A trio of decisions emanating from California could prove of great peril to franchisors nationwide.

'Dynamex'

The first decision came from the Supreme Court of California in Dynamex Operations West, Inc. v. Superior Court, 4 Cal. 5th 903, 416 P.3d 1 (2018), and addressed when an individual should be properly classified as an “employee” or an “independent contractor” (of critical importance in franchising since virtually every franchisee is an independent contractor of its franchisor). As the court noted, the distinction is crucial since “…if a worker should properly be classified as an employee, the hiring business bears the responsibility of paying federal Social Security and payroll taxes, unemployment insurance taxes and state employment taxes, providing worker's compensation insurance, and, most relevant to the present case, complying with numerous state and federal statutes and regulations governing the wages, hours and working conditions of employees.”

In franchising, there are concerns of equal or greater importance: if a franchisee is deemed to be an employee, rather than an independent contractor, then its franchisor not only becomes liable for the above-referenced employer liabilities but, as well, becomes liable for all acts, errors and omissions of its franchisees under the doctrine of respondeat superior.

The court in Dynamex had before it two individual delivery drivers of a nationwide package and document delivery company who sued on their own behalf (and on behalf of a class of allegedly similarly situated drivers) claiming that defendant Dynamex had misclassified its drivers as independent contractors rather than employees.

In California (as in most other jurisdictions), an “employer” is defined as an individual or entity who “suffers or permits” another to work. The California Supreme Court then broke from precedent and instead invoked what is commonly referred to as the “ABC” test utilized in a few other jurisdictions to distinguish employees from independent contractors. Under this test, held the court, a worker is properly considered an independent contractor to whom a wage order (or other labor laws) does not apply only if the hiring entity establishes: (A) that the worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of such work and in fact; (B) that the worker performs work that is outside the usual course of the hiring entity's business; and, (C) that 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.

Critical to franchisors, of course, is the part “B” segment of the ABC test: whether a worker performs work that is outside the usual course of the hiring entity's business. In the franchise arena, the vast majority of franchisors own and operate businesses identical to those of their franchisees, such that it is almost always the case that a franchisee does not perform work that is outside the usual course of its franchisor's business.

And the California Supreme Court in Dynamex places the burden of establishing such distinction on the putative employer (or, in our setting, franchisor): “…a hiring entity must establish that the worker performs work that is outside the usual course of its business in order to satisfy part B of the ABC test.” The examples given by the California Supreme Court are not at all enlightening when it comes to franchising (on the one hand, a retail store hiring an outside plumber to repair a leak or an outside electrician to install a new electrical line and, on the other hand, a clothing manufacturer hiring work-at-home seamstresses to make dresses from cloth and patterns supplied by the company or a bakery hiring cake decorators to work on a regular basis on custom-design cakes).

The California Supreme Court then explicitly held: “In sum, we conclude that unless the hiring entity establishes [that it can satisfy the ABC test], the worker should be considered an employee and the hiring business an employer under the suffer or permit to work standard in wage orders. The hiring entity's failure to prove any one of these three pre-requisites will be sufficient in itself to establish that the worker is an included employee, rather than an excluded independent contractor, for purposes of [labor laws].”

Noting that defendant Dynamex's entire business is that of a delivery service company and its drivers merely deliver items to customers that Dynamex obtains, sets the rates for and advises drivers where to pick up and deliver those packages, the court advised that “…there is a sufficient commonality of interest” such that Dynamex could not satisfy part B of the ABC test.

Accordingly, the court affirmed the below Court of Appeal's decision below both certifying the class and denying Dynamex's motion to decertify the class.

Unfortunately for franchisors, the Dynamex decision does not at all specifically address franchising and it is entirely uncertain how Dynamex will be applied in the franchise arena. If taken literally, virtually every franchisor may be deemed an “employer” due to an inability to satisfy part B of the ABC test. This has happened before in Massachusetts, which features a similar ABC test and applied it to a janitorial service franchisor to conclude that its franchisees were, in fact, employees. Whether the courts of California will apply a carefully distinguished approach to franchising (as the California Supreme Court itself has done in other settings) will prove of critical importance to franchisors.

'Vazquez'

In a related and extraordinarily critical decision, the U.S. Court of Appeals for the Ninth Circuit decided early last month that the Dynamex decision and its new (for California) ABC test of employment applied retroactively to franchise relationships—even when those relationships terminated years before Dynamex was decided.

In Vazquez v. Jan-Pro Franchising International, Inc., 923 F.3d 575 (9th Cir. 2019), janitorial franchisees filed a putative class action alleging that their franchisor misclassified them as independent contractors rather than employees. The Ninth Circuit ruled that a retroactive application of Dynamex was proper under California law and consistent with due process.

The court also swept aside the seminal case of Patterson v. Domino's Pizza, LLC, 331 P.3d 723 (Cal. 2014), which carefully applied California's labor laws to franchisor Domino's Pizza, noted the unique economic structures and effectiveness of franchising and held that, unless it retained or assumed the right to generally control the relevant day-to-day operations of a franchised location, the franchisor could not be deemed an “employer” but, instead, the franchisor-franchisee relationship was that of independent contractors.

But the Ninth Circuit in Vazquez, splitting hairs to an extraordinary degree, held that whether an entity was an “employer” could give rise to two separate answers depending on whether the case involved a franchisor's vicarious liability for its franchisee's acts/errors/omissions vs. wage and hour, and other labor law provisions. In other words, and incredibly, the Ninth Circuit suggests in Vazquez, that a franchisor may be an “employer” for wage an hour, workers' compensation insurance premiums, unemployment insurance contributions and other labor law mandates, but not be an “employer” in a vicarious liability setting. In the words of Shakespeare, “confusion now hath wrought its masterpiece.”

'Bryman'

Lastly, as if rising a doctrine from the dead, the third decision under review herein involves a court declaring that franchisor El Pollo Loco violated the implied covenant of good faith and fair dealing by placing a company-owned restaurant in close proximity to a franchised restaurant even though the parties' franchise agreement explicitly permitted El Pollo Loco to do so.

In Bryman v. El Pollo Loco, 2017 WL 9772377, Sup. Ct. (2017), the court actually held that the subject franchise agreement's grant of permission to El Pollo Loco to place company-owned restaurants anywhere, even proximate to franchisee Bryman's restaurant, was “substantively unconscionable” and so one sided as to “shock the conscience.”

The court drew a distinction between a corporate unit being placed proximate to franchisee Bryman's restaurant vs. a franchised unit since “(t)he franchisor, by definition, has a lower cost structure for a company restaurant than a franchisee because the franchisor does not have [to] invest a substantial sum with a third party to purchase the franchise and does not have to pay continuing royalties and/or franchise fees. This means that defendant's franchise agreement, by its own terms, places itself at such a competitive advantage when it opens a company restaurant near or adjacent to a franchise restaurant so as to constitute unfair competition and implicate anti-trust principles.”

Accordingly, the court held that defendant El Pollo Loco violated the implied covenant of good faith and fair dealing and engaged in unfair competition in violation of California's Unfair Practices Act.

Following a bifurcated trial on damages, the jury awarded franchisee Bryman $8,837,806.

Seemingly returning from the dead in Bryman is the application of implied covenant of good faith and fair dealing to franchise disputes. While 30 years ago the implied covenant was routinely deployed by franchisees complaining of their franchisors placing company-owned or franchised units too close to a franchisee's unit despite contractual authorization to do so, that notion was swiftly discarded by the judiciary, which uniformly held that the implied covenant may never be used to upset the express terms of a franchise agreement. But in Bryman, the long discarded notion that the implied covenant may, indeed, trump the express provisions of a franchise agreement is revived.

David J. Kaufmann is senior partner of Kaufmann Gildin & Robbins in New York and authored the New York Franchise Act while serving as Special Deputy Attorney General of New York.