Ninth Circuit Refuses To Enforce Arbitration Clause In Sham Franchise Agreement

A short new opinion from the Ninth Circuit may run counter to long-standing Supreme Court precedent. In Casa Del Caffe Vergnano v. Italflavors, 2016 WL 1016779 (9th Cir. Mar. 15,2016), the court refused to enforce an arbitration agreement in a contract that the parties admitted signing, because the parties simultaneously signed a second agreement declaring the first one asham.

The story is that two undocumented immigrants chose to become a franchisee of an Italiancorporation, Caffe Vergnano, and open an Italian-style coffee shop in San Diego. They signedtwo contracts on the same day: a “commercial contract,” which was a standard franchiseagreement including an arbitration clause; and a “hold harmless agreement” that said thecommercial contract “does not have any validity” because it was designed simply to allow theimmigrantsto obtain visas to work in the U.S. The hold harmless agreement stated the parties“will sign a future contract which will regulate their commercial relationship.”

However, the parties did not enter into a new contract. Instead, the franchisees opened theirItalian coffee shop and it folded within eight months. The franchisees sued the franchisor forviolations of California statutes and the franchisor moved to compel arbitration.The district court compelled arbitration and the Ninth Circuit reversed.

Repeating language fromGranite Rock that contract formation is for courts to decide, and relying on federal common law regarding contracts,a majority of the panel concluded that the commercial contract “was a mere sham to help HectorRabellino obtain a visa” and was therefore unenforceable. The majority reasoned that the holdharmless agreement proved that the parties did not mutually consent to be bound by thecommercial contract.

This decision raises a close question between formation and validity, in my view, that the courtignores completely. On questions of a contract’s validity, the severability doctrine,clarifiedinBuckeye Check Cashing, dictates that a party challenging arbitrability must “challenge[] specificallythe validity of the agreement to arbitrate” in order to have that challenge heard by the court.Otherwise, the validity issue will be addressed by the arbitrator. SCOTUS found it wasimmaterial whether the challenge made the underlying contract void or voidable. In a footnote inBuckeye Check Cashing, however, SCOTUS excluded a limited set of formation issues from theseverability doctrine, suggesting those still belong in court:

The issue of the contract’s validity is different from the issue of whether any agreementbetween the alleged obligor and obligee was ever concluded. Our opinion todayaddresses only the former, and does not speak to the issue decided in the cases cited byrespondents (and by the Florida Supreme Court), which hold that it is for courts to decidewhether the alleged obligor ever signed the contract, Chastain v. Robinson-HumphreyCo., 957 F. 2d 851 (CA11 1992), whether the signor lacked authority to commit thealleged principal, Sandvik AB v. Advent Int’l Corp., 220 F. 3d 99 (CA3 2000); SphereDrake Ins. Ltd. v. All American Ins. Co., 256 F. 3d 587 (CA7 2001), and whether thesignor lacked the mental capacity to assent, Spahr v. Secco, 330 F. 3d 1266 (CA10 2003).

Is the franchisee’s argument that the hold harmless agreement nullified the commercial contractreally closer to an argument that the franchisee lacked mental capacity, and therefore belonged in court? Or is it closer to an argument that the commercialcontract was fraudulently induced? In my view, that is a close call, but fraudulent inducement seems the better fit, meaning this decision belonged to the arbitrator. The line between formationand validity is not clearly drawn in FAA jurisprudence, and this decision blurs it further.