Franchisors Challenge California’s AB 5 | Newsletters | Legal News: Distribution & Franchise

Introduction

On November 17, 2020, the International Franchise Association (IFA) filed suit in the U.S. District for the Southern District of California, challenging California’s AB 5 as it is applied to franchise relationships. The IFA’s lawsuit argues that the FTC Franchise Rule and the Lanham Act require franchisors to exercise a certain level of control over franchisees in order to preserve trademarks and other legal protections. However, the exercise of control required by the Franchise Rule and the Lanham Act risks triggering an employer/employee relationship under AB 5. The IFA’s lawsuit seeks injunctive relief and a declaratory judgment that franchisors and their franchisees should be exempt from the strictures of AB 5 and its so-called “ABC Test.”

A Brief History of AB 5

In 2019, California’s legislature passed AB 5, a bill that codified the ABC Test as the state’s default test for determining whether a worker is an employee or an independent contractor.

The ABC test places the burden on the hiring entity to prove that a worker is properly classified as an independent contractor by showing all three of the following:

the worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of such work and in fact;
the worker performs work that is outside the usual course of the hiring entity's business; and
the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity

The law has been subject to legal challenge and lobbying for certain industry-based exceptions. Notably, AB 2257 recently created additional exceptions, and Proposition 22 created an exception to AB 5 for app-based drivers.

Now, the IFA has filed suit seeking an exception for franchisors and franchisees. The IFA alleges that “[f]ranchising is fundamentally incompatible with the obligations that would be triggered if franchisees were deemed employees of franchisors under California’s ABC Test.” The IFA seeks a preliminary injunction against enforcement of AB 5 against franchisors and franchisees during the pendency of the suit. The IFA also seeks a declaratory judgment that franchisors and franchisees are exempt from AB 5.

The IFA’s suit focuses on the Lanham Act and the FTC Franchise Rule. The Lanham Act is a federal statute that protects trademarks and gives trademark owners certain legal rights and remedies, provided the trademark owners maintain control over the quality of the goods and services sold under the mark. The FTC Franchise Rule regulates the sale of franchises, including the disclosures franchisors are obligated to make to prospective franchisees. The FTC Franchise Rule notably defines employment and franchise relationships as mutually exclusive of one another.

The core of the IFA’s argument is that franchisors cannot comply with their obligations under federal law, particularly with respect to maintaining trademarks, without being subject to the ABC Test under AB 5. Similarly, the FTC Franchise Rule appears inconsistent with the ABC Test — the former treats franchise relationships as separate from employment relationships, while the latter could require franchisors to treat franchisees as employees. The IFA argues that these federal laws are, thus, inconsistent with AB 5 and because federal law preempts state law, AB 5 cannot be applied to a franchise relationship.

The IFA also argues that the purpose of AB 5 is not served when applied to franchises. The purpose of AB 5 is to address the harms when employers fail to classify workers as employees, denying them the benefits and protections of an employment relationship. The IFA argues that a franchisee is a business owner with its own employees, all of whom are already receiving the benefits and protections of an employment relationship under California law. Thus, according to the IFA, there is little benefit to workers from applying AB 5 to franchise relationships.

Key Takeaways

The IFA has filed a lawsuit in federal court in California, seeking an exception to AB 5 for franchisors and franchisees. If the suit is successful, the ABC Test will no longer be used to determine whether franchisees are properly classified under state law.
Franchisors and franchisees will want to monitor this case closely. If the court believes that the IFA has a substantial likelihood of succeeding on the merits of the suit, it may issue an injunction that prevents enforcement of AB 5 against franchisors and franchisees. For now, AB 5 remains in effect.
Franchisors and franchisees should not expect this case to be resolved any time soon. The case itself is likely to take months or years, and any decisions are likely to be appealed.