OBITER DICTA: REFLECTIONS ON THE LAW OF FRANCHISING

In litigation that has been winding its way through the courts for more than ten years, the Ninth Circuit recently issued an opinion that may have implications for the franchise business model in California.

The Vazquez Opinion

In the matter titled Vazquez v. Jan-Pro Franchising International, Inc., No. 17-16096 (9th Cir. May 2, 2019), the Ninth Circuit applied a test adopted by the Supreme Court of California to determine whether an independent contractor was really an “employee” subject to the wage orders of California.  (The Industrial Welfare Commission of California, an administrative agency, has issued seventeen “wage orders,” regulating the wages, hours, and working conditions in certain industries.)

The plaintiffs in the Vazquez matter are individuals who purchased “franchises” from Jan-Pro to clean office buildings; and the Ninth Circuit found that Jan-Pro must establish three elements to avoid having its franchisees classified as “employees” under California wage orders:

1. Jan-Pro’s franchisees are free from the control or direction of Jan-Pro in connection with the performance of work;
2. Jan-Pro’s franchisees perform work outside the usual course of Jan-Pro’s business; and
3. Jan-Pro’s franchisees are customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

All three elements must be established.  If any element fails, Jan-Pro will be classified as the “employer” of its franchisees.

Are Franchisees Really “Employees”

Unfortunately, hard cases may lead courts to make decisions appropriate for extreme circumstances, in so far as they seek to serve justice in the instant case, but inappropriate for more typical circumstances.  The opinion in Vazquez may be an example of this dynamic.

Under the classification scheme articulated by the Supreme Court of California and applied by the Ninth Circuit in the Vazquez opinion, many franchisors might be classified as the “employer” of its franchisees because:  (1) franchisors control and direct the performance of work, at least to the extent they are required to enforce brand standards; and (2) franchisees perform the same services as those offered by the franchisor.  (Interestingly, Jan-Pro claimed it was not in the business of providing cleaning services. Rather, Jan-Pro claimed it was in the business of franchising. This was a losing argument.)

The Vazquez opinion does not consider the realities of many franchise systems.  For example:

1. Franchisees are often a legal entity and not an individual.  Wage orders, by their very nature, do not apply to corporations, limited liability companies, or other legal entities.
2. Franchisees often contract independently for the inputs of their business, such as real estate, labor, and financial, insurance, and bookkeeping services.
3. Franchisees hire employees, pay wages, and withhold taxes.

Therefore, in many franchise systems, franchisees have the indicia of independent contractors, not employees.

Digging a Little Deeper

A conflict between Jan-Pro’s business model and the public policy of California may have played a role in the Ninth Circuit’s decision.  First, “compensation” paid to the plaintiffs in Vazquez may not be consistent with California wage orders relating to cleaning crews, which may diminish their capacity to “provide for themselves and their families.” Second, Jan-Pro’s business model may harm competitors. On this element, the Ninth Circuit cited the Supreme Court of California that wage orders are designed to ensure that “responsible companies are not hurt by unfair competition from competitor businesses that utilize substandard employment practices.”  Finally, the Ninth Circuit found that “wage orders benefit society at large.” While the Ninth Circuit did not mention that employment and other taxes may have been avoided by Jan-Pro’s franchise model, this too may have played into their decision.

Takeaways

While the Ninth Circuit opinion in Vazquez may not be good law for franchisors, franchisors should consider the following:

1. Any decision in the Vazquez matter will relate only to classifications under California wage orders.  In fact, the Ninth Circuit specifically acknowledged a separate test should be applied to determine vicarious liability.
2. Most franchise systems do not use a franchise model like Jan-Pro.  For example, most franchisees have the indicia of an independent contractor noted above.
3. Most franchisees would not likely be inclined to claim they are “employees” of the franchisor, even in California.  These claims tend to be relevant only to franchise systems that generate lower returns.
4. Technically, the Vazquez matter has not yet been decided.  It has been remanded to the District Court for reconsideration.
5. In the event the District Court does determine Jan-Pro is the employer of its franchisees under California wage orders, the court may develop a factual record to support a finding that the plaintiffs are individuals without the indicia of  independent businesses, making the decision of limited precedential import for more typical franchise systems.
6. If the District Court does determine that Jan-Pro is the employer of its franchisees, calculating damages and imposing sanctions may prove difficult to implement in a meaningful way due to facts that have not yet come to light.

I recently met with an executive new to franchising.  At the beginning of our meeting, she asked: “So, what obligations does the franchisor have to its existing franchisees?”  She asked me to be brief in my response.

I told her a franchisor’s obligations to its franchisees stem from the following four sources.

First and foremost, the franchise agreement governs most aspects of the relationship between the franchisor and the franchisee.  However, some jurisdictions impose an implied duty of good faith and fair dealing, either by case law or statute, which may impact enforcement of the franchise agreement.  The implied covenant of good faith and fair dealing does not rest on a uniform body of law.  The franchisor does not have a fiduciary duty to act in the best interest of the franchisee.

Second, some states have enacted franchise relationship statutes.  For example, the Iowa Franchise Act prohibits a franchisor from establishing a competing location that “adversely affects” the business of an existing franchisee.  This requirement negates any contractual provision to the contrary.

Third, although not a “relationship obligation,” the Amended FTC Franchise Rule and the states that regulate franchise sales impose disclosure requirements that may inform the franchisor’s decision about how to manage a franchise system and, therefore, may impact the franchise relationship.  For example, Item 8 of the Amended FTC Franchise Rule requires franchisors to disclose, [w]hether the franchisor or its affiliates will or may derive revenue or other material consideration from the required purchases or leases by franchisees.”  A requirement to disclose this source of revenue has led some franchisors to change the nature of their supplier relationships so that, instead of generating rebate revenue for the franchisor, suppliers provide benefits to a system-wide marketing fund.

Finally, in wrapping up, laws with general applicability may also impose obligations upon a franchisor.  For example, unfair trade practice statutes (sometimes called “Little FTC Acts”) and antitrust laws may impact franchise relationships and how a franchisor sets prices; intellectual property laws may impact how a franchisor polices its marks and system standards; and employment laws may impact how a franchisor offers training to its franchisees.

She thanked me for the “long” overview of franchise law and asked me to be more concise in the future.