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How Changes in Joint Employer Liability Could Impact Franchisors & Franchisees: An Economic Perspective

By James D. Woods, Ph.D. and Chris Johnson, CVA, CFE

Recent developments surrounding the National Labor Relations Board’s (NLRB) actions against McDonald’s Corp. highlight the economic costs of uncertainty for specific stakeholders, the franchise model and the economy generally.In July 2014, the NLRB named McDonald’s as a joint employer in 43 cases, many of which alleged that the restaurant corporation and certain franchisees violated the rights of workers during protests to increase wages and improve working conditions. In December 2014, the NLRB issued 13 formal complaints against McDonald’s, claiming that the company “engages in sufficient control over its franchisees’ operations, beyond protection of the brand, to make it a putative joint employer with its franchisees, sharing liability for violations.”

Few franchisors expect McDonald’s to back down on these complaints, but the NLRB’s decision has generated concern in the industry. Both franchisors and franchisees face the question as to how these complaints and the potential outcomes affect their businesses specifically and their industry as a whole.

We examine the possible impacts on franchisors in both the short- and long-run. In the short-run, franchisors first have to address the uncertainty of the situation. The legal framework for resolution of these complaints, potential timing of the actions of the parties, speculation as to the outcomes and ongoing updates as events actually unfold are all areas of focus for attorneys, journalists and other stakeholders. Franchisors, franchisees and the public will look to them for that expertise and input as the matters progress. From an economic and business valuation perspective, we suggest a thoughtful consideration of the uncertainty regarding what will come since this uncertainty is itself a cost of doing business.

To create a level playing field, improve the reliability of shared business information and/or clarify which actors will bear costs in the event of disputes, there is often a period when changes are proposed while stakeholders pursue legal, political, financial hedging or other strategies to resolve and manage the uncertainty. Thus significant resources can be spent on activities other than investing to grow businesses, serving clients or addressing specific social issues. A range of factors—from the extent of McDonald’s resources to the possible impact of broader political outcomes on the NLRB—suggest that this period of uncertainty may last for a prolonged time.

During this period of uncertainty in the short-run, franchisors will face challenges addressing the “joint employer” concept. Fundamental to the reinterpretation of a franchisor as “joint employer” is the simple question: who employs franchisees’ employees? Under most current franchise arrangements, the franchisee—as an independent business owner—holds the costs and control for acquiring and managing employees. The franchisee is also responsible for handling compliance with labor and human resource regulations, as well as liability for employee-related lawsuits (and related insurance outlays).

Many argue that this arrangement provides necessary distribution of overhead and business risks for the franchise model to function and prosper. This distribution of overhead or “cost sharing” can influence more start-up businesses to consider franchising, since they can spread start-up and labor-related costs across investors (i.e., franchisees). For larger and more established franchisors, the known limitations on overhead costs inherent to licensing arrangements allow them to invest more capital into expansion, marketing and R&D.

Under a different paradigm, there would be less “cost sharing” between the franchisor and franchisee as the overhead costs associated with franchisee oversight, employment issues and compliance would likely increase for franchisors. Additionally, a new direct liability for franchisees’ employees would increase franchisors’ exposure to employee-related lawsuits filed against franchisees. The insurance and possible future litigation costs incurred by franchisors to address this collection of risks may be significant. Whether this change will occur, the extent of the change, the standards and fact patterns used to determine “joint employer” status and the unknown timing are all drivers of uncertainty.

For franchisors, a major question is whether absorbing these new costs would be financially viable. In the short-run, it is unclear whether the parties would or could agree to change existing contracts. If franchisors face uncertainty regarding more responsibility for the franchisees’ employees, franchisors may seek to recoup their expected increased costs through increased royalties and other measures. In cases where franchisees do not agree to increases in costs passed down from franchisors and decreased day-to-day control of operations, many franchisors could be faced with a decision to buy back or shut down locations. Attempts to change contract terms unilaterally could result in expensive litigation. Alternatively, franchisors could absorb additional costs until existing contracts expire. But that approach could strain the financial resources of smaller and mid-sized franchisors.

In the long-term, franchisors may be faced with additional management costs and insurance premiums. It is unclear whether franchisors would be able to cover these costs with the available revenue generated from franchisees.

This decrease in independence in the long-run could also affect franchise valuations, since potential buyers may place a lower value on franchisee opportunities if ownership involves less day-to-day autonomy. Not only may valuations of franchisees and franchisors decrease due to increased costs, but the current uncertainty about future operations may also introduce a need for higher discount rates regarding future income. These factors could combine to produce a chilling effect on the industry as a whole: prohibiting or dissuading prospective franchisees from buying into the model; prompting current franchisees to opt out; and/or discouraging start-up businesses from adopting the franchise model from the outset.

While it is unknown how the story will unfold, it is clear that the complaints raised against McDonald’s could have significant implications in the franchising space. Uncertainty within the industry could produce far-reaching consequences, extending well beyond these businesses, their employees, their suppliers and their customers.

As the debate continues, franchisors and franchisees will be well served by carefully examining the range of potential economic impacts and the ramifications of uncertainty before undertaking significant investments, transactions or other important business activities.

James D. Woods, PhD, is a Principal in the Houston office of BDO Consulting, a division of BDO USA, LLP. Dr. Woods focuses on helping clients with issues relating to the value of intellectual property, including: expert testimony as to patent, trademark, trade secret and copyright infringement; royalty investigations; and intellectual asset management. He also assists clients with economic impact studies relating to major events, policy changes and corporate initiatives. Dr. Woods is a member of the Licensing Executives Society and the Association of Certified Fraud Examiners.

Chris Johnson, CVA, CFE, is a Director in the Houston office of BDO Consulting, a division of BDO USA, LLP. Mr. Johnson’s practice includes economic impact analyses estimating the effect of major stimulus initiatives, corporate relocations and events on regional economies. He also assists clients with analysis of class certification in class action lawsuits, intellectual property damages, and complex valuation issues using methodologies such as Monte Carlo analysis and lattice models. Mr. Johnson is a member of the National Association of Certified Valuation Analysts, Licensing Executives Society and Association of Certified Fraud Examiners.

 

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