In a recent opinion, the Texas State Office of Administrative Hearings (SOAH) disagreed with a Texas franchisor that claimed rent and other fees received from its franchisees were mandated by fiduciary duty to flow through to other entities and therefore not taxable revenue.

The Franchise Agreement and the Franchise Disclosure Document of the franchisor, an automotive maintenance and repair business with more than 150 franchises located nationwide, detail specific costs the franchisee is required to pay the franchisor, including the fees for rent, training, marketing, IT support, and software. The franchisor subleases the locations to, and collects rent from, the franchisees. There was no evidence establishing the amount the franchisor pays to third parties for services, such as software. Furthermore, the Franchise Agreement contained an Independent Contractor clause, indicating, in part, the terms of the agreement should not be construed to create an agency relationship. 

Nonetheless, the franchisor claimed that it had a fiduciary duty to distribute rent payments and other fees to the third parties. Therefore, those collected fees constitute flow-through funds and were not taxable revenue under Texas Tax Code §171.1011(f). Fiduciary duties arise either as a matter of law, such as in a trustee relationship, or informally, such as in a moral or personal relationship of trust and confidence. However, ordinary contractual duties do not rise to the level of a fiduciary relationship. The SOAH found the franchisor’s duties to pay rent and other fees to third parties were ordinary contractual duties and did not rise to the level to those of a fiduciary.

The franchisor also claimed that the payment of rent and other fees on behalf of the franchisee was mandated by law. Similarly, the SOAH found that the payments were governed by ordinary contractual duties and were not mandated by law.

Because the payment of rent and fees on behalf of the franchisees did not amount to a fiduciary duty and was not mandated by law, the franchisor was not entitled to exclude the collected fees from revenue and was required to pay taxes on the collected fees.

 

More and more states are launching online portals allowing franchise systems to file initial registrations, exemptions, renewals and amendment applications electronically.    The Indiana Secretary of State, Securities Division launched the Indiana Securities Portal  exactly one year ago.  According to the Indiana Division, the implementation has been very successful and the feedback over the past year has been very positive.   As a result, the Division decided that the portal will be the sole filing mechanism for a number of filings reviewed by the Division beginning in the new year.

Mark your calendars!  Effective January 1, 2020, franchise exemption requests and registration registrations and all amendments, supplemental materials and associated payments will only be accepted electronically through the Indiana portal.   Any filing, amendment, supplemental material or associated payment received outside of the portal after 1/1/2020 will be returned to filer with instructions to use the portal.     Questions about this new procedure can be directed to the Securities Division here.

Indiana joins Minnesota, Rhode Island, Utah, Washington and Wisconsin as the list of states that accept or require online filings for franchise registrations, renewals and amendments.    Many of these states, like Washington, concluded that eliminating the need to make any paper or other physical submissions conserves time and resources of the applicant and the division.

If you have not yet made the switch to paperless in Indiana, then be sure to notify the paralegals, attorneys and staff tasked with preparing and submitting these filings.   Renewal seasons is right around the corner!

The new year is often a time when successful entrepreneurs with thriving business concepts start looking to expand their brand using a franchise business model.  Franchising is an excellent way to grow a business rapidly, penetrate new markets, and leverage investment from the capital infusion and energy of franchisees.    However, there are a few very important steps we always recommend to clients committed to pursuing franchising before deciding to take the plunge.  With 2020 on the horizon, let us provide you with a list of tips to get you ready to launch!

  •  Develop a Profitable Business.  While this step may seem obvious, many businesses decide to franchise before having at least one business unit with at a few years of strong operating and financial performance that can provide prospective franchisees with proof of concept.  You also have to consider whether your business concept is likely to be profitable for franchisees after taking into account ongoing royalties, advertising, technology, and other fees.
  • Research Competitors in the Industry.   Do competitive analysis of not just franchise systems that directly compete in a certain industry sector but concepts with similar financial models.  For example, if you are a remediation service franchise, then a prospective franchisee may be comparing a cross range of service-based mobile models with similar price-points (lawn care, handy work, painting, or dryer vent cleaning, for example).
  • Organize the How-To.     Any sustainable franchise system will need to provide its franchisees with an Operations Manual that includes the processes, procedures, and methods of the franchise system concept.    The Operations Manual is the go-to resource for franchisees and key topics include: business overview, initial training, marketing and advertising, approved suppliers, required equipment, site selection (if applicable), inventory, and customer service.
  • DRILL DOWN on the Costs.   Remember that launching a franchise system is a new business in and of itself.    You will may need capital or financing to ensure you have the infrastructure in place to support your franchisees and the necessary business advisers retained to assist in the process (accountants, attorneys, potential franchise consultants, and new personnel, like trainers).
  • Confirm Your Trademark.  You should confirm that your business owns a federally registered trademark, and, if necessary, take steps to federally register all trademarks associated with the brand.  Franchise counsel should include this as part of a comprehensive package to get new systems prepared to franchise.

The beginning of a calendar year is often an excellent time to launch a new franchise system from a regulatory and accounting perspective.   If your fiscal year is 12/31, then  launching in the beginning of a calendar year provides you an entire year of use before annual updating is required.  This saves time and money, two things many start-ups don’t have in excess.   If you are ready to move forward, then discussions with an attorney with experience in franchising is an appropriate next step.

 

New York passed a cybersecurity and data breach law, effective October 23, and it expands many cybersecurity requirements to not only businesses operating in New York, but also those operating outside of the state. The SHIELD Act, as it is called, expands the scope of the current law by requiring covered entities to adopt a comprehensive data protection program and comply with additional data breach notification requirements.

The SHIELD Act expands the definition of private information to include biometric information and bank account or credit/debit card numbers, regardless of whether a password or security code is associated. Additionally, private information also now includes a username or email address in combination with a password or security question that would allow someone to access an online account.

The compliance requirements have also been expanded. If a business is not defined as “small”, it must designate and train employees to be responsible for compliance; require any third-party providers be capable of maintaining cybersecurity practices, with this requirement in the contract; perform risk assessments and monitor the effectiveness of the cybersecurity program; have safeguards in place to respond to attacks or failures; have processes for the disposal of private information; and update the cybersecurity program.

Obviously, franchisors and franchisees operating in New York must review the components of the SHIELD Act to ensure compliance. Moreover, employers who are not located in New York may still be required to comply with the SHIELD Act if they solicit or accept applications from a New York resident, if private information is part of this process. This is one area in particular where the Act could impact a non-New York franchisor. Many franchisors accept franchise applications from across the country, including from residents of New York. Although the franchisor may not be defined as an employer, it is a good practice for franchisors to review their cybersecurity systems to ensure compliance with the New York SHIELD Act. Moreover, any franchisees operating in this state must review the components to ensure they are following it.

Cybersecurity issues and data privacy laws are only going to become more complex, and the cost of compliance will likely increase. At the same time, this is a small price compared to the possible issues should there be a breach.

It’s the holiday season, but franchise lawyers may find little in recent events to celebrate. The challenges just keep on coming!

Most recently, we’ve been challenged by California’s AB5 legislation and Dynamex decision, the DOJ’s brief foray into challenging “no poach” provisions and the State of Washington’s energetic embrace of that campaign. Unfortunately, recent developments are not encouraging.

On the mildly positive side the DOJ’s antitrust chief testified in hearings before the House that no poach provisions can protect franchise owners’ investment in training, which is beneficial to franchisees. There’s little to indicate that the state of Washington will be swayed by the DOJ’s pro-competitive view of no poach clauses, however. In a written statement the Assistant AG for the State of Washington confirmed that its “goal is to end no-poach practices. Period.” The only other piece of mildly positive news is that Uber and Lyft are moving forward with a ballot proposal aimed at reversing Dynamex, but the proposal is directed to gig workers.

The disappointing news far outweighs the very dim bright spots. New Jersey is the latest state to introduce new AB5-type legislation; that happened a little over a week ago. Also on the AB5 front, the Ninth Circuit rejected Jan-Pro’s bid for rehearing in the Dynamex case. State and City attorneys in California, San Francisco and Oakland petitioned for a rehearing of Dynamex as well, but took a decidedly different position than Jan-Pro, arguing for an extension of the ABC test to include franchising. Their position statements suggest that the franchise community can expect governmental action to aggressively enforce AB5, particularly in the franchise industry, when it goes into effect in January.

Just to pour on the challenges, the FTC and Congress have been encouraged to take regulatory and/or legislative action to prohibit non-competes in certain circumstances. State AGs have urged the FTC to issue regulations to declare “abusive . . . non-compete clauses as an ‘unfair method of competition’ and per se illegal under the FTC act for low wage workers or where the clause is not explicitly negotiated.” [1]  While the FTC Act does not provide a private right of action, such a declaration may support a baby FTC claim under state law in a private civil action.

Meanwhile, state and federal bills to limit non-competes have been multiplying. Several states have passed laws prohibiting low wage workers from signing non-competes, including New Hampshire, Maine and Maryland. In October, the proposed Workforce Mobility Act was reintroduced in Congress; if enacted, it could establish a nationwide standard for the enforcement of non-competes. The Bill largely tracks the California approach, essentially barring non-competes, except in the context of business sales or partnership dissolution. Needless to say, if it gains traction, the Bill is at best problematic in the franchise context.

So, Happy Holidays?

[1] November 15, 2019 letter from Attorneys General of Minnesota, California, Delaware, DC, Illinois, Maryland, Maine, Iowa, New Mexico, North Carolina, Oregon, Pennsylvania, Rhode Island, Vermont, Virginia, Washington, and Wisconsin to Chairman of the FTC.

So we’ve talked a bit over the last couple of weeks about California’s AB-5 and the implications for franchising. But maybe you would like to learn more? Then you’re in luck! On Monday, October 28, 2019, at 9 am PT (12 noon ET), my colleagues Tami McKnew and Nancy Yaffe will be presenting a webinar entitled “Preserving Your Franchise System in the Face of California AB-5”. The webinar will cover:

  • Analyzing the potential risk in a wait-and-see approach
  • Implementation of the “A-B-C Test” in the franchise context
  • Strategies for limiting and isolating exposure from California-domiciled franchisees
  • Utilizing franchise agreement provisions to ensure maximum flexibility
  • The potential to mitigate exposure with insurance coverage

Don’t miss this great event. You can register here.

I admit I was among the scores of franchise lawyers whose blood pressure skyrocketed with passage of California’s AB 5. If a Franchise Agreement establishes an independent contractor relationship between franchisor and franchisee, will the A-B-C test render the franchisor the employer of the franchisee? And if that’s the case, how is the franchisor NOT the employer of the franchisee’s employees? Absent a statutory exemption for franchises, AB 5 invited those dark queries.

I’m exhaling now, and my blood pressure has subsided. The Ninth Circuit’s opinion in Salazar v. McDonald’s Corp., issued October 1st, supplies the exemption that AB 5 lacks. Rejecting the plaintiffs’ argument that the 2018 decision of the California Supreme Court in Dynamex Operations West, Inc. v. Superior Court controlled the employment analysis, the Ninth Circuit wrote that the “case has no bearing here, because no party argues that the Plaintiffs are independent contractors.”

The opinion provided further good news on the joint employer front. Although McDonald’s provided training, required use of its POS system, offered the franchisee use of its HR package software, and required the franchisee’s workers to wear uniforms, McDonald’s was not the joint employer of the franchisee’s employees. The franchisee, not McDonald’s, controlled hiring, firing, and work conditions. Importantly, the Court applied established California precedent, including Patterson v. Domino’s Pizza, Curry v. Equilon and S.G. Borello & Sons, Inc. v. Dep’t of Indus. Relations to guide its analysis.

We can walk back from the ledge, despite the vagaries of AB 5. That is, unless you or your client is a franchise system in which the franchisee depends on the services of independent contractors. The independent contractor model is common in some service industries, and the Ninth Circuit’s language will do little to calm nerves in that sector. Implicit in the Court’s pronouncement that Dynamex (and by extension AB 5) has no bearing “because no party argues that the Plaintiffs are independent contractors,” is that Dynamex (and AB 5) will apply when franchise workers are independent contractors.

McDonald’s naturally leads to the observation that franchisors whose systems use an independent contractor model for franchisees’ workers should consider restructuring to incorporate an employment model. Of course, that might be easier said than done. And there are still open issues to keep us on edge. For example, how safe is a franchisor where the franchisee’s workers are individuals operating under a DBA or single owner LLC? Or where, like the Vasquez v. Jan-Pro case (still winding its way through the California courts after being remanded by the Ninth Circuit,) there is a multi-layered franchise system with a regional and then a national franchisor? The impact of the new law on those models is still in play.

So exhale cautiously.

As noted in our first post on this topic, California’s AB-5 codified the employment test set forth in Dynamex Operations West v. Superior Court of Los Angeles, 4 Cal. 5th 903 (2018). Although the full implications of this new law are unclear, it will like have a major impact on the franchise industry.

If, as widely expected, AB-5 means that most franchisors will be considered joint employers of their franchisees employees, there will be both disadvantages and advantages . With the inevitability of joint employment, a franchisor might consider more closely monitoring a California franchisee’s employment practices, providing guidelines for hiring, firing, scheduling, and the myriad of other practices that affect franchise staffing. Against the possibility of greater control over employee practices, however, is the inevitability of increased cost and risk to the franchisor and franchisees. Will franchisors be willing to bear these costs, or will they be passed through to franchisees? Surely the latter. Royalty rates, franchise fees, and other in-term fees are likely to increase, if and when individual franchise agreements permit it.

In the short term, however, franchisors will reasonably turn to insurers. The risks exposure can affect franchisors across multiple lines of coverage. The biggest impact will most likely be felt in the EPLI and franchisor E&O insurance areas of coverage. At the outset, it is more important than ever that franchisees carry EPLI insurance. Bear in mind that “additional insured” status for the franchisor is typically not available on franchisee EPLI insurance policies.   A few carriers today will provide a sublimit of coverage for the franchisor under the franchisee’s EPLI policy for joint employer issues.

Franchisors should carry their own EPLI coverage as well if the courts determine the franchisor to be a joint employer. However, potential expanded joint employer liability exposure under AB-5 could impact a franchisor’s ability to secure affordable and adequate EPLI coverage. Franchisors should contact their broker to discuss insurance options in light of AB-5.

AB-5 was intended to benefit workers, including franchise employees, who are viewed as underpaid and overworked. Regardless of one’s opinion of the veracity of the assumption, the ultimate effect of AB-5 may be quite the opposite. The law may result in fewer franchisee employers, fewer employment positions in franchises, fewer entry level employment positions, and increased costs and control for franchisees who continue to operate in California. Is that really what the California legislature intended?

This is the second post regarding AB-5. The first post, which can be found here, discusses the law itself as well as suggestions for franchisors with existing franchisees in California.

“Some day, California’s going to fall into the ocean” usually refers to the San Andreas fault. Now it may refer to AB-5, and the future of the franchise industry in California.

The California legislature has now passed AB-5, and Governor Newsom has signed it into law. AB-5 codifies the Court’s decision in Dynamex Operations West v. Superior Court of Los Angeles, 4 Cal. 5th 903 (2018), which horrified the franchise industry last year. Application of Dynamex’s A-B-C employment test to the franchise model will likely result in most franchisors being deemed the employer of its California franchisees’ employees.

Opposition to AB-5, including organized opposition from the franchise industry, despite monumental efforts, has resulted in vague promises to “fix” the law in the next legislative term. But what aspects are amenable to revision, and whether California legislators will rally behind amending legislation, are anyone’s guess. Many commentators have discussed the implications of AB-5’s codification of the Dynamex ruling, but how to plan for the sweeping impacts of the law are less frequent topics. Business as usual is one choice, but wise franchisors aren’t holding their breath and waiting for a legislative fix. They are beginning to act now.

What can/should franchisors do now? How AB-5 will be enforced is anyone’s guess. In the immediate face of uncertainty, franchisors with only a small number of franchisee units may withdraw or refuse to locate in California; large, sophisticated franchisors may curb expansion in the state.

Withdrawal is an extreme choice, and undoubtedly faces legal hurdles, at the very least those imposed by franchise agreements. Stalling any future expansion is a relatively easy choice. But if a system already has a healthy population of franchisees, what else might a franchisor do?

Does it make sense to quarantine a franchisor’s California system into a separate corporate entity? That may not change the situation in California, but the specter of joint employment might not taint the system in other states. The existence of a separate California franchisor entity might also create more agility in the system, as the full implications of AB-5 develop or the “legislative fix” becomes a reality. Agility will be at a premium as the franchise industry responds to a changing legal environment. Planning needs to begin now, and aimed for expeditious implementation.

This is the first in a two-part post regarding AB-5. The second post will discuss important considerations in planning for joint employment implications as well as insurance concerns.

For over 40 years, Amzi Takiedine had been a 7-Eleven franchisee when he sued his franchisor in the United States District Court for the Eastern District of Pennsylvania. The case, Azmi Takedine v. 7-Eleven, Inc. has two published decisions. The case presents an explanation of the state of the law in Pennsylvania regarding the elements of breach of contract and the implied covenant of good faith and fair dealing.

Mr. Takiedine alleges that 7-Eleven was attempting to force older franchisees to end their franchise relationship so the franchisor could entered into franchise relationships with new franchisees on more favorable terms. He alleged that he was being coerced into doing so by 7-Eleven withholding store maintenance and repairs the franchisor was obligated to perform, being required to buy goods from expensive preferred vendors, and falsely accused of violating the franchise agreements. He claimed that this conduct was tantamount to termination and a violation of the implied covenant of good faith and fair dealing while he continued to operate his franchise.

The implied covenant of good faith and fair dealing has been the subject of many court opinions, some seemingly conflicting and others which take it for granted. Many judges will ask in settlement context, “How can you come to my Court and say your client is not required to act in good faith in the performance of the franchise agreement?” Others will say the UCC requires in the sales of goods that all parties act in good faith, so why is franchising different where livelihoods are at stake? The answer lies in the nature of the franchise relationship, where the bargaining power in favor of the franchisor seems overwhelming, but the consequences to the franchisor in the event of franchisee breach are disproportionate. Courts should be reluctant to imply contractual terms in these settings.

In this case, Judge Pratter in her June 27, 2018, decision dismissed the claim that the implied covenant of good faith and fair dealing applies when the franchisee continues to operate the franchise. Unlike the UCC, good faith and fair dealing is not implied in every contract under Pennsylvania law. Pennsylvania provides that “in the context of franchise agreements, a franchisor has a duty to act in good faith and with commercial reasonableness when terminating a franchise for reasons not explicit in the agreement.” This conclusion is compelled because the implied covenant cannot override explicit language in a franchise agreement, so it can only apply where (a) the grounds for termination are not explicit in the agreement and (b) only where the relationship is being terminated. The Court acknowledged that although the Pennsylvania Supreme Court had inferred that the implied covenant might apply to franchise disputes outside of termination issues, the federal courts in the district have followed the explicit limitation of the Supreme Court of Pennsylvania to apply the covenant only in the termination context.

The same logic compels the same conclusion when dismissing the constructive termination claim because the business continued to operate. The Court analogized this situation to where constructive termination of an employment relationship does not occur until the employee separates from employment. Similarly, by analogy to Mac’s Shell Service, Inc. v. Shell Oil Products Co. LLC, (U.S. Mar. 2, 2010), termination under the Petroleum Marketing Practices Act does not occur until one of the elements of the franchise is eliminated so that the business cannot operate. Judge Pratter concluded that a bright line test for constructive termination would be instructive to practitioners. Mr. Takiedine was permitted to amend his complaint to address the breach of contract claims to address the specific contract provisions breached.

Judge Pratter’s opinion dated February 22, 2019 discusses the application of the elements of contract breach to various claims by the franchisee. Mr. Takiedine alleged that 7-Eleven failed to provide fair and accurate merchandize audits. This breach of contract claim was dismissed for failure to timely object to the audit as required by the franchise agreement. Mr. Takiedine next argued that 7-Eleven failed to market and advertised as agreed. This claim was dismissed because the franchise agreement reserves the right to spend advertising in the sole discretion of 7-Eleven. Mr. Takiedine then claimed that 7-Eleven will increase its share of the profits at his expense unless the recommended vendor requirement is met. The recommended vendor claim was dismissed because Mr. Takiedine did not show how this provision was violated or harmed plaintiff.

The Court did sustain three contractual claims of Mr. Takiedine. 7-Eleven was contractually obligated to repair and maintain the roof and parking lot as it deemed necessary. The Court held that it was a factual issue whether these repair and maintenance issues were actually necessary. Mr. Takiedine also argued that 7-Eleven breached the provision of the Franchise Agreement to treat the franchisee as an independent contractor. The Court held that it was premature to determine whether this provision was breached as there were allegations that 7-Eleven controlled the means and manner of operation. Finally, an open contract claim remained regarding conflicting agreements regarding credit card fees because the record had not yet been developed sufficiently.

The last opinion is noteworthy because it also compels arbitration of claims involving vendor negotiating practices and allows unjust enrichment and conversion claims to proceed past the pleading stage. The case provides useful direction on how to proceed and analyze complex tort and contract claims which arise in long term franchise relationship.