The Renaissance Franchise Lawyer

Is the Franchising Business Model in Serious Trouble? New York Law Journal

September 15, 2014

Rupert M. Barkoff

Today, with the multiple recent legislative and judicial non-franchisor favorable developments relating to franchising, many are saying that the franchise model is headed for trouble. But others disagree. Some recent developments could mark the beginning of a period of change, and one that will clearly not be beneficial for franchisors; it may not be so favorable to some franchisees in the long run, either. Some franchisees may not be happy with the concept that their franchisors may be joint employers or vicariously liable for their franchisees' sins. On the issue of relationship legislation, and, more specifically, the recent amendments to the California Franchise Relationship Act (CFRA), it will not be likely that any franchisee would be opposed to it.

California Amendment

At the state level, there have been various franchise relationship bills brought before numerous state legislatures in the past two decades. The one thing most of them had in common: They failed to become law. The CFRA is the outlier because the California Legislature recently approved amendments to this act. In the California Senate, the vote on the bill was 24 in favor, nine against. Not exactly a close vote. As of the date of this column, the bill had not been signed into law by Governor Jerry Brown.

The amendments to the CFRA on the whole are mostly measures that the franchise community has seen before. These include: rights of association; restrictions on the franchisor's right not to approve a transfer; a prohibition on contractually excluding any covenant of good faith and fair dealing from a franchise relationship; a requirement that a franchise agreement may not be terminated or not renewed unless there has been a material and substantial breach; and a right for the franchisee to cure any breach within 30 days after receiving a formal notice of the breach.

If the bill is signed into law by the governor, will the landscape of franchising in California change significantly? The Iowa Legislature enacted a relationship law in 1992 that was more onerous than the one that may become law in California. As a result, many franchisors threatened to discontinue franchising in Iowa. However, franchising is alive in Iowa, and franchisors are selling franchises in that state.

The real question here is: Did enough franchisors withdraw or freeze their Iowa operations or franchise offerings such that Iowa's economy was hurt? I am not aware that any studies have been done in the some 22 years after the Iowa act became effective. So, using the Iowa act as a precedent, will the California franchise community be troubled if the California bill is signed into law? Probably not. Will the California economy be hurt? Possibly. Will malevolent franchisors become less abusive? Possibly. Are bad franchisees more likely to end up staying in the system, operating under the franchisor's mark and damaging the goodwill of the system? Probably yes.

Given the current environment of franchising, were the amendments to the CFRA really necessary? First, the franchise environment has changed dramatically from the days most of the 17 or so existing franchise relationship laws were enacted. There are, certainly, some bad actors in the franchise community. However, many franchisors have cleaned up their acts and are now finally paying homage to their franchisees and are more inclusive in involving them in the decisions as to the directions their concepts are heading.

In addition, there has been more focus on brand by many franchisors than was previously the case, with brand protection and expansion, in most circumstances, being the most important challenges in franchising. The great proponent of the importance of brands is Robert Gappa, CEO of Management 2000, who has been advocating in recent years that franchisors must realize it is the brand's customers that deserve extra attention, not the system's franchisees. Gappa emphasizes that the franchisees are not really the true customers of the franchisor, as some people suggest, so the focus on franchise relationships is misplaced.

There is one provision of the CFRA that is troublesome. This provision requires a franchisee be given a right to cure any default or breach. This provision, however, does not address the problem of the franchisee who exhibits a pattern of continual breaches, that is, a breach, followed by cure, followed by breach, and then cure, and so forth. The amendment simply doesn't address the problem created by a recidivist.

Overall, the importance of the California amendment is not its substance but the fact that it was enacted. Does it suggest that we will see a wave of new proposed franchise relationship laws throughout our country? It will be interesting to see if this occurs, for that happened to some degree after the Iowa relationship statute was enacted. However, the adoption of the California amendments is most likely to become an aberration, not the beginning of a trend. We may see more relationship bills introduced in the state legislatures, but it is highly questionable that many of them, if any, will be adopted within the next three to five years.

Another concern about franchise breaches is that all breaches are not equal in importance. As some courts have come to recognize, there are some breaches that are either incapable of cure, or are so egregious that immediate termination should be the appropriate remedy. For example, the Pennsylvania judicial system ruled several years ago that a franchisee who diverts business away from the franchisee's operation to a competitive operation established by the franchisee should not have been entitled to cure the breach, even though the franchise agreement expressly provided for a cure right. The court in LJL Transp. v. Pilot Air Freight Corp. felt that when the breach undermined the essential element of trust between the parties, the need to protect that relationship trumped the language of the contract.1

A more recent case, 7-Eleven v. Kapoor Brothers,2 has reached a similar conclusion. Although it is generally thought that after the Broussard decision in 1988,3 the franchise relationship is not a fiduciary one, the courts in LJL Transportation and Kapoor Brothers imply that the franchise relationship is broader than just a contractual one. Ironically, these decisions suggest that the special relationship between franchisor and franchisee is more weighted to protecting the franchisor, rather than the franchisee.

Issues of Control

Another area where franchising may be in flux involves the concept of control, how control affects the franchise relationship, and the franchisor's exposure to what could be excessive damage when it exercises control over a franchisee. In several cases, beginning with the notorious Coverall4 decision, courts have suggested that franchisees are not really independent contractors, as almost all franchise agreements provide, but instead they should be classified as employees in many situations. Coverall involved janitorial personnel who were sold franchises in which substantial control was retained by the franchisor. Among other things, the franchisor found the initial accounts for the franchisee; handled the collections and controlled the marketing; negotiated contracts and pricing on behalf of the franchisee; and established daily cleaning plans.

The restrictions placed on franchisees were viewed as so restrictive that a Massachusetts court ruled that the plaintiffs were not franchisees; they were employees. This gave them better rights under numerous federal and state labor statutes, such as the Fair Labor Standards Act. The effects of this decision are significant because the whole economic model in this industry works on the assumption that franchisees are in fact independent contractors. Not only does Coverall dramatically alter the economics in this particular industry, it leaves open the question of where the franchise agreement fits into the picture under the Coverall analysis.

If the franchisees are employees, what is the importance of the franchise agreement? Does the employee still have to pay royalties to the franchisor? Are they entitled to disclosure before accepting a position with the "franchisor"? If the agreement is not enforceable, can the "franchisor" fire the "employee" at will? And for whom do the employees of the "employee" (if any) work? Who can hire or fire them? And can the rules governing the franchise system's operations that are set forth in the franchise agreement still be unilaterally modified by the franchisor? If the Coverall principle spreads beyond the janitorial services industry, how many trees will be sacrificed when the pundits tell us what the consequences of this decision are, and whether they are good or bad for franchising and the economy as a whole?

Coverall is also significant because its principles are beginning to spread. A similar if not identical issue has come before the court in a convenience store case, involving the 7-Eleven franchise system.5

Although some franchisees might prefer to be classified as employees, in other circumstances, in vicarious liability settings, franchisees may not be supportive of the Coverall/7-Eleven trend, especially when claims by third parties are involved. In Patterson v. Domino's Pizza,6 the Supreme Court of California reversed a decision by a California appellate court, which had reversed a decision by a California superior court that granted summary judgment in favor of Domino's.

The Domino's trial court held that, on the facts before it, Domino's could not be held liable for an alleged sexual harassment incident that occurred at one of Domino's franchised stores. The specific issue in this case was whether Domino's exerted so much control over the franchisee that the franchisor should be deemed a joint employer or liable to the plaintiff employee under a vicarious liability theory. The Domino's California Supreme Court decision was consistent with existing California law, and as one reads both the majority and minority opinions, one can conclude that the justices were arguing not so much about the law, but whether there was a material issue of fact that should have resulted in the case being presented to the jury for determination.

The facts in this case, as presented in the majority opinion, show a carefully designed program by Domino's to stay out of franchisee affairs as they related to employment issues. Had Domino's lost the case, one must ask what else could Domino's have done to escape liability under a claim based on a joint employer theory or a claim of vicarious liability.

One aspect of the Domino's decision that is of particular intrigue goes back to the issue of brand protection, as mentioned above. Would it have been better for the franchisor to exert less control over its franchisees and reduce the risk of a joint employer/ vicarious liability claim? Or should the franchisor have asserted more control over franchisee employees in order to protect the brand, even though the franchisor might be more likely to be given joint employer classification and be subject to a vicarious liability claim?

Domino's almost became caught in this dilemma a few years ago after an employee of a franchisee made a video showing him putting a foreign object on a pizza and posted the video on the Internet. In this case, the franchisee took the correct step and, to my recollection, terminated the employee. But what if the franchisee, for whatever reason, decided not to do so, and Domino's consequently terminated the franchisee and the employee? Domino's might have been sued for wrongful termination, but presumably (1) it would have insurance that would have paid for all or a portion of the costs to defend the suit and any resulting liability, plus (2) the franchisor could always rely on its indemnification rights against the franchisee if the claim were asserted against Domino's by the employee of its franchisee. There is no happy solution for everyone in this situation, but in the foreign-item-on-the-pizza scenario, risking the lawsuit by the franchisee or its employee and taking the steps necessary to protect the brand might have been the preferred option. The damage would have been done once the video had been posted, but at least Domino's could face the public and say that this type of behavior would not be tolerated. Lawsuits are often not the best way to vindicate wrongs.

Conclusion

Theories of joint employer liability and vicarious liability are no newcomers to the judicial setting, where they are now causing even more havoc. An employee in one setting might not be an employee under the same set of facts where another type of legal claim is being disputed. Similarly, control might have different thresholds in various circumstances in order to impose liability on the franchisor. It is not surprising how difficult it is to predict the outcome of litigation relating to these claims, as we have seen in the past. Unfortunately, it is likely that it will be equally or even more difficult to predict the outcome of franchise employment related suits in the future.

Endnotes:

1. See LJL Transp. v. Pilot Air Freight Corp., 962 A.2d 639 (Pa. 2009) (Jan. 22, 2009).

2. No. 6:13-CV-953-Orl-36GJK, Giuffre Hyundai v. Hyundai Motor Am., 756 F.3d 204 (2d Cir. 2014).

3. Broussard v. Meineke Disc. Mufflers Shops, 155 F.3d 331 (4th. Cir. 1998).

4. See Awuah v. Coverall N. Am., 707 F.Supp.2d 80 (D. Mass. 2010), and 740 F.Supp.2d 240 (D. Mass. 2010). See also Coverall N. Am., Inc. v. Comm'r of The Div. of Unemployment Assistance, 957 N.E. 2d 1083 (Mass. 2006), Bus. Franchise Guide ¶13,491 (Mass. Dec. 12, 2006).

5. Naik v. 7-Eleven, Bus. Franchise Guide ¶15,332 (D.N.J. Aug. 5, 2014).

6 . No. S204543, 2014 WL 4236175 (Cal. Aug. 28, 2014).

Rupert M. Barkoff is chairman of the franchise team in Kilpatrick Townsend & Stockton's Atlanta office.