Plenty New on the Franchise Legal Front, Says WSJ

This posting was written by John W. Arden.

The year 2010 was another litigious one for the U.S. franchising “industry,” providing important new legal developments and trends, according to an article in The Wall Street Journal’s February 14 Small Business report

In a feature story (“Franchisee v. Franchiser: What’s new on the legal front? Plenty.”), reporter Richard Gibson asked prominent franchise lawyer Leonard D. Vines to “review the legal landmarks.”

Vines, a partner in the St. Louis office of Greensfelder, Hemker & Gale P.C., provided the following highlights.

Value menu pricing. Despite protests from franchisees, Burger King was allowed to require franchisees to sell a double cheeseburger for $1, a price franchisees said cost them money. The Burger King National Franchisee Association sued the franchisor, claiming that it had acted in bad faith in setting such a low price. The federal district court in Miami dismissed the action, ruling that Burger King had broad discretion in adopting marketing strategies and that the franchisees failed to show that the double cheeseburger “loss leader” threatened their viability. (National Franchisee Association v. Burger King Corp., CCH Business Franchise Guide ¶14,501) Further details are available in an earlier blog item (Trade Regulation Talk, December 27, 2010).

Franchisees as employees. A decision holding franchisees as employees of their franchisor sent shock waves throughout the franchising community, since an employer-employee relationship would place burdens on the franchisor, such as withholding federal and state taxes, paying for workers compensation insurance, and complying with wage laws. A Massachusetts federal court found that Coverall had misclassified its franchisees as independent contractors. Under Massachusetts law, an individual performing a service is considered an employee unless (1) the individual is free from control and direction in the performance of the service, (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 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,” according to the court. The franchisor in this case engaged in the same commercial cleaning business as the franchisees. (Awuah v. Coverall North America, Inc., CCH Business Franchise Guide ¶14,349 and ¶14,473) Additional information on this development appears in two previous blog items (Trade Regulation Talk, April 5, 2010 and October 25, 2010).

Various liability. A continuing hotbed of litigation, vicarious liability arises when a franchisor is held liable for the acts of its franchisee towards a third party. “The contention is that since a franchisor exerts so much control over the franchisee’s operations, the franchisee is effectively an agent of the franchiser, and as a result [the franchisor] should be held liable for the acts or omissions of the franchisee.” Vicarious liability can pose a dilemma for franchisors, says Vines. “If they exert too much control, they might be held liable for the franchisees’ conduct. If they do not exert enough control, they might be considered complicit, or seen as not properly training and education the franchisee.”

Disclosure. Whether a franchisor is obligated to disclose future business plans to a prospective franchisee has been a recurring issue. In Something Sweet v. Nick-N-Willy’s Franchise Co. (CCH Business Franchise Guide ¶14,398), a pizza franchisee purchased a carryout outlet, only to find out later that the franchisor intended to discontinue selling those types of franchises. The franchisee brought suit alleging that the failure to disclose this plan was a material omission that violated the Washington Franchise Investment Law. However, a Washington state court found that as long as the franchisor continued to support the carry-out franchises, there was no misrepresentation for failure to disclose plans. “According to this analysis, a franchiser is not obligated to disclose plans to a prospective franchisee if the plans wouldn’t adversely affect the franchisee’s ability to continue operating,” Vines observed. Further information on this case is available in a previous blog posting (Trade Regulation Talk, June 17, 2010).

Treating Franchisee as Independent Contractor Violated Workers’ Compensation, Wage Laws

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

A franchisor of janitorial cleaning businesses violated Massachusetts law by improperly requiring the franchisee-employee to pay for insurance and by failing to pay the franchisee-employee within a week of the pay period during which the wages were earned, a federal district court in Boston has determined. A group of the franchisees filed suit against the franchisor as representatives of a putative class action.

Misclassification

In an earlier ruling (Business Franchise Guide¶14,349), the court held that the franchisor had misclassified the franchisees as independent contractors.

The franchisee-employee argued that five categories of fees were improperly withheld from his wages by the franchisor due to this misclassification, despite the fact that he agreed to those fees in his franchise agreement. The five categories were:

(1) Franchise fees;

(2) Royalty and management fees;

(3) Insurance;

(4) Supplies and equipment; and

(5) Chargebacks—fees charged by the franchisor to its cleaning workers when a customer did not pay its bill for cleaning services.

Damages

The franchisor argued that the franchisee-employee was entitled only to damages incurred directly from the misclassification and that the fees were not directly related to the misclassification because they were the result of a freely undertaken contractual obligation.

The franchisor was correct that damages incurred must relate to the classification; however, there were certain statutory costs that a Massachusetts employer must bear, the court noted. Under Massachusetts law an employer was required to contribute to workers’ compensation insurance in the event that an employee was injured on the job. Had the franchisor provided the franchisee-employee with its statutorily mandated workers’ compensation insurance, the franchisee-employee would not have had to purchase the extensive liability insurance required by the parties’ agreement.

To the extent that the franchisee-employee paid premiums for insurance that the franchisor was statutorily required to provide, the franchisee-employee was damaged by his misclassification, the court ruled.

Similarly, the franchisor’s use of chargebacks was an attempt to circumvent the Massachusetts Wage Act. Under the parties’ agreement, the franchisor "advanced" wages to the franchisee-employee after he provided cleaning services, but did not consider the wages earned until the customer paid its bill.

The franchisee-employee had completed his job when he had performed all of the cleaning services that it required. At that time, he earned his wage. To impose an additional contingency of payment from a customer on the franchisee-employee, particularly where he had no involvement in collecting the payment, was an improper attempt by the franchisor to exempt itself from the Wage Act, the court held.

Although the franchisor improperly withheld chargebacks from the employee, all such wages were subsequently repaid. Nonetheless, such repayments were made after the statutory period. Thus, the franchisee-employee was entitled to interest on the chargebacks prior to their repayment.

Public Policy Towards Franchising

The franchisor’s system of doing business pursuant to which the franchisor would bill the cleaning clients and then remit payment to its franchisee-employees was not unlawful as against public policy under Massachusetts law, the court ruled.

The franchisee-employee plaintiff pointed out that the franchisor’s system of doing business was essentially to charge employees for performing work. The franchisee-employee argued that, although the Massachusetts legislature had not spoken on the issue, such a system must be against public policy in Massachusetts and that, at least in the cleaning industry, a franchise system must be unlawful. However, such a public policy argument required some indication from the Massachusetts legislature, executive, or judicial branches that the system was unlawful, according to the court.

Instead, there was no indication from any branch of the government that the franchise distribution system was disfavored. Indeed, the franchisor pointed to numerous statutes that appeared to condone a franchise distribution system, the court noted.

The decision is Awuah v. Coverall North America, Inc., CCH Business Franchise Guide ¶14,473.

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.”