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Independent Contractors—The Dynamex Case

The California Supreme Court’s Dynamex Decision creates a revolution for California workers and hard decisions for California businesses.

It has now been over a year since the California Supreme Court handed down its decision in Dynamex Operations West Inc. v. The Superior Court of Los Angeles which completely changed the test for determining whether a worker was an independent contractor or an employee. The difference between a worker being an independent contractor versus being deemed an employee is huge and could upend many businesses which have relied on workers being deemed independent contractors for years (think Uber and Lyft).

As a bit of background, since 1989 the determination of independent contractor versus employee status in California was based upon an 8 factor test adopted in the case of S.G Borello & Sons v. Department of Industrial Relations. This 8 factor test made it relatively easy to classify a worker as an independent contractor because if a company could satisfy at least 4 or 5 or more of the factors, there was little doubt that the worker would be deemed an independent contractor and not an employee. There was an assumption that if a worker signed on as an independent contractor, he/she would be treated as an independent contractor unless proven otherwise, with all the benefits and drawbacks to being an independent contractor. Countless California businesses have been formed or operated utilizing independent contractors due primarily to the ease with which independent contractors could be engaged and terminated along with the absence of providing employee benefits and job protections afforded to employees. On the other hand, workers were accorded the flexibility to perform work when and where they wanted. I believe many companies, particularly new start-ups, were more willing to utilize independent contractors because of these characteristics.

Then on April 30, 2018 the California Supreme Court decided the Dynamex case in which the Borello 8 factor test was replaced with a much stricter “ABC” test consisting of the following factors:

  • Is the worker free from control and direction in connection with performing the work assigned both under the contract for performance and in fact;
  • Is the work being performed outside the usual course of the hiring entity’s business, and
  • Is the worker customarily engaged in an independently established trade, occupation or business of the same nature as that involved in the work performed.

Under this new “ABC” test you can see that the plumber, attorney or accountant would still qualify as independent contractors. But what about Uber drivers, hair stylists, or IT people developing new computer applications for start-up high tech companies? Under the ABC Test the assumption changes to one that assumes every worker is an employee unless proven otherwise. Under this scenario companies like Uber and Lyft could become two of the largest “employers” in California! Likewise, California franchisors might be forced to become “employers” of their franchisees and the franchisee’s employees.

To make matters even more interesting, in May, 2019 the California Ninth Circuit Court of Appeals held that the Dynamex decision must be applied retroactively which means workers misclassified as independent contractors could have recourse to claim damages (ie pay and benefits) going back 2 or 3 years. Incredibly, the Ninth Circuit claimed retroactivity was appropriate because the Dynamex decision was only a “clarification rather than a departure from established law”. So controversial was this decision that on July 22, 2019 the Ninth Circuit withdrew its May decision and certified the question to be considered by the California Supreme Court.

Furthermore, competing Bills have been introduced in the California State Legislature; one aimed at codifying the ABC Test as a statute (making it the law of the land and much harder to change) while another Bill aims to lessen the impact of the ABC Test by exempting varies industries and professions.

Federal agencies have further clouded the issue. The US Department of Labor has found workers classified as independent contractors in the gig economy to indeed be independent contractors under the Fair Labor Standards Act. Similarly, the National Labor Relations Board has found many independent contractors to be properly classified as such, not employees, under the National Labor Relations Act.

In the meantime, most California businesses using independent contractors seem to be taking a “wait and see” attitude waiting for either worker groups or the California Attorney General to start filing lawsuits at which time companies will be forced to decide whether to fight or switch.

Article by Roger D. Linn © Barnett & Linn

Franchisors Beware

There are currently two “employer/employee” issues that could be of major concern to franchisors, one which has been previously discussed in my prior postings and one which is a new menace for companies and franchisors in California.

Joint Employer Status

Joint employer status arises when employees claim that they work for not one but two “employers” thus making both “employers” liable for tax withholding, employment benefits, wage & hour violations, etc. For years the National Labor Relations Board (NLRB) had applied a test which required that to be held as a joint employer, a company had to be shown to not only have the power to exercise control over a workforce’s terms and conditions of employment but also had to be shown that such company had actually exercised that control over the working environment. Exercising such control would include hiring and firing, setting wages and working schedules, etc.

The typical franchise agreement has always provided the franchisor with certain powers to insure the franchisee was in compliance with the franchise agreement and Operations Manual (prepared by the franchisor) in order to promote and maintain uniformity within the franchise network. However, so long as the franchisor avoided involvement in the day-to-day activities of a franchisee’s employees, the franchisor was considered safe from being held as a joint employer of the franchisee’s employees.

However, as I posted back in September 2015, in 2015 the NLRB made a decision in Browning-Ferris Industries in which the Board adopted a new test to determine when joint employment was present. Under the new test a company only had to possess the potential to exercise control over a workforce’s terms and conditions of employment regardless of whether the company had actually exercised that power. Needless to say, this sent shock-waves throughout the franchise industry. Under the new test, a franchisee’s employees could argue that the franchise agreement provided each franchisor with sufficient power (whether or not actually exercised) to satisfy the new test and make the franchisor a joint employer and thus jointly liable for any and all work place violations occurring at a franchisee’s establishment!

Sensing the disaster the Browning-Ferris decision posed, in 2017 the NLRB, in deciding the matter of Hy-Brand Industrial Contractors, over-ruled the Browning-Ferris test and reinstated the traditional test which had been in place prior to the Browning-Ferris decision (ie power to control + actual exercise of that power). Unfortunately the relief felt by all franchisors was short-lived as the NLRB’s Inspector General issued a subsequent finding that one of the Board’s members deciding the Hy-Brand case had a conflict of interest and should not have voted. As a result, the Hy-Brand decision was vacated earlier this year thus reinstating the Browning-Ferris test for defining joint employer status.

However, good news might be on the way for employers and franchisors. The newly appointed NLRB Chairman, John Ring, has promised to consider rulemaking to modify the current standard the Board uses to evaluate whether joint-employment exists. So, stay tuned for the next episode of this continuing saga.

Additional good news for franchisors was delivered in April, 2018, when the federal US District Court for the Central District of California granted summary judgment in favor of franchisor, 7-Eleven, Inc., finding that 7-Eleven was not a joint employer of franchisees’ employees under California law or federal law. In that case, employees of four 7-Eleven franchisees brought suit against franchisor 7-Eleven, Inc. alleging the franchisor was jointly liable for violations of the federal Fair Labor Standards Act (FLSA) and the California Labor Code.

Independent Contractor vs. Employee

The California Supreme Court has recently decided a case which could have a profound effect on franchisors/franchisees and indeed the entire gig economy. For nearly three decades California courts have determined an individual’s status as an “employee” or “independent contractor” using a multi-factor test set forth in S.G. Borello & Sons, Inc. v. Department of Industrial Relations. The Borello test provided that an individual hired as an independent contractor was presumed to be an independent contractor unless the application of the multi-factor test clearly indicated that such individual was in reality an employee and not an independent contractor. Under this test, the individual had the burden of proof to show he/she was in fact an employee.

However, in April, 2018, the California Supreme Court, in the case of Dynamex Operations West, Inc. v. Superior Court of Los Angeles County, abandoned the Borello test in favor of a new test referred to as the “ABC Test” that is used by some other states.

Under the ABC Test a worker is presumed to be an employee (regardless of what the terms of hire stated) and it is up to the hiring company to prove that the worker is indeed an independent contractor by showing:

  • The individual is free from the employer’s control and direction;
  • The individual performs work that is outside the usual course of the employer’s business;
  • The individual customarily engages in an independently established trade, occupation, profession or business of the same nature as that involved in the work performed.

So hiring an attorney, accountant or janitorial company would still be deemed independent contractors, but many other workers hired as independent contractors to perform specific projects for high tech companies or drivers for Lyft and Uber, for example, would now be subject to scrutiny as potential employees unless the hiring company can meet the ABC Test to show such individuals are properly classified as independent contractors. Indeed several independent contractor groups including Lyft drivers have already filed lawsuits claiming they are misclassified as independent contractors and should be declared employees instead with all the rights and benefits an employee is entitled to.

In light of the above, one can well imagine the consequences this decision could have on the franchising industry in which franchisees have always been deemed independent operators of their own business and not as employees of the franchisor.

This is a proverbial “sea change” in the employee – independent contractor analysis and is undoubtedly on its way to the US Supreme Court for a final decision.

Article by Roger D. Linn © Barnett & Linn

Congress Expands Availability of Regulation A

President Trump signed the Economic Growth, Regulatory Relief and Consumer Protection Act (the Act). As part of this Act, Section 508, titled “Improving Access to Capital”, amends Regulation A under the Securities Act of 1933. Since Regulation A was adopted and the fund raising limits were increased to $50 million (i.e. Reg A+), it was always limited exclusively to non-reporting companies. “Non-reporting companies” included any companies not filing annual and quarterly reports with the US Securities and Exchange Commission (SEC) pursuant to the Securities Exchange Act of 1934 (the 1934 Act). Compliance with Reg A requires the filing of an “Offering Circular” with the SEC which then must review and approve the Offering Circular disclosures. However, once approved, the issuer could sell such securities publicly much like a full-blown registered offering. As a general rule, the disclosure requirements of a Reg A Offering Circular were less burdensome and the Reg A filing was processed somewhat faster by the SEC, than a full-blown registration statement. One particular aspect of a Reg A offering was, unlike a registered offering, after the Reg A offering was completed, the issuer did not have to become a “reporting company” under the 1934 Act. Rather, the issuer could remain a private, non-reporting company post-offering and only required to file limited disclosures with the SEC for a limited time after the offering was completed. Reg A also offered a few additional perquisites like the right to “test the waters” by making a preliminary solicitation of potential investors with an abbreviated disclosure notice to see if there was sufficient investor interest in the issuer’s securities to justify proceeding with a Reg A offering.

As part of the “Improving Access to Capital” section of the Act, Congress mandated that Reg A should be made available to reporting companies as well as non-reporting companies. Reporting companies would still need to file and have approved by the SEC an Offering Circular to be used in the actual offering. However, the post-offering filing requirements of Reg A would be satisfied by the reports already being filed by the reporting company under the 1934 Act.

While expanding the use of Reg A to reporting companies as well as non-reporting companies certainly provides an added tool for raising capital, its use might be somewhat limited. This is because companies trading on a national exchange (i.e. NYSE or Nasdaq) as well as companies traded over-the-counter (i.e. OTCQB) with market capitalizations in excess of $75 million and current in their 1934 Act filings, can use the short Form S-3 registration statement which is generally much quicker, cheaper and simpler than even a Reg A offering.

So, practically speaking, the reporting companies most likely to utilize a Reg A+ offering would be those over-the-counter companies with capitalizations of less than $75 million or reporting companies which missed a 1934 Act filing deadline during the past 12 months.

We will await the SEC’s regulatory action implementing this expansion hopefully in the near future.

Article by Roger D. Linn © Barnett & Linn

Equity Crowdfunding is a Reality

As those of you who follow my posts are aware, I have published several articles regarding the concept of “equity crowdfunding” from back in 2012 when equity crowdfunding was first mandated by the Jumpstart Our Business Startups Act (“JOBS Act”), then again in October 2013 when the US Securities and Exchange Commission (“SEC”) released its proposed crowdfunding regulations, and again in December, 2015 when the final Regulation Crowdfunding (“Regulation CF”) was adopted by the SEC, and finally when those crowdfunding regulations became effective on May 16, 2016.

We have already seen various donation-based crowdfunding sites (charitable) and product-based crowdfunding sites (you get a free product being developed or perhaps just a model of the product). In addition, some states have passed regulations allowing equity crowdfunding within their borders. However, as of May, 2016, we now have a national based SEC regulation in place.

In July, 2017 I was the luncheon speaker at the Sacramento County Bar Association’s Business Law Section in which I provided an update on equity crowdfunding and some other recent changes in federal securities laws.

Set forth below is a summary of how the new Regulation Crowdfunding is working as well as the other recent amendments to securities regulations.

Regulation Crowdfunding Offerings

In researching how equity crowdfunding was doing so far, I found the following interesting aspects.

Funding Portals

As you are aware, equity crowdfunding can only be conducted through “funding portals” which must register with the SEC pursuant to Subpart D of Regulation CF and are monitored by the Financial Industry Regulatory Authority (“FINRA”).

  1. Currently 29 Funding Portals are registered with the SEC, the most popular being “Wefunder.com” which has hosted approx. a third of all crowdfunding offerings to date. The other registered portals at the present time, as published by FINRA, are:
Crowdboarders LLC Neighbor Capital
CrowdsourceFunded.com NetCapital Funding Portal Inc.
DreamFunded Marketplace,LLC NextSeed US LLC
EquityBender LLC NSSC Funding Portal, LLC
First Democracy VC OpenDeal Inc.
FlashFunders Funding Portal, LLC Razitall, Inc.
Funding Wonder Crowd, LLC SI Portal, LLC
Fundpass Inc. Sprowtt CrowdFunding, Inc.
Good Capital Ventures StartEngine Capital LLC
Gridshare LLC StartWise, Inc.
GrowthFountain Capital,LLC title3funds.com
Indie Crowd Funder, LLC Trucrowd INC
Jumpstart Micro, Inc. Venture Capital 500, LLC
Ksdaq Inc MinnowCFunding LLC

2. A Funding Portal will charge between 4% – 10% of proceeds raised. Some will also charge the investor a small percentage, (typically less than 1%) for a processing fee

3. I often wondered what Funding Portal would want to be exposed to the “gatekeeper” liability, but the SEC has signaled that Funding Portals are only responsible for making sure issuers have filed their Form C and have prepared a document covering the Rule 201 disclosure items. These Portals are not required to determine whether such disclosure is true or false or even if the disclosure is full and fair.

4. Late last year FINRA brought its first enforcement action against a funding portal called uFunding Portal (“UFP”). FINRA found that UFP was not verifying that listed issuers were filing their Form C with the SEC or that listed issuers had prepared the required disclosure document pursuant to Rule 201.

Number and Type of Offerings

  1. As of the end of 2016, approx. 152 issuers had filed Form C to commence a Crowdfunding Offering. Most common business type was 45 technology companies (27 of which were from Silicon Valley companies) followed by retail business (16), breweries, (my favorite) (13), and entertainment, real estate development, education, restaurants, and recreational industries rounding out the business types.
  2. Issuers are very young companies with minimal assets. 60% of issuers were less than a year old and another 25% were less than 5 years in existence. 70% of the issuers had less than $100,000 in assets.
  3. Most securities offered were either common stock or SAFE’s (Simple Agreement for Future Equity). {A SAFE is like a convertible note; investor gets future SAFE preferred stock (w/liquidation preference) but issuer doesn’t have to record the SAFE as debt.}
  4. Most issuers are apparently using the “do-it-yourself” method of preparing documents for the Crowdfunding Offering. While I believed securities counsel and accountants would be invaluable to crowdfunding issuer’s, such is NOT the case with most issuer’s incurring minimal legal and accounting fees.
  5. As of the end of 2016, just over one half of all crowdfunding offerings hit their funding goals.
  6. While Funding Portals might have reduced liability, Officers and Directors of the Issuer have heighted liability under §4(A)(c) of the Securities Act of 1933. Unlike typical securities claims that require a plaintiff to establish scienter, causation and reliance, under §4(A)(c), a plaintiff need only allege materiality, privity and compliance with the statute of limitations in a lawsuit against an issuer after which the burden of proof shifts to the defendant to show an absence of scienter, causation and reliance.

Number and Types of Investors

  1. Investors so far have been overwhelmingly from California and Texas.
  2. The typical crowdfunding offering consisted of average individual investments of $833 raised from approx. 300 investors.
  3. Average money raised is $226,000. On average it has taken 45 days for each successful offering to reach its minimum target amount with the total offering period averaging about 122 days.
  4. Marketing of a company’s crowdfunding offering seems to be the major challenge as companies are expected to convert their existing customers and followers to investors by using their mailing lists and social media presence to get the word out.

Rule 147 and New Rule 147A

Rule 147 is the “safe harbor” rule for the Securities Act §3(a)(11) exemption for intrastate offerings. Effective April 20, 2017, the SEC has made changes to liberalize the intrastate exemption.

1. The “doing business within a State” requirement has been changed from having a company’s “principal office” within the State to having the company’s “principal place of business” within the State. “Principal place of business” is defined as: location where officers or managers primarily direct and control activities of the issuer.

2. Rule 147 also required:

  • 80% of revenues from within the State;
  • 80% of assets located within the State; and
  • 80% of proceeds to be used within the State.

Revised Rule 147 only requires the issuer to meet one of the 80% tests.

3. Prior Rule 147 exemption was blown if even one investor was not a resident of the State, even if an investor lied about his/her residency. Revised Rule 147 now only requires the issuer to have a “reasonable belief” that each investor was a resident of the State. Presumably a proper Subscription Agreement and Investor Questionnaire would satisfy the “reasonable belief” standard.

4. Prior Rule 147 required that shares sold in an intrastate offering had to “come to rest” within the State with “coming to rest” defined as held by the investor for at least 9 months. Revised Rule 147 shortens the “coming to rest” period to 6 months.

5. Prior Rule 147 required the issuer to provide the resale limitations “in writing” to every offeree, which presented a potential problem with online or verbal offers. Revised Rule 147 only requires resale restrictions to be “disclosed” to offerees, with “written” limitations only required to be given to actual purchasers.

In addition, new Rule 147A has been adopted which pretty much makes Rule 147 superfluous. Rule 147A was adopted under the SEC’s general exemptive powers under §28 of the Securities Act. Rule 147A not only includes all the revisions to Rule 147 listed above but adds:

  1. The issuer no longer needs to be incorporated or formed in the State; and
  2. Rule 147 required the issuer to “limit” its offers to within the State. Rule 147A allows offers to be made outside the State so long has purchasers are only residents of the State.
  3. I think the SEC kept Rule 147 simply to provide a safe harbor for §3(a)(11) of the Securities Act, elsewise there would no longer be a way to effectuate the long standing §3(a)(11) exemption.

Further Changes to Regulation D

  1. Effective as of January 20, 2017, the maximum offering limit for Rule 504 offerings was raised from $1mil to $5mil.
  2. Effective as of May 22, 2017, Rule 505 was removed from Regulation D.

Final Thoughts

Seems to me that between the US Congress and the SEC itself, the jurisdiction of the SEC over securities offerings is receding, leaving the States and aggrieved investors to fend for themselves.

The explicit intent of Congress with the JOBS Act was to give all businesses, particularly small businesses, easier access to investor capital (ie more exempt offerings) and rely on Federal and State anti-fraud provisions when it turns out an issuer lied to or cheated investors. The reasoning here should come as no surprise because small companies represent the vast majority of new and existing jobs in the US. Hence, helping the creation and financing of new businesses with the expectation that new jobs will be created is the driving force in these congressionally mandated changes.

Feel free to give us a call to discuss equity crowdfunding as this new, innovative funding opportunity is built specifically for new and start-up companies.

Article by Roger D. Linn © Barnett & Linn

Make Every Minute Count

I represent many small companies in my business practice, many owned by a husband and wife or by two or three close friends. Unfortunately, with this close ownership/management relationship it is all too easy to forget to document corporate activity with Minutes of Directors meetings or Unanimous Written Consents without a meeting (UWC). And why not. After all, they see each other every day and often make business decisions over lunch without even thinking about writing something down and placing it in the corporate Minute Book.

The problem is that the corporation is a totally separate entity and, regardless of the close relationships of the owners and managers, established corporate formalities require that actions by the corporation must be documented with Minutes or UWC’s and retained in the corporate Minute Book. As I often tell clients, if I don’t see a corporate action noted in the Minute Book, then it hasn’t happened (officially at least). Having accurate and regular Minutes and UWC’s shows that the managers have been properly documenting material actions taken by the corporation and often times are necessary to show a third party that the corporation, and not Mr. and Mrs. Smith as the owners, took certain actions or is responsible for certain obligations.

A bigger problem can occur if the corporation is ever sued over some business transaction or event. As we all know, doing business in a corporate form, or LLC form, provides the officers and directors with limited liability for corporate actions. However, often Plaintiff’s counsel will attempt to “pierce the corporate veil” by arguing that the owners, Mr. and Mrs. Smith, were actually the “alter ego” of the corporation and should therefore be held personally liable along with the corporation, for the negligence/misdeeds of the corporation. As I have seen from experience, one of the first things the Plaintiff’s lawyer will ask for is the corporate Minute Book. If he/she finds that the last time you had a shareholder meeting was 3 years ago or the last time the Board held a meeting or made a decision was 2 years ago, it’s all too easy for that lawyer to argue that since the owners have obviously been ignoring documenting actions by the corporation, let’s just continuing ignoring the corporation for purposes of this litigation (and the limited liability protection it was meant to provide).

Due to the above, I always counsel corporate clients to literally look for reasons to have a Board meeting (which can be held over breakfast) or prepare a UWC (which can be signed over lunch). Obviously major events such as opening corporate bank accounts or selling a company-owned franchise shop require documented Board action. However, less obvious events like changing accountants, bringing in a new executive level officer or leasing a corporate vehicle should also be documented.

While I draft corporate Minutes and UWC’s for clients all the time, in many cases the Minutes or UWC could be just as easily drafted in-house. There is no specific format required but generally you start with a title of the document like: “Minutes of Board Meeting for XYZ Corp.”. You then want to: (1) note the date of the meeting and how notice was given (personally, by email, etc.); (2) who was in attendance and that a quorum (typically over 50%) of Directors or shareholders were present; and (3) who presided over the meeting (typically the senior officer in attendance) who is then referred to as the Chairperson for the meeting.

Generally, saying less is better with Minutes and UWC’s. A “WHEREAS” clause can state what the issue to be decided is (i.e. “the company is in need of additional capital and wants to raise such capital by issuing addition common stock” or “ due to expanding business the Company is in need of a Chief Operating Officer”). There can be an hour of discussion over the issue but none of that needs to be written in the Minutes. When a decision is reached (i.e. a majority of Directors/shareholders agree) then a “RESOLVED” clause can state what was decided (i.e. “the Company will offer 100,000 shares of common stock for $2 per share” or “the corporation is hereby authorized to hire Ms. Jones as the COO at a salary of $XXXX”). You don’t even need to record the vote so long as a majority has approved (unless a dissenter wants his/her dissenting vote noted for the record). Reflecting the decision made is important not only to show what action was approved but is also necessary to show that the corporation took the action and will be solely responsible for any liability for such action and to invoke the Business Judgment Rule which protects Directors for decisions made. Also keep in mind that, at a duly called Meeting of Directors, an affirmative vote by a majority of the Directors is required to approve an action while a UWC requires all Directors to sign the Consent. The Board/shareholder Minutes of a meeting need be signed only by the corporate secretary.

Lastly, everyone should be aware that the Minutes/UWC is the sole official record of that proceeding so each Director/shareholder should be satisfied with what the written Minutes/UWC actually say so if there is ever a later dispute, the written Minutes/UWC’s duly filed in the corporate Minute Book will prevail.

Lastly, California requires1 that a shareholders meeting be held annually to, among other things, elect the Directors for the corporation. While there is no practical consequence to not holding an annual shareholder meeting, it is nevertheless a corporate formality that should be observed. It is for this reason that I typically provide in a corporation’s Bylaws the day each year when the annual shareholder meeting is to be held so it can be planned for accordingly.

With regard to a limited liability company (LLC), the manager(s) of an LLC are typically given broad authority to operate the LLC’s business with few required formalities or need for Member approval except in a few extraordinary circumstances. Nevertheless, for all the reasons cited above, I always recommend that Managers regularly record material decisions made on behalf of the LLC (i.e. Manager’s Consent form) and keep a written record of the action taken by the Manager(s).

Article by Roger D. Linn © Barnett & Linn

1   California Corporations Code §600(b)

Vicarious Liability of Franchisors – Redux

One of our Firm’s specialties is representing Franchisors and Franchisees. In the context of the franchisor-franchisee relationship many issues can arise which the parties try to anticipate in the Franchise Agreement. In late 2012 I wrote an article discussing one of those issues which was the potential liability of the franchisor for the wrongful or negligent actions/inaction of the franchisee, which we refer to as “vicarious liability”. As I pointed out previously, the critical element of vicarious liability in the franchise context is typically the amount of control a given franchisor exercises over the operations of a franchisee. In the franchisor/franchisee situation, this “control” issue can be very tricky.

On the one hand, the backbone of any franchise system is uniformity of service or product. To ensure this uniformity throughout the franchise system, a franchisor necessarily must establish guidelines in order to maintain the standards of quality and operation of the system which are typically expressed in the Franchise Agreement and franchisor’s Operations Manual. Obviously, the franchisor must maintain a certain amount of control over franchisees’ operations in order to ensure the operating guidelines and hence the uniformity of the franchise system are maintained at each franchise location. In addition, the franchisor must maintain the ability to enforce the operating guidelines and take action against franchisees who fail to follow the guidelines.

On the other hand, a typical franchise agreement makes it clear that each franchisee is an independent contractor wholly and exclusively responsible for the safe and proper operation of his/her franchise establishment.

So herein lies the dilemma, to what extent can a franchisor exert “control” over a franchisee to ensure compliance with the uniform operation of the franchise system while not being held liable for arguably “running” the franchisee’s business and hence being held liable along with the franchisee when trouble arises. Courts generally start with the proposition that a bona fide franchisor will not be deemed vicariously liable as an “employer” when a plaintiff works for or was injured by an independently owned and operated franchised business. However, cases continue to arise in which a franchisor has crossed that imaginary “control line” resulting in the franchisor being held liable to a third party along with the franchisee due to the franchisor’s level of control/involvement. For example, in the case last year of Orozco v. Plackis, franchisor-chef Craig Plackis was held liable along with his franchisee for violations of the Fair Labor Standards Act because he got too involved in the day-to-day operation of a franchisee including advising the franchisee about terminating employees and arranging employee work schedules.

So here are some tips gleaned from several past lawsuits involving franchised businesses to avoid a franchisor crossing that imaginary “control line”:

DO NOT run payroll or maintain employment records for franchisee employees. While a franchisor may designate a payroll or bookkeeping service to be utilized by franchisees, such service should not be the franchisor or a subsidiary of the franchisor.

DO NOT set or enforce franchisee’s employment policies. While the franchise agreement and operations manual may provide certain employment policies like requiring professional, courteous conduct of employees, or the wearing of certain uniform clothing, the specific work rules and procedures to be followed by the franchisee’s employees should be determined by and enforced by the franchisee not the franchisor.

DO NOT micromanage, train or directly supervise the franchisee’s employees. While the franchisor will typically provide initial and ongoing training to the franchisee and its managers, training the franchisee’s employees should be left to the franchisee. Similarly, if the franchisor is aware of certain operational deficiencies with the franchisee, the franchisee should be made aware of such deficiencies and it is the franchisee who should take remedial action.

DO NOT establish, control or change the employment conditions of the franchisee’s employees (e.g. scheduling, meals and breaks, timekeeping, etc.). While the franchise agreement and/or operations manual may require certain aspect of the work environment such as hours of operation, staffing requirements, types of service to be provided and equipment to be used, how the services are rendered and the operation of equipment and the day-to-day operation of the franchised business should be left to the franchisee.

DO NOT control the hiring, firing, pay, promotion, demotion or classification of franchisee’s employees. While the franchise agreement and/or the operations manual may specify certain minimum age, experience, or certifications of franchisee’s employees, all decisions as to who to hire, terminate, promote and the pay scales of employees should be made by the franchisee.

While the above precautions are not an exhaustive list of control indicators to avoid, they hopefully provide some guidance is recognizing when the “control line” may be crossed.

The above would also suggest that should a franchisor enter into a management agreement with a franchisee or find it necessary to take over temporary operation of a franchisee’s business (as often times permitted by the franchise agreement under certain circumstances), the franchisor would most likely be exposed to liability during the period of such direct involvement and operation of the franchisee’s business.

The above list should also be instructive to franchisees. The franchisor provides a model for operating a franchised business and can monitor and assist (but not control) the franchisee in achieving a successful business. However, the operation of, and ultimately the success or failure of, the franchise business rests with the franchisee.

Article by Roger D. Linn © Barnett & Linn

This document has been provided for informational purposes only and is not intended and should not be construed to constitute legal advice. Please consult your attorneys in connection with any fact-specific situation under federal law and the applicable state regulations that may impose additional obligations on you and your company.

No Business Judgment Rule for Corporate Officers

As if corporate officers didn’t have enough to worry about, i.e. properly evaluating the market place, making strategic moves, evaluating business transactions, divining future trends, and getting and keeping customers, here in California, decisions by corporate officers that turn bad are a little more risky to that corporate officer.

Years ago, in order to encourage companies to innovate, States adopted the “Business Judgment Rule” (“BJR”). The BJR simply states that if a business decision is made in good faith, the fact that such decision, in hindsight, ends-up being poorly reasoned or even negligent, the decision makers won’t be held personally liable. In general, the BJR creates a presumption that if the decision maker used reasonable care, including reasonable diligence, in making the decision, and the decision is made in good faith, then the decision maker will not be liable if such decision turns out badly unless there if proof of gross negligence or fraud. In California the BJR is codified in California Corporations Code §309.

However, §309 as written, only extends the BJR presumptions and protections to directors of a corporation but does not mention officers. Most other state courts and commentators, either explicitly (i.e. written in the BJR statute) or implicitly (i.e. intended to be covered by the BJR statute) have extended the BJR to include corporate directors and officers. Unfortunately, California has taken a different, more restrictive position. In a recent decision in the case of FDIC as Receiver for IndyMac Bank FSB v. Matthew Perry, a federal District Court in California has ruled that since the California BJR statute (§309) only refers to “directors”, the BJR is not available to corporate officers. In the FDIC v. Perry case, Mr. Perry was both a director and CEO of IndyMac Bank and in those capacities, made certain investment decisions which eventually created huge losses for the Bank. The Bank eventually failed and the FDIC sued Mr. Perry for the investment losses sustained by the Bank. Mr. Perry sought to assert the BJR in his defense but the Court ruled that he made the investment decisions in his officer capacity as CEO (not as a director) and went on to rule that §309 does not apply to corporate officers. Consequently, Mr. Perry could not claim the protections of the BJR.

What this means for officers of California companies is that, absent the protections of the BJR, corporate officers can be second-guessed and held liable for decisions that don’t produce the intended results or result in losses to the company, even if such decisions, when made, were made in good faith and with the best of intentions. On the other hand, corporate directors can rely on the BJR to protect themselves from liability for the same bad decisions.

The take-away is that corporate officers in California must be careful to make informed, considered decisions and be prepared to defend those decisions if they eventually prove to fall short of their intended goal or, worse yet, result in losses to the company. With regard to such a defense, corporate officers should make sure they are indemnified by the corporation or by Officer/Director liability insurance to the maximum extent permitted by California law under California Corporations Code §317.

Article by Roger D. Linn © Barnett & Linn