Does Litigation Indicate Growing Rift Between Franchisees and Franchisors?

This posting was written by John W. Arden.

A recent Wall Street Journal new story, describing how difficult economic times have resulted in contentious franchise litigation, has caused a controversy about the financial health of franchising and relations between franchisees and franchisors.

The February 9 article (“Tough Time for Franchising: As Business Disputes Spark Tensions, Some Franchisees Take Franchisers to Court” by Sarah E. Needleman) stated that “[t]wo closely watched disputes now playing out in the courts are shining a light on a growing rift between franchisees and franchisors.”

The article cited:

(1) A suit brought by an association of 185 U.S. franchisees of Cold Stone Creamery Inc., claiming that the franchisor refused to provide detailed information about funds that the franchises believe should be set aside for their benefit in a marketing fund, and

(2) An action filed by a group of franchisees against Edible Arrangements, claiming that the franchisor abused it discretionary authority by mandating that all franchises be open on Sunday and an additional two hours every other day of the week. Another recent action filed by Edible Arrangements franchisees is seeking to stop the franchisor from collecting a two percent royalty on orders placed over the Internet, a fee implemented last month.

These disputes, and others like them, were attributed to financial problems, “At the end of the day, it just boils down to profitability,” said Eric Stites, managing director of a franchise market research company. “When franchisees aren’t making money, that’s when you see them form associations and sue the franchisor.”

“Litigation sends a signal to the franchisor and others that something is wrong,” said John Gordon, an independent chain-restaurant analyst.

IFA Response

In response to the article, Stephen J. Caldeira, President of the International Franchise Association (IFA), published a Letter to the Editor, charging that the article “overlooks significant economic evidence and ignores that more than 90% of franchisees renew their contracts with franchisers at the end of their terms.” The IFA is the oldest and largest trade group representing franchising.

“By focusing on litigation by a small percentage of franchisees, you cast aside the more than 2,000 franchise systems in the U.S. today that are healthy, thriving, and creating jobs and that have franchise relationships that are strong and effective.”

Caldeira asserted that the number of franchised establishments and jobs are predicted to meet pre-recession levels this year and that franchisors have focused on increased collaboration with franchisees during the economic downturned.

“Differences arise,” Caldeira concluded. “Franchise advisory councils are the best approach for addressing those issues. Working within the system is the true essence of what makes the franchise model so successful.”

Growth Predicted for 2012

After three years of decline in the number of franchises, franchising is expected to experience modest growth in the number of establishments, employment, output, and contributions to the U.S. gross domestic product (GDP) in 2012, according to a study recently released by the IFA.

The number of franchise establishements is expected to increase by 1.9%, from an estimated 735,571 to 749,499. The number of direct jobs will increase by 2.1%, from 7,934,000 jobs to 8,102,000 jobs, according to a report prepared by IHS Global Insight. The output of franchise businesses is predicted to grow by 5%, from $745 billion to $782 billion, and the growth of GDP originating in the franchise sector is expected to increase by 4.8%, from $439 billion to $460 billion.

A press release on the study appears here on the IFA website.

International Franchise Association Comments on Two Massachusetts Bills

This posting was written by Pete Reap, Editor of CCH Business Franchise Guide.

The International Franchise Association (IFA) has recently made its views known on two Massachusetts bills by submitting “testimony” concerning the proposals in letters to the state legislature’s Joint Committee on Community Development and Small Business.

In the letters, IFA’s Senior Vice President of Government Affairs and Public Policy, Judith Thorman, expresses the organization’s support for Massachusetts House Bill No. 3513, which would amend the state labor laws to clarify that franchisees are not employees, and voices the IFA’s arguments against advancement of Massachusetts Senate Bill No. 1843, a proposed franchise relationship/termination law.

Franchise as Employment Relationship

House Bill No. 3513, An Act Relative to Clarifying Franchises, “only makes clear that the relationship between the franchisor and franchisee is not one of employer and employee,” according to Thorman. Specifically, the bill, which was filed on behalf of the IFA, would amend the Massachusetts labor, unemployment insurance, and workers’ compensation statutes by including the following (or a very similar) provision:

"Notwithstanding the provisions of this section, an individual who owns a franchise, or is a party to a franchise agreement under which he or she is authorized to sell products and/or services (a) in accordance with prescribed methods and procedures; and (b) under service marks, trademarks, trade names and other intellectual property licensed under such agreement, shall not be considered an employee of the franchisor."

Massachusetts uses a three-pronged “ABC Test” to assess whether an employment relationship exists between individuals and/or business entities. Under the test, an individual will not be considered an employee if:

(A) Such individual has been and will continue to be free from control and direction in connection with the performance of such service, both under his contract for the performance of service and in fact; and

(B) Such service is performed either outside the usual course of the business for which the service is performed or is performed outside of all the places of business of the enterprise for which the service is performed; and

(C) Such individual is customarily engaged in an independently established trade, occupation, profession or business of the same nature as that involved in the service performed.

“The problem from a franchising perspective—and the reason for this legislation—is that, while a rational person would think otherwise, an argument can be made that a franchise system fails all three prongs of Massachusetts’ ABC Test,” in Thorman’s view.

For example, “while prong (a) of the test requires the individual to be free from control, both under the parties’ agreement and in fact, under federal law, a franchisor must maintain certain controls over the use of its brand, marks and system, or risk losing trademark rights.”

The proposed legislation would not absolve employers from adhering to Massachusetts law, Thorman continued. Franchisees would remain fully liable to their employees for all appropriate obligations, just as franchisors would continue to be responsible for their employees.

Furthermore, if franchisees were treated as employees under Massachusetts law, “some franchisors will seek to impose the resulting costs on the franchisee, since they are properly the costs of operating the franchisee’s business, Thorman commented.

“Other franchisors will simply stop selling franchises in a jurisdiction that finds them to be ‘employers,’ go elsewhere, and thereby reduce the opportunities for those entrepreneurs left behind.” Both results would fail to promote the legitimate state objectives and punish those who wanted to be entrepreneurs.

Franchise Relationship Bill

“The underlying implication of Senate Bill No. 1843 is that franchisors and franchisees are on opposite sides competing against one another,” according to Thorman. “This could not be farther from the truth. At the heart of franchising is a mutually dependent relationship requiring the franchisor and the franchisee work together to achieve shared success, since neither will be successful without the other.”

Moreover, the proposed language of S.B. 1843 was nothing new and had been previously proposed and rejected in Massachusetts multiple times, according to the letter.

To understand the IFA’s concerns over the proposal, Thorman referenced Iowa's enactment of similar legislation in 1992. As a result of the enactment of a relationship law, “growth of the franchising business model ground to a halt” in Iowa, especially in comparison to the strong growth rates experienced by the surrounding states of Illinois, Minnesota, Nebraska, South Dakota, and Wisconsin during the years following 1992.

The Massachusetts bill would prohibit a franchisor from terminating or failing to renew a franchise, except for “good cause showing which shall include, but not be limited to, the franchisee’s refusal or failure to comply substantially with any material and reasonable obligation of the franchise agreement.” It also would also require written notice of termination or nonrenewal be provided to a franchisee at least 90 days in advance, along with the cause for the action.

The bill would hold any franchisor that developed a new outlet or location that had an adverse impact on the gross sales of an existing franchise liable to the affected existing franchisee for monetary damages, unless certain exceptions applied.

The proposal also imposes an inventory repurchase obligation on franchisors and prohibits franchisors from several types of actions, including: (1) prohibiting the right of free association among franchisees; (2) imposing unreasonable standards of performance on a franchisee; and (3) failing to deal in good faith with a franchisee.

IFA Legal Symposium, IBA/IFA International Franchising Conference Scheduled for May

This posting was written by John W. Arden.

The annual International Franchise Association Legal Symposium and the International Bar Association/International Franchise Association Joint Conference on international franchising are scheduled for mid-May in Washington, D.C.

Legal Symposium

The 44th annual IFA Legal Symposium—featuring three general sessions, 21 concurrent workshops, and a six-part Basics Track—will be held on May 15-17 at the J.W. Marriott Hotel in Washington, D.C.

Topics and speakers for the general sessions include: (1) embracing change before your franchise gets left behind, Jack Uldrich; (2) a panel discussion on adapting to change, Brian Schnell, Jack Earle, Steve Joyce, Victoria Blackwell, and Rochelle B. Spandorf; and (3) a judicial update, David Beyer and Nina Greene.

Twenty-one concurrent workshops will feature presentations on state regulation, pitfalls for start-up franchisors, mass franchise disputes, changing technology in franchising; key ethics issues; enforcing international agreements; data security and privacy laws; disclosure, exemption, and registration issues; mistakes in the pre-sale disclosure process; arbitration; pricing programs after Leegin; enforcing social media policies around the world; defaults in international agreements; and implementing system upgrades and enhancements.

Further information on the symposium can be found here on the IFA website. Information on online registration appears here.

IBA/IFA Joint Conference

The 27th annual IBA/IFA joint conference (entitled “New Approaches and Challenges in International Franchising”) will follow the IFA Legal Symposium on May 17-18 at the J.W. Marriott.

The conference will start with a reception and dinner on May 17 at the Occidental Grill in the Willard Hotel. The next day’s program will feature three plenary sessions, three workshops, and a luncheon panel discussion.

Introduced by John R.F. Baer, Chair of the IBA International Franchising Committee, the program will include the following plenary sessions: (1) selecting the appropriate vehicle for international expansion, Philip Zeidman, Daniella Canale, Ned Lyerly, John Pratt, and Will Woods; (2) news from around the world, Mr. Baer, Andrew Wiseman, Stephen J. Caldeira, Rafael Escalera, Peter Snell, Fabio Bortolotti, and Jorge Mondragon; and (3) vicarious and franchisor liability, Larry Weinberg, Penny Ward, Gregg Rubenstein, and Francesca R. Turitto.

A luncheon panel discussion—“International Franchise Development: How Do You Pick Your Franchisees?”—will feature Mr. Baer, Yoshino Nakajima, Melissa Rothring, and Luiz do Amaral.

The workshops will feature the following topics and speakers: (1) control of premises in international franchising, Marco Hero and Carl Zwisler; (2) advertising funds in international agreements, Pascal Hollander, Daniel Waddell, and Oliver Binder; and (3) franchising in regulated industries, Rocio Belda, Frank Zaid, and Mark Kirsch.

Details regarding the session and program registration are available here on the IFA website.

Cleaning Service Franchisees Qualify as “Employees” Under Massachusetts Law

This posting was written by John W. Arden.

Cleaning service franchisees were employees—rather than independent contractors—within the Massachusetts Independent Contractor statute, according to the federal district court in Boston.

Under the statute (Mass. Gen. Laws ch. 149, §148B), an individual performing a service is considered an employee unless:

(1) 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; and

(2) the service is performed outside the usual course of the business of the employer; and

(3) the individual is customarily engaged in an independently established trade, occupation, profession or business of the same nature as that involved in the service performed.

The franchisor (Coverall North America, Inc.) failed to carry its burden of establishing all three elements, the court held. In particular, the franchisor failed to establish the second prong of the test—that the franchisees were “performing services that are part of an independent, separate, and distinct business from that of the employer.”

Cleaning Business v. Franchising Business

In attempting to establish that the franchisor and its franchisees are distinct businesses, the franchisor argued that it is not in the commercial cleaning business, but is in the franchising business, the court noted.

The franchisor maintained that it sells franchises and trains and supports the franchises, but neither cleans any establishment nor employs anyone who cleans any establishment. It further claimed that “numerous courts have accepted that the functions and business of a franchisor are separate and distinct from those of a franchisee and that their shared economic interest does not make one the employer of the other.”

The court agreed that there have been rulings that shared economic interests do not make one the employer of the other, but that such rulings did not establish the conclusion that the functions and business of a franchisor are separate and distinct from those of a franchisee.

“Coverall’s argument is not unlike arguments made by other employers in Massachusetts who also required their employees to sign agreements stating that they were independent contractors,” the court stated.

“Ponzi Scheme”

According to the court, “[d]escribing franchising as a business in itself, as Coverall seeks to do, sounds vaguely like a description for a modified Ponzi scheme—a company that does not earn money from the sale of goods or services, but from taking in more money from unwitting franchisees to make payments to the previous franchisees.”

Such a description does not apply to the franchisor, the court said. As a result of the expenditure of time, skill, effort, and money, Coverall developed the system used by its franchisees. It trains franchisees and provides them with uniforms, contracts with all customers, and receives a percentage of revenue earned on every cleaning service.

“These undisputed facts establish that Coverall sell cleaning services, the same services provided by these plaintiffs,” the court found.

Because the franchisees did not perform services outside the usual course of Coverall’s business, the franchisor failed to establish that the franchisees were independent contractors, in the court’s view.

The decision is Awuah v. Coverall North America, Inc., Civil Action No. 07-10287-WGY, March 23, 2010. It will appear in the CCH Business Franchise Guide.

Reaction

In a March 29 news release, the International Franchise Association (IFA) said that the ruling will “severely impact the ability of franchise businesses to operate, create jobs and provide millions in economic output” in Massachusetts.

“We feel the judge did not take fully into account the unique attributes of franchising and the federal regulatory oversight of the franchise business model,” said David French, IFA Vice President of Government Relations.

“Wrongfully defining franchisees as employees of the franchisor instead of business owners, as the ruling does, threatens the viability of franchising as a business model in Massachusetts and will likely lead to franchise companies ceasing operations,” he stated.

The IFA is supporting legislation filed in Massachusetts that would change the independent contractor law to require violation of all three prongs for an entity to be deemed a “misclassified worker.”