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.

In my recent experience, most franchise start-ups and emerging systems typically charge a technology fee or, at a minimum, reserve the right to charge a technology fee in the future.   These fees are easily justifiable.  Franchisors are routinely creating, developing, managing, and upgrading software programs, websites, phone systems, online platforms and similar technology solutions used by the system franchisees to effectively run their businesses.

As detailed in a recent issue of Franchising World by Keith Gerson, FranConnect undertook an interesting review and analysis of the use of technology fees in over 2,191 franchise disclosure documents over a three year period.  It found the following:

(1) 61.9% of all franchisors now collect technology fees.

(2) The vast majority of franchisors (60.4%) have a set fee while only 1.5% utilize a fee based on a percentage of revenue.

These statistics track experiences with our clients in recent years as well.  If your franchise system does not charge (or reserve the right to charge) a technology fee, your ability to adapt to changes in the marketplace may be impeded.   We represent a fair number of franchisors who will absorb (or at least share) in the cost of initial major technology overhauls that benefit franchisees.  However, this option is often only possible for very developed franchise systems.   Most franchise systems need the ability to shift the costs of new or improved technology to the franchisees.  This is an equitable allocation of costs, as franchisees will benefit from the technology on a daily basis.

How a system addresses the technology fee varies dramatically from franchisor to franchisor.  From a legal perspective, this means reserving rights in the franchise agreement with maximum flexibility as to cost and terms of collection (like timing and ACH withdraw when royalties are drawn).   Adequate disclosure in the FDD under Item 6 is also important.  Franchisors should keep in mind that state regulators could require the disclosure of a numerical value or limit placed on the amount a franchise system may collect.

However, there are considerations beyond the legal. Keeping the lines of communication open with franchisees is key.  Franchise systems must be able to articulate sufficiently why the technology is important.  Showing how it will increase efficiency, generate additional revenue in the long-term, or solve an existing logistical problem for the franchisees is critical.   If franchisees do not see the value to their business operations, then it may lead to disgruntled franchisees.  When the need for new fees is not adequately “sold,” then it can result in accusations that the franchisor is trying to unfairly shift its own cost of doing business or “wasting” franchisees’ hard earned profits.

The first step in creating or renegotiating a supply chain is understanding its component parts, and the roles each part plays: Producers, Manufacturers, Distributors, Retailers, and Consumers. These roles are not exclusive. For instance, the producer of a raw good, such as milk or software code, may also be the manufacturer of the finished good or service (in either case or collectively, a “supplier”), and manufacturers often handle distribution themselves, especially if the franchisor is the manufacturer. A franchisor could theoretically be the producer, manufacturer, and distributer all at once, and the distributor could also be the retailer if the franchise offers just-in-time direct delivery to customers. The exact structure of the supply chain and its elements thus depends on the nature of the franchise system. The consumer naturally stands apart and is the final stop and ultimate driver of the supply chain.

The end goal of the supply chain is to ensure that each element achieves service consistency and quality control as the strength of the brand depends on these. It is therefore critical to pick the right vendors. The selection process usually begins with a request for proposal (“RFP”). The RFP, which is driven by businesspersons, typically includes key elements of performance, leaving particulars to the eventual written agreement, which is often drafted by lawyers. Nonetheless, a savvy franchisor will communicate deal-breaking issues at this early stage. Other key concerns in the selection process are geography and reliability/quality control.

In creating the supply chain, franchisors should anticipate and plan for hypothetical events. What happens if the supplier does not deliver? What is the backup plan? What if the franchise system outpaces the supplier? What are the supplier’s financial limits? A franchisor could find itself in dire straits if its chief or sole supplier gets into financial trouble, including going out of business. It may make sense to build competition into the system, or at least experiment with this idea, but franchise systems might want to avoid dependency on a single supplier. Having multiple suppliers creates an internal market, gives the franchisor bargaining leverage, and provides a backup plan. That said, some franchisors have successfully and profitably used a single supplier for decades. It depends on your system’s desires and needs. Incidentally, it should not be a major problem for suppliers to guarantee or indemnify their services, and a franchisor should be wary of any supplier who refuses to do so.

While the rest of the presentation addressed key terms of supplier (pricing) and distributor (inspection rights) agreements, the speakers made special note of the need to address ownership of intellectual property in supply agreements. The bigger the system, the greater the chance that a franchisor will create new technology that offers benefit to the whole system. Franchisors should make certain that their ownership rights are clear from the agreement. Another oft-overlooked concern, for both supply and distributor agreements is licensing. If any role-player in the supply chain is not properly licensed to exist or to move or offer certain goods or services, it could shut down the entire chain pending legal and/pr regulatory compliance.

The IFA Legal Symposium occurred May 7-9, 2019 in Washington, D.C. Several attorneys attended this event and took away numerous tips. This post is one of a series of posts reporting from this event and summarizing details from the sessions. This post is based on the session entitled Supply and Demand: How to Negotiate Supplier and Distributor Agreements and Work with Franchisees Regarding their Implementation, presented by David B. Ramsey (Kaufmann Gildin & Robbins LLP), Curtis S. Gimson (Arby’s Restaurant Group), and Robert G. Huelin (Wireless Zone LLC).

In a recent post, I expressed the view that no-poach clauses in franchise agreements are unlikely to violate the antitrust laws. Recent activity, however, has given me a “maybe yes, maybe no” on my prediction.

First, two recent rulings offer differing views on the issue of the appropriate standard to apply to the antitrust analysis. The possible standards of review, from the most lenient to the most demanding, include per se (automatically illegal), quick look, and rule of reason. On August 7, 2019, in Conrad v. Jimmy John’s Franchise, LLC, No 3:18-cv-00133 (S.D. Ill.), the Court refused to grant the franchisor’s request for an interlocutory appeal from a prior order of the Court allowing the employee’s per se pleading to stand. By contrast, on July 29, 2019, in Ogden v. Little Caesar Enterprises, Inc., No. 18-12792 (S.D. Mich.), the Court dismissed the complaint, with particularly strong criticism of the employees’ attempted application of a per se or quick look standard. The Court additionally commented that the “plaintiff has not made a serious effort to state a case under a rule-of-reason antitrust theory.”

Second, several New England states, including Massachusetts, Vermont, and Rhode Island, have enacted wage limitations on an employer’s right to require non-compete agreements from employees. Essentially, employers are prohibited from asking low paid employees to sign non-competes. Similar legislation has been introduced in several other states.

The two cases cited above, both obviously at an early stage, made me reassess my optimism. However, the procedural setting of the Conrad case (which began life with a Sylas Butler as lead plaintiff) leads me to believe that my now-cautious optimism is reasonable. The Court’s original ruling was issued in July 2018, by a now-retired federal judge. In the most recent opinion more than one year after that ruling, the newly-assigned judge viewed the ruling as “law of the case,” and that the franchisor had not demonstrated clear error. That’s not a ringing endorsement of the applicability of the per se standard, particularly in comparison to the language of the Court in the Ogden case. Action by state legislatures to curb the use of non-competes, however, may moot these judicial pronouncements.

I was absolutely correct in one comment in the prior blog: if you have franchisees or dealers in Washington, all bets are off. The state of Washington has reportedly entered into settlements with four additional national chains prohibiting the enforcement of “no poach” contract provisions.

As I said before: if a no-poach clause isn’t really necessary, why run the (however small) risk?

The 2019 “Best and Worst Franchise” rankings have been published by Forbes. The franchise analytics firm, FRANdata, was commissioned to apply a methodology that ranks franchise brands on “health and appeal,” from the perspective of a prospective franchisee. This is the fifth report FRANdata has produced for Forbes, this time using information spanning the five-year period between 2013 and 2017. While the rankings are interesting, the methodology used by FRANdata must also be considered because the interests of franchisees buying into a franchise system may be very different than the interests of lenders, investors, and competitors.

Over 3,000 brands had to be considered, but FRANdata would consider only franchisors that had a least 20 franchise units at the beginning (2013) and the end (2017) of the examined period. The brand needed to demonstrate it had been actively marketing franchise opportunities and enough performance history over the five years to be considered. These brands needed a sufficient number of franchisees to demonstrate that the business is adaptable to different geographic markets, and that their performance could be replicated.

The five criteria used for evaluation were: (1) system sustainability; (2) system demand; (3) value for investment; (4) franchisor support; and (5) franchisor stability.

Success is built on the sustainability of the system. Fast growth and demand for franchises is effectively only a snapshot of the value of that brand, in terms of business opportunity and consumer perspective. Fast growth only has value if that growth is health and sustainable. Sustainability was weighed more heavily to emphasize the importance of a healthy system to the long-term success of franchise business owners.

The primary measure of an investment is return on investment. The value of investment criterion assesses and rewards brands that allow transparency into franchisee unit earnings data in the Franchise Disclosure Document. This metric assesses and highlights brands that allow transparency into this data, have sound unit economic performance, and offer operators a possibility of achieving financial success.

Franchisor support and franchisor stability also are of great importance to potential franchisees. Support is important because it has been shown that the amount of initial and ongoing support provided by the franchisor directly correlates to the success of franchise units in the system. Additionally, one of the benefits of joining a franchise system is the level of operational and financial knowledge and support a franchisee can derive from the franchisor.

The criteria did not list certain other issues that lawyers might consider as important, such as litigation and bankruptcy history of the company or its key employees, balance sheet contingencies, trademark strength, and trends in the marketplace that might affect future operations or profitability, such as labor or finance costs.

For the franchise buyer, the decision often is made on culture and lifestyle, rather than plain metrics. The buyer needs to invest themselves into the brand and be proud of its investment. The same is true of any other investor into a franchise company. The brand is everything, and you must adopt the brand to be successful. It is good to see that so many brands are growing through strong franchisee and investor interest.