Lessons Unlearned: Franchise and Independent Contractor Agreements Can Be Kiss of Death

by Pepper Hamilton LLP
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The Third Circuit’s decision is a pointed reminder to franchisors, as well as businesses that use independent contractors, that the form of their agreements can either serve their legal interests or harm them in employee misclassification cases.

On September 21, the U.S. Court of Appeals for the Third Circuit issued a stinging decision against commercial cleaning franchisor Jani-King, certifying a class action in an independent contractor (IC) misclassification case arising in the franchising context. Williams v. Jani-King of Philadelphia Inc., No. 15-2049 (3d Cir. Sept. 21, 2016). The court affirmed the district court’s decision to grant the plaintiffs’ motion for class certification in the case, which seeks unpaid wages under Pennsylvania wage and hour laws based solely on the terms of documents created by Jani-King itself. These documents include Jani-King’s franchise agreement and its franchise manuals, which retained sufficient control over the manner in which the franchisee cleaners were required to perform their services and which the plaintiffs argued established an employment relationship. The Third Circuit’s decision, written for a three-judge panel by Judge Fisher, once again highlights the fact that companies can be their own worst enemies when they create agreements and manuals that, on their face, provide plaintiffs’ class action lawyers with all they need to prove that ICs and franchisees are employees as a matter of law.

Prior to the Jani-King decision, the most poignant example of a company creating its own legal trouble by failing to properly structure and document its IC or franchise relationships was FedEx Ground. The legal landscape for FedEx was mixed until August 2014. Before then, FedEx had won a number of its earlier IC legal skirmishes with its home delivery and ground division drivers and lost some. But all that changed when the U.S. Court of Appeals for the Ninth Circuit issued a blockbuster decision on August 27, 2014, concluding that FedEx misclassified those drivers as ICs as a matter of law. That decision was followed only five weeks later by a similar decision from the Supreme Court of Kansas, and the Kansas decision was then adopted in July 2015 in an opinion by the U.S. Court of Appeals for the Seventh Circuit. The Kansas Supreme Court issued a particularly harsh critique of the IC contract, noting that it agreed with yet another appellate court that FedEx’s IC agreement is a “‘brilliantly drafted contract creating the constraints of an employment relationship with [the drivers] in the guise of an independent contractor model—because FedEx not only has the right to control, but has close to absolute actual control over [the drivers] based upon interpretation and obfuscation.’”

The Court’s Decision and Rationale

The named plaintiffs in the Jani-King case are two individuals: one who never hired any employees and performed cleaning services for his franchise himself, except for occasional help from his wife and friends, and the other who performed the cleaning himself, except for a two-month period when he paid an employee to help him. Other franchisees ranged from individuals to those who employed multiple workers.

The Third Circuit noted that there are a number of factors used by the courts under Pennsylvania law in determining if workers are employees or ICs. It stated that “[a]lthough no factor is dispositive, the ‘paramount’ factor is the right to control the manner in which the work is accomplished.” (Emphasis added.) Jani-King argued on appeal that “actual control, not the right to control, is the key factor in the test,” but the court rejected that argument as being inconsistent with Pennsylvania law.

The Third Circuit then examined the specific provisions in the Jani-King franchise agreement as well as its policies manual and training manual and concluded that they show that “Jani-King has the ability to control the manner in which in which the franchisees perform their day-to-day tasks.” Specifically, the Third Circuit quoted from the district court’s decision, which enumerated a number of such “control” provisions in those documents, including:

  • how often franchisees must communicate with customers

  • how franchisees must address customer complaints

  • where franchisees can solicit business

  • what franchisees must wear

  • what types of records franchisees must keep

  • how franchisees may advertise

  • how far in advance franchisees must inform the franchisor of vacations

  • how quickly franchisees must be able to be reached.

The Third Circuit also noted that Jani-King controls the franchisees’ work assignments; has the right to inspect the franchisees’ work; has the ability to change, as it sees fit, the policies and procedures that the franchisees must abide by; and has the right to terminate the franchise agreement at any time. All of those provisions in the documents prepared by Jani-King “‘could be read’ to give Jani-King the right to control the franchisees.” While the court said it was not reaching the merits of the case, it held that those factors supported the district court’s decision to conditionally certify the case as a class action.

Before concluding its decision, the Third Circuit considered one final argument by Jani-King: Franchising is an important and beneficial way of conducting business “that is fundamentally different from other situations involving misclassification claims.” Both Jani-King and the International Franchise Association, which filed an amicus brief on behalf of Jani-King, argued that an adverse decision “directly threatens the viability of franchising in Pennsylvania” and that “systems controls inherent in franchising should be irrelevant when considering whether an alleged employer has the right to exercise day-to-day control.”

The Third Circuit, however, rejected that argument. It noted that, unlike the law in some other states, Pennsylvania law “does not distinguish between controls put into place to protect a franchise’s goodwill and intellectual property and controls for other purposes.” In other words, while Pennsylvania franchise law may allow the franchisor to retain the right to control a franchisee’s actions in order to protect the valid interests of the franchisor, such controls may conflict with Pennsylvania employment and IC laws that regard such controls as indicators of employee status.

Judge Cowen filed a lengthy dissent. He stated that, while he disagreed with Jani-King that franchise system controls are irrelevant to the employment inquiry, he would find in this case that the controls identified by the two other members of the Third Circuit panel “are insufficient by themselves to establish the existence of an employer-employee relationship.” Rather, in his view, the controls must “exceed what is necessary to protect a franchisor’s trademark, trade name, or goodwill.”

The Significance of Jani-King from Both the Employment and Franchise Law Perspectives

The Third Circuit’s decision is a pointed reminder to franchisors, as well as businesses that use ICs, that the form of their agreements can either serve their legal interests or harm them in these types of employee misclassification cases, which have become increasingly prevalent. The Jani-King and FedEx decisions confirm that the best protection for franchisors and businesses that use ICs is to structure, document and implement the franchisee/IC relationship in a manner that is consistent with the IC laws in the states in which the business operates.

While the laws in most states regarding the test for IC status vary considerably, the principal factor in Pennsylvania is the same throughout the nation — whether the business retains the right to control “how” the contractor performs the agreed-upon services. Stated in another way, for IC misclassification purposes, when there are fewer contractual rights to direct and control the individuals in question, courts will be more likely to conclude that the business is compliant with the IC laws.

Of course, merely drafting a franchise or IC agreement that limits the business’s right to control how the services are to be performed is of little value legally if, in practice, the business exercises direction and control over the manner in which services are actually rendered. Such agreements, at most, provide cold comfort to businesses.

Franchisors certainly have every right to protect their valuable interests in their trademarks, trade name and goodwill under franchise law. But, there is no reason why franchise agreements cannot be drafted so as to protect those valuable interests without needlessly over-dictating how the services are to be performed.

Lessons to Learn from Jani-King

The Ninth and Seventh Circuit decisions adverse to FedEx eventually forced that company to settle dozens of IC misclassification lawsuits around the country for $466 million. If Jani-King had learned from the FedEx cases and drafted its franchise agreement and policies with a close eye on IC law, it may have succeeded in preventing conditional class certification in this lawsuit under Pennsylvania law. Many businesses that seek to reduce direction and control, yet wish to maintain a valid franchise or IC model, have resorted to the use of IC Diagnostics™, a proprietary process that examines whether a group of workers would pass the applicable tests for IC status under governing state and federal laws. IC Diagnostics™ then offers a number of practical, alternative solutions to enhance compliance with those laws. For existing businesses, those alternatives include restructuring, reclassification or redistribution, as more fully described in our White Paper.

There is nothing in the majority or dissenting opinions that says that a franchisor cannot seek to protect its intellectual property and goodwill. The challenge is to do so consistent with state IC and employment laws.

One way for franchisors to do so without undue exposure to misclassification liability is through the use of IC Diagnostics™. That process affords franchisors a way to genuinely restructure, re-document and re-implement franchise relationships in a manner that enhances IC compliance, consistent with franchisors’ rights under franchise law. Those relationships need to be documented in a state-of-the-art and bona fide manner that complies with the law yet maintains the essential components of the company’s franchise model. By doing so, companies can maximize the likelihood that they will be able to avoid the types of IC misclassification exposure that Jani-King is now facing simply because its franchise agreement and policy documents did not seek to protect its legitimate franchise interests in a manner consistent with IC law.

 

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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