Choice of Law and Forum Clarified in Recent
Franchise Cases
By Craig Tractenberg
This article on choice of law and forum
provides insight into non-compete provisions in franchise agreements as
regards California law. Franchisors and franchisees will find the results of
these recent decisions helpful.
A recent favorable decision for a Nixon Peabody
client, served as a reminder of the importance of choice of law and choice
of forum clauses in franchise agreements.
The importance of these clauses in franchise
agreements has been clarified as a result of two recent arbitration
decisions involving Paul Green School of Rock Music Franchising ("School of
Rock"). One of those decisions was recently affirmed by the U.S. Court of
Appeals in Paul Green School of Rock v. Smith.
The cases involved disputes between School of Rock
and two of its franchisees—Smith and the Giammarrusco’s, who collectively
acted to repudiate their franchise agreements to start a competitor, Rock
Nation (the "Smith" and "Rock Nation" cases respectively). The cases had
similar facts. Each involved California franchisees, breach of the
respective franchise agreements, and similar claims including non-payment of
royalties to School of Rock. Both cases involved franchise agreements that
contained arbitration and non-compete clauses. The fundamental difference
between them is that the franchise agreement in Smith provided for
arbitration in Pennsylvania pursuant to Pennsylvania law, while the
franchise agreement of the Giammarrusco’s in Rock Nation required
arbitration in California under California law.
California law, unlike Pennsylvania law, considers
covenants not to compete to violate public policy—a key difference between
the two states. California law generally prohibits such covenants, and
California courts rarely prohibit competition, doing so only when necessary
to protect trade secrets.
The Smith case was arbitrated in Pennsylvania.
Ultimately, the arbitrator ruled that Smith must pay damages including
attorney’s fees and future lost profits to School of Rock, and that he was
bound by the non-compete clause in the franchise agreement. The arbitrator
was not bound by the prohibition on restrictive covenants found in
California. In contrast to Smith, School of Rock’s arbitration award in Rock
Nation was lower in damages for unfair competition with no damages for
future lost profits. The arbitrator also refused to uphold the non-compete
clause as against California’s public policy.
These cases provide franchisors with a guide for
constructing franchise agreements for use in California. However, the extent
to which clauses choosing non-California law are enforceable in California
franchise disputes is still not completely clear. Prior to the arbitration
in Smith, Smith objected to the choice of law and forum provisions in a
California court, arguing that the provisions were unconscionable. However,
the court found that, since Smith’s California rights would be recognized in
Pennsylvania, the provisions should be enforced. Notably, not all California
cases since Smith have been similarly decided. In Bridge Fund Capital Corp.
v. Fastbucks Franchise Corp., the court refused to follow Smith. The court
found that the choice of forum and law provisions in the franchise
agreement, which designated Texas and Texas law, were not enforceable since
there was no evidence that the franchisee’s California-based rights would be
recognized in Texas.
Regardless of uncertainty created by Fastbucks,
Smith provides a practical guide on how to avoid California’s prohibitions
of non-compete covenants, and how franchisors in California can obtain the
greatest possible protection if disputes arise. Smith and Rock Nation prove
that strategically choosing the governing law and forum can make all the
difference in franchise dispute resolution results, and selecting
non-California law in the franchise agreement will likely provide better
protection to franchisors.
Craig Tractenberg is a partner in
the business litigation and bankruptcy teams in the New York and
Philadelphia offices of Nixon Peabody LLP. He can be reached at
ctractenberg@nixonpeabody.com or 212-940-3722
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