Vicarious Liability: A Continuing Enigma

Yet, the recent California decision in Patterson v. Domino's Pizza, LLC, 143 Cal. Rptr. 3d 396 (Cal. App. 2d Dist. 2012), suggests that a franchisor should never feel confident that it is fully protected against such claims, even with layers of insurance.

The facts of this case are simple ' or are they? A teenage employee is allegedly sexually harassed by her supervisor and sues both the franchisee and the franchisor. The franchise agreement, as is almost always the case, states that the franchisee is an independent contractor. Nevertheless, on appeal, the franchise agreement is viewed by the appellate court as being only one factor in determining whether the franchisor should be held liable under these circumstances, and the court reversed the trial court's decision granting summary judgment in favor of franchisor Domino's.

At first blush, the appellate court's reversal is chilling because the franchisor, in many respects, was isolated from the conduct of its franchisee. But a deeper look into the facts suggests that all is not hopeless for other franchisors. The Domino's franchise agreement has all the typical controls that most franchisors impose upon their franchisees' operations; unfortunately ' for Domino's ' it also has more. The most extraordinary control was the limitation on franchisees' unrelated investments. The franchisor also made the mistake of trying to spell out too many of the limitations imposed on franchisees, thus giving the court a laundry list of things to choose as evidence of micro-manager control. Might it have been wiser simply to say “Follow the operations manual,” and leave it at that?

However, there is even more to this picture to consider. The facts showed that one of the field representatives of the franchisor went beyond normal practices. The field representative ordered the franchisee to fire an employee under the threat that there would be trouble for the franchisee if the field representative's demand was not followed. The franchisee had also gone bankrupt, which meant one fewer pocket for the aggrieved employee to pursue. In light of these facts, the decision by the appellate court was not that surprising.

A Difficult Subject

Vicarious liability is one of the more difficult subjects about which franchise lawyers provide counsel to their clients. As Patterson illustrates, judicial decisions are very much influenced by the facts. The Patterson facts might have come before any California court, and the oddsmakers would probably not have given better than even odds to the franchisor on the outcome. The problem is especially complicated for franchisors because franchise systems typically operate in more than one state. The courts of some states look for actual control in reaching their decisions, but in others, merely having the right to control can be outcome determinative. Thus, franchisors can find very similar facts leading to opposite conclusions.

Many of my colleagues try to dance a fine line in advising their clients on this subject. They say exert control, but don't exert too much control. I think that advice is inadequate. Clients want more definitive answers, and like in so many other situations, risk must be assessed, and then, ways to reduce risk must be considered. For franchisors, particular consideration must be given to protecting the brand, for this intangible asset may be the franchisor's most significant one. For franchise systems where franchisees comprise a substantial portion of the units or activities, brand protection becomes all-the-more difficult because, regardless of what restrictions are placed on franchisees, the franchisor will always be less able to govern the franchisees' activities. In many states, an employer can easily terminate an employee, such as a manager, without cause, unless there are state statutes to the contrary, or unless the employee has an employment contract, or unless the basis for the termination is a violation of the employee's federally or state protected rights against discrimination. It is considerably more difficult to terminate a franchisee. The contract must be considered; there may be statutes that require notice or “good cause” before a termination can become effective; and there is always the potential claim by the franchisee that the franchisor has violated the covenant of good faith and fair dealing (whatever that term means!).

And there is also the problem of the franchisee's rogue employee. The franchisee may be a good citizen, but think of the Domino's incident a couple of years ago, when a franchisee's employee put a foreign substance on a pizza, videotaped himself in the act, and posted it on the Internet! Could the franchisor have fired the employee? Again, the oddsmakers would probably suggest that smart money would be bet in favor of the franchisor not being able to do so.

What to Do

So what is a franchisor to do? Let me suggest the following:

1) As a first step, don't focus on liability ' focus on brand protection. Ask the question: What are the primary items to consider to protect the brand?

For example, as for restaurants, I perceive foodborne illnesses as being the major villain. In the wake of the Jack in the Box e. coli problem in the Northwest in 1993, I am told that sales for that franchise system went down some 25% during the following months ' not only at that franchisor's restaurants, but also at its competitors'. If sales did not ultimately rebound, the bell would have tolled for the adversely affected franchisees. Obviously, the Jack in the Box brand was severely damaged, and the damage could have been reduced had the franchisor better policed the cooking practices of its franchisees.

For child-care franchises, the greatest concern relates to the welfare of the children. An incident involving child safety or child molestation may paralyze the franchisee's efforts to obtain or maintain enrollment, and certainly would raise concern for the franchisor's public image.

2) Once the greatest vulnerabilities have been identified, draft the steps necessary to reduce the possibilities of the adverse events occurring. For restaurants, controls over supply and cooking standards must be demanding, regardless of the risk. For child-care franchises, background checks of employees are essential.

3) Inspect and inspect often. Failure to monitor the franchisee's activities can not only lead to liability to third parties if totally ignored, it could lead to loss of trademark rights. I do not think it is advisable to put controls on franchise field representatives that make them appear like the Gestapo, but policing of standards must be performed.

4) If all else fails, make sure that appropriate insurance is in place. Almost any catastrophic risk can be insured. The issue is how much coverage is necessary and what will that insurance cost. Nearly all franchisors require their franchisees to carry insurance. But the due diligence I have performed in connection with franchise acquisitions often shows that: 1) necessary insurance has not been purchased; 2) the insurance has lapsed, and the franchisor has not demanded that the franchisee take corrective steps to reinstate insurance coverage; 3) the franchisor has not examined the scope of insurance coverage held by the franchisee; and 4) the amount of the insurance is insufficient. I have seen numerous franchise agreements in which the coverage is a mere $1 million. This amount may be appropriate for franchises where the risks are low for franchisors, such as coupon mailers or the like. But I would suggest that it is totally inadequate for restaurants or other businesses that employ many people, have high levels of customer traffic, or that offer services that have a high degree of danger involved (such as rental cars).

5) And, as most franchisors know, the franchisee's insurance is only the first trench of protection. The franchisor must also purchase appropriate insurance to cover risks where the franchisee's coverage might not be adequate in scope or amount.

Conclusion

In light of Patterson, contractual protection will not give much protection to franchisors worried about vicarious liability, no matter how clever their lawyers may be. Look diligently at insurance coverage.

But insurance is not the end-all, be-all. It will not eliminate all foreseeable risk, and the policy typically has language that exempts the insurer from liability for many common risks. (As one friend has said, it does not insure the events that are mostly likely to occur.) Insurance can be too expensive (try buying flood insurance in coastal Florida). Insurers can go bankrupt.

So, in the end, there are no safe harbors for franchisors from vicarious liability claims. The franchisor must accept the fact that its business will always be at risk, and taking it on the chin as a result of vicarious liability risk is simply another fact of life.

Rupert M. Barkoff is a member of this newsletter's Board of Editors and a partner in the Atlanta office of Kilpatrick Townsend & Stockton LLP, where he chairs the firm's Franchise Practice Team. He is a former chair of the American Bar Association's Forum on Franchising and co-editor-in-chief of the Forum's Fundamentals of Franchising book. He can be reached at 404-815-6366 or at mailto:[email protected].

Let's play Jeopardy.

The answer: insurance.

The question: What's the best way for a franchisor to protect itself against vicarious liability claims brought by third parties against one of its franchisees and the franchisor itself?

Yet, the recent California decision in Patterson v. Domino's Pizza, LLC , 143 Cal. Rptr. 3d 396 (Cal. App. 2d Dist. 2012), suggests that a franchisor should never feel confident that it is fully protected against such claims, even with layers of insurance.

The facts of this case are simple ' or are they? A teenage employee is allegedly sexually harassed by her supervisor and sues both the franchisee and the franchisor. The franchise agreement, as is almost always the case, states that the franchisee is an independent contractor. Nevertheless, on appeal, the franchise agreement is viewed by the appellate court as being only one factor in determining whether the franchisor should be held liable under these circumstances, and the court reversed the trial court's decision granting summary judgment in favor of franchisor Domino's.

At first blush, the appellate court's reversal is chilling because the franchisor, in many respects, was isolated from the conduct of its franchisee. But a deeper look into the facts suggests that all is not hopeless for other franchisors. The Domino's franchise agreement has all the typical controls that most franchisors impose upon their franchisees' operations; unfortunately ' for Domino's ' it also has more. The most extraordinary control was the limitation on franchisees' unrelated investments. The franchisor also made the mistake of trying to spell out too many of the limitations imposed on franchisees, thus giving the court a laundry list of things to choose as evidence of micro-manager control. Might it have been wiser simply to say “Follow the operations manual,” and leave it at that?

However, there is even more to this picture to consider. The facts showed that one of the field representatives of the franchisor went beyond normal practices. The field representative ordered the franchisee to fire an employee under the threat that there would be trouble for the franchisee if the field representative's demand was not followed. The franchisee had also gone bankrupt, which meant one fewer pocket for the aggrieved employee to pursue. In light of these facts, the decision by the appellate court was not that surprising.

A Difficult Subject

Vicarious liability is one of the more difficult subjects about which franchise lawyers provide counsel to their clients. As Patterson illustrates, judicial decisions are very much influenced by the facts. The Patterson facts might have come before any California court, and the oddsmakers would probably not have given better than even odds to the franchisor on the outcome. The problem is especially complicated for franchisors because franchise systems typically operate in more than one state. The courts of some states look for actual control in reaching their decisions, but in others, merely having the right to control can be outcome determinative. Thus, franchisors can find very similar facts leading to opposite conclusions.

Many of my colleagues try to dance a fine line in advising their clients on this subject. They say exert control, but don't exert too much control. I think that advice is inadequate. Clients want more definitive answers, and like in so many other situations, risk must be assessed, and then, ways to reduce risk must be considered. For franchisors, particular consideration must be given to protecting the brand, for this intangible asset may be the franchisor's most significant one. For franchise systems where franchisees comprise a substantial portion of the units or activities, brand protection becomes all-the-more difficult because, regardless of what restrictions are placed on franchisees, the franchisor will always be less able to govern the franchisees' activities. In many states, an employer can easily terminate an employee, such as a manager, without cause, unless there are state statutes to the contrary, or unless the employee has an employment contract, or unless the basis for the termination is a violation of the employee's federally or state protected rights against discrimination. It is considerably more difficult to terminate a franchisee. The contract must be considered; there may be statutes that require notice or “good cause” before a termination can become effective; and there is always the potential claim by the franchisee that the franchisor has violated the covenant of good faith and fair dealing (whatever that term means!).

And there is also the problem of the franchisee's rogue employee. The franchisee may be a good citizen, but think of the Domino's incident a couple of years ago, when a franchisee's employee put a foreign substance on a pizza, videotaped himself in the act, and posted it on the Internet! Could the franchisor have fired the employee? Again, the oddsmakers would probably suggest that smart money would be bet in favor of the franchisor not being able to do so.

What to Do

So what is a franchisor to do? Let me suggest the following:

1) As a first step, don't focus on liability ' focus on brand protection. Ask the question: What are the primary items to consider to protect the brand?

For example, as for restaurants, I perceive foodborne illnesses as being the major villain. In the wake of the Jack in the Box e. coli problem in the Northwest in 1993, I am told that sales for that franchise system went down some 25% during the following months ' not only at that franchisor's restaurants, but also at its competitors'. If sales did not ultimately rebound, the bell would have tolled for the adversely affected franchisees. Obviously, the Jack in the Box brand was severely damaged, and the damage could have been reduced had the franchisor better policed the cooking practices of its franchisees.

For child-care franchises, the greatest concern relates to the welfare of the children. An incident involving child safety or child molestation may paralyze the franchisee's efforts to obtain or maintain enrollment, and certainly would raise concern for the franchisor's public image.

2) Once the greatest vulnerabilities have been identified, draft the steps necessary to reduce the possibilities of the adverse events occurring. For restaurants, controls over supply and cooking standards must be demanding, regardless of the risk. For child-care franchises, background checks of employees are essential.

3) Inspect and inspect often. Failure to monitor the franchisee's activities can not only lead to liability to third parties if totally ignored, it could lead to loss of trademark rights. I do not think it is advisable to put controls on franchise field representatives that make them appear like the Gestapo, but policing of standards must be performed.

4) If all else fails, make sure that appropriate insurance is in place. Almost any catastrophic risk can be insured. The issue is how much coverage is necessary and what will that insurance cost. Nearly all franchisors require their franchisees to carry insurance. But the due diligence I have performed in connection with franchise acquisitions often shows that: 1) necessary insurance has not been purchased; 2) the insurance has lapsed, and the franchisor has not demanded that the franchisee take corrective steps to reinstate insurance coverage; 3) the franchisor has not examined the scope of insurance coverage held by the franchisee; and 4) the amount of the insurance is insufficient. I have seen numerous franchise agreements in which the coverage is a mere $1 million. This amount may be appropriate for franchises where the risks are low for franchisors, such as coupon mailers or the like. But I would suggest that it is totally inadequate for restaurants or other businesses that employ many people, have high levels of customer traffic, or that offer services that have a high degree of danger involved (such as rental cars).

5) And, as most franchisors know, the franchisee's insurance is only the first trench of protection. The franchisor must also purchase appropriate insurance to cover risks where the franchisee's coverage might not be adequate in scope or amount.

Conclusion

In light of Patterson, contractual protection will not give much protection to franchisors worried about vicarious liability, no matter how clever their lawyers may be. Look diligently at insurance coverage.

But insurance is not the end-all, be-all. It will not eliminate all foreseeable risk, and the policy typically has language that exempts the insurer from liability for many common risks. (As one friend has said, it does not insure the events that are mostly likely to occur.) Insurance can be too expensive (try buying flood insurance in coastal Florida). Insurers can go bankrupt.

So, in the end, there are no safe harbors for franchisors from vicarious liability claims. The franchisor must accept the fact that its business will always be at risk, and taking it on the chin as a result of vicarious liability risk is simply another fact of life.

Rupert M. Barkoff is a member of this newsletter's Board of Editors and a partner in the Atlanta office of Kilpatrick Townsend & Stockton LLP, where he chairs the firm's Franchise Practice Team. He is a former chair of the American Bar Association's Forum on Franchising and co-editor-in-chief of the Forum's Fundamentals of Franchising book. He can be reached at 404-815-6366 or at mailto:[email protected].