When is a Franchise Agreement Unconscionable and Therefore Unenforceable as a Matter of Law?

When is a franchise agreement unconscionable and, therefore, unenforceable as a matter of law? Legal precedent from the United States Court of Appeals for the Seventh Circuit is illustrative on this point. We Care Hair Development, Inc. v. Engen, et. al., 180 F.3d 838 (7th Cir, 1999).

In that case, a group of franchisees filed a class action lawsuit in the circuit court of Madison County, Illinois (“state circuit court”) against We Care Hair Development, Inc. (“We Care Hair’) and others, claiming among other things, breach of fiduciary duty, fraud and violations of the Illinois Franchise Disclosure Act.  The state circuit court held that the arbitration clauses in the franchise agreements (“Agreement(s)”) were void and unenforceable.  However, the lower court (the Federal District Court for the Northern District of Illinois) upheld the Agreements and ordered the franchisees to arbitrate their claims, enjoining them from further action in the state court lawsuits.  The Franchisees appealed.

All the franchisees entered into Agreements that contained arbitration clauses as a “condition precedent to the commencement of legal action for all disputes arising out of or relating to the franchise agreement.” Id. at 2.  The franchise agreements provided that the laws of the State of Illinois would govern the Agreements.  The franchisees were required to sublease their premises from a leasing company, We Care Hair Realty (“Hair Realty”), an alter ego of We Care Hair.  Under the subleases, arbitration was not required, but the subleases allowed the leasing company to file eviction lawsuits against a franchisee for any breach of the sublease. See id.  There was a cross-default provision in every sublease. That meant that every breach of the Agreement would also be a “cross-default” precipitating a breach of the sublease.  The uniform offering circular for We Care Hair salons advised the prospective franchisees that the leasing company, Hair Realty, could terminate a sublease without We Care Hair also terminating the Agreement. See id.

On appeal, the franchisees contended that the District Court erred in failing to give full faith and credit to the Illinois State Circuit Court’s decision holding the arbitration clauses unenforceable.  They based this on the legal concept of  res judicata (claim preclusion) which states that if one court issues a ruling, a second court will be bound to apply that ruling if:

1) a final judgment or order on the merits has been entered by a court of competent jurisdiction;

2) the same causes of action were involved in both; and

3) the identical parties or their privies were litigants in both lawsuits.

Id. at 4.

The Appellate Court found that since the Illinois Circuit Court’s order was not a final order, res judicata did not apply. Therefore, the District Court did not err in independently finding that the arbitration clauses were enforceable.  See id. at 4.

Next, the franchisees claimed that the District Court ruling was in error because the arbitration clauses and the cross-default provisions in the subleases were unconscionable.  See id.   The franchisees stated that the clauses were unconscionable because they “required[d] the franchises to arbitrate their claims while permitting the franchisor to litigate its claims through eviction actions filed in the name of the alter ego leasing company.” See id.

However, as the Seventh Circuit noted, Illinois courts examine the circumstances existing at the time of the contract’s formation when assessing the enforceability of a contractual provision. See id.  This means that the bargaining positions of the parties were examined and a determination was made as to whether the provisions operation would result in unfair surprise. See id.  The Seventh Circuit found that the arbitration clauses did not create unfair surprise in that case.

The Seventh Circuit acknowledged that each franchisee was provided with a copy of the uniform offering circular before signing the Agreement and it clearly disclosed all of the terms and rights of the parties. See id. at 5. Furthermore, the Seventh Circuit felt that the franchisees were not unsophisticated or helpless consumers and were not forced into the Agreements.  See id. Ultimately, the Seventh Circuit affirmed the District Court’s holding, and held that the arbitration clauses, even when coupled with the cross-default provisions of the subleases, were not unconscionable.

Before invalidating an arbitration clause in a Franchise Agreement, a Court may consider the circumstances existing at the time of the parties’ transaction along with any other evidence displaying an unequal bargaining power between the parties.

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