The "progressive" effort to have franchisors declared the employers of their franchisees may have become law in California under a bill (AB-5) just enacted by its Legislature and signed into law on Sept. 18, 2019 by Gov. Gavin Newsom.

Statute May Deem Franchisors Employers of Franchisees

California Assembly Bill 5 (AB-5) was approved by the California Legislature on Sept. 10-11, 2019 and a week later signed by California Gov. Gavin Newsom. And New York's Gov. Andrew Cuomo thereupon expressed his interest in considering such legislation.

AB-5 is the product of intense political lobbying and contributions by the Service Employees International Union (SEIU), whose goal is to eradicate the notion of independent contractors and convert them to employees ripe for unionization.

This is a fatal threat to franchisors and franchising. AB-5 may clearly be deemed to characterize franchisors as the employers of their franchisees, in stark contrast to the literally hundreds upon hundreds of judicial decisions holding that franchisees are independent contractors.

AB-5 echoes the California Supreme Court's ruling in the Dynamex case, discussed below.

As summarized in a California Legislative Counsel's Digest, AB-5 provides (as in Dynamex) that "a person providing labor or services for remuneration shall be considered an employee rather than an independent contractor unless the hiring entity demonstrates that the person is free from the control and direction of the hiring entity in connection with the performance of the work, the person performs work that is outside the usual course of the hiring entity's business, and the person is customarily engaged in an independently established trade, occupation or business."

Of course, in the franchise arena, virtually every franchisor may under AB-5 be deemed its franchisees' "employer" due to its inability to establish that its franchisee "performs work that is outside the usual course of the hiring entity's business," since the vast majority of franchisors own and operate businesses identical to those of their franchisees.

AB-5 will certainly be the subject of immediate litigation since it so directly, and potentially fatally, impacts not only franchisors but franchisees, who would morph from owning their own businesses to merely being employees of their franchisors.

And the situation confronting franchisors as a consequence of AB-5 is grim. If now deemed the legal "employer" of their franchisees, franchisors will find themselves liable for franchisee wages; FICA contributions; unemployment insurance premiums; workers' compensation premiums; Affordable Care Act mandates; wage-and-hour compliance; and all of the other duties, requirements and prohibitions imposed by federal and state law upon employers. This after 60 years of courts affirming that franchisees are not the employees of their franchisors but, instead, independent contractors.

As well, under the doctrine of respondeat superior, franchisors—which, under AB-5 are the "employers" of their franchisees—may find themselves liable for all acts, errors and omissions which transpire at franchised outlets, a critical and expansive liability exposure never anticipated. And to complicate matters even further, reverting to the "joint employer" discussion of many New York Law Journal columns, just whose employees are workers at franchised units? The franchisee's employees (which would be an odd conclusion if the franchisee itself is now an employee of its franchisor)? Or does AB-5 require that all employees of franchised units, as well as the franchisees themselves, now be deemed the employees of the franchisor?

So Draconian is this paradigm shift, and so unanticipated, it is not hard to conceive that franchisors will either cease franchising in California and, with respect to existing franchisees, may invoke the "frustration of purpose" legal doctrine and thereunder terminate all of their franchise agreements (and, pursuant to the customary contents of those agreements, acquire their franchisees' assets, convert the former franchised units to company-owned units and simply hire the former franchisees as managers). Indeed, it is axiomatic that the doctrine of frustration of purpose permits such a course of conduct to ensue, as made clear by the Restatement of Contracts: "Where, after a contract is made, a party's performance is made impracticable without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made, his duty to render that performance is discharged, unless the language or the circumstances indicate the contrary." Restatement (Second) of Contracts, §261 (1981).

A more perverse outcome could hardly be imagined. Franchisees constitute the very class which have had special protections afforded them by "franchise relationship" statutes enacted in California and 20 other states (and Washington, D.C., Puerto Rico and the U.S. Virgin Islands). Alaska Stat., Title 45, Chapter 45, Article 9A, Distributorships; Arkansas Franchise Practices Act, Ark. Code Ann., Title 4, Ch. 72, §4-72-201 et seq.; California Franchise Relations Act, Cal. Bus. & Prof. Code, Div. 8, Ch. 5.5, §20000 et seq.; Conn. Gen. Stat., Title 42, Ch. 739 §42-133e et seq.; Delaware Franchise Security Law, Del. Code Ann., Title 6, Ch. 25, §2551 et seq.; Hawaii Franchise Rights and Prohibitions Act, Haw. Rev. Stat., Title 26, Ch. 482E, §482-E6; Illinois Franchise Disclosure Act, Ill. Comp. Stat., Ch. 815, §§705/18-705/20; Indiana Deceptive Franchise Practices Law, Ind. Code, Title 23, Art. 2, Ch. 2.7, §1 et seq.; Iowa Code, Title XIII, Ch. 523H, §§523H.1 et seq. and Laws of Ch. 1093, §537.A.10; Kan. Stat. Ann. Ch. 16, Art. 1, §16 et seq.; Michigan Franchise Investment Law, Mich. Comp. Laws, Ch. 445, §445.1527; Minn. Stat., Ch. 80C, §80C.14; Miss. Code Ann., Title 75, Ch. 24, §75-24-51 et seq.; Mo. Rev. Stat. 1986, Ch. 407, §407.400 et seq. and 407.420; Nebraska Franchise Practices Act, Neb. Rev. Stat., Ch. 87, Art. 4, §87-401 et seq.; New Jersey Franchise Practices Act, N.J. Rev. Stat., Title 56, Ch. 10, §56-10-1 et seq.; Rhode Island Fair Dealership Act, R.I. Gen. Laws. §6-50-1, et seq.; Utah Consumer Sales Practices Act, Utah Code Ann., Rule R152-11-11; Virginia Retail Franchising Act, Va. Code Ann., Title 13.1, Ch. 8, §13.1-564; Washington Franchise Investment Protection Act, Wash. Rev. Code, Title 19, Ch.19.100, §§19.100.180 and 19.100.190; Wisconsin Fair Dealership Law, Wisc. Stat., Ch. 135, §135.01 et seq.; District of Columbia Franchising Act, D.C. Code, Tittle 29, Ch. 12, §29-1201 et seq.; Puerto Rico Dealers' Contracts Act, P.R. Laws Ann., Title 10, Chapter 14, §278 et seq.; Virgin Islands Franchise Business Act, V.I. Code Ann., Title 12A, Chapter 2, Subchapter III, §130 et seq.

But as a consequence of AB-5, those franchisees' enterprises and their ability to earn profits therefrom may very well evaporate and their futures destroyed.

And if AB-5 is indeed applied to franchising, the economy of California will also dramatically suffer. According to the International Franchise Association (IFA), there are over 75,000 franchised businesses in California which currently employ nearly 730,000 people and provide over $40 billion to California's GDP. But this vital economic sector of California's economy may be doomed along with individual entrepreneurs' ability to own and operate franchised businesses independently in the hope of securing profits way beyond wages.

As suggested earlier, AB-5 will most certainly be the subject of vigorous litigation. AB-5 directly contravenes every federal and state franchise law, rule and regulation (whose definitions of "franchise" assume franchisee independence); the Lanham Trademark Act; and over half a century of judicial precedent holding that franchisees are independent contractors of their franchisors.

California Supreme Court 'Dynamex' Decision

A decision from the Supreme Court of California addressing who can be classified as an "employee" as opposed to an "independent contractor" not only makes California a hostile venue for franchising but set the table for the California Legislature to enact Draconian legislation (Assembly Bill 5, or AB-5, addressed in detail above) which could end franchising as we know it in California.

The decision in Dynamex Operations West v. Superior Court, 4 Cal. 5th 903, 416 P.3d 1 (2018), 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 contractually deemed, and operates as, 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."

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 … 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.

Whether Dynamex applies retroactively is still under consideration by the judiciary in California.

Unfortunately for franchisors, neither California AB-5 nor the Dynamex decision specifically address franchising and it is entirely uncertain how they 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.

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