The Current Plight of the California Franchise Business Model

• Publication year: 2020
• Author: Grant Nigolian

The Current Plight of the California Franchise Business Model

Grant Nigolian

Grant Nigolian is a certified specialist in Franchise & Distribution Law, has served as a commissioner for the Franchise Distribution Law Advisory Commission for the State Bar and served as a member of the Franchise Law Committee for the BLS since 2010. Grant is currently a member of Executive Committee for the BLS.

Do the amendments to California's Labor Code, Unemployment Insurance Code, and Industrial Wage Orders within California's Assembly Bill number 5 (AB 5) constitute a violation of procedural due process rights when applied to the franchise business model? This article takes a closer look at the constitutionality of AB 5.

1. Introduction

The franchise business model relies on a franchisor's grant to a franchisee of a license of specified rights for use in the franchisee's independently owned and operated business that employs its own workers. But AB 5 and the California Supreme Court's decision in Dynamex Operations West, Inc. v. Superior Court¹ threaten the independent business relationship existing between the franchisor and the franchisee.

The plight began with the benevolent social policy to assure wages were paid by employers.² That policy resulted in a broad definition of "employ" for Industrial Wage Orders³: namely, "engage, suffer, or permit to work." In 2010, in support of the policy, the California Supreme Court, in Martinez v. Combs,⁴ expanded and explained the definition of "employ" as: "(a) to exercise control over the wages, hours or working conditions, or (b) to suffer or permit to work, or (c) to engage, thereby creating a common law employment relationship."⁵

The definition of "employ" provided in Martinez casts a wide net that makes virtually any relationship arguably one based on employment if one party "suffers" or "permits" another "to work. " For example, a party's allegation that another party "allowed" the party making the allegation to do some "work" or did not "prevent" them from doing that "work" arguably asserts the existence of an employment relationship within the parameters of Martinez. Within the franchise business model, this employment dynamic is easily asserted by franchisees alleging they were permitted by franchisors to work for the franchisor in operating the franchise location and, hence, were the employees of the franchisor. The same assertion of employment arises when a franchisee's employee alleges the franchisor should be responsible for employment-based claims, such as unpaid wages.

But Dynamex recently—and substantially—narrowed a putative employer's ability to rebut a presumption of employment in the context of enforcing Industrial Wage Orders, including a franchisor's ability to establish that franchisees were independent contractors running their own independent business operations. Specifically, the California Supreme Court, in Dynamex, adopted the "ABC test" for determining whether a worker qualifies as an employee or an independent contractor for the purposes of a wage and hour claim filed under an Industrial Wage Order.⁶ Dynamex articulated the ABC test as follows:

[A] worker is properly considered an independent contractor to whom a wage order 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.⁷

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So, Martinez's expansive definition of "employ" increases the scope of putative employers, including for "worker[s]" asserting a wage and hour claim under an Industrial Wage Order, while Dynamex's ABC test constricts the putative employer's ability to rebut the alleged employment by establishing the worker is instead an independent contractor.

Within the franchise context, at least one prong of the ABC test is difficult, if not impossible, to satisfy, namely, that the worker "performs work that is outside the usual course of the hiring entity's business." The phrase "outside the usual course" is patently ambiguous, especially when applied to franchising, because a franchise is, by its very definition, a license granted to operate a business "under a marketing plan or system prescribed in substantial part by a franchisor."⁸ Franchisors are primarily in the business of licensing their intellectual property rights and, in some limited cases, secondarily in the business of operating some of the actual franchise-model businesses as corporate-run locations, usually until a franchisee is found for the location. But Dynamex provides no guidance on how to reconcile the two regimes.

Thus, as applied within the context of enforcing Industrial Wage Orders, the policy driving Dynamex and the ABC test leads to the unintended consequence of recasting franchisees that are proud independent business owners (and, possibly, even the franchisee's own employees) into the role of "employee" of the franchisor, and imposing on franchisors all of the obligations associated with initiating, maintaining, and ending an employment relationship, including, without limitation, taxation, regulation, and reporting.

Legislation recently adopted in California codified the ABC test set forth in Dynamex and expanded its application beyond Industrial Wage Orders to the California Unemployment Insurance Code and the California Labor Code.⁹ In particular, AB 5 added section 2750.3 of the Labor Code and amended section 621 of the Unemployment Insurance Code, both of which codify the ABC test (collectively, the "Amendments"), to provide as follows:

(a)(1) For purposes of the provisions of this code and the Unemployment Insurance Code, and for the wage orders of the Industrial Welfare Commission, a person providing labor or services for remuneration shall be considered an employee rather than an independent contractor unless the hiring entity demonstrates that all of the following conditions are satisfied:

(A) The person is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact.
(B) The person performs work that is outside the usual course of the hiring entity's business.
(C) The person is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

Notably, AB 5 received heavy support from influential labor unions, which stand to benefit from a potential increase in their membership.¹⁰

Prior to its approval, numerous industries and professions raised concerns about AB 5 and successfully lobbied to exclude their particular constituents from the ABC test. As a result, AB 5 includes many exceptions.¹¹ The franchise community also raised concerns with legislators about AB 5's potential impact on the franchise business model, including its vague language. But the unintended impact on the franchise business model was disregarded, and the state legislature approved AB 5 and sent it to the Governor for his signature without addressing the franchise business model.¹²

As a result of the Amendments, most franchise practitioners agree that the current state of the law needs clarification, especially since Dynamex itself did not involve franchising and did not mention or address prominent California Supreme Court opinions regarding franchising, such as Patterson v. Domino's Pizza LLC,¹³ which clearly states, "[f]ranchising is different."¹⁴ This article focuses on an issue that has been, and is being, overlooked by the franchise industry, even though the issue raises the industry's primary concern about AB 5 and the ABC test: namely, its uncertain application to franchise business models and whether a franchise model can rebut the imputation of conditions of employment. The uncertainty of AB 5 and the ABC test as applied is a result of the vagueness of the statutory language. Consequently, AB 5 and the ABC test threaten procedural due process rights of franchisors in knowing whether, under AB 5 and the ABC test, their business model is at risk of being recast as an employment relationship, with all the attendant obligations and potential penalties.

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2. Due Process Challenge of Economic Regulation

The due process protections of the Fifth and Fourteenth Amendments of the U.S. Constitution and corresponding protections in the California Constitution provide the foundation for challenging the Amendments on vagueness.¹⁵ Federal and state due process concerns are implicated because recasting an independent contractor as an employee based on AB 5 imposes obligations to report and pay both federal- and state-level wages and withholdings. Franchisors have due process rights.¹⁶ Money qualifies as a protected property interest.¹⁷ And a law may be challenged as "unduly vague" in violation of due process, even if it is not challenged as "overbroad."¹⁸ The Amendments are therefore subject to due process challenges by franchisors and franchisees.

2.1. Impermissibly Vague Economic Regulation

In Village of Hoffman Estates v. Flipside, Hoffman Estates, Inc., the Supreme Court identified standards for evaluating a vagueness challenge of an economic regulation that does not implicate protected rights (e.g., speech).¹⁹

In Hoffman Estates, the plaintiff challenged the constitutionality of a local ordinance that regulated the sale of drug paraphernalia by requiring, among other things, a license fee and affidavits addressing non-drug-related convictions. Specifically, the plaintiff claimed that the local ordinance was overbroad and vague. After finding that the ordinance was not overbroad, the Court...