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.
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:
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.
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:
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:
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.
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.”).
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:
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.
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.
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.
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.
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.
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.