1. US Case Law: Doctors' Associates, Inc v Uninsured Employers' Fund
The Kentucky Supreme Court has held that Doctors Associates, Inc (which owns the "Subway" trademark and franchises the right to operate Subway sandwich shops worldwide) was not liable for its franchisee's employees' compensation payments (which the franchisee had failed to make). This was a significant decision. It clarified uncertainty about whether a franchise relationship could be deemed to be an employer/employee relationship, rather than a contract for services with an independent contractor. This distinction is important and impacts upon a franchisor's potential vicarious liability for the acts/omissions of a franchisee, or of the franchisee's employees.
This was a welcome decision in the US as some US courts had previously considered the franchise relationship to be akin to a 'master and servant' employer relationship and found franchisors to be vicariously liable for the actions of the franchisee, or its employees. The International Franchise Association (IFA) considers that the misclassification of franchisees as employees is a real threat to the franchise business model and has been lobbying state legislatures to amend state laws to properly account for what the IFA refers to as "the unique relationship at the heart of franchising".
2. The UK Position
There has been no equivalent direct clarification in the UK. A franchisor might, for instance, find itself liable for the acts of one of its franchisees if it can be considered to be the employer of the franchisee. In broad terms, only an employer can be held liable for the acts or omissions of its employees and such a liability will not exist in an equivalent independent contracting relationship.
So, when could a franchisee be considered an employee, and when an independent contractor? Whilst the issue has not been addressed in circumstances similar to those in the Kentucky case, courts in the UK have considered the nature of the relationship between franchisor and franchisee when addressing the enforceability of restrictive convenants. The common approach (following cases such as Office Overload v Gunn and Dyno-Rod v Reeve) is that the franchisor / franchisee relationship is more akin to that between a vendor and purchaser than an employer / employee and, for that reason, the courts have enforced restrictive covenants in franchise cases which would be far too onerous to be enforceable against an employee. However, this issue does depend on the facts of the individual case as was reinforced by the first instance decision in Fleet Mobile Tyres v Stone and Another in which the Judge said that there were certain aspects in which the parties relationship was not so completely kept at arm's length as it would be in the case of vender and purchaser.
Therefore the answer will depend on the nature of the relationship between the parties. The fundamental principle of franchising has always been that the parties to a franchise agreement are separate and distinct business entities. But this principle is complicated by the fact that:
- franchisees derive their corporate identity and working practices from intellectual property rights licensed to them by the franchisor;
- the relationship will often be governed by strict contractual terms and the requirements imposed on the franchisee by a detailed operating manual. These mechanisms give the franchisor a high level of control over the franchisee's business.
Although franchise agreements typically specify that the franchisee is to be regarded as an independent contractor, the court will look through that and examine the true nature of the relationship between the parties and the business realities. The court will particularly consider the level of control a franchisor has over a franchisee's business in determining whether the franchisee is, in reality, an employee.
Although the State of Kentucky has provided clarification on this issue, this is not yet reflected in all states of the US nor in the UK. Until further guidance is provided by the UK courts, franchisors can be at risk of claims from franchisees' employees or third parties.
In order to minimise this risk, franchisors should:
- ensure that the franchise agreement and operating manual are drafted in such a way which consistently characterises the parties' relationship as that of independent franchisor and franchisee; and
- not exercise undue control over the day-to-day running of the franchisee's business. This could occur cumulatively, with control being extended over too many aspects of the business, or too intrusively, so that the legal independence of the franchisee is overwhelmed by him being regarded as at the "beck and call" of the franchisor. Every situation will be different, as both the legal structures, as well as the means by which the franchisor interferes in the franchisee's business, vary radically from one business to the next.
It is easy to assume that because nothing has happened "it ain't broke, so don't fix it". The reality is that some businesses may have allowed "control-creep" to build up over the years, and in different ways, and it is likely that in some networks there may be a serious "legal accident" waiting to happen.
What is clear is that situations where the franchisee is a sole trader or, if using a limited company, where the individual is in reality doing all the work, can be contrasted with bigger, more 'corporate' franchisees where the risks are likely to be much reduced.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.