For generations of small business owners franchising serves as a successful business model. Under this paradigm a franchisor grants a franchisee a license to use the franchisor’s trademark and business concept in exchange for the payment of an initial franchise fee and periodic royalties. Today, according to the International Franchise Association, there are more than 700,000 franchise establishments throughout the United States. While the franchise model continues to evolve, it has not been without its legal challenges, including those posed by federal and state labor agencies trying to link franchisors and franchisees as joint employers. Most recently a New York federal district court breathed new life into the joint employment conundrum by torpedoing a recently published final order issued by Department of Labor (DOL) in January 2020, which seeks to clarify the status of joint employment under the Fair Labor Standards Act (the “Final Rule”). Through the Final Rule it was thought that joint employment would cease to be a threatening issue to franchising.
The theory of joint employment focuses on the view that employees can have multiple employers under the same employment relationship. A finding of joint employment can expose each joint employer to liability under the Fair Labor Standards Act (FLSA), which addresses minimum wage, overtime pay, and employee record keeping. If a franchisor and franchisee are considered joint employers, the franchisor and the franchisee both will be responsible for the employment obligations of the franchisees’ employees. A finding of joint employment undermines the independence of the franchise relationship and generally casts doubt on the feasibility of the franchise model.
Consequently, in every way possible, franchisors try to distance themselves from exercising control over their franchisees beyond supporting the business model and maintaining the integrity of its trademarks. Prior to the DOL’s Final Rule, the agency had been at odds with the franchise model by injecting additional control criteria into the historical mix, making it more difficult for franchising to defend its independent contractor model. After considerable push back from the franchise community, the DOL recently clarified the status of the franchise relationship in its Final Order.
Prior to the DOL establishing its Final Rule, many states relied on what is known as the ABC test to establish whether another person besides the known employer could be considered a joint employer. California established the ABC test in 2019. Many other states adopted California’s ABC test or a similar test in determining whether an independent contractor designation really constituted a joint employment relationship. Under the ABC test a worker would be considered an independent contractor only if they met each of the three criteria: (A) the worker is free from the control and direction of the hiring entity in connection with the work’s performance both under the contract and, in fact, (B) the worker performs work that is outside the usual course of the hiring entity’s business, and (C) the worker is customarily engaged in an independently established trade occupation or business of the same nature as the work performed. Franchisors found it increasingly more difficult to satisfy the second prong of the ABC test because some courts found that franchisors and franchisees perform the same work. Franchisors resisted this classification by claiming that they develop and manage a franchise system, while their franchisees sell products and services under the franchisor’s model. In essence, they claimed that the franchisor and the franchisee engaged in separate businesses.
In the Final Rule the DOL eschewed the ABC test in favor of a four-factor balancing test to determine the existence of a joint employment relationship. Under the Final Rule test, a joint employment relationship can be established if the second person, who claims not to be an employer, does one or more of the following: (1) hires or fires the employee; (2) supervises and controls the employee’s work schedule or conditions of employment to a substantial degree; (3) determines the employee rate and method of payment; or (4) maintains the employee’s employment records. The four-factor test is more representative of how the employment relationship was historically characterized.
Under the DOL’s Final Rule, in order to be a joint employer under the FLSA the alleged additional employer must actually exercise one or more of the four control factors. In its final commentary, the DOL identified certain business models, including the franchise model, as not being considered a joint employment relationship unless that relationship satisfies one of the four control factors. By enacting the Final Rule, the DOL hoped to provide franchising with more clarity regarding what actions will result in joint liability under the FLSA.
Unfortunately, the recent court filing in New York was not the response the DOL hoped for. In September 2020, 18 states filed a claim against the DOL challenging the Final Rule and claiming that it conflicted with the FLSA. A federal district court in New York City agreed with the states’ allegations and found that not only was the Final Rule in conflict with the FLSA, it was arbitrary and capricious. Among the problems that the court noted with the Final Rule was that it ignored the FLSA’s broad definition of employment.
While the DOL has not surrendered to the court’s ruling -- it likely will re-write the Final Rule --it does leave the franchise model relative to joint employment in an unsettled position. While the DOL is not likely to enforce the FLSA using the prior employment test, the ABC test will continue to be available to challenge the franchise relationship in local court actions.
Before raising the white flag, franchisors should take some solace in the recent court decision involving 7-Eleven franchisees. In the case of Patel v. 7-Eleven, Inc., a Massachusetts court found that despite the control exercised by the franchisor over its franchisees, those compliance requirements did not run counter to the ABC test used in Massachusetts. In an interesting twist, what appeared to save the day for the franchisor in this case was the role of the Federal Trade Commission’s Franchise Rule, which regulates the sale of franchise opportunities. 7-Eleven argued that the Federal Trade Commission’s regulations made it impossible to satisfy the first prong of the Massachusetts test because the franchise rule acknowledges that the franchisor will exert or has authority to exert a significant degree of control over a franchisee’s method of operation or provide significant assistance in the franchise method of operation. In its decision finding for 7-Eleven, the court noted that the franchise-specific regulatory scheme of the Federal Trade Commission governs over the more general independent contractor test in Massachusetts. Therefore, the Massachusetts Independent Contract Law did not apply to 7-Eleven in those circumstances.
While the Patel case cannot be viewed as the cavalry coming to the rescue of franchising, it does extend the battle lines beyond blind reliance on the ABC test while waiting for the DOL to further clarify its Final Rule.
For franchising the joint employment caution flag is raised once again, necessitating that franchisors continue to moderate control factors over their franchisees. Specifically, beyond the wording in their franchise agreements, franchisors should review their operating manuals and other operating directives to ensure that these manuals and directives do not overly restrict or control the operations of their franchisees.