendered within sixty or ninety days of appointment of the arbitrator. Specific time frames, however, are often unworkable in commercial cases, and may be particularly ill-advised in distribution disputes where the viability of the distributor s or franchisee s business may be at stake. By their nature, such cases often require, and deserve, appropriate discovery, full presentation of evidence, and careful deliberation. Artificial contractual deadlines may hinder the process and are often modified by parties and arbitrators as they confront the matters required to resolve a particular dispute properly. However, if a time limitation is included in the arbitration agreement, it is binding absent agreement of the parties. Accordingly, special care must be taken before such clauses are included in the arbitration clause. F. Venue Arbitration provisions drafted by manufacturers and franchisors usually specify that the venue and governing law for arbitration shall be determined by the location of the manufacturer s or franchisor s principal place of business. Such provisions generally are enforced by U.S. courts. If distributors and franchisees have sufficient bargaining power, they may seek to lay venue and choice of law in their home state. The importance of these provisions, however, should be analyzed separately. Choice of law is perhaps the less important of the two because distributors and franchisees usually enjoy the protection of equipment dealer or franchise statutes in their home states. Those statutes apply regardless of any contractual choice of law. In addition, those statutes and related caselaw typically provide that any provision in the contract purporting to waive the protection of those statutes is void and/or against public policy. Distributors and franchisees thus enjoy a fair degree of statutory protection regardless of any contractual choice of law. The venue of the arbitration is important for two independent reasons. First, the location of the venue usually has an impact on the expense of the proceeding. An arbitration in one s home state clearly will engender less expense and inconvenience than one venued on the other side of the country. Second, the venue of the arbitration plays a significant role determining which witnesses can be subpoenaed to attend the hearing on the merits. If third party witnesses are more likely to be located in the same state as the distributor or franchisee, those parties should seek the fix venue in their home states. 6
VI. Conclusion Distribution disputes often involve parties of unequal size and resources, with enormous stakes for the smaller party. Distribution disputes can be efficiently and fairly resolved in arbitration, particularly when the arbitrator is skilled in dispute resolution generally and experienced in distribution matters particularly. ********************* Gerald Saltarelli, a trial lawyer with 43 years experience in commercial disputes, has been an arbitrator for 25 years, serving on the American Arbitration Association s Commercial, Large Complex Case, and ICDR panels, as well as the CPR s Insurance and Franchise panels. He has tried to conclusion and issued reasoned awards in dozens of domestic and international cases. Mr. Saltarelli is a Fellow of the College of Commercial Arbitrators and a Fellow of the Chartered Institute of Arbitrators. 2017 College of Commercial Arbitrators 7