Making Lemonade: 2016 Legal Strategy Seeks to Overcome 2015 Legislative Lemons

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Last year’s legal developments must be confronted. As in the past, franchisors can find a way to use turn those developments into opportunities moving forward.

By Gaylen Knack, CFE

Let’s face it — 2015 was a tough year for franchisors when considering the wave of legal developments that arose during the year. The phrase “joint employer liability” became synonymous with evil and was seen as a direct attack on the core principals of franchising. It also was viewed as yet another attempt by unions — this time working through the U.S. National Labor Relations Board (NLRB) — to regain momentum after decades of declining membership.

The NLRB and joint employer liability was not, however, the only legal challenge facing franchisors. Franchisors faced parallel employment-related challenges from the Department of Labor as well as from states such as California and Washington, seeking to increase state revenues amid state budget shortfalls. State activity also spilled over into the franchise relationship arena as California amended its franchise law to further burden franchisors in such areas of transfers, terminations and repurchase obligations.

Other employment-related initiatives included minimum wage increases, most notably in Seattle, that discriminated against franchise systems, as well as efforts to increase workers’ rights through various mandates such as employee scheduling. Finally, franchisors faced increased disruption in the SBA loan process and faced a state franchise administrator-led (NASAA) proposal to restrict the increasingly widespread use of financial performance representations in the franchise sales process.

All of these legal developments appeared to leave franchisors and their franchisees battered and bruised, and raised questions as to whether the franchise model itself would be seriously damaged.

While people can disagree as to the long-term impact of legal developments in 2015, early indications suggest that 2016 will not be nearly as sour and that many of the lemons of 2015 can be turned into lemonade. First, the International Franchise Association and others have had time to digest the legislative initiatives of 2015, as well as more recent developments suggesting a moderation of harsher rhetoric from the NLRB and others. In addition, franchisors can take productive steps to minimize the potential damage caused by these developments and, in doing so, strengthen their franchise systems long term.

The NLRB’s attack on McDonalds USA in December 2014 and a widely proclaimed change in its interpretation of joint employee liability caught many in franchising by surprise. As 2015 came to a close, however, the NLRB appeared to moderate its position without abandoning its viewpoint that a franchisor’s potential control (vs. actual control) of the terms of employment for its franchisee’s employees was sufficient to find joint employer liability. More specifically, comments from the NLRB’s General Counsel, Richard Griffin, at the American Bar Association’s Forum on Franchising, suggested that the NLRB would pursue franchisors only in more limited situations in which franchisors retain the right to exercise control over the “terms and conditions” of employment of their franchisees’ employees. While Mr. Griffin would not agree to provide IFA with further guidelines helpful to franchisors, the NLRB’s published analysis in the Freshii’s advice memorandum does provide franchisors with guidance to reduce risks of joint employer liability. Separately, the association and the IFA-led Coalition to Save Local Businesses have initiated proposals at the federal and state level to protect the franchise model and reinforce the long-standing position that joint employer liability requires a practical, not theoretical, analysis of franchisor control. Finally, many anticipate that the results of the 2016 presidential election will have a significant impact on future administrative policies including this issue.

At the state level, an IFA-led coalition was largely successful in moderating a far-reaching proposal in California that would result in monumental shifts in the regulation of the franchisor-franchisee relationship. The final compromise resulted in amendments to California’s franchise law that, while impacting franchisors to varying degrees, could have been much worse. More importantly, the end result likely reduced concerns that other states will follow suit and adopt similar far-reaching legislation. While franchisors can anticipate continued sporadic efforts at the state level to alter or introduce franchise relationship laws, early indications suggest that franchisors and their franchisees will focus more intently on legislative and governmental administrative policies that directly impact franchisee profitability such as union-led minimum wage initiatives.

Some uncertainty from 2015 developments does remain involving SBA loan delays and NASAA’s initiative to create a more restrictive environment for use of financial performance representations (FPRs). SBA delays in approving franchisor applications under the SBA Franchise Registry remain a problem. Fortunately for franchisors, efforts have been made to reduce the SBA bottleneck and hopefully reduce delays in SBA-backed financing. In addition, a favorable lending environment has led to the availability of other lending options that may reduce franchisor and franchisee reliance on SBA-backed financing for franchise development. As for NASAA’s FPR initiative, the administrative body delayed finalizing its FPR proposal following comments received from the franchise community. Hopefully, NASAA will alter certain flawed assumptions and release a final guideline that continues to encourage, not restrict, franchisor use of FPR’s in the franchise sales process.

Franchisors do not need to wait for factors outside their control to minimize the impact of the legal and political lemons of 2015. They can play a direct role in minimizing the impact on themselves and their franchise systems. Franchisors can significantly reduce the risk of joint employer liability by reassessing their control over the operation of the franchisee’s business and, specifically, control over working conditions of the franchisee’s employees.

In reassessing control over franchisee operations and employees, franchisors should focus on three areas: the franchise agreement (and related agreements), the operations manual, and day-to-day operational advice and communications. As the franchise agreement serves as the framework for the franchisor-franchisee relationship and contains few operational details, most franchisors will find that they need to make only minimal changes to the franchise agreement. That news is good, as significant modifications to franchise agreements for an entire system can be difficult to implement quickly.

The primary focus of franchisors in reassessing system-wide controls should be the operations manual. The operations manual is the “black hole” into which franchisors often throw policies, standards, recommendations and other communications respecting the franchise system. Because franchisors often define the operations manual as a manual that includes any and all system-related communications, this all‑encompassing document can become a land mine for franchisors.

In reviewing the operations manual, franchisors should: (1) determine the policies, guidelines and other communications that make up the operations manual; (2) establish a framework for the manual that is flexible but not limitless; and (3) remove directives and other controls that do not directly protect the quality of the brand, product or service.

Finally, franchisors should review franchise operational support and other communications with franchisees to insure that those activities are consistent with the level of control exercised through the operations manual.

Franchisors that carry out this reassessment of the operations manual and operational support can benefit in other ways. First, cleaning up the operations manual can reduce conflicting or outdated messaging to the system. Second, to the extent a review leads to a reduction in certain controls over the franchise system and franchisees, the franchisor can reduce its exposure to vicarious liability claims. As the operations manual often is one of the most overlooked aspects of the franchise system, close evaluation of the operations manual can benefit franchisors and franchisees on several fronts.

Franchising has faced challenges in the past and the model has shown resilience in addressing those challenges. The legal developments of 2015 remain lemons that must be confronted but, as in the past, franchisors can find a way to use those lemons to make lemonade going forward.

Gaylen Knack, CFE, is an attorney at Gray Plant Mooty. Find him at fransocial.franchise.org