Franchisor 101: AB 5’s Preemptive Strike

Lewitt Hackman

Franchisors faced unprecedented challenges in 2020. Enactment of California’s Assembly Bill 5 on January 1, 2020 was just the tip of an iceberg. As the COVID-19 pandemic upended franchise systems across all industries, franchisors grappled with legal, operational and business consequences of AB 5’s “ABC Test.” Are franchisees now employees? Do all types of franchises meet the ABC Test or just some of them? Will franchised businesses be exempt? These questions loomed large one of the most challenging years ever as the franchise industry sought reprieve from AB 5.

Several more bills sought to exempt franchise companies. None gained traction. The last lobbying opportunity was an assembly bill by the same AB 5 author. It passed with exemptions for 18 industries, but franchising was not one of them.

The International Franchise Association (IFA) took action after the latest derailed effort. In November, IFA, independent Supercuts and Dunkin’ franchise associations and the Asian American Hotel Owners Association, sued in federal court to challenge AB 5’s application to franchise relationships. The suit seeks a court declaration that franchisors and franchisees alike are exempt from AB 5’s sweeping ABC Test.

The crux of IFA’s suit is that franchising is stuck between a rock and hard place. Federal law, such as the FTC Franchise Rule and Lanham Act, require franchisors to exercise control over franchisees to protect their trademarks and other legal rights. The Lanham Act is a federal law that gives trademark owners protections, legal rights and remedies, but only if the trademark owner maintains control over quality of goods and services sold under the mark. But now, this mandated exercise of control risks triggering an employer/employee relationship under the ABC Test.

Similarly, IFA claims federal franchise law is inconsistent with the ABC Test. The FTC Franchise Rule regulates sales of franchises, including disclosures franchisors must make to prospective franchisees. The Rule defines employment and franchise relationships as mutually exclusive of one another. If franchisors cannot comply with their obligations under federal law, without being subject to AB 5 and its ABC Test, IFA’s argument is federal law preempts the inconsistent state law, therefore AB 5 cannot apply to the franchise relationship.

Supporting IFA is a recent federal court decision in Massachusetts. 7-Eleven prevailed against franchisees claiming they were misclassified as independent contractors under the state’s equivalent of the ABC standard, due to control by 7-Eleven over the business relationship. The court found the FTC Franchise Rule and Massachusetts’ ABC test conflicted and could not be reconciled. Similar to the IFA lawsuit, the court noted that any ruling that franchisees under federal law were also employees under state law would eviscerate the franchise model by penalizing franchise companies for misclassification based on nothing more than complying with one law over another.

Franchisors and franchisees will want to monitor IFA’s lawsuit and communicate with their franchise counsel. If IFA’s suit is successful, the ABC Test will not apply to determine if franchisees are properly classified under state law. However, franchisors and franchisees should be mindful of proposed federal law, such as the Protecting the Right to Organize (“PRO”) Act, that seeks to codify a federal ABC standard. Passage of the PRO Act could moot IFA’s argument.

Read: IFA et al. v. State of California, No. 3:20-cv-02243-BAS-DEB (filed Nov. 17, 2020)

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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