This article explains how competition authorities approach the following questions:
- Are the restrictions contrary to competition law?
- If they are, should they still be permitted on efficiency grounds?
UK/EU competition law
The UK Competition Act 1998, s.2, and Article 101(1) Treaty on the Functioning of Rome (TFEU) both prohibit agreements that prevent, restrict or distort competition. The Competition Act 1998 applies to agreements that have an effect on trade within the UK, and Article 101 TFEU applies to agreements that have an effect on trade between EU member states. Many agreements in force in the UK will need to be considered under both. However, as s.60 of the Competition Act 1998 requires UK competition law to be interpreted consistently with EU competition law, there is no practical distinction between analysing the effects of each prohibition.
Agreements that infringe competition law are automatically void, are unenforceable, and can lead to fines of up to 10% of total group turnover. In addition, directors involved (or who should have known about) competition law infringements can be disqualified and anyone who has suffered loss as a result of an infringement may bring an action for damages.
Franchise restrictions which are not contrary to competition law
Confusingly, some restrictions on competition in franchise agreements are not considered anti-competitive.
According to the European Court of Justice in its 1986 judgment in Pronuptia, a franchise system is a way for a business to derive financial benefit from its expertise without investing its own capital by establishing a uniform network to get its products or services to market. At the same time, such a system allows traders without the necessary experience, access to business methods which they would not have developed without considerable effort. It also allows them to benefit from the reputation of the franchisor’s name and its trademarks.
A franchise has to be distinguished, firstly from an agency agreement where the agent does not take ownership of products or risk in the business and competition law concerns generally do not arise.
Secondly, it can be distinguished from a selective distribution system where the product manufacturer exercises a degree of control over its distribution system (albeit less than control than a under a franchise system),. This may give rise to competition issues and a need to assess any associated restrictions under the Vertical Agreements Block Exemption.
The ECJ recognised that for a franchise system to work, two conditions need to be met:
- The franchisor must be able to communicate its knowhow to the franchisees, and provide them with necessary assistance in order to enable them to apply its business methods without running the risk that the knowhow and assistance might benefit competitors.
- The franchisor must be able to take measures necessary for maintaining the identity and reputation of the network bearing its business name and reputation.
- All agreements need to be considered on a case by case basis (taking into account in particular the value of the knowhow transferred from the franchisor to the franchisee), The ECJ and the European Commission have considered that franchise agreements containing the followingg restrictions should not generally be considered anti-competitive:
- Engaging in any business which competes with the franchisor (or its other franchisees) during the franchise term and for a reasonable period thereafter (normally one year) in the franchisee’s exclusive territory or the exclusive territory of another franchisee.
- Devoting all their energies to the franchise business.
- Not transferring the franchise to another party without the approval of the franchisor.
- Using only the franchisor’s business methods and knowhow.
- Selling only the goods covered by the franchise in premises laid out and decorated in accordance with the franchisor’s requirements (to ensure uniform presentation of franchise stores).
- Only operating from premises in a location approved by the franchisor.
- Not obtaining goods other than from the franchisor (or other franchisees.
- Obtaining the franchisor's approval for all local advertising materials.
Franchise restrictions which may be permitted on efficiency grounds
The key franchise restriction that is generally likely to be considered potentially anti-competitive but which may be permitted on efficiency grounds, is the granting of exclusive territories to franchisees for active sales (and the accompanying restriction to only operate from an agreed location).
This means that while it will normally be permissible to restrict franchisees from advertising or actively marketing to customers outside their exclusive territories, if they are contacted by such customers then they must be allowed to sell to them. This is a form of ‘market sharing’ that would normally be prohibited if it did not benefit from an exemption on efficiency grounds.
The European Commission has recognised in a number of decisions that the provision of territorial exclusivity as regards active sales is essential for the working of the franchise system. A potential franchisee would not be willing to make the necessary start up investments in the franchised business if they were not assured of a degree of territorial protection from the franchisor or another franchisee. In the relevant cases, there are a number of reasons for this:
- Franchisees have been able to compete with each other with passive sales outside their exclusive territories (and into the exclusive territories of other franchisees or the franchisor).
- Franchisees are able to buy and sell franchise products to each other.
- Franchisees are able to set their own prices for the franchise products or services.
Competition law provides scope for a number of seemingly competition constraining provisions to be included in franchise agreements. However, there are limits as to the restrictions that may be included. Precisely what these limits are will always depend on the specific circumstances: including the benefits conferred on the franchisee through the agreement, the scope of the restrictions themselves and the strength of competition on the relevant market(s).