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Are Franchisees Independent Contractors? Not Everyone Agrees

Franchising World July 2008

It appears that the law of unintended consequences is once again asserting its presence and franchisors of all shapes and sizes, especially those with franchisees who have few, if any, employees, and are conducting business as sole proprietorships, should proceed with extreme caution.

By Arthur L. Pressman and Gregg A. Rubinstein

Virtually every franchise agreement contains a boilerplate provision that restates what is obvious to franchisors: an acknowledgment that the franchisee is an independent contractor, and not a partner, joint venturer, agent or employee of the franchisor.  This independent contractor status is also obvious to franchisees who have made a significant investment of money and personal resources into a franchise offering with the goal, in part, at least, to be in business for themselves, and no longer be an employee.  Sometimes, a franchisee’s status as an independent businessperson, and not an agent or employee of the franchisor, is not as clear to members of the public as it is to the franchisor and franchisee.  When that occurs, and an accident or injury takes place at the franchised business or in connection with the franchisee’s business operations, vicarious liability issues arise.  Most franchisors are familiar with the risks of vicarious liability, and have taken steps to minimize the risks, for example, requiring franchisees to post conspicuous signage alerting the public that the franchise is owned by an independent businessperson, and not by the franchisor.  Or they insure against the risks, for example, by requiring additional or named insured coverage on franchisee insurance policies. 

 Some risks associated with a franchisee’s independent contractor status are not so easily understood or insured against as the risks associated with claims of vicarious liability.  Chief among those risks in 2008 is a risk that a franchisee’s independent contractor status will be disregarded in its entirety by state agencies charged with the responsibility of protecting workers from injury (workers’ compensation), unemployment (unemployment compensation) or from employers who do not fairly pay employees in accordance with wage payment and collection laws.  If this happens, not only will franchisors find themselves liable for payment of the expenses on a “going-forward” basis, which can be substantial depending on the number of “employees,” but possibly premiums and expenses for past years and statutory penalties.
 
As a practical matter, these state agencies are not usually concerned with substantial franchisees which themselves have multiple employees on whose behalf the franchisee-employer makes contributions to state workers’ compensation and unemployment benefit programs, and pays employees overtime and other benefits as required by law.  Smaller franchisees are, however, increasingly getting attention from state attorneys general charged with enforcing wage and labor laws.  Many times these smaller franchisees have few, if any, employees, and are conducting business as sole proprietorships.  Often, they may conduct the franchise business as a second job, or at nights, or from a panel truck bearing the franchisor’s trademark while they drive from customer-to-customer, repairing homes, cleaning houses, bathing pets or performing any of the myriad activities that have been successfully franchised.  Sometimes, the total franchise investment required is comparatively modest, at least, as compared to a major restaurant brand. Other times, the franchisor will finance the franchise investment and sometimes, the franchisee will be an immigrant or have limited English language skills. 
 
The universe of franchise systems whose offerings fall within some or all of these buckets (relatively smaller investment, second job, mobile workspace, relatively unskilled service) is enormous.  That’s why the issues prompted by states’ efforts to severely limit who can legitimately call themselves an independent contractor should be of critical concern to all smaller investment franchisors with a franchisee profile that includes, or is predominated by, one or two person (“Mom and Pop,” frequently) operators.  Moreover, the analysis that state attorneys general and courts make when faced with independent contractor issues often turns on legal issues that larger investment franchisors have in common with smaller investment franchisors.  That’s why these issues should be of concern to everyone in the franchise community.

How do these issues arise?
As is the case with many franchisor-franchisee relationship issues, the problem of franchisees’ status often arises in connection with other relationship problems; most notably termination.  When franchisees are profiting from their business and prospects for continued growth look good, issues concerning their independent status rarely arise.  When a business is either failing or has failed and a franchisee finds himself or herself without an income and no possibility of recouping costs sunk in the franchise, status as an “employee” of the franchisor may provide a financial lifeline not otherwise available.  Needless to say, as economic conditions remain challenging or further worsen, these types of claims are only likely to increase.  Alternatively, when a franchisee is unable to perform business due to a disability and no insurance is available either to pay the medical bills or replace lost income, a status claim may arise to gain the protection of a state workers’ compensation laws.

As if these one-off situations were not bad enough, recent developments suggest that plaintiffs’ attorneys are now actively looking to organize state-wide and nationwide classes of franchisees to challenge their independent contractor status.  While plaintiffs’ attorneys have had relatively little success to date in these endeavors, the limited success they have had strongly suggests that the number of attempts will only increase as will the success ratio.

Recent Franchisee Claims and State Enforcement Actions 
When franchisees decide to challenge their independent contractor status, they often rely upon independent contractor laws already on the books in several states.  Moreover, according to the International Franchise Association, 18 ICL laws have been introduced in 13 states in 2007-2008 alone.  The focus of these laws and proposed legislation is to crack down on employers who intentionally misclassify workers, often to pay them under the table, with no benefits, at less than minimum wages.  Some of these workers are seasonal, such as accountants brought in to work in tax season side-by-side with an accounting firm’s year-round employed accountants, and others are in construction or similar trades, employed by employers who simply wish to avoid benefits.  While these ICLs admittedly help to uncover and remedy wrongful employment practices, they may also ensnare legitimate franchise businesses, particularly small, investment-range franchises. 
 
Franchisees have also begun bringing lawsuits challenging their independent contractors status.  A recent example of this issue occurred in Massachusetts when a janitorial services franchisee operating as a sole proprietor without any employees sought and was awarded unemployment insurance after her franchise failed.  In Coverall North America, Inc. v. Commission of the Division of Unemployment Assistance, the Massachusetts Supreme Judicial Court agreed with the plaintiff that she was an employee and not an independent contractor because Coverall could not prove that the plaintiff could perform janitorial services for any customer wishing to avail itself of cleaning services.  In reaching its decision, the court failed to recognize the distinction between the franchisor’s primary business of selling franchises and the franchisee’s primary business of selling cleaning services to customers.  Instead, the court found that “the claimant was required to allow Coverall to negotiate contracts and pricing directly with clients, bill clients, and provide a daily cleaning plan to which the claimant was required to adhere” and therefore not truly “independent.”  Importantly, the court held that it was Coverall’s burden and not the franchisee’s to establish independent contractor status.  This approach, which strongly favors franchisees challenging their status, is sure to encourage further claims by franchisees.

While the Coverall case is limited to its facts and the ICL in a particular state may or may not address the nature of the specific relationship in a given franchise system, the rationale underlying both should give pause to both franchisors large and small.  All franchise systems exert some level of control of their franchisees.  Indeed, it is precisely that control that attracts franchisees to a particular system, i.e., the right to sell a particular product or service in a specified fashion using recognized trademarks.  Yet, franchisees are now using the lack of “independence,” for which they bargained and recent ICL laws never intended to address franchising to claim rights and benefits to which they were never entitled.  It appears that the law of unintended consequences is once again asserting its presence and franchisors of all shapes and sizes, especially those with franchisees who have few, if any, employees, and are conducting business as sole proprietorships, should proceed with extreme caution.

Arthur L. Pressman and Gregg A. Rubenstein are partners and members of Nixon Peabody LLP’s Franchise and Distribution Team, Boston office.   They can be reached at  apressman@nixonpeabody.com and grubenstein@nixonpeabody.com.