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Coverall Ruling Sends Shiver through Franchising

BOSTON — In a webinar presentation this week entitled The Awuah Case: Bellwether or Outlier?  Nixon Peabody attorneys addressed concerns related to a disturbing court decision (pdf) that has sent a chill through the franchisor community. The issue? Can franchisees be classified as employees instead of independent business owners? If so, what will be the consequences to franchisors? 

Although this matter has cropped up before, a recent decision by a Massachusetts federal judge has again brought the notion to light. In his decision, Honorable Judge William G. Young likened business format franchising to a “modified Ponzi scheme,” ruling that a franchisor is the “employer” of its Massachusetts franchisees.

Arthur Pressman, Nixon Peabody partner, said that the judge’s decision is making waves because of his comments about franchising that go beyond the facts of the lawsuit, Awuah v. Coverall North America. Arthur Pressmanexplained that the case actually began much earlier than 2007 when the class action litigation was filed against the janitorial franchise company. It started in 2004 when a single franchisee filed for unemployment compensation after she was terminated from the Coverall system. The franchise operator’s relationship with Coverall started as an employee of another franchisee, where she worked exclusively for the Sunrise Nursing Home. When that franchise owner left the system the employee was out of a job. After she inquired how she could continue her employment with Coverall, they arranged for her to become a franchisee, continuing her cleaning job at the Sunrise nursing facility.

Although her claim for unemployment compensation was first denied, she took it on appeal and won. Coverall then appealed to Massachusetts Superior Court, and it was from that point that the case took off in an unusual way.

According to Pressman, the Massachusetts Supreme Judicial Court, the highest court in the state, unilaterally plucked the case from that appeals court and took it upon itself to review it. In 2006, the high court under Coverall North America v. the Commissioner of the Division of Unemployment Compensation ruled that it would not disturb the finding that the franchisee qualified for compensation. “The court based its analysis upon the Massachusetts Independent Contractor Statute as it applies to unemployment compensation,” he explained. “It ruled that the franchisee was not engaged in an independently established trade, which is the third prong of the ‘independent contractor’ test.” Pressman said that was one of the factual issues that the court looked at to determine that the franchisee was not an independent business person.

The Coverall system in Pressman’s view is similar in many regards to virtually every other franchise system.  Each Coverall franchisee prospect receives the franchise disclosure document with an agreement that states the franchisee is an independent contractor and the nature of the relationship. They also wear uniforms and identification of the brand, and there is a third element that is not particularly unique to Coverall. “Up until May 2009, the franchisor was the party with customer-to-customer contracts and the franchisor performed “back-of-the-house” functions—billings and collections—and remitted the balance to franchisees after collections,” he explained. Pressman said there are many other franchisors who are not in the commercial cleaning business that perform back-of-the-house functions. “So this is not a case ultimately that is limited to Coverall or commercial cleaning businesses. It has wider implications,” Pressman warned.

He reiterated that the Awuah case was filed on the heels of the Massachusetts Supreme Judicial Court case, the unemployment compensation case, which was the springboard for the litigation that has followed in Massachusetts. He explained that some of the participants in the unemployment compensation case are also in the current litigation, namely the plaintiff lawyers.

Judge Young’s decision (pdf) on March 23, 2010 granted summary judgment to the Awuah franchisee plaintiffs on [employment] misclassification claims, although he did not grant summary judgment as to damages. The judge also did not grant any dispositive motions as to the remaining franchisees and in fact those cases are currently scheduled for trial before Judge Young, Pressman stated.

Who Is an Employee? Who Is Not?

Nixon Peabody partner Gregg Rubenstein reminded participants that Massachusetts is not just a far-leftGregg  Rubenstein- leaning state different from all other states. He adds, “It has adopted one of the two primary ways of determining who is an employee and who is an independent contractor.”  The most familiar one is the common law test which basically determines whether or not the principal or employer has sufficient control over the agent or employee to constitute an employment relationship. But Massachusetts and 25 other states have rejected that common law approach, and have adopted something called the ABC test, the three prongs the legislature has enacted to determine where people fall on that spectrum.

Rubenstein explained that if the putative employer fails any one prong an employment relationship is established under Massachusetts law and other jurisdictions that adopted the same test. “But now, as if that weren’t complex enough I want to caution you that states have different variations of the ABC test,” he said, adding, "and sometimes states will have different tests in establishing who is an employee and who isn’t."

Rubenstein explained that Judge Young’s decision focused only on prong B of the test, instead of all three. “He didn’t do that by coincidence, he did that because that’s where plaintiff’s counsel directed him.” In rendering his decision, the judge focused on what is the business of Coverall and what is the business of franchisees. Coverall’s position was that its business is franchising, licensing of franchisees, the use of its trademark, and their provision of a business format through which they can conduct their own independent business. Coverall argued that it satisfied B, saying their business is franchising; their franchisees’ business is performing cleaning services.

But the court rejected that concept stating that franchisors are in the business of selling goods and services. Judge Young stated:

Describing franchising as a business in itself, as Coverall seeks to do, sounds vaguely like a description for a modified Ponzi scheme – a company that does not earn money from the sale of goods and services, but from taking in more money from unwitting franchisees to make payments to previous franchisees.

Rubenstein said, “Not surprisingly, we think there is a lot wrong with this analysis.”

Eric KarpIn presenting a different view, Eric Karp of Witmer Karp Warner & Ryan said the comments of the judge’s reference to a Ponzi scheme have been overstated.  “I don’t think that Judge Young’s ruling imperils franchising in general or franchising in Massachusetts,” he said. Karp feels the judge’s reference to a Ponzi scheme was based on a model of the franchise relationship, which he explicitly said was not the case. “To suggest somehow that Judge Young was suggesting that all franchises are Ponzi schemes or that every franchise model in Massachusetts might run afoul of the independent contractor law is a vast overstatement,” he added.  

Broader Implications of Awuah Decision

Nixon Peabody associate attorney Diana Vilmenay presented on the broader implications of Judge Young’s Diana  Vilmenaydecision. “I think it is going to be important to pay close attention to the opinions other courts begin to take on similar cases. It is also going to be interesting to see if other courts are going to take a Young-like approach to the issue [of distinguishing between independent contractor and employee status].” 

Vilmenay said there has already been reaction to the Young decision, citing a recent Wall Street Journal article, which notes that some franchisors have been advised to stop selling franchises in Massachusetts for the time being.  In a Franchise Times piece, she said Coverall is currently treating 250 plus franchisees as employees until the litigation is worked out.

Vilmenay affirms that the change in the law and this decision are not just affecting the franchise community or the franchise business model. “It is also affecting freelancers like editors, graphic designers, software developers, commercial trucking individuals and driving companies. Basically, all businesses that hire contract workers,” she emphasized. She cited a Boston Globe article. “It published an interesting article where it talked about the case of one freelance author who had actually moved from Massachusetts to New Hampshire simply to maintain her livelihood. The Globe made it clear that she moved so that her publishing client did not have to worry about misclassifying her as an independent contractor.” 

There are other issues that have to be considered. Vilmenay explained, “Think about, for example, potential federal and state income tax liability. Could a putative employer be held liable for failing to withhold income tax from putative employees and remitting to the appropriate tax agencies? This liability could include penalties and interest and potentially unlimited look-back periods, depending on the circumstances.”  She said wages could include holiday and vacation pay, workers compensation, income tax withholding. 

On another issue, Vilmenay said that Mr. Awuah could walk into a court with a private right of action under Massachusetts law on a claim of misclassification of him as an employee of an independent contractor and could claim payment of wages. She said, “A successful claim would garner someone like Mr. Awuah up to treble damages for the violation and attorney fees.”

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About Janet Sparks

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Janet Sparks is the former publisher of the Continental Franchise Review, an industry newsletter that covered the franchise community for over 30 years. She has also been a columnist for a leading franchise magazine for the past 13 years. Today she is an independent journalist who engages in investigative reporting, tackling complex issues that impact the franchise industry.

Janet can be reached at jsparks@bluemaumau.org or at 303-799-7398.