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INSIGHT: California Franchisors Need to Minimize Risk Before ‘Employee’ Storm Hits

Oct. 28, 2019, 8:01 AM

The recent passage of new legislation (AB-5), and two Ninth Circuit opinions have left franchise and distribution businesses in California with a great deal of anxiety and incoherent directives as to where they stand and what they need to do.

Franchisors now face the threat that their franchisees and their franchisees’ employees have all become their employees, and indeed may have been their “employees” for the last four years. Along with the risk of damages claims for overtime and missed meal and rest breaks for all these newly-ordained “employees,” franchisors also face potential liability for any costs or losses incurred.

Knowing that a tornado is heading their way, franchise and distribution businesses must board up their windows as best they can to prepare for the coming storm.

Overview of Franchising in California

California is the birth-place of many iconic franchise brands, including McDonald’s (1937), Carl’s Jr. (1945), Jack-in-the-Box (1951), IHOP (1958), and Taco Bell (1962). Franchising has been heavily regulated since the California Legislature passed the first franchise law in the country in 1970.

The recent reissuance of the Ninth Circuit opinion in Vazquez v. Jan-Pro, (May 2) (opinion withdrawn July 22, then reinstated in part Sept. 24), coupled with the passage of AB-5, has caused disruption in the franchise business model, as franchisors come to grips with their potential expanded exposure to litigation and damages claims for alleged California Labor Code violations.

The subsequent Ninth Circuit opinion in Salazar v. McDonald’s Corp., (Oct. 1), issued a week after Vazquez but approaching the same issues in a different manner that shows respect for the franchise business model, adds to the overall uncertainty.

The typical franchisee is an entrepreneur who enters into a franchise relationship for the opportunity to run his or her own business. In exchange for what is often a modest initial fee and ongoing royalties, the franchisee obtains the right to use the trademark, trade secrets, and operational system of the franchisor.

Nearly every franchise agreement contains a provision that states that the franchisee is an independent contractor with full control over all aspects of employment at the franchised location, including the hiring, firing, training, scheduling, and compensation of all workers.

The Standard for Determining Employment Before Vazquez

Until recently, a franchisor risked being deemed an employer or joint employer over its franchisees’ employees only if it exerted too much control over the franchisee or its employment practices. See Patterson v. Domino’s Pizza LLC (2014) (a franchisor is liable “only if it has retained or assumed a general right of control over factors such as hiring, direction, supervision, discipline, discharge, and relevant day-to-day aspects of the workplace behavior of the franchisee’s employees.”); Cislaw v. Southland Corp. (1992) (“the franchisor’s interest in the reputation of its entire system allows it to exercise certain controls over the enterprise without the risk of transforming its independent contractor franchisee into an agent.”).

Vazquez Retroactively Changes the Rules for Franchisors

In 2018, the California Supreme Court, in Dynamex Operations West Inc. v. Superior Court of Los Angeles implemented the ABC test in California (as to wage orders only), which presumes that all workers are employees instead of independent contractors unless the hiring entity can show that:

  • (A) the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
  • (B) the worker performs work that is outside the usual course of the hiring entity’s business; and
  • (C) the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed. Dynamex, at 916-917.

Notably, Dynamex was not a franchise case, so it did not analyze whether the ABC test could or should be applied to the franchise model. More recently, the California Legislature, in enacting AB-5, codified Dynamex and extended its application beyond wage orders to the California Labor Code, generally.

The Ninth Circuit in Vazquez applied the Dynamex ABC test to the franchise business model. In determining that the ABC test should be applied to a janitorial franchise system, the Ninth Circuit disregarded the special protections for franchising that the California Supreme Court had endorsed only a few years earlier in Patterson.

The Vazquez court held that the holding in Patterson was limited to vicarious liability claims and did not apply to wage orders. The Ninth Circuit remanded the determination of employment status back to the district court, but directed that the ABC test should be applied and the holding in Patterson should not be considered.

Patterson made allowances for the control that necessarily comes with the licensing of a trademark. Because all franchises are based on the licensing of trademarks, control must be exerted over franchisees. Because franchisors usually license their franchisees to operate the same kind of businesses, it will be difficult for many franchisors to defeat the “B” prong of the ABC test.

The original Vazquez opinion also held that Dynamex applies retroactively. The Ninth Circuit has since withdrawn the retroactivity portion of its opinion and asked the California Supreme Court to issue a ruling regarding whether the Dynamex standard applies retroactively, recommending its own reasoning on retroactivity to the court.

If the ABC test is applied retroactively, a franchisor could be liable for a franchisee that previously had failed to treat workers in accordance with California’s Labor Code. Franchisors will potentially be responsible for damages for unpaid overtime, missed meal and rest breaks and the costs or losses of “employees” pursuant to California Labor Code § 2802 going back for as long as four years.

How Should Franchisors Respond?

In response to Dynamex, AB-5, and Vazquez, all franchisors should carefully review their franchise systems to analyze their risk exposure. Franchisors have generally ceded complete control over employment issues to their franchisees. Some franchisors may have to reconsider their relationship to their franchisees’ labor issues.

The law in this area continues to develop and it remains possible that either the California Legislature or the courts will step in to protect franchising. But until such time as the law is modified, franchisors should take this risk seriously and take steps to minimize their risks.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Jonathan Solish is a partner in the Los Angeles office of Bryan Cave Leighton Paisner. Who’s Who Legal ranks him as one of the 10 most highly regarded franchise lawyers in North America.

Glenn Plattner is a partner in the Los Angeles office of Bryan Cave Leighton Paisner. He focuses his practice on franchise, hospitality, banking, and business litigation.

Ashlee C. Difuntorum is a member of Bryan Cave Leighton Paisner’s Commercial Disputes Practice Group in the Los Angeles office. She focuses her practice on complex commercial litigation involving a variety of subject matters.