Surviving The Apocalypse: Strategies for Franchisors

By: Tami McKnew at Fox Rothschild, LLP

The franchise industry is facing its greatest challenges in its history, challenges that strike at the heart of a successful business model that has allowed trademark owner franchisors and trademark licensee franchisees entrepreneurial opportunities to build wealth. The vibrancy of the franchise industry is well-documented: nearly 800,000 franchised businesses employ 7.5 million workers; people of color, women, and veterans comprise more than 30% of franchisees, and franchised businesses generate revenues of approximately $670 billion. In short, franchising is a vibrant, progressive and very successful industry.

The foundation of the franchise industry is the relationship between franchisor/trademark (or service mark) owner and franchisee/licensee. A franchisor monetizes its trademarks or service mark assets by licensing them for use by a franchisee, affording both parties an opportunity to enjoy revenues from their use. The license, however, must include means by which the licensor prescribes and polices the quality of goods and services offered under the mark; this is accomplished via the franchise agreement. Quality control and policing use of the marks are obligations of all mark owners under the Lanham Act; failure to exercise quality control risks loss of the mark.

The current assaults on franchising go the heart of this franchisor/franchisee or licensor/licensee relationship that undergirds the entire industry. Recent federal and state regulatory and legislative proposals and actions threaten the ability and right of the franchisor to monetize its marks by licensing to third parties, and the ability of existing and prospective licensees to exploit licensed rights in their own businesses. In terms of functional economics, these governmental actions could destroy the ability of individuals to establish businesses by exploiting the good will of established brands and the know-how associated with those brands.

The Threats

Wolves in sheep’s clothing is perhaps an accurate description of the legislative and regulatory actions that pose an existential threat to franchising. They include:

  1. The PRO Act and the ABC classification standard

The pending Protect the Right to Organize (PRO) Act, if enacted, could do serious, and perhaps mortal, damage to the franchise industry. The Act would make sweeping changes to the National Labor Relations Act (NLRA), the Labor Management Relations Act (LMRA), and the Labor Management and Disclosure Act (LMDA). Most pertinent to franchising, the PRO Act would adopt the California ABC standard for determining employment status for purposes of the NLRA. Initiated in Dynamex Operations West, Inc. v. Superior Court,[1] the ABC standard was later a feature of Assembly Bill 5 (AB-5), enacted and codified as Section 2750.3 of the California Labor Code. Under that test, a worker is presumed to be an employee unless the hiring entity can demonstrate all of the following:

  1. The worker is free from control and direction of the hiring entity in the performance of the work, both under the contract and fact; and
  2. The worker performs work that is outside the usual course of the hiring entity’s business; and
  3. The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.

It is widely recognized that few franchisors would be able to demonstrate all three of these features. Thus, a franchisor would likely be deemed the employer of its franchisees and the franchisee’s employees under the ABC test, at least for purposes of the NLRA, negating the essential basis of the franchise relationship. Most significantly, application of the standard could rob franchisees of their investment in, and the value of, their businesses.

Exacerbating the risks under the PRO Act, misclassification of an employee’s status is an unfair labor practice, a violation of the NLRA. The penalty for each violation would be up to $50,000 for each misclassified employee, as each misclassification may constitute a separate violation. Penalties could be monumental. Other union-friendly provisions of the PRO Act include the effective elimination of Right to Work laws in twenty-eight states and the imposition of personal liability for labor law violations on corporate officers and directors in certain circumstances.

It is worth noting that the PRO Act does not directly affect the determination of joint employer status under statutes regulated by the Department of Labor (“DOL”), e.g., wage and hour laws. But the existence of legal support for an ABC standard in federal law may provide a critical rationale for the adoption of a similar joint employment standard by the DOL.

The momentum for passage of the PRO Act as part of the Biden administration’s infrastructure proposal seems to be waning, and passage of the Act in its present form is unlikely.[2] However, a number of states have adopted variations of the ABC test, including of course, California.[3]

  1. The Joint Employment Standard

The second troublesome factor is the joint employment standard. The Obama Department of Labor caused angst in the franchise industry in January 2016, when it adopted a joint employment standard that focused on “whether the employee is dependent on the potential joint employer who, via an arrangement with the intermediary employer, is benefitting from the work.”[4] The Interpretation explained that “the vertical joint employment analysis must be an economic realities test and cannot focus only on control.”[5] The Department described a seven factor analysis:[6]

  1. Does the putative joint employer direct, control or supervise the work performed “beyond a reasonable degree of contract performance oversight?”
  2. Does the putative joint employer control employment conditions, directly or indirectly, even if such control is not exclusive?
  3. Is the putative joint employer’s relationship with the employer a long-term relationship?
  4. Is the nature of the employee’s work repetitive, rote, relatively unskilled and/or does it require little or no training?
  5. Is the employee’s work integral to the putative joint employer’s business?
  6. Is the employee’s work performed on premises owned or controlled by the putative joint employer?
  7. Does the putative joint employer perform administrative functions related to employment, e.g. “handling payroll, providing workers’ compensation insurance, providing necessary facilities and safety equipment, housing, or transportation, or providing tools and materials for the work.”

The DOL’s action followed a ruling by the NLRB in Browning Ferris Industries of California, Inc.,[7] in which the Board held that a third party with indirect control could be held jointly responsible, with the direct employer, for actions taken by employees. This was the case regardless of whether the putative joint employer had ever actually exercised such control.

The franchise industry wrestled with the “economic realities” standard through the remainder of the Obama administration, urging the DOL and the NLRB to acknowledge the existence of bona fide franchise/franchisor relationships. The agencies ultimately did so, by focusing not only on a franchisor’s contractual right to control aspects of franchised operations, but on the franchisor’s use of that power. Thus, in 2018, the Trump-era NLRB concluded in Hy-Brand Industrial Contractors, Ltd & Brandt Construction Co.,[8] that the potential joint employer must have actually exercised joint control over the employee. The Board reiterated that position in Browning-Ferris Industries of California, Inc.,[9] declaring that a joint employer must possess and exercise direct and immediate control over at least one essential term or condition of employment.

A similar phenomenon occurred in the Department of Labor. The Trump DOL withdrew the Obama economic realities standard and engaged in a rule-making process that reverted to a control test of joint employment. However, in May 2021, mere days before the Trump rule was to become effective,[10] it was withdrawn by the new Biden administration. A new rulemaking process is anticipated.  

David Weil, Wage and Hour Administrator in the Obama administration, has been tapped to occupy the same position in the Biden administration. Whether or not the PRO Act becomes law, Weil may be inclined to either revert to the Obama era “economic realities” joint employment standard or could propose an even stricter ABC joint employment test.  The NLRB is wedded to existing legislation and cannot independently adopt all the changes featured in the PRO Act.[11] The Board could change its definition of employee, as it did before, however, in the course of its quasi-judicial activities.[12]

  1. State legislation

The states have also acted aggressively toward the franchise industry of late. As mentioned above, the ABC employee classification test, with variations, has been adopted in many states.[13] The California test is arguably the least franchise-friendly. The fate of the PRO Act does not affect those state laws.

In addition to its aggressive ABC test, the California legislature very recently but narrowly defeated the FAST Recovery Act, designated AB 257. That Act would have established unelected councils with power to establish industry-wide standards on wages, hours and working conditions in the fast food industry. In addition, it would have established joint liability for fast food franchisors and franchisees, substituting the council’s policies for the owner-franchisee.[14] The FAST Act failed by a mere three votes. It is likely to appear again.

  1. Surviving the Tumult

In the midst of such turbulence, franchisors and franchisees still have businesses to run. But how they might be able to do so depends on the ultimate outcome of the PRO Act, the composition of the NLRB, and the DOL’s rulemaking process? Here are some possible combinations that face the industry:

            Scenario 1:      PRO Act becomes law; DOL adopts ABC joint employment standard.

            Scenario 2:      PRO Act becomes law; DOL adopts economic reality joint employment. Standard.

            Scenario 3:      PRO Act fails; NLRB and DOL adopt ABC joint employment standard.

            Scenario 4:      PRO Act fails; NLRB and DOL adopt economic reality standard, broadly stated.

            Scenario 5:      PRO Act fails. DOL and NLRB adopt economic reality standard, including the requirement that a potential joint employer must possess and actually exercise direct control over at least one essential term or condition of employment.

As of this writing, it appears that the PRO Act in its present form will fail. However, the DOL could adopt an ABC employment standard through a rulemaking process, and the NLRB could apply the same standard in its decisions. When David Weil did his first tour of duty with the DOL, he authored the economic reality standard, but the Department ultimately acknowledged the essential nature of the franchisor/franchisee relationship with a “possess and exercise control” caveat. Whether Weil would push an ABC standard that negates the foundations of the franchise relationship is unknown.

An intersecting Venn diagram to the federal scenarios incorporates state actions, most importantly the adoption and scope of the ABC classification standard by a state. In California, for instance, regardless of federal activity, the ABC standard would likely declare the franchisor to be the employer of both the franchisee and the franchisee’s employees. As challenging as the current situation in California may be, a reappearance and passage of the FAST Act would work catastrophic changes in the fast food sector.

Finally, the adoption of employment standards that negate the independence of franchisees is likely to influence the application of vicarious liability principles. Franchisors and franchisees may be at greater risk of being found responsible for the actions of their “employees” under common law, due to the influence of either the ABC standard or the economic reality standard.

Unsurprisingly, there is no clear path through this environment. Decision-making in the fog of the unknown is risky but necessary. Beginning with a thorough review and understanding of all aspects of the franchise system, a franchisor should assess the potential financial and legal impact of joint employment responsibility and potentially increased vicarious liability risk under each of these possible scenarios. The critical question is:

            Does it make sense to continue to operate a franchise system, and if so, how can we minimize the impact of these challenges?

The decision tree is at once simple and complex, and there are at least as many answers as there are franchise systems. The suggestions below are just that – suggestions. The only absolute is that ignoring the issue is probably not the best choice.

If the answer to the overarching question is YES, a franchisor might consider the following potential ameliorating actions:

  • Reduce employment control factors to the minimum and tie operational standards closely to brand quality in franchise agreements and brand quality manuals (All scenarios).[15]
    • Downside: Many franchisees want more operational and employment guidance from the franchisor.
    • Downside: Unclear whether quality control required by the Lanham Act will preclude application of the ABC test.[16]
    • Downside: Removal of control risks loss of mark.
  • Train field personnel to focus on brand compliance only, consistent with franchisor’s focus (All scenarios).
  • Encourage/require franchisees to operate as corporate entities (All scenarios).
  • Raise wages and benefits in franchisor-operated locations, to avoid joint liability with its franchisees in wage and hour complaints (Scenarios 1, 2 and 4).
  • Seek out potential franchisees in radically different businesses, who can treat franchise outlets as portfolio assets, e.g., private equity investment entities, companies with multiple brand or business operations; or who can operate a franchise outlet as an adjunct to their regular business, e.g, supermarkets, universities, multi-brand concessionaires, gas stations (Scenarios 1 and 2).
    • Downside: Lesser control over franchise operations.
    • Downside: Divided loyalties of franchisees.
  • Grant franchises in locations over which franchisor has little or no ability to control work conditions, e.g., sports arenas, university campuses, convenience markets, supermarkets, recreation areas (Scenarios 3 and 4).
    • Downside: Lessor control over franchise operations.
  • Reassess/change the system financial model to anticipate increased expense and risk (All scenarios).
    • Require franchisees to escrow funds (e.g., equal to quarterly salaries).
    • Increase royalty payments or other fees.
    • Require additional or greater levels of insurance (e.g., EPLI).
    • Require irrevocable letters of credit from franchisees.
    • Downside: Franchise agreements may not permit.
    • Downside: Many franchisees will be priced out of the relationship; favors multi-unit franchisees.
    • Downside: Franchisee litigation.
    • Downside: May be unworkable long term.

If the answer to the question is NO, a franchisor should consider whether and how it can extricate itself from problematic franchise relationships. For instance, a franchisor might consider the following:

  • Terminate franchise agreements, based on force majeure, impossibility of performance, or a similar legal principle.
    • Downside: Limited by state laws.
    • Downside: Uncertain application of legal principles.
    • Downside: Franchisee litigation.
  • Buy out franchisees.
    • Downside: Franchise agreement and state laws may not permit.
    • Downside: Expensive to buy out franchisees.
    • Downside: Franchisee litigation.
  • Offer management contracts to franchisee in lieu of franchise.
    • Downside: Franchisee loses investment; needs incentive.
      • Offer franchisees stock in franchisor?
      • Include generous bonus on signing and going forward?
    • Downside: Accedes to employment relationship.
    • Downside: Creates a company-based system, with long term implications.
  • Terminate franchise agreements at end of franchise term.
    • Downside: Delayed effect, risk remains prior to expiration.
    • Downside: May be limited by terms of franchise agreement or state law.
    • Downside: Franchisee litigation.
  • Solicit purchase of locations by franchisees at end of franchise term.
    • Downside: Will require relaxation or waiver of post-term non-compete and confidentiality obligations.
    • Downside: Establishes competition for remaining franchisees and/or franchisor.
    • Downside: Delayed effect, risk remains prior to expiration.
    • Downside: Favors multi-unit, well-heeled franchisees.

If the answer to the question is YES in some states, but NO in others, the franchisor will apply different rationales in different states. In that instance, the franchisor might consider establishing separate corporate franchising entities in states impacted by strict ABC statutes, to which franchise agreements from those states are assigned. The franchisor could then consider the strategies described above or others, based on the specific situation in each state.

CONCLUSION

While the road ahead is uncertain, the potentially catastrophic effects of legislative and agency actions on franchisees and the public are readily apparent. Franchises may close entirely, destroying franchisee equity, eliminating jobs and eliminating entrepreneurial opportunities. Franchisees may become management employees, rather than business owners, depriving them of the opportunity to build independent wealth. The consuming public may lose service and product suppliers on whom they depend, and the country’s financial structure will lose or at least seriously hobble what is now a vibrant and valuable sector of the economy.

 

[1] 4 Cal. 5th 9013 (2018)

[2] It is doubtful that reconciliation is a potential path to enactment of the PRO Act. The reconciliation process is limited to budget-related legislation.

[3] Alaska, Arkansas, California, Colorado, Connecticut, Delaware, Georgia, Hawaii, Idaho, Illinois, Indiana, Kansas, Louisiana, Maine, Massachusetts, Montana, Nebraska, Nevada, New Hampshire, New Jersey, New Mexico, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, Tennessee, Utah, Vermont, Virginia, Washington, West Virginia, Wisconsin and Wyoming.

[4] Administrator’s Interpretation No. 2016-1, U.S. Department of Labor, January 16, 2016 (the “Interpretation”) Section II B.

[5] Id.

[6] Id. This list is a summary of the factors, each of which is more fully described in the Interpretation.

[7] 362 NLRB No. 186 (2015).

[8] 366 NLRB No. 94 (2018).

[9] 369 NLRB No. 139 (2020).

[10] The Rule was to go into effect in March 2021, but the Biden administration at first delayed its implementation, then withdrew the Rule.  

[11] The PRO Act would embed the indirect control standard into the NLRA.

[12] The NLRB traditionally has three members from the President’s party and two from the opposition. With staggered terms, the Board’s composition can be slow to change. However, with Biden’s recent nominations to the Board, control of the NLRB could change to Democratic as early as August 2021.

[13] See footnote 4, infra.

[14] In an ironically positive vein, the FAST act would make it very difficult to support a theory that the franchisor or the franchisee controlled or directed the employees of fast food franchises.

[15] Many franchisors began this practice in during the Obama administration, in light of the economic realities joint employment standards.

[16] The theory was successful in Massachusetts (an ABC state) in Patel v. 7-Eleven 485 F. Supp. 3d 299 (D.Mass. 2020). In that case, the court addressed a state ABC statute and its inherent conflict with the FTC Franchise Disclosure Rule and found that the federal rule must trump the state statute. The IFA filed suit in federal court in the Southern District of California, International Franchise Association v. State of California, Case No. 3:20- cv-02243, which includes a similar claim. A Motion to Dismiss is scheduled for hearing on July 12, 2021. Both of those cases challenged state ABC classification statutes; if an ABC standard is adopted federally (whether by statute or regulation), the Patel argument may not apply.