The battle to define the dividing line between two business models (franchisee versus employee) continues in the courts, state legislatures, and federal agencies, as employee activists continue to press the case that certain franchise relationships actually constitute an employment relationship.

Franchisors need to be aware of the legal developments in this area, discussed below, to ensure their systems are structured in a manner that will make it less likely a court or agency will ever find that their “franchisees” are actually glorified “employees.”

Applying the “employee” label can have drastic financial implications. If the relationship is actually an employment relationship (rather than a franchise), then the “franchisor” is legally required to abide by a whole host of government regulations in dealing with the franchisee including abiding by the wage laws (such as income tax withholding, workers compensation insurance, unemployment insurance, minimum wage, and overtime), employment anti-discrimination laws, and union laws which prevent employers from taking actions against employees who engage in protected concerted activity which could lead to the formation of a union.

The overlapping nature of the two models becomes most evident when a franchisor exercises almost complete control over every aspect of the franchisee’s business, including finding and providing customers, collecting customer payments, and approving all business decisions. This situation can sometimes be found in some office cleaning franchises, car service franchises, and retail stores such as 7-Eleven. In some of these systems, the franchisor provides all of the customers, approves most business decisions, and collects all of the customer payments, forwarding a portion to the franchisee. 

In such cases, especially when the franchisee is an individual rather than a business entity, these systems can sometimes come to closely resemble an employment relationship.

The following are recent court decisions, state laws, and regulatory actions addressing the dividing line between a “franchisee” and an “employee.”

• Massachusetts federal court decision. Addressing conflict between state law “ABC Test” and specific federal regulatory scheme.

In an order last month, (September 2020), a Massachusetts federal court dismissed a proposed class action by 7-Eleven franchisees who claimed they were essentially glorified store managers and should be treated as the company’s employees under state wage laws. 

The court recognized that, under the general state law test for deciding whether a person was an employee versus an independent contractor, the 7-Eleven franchisees might fall within the employee category, because under the state law “ABC Test,” described below, any person who provides a service is presumed to be an employee unless they are “free from control and direction.” The court found that this determination would conflict with the Federal Trade Commission (“FTC”) regulations governing franchises because the regulatory definition of a “franchise” presumes that the franchisor does exert a significant degree of control or provide significant assistance to the franchisee in the method of operation.

Where there is a conflict between a general state worker classification law and a specific federal regulatory scheme, “the specific trumps the general,” the court explained. “It cannot be the case, as plaintiffs suggest, that in qualifying as a franchisee pursuant to the FTC’s definition, an individual necessarily becomes an employee. In effect, such a ruling by this court would eviscerate the franchise business model.” According to the court, the FTC regulations effectively established “a regulated classification status unique from that of an employee or independent contractor.” The court’s decision is on appeal by the 7-Eleven franchisees.

• New California law – Adopting the ABC Test. 

In January 2020, a new California law, called AB-5, took effect, which adopted a very broad definition of an employment relationship, referred to as the “ABC Test.” This test is similar to the legal test already used in New Jersey, Massachusetts, New York (for construction industry service providers only), and other states. 

Under the ABC Test, a relationship must meet each of the following characteristics to qualify as an independent contractor (versus an employee) relationship: A) the person providing the service is free from control and direction of the hiring entity in connection with the performance of the work; B) the person performs work that is outside the usual course of the hiring entity’s business; and C) the person is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work.
Applying this test, some franchisees arguably might be considered employees, because they might fail the first or second parts of the test, because the franchisor and franchisee are engaged in the same business where the franchisor has company-owned locations, or the franchisee is not considered “free from control and direction” of the franchisor.

The new California law does include a catch-all exemption for “business-to-business relationships,” but it is not clear whether this exemption applies to franchise relationships. 

Franchise industry advocates have been lobbying the California state legislature to adopt a proposed amendment which would specifically exclude franchises from this legal test, but so far, the legislature has not adopted such an amendment.

• Proposed new federal regulations. A Modified “Economic Realities” Test.

At the federal level, the Department of Labor (“DOL”) last month, (September 2020), issued a proposed rule intended to “clarify” the long-standing federal “economic realities” test for defining an employment relationship, summarized in a DOL Fact Sheet, which requires consideration of various factors. 

The proposed new rule modifies the factors and gives greater weight to two “core” factors, namely “the nature and degree of the individual's control over the work” and “the individual's opportunity for profit or loss,” which the rule says may be determinative. The rule lists three additional factors to be considered, namely the amount of skill required for the work, the degree of the working relationship between the individual and the potential employer, and whether the work is part of an integrated unit of production. The ultimate test, the Rule commentary states, is whether “the individual is, as a matter of economic reality, in business for him or herself.” If adopted, the proposed rule will make it less likely a franchise relationship would be considered an employment relationship under federal law. 

In a statement accompanying the proposed rule, the DOL noted that many arrangements which would otherwise be considered an employment relationship under California’s broader “ABC test” are not considered an employment relationship under the federal “economic realities” test.