California AB 5; and Differences Between Franchises and Other Business Arrangements

California Assembly Bill 5 (2019)

California Governor Gavin Newsom signed into law Assembly Bill 5 (“AB-5”). AB-5 codifies into California’s Labor Code the “ABC test” for determining employee or independent contractor status, as adopted by the California Supreme Court in Dynamex Operations West, Inc. v. Superior Court, 4 Cal.5th 9 (2018). Under the ABC test a person is an employee, not an independent contractor, unless (1) the work she performs is free from control of the hiring entity, (2) the work is outside the usual course of the hiring entity’s business, and (3) the worker is customarily engaged in an independent trade. All three elements must be met for independent contractor status. If an individual is an employee under AB-5, the California Labor Code, Unemployment Insurance Code, and California Industrial Welfare Commission Wage Orders apply.

The bill received attention as a political measure to protect gig economy workers. But it may have far reaching effects on franchising. Most franchisors can usually pass the first and third elements of the ABC test. But overcoming the second element, that the franchisee’s work is “outside the usual course of the hiring entity’s business,” is challenging. However, an entity franchisee is unlikely to be deemed an “employee” of a franchisor. This is because employees are individuals, not business entities.

AB-5 requires an employer to pay the expenses and losses incurred by an “employee” at the request of the employer. If classified improperly as an independent contractor, a franchisee could sue a franchisor to recover money spent running the franchise, including hiring employees, paying rent, and other operational costs, as employee expenses and losses. Franchisees may also apply for employment benefits as employees. The International Franchise Association lobbied the California legislature for a franchise exemption, but no such exemption was included.

Post-Dynamex cases such as Vasquez v. Jan Pro Franchising have held that the ABC test may apply to franchise relationships. A court following this reasoning could find that franchisors are employers of both their franchisees and their franchisees’ employees, if the relationship meets the ABC test. Vasquez also held that the ABC test is retroactive, enabling wage and hour claims to encompass 4 years before the lawsuit is filed. The holding regarding retroactivity was withdrawn, but its core holding on the ABC test in the franchise model was reinstated. AB-5 states that certain provisions are retroactive “to the maximum extent permitted by law.” AB-5 takes effect January 1, 2020. Proactive franchisors may wonder how to maintain existing commercial relationships and sell franchises without unintended liabilities of employers. Franchise counsel should be consulted to review controls in place for brand protection, and the flow of monies in certain systems to identify key risk factors under the ABC test.

The Differences Between Franchises and Other Business Arrangements

Under California law, a business relationship is a “franchise” if: (1) the business will be substantially associated with the franchisor’s trademark; (2) the franchisee will directly or indirectly pay a fee to the franchisor for the right to engage in the business and use the franchisor’s trademark; and (3) the franchisee will operate the business under a marketing plan or system prescribed in substantial part by the franchisor.

Licensing, distributorship, and dealership arrangements are not franchises because they are missing at least one of the three elements of a franchise. For example, under a typical licensing arrangement, one company licenses another to sell its products or services in exchange for a specified amount of the proceeds without any additional involvement of the licensor.

In dealership and distributorship arrangements, independent businesses operate under their own trade names and usually buy products or services from another other party at wholesale prices and then resell them to the public. Neither party is substantially involved in the business affairs of the other. Generally, distributorship arrangements do not constitute franchises because the definition of a “fee” is not met,  because, a “fee” does not include payment for the purchase of initial and ongoing inventory at bona fide wholesale prices.

Licenses are private contracts. Licensors do not have to make public disclosure about their financial condition or other sensitive business information. Franchising, however, is regulated by federal law and by many state’s laws. Under California’s Franchise Investment Law, it is unlawful to offer or sell a “franchise” in California unless the offering has been registered with the Department of Business Oversight (DBO) or it is exempt from registration. If a business relationship satisfies the elements of a franchise under California law, the franchisor must: (1) file a franchise disclosure document with the DBO outlining the franchise opportunity in detail and providing information regarding the franchisor’s background and business experience before entering into any discussions with potential franchisees; and (2) disclose potential franchisees with its registered franchise disclosure document and wait at least 14 full days before having the franchisee execute any franchise documents or make any payments to the franchisor. These burdens are not imposed in licensing, distributorship and dealership relationships.

The DBO and California courts have little compassion for trademark owners that claim they did not know the law or argue that there was no intent to create a franchise. The DBO closely monitors franchisor-franchisee arrangements and may assess penalties of $2,500 per violation of the California Franchise Investment Law. The DBO also has the authority to require franchisors to provide its franchisees with written notice of the violation, offer rescission of the franchise, and refund payments made by the rescinding franchisees. These unexpected consequences can prove painful to an accidental franchisor.

The determination whether a license, distribution or dealership arrangement should be treated as a franchise must be made after a thorough analysis of a trademark owner’s business structure. Understanding the basics of franchising will help you recognize when it is time to contact a franchise law specialist to avoid a potential minefield of unintended consequences.

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