Evolving Worker Classification Standards and the Future of Franchising

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From a ballot measure in California, to a court decision in Massachusetts, to federal regulations proposed by the Department of Labor, several recent developments could impact whether a franchisor’s independent franchisees are deemed to be “independent contractors” or “employees” of the franchisor. As such determinations strike at the heart of the traditional franchise model, all franchisors should remain up to date on these developments.

California AB-5 and Retroactive Application of ABC Test

On Election Day, California voters passed Proposition 22, which allows app-based transportation and delivery companies (e.g., Uber, Lyft, DoorDash) to classify their drivers as “independent contractors” rather than “employees” under California law, and exempts these companies from many of the requirements of California AB-5. Under Proposition 22, these companies must still provide certain benefits to their drivers, including paying at least 120% of minimum wage and providing health insurance subsidies and accident subsidies. While Proposition 22 does not have a direct impact on franchisors or franchisees, the results of the ballot measure may prompt the state legislature to consider similar exemptions for franchising.

California AB-5, which became effective on January 1, 2020, made it harder for a company to classify a worker as an independent contractor, instead of as an employee. The bill codified the holding of Dynamex Operations West, Inc. v. Superior Court of Los Angeles, a 2018 California Supreme Court case that created the presumption that a worker who performs services for a company is an employee for purposes of receiving wages and benefits under California law, unless the company can prove that the arrangement meets the following three requirements (the “ABC Test”): (1) the worker is free to perform services without the control or direction of the company; (2) the worker is performing work tasks that are outside the usual course of the company’s business activities; and (3) the worker is customarily engaged in an independently established trade, occupation or business of the same nature as that involved in the work performed.

Though Dynamex did not involve a franchisor and California AB-5 does not expressly mention franchising, there is significant concern that strict application of the ABC Test risks rendering every independent California franchisee an employee of the franchisor. Such fears are stoked by the Ninth Circuit’s 2019 decision in Vazquez v. Jan-Pro Franchising, in which the federal appellate court applied Dynamex to hold that Jan-Pro franchisees were employees, not independent contractors, of the franchisor. The court speculated that in most, if not all, instances, a franchisor will be unable to satisfy the ABC Test because the franchisor will be unable to show that franchisees are doing work outside the usual course of the franchisor’s business. There are also concerns that the typical controls a franchisor must exert over use of its trademark and system to be a successful franchise system (and to comply with the Lanham Act) would negate the first element of the ABC Test as applied in California.

On Election Day, the California Supreme Court heard arguments in Vazquez (following certification from the Ninth Circuit) about whether Dynamex should apply retroactively to misclassification claims filed before Dynamex was decided. To the extent the California Supreme Court concludes Dynamex announced major changes to California’s worker classification rules, Dynamex will not apply retroactively and will only apply prospectively. On the other hand, if the court finds Dynamex merely “refined” existing worker classification rules, Dynamex will apply retroactively.

California AB-5, Dynamex and Vazquez have cast doubt on the viability of the franchising model in California. The legislation creates the presumption that franchisees are employees of their franchisors, given the inherent control franchisors have over their franchise system and franchisees’ operations. In addition, it is difficult for most franchisors to meet the second prong of the ABC Test—that their franchisees are performing work tasks that are outside the usual course of the company’s business activities. The California legislature refused to amend California AB-5 this year to exempt franchises, and Proposition 22 did not extend to franchising. But now, with the app-based transportation and delivery industry successfully securing exemptions from the applicability of California AB-5, there may be more avenues for franchised businesses to obtain similar exemptions from the applicability of California AB-5 to franchising.

Massachusetts’ ABC Test and Franchising

Long before California adopted the ABC Test in Dynamex, Massachusetts began using the ABC Test to evaluate worker misclassification claims. A recent federal court decision out of Massachusetts may provide clarity regarding application of the ABC Test to franchising and provide a roadmap to franchisors seeking to avoid such claims. In September, a federal judge in Massachusetts dismissed Patel v. 7-Eleven, Inc., a lawsuit brought by 7-Eleven franchisees who claimed they were employees, not independent contractors, under the Massachusetts Independent Contractor Law. The judge found a direct conflict between Massachusetts’ ABC Test and the FTC Franchise Rule. Under the first part of the Massachusetts’ ABC Test, there is a presumption that “an individual performing any service” for a company is an employee, unless the company can show “the individual is free from control and direction in connection with the performance of the service, both under his contract for the performance of service and in fact.”  However, the FTC Franchise Rule classifies franchisees in a manner that “is nearly identical” to how Massachusetts’ ABC Test defines employees. Indeed, franchisor control over the system’s brand standards and trademarks is a touchstone of franchising. As the district court observed, “[i]t cannot be the case . . . that, in qualifying as a franchisee pursuant to the FTC’s definition, an individual necessarily becomes an employee. In effect, such a ruling . . . would eviscerate the business franchise model, rendering those who are regulated by the FTC Franchise Rule criminally liable for failing to classify their franchisees as employees.”  As a result, the district court found that the Massachusetts ABC Test did not apply to 7-Eleven, granting the franchisor summary judgment and dismissing all of the plaintiff-franchisees’ claims.

This decision is a win for franchisors who often find themselves defending misclassification claims by franchisees who desire to avail themselves of benefits and protections afforded to employees—but not independent contractors—under state law. Because the court recognized the preemptive nature of the FTC Franchise Rule over the Massachusetts’ ABC Test, it will be interesting to see if other jurisdictions (including California) will adopt similar reasoning to exempt franchise relationships from the purview of state ABC Tests.

Department of Labor Rule-Making

Meanwhile, at the federal level, the U.S. Department of Labor (DOL) has proposed revising its regulations to significantly clarify how the DOL distinguishes between employees and independent contractors for purposes of federal wage-and-hours law, the Fair Labor Standards Act (FLSA). The DOL is proposing to introduce new provisions to address whether workers are “independent contractors” or “employees” under the FLSA. The DOL’s proposal includes: (1) a provision discussing the “economic reality” test for distinguishing FLSA employees from independent contractors, clarifying that the concept of “economic dependence” turns on whether a worker is in business for him- or herself (independent contractor) or is economically dependent on a potential employer for work (employee); (2) provisions listing the factors examined as part of the economic reality test, and describing the two “core” factors—the nature and degree of the worker’s control over the work and the worker’s opportunity for profit or loss—which are afforded greater weight in the analysis, as well as three other factors (skill, permanence and integral part); and (3) a provision advising that the parties’ actual practice is more relevant than what may be contractually or theoretically possible.

To date, the DOL has not published a generally applicable, final regulation regarding who is an independent contractor and, therefore, not an employee under the FLSA. Accordingly, the proposed rule would be the DOL’s sole and authoritative interpretation of independent contractor status under the FLSA. The DOL received over 1,800 comments, which were due on October 26, 2020, regarding the proposed rule. The International Franchise Association (IFA) commended the proposed rule for providing “greater clarity and recognition that the franchisor-franchisee relationship should not be subject to independent contractor tests.”  The IFA submitted comments recommending “the DOL acknowledge the economic uncertainty and potential conflicts in law created by AB-5 and other expansive ABC [Tests] in its final rule” and requesting that the final rule clarify “that franchisees are not part of the franchisor’s integrated production process” (i.e., the franchisor does not provide services to franchisee’s customers, who are the end consumers). The DOL expects to finalize the proposed rule before the end of the year, but the possibility of a new administration and changes in Congress could impact this plan.

Conclusion

The standards for classifying a worker as an “employee” or “independent contractor” remain in flux. While the DOL’s proposed rule and decisions like Patel are positive news, franchisors should continue to carefully monitor the scope and application of the ABC Test in California and worker classification standards in other states.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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