California Gov. Gavin Newsom signed Assembly Bill 5 (AB-5) on September 18, 2019, which adopts the “ABC test” for certain California employment laws. Soon after, on September 24, 2019, the U.S. Court of Appeals for the 9th Circuit held in Vazquez v. Jan-Pro Franchising International, Inc., that “the special features” of franchising do not impact how the ABC test applies to franchisors.

Based on these two developments, the ABC test will be used to determine when an individual (such as a franchise owner) is an employee rather than an independent contractor under California law. Although the stated purpose of AB-5 is to classify workers in the “gig economy” for companies such as Uber and Lyft as employees rather than independent contractors, the decision in Vazquez shows that franchising is also impacted by the broad-reaching ABC test.

This alert summarizes the ABC test and AB-5, their potential impact on franchisors and franchise systems, a key limitation on the scope of the ABC test and AB-5, best practices to help protect independent contractor relationships, and possible ramifications for franchisees’ independently established businesses in California.

The bottom-line message is stay tuned, as the situation in California is fluid and seems to change by the month depending on the most recent legislative development or judicial decision, especially when one considers the interplay between the independent contractor/employee and joint employer pressure points.

What Are the ABC Test and AB-5?

In April 2018, the California Supreme Court handed down a landmark ruling known as the Dynamex decision. Although not a franchise case, Dynamex created a new and far more stringent standard – the ABC test – for determining whether a worker is an employee or an independent contractor in California.

Under the ABC test a worker is presumed an employee – not an independent contractor – unless the hiring entity can show all of the following:

1. The worker is free from control and direction of the hiring entity in the performance of the work, both under the contract and in fact.
2. The worker performs work that is outside the usual course of the hiring entity’s business.
3. The worker is customarily engaged in an independently established trade, occupation or business of the same nature as the work performed for the hiring entity.

AB-5 codifies into California law the ABC test as adopted in Dynamex. Additionally, Vazquez confirms that the ABC test is applicable to franchising. There are some exemptions built into AB-5 for certain professions (e.g. physicians, engineers, insurance brokers). To date, the International Franchise Association (IFA) has not been successful in its efforts to pursue an exemption for franchising.

While AB-5 does not take effect until January 1, 2020, it remains undecided if Dynamex (and thus the ABC test) applies retroactively. The 9th Circuit in Vazquez recently certified that question to the California Supreme Court.

How Do the ABC Test and AB-5 Impact the Relationship Between Franchisees and Franchisors?

Franchise systems are fundamentally based on the independent contractor business model, with franchisees intended to be independent contractors under the franchise agreement. The franchise agreement governing the franchised business generally provides franchisees with certain rights and responsibilities that are inherent in an independent contractor status. For instance, common provisions in a franchise agreement require that the franchisee – not the franchisor – do the following:

• Control and direct employment matters
• Control and direct the day-to-day performance of the work
• Engage in local marketing of the products and services offered by the franchised business
• Identify and obtain a storefront or office location
• Conduct the franchised business operations in compliance with all applicable laws, regulations, codes and ordinances
• Manage its own taxes for the franchised business

The franchise agreement also typically requires franchisees to advise the public that they are independent contractors who independently own and operate their franchise business. For instance, a franchise agreement might require that the franchisee:

• Include a statement on any materials with the franchisor’s marks to indicate that the franchised business is independently owned and operated
• Put customers on notice that the business is independently owned and operated
• Put employees on notice that the business is independently owned and operated
• Not enter into any agreement or purport to create any obligation on behalf of the franchisor

It does not appear that AB-5’s sponsor intended to transform the owners of independent franchised businesses into employees. In advocating for AB-5, its sponsor, Ms. Lorena Gonzalez, explained that “workers [who] want to go into business for themselves as independent contractors, they will continue to have that choice after AB5 is signed into law” and “there will always be a place in the California economy for those who want to be their own boss and contract their services to law-abiding businesses.” Yet, as previously noted, lawmakers did not include an exemption for franchising in AB-5, despite extensive lobbying.

Further, an important court decision indicates that the ABC test and AB-5 may have ramifications for the franchise business model in California. Before Gov. Newsom signed AB-5 into law, courts applied Dynamex’s ABC test to find that franchisees could be employees of their franchisor. In the 9th Circuit’s initial opinion in Vazquez, it applied the ABC test to find that Jan-Pro’s unit franchisees could be employees, especially because “prong B” required Jan-Pro to show that the unit franchisees perform work outside the usual course of Jan-Pro’s business.

Specifically, the court found that Jan-Pro and its unit franchisees may have been in the same business of commercial cleaning. It noted that Jan-Pro actively and continuously profited from the unit franchisees’ performance of cleaning services, had a business model that relied on unit franchisees continuously performing cleaning services, and marketed itself in the same line of business, commercial cleaning, as unit franchisees.

The 9th Circuit withdrew its initial opinion because it asked the California Supreme Court to decide if the ABC test applies retroactively. However, on September 24, 2019, the 9th Circuit claimed to “re-establish the remaining holdings [that are unrelated to retroactivity] from our now-withdrawn opinion.”

The 9th Circuit’s analysis should concern franchisors in any industry because it ignores the fundamental structure of most franchise models. For example, according to the 9th Circuit, a franchisor is potentially an employer for deriving profit from the franchisee’s business or earning a percentage of customer payments made to the franchisee’s business, i.e., the percentage-based royalty fee franchisors commonly charge for use of their trademarks. Another indicator of an employment relationship, according to the court, is a franchisor’s reliance on its franchisees to continuously deliver the franchisor’s trademarked services. Similarly, the court believes that a franchisor’s marketing of the products or services sold under its trademarks, such as Jan-Pro marketing cleaning services, is evidence that the franchisor employs its franchisees.

The 9th Circuit’s analysis in Vazquez, however, seems in tension with the California Supreme Court’s and the 9th Circuit’s recognition in other circumstances that the defining features of modern franchising cannot automatically create liability on the part of franchisors. See Patterson v. Domino’s Pizza, LLC, 333 P.3d 723, 726 (Cal. 2014) (vicarious liability and employer liability); Salazar v. McDonald’s Corp., No. 17-15673, 2019 WL 4782760, at *6 (9th Cir. Oct. 1, 2019) (joint employer).

In summary, there is significant uncertainty about how the ABC test and AB-5 will impact franchising because there is no exemption for franchising in AB-5 and the 9th Circuit applied the ABC test to franchising in Vazquez.

How Do the ABC Test and AB-5 Impact the Relationship Between Franchisees’ Employees and Franchisors?

Franchisors should not have employment or independent contractor relationships with franchisees’ employees. However, a franchisor may still face vicarious liability and joint employment claims by a franchisee’s employees. These claims often allege the franchisor is the employer of its franchisee’s employees. Under California law, a franchisor is potentially vicariously liable for the actions of a franchisee’s employee or a joint employer “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.” Patterson v. Domino’s Pizza, LLC, 333 P.3d 723, 739-440 (Cal. 2014).

On October 1, 2019, the U.S. Court of Appeals for the 9th Circuit held in Salazar v. McDonald’s Corp., Case No. 17-15673, that the ABC test has no application to whether a franchisee’s employees are jointly employed by a franchisor. The court wrote that Dynamex “has no bearing here, because no party argues that Plaintiffs are independent contractors.” While the 9th Circuit did not directly address AB-5 in its opinion, AB-5’s text is also focused on whether a person “shall be considered an employee rather than an independent contractor” for purposes of California’s Labor Code, Unemployment Insurance Code and wage orders of the Industrial Welfare Commission. Cal. Labor Code § 2750.3 (a)(1) (as amended Jan. 1, 2020).

At least for now, the ABC test and AB-5 appear limited to “misclassification” claims where the franchisor allegedly misclassified its franchisees as independent contractors rather than employees. They should not impact the general rule that a franchisor does not have an employment relationship with a franchisee’s employees unless the franchisor retained or assumed a general right of control over the factors identified in Patterson.

In summary, California courts still hold that a franchisor’s mere enforcement of uniform systemwide brand standards does not necessarily lead to vicarious liability or joint employment liability. E.g., Patterson, at 29 (franchise operating system alone cannot constitute “control” necessary for vicarious liability); id. at 32 (franchise operating systems do not “necessarily” establish an employment relationship as this “would turn business format franchising on its head.”); Salazar at *17 (“McDonald’s exercise of control over the means and manner of work performed at its franchises is geared specifically toward quality control and maintenance of brand standards. Thus, McDonald’s cannot be classified as an employer of its franchisees’ workers under the common law definition.”).

What Are Best Practices for Franchisors to Protect the Independent Contractor Relationship With Franchisees After AB-5?

Given AB-5, IFA’s ongoing efforts for an exemption, and the Dynamex, Vazquez and Salazar decisions, franchisors are faced with a level of uncertainty in deciding whether they need to make changes in how they approach franchising in California. Part of the confusion flows from there being no clear-cut guidelines and how some of the issues, especially those related to joint employment, extend beyond California. Here are a few best practices for a franchisor to consider:

1. Balance the interests of the franchisor, franchisee and the system as a whole. Maintain a clear distinction between the role of the franchisor to develop, evolve and enforce the system, and the role of the franchisee to operate an independent business under the system. The successful franchisor establishes a culture of voluntary compliance with brand standards (the rules) to protect its trademarks and vigorously enforces compliance by errant franchisees, while giving the franchisee control over the day-to-day performance of delivering on the brand promise.
2. Utilize the franchise agreement and operations manual to protect the system and appropriately define the roles and responsibilities of the parties. Franchisors rightly impose requirements and system standards to assure uniformity in the franchise system and protect their trademarks. Those fundamental requirements should not be twisted by courts or legislators to impose liability on the franchisor for wrongdoing by the franchisee or the franchisee’s employees or create an employment relationship between the franchisor and its franchisees.

   To minimize this risk, the franchise agreement should expressly declare that any required standards exist to protect the franchisor’s interests in the system and the trademarks, and not for the purpose of establishing any control or duty to take control over those matters that are reserved to the franchisee. Your franchise agreement should reiterate within particular subject areas such as employment, technology, training and elsewhere, that any particular standard is not intended to exercise control and that the franchisee is responsible for such control.

   In addition, your operations manual should appropriately balance the roles and responsibilities of the franchisor and franchisee. The franchisor’s role is to protect, grow, and evolve the brand and system. The franchisee is responsible for the day-to-day operation of the business. The operations manual reinforces the nature and scope of controls, as well as distinguishing the difference between required system standards and recommendations, guidelines and best practices to achieve those standards.

3. Educate and train your field support team. Your field staff should be passionate about helping your franchisees succeed and grow their businesses. But your field staff also need to conduct themselves with an understanding that each franchisee is an independent contractor who has control over its day-to-day operations, that the franchisee is not an agent of the franchisor and that the franchisee acknowledges that it is ultimately responsible for all aspects of its business operations.

   Make sure your field staff understand that they should not get involved in a franchisee’s HR-related matters or in training employees on the day-to-day operational aspects of the business. Provide them and other franchisor team members with appropriate and ongoing training, guidelines and best practices to enable them to effectively fulfill the key roles they play and understand the boundaries of their roles in the system.

4. Focus on recommendations that impact the franchisees’ bottom line. Offer guidance that potentially improves the franchisee’s bottom line. This does not mean dictating the day-to-day work of franchisees. Rather, it is offering resources that help franchisees understand business success drivers (KPIs) and potential options to better and more profitably serve customers with the products and/or services offered under the franchisor’s trademarks.
5. Be deliberate in requirements and recommendations. Customers and employees of franchisees frequently sue the franchisor for the actions of the franchisee or the franchisee’s employees. Plaintiffs argue that the franchisor should be responsible for the actions of the franchisee or the franchisee’s employees because of the franchisor’s controls. Courts may not look kindly on franchisor requirements that extend far beyond protecting the system and trademarks.

   In order to minimize this risk, evaluate whether requirements currently imposed on your franchisees are truly necessary or merely a suggestion. Understand the difference between mandating system standards versus unnecessarily mandating the manner and means of meeting the standards. It is often more appropriate to identify guidelines, recommendations or best practices to meet the standards. Do not let tradition keep you from making changes (i.e. “That’s not the way we’ve done it in the past.”). Also confirm that your franchise agreement and operations manual explain the difference between requirements and recommendations.

6. Empower franchisees. A culture of collaboration empowers franchisees to make their own decisions about the day-to-day operations of their franchised businesses, so long as they work within the franchisor’s brand standards and system for protecting its trademarks. Your franchisees can be empowered to address customer concerns, so the customer has a positive brand experience rather than feeling disappointed or frustrated if the brand promise is not met.

   Make sure that franchisees conspicuously identify themselves and their businesses as an independent franchise in all dealings with clients, customers, suppliers and others. This can include appropriate statements on signage at the business, your website, customer order forms and other related items. On issues unrelated to protecting the system or trademarks, embrace your franchisees’ desire to operate independent businesses as part of a network. Also, encourage your franchisees to remind their employees, customers, lawmakers and communities that they are independently operated.

7. Stack the deck with “ace” franchisees. Alleviate risk with a franchise development process focused on recruiting high-quality franchisees who want the opportunity that comes with owning and operating an independent business. As part of the development process, set an expectation that a franchisee operates as a corporate entity rather than a sole proprietorship. Seek quality over quantity, and protect the brand by walking away from marginal candidates who may not have the capability to operate their own independent business.
8. Maintain an undying devotion to the brand. Customer goodwill associated with your trademarks is central to your brand. Make a commitment to customer experience – and give your franchisees the guidance and recommendations to help them deliver on it. A franchisee’s delivery on the brand promise, as an independent business, is fundamental to the customer goodwill toward your trademarks and your brand’s reputation. When done properly, franchisees are fully engaged, and you and your franchisee can focus on effective collaboration on customer-centric initiatives and activities that reinforce an undying devotion to the brand.

Finally, despite IFA’s so-far unsuccessful attempts at obtaining a franchise exemption under AB-5, it has stated it will continue those efforts in the next legislative session in California. Franchisors and franchisees alike should join IFA in those efforts, as all franchise stakeholders have a vested interest in that outcome. Now is the time to get involved. We are available to discuss what actions you and your franchisees can pursue on the legislative front.

A Final Word on How AB-5 Impacts the Relationship Between Franchisees and Their Workers

If California-based franchisees choose to use independent contractors in their franchised businesses, they are solely responsible for deciding if and how AB-5 potentially impacts that relationship. Under the franchise agreement, franchisees are usually responsible for complying with all applicable laws. To that end, given this change in California law, it may be appropriate to encourage, but expressly not require, that franchisees seek independent legal counsel to assist them in analyzing AB-5’s application to their businesses.