Client Bulletin #593

UPDATE (10/7/16): Jani-King has petitioned for rehearing by all of the judges on the Third Circuit.

The U.S. Court of Appeals for the Third Circuit recently dealt a blow to franchisors everywhere in Williams v. Jani-King of Philadelphia, Inc. Granted, the court only affirmed a ruling that the case can be litigated as a class action, but in doing so, it missed an important opportunity, one highlighted by the dissent.

The two named plaintiffs (and the class they claim to represent) are commercial cleaning franchisees. What does this mean? They bought a commercial cleaning business under federal franchise laws, and they run a business. They are literally defined as business owners under federal franchise laws. In fact, the Third Circuit acknowledged that certain of their businesses earn more than $40,000 in gross revenues a month, or about $500,000 a year. They have their own employees, and they are responsible for hiring, firing, and compensating their own employees. With their business, as with any other, they are responsible for complying with all laws, including employment laws. And unlike employees, they keep approximately 85 percent of the revenue they generate.

Nonetheless, the plaintiffs allege they are not business owners but “employees” under Pennsylvania state law. After their franchises failed, they brought this lawsuit on behalf of all other supposedly similar disgruntled business owners alleging “misclassification.”

But ask the franchisees who still own and operate their businesses whether they want to be employees – e.g., sign in, sign out, show up on time, be told where to go and when to go there, and be subject to disciplinary action and termination if they are “insubordinate” – and they’ll reply, “Of course not!  That’s why I bought a business.”

The majority opinion in the Third Circuit could not seem to grasp this point. Instead, looking rigidly at the factors that make an individual an “employee” rather than an independent contractor, the majority determined that Jani-King, as franchisor, retained substantial controls over the franchisees by virtue of provisions of the parties’ form franchise agreement. Thus, given that rights of control were found to be the key component demonstrating a “master-servant” relationship under Pennsylvania law, a common issue of law and fact predominated over individual issues: whether the controls possessed by Jani-King under the franchise agreement were sufficient to create an “employment relationship” between it and the franchisee plaintiffs.

Statutory and case law from jurisdictions across the country teaches that franchisors must control their franchisees. Indeed, the very essence of a franchise relationship requires the franchisor to control the franchisee’s business operations so that there is uniformity throughout the franchise system, a common experience for the end user (here, the customers receiving the commercial cleaning service), and a business format that, if followed, will lead to a successful outcome for the unit franchise owners. The U.S. Code of Federal Regulations (scroll down to subsection (h)(2) at the link) defines a franchise as one in which the franchisor has “authority to exert a significant degree of control over the franchisee's method of operation, or provide significant assistance in the franchisee's method of operation.” In other words, “rights of control” are required of Jani-King under federal franchise law, and it is this same “right of control” that is the most important component for determining an employment relationship under Pennsylvania law. It’s enough to make your head spin.

The majority was not unaware of these issues. In their defense, they took care to note that their decision affirming that the case continue as a class action was not a ruling on the merits at all. As they noted, Jani-King can still prove that its franchisees are not in fact its employees, and such a ruling would be binding on all members of the putative class. To get there, Jani-King will now have to go through disruptive and expensive litigation, with no sign that the Third Circuit truly appreciates the requirements of franchise law.

In contrast, the dissent noted (correctly, in our opinion) that in conducting a misclassification analysis the court should disregard any controls required by franchise law to promote uniformity within the system and manage the end-user’s experience with the franchise brand. Once the controls required by franchise law were ignored, the dissent recognized, there really were no “controls” left.

In a virtually identical case, Juarez v. Jani-King, Jani-King prevailed on the same argument under California law. In Juarez, applying California law, the court found that the “rights of control” were not the kind that created an employment relationship. As the court noted,

under California law, a franchisee must show that the franchisor exercised ‘control beyond that necessary to protect and maintain its interest in its trademark, trade name and goodwill’ to establish a prima facie case of an employer-employee relationship.  ...  As such, the Court can safely exclude from the employee-employer relationship analysis facts that merely show the common hallmarks of a franchise – those that constitute a “marketing plan or system” under which the franchisee’s operation is “substantially associated with the franchisor’s trademark, service mark, trade name,” or good will.

California is one of 14 “registration states.” It has its own franchise law. Thus, the analysis of California courts on the subject is more sophisticated and advanced than in states like Pennsylvania that are not “registration states.” In Williams, the Third Circuit had a thoughtful and direct precedent within the same franchise system, and a well-reasoned analytical framework that it could have applied. The majority in Williams did not attempt to distinguish the Juarez decision, perhaps because it couldn’t. It simply said that, for now, it disagreed with Juarez.

Let’s hope that Jani-King hangs in there. Unfortunately, as the Williams dissent noted, the majority’s opinion raises the stakes for the franchisor. It’s enough to cause the business minds behind the franchise system to start weighing economic risks.

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