Franchisor’s Misclassification of Franchisees – Do You “Like” Your Franchisee?

In today’s social media world we are encouraged to become someone’s friend or to “like” something they say or do.  Since long before the internet, franchisors have tried to attract people who will “like” their concept.  Franchisors develop systems that allow them to sell their goods and services, and they spend time, capital and human resources hoping to attract franchisees that will like their concept and be compatible business partners.  The selection process is akin to dating, which then hopefully leads to a successful marriage.  Sometimes franchisors find themselves dealing with franchisees they never “dated,” let alone “married,” who somehow think they have a relationship. Other times, parties who agreed to be their franchisees now want to change the relationship through “divorce.”  When a business relationship turns sour, some people will claim to be a franchisor’s friend and others may claim that despite a franchise agreement, the franchisor is in fact their employer. 

Classification and characterization of franchisees is a topic that is being litigated more frequently.  Recently, janitorial supply companies have been the subject of litigation where the franchisees claimed that instead of being independent contractors, they were in fact employees of the franchisor.  On the issue of improper classification as an independent contractor rather than as an employee, in Juarez v. Jani-King of California, Inc., 2012 WL 177564 (N.D. Cal.), a California district court granted Jani-King’s motion for summary judgment, ruling that the franchisor did not exercise sufficient control over the plaintiffs to render them employees.  Despite the fact that Jani-King imposed a number of controls on the franchisees, these controls were no greater than necessary to protect its trademark, trade name and good will.

Contrast this decision with the line of cases known as Awuah v. Coverall which have made their way through the Federal District Court of Massachusetts (Awuah v. Coverall, N. Am., Inc., 707 F.Supp.2d 80, 81 (D. Mass, 2010) (Awuah I) and 740 F.Supp.2d 240, 241 (D. Mass, 2010) (Awuah II)) and state court system (460 Mass. 484, 952 N.E.2d 890, Mass., 2011).  In Awuah I, the judge ruled that the Coverall franchisees were misclassified as independent contractors and found them to be employees.  The district court judge certified questions to the Massachusetts state court for a determination.  The state court ruled that Coverall as an employer, not as the franchisor, was required to repay “franchise fees” because in this context they amounted to requiring an employee to buy its job from an employer and was violative of public policy.  Additionally, payments made by the employee (franchisee) for workers’ compensation insurance were recoverable because it is against public policy to require an employee to agree that it is responsible to obtain and pay for workers’ compensation insurance. 

Another recent case in the janitorial supply setting, Hayes v. Enmon Enterprises, LLC, dba Jani-King of Jackson and Jani-King Franchising, Inc. (2011 WL 2491375 (S.D. Miss.)), has raised eyebrows because of its holding that a franchisor may be vicariously liable for the negligence of its franchisee.  In this case, Jani-King, in its motion for summary judgment, was unable to convince a United States district court judge in Mississippi that it was not liable as a matter of law when a customer of one of its franchisees slipped and fell on the restroom floor and injured himself.  The injured party claimed that there was no “wet floor” sign warning of the wet conditions.  The franchisor was unsuccessful in its motion for summary judgment in part because the judge held that the franchise agreement more closely resembled the characteristics of an employer-employee relationship.  Looking at 10 factors delineated by the Mississippi Supreme Court to establish an employer-employee relationship, the court found there were five factors suggesting that the franchisee was an independent contractor and five factors suggesting an employer-employee relationship.  Although a close question, the court ruled that the franchise agreement demonstrated such a level of control over the franchisee’s conduct that it was unwilling to find that an independent contractor relationship was created.  It remains to be seen what will happen when the case goes to trial, but because slip and fall cases routinely occur in franchised locations and rarely has a franchisor been held vicariously liable for the negligent acts of its franchisee, it will be an important case to follow.

Another interesting twist in the area of properly classifying the relationship between a franchisor and franchisee is insurance agents.  When Allstate New Jersey Insurance Company took actions to terminate some of its insurance agents for failure to meet certain, expected results, one agent filed suit in Marco DeLuca v. Allstate New Jersey Insurance Company (unreported Bergen County Superior Court) claiming that he was a franchisee who was entitled to the protection of the New Jersey Franchise Protection Act.  The New Jersey Act provides that there must be good cause for termination.  The case is set for summary judgment, and attempts to remove it to federal district court have been unsuccessful as the district court has remanded the case back to the Superior Court of New Jersey.  Connecticut has ruled in the past that insurance agents may be franchisees (see Charts v. National Insurance Company, 397 F.Supp. 2d 357 (D. Conn. 2005)), while other states have not elevated insurance agents to the status granted to a franchisee. 

Another business structure that is widely utilized is the supplier-distributor relationship.  Often, when the distributor sells less of the supplier’s product than is expected, the supplier will terminate the relationship.  When faced with termination, the distributor will often look at its supplier and try to change the relationship to one of franchisor-franchisee so it receives the protection that state franchise laws provide.  In Echo v. Timberland Machines & Irrigation, Inc. (2011 WL 148396, N.D. Ill., 2011), Timberland, a Connecticut-based distributor of Echo’s products, was given notice of termination and unpaid invoices.  Timberland counterclaimed that Echo violated the Connecticut Franchise Act.  To receive the protection of the Act, Timberland had to establish that its business was substantially associated with the Echo trademark and, because its Echo sales accounted for only 30 to 35 percent of its total sales and gross profits, it was unable to do so.  The Illinois court, applying Connecticut law, granted summary judgment for Echo.  The court found that because Timberland’s business with Echo never amounted to more than 50 percent of its business, they were not substantially associated with each other and therefore were not franchisor and franchisee.  The Seventh Circuit Court of Appeals affirmed the district court’s granting of summary judgment in Echo, Inc. v. Timberland Machines & Irrigation, Inc. (661 F.3d 959, C.A. 7 (Ill.), 2011).

The janitorial cases, insurance agent cases and distributor-supplier cases are all illustrations of the lengths to which parties will go to either establish a franchise relationship or to disassociate from one another to make the franchisor-franchisee relationship into something not originally contemplated when the parties first met and signed a franchise agreement.  So in today’s world, even though you may choose to “like” someone and they you, the relationship can sour – and you can also find yourself being “liked” or “disliked” when you really don’t want to reciprocate. 

Contact: Richard S. Mulligan

614.723.2035

rmulligan@ralaw.com

Subway Franchisee Ordered to Pay Back Wages for Failing to Compensate Employees for Training

On April 9, a Subway franchisee with 29 locations in Tampa, Florida was ordered to pay back wages to 122 employees after a Department of Labor (DOL) investigation concluded that employees were not compensated for taking Subway “Sandwich Artist Certification” training, a violation of the Fair Labor Standards Act (FLSA).

Commenting on the investigation, the DOL director of the Wage and Hour Division’s Tampa District Office stated, “The Wage and Hour Division is continuing its restaurant enforcement initiative throughout Florida to make sure employees of both full-service and limited-service restaurants receive their full pay, and that employers who follow the law do not have to face unfair competition from those who ignore it.”

Franchisees can learn several lessons from the DOL’s investigation:

1.   Be aware that this initiative is not limited to Florida, so the restaurant industry as a whole should be aware it is under heightened scrutiny from the DOL.

2.   Pay attention to training time. Training time is a topic that generates significant litigation under the FLSA because of confusion as to when employees must be compensated for training. An easy rule to follow is that most training time is work time. Employers must compensate employees for training that occurs during an employee’s regular shift as well as training that is required by the employer. Training time does not need to be counted as work time if: 1) it occurs outside of an employee’s normal work schedule; 2) the training is voluntary (there must be no pressure from the employer and no adverse consequences for failing to attend); 3) the training is not directly related to the employee’s current job (typically it is designed to qualify the employee for advancement); and 4) the employee performs no other work during the training.

3.   It’s important to note that in the case of the Subway franchisee, the DOL expanded its investigation to other locations owned by the same franchisee, greatly increasing the cost and liability for the franchisee. Likely, the DOL received a tip or complaint related to one particular location, and when the DOL discovered the same franchisee owned other stores, it requested records related to each one. Accordingly, franchisees with multiple locations should ensure that each location is in compliance with the law. 

Contact: Jon Secrest

614.723.2029

jsecrest@ralaw.com

Changes to ADA Accessibility Standards Go Into Effect March 15th

Under Title III of the Americans with Disabilities Act (ADA), no individual may be discriminated against on the basis of disability with regard to the full and equal enjoyment of the goods, services, facilities, or accommodations of any place of public accommodation by any person who owns, leases (or leases to), or operates a place of public accommodation. “Public accommodations” include most places of lodging (such as inns and hotels), recreation, transportation, education, and dining, along with stores. Importantly, Title III requires places of public accommodation to be designed, constructed, and altered in compliance with the ADA’s accessibility standards. These standards were amended in September 2010 with some provisions taking effect last year and the provisions related to accessibility taking effect on March 15, 2012.

The current accessibility standards were established in 1991. Facilities that were addressed in the 1991 standards and that comply with the 1991 standards do not have to comply with the 2010 amendments. If a 1991 standards-compliant facility changes a 1991 standards-compliant element, it must come into compliance with the 2010 standards.

The 1991 standards, like the 2010 standards, require removal of architectural barriers when it is “readily achievable” to do so. What constitutes “readily achievable” is typically a battle of expert witnesses in any litigation brought to remove such barriers. Now, however, any facility removing such barriers must comply with the 2010 standards.

The 2010 standards apply to any new construction or alterations that go beyond mere maintenance. Any facility undertaking construction or alterations should ensure its planners, designers, and/or architects certify the facility is in compliance. The actual standards are available on the U.S. Department of Justice’s website: http://www.ada.gov/2010ADAstandards_index.htm. Examples of the 2010 standards and elements covered include:

·        Mounting height requirement for light switches and thermostats (lowered from 54 inches to 48 inches);

·        Van-accessible parking spaces requirement (raised from one for every eight spaces to one for every six spaces);

·         Exercise machine and equipment requirements;

·         Play area requirements;

·         Swimming pool requirements; and

·        Golf facility requirements.

The Department of Justice and plaintiffs are active in pursuing claims related to ADA accessibility. If you own, lease, or operate a place of public accommodation it is in your best interests to review the standards, especially if you are undertaking any construction or remodeling.

Contact: Jon Secrest

614.723.2029

jsecrest@ralaw.com

Continued Trademark Use by Former Franchisee Constitutes “Counterfeiting”

On December 19, 2011, an Indiana federal district court held that a franchisee that continues to use a franchisor’s trademarks after termination of its franchise agreement is liable for counterfeiting – and mandatory treble damages and attorneys fees - under 15 U.S.C. §§ 1116(d)(1)(B) and 1117(b).

In Century 21 Real Estate, LLC v. Destiny Real Estate Properties (2011 WL 6736060 (N.D.Ind.)), franchisee Destiny Real Estate obtained a license, under its franchising agreement with franchisor Century 21, to use Century 21’s federally registered trademarks. In exchange, Destiny agreed to pay an annual commission and advertising fee. When Destiny failed to pay, Century 21 terminated the franchise agreement; however, Destiny continued to use Century 21’s trademarks on signs and websites. Century 21 brought claims against Destiny, including one for counterfeiting under 15 U.S.C. § 1116(d)(1)(B), which, if successful, would entitle Century 21 to mandatory treble damages and attorneys fees under 15 U.S.C. § 1117(b). To make this claim, Century 21 needed to show that: (1) the mark in use by Destiny was “a spurious mark which is identical with, or substantially indistinguishable from” Century 21’s registered mark; (2) Century 21’s mark was registered on the U.S. Patent & Trademark Office’s principal register for use with the same services with which Destiny used the mark; (3) Destiny was not authorized to use the mark at the time the services were provided; and (4) Destiny acted with knowledge and intent. 

The main question for the court was whether the continued use of a mark by a formerly authorized franchisee constituted “use of a counterfeit mark.” The court held that, in fact, it did, stating:

[i]f an unrelated entity had created an identical trademark and provided authorized goods or services (or the kind provided by the owner of the mark) under that mark, there would be no question that there was counterfeiting. The Court can conceive of no reason why an ex-franchisee should escape liability for counterfeiting simply because that person had access to a franchisor's original marks because of the former relationship and therefore did not need to reproduce an identical or substantially similar mark.

Century 21, 2011 WL 6736060, at *5. 

Although franchisors frequently and successfully assert trademark infringement claims against former franchisees, the decision in Century 21 gives franchisors a new weapon in their arsenal for enforcing their trademark rights against ex-franchisees. The threat of additional damages and attorneys’ fees afforded by the counterfeiting claim could encourage ex-franchisees to comply more readily with franchisors’ demands for cessation of use. Franchisees, on the other hand, will have an added incentive to exercise more diligence in promptly ceasing use of franchisor trademarks after termination of a franchise agreement.

Contact:

Suzanne K. Ketler, Ph.D.

330.849.6641

sketler@ralaw.com

Do You Know What Your Employment Practices Liability Insurance Covers?

You might be surprised to find out what your employment practices liability insurance (EPL) covers or, more importantly, what it does not cover. Recently, Cracker Barrel discovered that a lawsuit brought by the Equal Employment Opportunity Commission (EEOC) was not covered by its EPL. As a result, Cracker Barrel is on the hook for the $2 million settlement and $700,000 in legal fees. The case, Cracker Barrel Old Country Store v. Cincinnati Ins. Co., is currently on appeal in front of the United States Court of Appeals for the Sixth Circuit.

The issue boils down to the definition of a claim under the policy. The policy defined a “claim” as “a civil, administrative or arbitration proceeding commenced by the service of a complaint or charge, which is brought by any past, present or prospective ‘employee(s)’ of the ‘insured entity’ against any ‘insured’ for any of the following causes… .” The causes listed in the policy encompassed the usual discrimination, sexual harassment, and wrongful discharge. Between December 1999 and March 2001, 10 Cracker Barrel employees filed charges of discrimination with the EEOC. Cracker Barrel provided notice of these charges to Cincinnati Insurance. On August 11, 2004, the EEOC brought suit against Cracker Barrel. The EEOC’s lawsuit arose from allegations of sexual harassment, racial harassment, race discrimination, and retaliation and included the allegations from the 10 charges of discrimination. Cracker Barrel again provided notice of the lawsuit to Cincinnati.

Cincinnati denied coverage and Cracker Barrel brought suit requesting the court declare that Cincinnati had both a duty to defend and a duty to indemnify Cracker Barrel for any loss. Cracker Barrel also asserted a claim for bad faith against Cincinnati. A duty to defend is broader than the duty to indemnify. Typically an insurance company has a duty to defend if the policy arguably covers any of the claims. Cracker Barrel argued that at the very least it was entitled to reimbursement of the $700,000 in attorney fees it incurred because Cincinnati had a duty to defend. Cincinnati argued it had no duty to defend or indemnify.

The court determined that in order for claims to be covered under the policy they must be brought by an employee. In this case, the claims were brought by the EEOC. As such, the court determined that Cincinnati did not have a duty to defend or indemnify Cracker Barrel.

EPL policies differ in their definitions of claim. As noted, the definition of claim in this policy included language that it must be brought by an employee. Many policies do not include this limiting language. It is in the employer’s best interests to review EPL policies and understand what claims are covered before incurring liability or spending significant attorneys’ fees defending a claim that the insurance company does not cover. This is especially applicable now as the EEOC recently reported that in 2011 it filed 300 lawsuits against employers compared to 271 lawsuits in 2010. Additionally, for the third year in a row the total monetary relief the EEOC obtained from filing lawsuits increased.  

Contact: Jon Secrest

614.723.2029

jsecrest@ralaw.com

Does It Matter How You Own Your Franchise?

Richard S. Mulligan, a partner in the Columbus, Ohio office of Roetzel & Andress, recently wrote an article for Franchise Law News, “Does It Matter How You Own Your Franchise?" in which he examines the ownership structure of franchisees and the importance of understanding that this structure is subject to the rules and procedures set forth by the franchisor. If a franchise is not owned in the proper manner, the franchisor has the right to object and may terminate the franchise.

The article discusses a State of Washington Appellate Court ruling (Marte v. Hernandez, May 16, 2011). The case involved the purchase of two McDonald's franchises by a pair of brothers, and demonstrates that deception can cause even blood relationships to disintegrate. Click to read the entire article. 

Contact: Richard S. Mulligan
614.723.2035
rmulligan@ralaw.com

It Doesn’t Always Pay to Be Royalty, Especially if You’re a Dairy Queen

While the general public is star struck by the glamour and glitz of royalty, in the franchise world, royalty is not always desirable, especially if the franchisor is a closely held corporation.

If a franchisor is deemed to be a closely held regular corporation for federal tax purposes, negative tax consequences can result from the franchisor’s receipt of certain royalty payments. Such royalty payments can be construed to be personal holding company income and thereby subject the corporation to a penalty tax on its undistributed earnings, known as the personal holding company (PHC) tax.

Under Section 541 of the Internal Revenue Code (Code), in addition to other taxes, there is a tax imposed on the undistributed PHC income of every personal holding company equal to 15% of the distributed income of the PHC.

What, then, is this mysterious PHC income? PHC income is income derived from any one of eight specific categories, but for our purposes, the category of focus is dividends, comprised of dividends, interest, royalties (other than mineral, oil or gas royalties or copyright royalties), and annuities.

The bottom line is that if you are a franchisor operating through a closely held corporation and you receive royalty payments, you could be subject to PHC tax. The Tax Court has had tremendous difficulty wrestling with the issue of PHC income.

The most notable line of cases with respect to characterization of royalty income to a franchisor involves Dairy Queen. In each of the Dairy Queen cases, the franchise agreements governing payment to the franchisor contained varying language regarding the characterization of certain rights transferred to the franchisees and the consideration paid to the franchisor for such rights. The courts in multiple jurisdictions produced wildly varying results with respect to the characterization of income earned, partly because of the differing language in each of the franchise agreements. Finally, Congress enacted Code Section 1253, effectively characterizing payments received by franchisors as ordinary income.  

Even after the enactment of Code Section 1253, known in tax circles as the “Dairy Queen section,” courts continue to grapple with the question of whether “royalties” should be characterized as PHC income or ordinary income because, while Code Section 1253 characterized royalty income as ordinary income, Congress left open whether the ordinary income should be characterized as PHC income. PHC income is subject to PHC tax while income that is not PHC income is not subject to PHC tax.

Given that the franchisor does not want its income characterized as PHC income, the first step is to fight the characterization of payments received as “royalties” as PHC income. In order to avoid this characterization, special care must be given to the franchise agreement. In most franchise agreements, royalty payments to franchisors are not solely for the use of a trademark or license, but include other services rendered. The payments for other services rendered should not be royalty income for PHC income, but ordinary income that is not subject to PHC tax.

The Tax Court has examined the language in franchise agreements to determine whether royalty payments should be characterized as PHC income. If a franchise agreement does not contain provisions with respect to other services rendered as part of the royalties paid to a franchisor, the Tax Court has held that the franchisor has not met the burden of proof required to classify royalty payments to a franchisor as non-PHC income for services rendered.

Contact Tae Shin and the franchise attorneys at Roetzel & Andress to discuss drafting your franchise agreements to properly characterize royalty payments.

Contact: Tae Shin

407.245.2452

tshin@ralaw.com