What Does Dynamex Really Mean For Franchising in California?

The California Supreme Court’s decision in Dynamex Operations W., Inc. v. Superior Court, 416 P.3d 1 (Cal. 2018), sent shockwaves through California’s business community in May when the court adopted a new standard for classifying workers as independent contractors or employees. The standard is heavily tilted in favor of the latter, beginning with a presumption that a worker is an employee, and placing the burden on the hiring entity to establish three factors supporting its classification otherwise. The decision could theoretically affect a host of industries in California, including franchising, which depend on the flexibility associated with contractual relationships as opposed to employment ones. But is California really poised to destroy the franchise business model by classifying franchisees as employees of franchisors?

Dynamex is certainly bad news for businesses that rely on independent contractors as a component of their operations, but there are legal and empirical reasons to believe that its implications will not extend to franchising.  At the outset, Dynamex is not a case about franchising. The issue in Dynamex was the proper classification of delivery drivers as employees or independent contractors for the purpose of California's Wage Orders, which provide employees with protections for minimum wages, overtime pay, and rest breaks. In evaluating whether the delivery drivers were independent contractors or employees protected by California's wage and hour laws, the court announced its departure from a decades-old multifactored approach, and instead adopted the following ABC test:

[U]nless the hiring entity establishes (A) that the worker 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) 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, the worker should be considered an employee and the hiring business an employer.

This standard will make it exceedingly difficult for businesses to classify workers as independent contractors. As the court explained, "The hiring entity's failure to prove any one of these three prerequisites will be sufficient in itself to establish that the worker is an included employee, rather than an excluded independent contractor, for purposes of the wage order." To this end, "a court is free to consider the separate parts of the ABC standard in whatever order it chooses," because "in many cases it may be easier and clearer for a court to determine whether or not part B or part C of the ABC standard has been satisfied than for the court to resolve questions regarding the nature or degree of a worker's freedom from the hiring entity's control for purposes of part A of the standard." It will be particularly challenging for many businesses to establish part B of the standard, which requires that their workers perform work that is outside the usual course of their business.

But the part of the Dynamex decision that really set off alarm bells for franchisors was the court's citation of two Massachusetts cases as examples of a hiring entity that had failed to satisfy part B of the standard, Awuah v. Coverall N. Am., Inc., 707 F. Supp. 2d 80, 82 (D. Mass. 2010) and Coverall N. Am., Inc. v. Com'r of Div. of Unemployment Assistance, 857 N.E.2d 1083, 1087 (Mass. 2006). Many franchisors may recall the controversy raised by these decisions, where courts in Massachusetts held that Coverall's franchisees were actually employees under a standard similar to the ABC test adopted in Dynamex. The court in Awuah awarded the franchisees $3 million in treble damages and refunds of their franchise fees, business fees, and insurance deductions. The result even led Coverall to cease its franchising operations in Massachusetts.

The implications of these decisions, however, ultimately proved to be more limited than many initially feared. The Massachusetts courts' classification of Coverall's franchisees as employees was factually dependent on Coverall's unique business model. Both cases focused on whether Coverall's franchisees performed work that was outside the usual course of Coverall's business. Coverall characterized itself as being in the franchising business, licensing a system for providing commercial cleaning services to its franchisees, who then performed such work in their independent businesses. Citing the same reasons, the courts in both cases disagreed.

In Coverall N. Am., Inc. v. Com'r of Div. of Unemployment Assistance, the court noted that Coverall's franchise agreement included "a provision that gives Coverall the exclusive right to perform all billing and collection for services provided by a franchisee and to deduct any fees from these collections before remitting payment to the franchisee." The court explained that in Coverall's franchise system, "all customer contracts were with Coverall, [and] the franchisees could not be a party to the contract unless the customer specifically requested a direct contract with the franchisee." In Awuah, the court likewise observed that new customers were "required to sign a contract with Coverall," "Coverall directly bills all customers," and "[i]n turn, the franchisee receives payment from Coverall for the services rendered to the customers." As a result, the court held that "Coverall sells cleaning services" and "the franchisees did not perform services outside the usual course of Coverall's business." In other words, Coverall was in the same business as its franchisees because it engaged in direct business with their customers.

Coverall's unique franchise system produced an anomalous result under the ABC test. Most franchisors do not pay franchisees from revenue collected by franchisors from billing customers under contracts directly between the franchisor and customer. This is the reverse of most franchise relationships, where the typical transaction that occurs is the franchisee paying a royalty fee to the franchisor in exchange for the franchisor's license to use its brand and system. So long as the franchise relationship can be characterized in this way, there is a much better argument that the franchisor and franchisee are not in the same line of business.

Dynamex remains a concerning decision for California businesses that rely on independent contractors, as well as individuals' freedom to contract, and workers who enjoy the flexibility that was provided by the gig economy. Franchisors will need to continue to monitor California law to see how its courts develop the ABC test. Plaintiffs’ attorneys will certainly attempt to apply its presumption of employment to the franchise relationship. Franchisors can minimize their exposure to such claims by avoiding practices that involve directly contracting with franchisees' customers, billing those customers, and remitting payments to franchisees. Franchisors should also require their franchisees to establish independent business entities and educate their franchisees on their independent status. Many of the best practices for minimizing joint-employer liability are equally applicable to employment classifications. If you are at all concerned about the implications of the Dynamex decision on your franchise system, do not hesitate to contact an attorney with Larkin Hoffman's Franchise and Distribution team.