A Franchisor's Liability for Discrimination by Franchisees

The New York Law Journal
June 3, 1996

FRANCHISORS WITH nationally recognized names have been a frequent target of law suits arising out of incidents occurring at one of their franchises. Perhaps the most publicized example of this is the 1994 case against McDonald's Corp., in which a jury awarded a woman $2.9 million for burns suffered after spilling hot coffee in her lap.1 In addition to tort claims, plaintiffs have sought to hold franchisors liable for the acts of franchisees under the anti-discrimination laws.

Such claims have exposed franchisors to enormous liability. For example, in Haynes v. Shoney's Inc., 1993 U.S. Dist. Lexis 749 (N.D.Fla. Jan. 25, 1993), the court approved the largest racial discrimination settlement in history -- $105 million -- against the franchisor of Shoney's Restaurants.2 The suit was based on a claim that Shoney's and its franchisees followed a policy of discriminating against black employees for ''front of the house'' jobs.3

In recent years, both private and government plaintiffs have brought an increasing number of cases against franchisors under the anti-discrimination laws. Developments in two such cases in just the first few months of this year may be indicative of an increased risk facing franchisors under these laws.

In February, the Justice Department filed lawsuits in five states against a hotel franchisor Days Inn of America Inc., alleging that the design and construction of new buildings by five of the company's franchisees violated the Americans With Disabilities Act (ADA).4 In March, a federal court certified a class action against Hooters of America Inc., alleging that Hooters discriminated on the basis of sex in refusing to hire males as waiters, purportedly pursuant to a mandate by the franchisor that servers must exhibit a certain kind of sex appeal.5

In most cases like these, franchisors have asserted that their franchisees' employees could not pursue claims against them under the anti-discrimination laws because such claims lie only against the employee's direct employer, the franchisee. However, in certain situations, courts have construed the term ''employer'' to include both the franchisor and franchisee, thus allowing franchisee employees to assert claims directly against the franchisors.

This column analyzes franchisors' defenses to claims by franchisee employees under the anti-discrimination laws. Such defenses are based on the theory that the franchisee as the employer and primary operator of the franchise is the only proper party to such a suit. We also analyze how franchisors can protect themselves through an appropriate franchise agreement that avoids exerting excessive control over the franchisee and contains enforceable indemnification clauses and adequate insurance requirements.

'Control' Test

The various federal, state and local anti-discrimination statutes prohibit discrimination by ''employers'' against their employees on the basis of a number of protected classifications, including; race, color, religion, sex, national origin, age, disability, and other protected statuses.6 Employees of the local franchisees often have argued in court that their ''employer'' was not just the franchisee, but the franchisor as well.

Courts and administrative agencies have responded to these contentions by adopting a number of legal theories to determine whether a franchisor may be considered the ''employer'' of the franchisees' employees. Accordingly, labels such as ''joint employer,'' ''single employer'' or other names have been used when analyzing claims against franchisors.7 While the emphasis of each of these tests is slightly different, and courts frequently apply several theories or blur the distinctions between them,8 the primary factor that will determine whether a franchisor is amenable to suit, regardless of the terminology used, is the extent to which the franchisor controls the terms and conditions of employment of the franchisees' employees.

As early as 1970, the Equal Employment Opportunity Commission issued a decision in which it found that an unidentified franchisor that marketed ice cream through a ''franchise operation'' with more than 700 stores could be held liable as a ''joint employer'' for acts of discrimination committed by one of its franchisees.9 The EEOC rejected the franchisor's argument that its franchisee was not a joint employer, but rather an independent contractor that employed its own employees. The EEOC based this conclusion on its finding that, under the franchise agreement, the franchisor controlled the hours of work and work assignments of the franchisees' employees and was a named insured in the insurance policies that covered the franchisee's property.

Operational Standards

This early EEOC opinion establishes that a franchisor's direct control over such terms and conditions of employment as hours and work assignments will likely create an employment relationship. However, subsequent judicial opinions have clarified that a franchisor may retain control over franchisee operations relating to ''quality standards'' without running the risk of liability.10

In this regard, the widely cited case Evans v. McDonald's, 936 F2d 1087 (10th Cir. 1991), exemplifies how McDonald's, while being careful not to interfere with the terms and conditions of employment of its franchisees, has been able to control numerous aspects of its franchisees' operations. In Evans, an employee of a McDonald's franchisee alleged that she was sexually harassed by a consultant employed by McDonald's, in violation of Title VII. In analyzing whether McDonald's and its franchisee were a ''single employer,'' the court considered ''(1) interrelation of operations, (2) centralized control of labor relations, (3) common management, and (4) common ownership or financial control'' of the two entities.11

The court recognized that McDonald's operations and those of its franchisee were interrelated, that McDonald's conducted frequent inspections and that McDonald's provided training for franchisee employees. The court alsorecognized that the alleged harasser who was providing consulting services to the franchisee was employed directly by McDonald's Corp., not the franchisee.

Notwithstanding what plaintiff characterized as McDonald's ''monumental control'' over the franchisee, the court found such control to be nothing more than ''the necessary control over conformity to standard operational details inherent in many franchise settings.''12 Significant to the court's conclusion was McDonald's lack of control over the franchisee's labor relations and finances, which precluded a finding that McDonald's and its franchisee were a ''single employer'' under Title VII.

While the Court in Evans relied on the fact that the franchisor did not take any actions that affected the terms and conditions of employment of the franchisees' employees, a court may find that an employment relationship has not been established even where a franchisor initiates limited policies touching on employee relations.

In Scales v. Sonic Industries Inc., 887 F. Supp. 1435 (E.D. Okla. 1995), the court refused to hold that the franchisor was the plaintiff's employer even though the franchisor provided its franchisees an Operations Manual that (1) designated the franchisor as final arbiter in matters of labor relations, (2) established a grievance procedure for employees with the franchisor's president as the final step in the process, and (3) provided that employees could report any violation of law to the franchisor.

Applying the Evans holding, the court stated that the policies in the operations manual reflected an inherent interrelation of operations between the franchisor and the franchisee and the goal of ''attaining conformity to certain operational standards and details.''13 The court recognized that the franchisee retained control over the day-to-day operations of the Sonic Drive-In restaurant and that the operations manual did not transfer control over labor relations to the franchisor.

Franchisor Liability

The safe harbor for franchisors offered by Evans and Scales has its limits. While a franchisor may be entitled to impose standards on franchisees designed to protect its trademark and tradename, if such requirements sufficiently affect the employment relationship they may establish the basis for franchisor liability.

For example, in Latuga v. Hooters Inc., 1996 WL 164427 (N.D.Ill. March 29, 1996), a federal court certified a class action brought by three males who claimed they were denied employment at two ''Hooters'' restaurants in Orland Park and Downers Grove, Ill., because of their sex, in violation of Title VII. Despite the franchisor's objections that the class should be limited to applicants to the two franchises' restaurants to which plaintiffs had applied, the court certified a nationwide class of all male applicants at all restaurants owned directly by the franchisor as well as all the independent franchisees.

Through common ownership and management, the court found that Hooters Inc. and nine of its franchises were ''single employers'' under the same four-part test applied in Evans. Moreover, through a license agreement with another company named Hooters of America, the court found that Hooters Inc. retained significant control over another 150 franchises in 38 states. This included control over the chain's ''core concept'' of a female waitstaff wearing cutoff T-shirts, tank tops and orange jogging shorts.

Even though Hooters Inc. did not have any direct control over the hiring practices or working conditions at the franchises, the court found it sufficient that the company controlled an allegedly discriminatory policy that ''significantly interferes with the opportunity for males to obtain jobs at Hooters restaurants nationwide.''14

Similarly, in Bradley v. Pizzaco of Nebraska Inc., 7 F3d 795 (8th Cir. 1993), the EEOC and a pizza delivery man alleged that a nationwide ''no-beard'' policy established by the franchisor, Domino's Pizza Inc., violated Title VII in that it had a disparate impact on black males, a large percentage of whom suffer from a skin condition called pseudofolliculitis barbae that is aggravated by shaving.

Although denying relief to the individual plaintiff whose skin condition was found not to have prevented him from shaving off his beard, the court granted the EEOC an injunction requiring Domino's to recognize a medical exception to its no-beard policy. While the court did not discuss the basis for the franchisor's liability to the franchisee's employees, the court implicitly held that Dominos's exercised sufficient control over its franchisee's labor relations by imposing the ''no-beard'' policy that it could be considered plaintiff's employer under the law.

Disability Bias

There are not as yet any reported cases in which an employee of a franchisee has sued the franchisor for disability discrimination. However, in two recent cases, customers of franchisees sued the franchisor under the Americans With Disabilities Act. The judicial opinions in those cases may be instructive to franchisors in the employment area as well.

In Staron v. McDonald's Corp., 51 F3d 353 (2d Cir. 1995), a group of customers of McDonald's and Burger King who were allergic to smoke sought a declaratory judgment that the franchisors and their franchisees violated the ADA by allowing smoking in their restaurants. The plaintiffs also sought to have the defendants and their franchisees adopt no-smoking policies at all of their locations. The trial court found that such a policy was not required under the act and dismissed the case. Immediately following the dismissal, McDonald's banned smoking at all of its corporate-owned, but not its franchised, restaurants.

The appellate court rejected McDonald's argument that this new policy rendered the plaintiffs' claim moot. While the court did not state its rationale for this conclusion, one can only presume that the court reached this decision because there continued to exist a live controversy based on McDonald's potential to control the policies of its franchisees. Accordingly, the Second Circuit reversed the trial court and remanded for further proceedings the question whether a total ban on smoking is a reasonable modification to permit plaintiffs access to defendants' restaurants.

Although Staron signals a potentially broad reading of the ADA, creating the possibility that franchisors may be held liable for their franchisees' failure to comply with the law, at least one other court has criticized this aspect of Staron. In Neff v. American Dairy Queen Corp., 58 F3d 1063 (5th Cir. 1995), cert. denied, 116 S. Ct. 704 (1996), the court refused to hold the franchisor liable for a franchisee's alleged failure to make its restaurant wheelchair accessible.

The court stated that in order for the franchisor to be liable under the act, it would have to be considered the ''operator'' of the franchise. Again, as in employment discrimination cases, the critical factor in making this determination is control. In this context, the court found the relevant inquiry to be ''whether [the franchisor] specifically controls the modification of the franchises to improve their accessibility to the disabled.''15

A review of the franchise agreement established that the franchise was to be constructed in accordance with franchisor approved standards. Further, the franchisor retained the right to set building and equipment maintenance standards and to reject proposed structural changes. However, the court held that such control was insufficient to render the franchisor the operator for purposes of the ADA.

Given the control that the franchisor retained over construction and modifications of the franchise, the Neff opinion recognized that its interpretation of the term ''operator'' may be narrower than the interpretation that appeared to have been adopted by the Second Circuit in Staron.16 Because of the apparent conflict between the Second and Fifth Circuits and the dearth of case law on the subject, it is too early to tell what level of risk franchisors face under the ADA for structural changes to franchisee's buildings.

Practical Factors

Franchisors that wish to retain significant control and take an active part in the routine operations of their franchises run the risk of increased liability for acts of their franchisees. However, case law indicates that franchisors may generally retain a certain amount of control in order to ensure that franchisees live up to quality standards, without being considered employers or operators of independent franchises. Therefore, there are several steps that franchisors can take in order to minimize liability.

First, franchise agreements should clearly provide that licensing decisions are based solely on the franchisees' conformity to specified quality standards. In this regard, it should be established that any suggestions made by the franchisor not related to such standards are entirely optional.

Franchisees should be responsible for making all hiring, firing and other employment related decisions. Any involvement by the franchisor in this regard should be clearly advisory or related to the uniform operation of the franchises. Specifically, franchisee employees should be informed that franchisor employees are not their employers. Further, franchisors should establish clear policies dictating the scope of interaction between its employees and franchisee employees. Such policies should include clear descriptions of appropriate behavior.

Franchisors should include broad and specific indemnification provisions in their franchise agreements that cover all claims of third parties (including employees) arising out of the operation of the franchise. This generally does not prevent a third party from bringing suit against the franchisor.17 However, if the franchisor is found liable, a properly drafted indemnification agreement will generally be enforceable against the franchisee, even in cases where the franchisor's negligence arguably caused the injury to the third party.18

Franchisors also may require franchisees to maintain insurance policies covering employment discrimination claims or require franchises to conduct compliance audits in conjunction with outside counsel.19

Franchisors should carefully consider all of their core policies to assess whether they are potentially discriminatory or otherwise establish excessive control over terms and conditions of employment of the franchisees' employees. Such policies should be modified in conformity with Evans and Scales.

The franchise agreement should state clearly that no policy shall be interpreted to prevent a franchisee from complying with any federal, state or local law. Naturally, this statement includes all labor and employment laws.

(1) See, e.g., ''McDonald's Settles Out of Court Over Coffee Burns,'' Leg. Intelligencer, Dec. 5, 1994, at 4. A judge later reduced the award by more than $2 million. Ultimately, the case was settled for an undisclosed amount. Id.

(2) See, e.g., ''Shoney's Settles Bias Suit,'' National Law Journal, Nov. 16, 1992, at 15.

(3) See, Dorothy J. Gaiter, ''How Shoney's, Belted by a Lawsuit, Found the Path to Diversity,'' Wall Street Journal, April 16, 1996, at A1.

(4) See, ''Justice Sues Days Inn Chain Over Disabled Facilities -- HFS,'' Feb. 8, 1996 Dow Jones News Serv. 17:50:00. Days Inn had previously filed its own action in a Texas court to determine whether as a franchisor it has any duty to ensure that new structures built by its franchisees conform with the ADA. Id.

(5) See Latuga v. Hooters Inc., 1996 WL 164427 (N.D.Ill. Mar. 29, 1996).

(6) See, e.g., Title VII of the Civil Rights Act of 1964, 42 USC §2000e-2 (race, color, religion, sex and national origin); Age Discrimination in Employment Act of 1968, See 29 USC §623 (age); Immigration Reform and Control Act of 1986, 8 USC §1324b(a)(v) (citizenship); New York Human Rights Law, N.Y. Executive Law §296 (age, race, creed, color, natural origin, sex or disability or marital status); New York City Human Rights Law, NYC Administrative Code §8-107 (actual or perceived age, race, creed, color, national origin, gender, disability, marital status, sexual orientation or alienage or citizenship status).

(7) Other tests that have been applied include common law principles and the ''economic realities'' test. See, e.g., Kennedy v. McDonald's Corp., F. Supp. 203 (S.D. W.V. 1985).

(8) See, e.g., Hulsey v. Gunn, 905 F. Supp. 1067 (N.D.Ga. 1995) (finding that franchisor was not plaintiff's employer under either the ''joint employer'' or ''single employer'' theories).

(9) See EEOC Dec. No. 71-708 (Dec. 17, 1970).

(10) See People v. Holiday Inns Inc., 62 FEP 826 (WDNY 1993) (holding that the hotel franchisor was not the plaintiffs' employer, even though it conducted frequent inspections of franchisee properties and required franchisee employees to attend training sessions, including one on labor relations).

(11) Evans, 936 F2d at 1089.

(12) Id. at 1090.

(13) Id. at 1439.

(14) Id. at *8.

(15) Neff, 58 F3d at 1066.

(16) See Neff, 58 F3d at 1069 n.12.

(17) See, e.g., Morris v. McDonald's Corp., 650 NE2d 1219 (Ct. App. Ind. 1995) (holding that indemnity clause in franchise agreement did not prevent injured customer from bringing suit against franchisor).

(18) See, e.g., Cohen v. Steve's Franchise Co., 927 F2d 26 (1st Cir. 1991) (enforcing indemnification agreement against franchisee even though franchisor's negligence caused injury to employee).