What Is Arbitration
Arbitration is a binding dispute resolution process where a neutral arbitrator (or panel of arbitrators) hears evidence and makes a final, enforceable decision outside the court system. In franchise relationships, arbitration clauses typically appear in the Franchise Agreement and are designed to resolve conflicts between franchisors and franchisees without litigation.
Arbitration in Franchise Agreements
Most franchise agreements contain mandatory arbitration clauses that cover disputes related to franchise fees, territory rights, renewal terms, and franchisor obligations. When you sign a franchise agreement with an arbitration clause, you typically waive your right to sue in court and agree to resolve disagreements through arbitration instead.
The Federal Arbitration Act (FAA) of 1925 generally enforces arbitration agreements, and courts have consistently upheld franchisor-required arbitration clauses. However, some states, including California, impose limitations on arbitration in franchise disputes. California's Franchise Relations Act, for example, allows certain franchise-related claims to proceed in court despite arbitration clauses.
Key Considerations During Due Diligence
- Item 19 disclosure: Review Item 19 of the Franchise Disclosure Document (FDD) carefully. This section lists all litigation and arbitration claims filed against the franchisor in the past 10 years, including the names of parties, issues, outcomes, and settlement amounts. A franchisor with numerous arbitration claims related to territory disputes or fee collection suggests operational friction.
- Arbitration scope: Determine whether the clause covers all disputes (including fee disagreements, territory encroachment, and renewal refusals) or only specific categories. Broader clauses limit your legal recourse options.
- Cost allocation: Arbitration is not free. Arbitrator fees typically range from $3,000 to $10,000 per day, and cases may span multiple days. Confirm whether your franchise agreement requires you to split costs with the franchisor or pay them entirely yourself.
- Appeal limitations: Arbitration awards are final and nearly impossible to overturn. Unlike court decisions, arbitration offers no meaningful appeal process. This matters significantly when large sums are at stake, such as disputes over renewal terms or territory modifications.
- Confidentiality clause: Arbitration proceedings and awards are typically confidential. While this protects the franchisor's business secrets, it also prevents you from discussing the outcome with other franchisees, limiting collective knowledge about franchisor practices.
When Arbitration Works Against You
Arbitration favors franchisors in several ways. Franchisors often have deeper legal resources and experience managing multiple arbitration cases. Class action lawsuits, which pool claims from many franchisees, are typically blocked by arbitration clauses, preventing collective leverage. Additionally, if you dispute a renewal decision, franchise fee increase, or territory boundary change, arbitration binds you to the arbitrator's decision with no court review.
Common Questions
- Can I negotiate the arbitration clause out of my franchise agreement? Some franchisors will modify arbitration terms during negotiation, particularly around cost-sharing or scope limitations. However, most major franchise systems will not eliminate arbitration entirely. Focus negotiations on cost allocation, appeal processes, or carve-outs for specific disputes like IP infringement.
- What happens if I refuse to arbitrate when required? If a dispute arises and your agreement mandates arbitration, the franchisor can file a motion to compel arbitration in court. A judge will almost certainly grant it, and you'll end up in arbitration anyway, having incurred legal fees in the process.
- Should I choose mediation instead? Mediation is voluntary, non-binding, and less expensive than arbitration, but it only works if both parties agree to participate. Many franchisees request mediation as a first step before arbitration to resolve issues without the finality and cost of formal arbitration.