ANATOMY OF AN INTERNATIONAL FRANCHISE DIVORCE LAST TANGO IN MINNEAPOLIS

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1 ANATOMY OF AN INTERNATIONAL FRANCHISE DIVORCE LAST TANGO IN MINNEAPOLIS JOHN M. VERNON Jenkens & Gilchrist, P.C Ross Avenue, Suite 3200 Dallas, Texas Phone: Fax: th Annual Conference THE INCREASING GLOBALIZATION OF FRANCHISING International Bar Association on Business Law and the International Franchise Association Capital Hilton Hotel Washington, D.C. May 14-15, 2002 The author gratefully acknowledges the assistance of Andrew Selden, with the Briggs and Morgan law firm; Peter Klarfeld, with the Wiley, Rein & Fielding law firm; Alberto Echarri, with the Mullerat law firm; and, Claude Rich, with the Jenkens & Gilchrist law firm.

2 ANATOMY OF AN INTERNATIONAL FRANCHISE DIVORCE LAST TANGO IN MINNEAPOLIS The convergence of legal systems in international transactions poses interesting challenges to attorneys participating in cross-border negotiations and arbitral proceedings. Attorneys not trained in differing legal systems can find themselves at a settlement or negotiation meeting fighting over standard provisions under one legal system, but which are fundamentally different from the ones they are accustomed to. In extreme circumstances, this lack of understanding can lead to the break-up of a transaction or the failure of an arbitral proceeding. The two most common legal systems attorneys involved in cross-border transactions are faced with is common law and civil law. Civil law is viewed as being highly structured, relying on basic and detailed regulation which is construed and implemented where needed by jurisprudence. 1 In contrast common law hones in on details and narrow interpretations of legal principles. Further, common law basis its jurisprudence on precedent, with statutory interpretations completing such interpretations. The result is a judge s strict adherence to precedence and statutory interpretations that lead to detailed drafting styles to ensure contractual clarity, and a clear indication of the contracting parties' intentions. These principles of common law precedent directly contrast civil law principles of reliance on codified norms and guidelines for interpretation and analysis. The result under civil law is clear and concise contracts, leaving contract void of principles and rules which are embedded in codifications. The results can be drastic. Some of the most common issues that arise between attorneys taught under these different systems are: termination clauses and integration clauses. Termination clauses drafted by common law attorneys tend to be long, specific and exhaustive, specifying causes of default that lead to immediate termination, termination upon notice and termination upon notice and cure. In contrast, civil and commercial codifications allow termination clauses drafted by civil law counterparts to be shorter and more specific, allowing reference to a civil or a commercial statute to determine the need for notice, general causes and consequences of default. However the complexity of current transactions has led to more elaborate termination clauses in order to avoid misunderstandings between the parties and the need for costly and time-consuming court procedures. The result being that civil law termination clauses are also very specific and exhaustive depending on the transaction. Similarly, even simple contract provisions like integration clauses can be contested points in a negotiation involving civil law and common law attorneys. Integration clauses are found in almost every common law contract specifying when a contract can be amended and that it can only be amended by agreement of the parties. In contrast, the idea that a contract can only be amended by agreement of the parties is so fundamental to the civil law system that integration clauses are almost never included in civil law contracts. Further, any provision to the contrary would be deemed a violation of public policy and null and void ab initio. 1 William Tetley, Mixed Jurisdictions: Common Law v. Civil Law, (Spring 2000).

3 Keeping these basic differences between common law and civil law jurisdictions in mind, it is crucial for the parties to agree from the start the law that applies to the contract. The lack of a choice of law clause will make the resolution of any controversy arising between the parties even more difficult, leaving the determination of law to the court or arbitration institution. Following the above explanation, we will look at how the International Chamber of Commerce and the American Arbitration Association treats a hypothetical situation involving parties involved in a cross-border transaction that has soured and where no provision was made as to the choice of law, jurisdiction and venue of the arbitration proceedings. The facts are as follows: A Spanish franchisor of dance studios (Arturo Murray) (Pepe is even more typical than Arturo for a dancer) granted master franchise rights to an entity located in Minneapolis, Minnesota. The parties have tangoed (This is just a cultural note: tango is not a Spanish dance but rather the typical Argentinean dance. It would be more correct and more colorful to say that the parties have flamencoed and also because castanets are only used in flamenco dancing) themselves into a situation giving rise to the following claims by the master franchisee: (a) franchisor's failure to provide personalized assistance and training; and (b) franchisor's failure to provide master franchisee with specifications relating to site selection for a suitable dance studio. The basic terms and conditions of the master franchise agreement required master franchisee to (a) pay a 5% royalty; (b) follow the system standards; (c) purchase castanets only from franchisor; and (d) not compete within a 50 mile radius of any of franchisor's former franchisees for a one year period upon termination of the agreement. After two years of operation, master franchisee has only opened one dance studio and claims that franchisor has failed to provide the support promised and the cost of opening the dance studio cost in excess of franchisor's estimates. Master franchisee also requested that franchisor agree to a reduction of the royalty payment from 5% to 2%. Franchisor refused, and master franchisee unilaterally reduced the rate. In addition, master franchisee has taken down the signs bearing franchisor's marks, but has continued to operate the studio in contravention of the non-competition provision. In response, franchisor sent master franchisee a termination notice that master franchisee failed to respond to. After evaluating its options, franchisor instituted an arbitration proceeding in Washington, D.C. pursuant to the terms of the arbitration agreement contained in the master franchise agreement. Franchisor is seeking $200,000 in unpaid royalties, lost future royalties, and injunctive relief to enforce its covenant not to compete. The master franchisee has counterclaimed, seeking damages for inadequate assistance and wrongful termination and declaration that the non competition provision is unenforceable. First let's see how the outcome of the following dispute might occur under the International Chamber of Commerce Rules ("ICC Rules"). Proper venue for an arbitral proceeding under the ICC Rules is where the parties have agreed, or in the absence of agreement, as determined by the arbitrators. Under the facts of our hypothetical, proper

4 venue for arbitration will hinge on what the master franchise agreement provides. In our set of facts, proper venue is Washington, D.C. Second, the rules that will govern the arbitration proceeding will be the ICC Rules. Where the ICC Rules are silent, the arbitrators will apply the rules they deem appropriate or the rules agreed upon by the parties to the proceeding. Rules of law applicable to the merits of the case will be determined in accordance with article 17 of the ICC Rules. The arbitration panel can be composed of either one or three arbitrators, depending upon the arbitration agreement. If silent, the ICC Rules call for a sole arbitrator, except in circumstances in which the appointing court determines that a three arbitrator panel is needed. In the event of a three member panel, a majority decision is needed to render an award that is final and binding. The facts of a particular case are established by submissions of the parties accompanied by all relevant documents and papers. The parties may appear before the arbitrator(s) and may call witnesses, experts and introduce other evidence deemed pertinent and necessary to establish the underlying facts of the dispute. Unless specifically requested by the parties, the arbitrator(s) may decide the case solely on the written documents submitted by the parties. Applying these general principles to the facts at bar, in order to be awarded damages and loss profits, the franchisor would have to submit enough evidence, written or otherwise, to permit the panel to find in favor of the franchisor. Under our specific facts, master franchisee's unilateral payment of royalty into an escrow account may persuade the panel to award the franchisor the requested $200,000. The lack of an integration clause or other provision dictating how the master franchise agreement can be modified is of further relevance in reaching a final determination of whether the master franchisee was warranted in reducing the royalty rate. The fact that the master franchisee acted arbitrarily and without consent may damage master franchisee s position. By arbitrarily reducing the royalty rate payable by the master franchisee to franchisor, the master franchisee has breached the master franchise agreement. This breach, arguably entitles the franchisor to damages. However, the master franchisee could counter, claiming that such a redirection was warranted due to franchisor's lack of service and assistance, finding that a partial reduction in the royalty rate was warranted in response to franchisor s breach of the master franchise agreement. With respect to lost profits, the ICC Rules do not specifically indicate what kind of damages are available. Whether the franchisor is able to recoup lost profits is an issue to be determined by the arbitrators based on which substantive law they choose to apply, on the facts presented by the parties. The ICC Rules permit interim measures, however they require that the requesting party set aside a predetermined sum of money to compensate the aggrieved party if it is determined that the interim measure was not appropriate. Under the facts of this hypothetical, it is unclear whether the arbitration panel would grant a temporary injunction against the master franchisee ordering him to stop operating the dance studio. A more appropriate forum for obtaining an injunction against the master franchisee, and usually master franchise agreements contain a carve out for these types of orders, would

5 be to apply to a Spanish court for a temporary injunction requiring the master franchisee to immediately stop operating the dance studio. The franchisor could argue that the master franchisee s continued operation of the dance studio is a direct violation of the master franchise agreement that is causing direct economic harm to the franchisor. The master franchisee might challenge franchisor s argument asserting that the breadth of the covenant not to compete is overly broad in time, geographic space and scope, and that therefore, the covenant as a whole should be set aside. Additionally, the master franchisee could argue that the covenant not to compete effectively prohibits the master franchisee from earning a living, something which some civil law countries argue is a fundamental right of public policy. For a further elaboration of the ICC Rules, please see the attached copy of the rules. Applying our same hypothetical to the American Arbitration Association s international rules ( AAA Rules ), a similar outcome is likely. To initiate an arbitration proceeding under the AAA Rules is identical to the ICC Rules. A notice of arbitration and statement of claim is made by the party asking for arbitration and the arbitration process begins. Once a notice of arbitration is initiated, the party against whom arbitration is commenced has an opportunity to defend and counterclaim. This process is identical under the ICC Rules. Similar to the ICC Rules, the AAA Rules permit either a three member or one member panel. In absence of an agreement between the parties, the AAA Rules call for a one member arbitration panel. Venue for the arbitration proceedings is dictated by the agreement of the parties. This is why it is important when drafting arbitration agreements, that the drafter clearly select where the arbitration is to take place. If there is a disagreement between the parties as to proper venue of arbitration the administrator of the arbitration proceeding may initially determine the place of arbitration; all subject to the tribunals final approval. One major difference between the ICC Rules and the AAA Rules, is that under the AAA Rules, the arbitration tribunal has the power to rule on its own the rules that will govern the interpretation of the disputed contract; this in spite of what the underlying arbitration agreement states. Under the ICC Rules, the tribunal is bound by the choice of law stated in the arbitration agreement. This difference can be significant in certain countries, including Spain, where upon termination or expiration of the agreement compensation may be determined on the basis of the rules applicable to agency agreements, under which the agent is entitled to receive substantial compensation. For a United States franchisor, the applicability of an agency law can mean the payment of damages to the terminated agent. Therefore, the applicability of the ICC Rules may be preferable since the arbitrators are likely to apply the laws stated in the agreement. In our scenario, the application of the AAA Rules could permit the tribunal to apply the laws of the United States and the laws of Minnesota; something which the franchisor would like to avoid since the franchisor is a Spanish entity and unlikely familiar with the laws of the United States and those of the state of Minnesota. Finally, using the United Nations Commission on International Trade Law Rules governing arbitration ("UNCITRAL Rules"), to determine the outcome of our

6 hypothetical, we are likely to achieve a similar result as that under the ICC and AAA rules. It is important to note that the UNCITRAL Rules were prepared in connection with interpreting other international arbitration organizations' rules and procedures. Therefore, the UNICTRAL Rule are similar to the AAA and ICC rules governing international arbitrations. Under the UNCITRAL Rules, the terms and conditions of an arbitration agreement will dictate the arbitration, except where the arbitration agreement provides for rules or policies which are against public policy. As with the ICC Rules and the AAA Rules, arbitration is initiated by a notice of arbitration filed by one of the parties to the arbitration, which notice shall include the following: (a) a demand that the dispute be referred to arbitration; (b) the names and addresses of the parties; (c) a reference to the arbitration clause or the separate arbitration agreement that is invoked; (d) a reference to the contract out of or in relation to which the dispute arises; (e) a general description of the nature of the claims; (f) the type of relief sought; and (g) a proposal as to the number of arbitrators to preside over the arbitration proceedings. As with the ICC and AAA Rules, proper venue for arbitration is where agreed upon by the parties. In the absence of agreement, the tribunal is free to select the local for arbitration. In our fact scenario, since the arbitration agreement provides for arbitration in Washington, D.C., the tribunal will most likely hold the proceedings where agreed upon by the parties. Similarly, the language in which the arbitration proceedings will take place are subject to the parties' agreement. Under our facts, the arbitration agreement appears to be silent on the language to apply. Therefore, the tribunal is free to determine which language to apply to the proceedings. Since arbitration will take place in the United States, it is likely that the proceedings will take place in the English language. Once the arbitration tribunal is formed, the party who commenced the arbitration proceeding must make a statement of claim identifying the parties involved; a statement of the underlying facts; the issues that gave rise to arbitration; and the remedy or relief sought. The statement of claim can be, but is not always contained in the notice of arbitration. Once a statement of claim is filed, the party against whom arbitration has been initiated has an opportunity to submit a statement of defense, outlining any defenses and counterclaims. If the party fails to respond, the tribunal may render a decision on the facts presented by the party who initiated the proceedings. Applying these principles to our hypothetical, our outcome is likely to be the same as that under the ICC and AAA Rules. Mainly, that the proceedings will be held in Washington, D.C., the tribunal may award franchisor damages as much as $200,000; and the non-competition covenant may be deemed enforceable. All three rules allow the Master Franchisee to pursue his counterclaims. The similarity among the rules of the various international arbitration organizations permits drafting of arbitration clauses or agreement with ease. By using the sample clauses suggested by each arbitration organization, with minimal modifications,

7 DA v drafters of arbitration provisions can be relatively certain that their arbitration provisions will be valid and enforceable. In drafting arbitration agreements, it is important to choose the rules which are more advantageous to the drafter. Although the ICC Rules, the AAA Rules and the UNCITRAL Rules are all similar, there are some subtle differences that may be significant. In addition, parties involved in cross-border transactions need to be sensitive to different legal systems, rules and interpretations and language differences. Arbitration is a dispute resolution procedure that may be less expensive and time consuming than litigation. Further, arbitration provides for a relatively expeditious resolution to disputes between international parties. If a franchisor initiates an arbitration proceeding, the ICC Rules, the AAA Rules and the UNCITRAL Rules do not permit a party against whom a proceeding has been initiated to stonewall the process. The failure to respond to an arbitration notice merely permits the tribunal to proceed without that party. Therefore, it is important to respond to an arbitration notice, otherwise the tribunal can render a decision on the facts of the franchisor. An additional advantage to arbitration is the enforcement of an award. If a franchisor receives an award and the franchisee has assets available to execute upon the judgment, then the process of executing the judgment can be quick. Alternatively, if the franchisee does not have assets to seize, then the franchisor will most likely have to have the arbitral award enforced in a foreign country. Due to national conventions and bilateral treaties on the recognition and enforcement of arbitral awards, the enforcement of arbitral awards are generally easier than trying to enforce a foreign court judgment. Considering the costs associated with international litigation and the difficulty of enforcing foreign judgments, arbitration may be preferable to litigation. Therefore, when drafting arbitration provisions in franchise agreements, it is important to be specific and outline the major concerns a franchisor will be faced when bringing an action for a breach. Arbitration panels usually follow the terms and conditions set forth in the arbitration provisions, however if silent, the tribunal will apply the rules of the relevant organization. This paper merely seeks to address a hypothetical fact pattern and what the outcome might be under the ICC, AAA and UNCITRAL Rules. Attached for review are printouts of the ICC, AAA, UNCITRAL and WIPO Rules relating to arbitration. Please review these for the actual procedures and rules governing arbitrations under these various organizations. Also, the rules contain sample arbitration clauses that may be helpful in drafting arbitration agreements.