Franchising environmental liability.

Franchisors take note: The escape from environmental regulations that you've enjoyed thus far may be approaching an end as courts and regulatory authorities seem more inclined to hold franchisors liable for the environmental infractions of their franchisees.

There are signs that franchisors may soon feel the full weight of environmental regulation. This prospect seems even more likely when one considers that franchise products and services touch upon environmental concerns at almost every turn.

For instance, laundries use hazardous cleaning solutions, bakeries release carbon dioxide, quick-lube automotive services discharge used oil, and one-hour photo developers use toxic fluids. Recently, a federal court ruled that the owner of a dry cleaning business and the owner of the property on which the business is located must split the cost of cleaning up contamination on the property.

Franchisor exposure to environmental liability is a largely unexplored realm, as few state and federal statutes or court decisions address the issue.

Increasing liability

However, environmental liability is increasing in general and has recently been extended to some business relationships that are comparable to franchises. Among these are parent-subsidiary and secured creditor-borrower relationships. As it becomes more likely that franchisors will be subjected to claims for environmental liability, it is important that they become aware of how such liability can occur and how to reduce their exposure.

Environmental statutes increasingly attach the ultimate liability for such costs to the owners and decision-making centers, often far removed from the actual site of the environmental problem.

The pivotal question thus is whether a franchisor can be seen as the owner, or the "power behind the throne," responsible for problems related to franchisees.

A question of control

The answer lies in determining the degree of control a franchisor exercises over the franchisee's operations, and in the franchisor's ownership or interest in the franchisee's premises, wastes, or storage facilities.

Franchises are usually one of two kinds: product franchises, in which a trademarked line of products is licensed, or business format franchises, in which the franchisor supplies not only products, but support services, resources and market strategy.

Of the two, product franchises are most likely to result in direct franchisor liability, due to the operation of hazardous warning laws. California's Proposition 65, for example, requires products which may expose consumers to certain types of hazards to display information regarding such hazards on its label. The business format franchise is more likely to pose indirect risk to the franchisor for actions by the franchisee, due to the franchisor's greater involvement in the franchisee's operations. A typical business format franchise agreement will include, apart from the purely financial aspects, the franchisor's right to set comprehensive quality standards to protect its trademarked products and the right to control training and supervision.

Control rights

Unfortunately, it is exactly the exercise of these control rights which may expose a franchisor to the greatest environmental liability.

The Superfund law, officially titled the Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA"), is one of the broadest of environmental statutes in terms of its liability potential. It has also been a model for the environmental statutes which have followed it (such as some of the enforcement provisions of the 1990 Clean Air Act Amendments). The potential exposure for franchisors under Superfund presents a "worst case" scenario in many ways. However, exposure under statutes such as the Resource Conservation and Recovery Act ("RCRA"), the Clean Air and Water Acts, and the various California laws may present their own, separate risks.

Superfund liability

Superfund liability is not apportioned among responsible parties, but is generally imposed jointly and severally upon all responsible parties. Thus, the full expense of a cleanup may, and often does, fall on a deep pocket (such as a franchisor), who may have comparatively little connection to the problem. The most likely circumstances under which a franchisor could be found liable under Superfund is if it is found to be the "owner" or "operator" of the property where hazardous substances have been released, or if it is found responsible for "arranging" for hazardous wastes to be taken to that property.

At first glance, a franchisor may not seem likely to be found an "owner" or "operator" of a franchise. However, judicial decisions under Superfund reveal the ease with which a party who is not an owner or operator in the ordinary sense may be considered an "owner" or "operator" of another party's facility. Several important cases have defined the "ownership" criteria very broadly, but even these cases do not always establish distinct and definite rules for determining ownership. Unfortunately liability as an "operator" is even less defined than that of an owner. In general, however, the cases have turned upon the level of a franchisor's participation in the activities of the site. This means that the greater the extent of ownership, or the extent of control, the greater the likelihood that the franchisor will find itself on the hook. It is also important to recognize that even if the franchisor is ultimately exonerated, the degree of its ownership or involvement in the franchise increases the risk that the franchisor will be involved in expensive litigation.

Agency liability

In addition to liability under general environmental laws, franchisors may be liable for the acts of a franchisee if there exists an agency relationship. The central concept of agency law is that the principal (theoretically the franchisor) is liable for the acts of its agents (theoretically the franchisees) who are acting within the scope of actual or apparent authority granted by the principal. Courts have found that the right to control the actions of another is sufficient to support an agency relationship, regardless of whether the control is actually exercised. However, courts have also held that the mere licensing of trademarks, the primary activity in a franchise relationship, does not in itself create an agency relationship. To determine the degree of control required for an agency relationship, courts have looked to the intention of the parties, as indicated by a written agreement and the accompanying circumstances, as well as their actual actions.

The language of the franchising agreement itself may not be enough to protect the franchisor.

Cases involving franchise agreements are split on the issue of whether an agency relationship exists. The level of control required to create an agency relationship differs among the states. However, cases tend to show that the franchisor's control is such that the franchisee is deprived of any real independence in operating its business, an agency relationship will generally be found to exist.

Factors which may suggest excessive control in a franchise agreement include a franchisor's right to require site approval, compliance with construction and operational standards, advertising payments, submission of reports and tax forms, audit records and site inspections, insurance benefiting a franchisor, indemnity and royalties.

Typical agreements

However, factors which may tend to show that the franchisee is merely an independent contractor and not an agent are the franchisor's inability to hire or fire employees, set levels of compensation, provide daily instructions to the franchisee's employees, or otherwise control daily operations.

Typical franchise agreements provide a franchisor with a substantial degree of control over the franchisee's business, including location, design and construction of facilities, operating manuals, franchisor-trained management, and the right to inspect the franchisee's premises, books and records. This degree of control may be sufficient to create an agency relationship between a franchisor and the franchisee. If a third party may reasonably believe that the franchisee is authorized to act on behalf of the franchisor the court may deem an agency relationship to exist.

Because of the breadth of franchise operations and the number of hazardous substances used, franchisors may not safely assume that they are immune from Superfund or other environmental liability. Both franchisors and franchisees would be well advised to start scrutinizing their franchise agreements so that they can assess their respective potential environmental liability exposure.

Franchisors need to evaluate whether their current policies and practices in terms of control are posing a risk, and whether that risk matches the consequences of environmental liability. Franchisees, on the other hand, need to recognize the "bail-out" scenario by which they can assert the "power behind the throne" defense so as to minimize their environmental exposure.

Anthony C. Ching is the managing environmental partner in Orrick, Herrington & Sutcliffe's Los Angeles office. Arthur Haubenstock is an associate at the firm who specializes in environmental compliance and litigation.