Understanding the IFA litigation against California regarding AB-5

In a previous blog, we discussed the recent California legislation (AB-5) and the consequences it could have on franchises in The Golden State. Late last year, the International Franchise Association (IFA) filed a complaint against the State of California for declaratory and injunctive relief from that legislation to stop the legislation from applying to franchises.

The legislation sets out a test for distinguishing employees from independent contractors, but the legislation is phrased in such a way that it could be read to include franchises, as well, making franchisees employees of their franchisors. The IFA asks the California to carve franchises out of the legislation.

Here’s what you should know about the pending litigation and how it could impact California franchises.

What is in the IFA’s complaint against the new legislation?

Since representatives introduced AB-5 in the California legislature, it has been a subject of debate. The IFA’s lawsuit is not looking to nullify the bill, only to carve franchising out of the provisions.

One of the main components of AB-5 is the section that adopts the ABC test to determine whether a worker is an employee or an independent contractor. The concern is that under the ABC test, franchisees would be considered employees of their franchisors, not independent business owners. In the IFA’s complaint, the IFA states that franchising already has substantial federal and state regulations to support it, as well as having relationships built on strong and sound contracts.

The IFA states further that the franchise relationship is not an employment relationship, but a contractual one. A franchisor does not hire a franchisee as an employee; a franchisor enters into a contract with a franchisee/independent business owner to expand their brand for the benefit of both parties.

Benefits of the pre-ABC test franchise structure

The most significant benefit to the pre-ABC test structure for franchises is that the existing federal law, under the Federal Trade Commission (FTC), treated franchises as independent business owners. A franchisee was never intended to be an employee. If a business wanted to expand their brand with employees, they would not franchise their business, but just expand with company locations.  This is what Starbucks Coffee Company decided to do to expand their brand; their stores are all company stores run by employees of the company.

If franchisees are considered employees, it would alter the entire structure of franchising. Rather than a relationship based on a contractual agreement, the relationship would be employment based and franchisors would have to provide employment benefits and act in ways that a franchisor normally is not required to act with its franchisees.  It would destroy the benefits to anyone who wants to become an independent business owner by becoming a franchisee.  It is generally not beneficial to either the franchisor or the franchisee.

A few years ago, Massachusetts attempted similar legislation that had the same impact on franchises. The IFA brought a claim in that case, as well. Ultimately, in Massachusetts, courts decided to carve franchises out of the ABC test, allowing Massachusetts franchises to follow the federal laws that already governed franchises.

IFA’s argument

Over the history of franchising, the federal government has put rules in place to regulate franchises and how they conduct business. The FTC created the rules with the franchise concept in mind to eliminate fraud in the industry and protect franchisees.

The IFA and franchise owners are concerned that the ABC test would convert all franchise relationships into employment relationships. Before introducing the ABC test in California, franchises followed the FTC Rule and the California franchise laws.

The ABC test is not filling a void in the franchisee/franchisor relationship like it does in other situations with independent contractors. Instead, the ABC test creates a regulation that would overpower the previous rules and remove franchises from the federal and state regulations already in place.

The IFA’s proposal

Similar to what happened in Massachusetts, the IFA would like a declaration that the ABC test does not apply to franchises. The IFA stated in their complaint that franchises are better regulated under existing laws such as the Lanham Act, the FTC Franchise Rule, and California franchise law.

The ABC test and the resulting conversion of franchisees to the traditional employment relationship would irreparably harm franchisees, franchisors and their franchise systems. Rather than a catalyst for independent business, new regulations could cripple franchises by superseding rules franchises already follow.  This would not help franchisees and would be quite detrimental to business in California in general.

What happens if courts do not carve franchising out of AB-5?

Pre-AB-5 legislation allowed franchisors to contract with franchisees so that franchisees could create a business that gave them some of the freedoms of owning a business and the structure and guidance that came with an established brand. If courts decide that franchises should not be carved out of the law, it will destroy the franchise model.

While the category of an employee could come with some advantages, there are also some potential problems. Without the flexibility of a contractual relationship (instead of an employment one), franchisees could have less freedom to operate their franchise as they would before AB-5. Establishing an employment relationship could also inhibit potential growth and profitability for all parties and is contrary to what either party intended when they entered into the franchisor/franchisee relationship. The likely net result will be fewer franchisors willing to open franchises in California thereby creating a lack of competition and fewer businesses.

What happens next?

Over the past few months, there have been several motions and amendments in the IFA lawsuit for the court to consider. No date is currently set for the case to be heard in California.

In the meantime, most California franchises are operating their current locations exactly as they were before the passage of AB-5. However, some franchises are waiting until there is an official ruling on the matter before they open new locations. We will all have to wait to determine how the ABC test will be applied to franchising both in California and nationally (the Protection of the Right to Organize (PRO) Act is a federal proposed bill that would require the ABC test for determining employees and independent contractors with no carve out for franchises).