Are Franchisees a Franchisor’s Employees Under State Law? The Massachusetts Experience

Vol. 14, No. 4

By

Weston Patrick, P.A.

Nationwide, franchise companies and their lawyers have voiced serious concern that their franchisees, long assumed to be independent contractors, may be held to be employees under labor, tax and other laws.  This concern derives directly from recent rulings by Massachusetts state and federal courts that analyzed franchise relationships in the commercial cleaning service industry.  In the most recent decision, Awuah v. Coverall North America, Inc., 460 Mass. 484, 2011 Mass. LEXIS 734 (decided on August 31, 2011) (“Coverall IV”), the Massachusetts Supreme Judicial Court (“SJC”) did nothing to allay this concern.  In a unanimous ruling, it held that a franchisee of a cleaning service franchisor, who was among a group of franchisees that had been found by a federal court to be the franchisor’s employees for state labor law purposes as a result of their misclassification as independent contractors, was entitled to recover significant damages.

Some suggest that franchise companies will cease franchising in Massachusetts and/or curtail their operations here due to these recent rulings, and that there will be a ripple effect in other states that may follow Massachusetts’ lead in this area.  Are these heightened concerns justified?  Not necessarily, because the contract structure in the cleaning service franchise under review differs significantly from contract structures traditionally used in most franchise relationships.

 

Summary of Prior Coverall Cases

A brief history of the Coverall litigation is necessary to understand the SJC’s recent ruling.  In Coverall North Am., Inc. v. Com’r of Div. of Unemployment Assistance, 447 Mass. 852 (2006) (“Coverall I”), a Coverall franchisee sought, and obtained, state unemployment benefits following the termination of his franchise agreement.  Coverall opposed its franchisee’s receipt of the benefits on the ground that the franchisee was an independent contractor, not an employee, and was therefore ineligible to receive such benefits.  The franchisee’s claim was upheld in administrative proceedings, and affirmed, ultimately, by the Commonwealth’s highest court.  The SJC held that the franchisor was unable to establish that the franchisee was an independent contractor under G. L. c. 151 sec. 2(c).

In 2007, certain Coverall franchisees brought a class action in federal court.  Granting plaintiffs’ motion for partial summary judgment in March 2010, Judge William Young ruled that Massachusetts franchisees of Coverall had been misclassified as independent contractors under the Commonwealth’s misclassification statute, G. L. c. 149 sec. 148B, and, accordingly, were “employees.”  Awuah v. Coverall N. Am. Inc., 707 F. Supp.2d 80 (D. Mass. 2010) (“Coverall II”).  Judge Young held that the franchisor failed to carry its burden to satisfy section 148B’s three-prong test.  To avoid employee status (and, conversely, to be an independent contractor), one must show that the worker who performs a service:  (i) is free from control and direction in connection with the performance of the service, both under his contract for performance of the service and in fact; (ii) the service is performed outside the usual course of the business of the employer; and (iii) the individual is customarily engaged in an independently established trade, occupation, profession or business of the same nature as that involved in the service performed.

Focusing on the second prong, Judge Young concluded that Coverall and its franchisees were not in separate and distinct businesses.  He rejected Coverall’s contention that it was simply in the franchising business and not the commercial cleaning service business.  This conclusion was buttressed by the fact that the franchisor dealt directly with customers for whom the plaintiffs provided cleaning services, including contracting with them to provide the service (furnished by the franchisees), billing them and collecting payment for same.  After deducting its royalties, management fees and other sums due from the franchisee, Coverall paid the franchisee what remained, if anything, from customer payments.  For an excellent discussion of Coverall I and Coverall II, and a comparison of Massachusetts’ wage and hour statute with its predecessor and those of other states, see M. Radin, “Cleaning Franchisees Held to be Employees in Massachusetts,” The Franchise Lawyer, Vol. 13 No. 3, ABA Forum on Franchising (Summer 2010).

Subsequent to the district court’s ruling in Coverall II, certain franchisees’ cases went to trial before Judge Young while others were arbitrated pursuant to arbitration clauses in their franchise contracts (curiously, also before Judge Young as arbitrator).  The court then denied class certification without prejudice to possible later certification of a class raising Massachusetts misclassification claims.  The parties filed cross motions for summary judgment on damages suffered by one such misclassified worker.  The judge rejected the plaintiffs’ contention that franchise systems in the commercial cleaning industry are unlawful as contrary to public policy.  Awuah v. Coverall N. Am., Inc., 740 F. Supp.2d 240, 242 (D. Mass. 2010) (“Coverall III”).  Also, Judge Young essentially agreed with the franchisor that most elements of damage claimed by the franchisees (e.g., initial franchise fees, royalties and management fees) may not be recoverable unless they related to the misclassification (e.g., statutory costs that an employer must bear).  Id. at 243.  Seeking guidance on the issue of “damages incurred” under Massachusetts law, Judge Young certified questions to the Supreme Judicial Court, as described below.

 

Coverall IV

The certified questions in Coverall IV related to damage calculations primarily under the Massachusetts Wage Act, G. L. c. 149 sec. 148 and sec. 150.  The SJC ruled that the franchisor’s accounts receivable financing system used to pay the franchisee-employee improperly deferred payment of his earned wages and that an employer (here, also franchisor) may not deduct certain insurance costs (e.g., workers’ compensation charges that normally are the employer’s responsibility) from an employee’s earned wages.

Importantly, the SJC was not asked to, and did not, address the district judge’s ruling in Coverall II that the franchise owners were Coverall’s employees (and improperly misclassified as independent contractors).  The SJC said that its answers to the district judge’s certified questions were premised on the plaintiffs’ agreed-on employee status.  Notably for franchising generally, however, citing Boulanger v. Dunkin’ Donuts, Inc., 442 Mass. 635 (2004), the SJC stated:  “Our answers to the certified questions . . . have no application to properly classified independent contractors operating under franchise agreements.”  Coverall IV, supra at 486 n.3. 

Construing the Wage Act, which requires “prompt and full payment of wages due,” the SJC answered the district judge’s questions as follows:

“1.  Under Massachusetts law, may a franchisor lawfully use customer accounts receivable financing to pay a franchisee who is characterized as an employee under [G. L. c. 149, § 148B]?”

NO.

Rationale:  The Wage Act demands that wages earned must be paid within a set time following each pay period.  The employee, having provided his labor, service or performance, earned his wage.  The SJC rejected the franchisor’s argument that no pay was due until all “contingencies,” including customer payment, were satisfied.  In addition, the franchisor’s accounts receivable financing system (which allowed it to recoup advances to the employee if a customer did not pay) violated the “special contracts” provisions of the Wage Act.  Under sec. 148, no person may by special contract with an employee or by any other means exempt himself from sec. 148 or sec. 150.  Also, the method of recoupment (“chargeback”) was an improper deduction under the Wage Act.

“2.  Under Massachusetts law, do the ‘damages incurred’ for which a misclassified worker can seek recompense under [G. L. c. 149, § 150,] include costs that an employer statutorily must bear?”

YES.

Rationale:  To permit an employer to transfer to its employee the cost of workers’ compensation insurance premiums would be inconsistent with both the general intent and specific language of the Workers Compensation Act (“WCA”).  The WCA represents an exercise of the state’s police power to impose on designated classes of employers the burden of compensation for injuries to employees arising out of their employment.  The employer can reimburse itself for this expense as part of the cost of its products or services.  Thus, the SJC concluded that the employee could recover as damages incurred any such insurance premiums that he was obliged to pay Coverall under his contract.  The franchisor argued that while it may be required to provide workers’ compensation insurance for its workers, nothing in the WCA prevents an employer and employee from agreeing that the employee is to be responsible for the premiums.  The SJC ruled there was no merit to this claim.

“3.  Under Massachusetts law, may an employer lawfully withhold wages to an employee if the employer and employee agree that such wages are not earned until a customer remits payment?”

NO.

Rationale:  See discussion of certified question 1 above.

“4. Under Massachusetts law, may an employee and his employer lawfully agree that the employee will pay some or all of the cost of workers’ compensation or other insurance coverage procured to alleviate the liability of the employer?”

NO.

Rationale:  See discussion of certified question 2 above.

Finally, the SJC took the opportunity to respond to Judge Young’s statement that he welcomed other advice about Massachusetts law relevant to the case.  Addressing the initial and additional (royalty) franchise fees that the plaintiff paid (or agreed to pay) in order to enter into the relationship, the SJC said:  “Our view is that fees such as these constitute ‘special contracts,’ not usual between employers and employees.  In substance, they operate to require employees to buy their jobs from employers and in that respect, we think they violate public policy.  [citation omitted].”  Id. at 497-98.  The SJC went on to quote from a dissenting opinion by Justice Brandeis in Adams v. Tanner, 244 U.S. 590, 604 (1917):  “Paying for the privilege of going to work, and paying more the more urgently the job is needed, not only keeps people unnecessarily unemployed, but seems foreign to the spirit of American freedom and opportunity.”  Id. at 498.

Stating that a contract term that violates public policy is not entitled to be enforced, the SJC ruled that in the context of the Wage Act, the “franchise fees” paid by the plaintiff did not represent a “clear and established debt,” and to the extent that such fees are paid back to Coverall out of wages earned from Coverall, they represent a prohibited assignment of an employee’s future wages to his employer under G. L. c. 149 sec. 150.  This result may mean a significant damage recovery for those franchisees who paid initial franchise fees and royalties to the franchisor.

Once again, however, in a footnote, the SJC excluded standard franchise arrangements from the sweep of its ruling.  It said:  “We emphasize that our concerns over ‘franchise fees’ relate to the potentially exploitative nature of payments by an employee to an employer for the purpose of securing employment.  We expressly do not conclude that franchise fees violate public policy when they are agreed to by parties who are not in an employer-employee relationship.”  Id. at 498 n.23.

 

Legislative Development

Earlier this year, Judge Young’s rulings spawned a legislative effort to address this situation. It was supported by certain franchisors and the International Franchise Association.  A Massachusetts bill was introduced (House Bill No. 3513) to amend state labor, unemployment insurance and workers’ compensation statutes by including the following:  “Notwithstanding the provisions of this section, an individual who owns a franchise, or is party to a franchise agreement under which he or she is authorized to sell products and/or services (a) in accordance with prescribed methods and procedures; and (b) under service marks, trademarks, trade names and other intellectual property licensed under such agreement, shall not be considered an employee of the franchisor.”  In June 2011, this bill was referred to the legislature’s Joint Committee on Community Development and Small Business chaired by the Honorable Linda Dorcena Forry.

 

Practice Tips

Commercial cleaning service franchisors primarily, and all franchisors secondarily, should analyze their franchise business models against independent contractor laws (e.g., labor, unemployment insurance and tax laws) of states where their franchisees transact business.  If they see a problem (e.g., the franchisees may be held to be their employees under state law á la Coverall), they should strongly consider revamping the model to solve it.  Alternatively, they could consider converting affected franchisees to a straight employment relationship.  This means assessing possible exposure to claims by franchisees who may have been wrongly classified and suffered recoverable damages as a result (which is not necessarily a foregone conclusion), as well as restructuring the franchise contract and relationship going forward.

If contract restructuring is the preferred choice, franchisors and their counsel should consider the following modifications:

  1. Change the administrative servicing function so that the franchisee (not the franchisor) bills the customer, collects payment from the customer, maintains accounting records for each transaction and pays the franchisor its royalty and other fees, if any.  If the franchisee is unable or unwilling to properly perform this function, a third party servicer might be engaged to do so by/for the franchisee subject to the franchisor’s standards and approval.
  2. Customer contracts for cleaning services used by the franchisee should reflect the new structure and otherwise be in a form satisfactory to the franchisor.
  3. Operations manuals, training programs and materials should be revised to reflect the new structure.
  4. Care should be taken that the franchisor does not exercise too much control over franchisee operations, particularly day-to-day operations.  For example, the franchisor should consider not controlling franchisee pricing.
  5. When granting franchises, have each franchisee be an entity (e.g., a corporation or LLC), but with a personal guarantee for obvious reasons.
  6. Do not charge the franchisee for costs that the franchisor (if an employer) statutorily should bear, such as workers’ compensation insurance premiums.
  7. Consider granting the franchise rights from an entity that is different from one that operates company-owned units (if any) and, perhaps, different from one that provides franchisor support functions. 

Please note that some of these ideas were suggested by attorney Michael Radin whose article is cited above.

 

Severability Clause

Finally, consider the severability clause that typically appears as “boilerplate” in most franchise agreements.  Please forgive my use of the term; but in 30 plus years of practicing franchise law, this is the first time I have seen a severability clause come into play.  Typically, these clauses say that if a provision is found to be contrary to or in conflict with applicable present or future law:  (i) it may be severed from the contract; (ii) operation of the remainder of the contract (if it remains otherwise intelligible) shall not be impaired or otherwise affected; and (iii) the franchisor may have the right to modify the invalid or unenforceable provision to the extent required to make it valid and enforceable.  In some cases, franchisors may have even reserved the right to terminate.  Because it is highly likely that the specific language of these clauses will vary among franchise systems and among different contract versions in the same franchise system, each affected franchisee’s contract (and severability clause) should be checked carefully to determine to what extent, if any, the franchisor actually has reserved the right to restructure the deal, in some cases without having to obtain the franchisee’s agreement on the new terms.

 

Conclusion

Certainly, Coverall IV is a significant legal development for the franchise community.  It does not mean that all franchise systems are necessarily at risk, however.  Nor is it a “death knell” for franchising in Massachusetts.  Clearly, cleaning service franchisors with Coverall-type contract structures should take serious note and govern themselves accordingly.  For example, franchisors could convert their franchisees into true employees or restructure their franchise relationships by not charging and accepting payments from cleaning service customers.

In light of the SJC’s comments regarding franchise contracts between true independent contractors (which represent the majority of franchise relationships), however, legislation such as Massachusetts House Bill No. 3513 is not needed.  This is because franchisors that use more traditional contract approaches (where franchisee and franchisor are not in the same business dealing directly with the same customers) are not as likely to be at risk that their franchisees may be misclassified as independent contractors.

But, as attorney Radin concluded last year:  “Stay tuned as this play has a few more acts left in it.” Radin, supra.

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