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Franchisor Control and the Risk Of Overreaching

July 22, 2013, by Rashad M. Collins, on Franchising |

Franchisors must be able to exercise significant control over their systems in order for the franchise model to be effective.  To that end, franchisors require franchisees to enter into strict franchise agreements whereby franchisees are designated as independent businesses/contractors and prohibited from amending, damaging, or operating their franchises in any fashion that is contrary to the agreement.  Franchisors dictate precise guidelines concerning the required structure and operation of each unit, including: the location; signage; hours of operations; promotional deals; product purchase requirements, sales prices, etc.  The point of this level of control by the franchisor is intuitive - all franchise locations should look and feel the same to the greater public.   

Uniformity is an essential driver of revenues and goodwill for franchise concepts because as customers develop a liking for a particular franchise’s products, they patronize that brand anywhere they travel.  The drawback to franchise uniformity is when a customer develops a dislike for an individual unit franchise, they often refrain from patronizing every other location of the brand.  Thus, franchisors must constantly police the actions of franchisees within the system in order to protect the brand.

This concept is easy to comprehend, but sometimes impossible to properly employ from a legal standpoint.  Franchisors must carefully balance their use of the control mechanisms within franchise agreements and their actions of policing the network, against trespassing on the sovereign authority reserved for their “independent business/contractor” franchisees.  This thin line separating franchisor control from franchisee autonomy will be termed the “independence threshold.”

Courts today are less likely to simply look at the franchise agreement and respect the parties’ designation as franchisor and independent business/contractor franchisee.  Rather, they view the contractual designation as informative but not dispositive, as aptly stated by the Wisconsin Supreme Court.  Thus, whenever courts determine that franchisors improperly crossed the “independence threshold,” franchisors become exposed to various forms of liability at the individual storefront level and could incur substantial damages.

Patterson v. Domino’s Pizza, LLC (“Patterson”) is a case pending before the California Supreme Court that serves as an excellent example of this concept.  In Patterson, an employee (a minor) at a Domino’s Pizza franchise claimed that her manager sexually harassed and assaulted her while at work.  The employee named both the Domino’s franchisee and the Domino’s franchisor (“Domino’s”) as defendants in the lawsuit.  Domino’s filed for summary judgment claiming that the franchisee was an independent contractor pursuant to the terms of the franchise agreement, thus precluding a finding of a principal-agent relationship between them.  The plaintiff opposed the motion arguing that Domino’s exercised substantial control over the franchisee, leaving triable issues of fact relating to whether Domino’s is vicariously liable for the manager’s bad acts.

Citing language in the franchise agreement, the trial court granted the Domino’s motion for summary judgment on the grounds that Domino’s had no role in the franchisee’s employment decisions.  Contrarily, the California Second District Court of Appeal (the “appellate court”) overruled this decision upon a review of the totality of the circumstances.  The appellate court stated that a franchisor’s interest in the reputation of its entire system allows it to exercise certain controls over the enterprise – such as its trademarks, products, and the quality of its services – without running the risk of transforming its independent contractor franchisee into an agent; nonetheless, the franchisor may be subject to vicarious liability where it assumes substantial control over the franchisee’s local operation, its management-employee relations, or employee discipline. 

The appellate court went on to enumerate a plethora of guidelines and rules that Domino’s allegedly required its franchisee to implement.  The appellate court also highlighted deposition testimony from the franchisee business owner where he claimed to terminate some of his employees at the “suggestion” of Domino’s representatives.  He testified that he feared Domino’s would either find a way to terminate his franchise agreement prematurely, or decide not to renew the franchise agreement upon expiration if he did not heed their recommendations.  The case has since been appealed to and accepted by the California Supreme Court (the “Supreme Court”).

Whether, and upon what grounds, the Supreme Court affirms or denies the Domino’s motion for summary judgment could have far-reaching implications given California’s historical role in progressing American jurisprudence.  Anything short of a victory on summary judgment should be considered a loss for franchisors, as it seems doubtful that the case will turn on any of the mundane instances of control cited by the appellate court.  The more interesting matter is the level of importance that the Supreme Court will attribute to the franchisee owner’s testimony about Domino’s “suggestions” to him regarding the termination of certain employees, among other things, and what he reasonably could have perceived to be the ramifications of ignoring the same. 

The ramification the franchisee owner feared most was likely nonrenewal, as franchise agreements are very clear regarding the specific events that give rise to immediate termination.  Nonetheless, the threat of nonrenewal can be a formidable tool employed to bully franchisees, and states like California have taken notice.  In an effort to balance power between their resident franchisees and, often, out of state franchisors, states have begun implementing so-called “franchise relationship laws”.  Franchise relationship laws discourage franchisor unilateral termination and nonrenewal by making it harder for them to accomplish the same without first clearing various hurdles.  In fact, earlier this summer there was a bill in the California Senate Judiciary Committee which sought to strengthen the California Franchise Relations Act regarding franchisor liability for nonrenewal and other acts ending the franchise relationship. Similar to a judge forcing rehabilitative counseling before granting a divorce, state regulators are now pushing franchisors to communicate their concerns with franchisees prior to the expiration or termination of the franchise agreement.  As such, the net effect of franchise relationship laws may be to force increased communication or “suggestions” from franchisors to franchisees about how the latter can better manage their businesses and expose the franchisor’s brand to fewer risks.  

This presents an obvious conundrum for franchisors.  On one hand, states are effectively pushing franchisors to open dialogue with franchisees about changing their in-store business management practices; on the other hand, when considering vicarious liability, courts are looking past the franchise agreement and examining the extent of dialogue or top down  “suggestions” from franchisors to franchisees concerning in-store business management practices.  Insert Patterson.  The facts of the Patterson case and the nature of California’s relationship laws make for an interesting alignment of the stars. Domino’s will argue, and rightfully so, that it had a strong interest in policing its brand when it discovered that a manager sexually assaulted a subordinate employee (who also was a minor) inside one of its franchise stores (if handled improperly by the franchisee, this situation easily could become damaging national news for Domino’s); Domino’s clearly traversed the independence threshold when it strongly “suggested” that the franchisee terminate the suspected manager along with other employees of the franchisee; and California certainly has done its best to pressure franchisors to communicate with franchisees in this exact manner, as opposed to simply terminating or not renewing the franchisee for disapproval of his hiring decisions.  It will be interesting to see how, if at all, the Court addresses these issues in its opinion.

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