The interpretation and enforcement of non-competition covenants is always a hot button issue and varies from state to state. In Our Town v. Michael Rousseau and Jennifer Rousseau, the United States District Court for the Middle District of Pennsylvania (“Court”) granted a temporary restraining order filed by a franchisor, Our Town, against its former franchisees to prohibit them from operating a competing business in direct violation of the terms of the franchise agreement.

Copyright: jossdiim / 123RF Stock Photo
Copyright: jossdiim / 123RF Stock Photo

Here, on the same day that the former franchisees sent a letter to Our Town in November 2016 to inform Our Town that it was terminating the franchise relationship, Our Town learned that the former franchisees were operating a similar publication called “Home Town” in the same geographical region as its former franchised business.

As such, Our Town filed for a temporary restraining order to prevent such competitive conduct because it violation of the franchise agreement. In interpreting non-competition covenants in franchise relationships in Pennsylvania, courts look to the rule in Piercing Pagoda, Inc. v. Hoffner, which provides that non-competition clauses will be upheld in Pennsylvania if the clause relates to a contract for the sale of goodwill or other proprietary interests, the clause is supported by sufficient consideration, and the restriction is reasonably limited in time and scope. The Court first determined that the covenant is ancillary to sale of a business interest (the Our Town franchise and its goodwill) and that the $3,800 franchise fee was sufficient consideration.

Next, the Court analyzed the language of the franchise agreement in connection with the Piercing Pagoda standard, which provided that the former franchisees could not operate any business that is similar to the former franchised business for a period of three years after the termination or expiration of the franchise agreement either at the franchise location or within fifty miles of any Our Town franchised location. Further, the franchise agreement provided Our Town with the right to seek injunctive relief for violations of the non-competition covenant. The Court held that these restrictions were reasonable because other courts in Pennsylvania had also held three-year time limits and 50-mile geographical limits to be reasonable. However, please note that the Court did not specifically rule on whether the entire geographical restriction was reasonable; only that part which applies to the operation of a competing business in the same location as the former franchised business. As such, in granting the temporary restraining order, the Court held that Our Town was likely to succeed in showing that the former franchisees acted in direct violation of the franchise agreement and that such provisions of the franchise agreement were enforceable. Further, the Court held that Our Town will suffer irreparable injury in the absence of this relief because Our Town’s legitimate business interests will be affected and the harm to the non-moving party, former franchisees, weighs in favor of granting the injunction due to the self-inflicted nature of the harm.

With that said, drafting an enforceable non-competition covenant is a very complicated task and should be approached with care. It is important to keep in mind that all restrictions must be reasonable in geography, time and scope of activities. Lastly, it is important that a franchise agreement contain language that provides a franchisor with the immediate right to obtain injunctive relief to stop such behavior.

Many franchisors have experience with the U.S. Small Business Association (“SBA”) as numerous franchisees utilize the SBA’s loan programs for small businesses. Previously, franchisors could send an application to the SBA to get on the Franchise Registry. During this process, the SBA reviewed the franchise agreement and drafted an addendum to revise the franchise agreement to avoid inclusion under the SBA’s “affiliation” rule (“SBA Negotiated Addendum”). This process was time-consuming and costly to all parties involved.

On November 22, 2016, the SBA issued an information notice to streamline the process for loan programs for franchised businesses (“Information Notice.”) The Information Notice became effective January 1, 2017. First, the SBA announced a revision to the principles of affiliation with respect to franchise programs. The SBA now focuses on whether the franchisee “has the right to profit from its efforts and bears the risk of loss commensurate with ownership.” 13 CFR 121.301(f)(5). This is the key factor in ensuring that the franchisee maintains its eligibility status as a “small business” .

Copyright: belchonock / 123RF Stock Photo
Copyright: belchonock / 123RF Stock Photo

In the Information Notice, the SBA stated that it would no longer review franchise agreements. Instead, the parties falling under the definition of a “franchise” (under the FTC Rule on Franchising) would be required to execute the new standard addendum (“SBA Standard Addendum”). Further, the SBA removed the Franchise Registry and SBA Franchise Findings List.

On February 14, 2017, the SBA issued a new policy notice outlining temporary changes to the new process for loans to franchisees (“Policy Notice”). Specifically, if a franchisor developed a SBA Negotiated Addendum with the SBA during 2015 or 2016, the franchisor can continue using that form of SBA Negotiated Addendum instead of the new SBA Standard Addendum. With that, the franchisor also has to sign the required form of certification (“Certification”), which is attached to the Policy Notice. The Certification certifies, among other things, that the SBA previously approved its SBA Negotiated Addendum and determined that the franchise relationship did not create an affiliate relationship. It also certifies that the franchisor has not revised the franchise agreement with respect to the terms that relate to affiliation.

Many franchisees utilize the SBA loan programs and it is important for franchisors and their legal counsel to be well-versed in this process to expedite the loan process . The Policy Notice expires on February 1, 2018, so franchisors must review and revise their process for franchisees seeking SBA loans.

In Gessele v. Jack in the Box, Inc., the franchise world got a win in the joint employer battle when the United States District Court for Oregon (“Court”) held that Jack in the Box, Inc. (“JIB”) was not the joint employer of certain employees of its franchisees as a matter of law using the economic reality test in granting summary judgment in JIB’s favor.

Here, several employees brought a putative class action lawsuit against JIB for violation of the minimum-wage and overtime provisions of the Fair Labor Standards Act (“FLSA”) and various other Oregon wage-and-hour laws as a joint employer. After a long litigation history that involved dismissing the first suit and the employees re-filing this suit, JIB moved for summary judgment arguing that it did not violate the FLSA or any other law with respect to the employees because it was not a joint employer.

Copyright: bluedarkat / 123RF Stock Photo
Copyright: bluedarkat / 123RF Stock Photo

In analyzing whether JIB was a joint employer of the employees, the Court utilized the “economic reality” test which outlines on four main factors including whether the alleged employer: (i) had the power to hire and fire employees; (ii) supervised and controlled employee work schedules; (iii) determined the rate and method of payment; and (iv) maintained employment records.

Pursuant to the factors listed above, JIB argued that it did not have any power to hire and fire employees, control employee work schedules, determine employee pay rate or maintain employment records citing relevant portions of the franchise agreement which state that franchisees are solely responsible for hiring and firing decisions, employee decisions and the day-to-day operations of the restaurant. Further, JIB relied on the testimony of JIB’s legal department, JIB’s franchisees and the employees themselves, which provided that the franchisees determine all conditions of employment for employees of the restaurant, are in charge of all hiring and firing decisions. Further, in actual practice the franchisees and its managers were in charge of all employment matters. The employees argued that while JIB did not have the specific authority to control these employment matters, JIB still fulfilled the economic reality test because JIB imposed very specific requirements for who the franchisees were allowed to hire, made franchisees’ employees use the designated time-keeping software and scheduling system, and maintained a collection of franchisees’ employee’s data through its required software.

In making its decision, the Court was unconvinced by the employees’ arguments and noted that the Ninth Circuit had previously found that franchisor/franchisee relationships with similar circumstances failed to surpass the requirements of the economic reality test. The Court utilized these cases as guidance for ruling in favor of JIB’s motion for summary judgment noting that the power to terminate a franchise alone is insufficient to create a joint employment relationship.

The Takeaway. It is of utmost importance to ensure that both the franchise agreement and franchise disclosure document contain language to protect the franchisor in the context of a potential case of joint employment. Best practices include making sure the franchise documents provide that all employment matters and day-to-day decisions are the sole responsibility of the franchisee. Additionally, please be aware that any court will examine the conduct of the parties and all circumstances surrounding the relationship in making a joint employment determination. As such, it is important not only to ensure that the franchise documents adequately protect a franchisor but that your actions are not in contravention to the explicit terms of the franchise documents, and that your training of franchisees and employees–especially regional staff–reflect this reality.

Copyright: bbbar / 123RF Stock Photo
Copyright: bbbar / 123RF Stock Photo

The attorneys of Fox Rothschild’s Franchising, Licensing & Distribution practice are excited to welcome associate Megan Center as she joins Fox’s franchise practice group.  Prior to joining Fox Rothschild, Megan spent four years at a well-recognized franchise boutique law firm in Philadelphia where she focused her practice on business transactions in the franchise context with an emphasis on state franchise registration and regulatory compliance.  Megan will work with the attorneys in the franchise practice group to provide general corporate and franchising counseling to start-up, emerging and established national and international franchise systems.   Moreover, as eagle-eyed readers may have already noticed, Megan will also be a frequent contributor to the Franchise Law Update.

Megan has experience drafting franchise disclosure documents, franchise agreements, consents to transfer, non-disclosure agreements and mutual release and termination agreements.   Megan’s skill and expertise are well recognized within the franchise community and she was named a 2016 Franchise Legal Eagle by Franchise Times Magazine, a prestigious list that highlights attorneys who have made significant strides in franchise law.

 

It is January and that means we are already counting down the days until the deadlines for updating your franchise disclosure document (FDD) and filing state franchise renewals are here.    Many franchisors’ fiscal year ended on December 31st.   The FTC gives a franchisor 120 days to update its franchise disclosure document (FDD) but some state deadlines many come much sooner.   Franchisors should already be gathering the information needed to update their FDD and file state renewal applications (if applicable).  Below are some quick tips franchisors should follow to ensure they meet the deadlines:

  1. Begin compiling the additional information needed to update your FDD in an organized and complete manner. This includes changes to executive personnel, disclosure of new litigation, updated financial performance representations under Item 19, and current franchise sales data for the 2016 year. If your outside or in-house counsel does not provide you with a renewal questionnaire or list of needed information to easily compile this data, then request they do so.

    Copyright: vician / 123RF Stock Photo
    Copyright: vician / 123RF Stock Photo
  2. Make sure that the outside or in-house counsel responsible for overseeing the final updates or filing state renewals are provided with accurate draft documents and other information with ample time to review, revise, comment, and finalize. Seasoned franchise counsel should have a streamlined system in place for handling updates and renewals. The starting place to this process, however, is getting accurate information from the franchisor.
  3. Pay extra close attention to states that recommend or require a renewal registration be filed in advance of the expiration date, such as California [pdf] and Rhode Island.
  4. Keep in contact with your accountants or finance division and remind them that the audited financials must be completed before April 30th. Many delays in updating an FDD will be the result of auditors not having adequate time to prepare the financials. For franchisors filing state registration renewals the deadline for the audit may be sooner. Some states require that renewal registration applications be filed days or weeks in advance of the 120 day deadline as stated above.  If you are filing state renewal registrations make sure you get your Consents of Accountant forms returned with the financials.

Failing to update or file renewal registrations on time can impede a franchisor’s ability to offer and sell. Therefore, it is important to get a head start on the process to give all parties involved adequate lead time.

50924014 - class action lawsuit concept as a plaintiff group represented by many judge mallets or gavel icons coming down as a symbol for social litigation or organized legal legislation.

Last week, the Supreme Court granted petitions for certioriari in Epic Systems Corp. v. Lewis, Ernst & Young v. Morris, and NLRB v. Murphy Oil USA.  All three cases involve clauses in arbitration agreements that require employees to waive their rights to pursue class and collective actions.

In theory, the Supreme Court will resolve a split between federal circuits and determine if employees can be compelled to litigate claims individually rather than in a class or collective action. However, because Justice Scalia’s seat remains vacant, it is possible that the justices deadlock.  In that case, the decisions of the circuit courts will be affirmed in each case and the split between the circuits will remain.

President Trump has a short list of potential nominees, but has not yet put forward a nominee for Justice Scalia’s seat that has been vacant for nearly a year.  It is unclear whether President Trump’s eventual nominee will be confirmed before these cases are decided.

In light of the Republicans’ steadfast refusal to even consider President Obama’s nominee Merrick Garland, Democrats are vowing to fight any Trump nominee.  It’s possible that the fight will be drawn out in addition to being nasty.  In order to overcome a filibuster that could block a vote on the nominee, Republicans would need 60 votes.  There are only 52 Republican senators.  Assuming every Republican votes for the nominee, some Democrats will have to jump ship before the GOP can obtain the votes needed to defeat a filibuster.

We will be keeping an eye both on the composition of the Supreme Court and these cases.

The question of whether a relationship between a watch manufacturer, Swatch, and a watch shop operator amounts to a “franchise” was answered in the negative by the U.S. Court of Appeals for the Third Circuit in Philadelphia in Orologio v. Swatch Group (U.S.) Inc. Here, after Swatch terminated its relationship with the operator, the operator brought suit against Swatch under the New Jersey Franchise Practices Act (“NJFPA”) claiming that Swatch’s termination of the relationship violated the NJFPA for termination of a franchise relationship without good cause.

Copyright: vician / 123RF Stock Photo
Copyright: vician / 123RF Stock Photo

Under the NJFPA, it is illegal to terminate a franchise relationship without good cause. However, in order to bring a lawsuit under the NJFPA, the parties must first establish that a franchise relationship exists. In determining whether a franchise relationship existed between Swatch and the operator, the Court utilized the community of interest balancing test, which focuses on the following four factors: (i) licensor’s control over licensee; (ii) licensee’s economic dependence on the licensor; (iii) disparity in bargaining power; and (iv) the presence of a franchise-specific investment.

First, the Court found that the operator was economically independent from Swatch because the operator derived only 25% of its revenue from Swatch and the operator still thrived after the termination of the relationship due to its relationship with other watch suppliers.

Second, the Court analyzed the “franchise-specific investments” submitted by the operator, including Swatch inventory as well as marketing, advertising and training costs. The Court determined that the inventory costs were irrelevant because Swatch offered to buy back the operator’s remaining inventory of Swatch required products. With respect to the marketing, advertising and training costs, the Court reasoned that these types of costs are inherent in the type of business the operator owns. Further, the operator failed to demonstrate that such investments were mandatory and the skills were not transferable to other inventory carried by it.

The Court also reasoned that there was not a significant disparity in bargaining power due to the absence of required, non-refundable investments. Lastly, the Court determined that Swatch did not exert the requisite level of control over the operator despite certain rules and limitations in place in connection with the sale of its watches. The Court determined these rules and limitations did not rise to the level of “unfettered control” over the operator, which is typical of a franchise relationship.

As such, the Court ultimately upheld the District Court’s grant of summary judgment in favor of Swatch ruling that no franchise relationship existed between the operator and Swatch. If you are creating a business relationship that you do not want to be considered a “franchise”, it is important to keep the community of interest factors in mind. Specifically, you want to ensure that each party maintains a significant degree of autonomy when structuring any relationship.

Is a franchisor liable as a “statutory employer” under Pennsylvania law if its franchisee fails to obtain workers’ compensation insurance?  The Pennsylvania Supreme Court recently answered “no” under the facts of Saladworks, LLC v. W.C.A.B. (Gaudioso). The decision is a victory for franchisor Saladworks on a narrow legal issue.  But it is a bigger win for the franchise model itself, which relies on the premise that a franchisor is not the employer of its franchisee’s employees.

Copyright: halfpoint / 123RF Stock Photo
Copyright: halfpoint / 123RF Stock Photo

In Saladworks, an employee of a Saladworks franchisee was injured on the job.  The franchisee did not have proper workers’ compensation insurance coverage.  Under Pennsylvania law, when an employee is unable to recover from its direct employer, the employee can file a workers’ compensation claim against a “statutory employer” under the Pennsylvania Workers’ Compensation Act.  If Saladworks was found to be a statutory employer, it would be liable for the employee’s injuries.

The Workers’ Compensation Judge initially held that Saladworks was not a statutory employer.  However, the Workers’ Compensation Appeal Board (the “Board”) reversed that decision and held Saladworks liable for the employee’s injuries.  The Board found that Saladworks was a statutory employer because it contracted with the franchisee to perform work which was a “regular or recurrent part of Saladworks’ business, occupation or trade.”

Here, the Board fundamentally misunderstood the franchise model.  Saladworks sells franchises.  Its franchisees sell salads and other food products.  For those familiar with franchising, these are distinctly different businesses.  In making its decision, the Board misinterpreted the franchise agreement, which (naturally) granted Saladworks franchisees the right to open a restaurant according to the Saladworks’ system.  The Board read this to mean that the franchisee was engaging in the same business as the franchisor, as if Saladworks had engaged a subcontractor to perform its regular duties.

On appeal, the Commonwealth Court reversed the Board’s decision.  It recognized the difference between Saladworks’ business model and the business engaged in by its franchisees.  In short, the court reasoned that “Saladworks is not trying to sell more salads . . . .”  The employee was injured while working for a franchisee engaged in the sale of food products, an entirely different business model than selling franchises.

The Supreme Court of Pennsylvania dismissed the appeal from the Commonwealth Court’s decision as improvidently granted. As a result, the Commonwealth Court’s holding remains intact.  Whether or not franchisors are liable if franchisees fail to obtain workers’ compensation insurance is a narrow issue.  But the decision was a victory for Saladworks nonetheless.  However, the big win is for the franchise model itself.  The Board’s decision was based on a fundamental misunderstanding of the relationship between franchisor and franchisee.  Had the decision been allowed to stand, it could have set a precedent for other cases dealing with broader issues.  The Commonwealth Court’s decision (as upheld by the Supreme Court) was based on a strong understanding of the franchise model, which will benefit franchisors and franchisees alike in future litigation.

A very important case for the retail industry–and all franchisors and franchisees operating within it–will be argued before the United States Supreme Court on January 10, 2017. The case is Expressions Hair Design v. Schneiderman. The issue is credit card surcharges.

The background is pretty simple. New York, nine other states, and Puerto Rico prohibit retailers from engaging in the practice of charging a surcharge when a customer uses a credit card. Importantly, the ten states involved are some of the biggest commercial states in the Union. In addition to New York, the list includes California, Texas and Florida. Those four states alone count over 107 million Americans–and each one is a major tourist destination in its own right.

Copyright: dacosta / 123RF Stock Photo
Copyright: dacosta / 123RF Stock Photo

The question before the Supreme Court changes depending upon who is framing it. The Petitioners, five New York state merchants, admit that New York law allows them to charge a higher price to those who pay by credit card. In fact, all states allow for such pricing. Their complaint lies with a state law which prohibits them from saying the higher price is a “surcharge”. Instead, New York law only allows merchants to offer “discounts” to those who pay in cash. The Petitioners allege that this law amounts to an illegal prohibition on their free speech rights under the First Amendment to the Constitution. Further, they claim the law prevents consumers from learning about the actual cost of using a credit card.

The Respondent, the New York Attorney General, responds that the law doesn’t implicate free speech at all. Instead, he argues that the law is a “classic form of price regulation”. All the law does, according to the Attorney General, is forbid the imposition and collection of additional fees from credit-card users in excess of the regular price for a good or service. Consequently, the Attorney General says the law governs conduct not speech. The Attorney General also makes an argument regarding the protection of consumers. Specifically, that the law prevents sellers from imposing special fees for those consumers who choose to use a credit card.

The issue of the difference between the regulation of speech versus conduct is extremely important. This is because a law regulating speech must pass the narrow constitutional test of “strict scrutiny”–which is a very high bar to meet. On the other hand, if the New York law merely regulates conduct in commerce, no special constitutional test is required.

As you might imagine, many, many amici briefs have been filed in this case on both sides of the issue. The case presents some very difficult questions at the intersection of commerce and speech. I personally am very excited about the upcoming argument–and we’ll continue to monitor the case, providing updates after argument and when a decision is handed down.

While the changes coming to Our Nation’s Capital in 2017 likely mean the end of the fight over reclassifying franchisees as employees at the federal government level, a recent New York state case suggests that the battle will remain alive and well at the state level. The case, In re Baez, was decided by the New York Supreme Court, Appellate Division. The question presented by the case was whether the franchisor, Jani-Pro Cleaning  Systems (“Jani-Pro”) was the employer of two independent franchisees for purposes of unemployment insurance contributions.

Copyright: axentevlad / 123RF Stock Photo
Copyright: axentevlad / 123RF Stock Photo

Baez was a franchisee of Jani-Pro who ceased his operations in 2009 and subsequently sought unemployment insurance benefits. At about the same time, the New York Department of Labor opened an unemployment tax audit of Jani-Pro. As a consequence of the combination of Baez’s application for unemployment benefits and the audit, the Department determined that Baez and all persons similarly situated—i.e., other New York franchisees of Jani-Pro—were employees of Jani-Pro and that Jani-Pro owed unemployment insurance contributions on their behalf.

Jani-Pro appealed and, after a hearing, an Administrative Law Judge reversed the Department’s determination. This decision, in turn, was reversed by an appeal board (“Board”), which reinstated the determination of the Department. Jani-Pro then appealed to the Appellate Division of the Supreme Court.

An extremely important consideration was that the Appellate Division showed great deference to the decision of the Board.  The Appellate Division said that whether an employment relationship exists is a factual question for the Board to determine and that no single factor was determinative of that question. The Appellate Division noted that there was evidence on both sides of the franchisee versus employee question. Nonetheless, it concluded that “substantial evidence” supported the Board’s determination.

The decision is far from detailed, unfortunately. Reading between the lines, however, it seems the Appellate Division was particularly troubled by the facts that Jani-Pro handled all of the franchisees’ invoicing and collections, and that Jani-Pro accepted all payments from the franchisees’ customers. The court also noted that Jani-Pro paid for the training of new franchisees, which is common in employment relationships. The court additionally explained that Jani-Pro maintained the relationship with a franchisee’s customers, retaining the right to discontinue the franchisee’s services “at any time”.

Nonetheless, the guidance offered by the Baez decision is limited. However limited it is, franchisors—and those franchisees who do not want to re-classified as employees—would be advised to take heed of the decision. Where exactly the line falls at which franchisors exert too much control over the operations of their franchisees can be a difficult call to make. It is always a balancing test. The Baez case shows, however, that the question will not go away solely because of the coming changes in Washington.