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A Discussion of the Consequences of Dynamex Operations West, Inc. v. Superior Court and California Assembly Bill 5

Background

In an effort to remedy certain purported employment disparities caused by the so called ‘gig economy’ (e.g., Uber and Lyft drivers who operate as independent contractors without any of the protections and benefits of true employees), on September 18, 2019, California Governor Gavin Newsom signed into law ‘California Assembly Bill 5’ or ‘AB-5,’ which the state’s legislature had passed on September 11, 2019. AB-5 transformed hundreds of thousands of independent contractors into employees, virtually overnight.

Importantly, while intended to address the ‘gig economy,’ AB-5 is far more reaching and has the potential to fundamentally disrupt the entire franchise business model.  Specifically, AB-5 codified the ABC test utilized in the recent California court case of Dynamex Operations West, Inc. v. Superior Court, 4 Cal. 5^th 903, 416 P.3d 1 (2018) (discussed below) in order to determine when an individual should be classified as an ‘employee’ versus an ‘independent contractor.’

Before delving into the law itself, and why it may prove devastating to the franchise business model, it is vital to understand the importance of a franchisee being deemed the independent contractor, rather than an employee, of the franchisor.  The franchise business model rests on two legs: (1) a controlled license of a franchisor’s trademark to a franchisee and (2) a franchisor’s lack of day-to-day control over the franchisee’s business.

With respect to trademark control, pursuant to the United States Lanham Act (also known as the Trademark Act of 1946), a federal registration gives the registrant, except for prior uses in any given market, protective rights throughout the entire United States of America.  In order to maintain ownership of a trademark, however, the owner must continuously monitor and actively control the use of its mark.  By way of example, if a franchisor trademark owner engages in ‘naked’ or uncontrolled licensing (i.e., it fails to exercise control over third parties using its marks and/or require third parties to enter into trademark license agreements delineating clear quality control provisions), it may lose control of its marks and therefore risk ownership thereof.  This control requirement is part of the reason franchise agreements exist to begin with – the limitations and requirements concerning use of the licensed trademark as well as standards governing the offer and sale of products and services associated with such trademark must be documented in order to prove that the franchisor has not engaged in naked licensing.

On the other hand, franchisees are independent business owners.  While franchisors have an interest in ensuring that their franchisees comply with brand standards (as required in order for the franchisor to maintain ownership in its licensed trademarks), franchisors lack control over their franchisees’ day-to-day operations.  The reason for this is twofold: (i) franchisees often invest hundreds of thousands or millions of dollars in order to own their own businesses (not to merely manage a business as the franchisor’s employee) and (ii) the financial bargain reached between the franchisor and franchisee specifically accounted for each parties’ respective liabilities (if the franchisor intended to be responsible for the employment liabilities and vicarious liabilities that are associated with running the franchised business, it would have accounted for those costs and liabilities in the calculation of fees charged to franchisees; but it did not).  The concept of the franchisee as an independent contractor is almost always explicitly provided for in the franchise agreement, and indeed, if a franchisor attempted to usurp a franchisees’ control over its franchised business, let alone designate employment obligations, the franchisor would find itself in breach.

It is in this backdrop that the absurdity of AB-5 rests.

Dynamex

As stated above, AB-5 embraces the holding and codifies the ABC test utilized in Dynamex.

The Dynamex case was commenced by individual delivery drivers of a nationwide package and document delivery company who sued on their own behalf (and on behalf of a class of allegedly similarly situated drivers) claiming that defendant Dynamex had misclassified its drivers as independent contractors rather than employees.

In California (as in most other jurisdictions), an ‘employer’ has historically been defined as an individual or entity who ‘suffers or permits’ another to work.  In Dynamex, however, this all changed.  Instead of relying on this traditional definition, the California Supreme Court relied on the ABC test in order to determine those types of relationships that are properly classified as an independent contractor relationship versus those types that should really be classified as employee-employer.

Under the ABC test, a worker is properly considered an independent contractor to whom a wage order (or other labor laws) does not apply only if the hiring entity establishes: (A) that 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; (B) that the worker performs work that is outside the usual course of the hiring entity’s business ; and, (C) that 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.

Based on the particular facts of the case, the court determined that defendant Dynamex’s entire business was that of a delivery service company and that its drivers merely delivered items to customers that Dynamex obtained, at the address Dynamex instructed, and at the rates set by Dynamex.  As such, the court held that there was sufficient ‘commonality of interest’ that Dynamex was unable to satisfy part B of the ABC test.  The court further stated that if the hiring party failed any one of the three components to the ABC test, that failure was sufficient to deem the subject worker an employee for purposes of labor laws, rather than an independent contractor.  Accordingly, the court affirmed the Court of Appeal’s decision below both certifying the class and denying Dynamex’s motion to decertify the class.

It is of note that although the Dynamex Court provided certain examples as to what types of relationships it had in mind (i.e., it distinguished between a retail store hiring an outside plumber to repair a leak versus a clothing manufacturer hiring work-at-home seamstresses to make dresses from cloth and patterns supplied by the company), it did not at all specifically address franchising.  This lack of clarity is especially troubling, given the court’s further ruling that the burden of establishing this distinction rests on the putative employer.

AB-5

AB-5, which was signed into law on September 18, 2019, codified the ABC test invoked in the above described Dynamex case.  As summarized in a California Legislative Counsel’s Digest, AB-5 provides (as in Dynamex) that ‘…a person providing labor or services for remuneration shall be considered an employee rather than an independent contractor unless the hiring entity demonstrates that the person is free from the control and direction of the hiring entity in connection with the performance of the work, the person performs work that is outside the usual course of the hiring entity’s business, and the person is customarily engaged in an independently established trade, occupation or business.’

Impact of Dynamex and AB-5 on Franchising

The distinction between an ‘employee’ versus an ‘independent contractor’ is an essential distinction in the franchise model.  Virtually every franchisee is contractually deemed, and operates as, an independent contractor of its franchisor.  If this paradigm changes, and a franchisee is deemed to be an employee of its franchisor, the franchisor will not only become responsible for employment liabilities, but also for all acts, errors and omissions of its franchisees under the doctrine of respondeat superior.

Notwithstanding the importance of this distinction, since the vast majority of franchisors own and operate businesses identical to those of their franchisees, it is likely that most will fail part ‘B’ of the ABC test (i.e., that the worker performs work that is outside the usual course of the hiring entity’s business ).  Indeed, it is almost always the case that a franchisee does not perform work that is outside the usual course of its franchisor’s business.  And, since the ABC test is a zero sum game, in which putative employers (in this case, the franchisors) must pass all three components in order for their putative employees (in this case, the franchisees) to be properly classified as independent contractors, failing part ‘B’ of the ABC test will: (a) deem virtually every franchisor the ‘employer’ of its franchisees, subsuming all of the costs and liabilities that come along with such title, and (b) transform virtually every franchisee into nothing more than an everyday employee.

Thus – – in direct contrast to the most standard and commonplace franchise agreement provisions; federal and state franchise laws, rules and regulations (in which the definition of a ‘franchise’ assume franchisee independence); the Lanham Trademark Act; and, over half a century of judicial precedent – – franchisors will now overnight be legally mandated ‘employers’ of their franchisees.  And in accordance with that title, franchisors will find themselves liable for franchisee wages; Federal Insurance Contributions Act. contributions; unemployment insurance premiums; workers’ compensation premiums; Affordable Care Act mandates; wage-and-hour compliance; and, all of the other duties, requirements and prohibitions imposed by federal and state law upon employers.  Further, as an employer, franchisors may find themselves liable for any and all acts, errors and omissions which arise from the franchisee’s business, despite its lack of day-to-day control over such business.

This change represents a dramatic shift in liability exposure that was neither anticipated nor bargained for by either party when entering into the franchise agreement.  Certainly, confiscating franchisees’ businesses and their ability to earn profits therefrom, and reducing franchisees to mere employees in exchange for their franchise investment, was not the intent of those the various U.S. jurisdictions that have enacted franchise registration, disclosure and relationship laws for the sole purpose of protecting franchisees from injustices.

Future of AB-5

As discussed above, neither AB-5 nor the Dynamex decision was intended to target the franchise industry and, despite the broad language of the ABC test, do not specifically address franchising.  In the wake of AB-5’s passage, which takes effect on January 1, 2020, as noted by the International Franchise Association, the industry is unfortunately left with more questions than answers (including, by way of example, when the franchisor is deemed the employer of its franchisees, who will be deemed the employer of the franchisees’ employees?).  However, what is clear is that AB-5 represents a fatal threat to franchisors, franchisees and the entire franchise business model, in particular, for those franchised businesses located in California and/or for franchisors whose franchise agreements are governed by California law.

Ultimately, franchisors may only have three options available: (i) commence litigation against the State of California to challenge AB-5’s applicability and legality in the context of franchising; (ii) either cease all future franchise sales in California or dramatically change the financial relationship between the franchisor and franchisee, taking into account the shift in expenses and liabilities; and/or, (iii) terminate and/or buy back existing California franchised businesses (which strategy, of course, is rife with its own legal risks).

In Mexico, the franchise agreement will be governed, and subject to the terms agreed, by the parties, as well as by the provisions set out in the Industrial Property Law (“IPL”) and its implementing Regulation and, for aspects not regulated in the IPL, the general rules of the Federal Civil Code and the Commercial Code will apply. Additionally, depending on the franchise, other laws may also apply; an example of which is the Data Protection Law.

A franchise is defined in Article 142 of the IPL, which establishes that a franchise exists when, with a license to use a trademark granted in writing, technical knowledge is transmitted or technical assistance is provided, for the licensee to produce or sell goods or render services in a uniform manner and with the operating, commercial and administrative methods established by the owner of the trademark, to maintain the quality, reputation and image of the products or services distinguished by the trademark.

When entering the Mexican market with a franchise system, certain legal aspects must be considered and complied with. For example, legal requirements under the Industrial Property law, such as providing a Franchise Disclosure Document 30 business days before executing the Franchise Agreement, observing the minimum provisions in the Franchise Agreement, and complying with obligations under the Data Protection Law. As in many countries now, Data Protection has gained importance in the last years in the country, and this trend is expected to continue.

Data Protection in Mexico

Following Constitutional amendments that included the right to data protection as a basic – human- right of individuals, in 2010 the Federal Law on Protection of Personal Data held by Private Parties was enacted, followed, in 2011, by its Regulations, and in 2013, by the Guidelines of the Privacy Notice (hereafter, together the “Data Protection Law”). These pieces of legislation, which are complemented by guides issued by the Data Protection Authority (“DPA”) (the National Institute of Transparency, Access to Information and Protection of Personal Data), apply at a Federal level and make up the Mexican Data Protection legal framework for the private sector.

The Data Protection Law applies to all processing of personal data by private entities or individuals, except when it is processed for personal or domestic use or by credit bureaus, which are governed by a special law. Under this law, all personal data must be processed in accordance with the data protection principles of consent, information, proportionality, purpose limitation, legality, loyalty, and accountability.

Franchisors and Franchisees will be data controllers with respect to certain personal data they process, for example, Franchisees will be controllers of their employees’ personal data, but may also be data processors in respect to other personal data and specific situations, depending on the degree of power or influence Franchisors exercise over Franchisees, such as in cases where Franchisor is data controller of customer data.

In this sense and being “personal data” any information concerning an identified or identifiable individual, both, Franchisors and Franchisees need to be aware of their obligations and responsibilities when processing such data, which are more cumbersome on data controllers. It is of the outmost importance to make sure what are the roles of the parties, that is, who is the data controller or the data processor in the various scenarios, or if responsibilities are shared, as this will be a determining factor for liability in the event of an infringement to the Data Protection Law.

Some of the general obligations of data controllers are: (i) to maintain appropriate physical, technical and organizational security measures, (ii) to provide a privacy notice to all data subjects from whom personal data is processed, (iii) to collect consent from data subjects, where necessary, (iv) to appoint a Person of Department of Data Protection, (v) to allow data subjects the exercise of their rights (access, rectification, cancellation, objection, etc.), and (vi) to notify security breaches when material.

Due to the nature of the Franchise, transfers of personal data between Franchisor and Franchisee are of the essence. It is therefore worth mentioning that personal data can be transferred to third countries regardless of the level of protection a country provides, as long as transfers are covered by an agreement that is in compliance with the Data Protection Law and with the privacy notice that was made available to data subjects. Explicit and/or written consent from data subjects for the transfer of their personal data is sometimes required. There are no localization laws and no need to register or request authorization from the DPA.

Third parties separate from the franchise normally also play an important role in the daily activities of both, Franchisor and Franchisee, as well as in the processing of personal data. When certain processing activities are carried out by these third parties, Franchisor or Franchisee, as the case may be, will remain accountable for the processing; reason why there should be agreements in place containing robust data protection obligations for the third parties.

Failure to comply with the provisions of the Data Protection Law may result in hefty fines, and, if personal data is processed deceitfully or for profit, penalties of imprisonment may be imposed.

At the moment, there have been no known cases regarding fines imposed to franchisees’ in Mexico nor franchisors, for not complying with the Data Protection Law.

Security Measures

Data controllers and data processors have the obligation to establish and maintain appropriate physical, organizational and technological security measures to protect personal data from unauthorized processing, access or disclosure. When determining what security measures are appropriate, the risk involved in the processing, sensitivity of the personal data, number of data subjects, and technological development shall be considered.

Franchisors must be aware that in the event of a security breach or of an investigation, the DPA, when analyzing if appropriate security measures were in place, will be prone to contemplate the degree of control Franchisor exercised upon Franchisee on the matter of selecting the security measures to be implemented, to allocate responsibility, being the logical conclusion that the more control a Franchisor exercises upon Franchisee, the more accountable will be for the processing of personal data.

Cybercrime

Although Mexico intends to ratify the Budapest Convention on Cybercrime, it has not done so, and it is not clear when it will ratify it.

Notwithstanding this, under the Federal Criminal Code, illicit access to systems, as well as to destroy or cause the loss of information are considered crimes, along with the disclosure of trade secrets and confidential information.

Additionally, data protection legislation establishes that it is a crime to cause a security breach involving personal data to deceitfully process it for profit. Some other cybercrimes, due to the lack of specific provisions, are treated by the police, as fraud. Recently there were amendments to the Criminal Codes to include higher penalties for cyber-related crimes, however, the main problem remains having criminal conducts specifically established in the codes, that apply to the activities occurring in cyberspace, so these can be pursued and enforce accordingly.

Social Media and E-Commerce

There are no specific regulations or provisions applying to Franchises and social media as such, nor codes of conduct in this regard; however, social media activity is mainly governed by the Data Protection Law, and legislation on Consumer Protection.

In this sense, it should be clear if Franchisees are allowed to create social media profiles, and if so, in what way these should be handle, i.e. what activities or posts are to be avoided, and to what extent the Franchisee may be active on social media. As social media’s main asset is personal data, special attention should be paid to the collection and further processing of personal data via social media, as the general data protection rules will apply to this processing of personal data, even if individual’s profiles are public.

E-commerce is regulated in Mexico by several laws, including the Code of Commerce and the Federal Law on Consumer Protection, which protects consumers in Mexico, regardless of location of providers, meaning that companies offering services or goods in Mexico must comply with Mexican regulations. Advertising is also regulated by the mentioned law and complementary regulations.

The Franchise agreement must be clear as to what Franchisees are authorized to do and if they may sell or offer goods or services online and, if so, under what conditions and in what territory. Attention must also be paid to the domain names that are registered and used for such purposes.

Enforcement Activity

Even though the DPA has been actively enforcing the Data Protection Law since it came into force, there are no reported cases involving a franchise or where issues inherent to a franchise have been considered, as it would be, for example, the control exercised by Franchisor upon Franchisee.

Nevertheless, there have been cases related to other issues that could also directly impact a Franchise. It is common to see disgruntle employees file complaints before the DPA, for various reasons, -from claiming not having received a privacy notice to not having consented to the processing of their personal data- and where the main objective is cause damages to the company or force a company to settle a labor case. Lack of transparency in the processing or not providing a privacy notice in terms of the Data Protection Law, have been issues constantly raised by data subjects and penalized by the DPA.

Not collecting appropriate consent for the processing and for the transfer of personal data has been a recurring issue in DPA’s resolutions; as there are specific requirements for collection of consent and three types of consent that can be collected depending on the categories of personal data being processed, complicating compliance with this obligation. In the franchise, Franchisor should pay special attention to this issue because if Franchisee does not appropriately collect consent from individuals, the whole processing of personal data, including any transfers of such data to Franchisor, could be considered illegal. It should be mentioned that the burden of proof regarding compliance with all data protection obligations always rests on the data controller.

As mentioned, fines tend to be hefty, ranging from approximately USD 4.00 to USD 1,300,000.00, with these amounts duplicating if sensitive personal data is involved in an infringement to the law or in case of recidivism. The DPA has discretion regarding the amount of the fines and so far, most of the fines have been in the millions of Mexican pesos.

Although it is possible to seek damages for the unlawful processing of personal data, there are no reported cases where damages have been obtained in connection with the processing of personal data; probably because this needs to be done via civil courts, with the standard of proof set very high.

Recommendations and Conclusions

It is important that both parties, Franchisor and Franchisee, are aware of their responsibilities when entering into a Franchise Agreement in Mexico, even when choice of law is elsewhere. Taking this into consideration, it is highly advisable to have local counsel guide and protect both parties, and to avoid any type of infringement that could produce irrevocable damage to the image of the Franchise.

It is custom in Mexico, as part of providing Technical Assistance for Franchisor to provide Franchisee with a list of legal requirements before opening and operating a Franchise. Such list should include Data Protection aspects. On the latter, reputational damage is one of the main risks associated with incompliance with the Mexican Data Protection Law and affecting both parties. Therefore, making sure and helping Franchisees comply with the law, will benefit the involved parties.

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