A key element of a franchise agreement is the licensing of certain intellectual property rights such as trademarks, designs and know-how for the use and distribution of goods or services. Franchise agreements usually contain a combination of different vertical restraints with regard to the products being distributed, such as exclusivity, quality requirement, assortment, customer group and certain internet sales restrictions. Often a franchisor also has specific views on retail pricing and discount strategy, or wishes to receive and exchange sales and customer data relating to sales transactions to improve marketing and sales strategies for the franchise network. Further, is it common that franchisees have to comply with a non-compete clause during the term of the agreement, and sometimes post-termination for a certain period of time and geographic area. Contractual restrictions like these may create competition concerns, particularly in the European Union.
Franchise agreements are subject to a full review under competition law. The only exceptions are intercompany agreements,2 franchisees that are integrated in the undertaking of the franchisor3 and activities that are not economic activities.4 Therefore a franchisor is not allowed to implement practices that are not permitted under EU competition law, such as vertical or horizontal price-fixing, sharing markets, prohibiting passive sales and imposing a direct or indirect ban on internet sales. However, franchise takes a special place within EU competition law. Specific contractual restrictions on the franchisee – which are necessary to protect know-how and goodwill, and to maintain the common identity of the franchise network – fall outside the European cartel prohibition.
In the event a franchise agreement infringes competition law, the consequences can be severe for a franchisor. In such event the agreement is null and void and therefore unenforceable. A fine of a maximum of 10 per cent of the group’s turnover can be imposed on the franchisor. Moreover, in some jurisdictions personal sanctions such as dismissal and imprisonment can be imposed on executives of the company infringing competition law. Further, the reputation of the franchisor and the franchise network can be damaged.
In this chapter we will outline some restrictive provisions and practices in cross-border franchise agreements that may be caught by EU competition law. Since EU competition law is one of the stricter regimes when it comes to vertical restraints, this overview will provide a helpful starting point for franchise networks expanding into Europe and globally.
Under European law, the cartel prohibition is laid down in article 101(1) of the Treaty on the Functioning of the European Union (TFEU). This article states, in short, that agreements that may affect trade between member states, and have as their object or effect the prevention, restriction or distortion of competition within the internal market, are prohibited. Article 101(2) TFEU sets forth that agreements that are covered by article 101(1) TFEU are void and unenforceable. This is different if the agreement satisfies the criteria of article 101(3) TFEU. This article states that article 101(1) TFEU may be declared inapplicable in the event the following four cumulative criteria are met; the agreement must:
- contribute to improving the production or distribution of goods or to promoting technical or economic progress;
- allow consumers a fair share of the resulting benefit;
- not impose on undertakings concerned restrictions that are not indispensable to the attainment of these objectives; and
- not afford such undertakings the possibility of eliminating competition in a substantial part of the products in question.
Franchise agreements in Europe are, regardless of the choice of law and forum, subject to EU competition law. This is because article 101 TFEU is considered by the European Court of Justice (ECJ) to be of a rule of public policy.5 This means that a national court must apply article 101 TFEU regardless of the choice of law that is included in a franchise agreement. However, article 101 TFEU is only applicable if the agreement has an appreciable effect on trade between member states. This does not mean that article 101 TFEU cannot be applicable to a franchise agreement between a franchisor and franchisee that are located in the same member state. Agreements that involve only parties situated in one member state are capable of affecting trade between member states if, for example, the agreement has propensity to foreclose a significant share of a national market, and such agreement makes it more difficult for undertakings from other member states to penetrate the national market in question either by means of exports or by means of establishment.6
If the effects are only on the national market, national competition law applies, which usually reflects EU law. The European Commission investigates and enforces EU competition law, and an appeal to the European Courts is possible. National authorities and courts apply both EU and national competition law, depending on the facts of the case. National courts can ask prejudicial questions to the ECJ, which will then lead to a decision of the ECJ on the points of law brought forward in the prejudicial questions.
Provisions necessary to protect know-how and goodwill and to maintain common identity
From the judgment Pronuptia de Paris v Schillgalis7 of the ECJ, specific rules for the assessment of provisions in a franchise agreement can be derived. The ECJ ruled in this case that article 101 TFEU shall not apply to certain clauses in franchise agreements if they are necessary to protect the know-how and goodwill of the franchisor that is licensed to the franchisee, and to maintain the common identity and reputation of the franchised network.8
The ECJ stated that a franchisor must be able to communicate his or her know-how to the franchisees and provide them with the necessary assistance to enable them to apply his or her methods without running the risk that the know-how and assistance might benefit competitors. The ECJ decided that provisions that are essential to avoid that risk do not constitute restrictions on competition for the purpose of article 101(1) TFEU. In that context, the following provisions are generally permitted in a franchise agreement:
- the prohibition for the franchisee, during the period of the contract and for a reasonable period after its expiry to open a shop of the same or a similar nature in an area where he or she may compete with a member of the franchise network;
- the franchisee’s obligation not to transfer his or her shop to another party without the prior written approval of the franchisor;
- the franchisee’s obligation not to carry on competing activities during the term of the agreement;
- the prohibition to solicit, for a reasonable period, customers who have been, during a certain period before the termination of the agreement, his or her customers; and
- the provision prohibiting the franchisee from subletting its shop, setting up a sub-franchise, placing its business under management by a third party or appointing a salaried shop manager without the express approval of the franchisor.9
In the Pronuptia case it has been decided that the franchisor must be able to take measures necessary for maintaining the identity and reputation of the network bearing his or her business name or symbol. Provisions that are necessary for that purpose do not constitute restrictions on competition for the purposes of article 101(1) TFEU. In that regard, the following provisions are generally allowed in a franchise agreement:
- the franchisee’s obligation to apply the franchisor’s business methods and know-how;
- the franchisee’s obligation to sell the goods covered by the contract only in premises laid out and decorated according to the franchisor’s instructions;
- prohibition of the assignment by the franchisee of his or her rights and obligations under the contract without the franchisor’s approval;
- the obligation on the franchisee to order the goods connected with the essential object of the franchise business exclusively from the franchisor or from suppliers designated by the franchisor;
- the franchisee’s obligation to sell only the products and provide the services authorised by the franchisor, or products and services of equivalent quality;
- the provision requiring the franchisee to obtain the franchisor’s approval for all advertising; and
- a ban on the franchisee reselling the franchisor’s goods to traders other than franchisees, franchise-corner retailers or retailers supplied by the franchisor.10
Provisions that are not necessary to protect know-how and goodwill, or to maintain the common identity or reputation of the franchised network, must be assessed on an individual basis under the cartel prohibition to conclude whether they infringe competition law.
Vertical block exemption regulation
Franchise agreements qualify as vertical agreements under competition law. A vertical agreement is an agreement that is entered into by undertakings that operate at different levels of the distribution chain.11 Because of the fact that franchise agreements qualify as vertical agreements, they can benefit from the Block Exemption on Vertical Agreements (the Vertical Block Exemption).12 Based on the Vertical Block Exemption, article 101(1) TFEU does not apply to vertical restraints in a franchise agreement if the market share of both the franchisor and the franchisee do not exceed 30 per cent on the relevant market and the agreement does not contain hard-core restrictions.
The following restrictions in franchise agreements are considered to be hard-core restrictions under competition law:
- restriction on a franchisee’s ability to determine its resale price;
- restriction on the territory into which or the customers to whom a franchisee may sell products; and
- an absolute direct or indirect ban on online sales.
If a franchise agreement contains one of the above restrictions, it is prevented from benefiting from the Vertical Block Exemption Regulation. In that case it must be tested on an individual basis whether the restriction constitutes an infringement of competition law pursuant to article 101(1) TFEU and whether the exception of article 101(3) TFEU applies or not. In that regard, the Guidelines on Vertical Restraints state explicitly that in the context of franchise agreements: ‘The more important the transfer of knowhow, the more likely it is that the restraints create efficiencies and/or are indispensable to protect the knowhow and that the vertical restraints fulfil the conditions of Article 101(3) TFEU.’13 However, hard-core restrictions are seen as being particularly serious and are normally considered not to produce any pro-competitive effects. They therefore almost always infringe competition law, may be punished by fines and are null and void, and therefore unenforceable.
It is important to note that the Vertical Block Exemption will expire on 31 May 2022. On 8 November 2018, the European Commission published its evaluation roadmap on the functioning of the Block Exemption on Vertical Agreements and the relevant Guidelines,14 which allows the Commission to determine whether it should let the Regulation lapse, prolong its duration or revise it in order to take proper account of new market developments or players such as online platforms. In the first quarter of 2019 a public consultation will be held, which, in particular, aims to gather information from the experiences of competition authorities and courts of the EU member states in applying the Block Exemption on Vertical Agreements. The evaluation also requires an analysis of new market developments and their impact on the supply and distribution of goods and services in the EU.15
Territory, exclusive and selective distribution
Under European competition law, it is permissible to allocate a certain territory or consumer group exclusively to a franchisee. This practice is called ‘exclusive distribution’. In the case of exclusive distribution, franchisees may be prohibited to actively sell into the exclusive territory or to an exclusive customer group that is allocated to another franchisee or that the franchisor reserved to itself. Passive selling, including online sales, may not be restricted. These arrangements are exempted by the Block Exemption Regulation if the market share of both franchisor and franchisee do not exceed 30 per cent of the relevant market and the agreement does not contain any hard-core restrictions.
Further, a franchisor can apply qualitative16 criteria to ensure the quality of the sales environment and service, or quantitative17 criteria to limit the number or size of the franchisees. This practice is called selective distribution. A franchise system in which purely qualitative criteria are used does not restrict competition if the following three conditions are met:
- the nature of the product in question necessitates a selective distribution system, in the sense that such a system must constitute a legitimate requirement, having regard to the nature of the product concerned, to preserve its quality and ensure its proper use;
- franchisees are chosen on the basis of objective criteria of a qualitative nature that are laid down uniformly for all and made available to all potential franchisees and are not applied in a discriminatory manner; and
- the criteria laid down do not go beyond what is necessary.18
If the above requirements are met, the franchise falls fully outside the scope of application of the cartel ban of article 101(1) TFEU, provided that no other hard-core restrictions are included.
Franchise systems that apply qualitative and quantitative criteria are exempted by the Block Exemption Regulation if the market shares of both franchisor and franchisee do not exceed 30 per cent on the relevant market and the agreement does not contain any hard-core restrictions. If the conditions of the Block Exemption Regulation are met, it is irrelevant whether it is a qualitative or a quantitative distribution system. In this situation, the nature of the products to which the franchise system relates is not of importance either.19 In the event the agreement does not fall within the Block Exemption Regulation, it must be assessed on an individual basis whether the system constitutes an infringement of competition law pursuant to article 101(1) TFEU and, if so, whether the individual exemption pursuant to article 101 (3) TFEU applies or not. In most jurisdictions, the burden of proof in civil litigations entails more than just claiming there is an infringement of competition to prove that a party is infringing competition law, and economic assessment is necessary.20
A combination of exclusive distribution and selective distribution is only exempted by the Block Exemption Regulation if active selling in other territories is not restricted.21
Vertical price-fixing is considered a hard-core restriction under competition law. A franchisee must always be free to set its own resale price. A franchisor may not oblige or incentivise its franchisees to sell goods for a certain minimum or fixed price. However, recommended resale prices and maximum resale prices are permitted (both as long as they do not, in practice, amount to a fixed or minimum price level).
Franchisors must also not impose a minimum resale price through indirect means. Some examples are: an agreement fixing the distribution margin; fixing the maximum level of discount the franchisee can grant from a prescribed price level; making rebates or reimbursements of promotional costs subject to the observance of a given price level; restricting the application of rebates or discounts by the franchisee; linking the prescribed resale price to the resale prices of competitors; threats; intimidation; warnings; penalties; delay or suspension of deliveries; and contract termination in relation to observance of a given price level.22
Further, franchisors should not implement price-monitoring systems to achieve price-fixing. Attention should be paid to practices such as the franchisor printing a recommended resale price on the product or the franchisor obliging the franchisee to apply a most-favoured customer clause.23
It is important to note that resale price maintenance can be allowed in the context of launching and promoting a new product. In such an event, the Commission states that a coordinated short-term low price campaign of two to six weeks could be allowed.24 Further, in the case of complex products, the extra margin provided by resale price maintenance may allow franchisees to provide additional pre-sales services. Customers could use these pre-sales services and then buy at a lower price from franchisees that do not provide such services and do not incur these costs. Resale price maintenance may prevent such free-riding. In such event the parties must demonstrate that the price agreement does not only provide the means but also the incentive to overcome free riding and that the pre-sales services benefit consumers (as part of the assessment under article 101(3) TFEU).25 In practice, companies rarely make use of these exceptions because they have the burden of proof to show the pro-competitive effects.
In the wake of the E-Commerce Sector Inquiry, the European Commission seems to be enforcing more vertical price-fixing (and market partitioning) practices than in the past. In 2018, the European Commission fined four different consumer electronics manufactures for imposing fixed or minimum resale prices on their online retailers in breach of EU competition rules.26 Further, the European Commission recently fined the fashion brand Guess for, among others things, restricting its authorised retailers from independently deciding on the retail price at which they sold Guess products.27 Some national competition authorities have regularly enforced these practices in the past. Other national authorities that have traditionally had a more relaxed attitude towards vertical price-fixing have recently been paying more attention to it. For example, the Dutch competition authority announced that it has launched an investigation into price-fixing agreements between consumer goods manufacturers and retailers (including online retailers) and has conducted dawn raids at various firms.28
Restrictions on internet sales
The rapid rise of e-commerce, online market places and platforms, and omnichannel retail has had a major impact on the retail landscape in Europe in general, including franchise systems. Online platforms for the resale of products, social networking sites and search engines play a key role in today’s economy. Because of the growth of e-commerce, consumers order more products through online shops and mobile applications than ever. Therefore, franchise concepts should integrate in their strategy and business methods digital sales and e-marketing. To maintain the identity and reputation of the network, franchisors increasingly desire to control the reputation of their brand and franchise concept by influencing the sales and other interactions (marketing communications and reservations, for example) on internet by their franchisees. In this section we will look into the applicable competition law regarding such restrictions.
Ban and restrictions on internet sales
Under European competition law it is not allowed for a franchisor to impose on its franchisees an absolute ban on online sales. Therefore, a franchisor cannot directly or indirectly forbid its franchisees to sell through their own website. This includes applying criteria that indirectly force the retailer to make the sale physically, such as the requirement that Pierre Fabre imposed on its distributors to sell its products in the physical presence of a person with a degree in pharmacy.29
Further, agreements to the following are problematic from a competition law point of view:
- the franchisee shall prevent customers located in another territory from viewing its website or shall automatically reroute its customers to the franchisor’s or other franchisee’s websites;
- the franchisee shall terminate consumer’s transactions over the internet once their credit card data reveal an address that is not within the franchisee’s territory websites;
- the franchisee shall limit its proportion of overall sales made over the internet (this does not exclude the franchisor requiring, without limiting online sales, that the franchisee should at least sell a certain amount of the products offline to ensure an efficient operation of its brick and mortar shop); and
- the franchisee shall pay a higher price for products intended to be resold by the franchisee online than for products intended to be sold offline.30
To maintain the identity and reputation of the network it is important that franchisors safeguard that websites of franchisees offer the same consumer experience, and look and feel, as a franchisor’s online store. Therefore, a franchisor can of course request its franchisees to comply with certain quality standards for the use of their websites. However, the criteria for online sales must be equivalent to the criteria imposed for the sales from the franchisee’s store. This does not mean that the online criteria must be identical to those imposed for offline sales, but they should pursue the same objectives and achieve comparable results. Moreover, the difference between the criteria must be justified by the different nature of these two distribution modes.31 Further, a franchisor can request that its franchisees have at least one bricks-and-mortar store or showroom as a condition for becoming a franchisee.32 Last, franchisors can prohibit franchisees from performing active online sales efforts in territories of other franchisees (if those territories have been allocated exclusively to other franchisees).33 Please note that internet sales are considered passive sales and thus cannot be restricted even if they take place in the exclusive territory of another franchisee.34
Third-party platforms ban
Taking into account their rapid rise, online marketplaces inevitably become relevant for marketing, advertising and, for some franchise concepts, sales to customers. Franchisees may think this and desire to use such platforms even if their franchisors would want to abstain from them. Many franchisors prefer to prohibit their franchisees to sell goods on online platforms because such platforms cannot guarantee the required quality environment, the uniformity and service level of the franchise network.
The recent and highly anticipated Coty/Akzente35 judgment gives guidance on the question if a ban on sales through online market places in a franchise agreement is permissible. This ruling confirms that resellers of luxury products that are members of a selective distribution system can be prohibited from selling the products through a (recognisable) third-party platform. Such is under the condition that the prohibition has the objective of preserving the luxury image of the products, is laid down uniformly, not applied in a discriminatory fashion and is proportionate in light of the objective pursued. The ECJ further ruled that a ban on sales through a third-party platform cannot be qualified as a hard-core restriction within the meaning of articles 4(b) and 4(c) of the Vertical Block Exemption. In its interpretation, the European Commission added that within the applicability of the block exemption, a third-party platform ban will be permissible.36
The ECJ recognised in the Coty judgment the importance for brands to preserve the luxury image of their goods. As a result luxury brands for which a selective distribution system is set up, may in principle ban their products from being sold on online platforms. Hence, based on the Coty case, a franchisor can – presuming the franchise network can be considered a form of selective distribution – prohibit its franchisees from using online third-party platforms under the conditions set out in the judgment. If the franchise network cannot be considered a form of selective distribution, an online marketplace ban falls outside the scope of article 101(1) TFEU if the franchise agreement can profit from the Vertical Block Exemption. In this context it is relevant that the ECJ ruled that – as stated above – online marketplace bans cannot be qualified as a hard core restriction.37 If the franchise agreement does not fall within the Vertical Block Exemption it should be assessed on an individual bases whether the agreement infringes article 101(1) TFEU. The rule that an online platform restriction is not hard core is also relevant in such individual assessment.
Draft regulation internet platforms
Online platforms and search engines play an unprecedented role in facilitating the creation and development of market opportunities, including for small and medium-sized enterprises such as franchisees or franchisors. In the view of the European lawmakers, providers often have superior bargaining power that enables them to harm the legitimate interests of their users and leaves the latter with ample possibilities to seek redress. For this reason, the European Commission proposed a draft EU Regulation on fairness of platform-to-business trading practices in the online platform economy.38 Complementing EU competition and consumer protection law, this proposal would be the first legislation that provides rules for relations of internet platforms, social media and search engines with business and corporate website users. The general objective of the initiative is to establish a fair, predictable, sustainable and trusted online business environment. The draft Regulation includes – among others – the following rules:
- providers of online intermediation services shall ensure that their terms and conditions are drafted in clear and unambiguous language, are easily available and set out objective reasons to suspend or terminate a commercial relationship with professional users;
- when deciding to suspend or terminate what a business user offers, providers of online intermediation services shall state their reasons to the business user concerned; and
- providers of online intermediation services shall set out in their terms and conditions the main parameters determining ranking, any differentiated treatment afforded to goods or services offered by their or other professional users and what data generated through their services can be accessed.
Rules determining what internet platforms can do on the market so far mostly concern consumer law and privacy and data protection laws. Competition authorities have also looked into online platforms and their use of data, such as the European Commission in the Google Shopping case regarding higher ranking of own search results than a competitor’s, and the investigations of the European Commission and Bundeskartellamt into Amazon.39 It can be difficult to obtain evidence of abuse of dominance in the economic sense being present.
Based on the above we can conclude that franchise agreements in Europe are, regardless of the choice of law and forum, subject to EU competition law. A franchisor is not allowed to implement practices that are not permitted under EU competition law, such as vertical or horizontal price-fixing, sharing markets, prohibiting passive sales and imposing a direct or indirect ban on internet sales. However, franchise takes a special place within EU competition law. Specific contractual restrictions on the franchisee – which are necessary to protect know-how and goodwill, and to maintain the common identity of the franchise network – fall outside the European cartel prohibition. Based on the Vertical Block Exemption, article 101(1) TFEU does not apply to vertical restraints (such as applying territory restrictions or certain restrictions on resale in selective distribution based on qualitative and quantitative criteria) in a franchise agreement if the market share of both the franchisor and the franchisee do not exceed 30 per cent of the relevant market and the agreement does not contain hard-core restrictions. In the event the agreement does not fall within the Vertical Block Exemption it must be assessed on an individual basis whether the system constitutes an infringement of competition law pursuant to article 101(1) TFEU and, if so, whether the individual exemption pursuant to article 101(3) TFEU applies or not. In most jurisdictions, the burden in civil litigations is set high.