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“Seventh Circuit Rules That an Undisclosed Franchise Owner Is Subject to the Franchise Agreement’s Arbitration Clause”

Franchise Law Insider By Andrew P. Beilfuss

The issue of whether non-signatories to an arbitration agreement can be forced to arbitrate is not new, but it’s an issue that doesn’t arise often in the franchise context. Recently, however, the Seventh Circuit ruled that an undisclosed partner in a franchised business was required to arbitrate her claims in accordance with the franchise agreement’s terms, even though she never signed the agreement. Everett v. Paul Davis Restoration, Inc., Nos. 12–3407, 13–1036, 2014 WL 5573300 (7th Cir. Nov. 3, 2014).

In 2004, Matthew Everett and EA Green Bay, LLC (EAGB) signed a franchise agreement with Paul Davis Restoration (PDRI). Initially, EAGB was owned, controlled, and operated by Mr. Everett. Later, however, his wife Renee became a 50% owner of EAGB. The Everetts did not disclose to PDRI that Renee had become a part-owner of the company, even though the franchise agreement required them to do so. However, Renee played an active role in running EAGB, holding herself out as the Executive Vice President of the franchise and attending PDRI franchise meetings as EAGB’s representative. In 2010, PDRI terminated the franchise agreement.

Under the non-compete clause of the agreement, the Everetts were barred from operating a similar business for two years since they were both principal owners of the franchise (although, again, PDRI wasn’t told about Renee’s ownership). Despite this, Renee, who now owned 95% of EAGB, continued to operate EAGB under a new name: “Building Werks.” Building Werks apparently served the same customers from the same location, using the same employees as EAGB. In fact, Renee even emailed customers from a PDRI marketing list with the subject line: “Same Great Service Under a New Name!”

PDRI responded by filing an arbitration demand against Renee, in accordance with the terms of the franchise agreement. Renee, in turn, filed a lawsuit asking the court to rule that she wasn’t required to submit to arbitration because she didn’t sign the franchise agreement. The trial court rejected that argument, and the case proceeded to arbitration. A panel of arbitrators subsequently entered a unanimous award against Renee.

But when PDRI returned to court to enforce the arbitration award, the district court reversed its earlier ruling. It said that Renee didn’t directly benefit from the franchise agreement, and so she wasn’t required to arbitrate after all. Based on that conclusion, the trial court vacated the arbitration award against Renee. PDRI appealed.

The Seventh Circuit reversed. The court acknowledged that in most circumstances, Renee wouldn’t be bound by the arbitration clause since she never signed the franchise agreement. But as the court noted, “[w]e have previously recognized a number of theories binding non-signatories to arbitrate, including the doctrine of direct benefits estoppel.” Under that rule, a non-signatory must arbitrate her claims if she “knowingly [sought] the benefits of the contract containing the arbitration clause.”

In this case, the court had little trouble concluding that Renee knowingly reaped the benefits of the franchise agreement. The court agreed with PDRI that she “received direct economic benefits that would not have existed but for the franchise agreement and that her new business, Building Werks, would not exist if not for her secret ownership and operation of the PDRI franchise.”

The court also pointed out (more than once, in fact) that the Everetts “colluded to avoid the franchise agreement.” The fact that the Everetts went to such lengths to conceal Renee’s ownership interest in the franchise – apparently to leave her free to operate a competing business later on if the relationship with PDRI faltered – was one fact that, from an equitable standpoint, no doubt played a role in the court’s decision.

Given the important function that restrictive covenants serve in commercial contracts (including franchise agreements), the court’s decision to hold Renee to the arbitration clause (which effectively enforced the non-compete clause against her) shouldn’t come as a surprise. If nothing else, the case is a pointed lesson to those who seek to avoid arbitration through deceptive means.