For many premises-based, consumer-facing brands (particularly those in the retail sector) which have used franchising as a tool to expand their business, the traditional approach has been to recruit experienced and well-capitalised local operators and grant them rights to open outlets in an allocated territory. Alternatively, brands which operate a centralised international e-commerce platform may use it to test the market before deciding to open outlets through a franchise model. Either way, the grant of franchise rights has tended to be on a 'pure-play' basis – that is, the franchisee is granted the right to open and operate branded physical premises selling products and services in an allocated territory, with the franchisor reserving its rights in respect of other channels, such as wholesale distribution, e-commerce and other forms of distance selling.
From a legal perspective, the reservation of channels such as e-commerce can work only in jurisdictions where local competition authorities do not view these restrictions as anti-competitive.
From a commercial perspective, this model is becoming increasingly outdated on two fronts:
- The rise of the tech-savvy 'global consumer' has disrupted the traditional buying cycle, meaning that – now more than ever – the success of a brand depends on its ability to create a consistent brand experience across all of its retail channels, regardless of whether it uses third-party relationships to exploit a particular channel.
- An imbalance exists in those franchise systems where the franchisee remains pigeon-holed in the traditional brick-and-mortar channel while the franchisor (or its nominee) sells the same products and services to consumers located in the franchisee's allocated territory through a reserved channel, such as e-commerce. This imbalance creates and builds tension in the franchisor-franchisee relationship.
This update considers:
- the various options for bringing e-commerce into the franchise system;
- the legal and commercial challenges to doing so; and
- the means for brands to develop and implement a strategy for e-commerce and franchising which creates a genuine win-win situation for them, their franchisees and their customers.
Whether a brand is looking at franchising for the first time or has already established a network of franchisees, the basic e-commerce options are as follows.
The franchisor follows the traditional pure-play model of using franchising only for the brick-and-mortar channel and reserving some or all of the other channels to itself or its nominees.
The franchisor compensates the franchisee using the revenue generated by the franchisor's direct sales of products and services through its centralised e-commerce platform to customers in the franchisee's allocated territory. This is a variation on Option 1, in which the franchisor recognises the importance of the physical premises in driving brand awareness and goodwill.
The franchisor retains the direct selling relationship with customers of its centralised e-commerce platform that are located in the franchisee's territory, but the franchisee is involved in local fulfilment and customer service and is compensated accordingly.
The franchisee is permitted to operate its own transactional website targeting consumers in its contractual territory. This can be either a constituent page on the franchisor's global platform or a standalone website. The franchisee takes on more (or all) of the burden of investing in infrastructure to support the online business and pays the franchisor a fee, which (depending on the preferred model) may be:
- a 'cost-plus' arrangement on the products ordered from the franchisor for online sales; or
- a royalty, based on the additional turnover generated through online sales.
The choice of option depends on key commercial factors, including:
- the maturity and potential of the allocated territory for online sales;
- seasonality and localisation of the product ranges;
- the franchisee's capability and desire to play a part in online sales;
- the ease (or difficulty) of selling via e-commerce into the allocated territory, including:
- the size of the market;
- import tariffs;
- postage and packaging costs; and
- the availability of international credit and debit card payment systems;
- the means of managing product returns and providing effective customer service in the local language and in tune with local customs; and
- the need for consistency of brand experience and associated marketing and promotion.
Option 1 is favourable from a control perspective, but does not appear sustainable in the long term (for the reasons outlined above). While Option 1 means that a franchisor retains control over e-commerce, it requires investment in building a logistical and operational infrastructure to serve consumers located in the franchisee's allocated territory; such costs may become prohibitive the further the customer is from the brand's central e-commerce operation. There is also the risk of a disconnect between the channels, which can erode trust between the consumer and the brand or the franchisor and its franchisee. For example, if a franchisor's online prices undercut its franchisee's brick-and-mortar retail price, friction in their relationship will inevitably increase. Equally, if the online offering is inconsistent with the local brick-and-mortar offering (particularly in markets that have a level of localisation and seasonality in the product mix) or the two channels are not connected in other respects, the reputation and goodwill associated with the brand will be diminished.
Option 2 retains control for the franchisor, but may address the relational issues with franchisees that would otherwise arise under Option 1. It can be a transitional solution if either or both parties are not yet ready to work together on e-commerce. Option 2 is viable for easily accessible markets which are close or culturally and economically similar to the franchisor's home market; however, it becomes increasingly difficult to manage in more remote and challenging markets. Perhaps the greatest disadvantage of Option 2 is the potential for inconsistency across the retail channels which may arise if the franchisee is not engaged at any level regarding local fulfilment and customer service for online sales.
Option 3 sees the franchisor relinquish some control; however, in return it can shift some of the investment and operational burden onto the franchisee and improve the consumer's brand experience.
Option 4 foresees two possible scenarios: the franchisor either establishes local, franchisee-operated pages on its global platform or allows standalone, local, franchisee-operated online stores. If it chooses the former, the franchisor must make a significant investment in the appropriate technology platform. In any event, Option 4 requires a carefully structured legal framework which will sit alongside the existing franchise agreement, together with additional training and support. Option 4 optimises the consumer experience, as it brings together the brick-and-mortar and e-commerce channels in the allocated territory. Retailers which are in a position to embrace Option 4 will have started the journey towards becoming truly global retailers.
The preferred commercial model must be tested against the applicable legal environment in the allocated territory before implementation and the key area of law which is likely to affect online sales is competition law.
From a European perspective, a franchising agreement is at risk of infringing EU competition law (specifically, Article 101(1) of the Treaty on the Functioning of the European Union) if it has the object or effect of restricting competition and is capable of affecting trade within the European Economic Area (EEA). Each member state has equivalent national competition rules which apply if trade in that market is (or can be) affected by the franchising agreement in question. Infringement of competition law can lead to substantial fines against the parties concerned. The non-financial implications are equally severe, including:
- damage to business reputation;
- unenforceability of contracts;
- risk of third-party damages actions; and
- penalties against individuals, including fines, disqualification and imprisonment.
There has been a longstanding false sense of security regarding EU competition law, particularly among small and medium-sized consumer brands. Historically, the attention of the European Commission has been focused primarily on investigating cartels between multinational corporations and abuses of dominant market positions. However, that assessment is now more dangerous than ever – recent case law shows that the European Commission is scrutinising the activities of brands which operate franchise networks within the European Union, irrespective of market share or geographic scope. Further, the European Commission recently commenced an investigation into e-commerce with a view to identifying and eliminating online barriers to the free movement of products within the EEA.
The basic challenge that EU competition law poses to the use of e-commerce in franchise systems is that the European Commission considers online sales to be a form of 'passive' selling (as opposed to 'active' selling). Outright bans on online sales – and most other restrictions on passive selling – contravene EU competition law. The European Commission takes a hard line on these abuses, deeming them to be 'hardcore' restrictions by object (as opposed to considering their anti-competitive effect). Hardcore restrictions are almost always prohibited and commonly lead to substantial fines. Inclusion of hardcore restrictions in franchising agreements can also complicate their enforcement, enabling franchisees that breach unrelated provisions to mount a 'Euro-defence' based on competition law and seek to have the whole agreement declared void and unenforceable.
Hardcore restrictions include:
- charging franchisees different wholesale prices for the same product depending on the sales channel they use;
- geo-blocking (ie, preventing consumers located outside of a franchisee's allocated territory from visiting that franchisee's website);
- diverting traffic from the franchisee's website by automatically re-routing a consumer to the franchisor's website;
- preventing a franchisee from displaying prices in different currencies or using different languages on their website; and
- (arguably) preventing a franchisee from purchasing search engine key words.
However, a franchisor may impose a number of controls on a franchisee's use of the Internet, including:
- preventing sales through third-party platforms such as Amazon and eBay (although this restriction should be examined carefully in each EU jurisdiction, as the interpretation of the law is inconsistent);
- withholding the right to use a domain name featuring the trademark;
- imposing the same quality standards on the franchisee's online store as for physical stores;
- preventing a franchisee from actively selling into territories exclusively allocated to another franchisee or reserved to the franchisor (although the boundary between legitimate restrictions on active online selling and illegitimate restrictions on passive online selling is unclear and needs careful consideration to implement in practice); and
- requiring a franchisee to operate at least one physical store before it starts selling online.
A franchise agreement must reflect the framework of the franchisor's chosen e-commerce model. The reservation of rights must be carefully worded, with clear parameters on what the franchisee may and may not do and what the triggers might be for the exercise of those rights.
Where a franchisee is granted multi-channel rights, new sections must be developed in the manual. It is advisable to express the multi-channel rights in the franchise agreement as a contractual option or right of first refusal, which is subject to certain conditions and requires the franchisee to enter into a separate e-commerce agreement on the exercise of the option.
The e-commerce agreement will set out the terms and conditions which will govern the establishment and operation of a transactional online store and refer back to the new provisions in the manual (just as the franchise agreement does for physical stores). Key terms and conditions include:
- a licence for the relevant domain name and other IP rights, including those which subsist in the design and content of the website (including source and object codes and the user interface itself);
- approval rights over content which is not sourced from the franchisor;
- the interplay with the franchisee's obligations to market and promote the business, including on social media platforms;
- handling of customer data collected online;
- customer service levels and expectations;
- training and support for customer service and technical support; and
- financial obligations in terms of both investment and the ongoing fee which the franchisee will pay to the franchisor (this could be a percentage of turnover generated through online sales).
The key takeaway is that no 'one size fits all' solution exists for the use of e-commerce within a franchise network. Different approaches are required for different markets and different partners, so it is imperative that brands devise a strategy which can be flexible and works from a legal and commercial perspective.
Franchise agreements and the accompanying e-commerce agreements must be carefully drafted and regularly reviewed by an experienced lawyer to ensure that they adhere to competition law. It is equally important for franchisors to put in place (and regularly review) a system of policies, procedures and training to enable employees and franchisees to anticipate and avoid potentially anti-competitive practices in their day-to-day dealings.
The ultimate goal for brands is to ensure that they are continually satisfying the shifting demands and expectations of consumers, while at the same time safeguarding the reputation and goodwill associated with their brand and products and maintaining strong and collaborative relationships with their franchise partners.
For further information on this topic please contact Gordon Drakes or David Bond at Fieldfisher by telephone (+44 20 7861 4000) or email (email@example.com or firstname.lastname@example.org). The Fieldfisher website can be accessed at www.fieldfisher.com.
This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription.