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Impact of California’s AB5 on Franchising

California’s passage of Assembly Bill 5 (“AB5”) represents a significant legislative shift in what constitutes and qualifies as an employer-employee relationship under California law. AB5 creates stricter requirements as to when a California business may classify an individual as an independent contractor and, thereby, extends California’s extensive employee wage and labor protections to individuals who previously qualified as independent contractors and who, now, must be classified as “employees”.

But what affect does AB5 have on franchisors in the State of California and what do franchisors need to know? Below we discuss what AB5 is, the standards legislated by AB5, and the potential impact on franchising.

What Is California’s AB5?

On September 11, 2019 California’s Governor signed into law Assembly Bill 5, commonly referred to as AB5 and will take effect on January 1, 2020. AB5 is a labor law that governs the employer-employee relationship in California and, in particular, expands the definition of when a business is required to treat an individual as an “employee” as opposed to an “independent contractor.”

The most direct and intentional impact of AB5 is on the “gig economy” and the relationship between companies such as Uber and Uber’s independent contractor designated ride-sharing drivers. Under AB5, Uber and many other companies may be required to reclassify their independent contractor relationships to employment relationships, thereby, triggering extensive employee legal protections and expenses. The impact of AB5 goes beyond technology driven businesses and potentially extends into all business relationships where a business relies on the services of an independent contractor.

As discussed below, AB5 may also significantly impact the franchise industry.

The ABC Test: Independent Contractor Relationship Versus Employer-Employee Relationship

To understand the potential impact of AB5 on franchising it’s important to have a general understanding of what AB5 does and the Dynamex and Vazquez decisions.

AB5 creates the legal standards and factors that determine when an individual must be classified as an employee as opposed to an independent contractor. AB5 codifies California case law and, specifically, the California Supreme Court’s ruling in the Dynamex decision where the court articulated the ABC 3-part test – Part A, Part B, and Part C – that must be satisfied before a business may classify an individual as an independent contractor. If the ABC test is not satisfied then the individual must be classified and treated as an employee.

Under California law (AB5), effective January 1, 2020, a business (referred to as a “hiring entity”) may only classify a person as an “independent contractor” if the following three-part ABC test is satisfied:

  • The Control Test – The person must be “…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.”
  • The Scope Test – The person must “…perfor[m] work that is outside the usual course of the hiring entity’s business;” and
  • The Trade Test – The person must be “…customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

If all three factors of the ABC test are not satisfied the person must be classified and treated an employee and not an independent contractor.

A significant concern for the franchise community involves the May 2019 decision in Vazquez v. Jan-Pro Franchising International where the Ninth Circuit held that the Dynamex decision and its ABC test could be applied retroactively to the franchisor-franchisee relationship. The facts underlying the Vazquez decision involved a traditional master franchise relationship where Jan-Pro granted master franchise rights to a master franchisee who then granted franchises to individual unit franchisees. In vacating the lower courts grant of summary judgment that was in favor of Jan-Pro and in remanding the case back to the district court for further proceedings, the Ninth Circuit held that the Dynamex ABC test should be applied to the franchisor-franchisee relationship in determining whether or not a franchisor possesses joint-employer liability for franchisee labor law claims. The Vazquez litigation is still proceeding and is not fully settled.

AB5’s Impact on Franchising

AB5 codifies into law the Dynamex ABC test and although AB5 is not a franchise specific law, AB5 presents two franchisor related risks, one a primary risk and the other a secondary, not yet determined, risk:

Risk 1: Primary Risk to Franchisors – The primary franchise risk relates to standard joint employer liability issues and is most applicable to franchise systems where franchisees rely on independent contractors as opposed to an employee classified workforce.

If your franchisees rely on independent contractors to provide goods or services then those relationships need to be reevaluated to determine whether or not the ABC independent contractor test is satisfied.

If the ABC test is not satisfied then your franchisees must reclassify their independent contractors to employees. Failure to do so will create California labor law violations and, potentially, if, as a franchisor you were subjected to “joint employer” liability (i.e., as a franchisor you maintain a form of direct control over your franchisee’s employees such as input into decisions involving hiring, firing, setting payroll, setting hours, etc…) then you could be exposed to joint employer driven AB5 liability for a franchisee’s misclassification of employees.

Risk 2: Secondary Risk to Franchisors – The secondary risk is a risk that has not yet fully materialized but has raised significant franchise industry concern and is one that has been wisely and proactively advocated against by the IFA. This secondary risk relates to the potential for AB5 and the ABC test to be used as a new and reduced standard for determining when a franchisor possesses joint employer liability.

The statutory language contained in AB5 is expressly based on the codification of the Dynamex decision and in light of the Ninth Circuit’s decision in Vazquez, a significant concern exists that AB5 may be used by plaintiffs’ lawyers to expand the circumstances as to when a franchisor is subjected to joint employer liability, i.e., in future labor litigation between franchisees and their employees, plaintiffs’ lawyers will attempt to argue that the franchisor should possess joint employer liability if the relationship between the franchisor and its franchisee satisfies the ABC test which, in almost all franchise relationships, would be satisfied. Applying the ABC to determinations of franchisor joint employer liability would represent a significant expansion of franchisor joint employer liability.

Proactive Measures Franchisors and Their Franchise Counsel Should Consider

Currently this is an evolving situation and the most pressing impact will be on franchise systems that have franchisees who rely on independent contractor relationships. If your model is independent contractor driven, franchisee-contractor relationships must be carefully reevaluated in light of AB5’s mandates. Misclassification of employees will create labor liability and, potentially, joint employer liability.

As to the potential industry-wide issue for all franchisors, i.e., whether or not the reduced ABC test standards will be applied by courts in determining whether or not a franchisor possesses joint employer liability, this issue is on-going and one that requires close monitoring. The IFA has been and remains a crucial advocate against this outcome and appears to be undertaking important lobbying efforts on behalf of the entire franchise industry.

We will be closely monitoring AB5 and all joint employer liability issues.

In the meantime, although not a complete solution, it remains important to stay vigilant with preventive measures to avoid joint employer liability. Make sure your franchise agreements contain express disclaimers as to joint employer liability and expressly limit any and all control over employee level decisions to issues of brand protection. Likewise, we recommend that you thoroughly review your operations manual to remove any and all references, guidelines, or recommendations that, in any way, may be interpreted as involving labor or employment decisions to be made by your franchisees.