United States: Arbitration Provision Rejected In Franchise Dispute

In Case Del Caffe Vergnano SPA v. ItalFlavors, LLC, the Ninth Circuit held that the court, not an arbitration tribunal, could review a franchise contract and determine it was a sham, based upon a second contract signed between the parties, and require the parties to litigate the dispute instead of arbitrate.

The facts of the case were straightforward but for one twist. Caffe Vergnano is an Italian corporation that opens Italian-style coffee shops. ItalFlavors, a U.S. entity formed by Argentinian shareholders, wanted to be a franchisee. So the parties entered into a Franchise Agreement that contained an arbitration clause: any disputes would be resolved under UNCITRAL Arbitration Rules under Italian law in Geneva, Switzerland.

Here's the twist: a second contract (styled as a "Hold Harmless" agreement) was signed the same day the Franchise Agreement was signed that stated the Franchise Agreement "does not have any validity or effectiveness between the parties, as it was prepared and delivered by [Caffe Vergnano] solely for the purpose of allowing [the Argentinian shareholders] to submit a copy of it to the pertinent international agencies in order to obtain an entry visa to work in the United States of America. . . . This contract does not produce any effect between the parties, who as agreed will sign a future contract which will regulate their commercial relationship as soon as it is prepared in accordance with the federal and national laws of the United States of America." 

The coffee shop failed and ItalFlavors blamed Caffe Vergnano's failure to provide sufficient support. Instead of bringing arbitration, ItalFlavors sued in California Federal Court based upon state franchise law, and Caffe Vergnano sought to compel arbitration. ItalFlavors defended by claiming the Franchise Agreement was a sham – the parties signed a second contract stating as much – so that ItalFlavors principals could obtain a visa. Caffe Vergnano claimed the Hold Harmless agreement was merely a protection method: Caffe Vergnano would not be liable if ItalFlavor's principals used the Franchise Agreement to violate U.S. immigration laws.

Fundamentally, the case is one about arbitrability of a franchise dispute: Did the parties form a contract consenting to arbitration (the Ninth Circuit majority held no) or did they agree after signing the arbitration contract that it was invalid, a fact dispute to be resolved by the arbitration panel (the dissent said yes)? The legal framework is relatively settled, with the Second Circuit providing the best formulation in its analysis of "void" versus "voidable" contracts. Void contracts have no legal effect because it never comes into existence. Voidable contracts, on the other hand, exist but are not enforceable for some reason. Sphere Drake Ins. Ltd. v. Clarendon Nat. Ins. Co., 263 F.3d 26, 29-32 (2d Cir. 2001). Other circuits offer similar formulations. E.g., Momot v. Mastro, 652 F.3d 982, 987 (9th Cir. 2011) (citing Green Tree Fin. Corp. v. Bazzle, 539 U.S. 444, 452 (2003)); Banc One Acceptance Corp. v. Hill, 367 F.3d 426, 429-30 (5th Cir. 2004) ("Will-Drill distinguished the far more common argument made by a party who does not challenge the existence of a contract, but rather attacks the enforceability of the agreement alleging that the contract is void ab initio or voidable.") (citing Will-Drill Res. Inc. v. Samson Res. Co., 352 F.3d 211, 218 (5th Cir. 2003)).

So the real issue was about the factual analysis of the Franchise Agreement and whether the Hold Harmless Agreement invalidated it. Because they were executed at or around the same time, the Ninth Circuit said the Franchise Agreement never came into existence. The dissent saw problems though, finding that a separate agreement cancelling the first agreement means the arbitration panel needs to resolve the issue. Indeed, the majority's analysis runs through machinations of the parol evidence and affidavits submitted by Caffe Vergnano to reach its conclusion.

Given the arbitration and choice of law clauses (something not addressed at all), that factual analysis is something much better suited for an arbitration panel to resolve after an examination of the facts. Of course, the majority was clearly worried that the parties appeared to enter into a sham contract, so there never was any deal (an analysis that will likely affect the merits of the dispute going forward, particularly since it makes no sense to open a franchise without some type of underlying agreement). But the real problem is not with the case before the Ninth Circuit. Instead, future litigants now have more precedent to try and avoid binding arbitration clauses with creative arguments: our contract was not finalized, we had a contemporaneous oral agreement effectively rescinding the written deal, etc. They may not be successful, but the delay in proceeding to arbitration can be just as costly for an aggrieved party. As they say, bad facts make bad law.

Curiously, the Ninth Circuit (and likely the parties before it) failed to raise any issues regarding the UNCITRAL rules, which allows in Article 23 for the arbitration tribunal to resolve questions of its own jurisdiction:

The arbitral tribunal shall have the power to rule on its own jurisdiction, including any objections with respect to the existence or validity of the arbitration agreement. For that purpose, an arbitration clause that forms part of a contract shall be treated as an agreement independent of the other terms of the contract. A decision by the arbitral tribunal that the contract is null shall not entail automatically the invalidity of the arbitration clause.

Other courts have previously used similar language allowing the tribunal to resolve questions of arbitrability as a basis to compel arbitration. See Contec Corp. v. Remote Solution Co., 398 F.3d 205, 208 (2d Cir. 2005) ("We have held that when, as here, parties explicitly incorporate rules that empower an arbitrator to decide issues of arbitrability, the incorporation serves as clear and unmistakable evidence of the parties' intent to delegate such issues to an arbitrator."). So has the Ninth Circuit: "We see no reason to deviate from the prevailing view that incorporation of the UNCITRAL arbitration rules is clear and unmistakable evidence that the parties agreed the arbitrator would decide arbitrability." Oracle Am. V. Myriad Group A.G., 724 F.3d 1069, 1074-75 (9th Cir. 2013). These analyses seem to lend more support for allowing the parties to resolve the underlying arbitrability of their dispute, especially when that issue resolves an examination of the underlying factual dispute.

One other point. In a similar case, the Second Circuit all but reached a conclusion opposite to that of the Ninth Circuit. In Denney v. BDO Seidman L.L.P., the Second Circuit stated that it was skeptical that parties who "agreed to arbitrate and . . . had the authority to do so" "should not be bound by an otherwise valid arbitration provision because of their (disputed) claim that they and their counterparts acted fraudulently." 412 F.3d 58, 68 (2d Cir. 2005). Although the court declined to reach that precise issue, it still compelled arbitration on other grounds. Id. at 69. Here, the Ninth Circuit basically gave ItalFlavors a windfall, helping it – the plaintiff in a lawsuit – escape arbitration against an Italian defendant because ItalFlavors engaged in fraud for its own benefit with respect to the immigration authorities. And that's a double whammy too: Caffe Vergnano, an Italian company, likely wanted to avoid U.S. courts and discovery by entering into an arbitration agreement with its franchisee. Good luck seeing a Caffe Vergnano in your neighborhood anytime soon.

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