What is an escalation clause, and do I have one in my franchise agreement?

When a dispute with a franchisee arises, franchisors are sometimes surprised to learn about the parties’ procedural obligations, some of which could affect the timing of filing a lawsuit or arbitration demand.

Most written agreements, including franchise agreements, contain dispute resolution provisions answering some key procedural questions that are triggered when a dispute arises, including, among other things:

• Can the parties go to court, or must they arbitrate?
• Where must the parties litigate or arbitrate?
• What jurisdiction’s laws will apply?
• Do any contractual time limitations restrict the filings of claims or damages available?

What is an escalation clause?

In addition to these customary dispute resolution provisions, some franchise agreements include pre-litigation or pre-arbitration conditions or prerequisites, which are often called escalation clauses, or tiered/multi-tiered dispute resolution provisions. These contractual prerequisites to litigation or arbitration might include requirements to:

• Give a particular type of notice before filing a lawsuit or arbitration demand
• Participate in formal or informal negotiations with the other party, and/or
• Participate in mediation, using a third-party neutral or other mediator.

If the franchisor has not had many previous serious disputes with its franchisees, it might be surprised to find that its franchise agreement contains an escalation clause – which they may consider either beneficial or challenging, depending on the situation.

Escalation clause pros:

• Gives the parties the opportunity to discuss and potentially resolve a dispute before it spirals out of control, and must be disclosed in Item 3 of the franchisor’s Franchise Disclosure Document
• Might help keep the dispute from becoming public and “spreading” to other franchisees
• May provide a forum for informal “free” discovery about a particular dispute
• May help narrow the issues in dispute and resolve certain factual misunderstandings, and
• Could reduce costs and attorneys’ fees.

Escalation clause cons:

• May cause unnecessary roadblocks to final resolution
• May waste executive and staff time and energy
• May create statute of limitations issues, depending on timing
• May impose additional costs (eg, mediator or legal fees for prerequisite steps that the franchisor finds unnecessary under the circumstances), and
• Impedes the franchisor from immediately initiating an aggressive course of action that it would prefer under the circumstances.

Careful drafting may help mitigate some of the “cons” above by, for example, making certain requirements unilateral or providing for franchisor opt-outs. However, franchisors may find themselves bound by escalation clauses drafted years ago and included without sufficient consideration of possible ramifications.

Enforceability of escalation clauses

Courts and arbitrators generally enforce escalation clauses if a party invokes them, although they vary as to whether the appropriate remedy is dismissal, or simply a stay until all prerequisites are fulfilled. Briefing and motion practice – regardless of which party invokes an escalation requirement – may be costly.

What can franchisors do?

Franchisors are advised to review their current franchise agreement to make sure they understand the various prerequisites (if any) to litigation or arbitration, when they might apply, and whether changes should be made to future agreements. Franchisors should also consider reviewing prior franchise agreement versions that may still be in force to make sure they understand, preferably before a dispute arises, what the parties’ pre-suit or pre-arbitration obligations could be.

Conclusion

If you have any questions about how your current franchise agreement dispute resolution provision would apply in practice, or with respect to a particular dispute, or if you would like to discuss possible changes to your franchise agreements, please reach out to Bethany Appleby, Stuart Hershman, or your usual DLA Piper contact.