New California Law Imperils Franchise Model

September 24, 2019Alerts

“Someday, California is going to disappear into the ocean.”

That phrase usually refers to the San Andreas Fault. But for those in the franchise industry, it may now refer to AB-5, a new California law that calls for sweeping changes in how businesses define the term “employee” and could profoundly alter how franchises are operated in the state – if at all.

Signed into law on Sept. 18 by Gov. Gavin Newsom, AB-5 codifies the California Supreme Court’s June 2018 decision in Dynamex Operations West v. Superior Court of Los Angeles, a decision that horrified the franchise industry.

Following Dynamex, AB-5 adopts the so-called “A-B-C Test” in determining when a person providing services for remuneration is an employee or an independent contractor. To establish independent contractor status, employers must satisfy all three of the following prongs:

A) The company must not be able to control or direct what the worker does, either by contract or in actual practice;
B) The worker must perform tasks outside of the hiring entity’s usual course of business; and
C) The worker must be engaged in an independently established trade, occupation or business.

The A-B-C Test applies to both the California Industrial Welfare Commission’s Wage Orders and the California Labor Code. The legislation takes effect on January 1, 2020 and the legislature has drafted a clear intent that the law will apply retroactively.

Franchisor-Franchisee Relationships Not Exempt

While AB-5 recognizes dozens of exemptions from the A-B-C Test for a range of professions, franchisor-franchisee relationships are not specifically exempted. Franchisees will likely fail the A-B-C Test and the application of the employment test to the franchise model will likely result in most franchisors being deemed the employer of its California franchisees’ employees. While there is case law that suggests the concern may be overstated as to joint employment issues, including those in a franchisor context (see Sadie Curry v. Equilon Enterprises LLC), the full extent of AB-5’s reach remains unclear for now.

Despite monumental efforts, opposition to AB-5, including organized opposition from the franchise industry, has resulted only 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, is unclear. Many commentators have discussed the implications of AB 5’s codification of the Dynamex ruling, but how to plan for the 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. Franchisors with franchisees in California may continue business as usual and risk being the test case on how the A-B-C Test is interpreted by the courts, or hope that ongoing challenges and lobbying efforts will eventually exempt the franchise industry.

In the immediate face of uncertainty, franchisors with only a small number of franchisees units may withdraw or refuse to locate in California; large, sophisticated franchisors may curb expansion in the state until, if and when, the legislature confirms that AB-5 is not intended to replace, alter or change joint employer liability between two businesses.

An Extreme Choice

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 and transfer the franchise agreements and operations 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.

If, as widely expected, AB-5 means that most franchisors will be considered joint employers of their franchisees' employees, both disadvantages and advantages should be evident. 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. In addition, franchisors will want to recommend to California franchisees that all employment related policies and handbooks are reviewed to ensure that they are in line with California law and AB-5. Against the possibility of greater control over employee practices, however, is the inevitability of increased cost and risk to the franchisor and franchisees. Franchisors will have to analyze whether the system is willing to bear these costs, or whether to pass the costs through to franchisees, and if so, which franchisees?

Joint Employer Liability Exposure

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 risk 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. There are a few carriers today that 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.

These fixes are no easy task, but then again, doing business in California has always been different (and at times, more complicated) than other states. A franchise system’s approach to AB-5 should be discussed on a case by case basis with legal counsel taking into account a myriad of factors, including current operations in California, the number of California domiciled franchisees, current franchise agreement provisions and risk appetite, among others.

For any questions about AB-5 or this alert, please contact any member of Fox Rothschild's Franchise & Distribution Practice Group.