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Franchising Notice


The application of certain provisions of the Competition Act 89 of 1998, as amended, to franchise agreements

1. PREFACE

1.1 This notice is prepared and issued by the Competition Commission (hereinafter “the Commission”) in order to inform franchisors and franchisees about the impact of the Competition Act 89 of 1998 (hereinafter “the Act”) on their activities and arrangements to enable them to comply with the Act.

1.2 This notice is purely a guide aimed at clarifying the areas of the application of the Act to various aspects of franchising agreements and is not binding on the Commission, the Competition Tribunal (hereinafter “the Tribunal”) or the Competition Appeal Court (hereinafter “the Appeal Court”) in the exercise of their respective judgment (ruling on cases), or their interpretation of the Act.

2. INTRODUCTION

2.1 Various industry players in the franchising sector have argued that the Act should not be made applicable to franchise agreements because of the nature of franchising as a business model.

2.2 Some of the arguments are that franchising should be seen as a specialist field with different elements and should be distinguished from ‘normal’ business entities. It is also argued that since franchising has generally a low rate of failure, it should be left alone unregulated so that it can continue to grow.

2.3 The Commission recognizes the contribution of franchising to job creation and the fact that it is one of the best vehicles and an effective way to opening up markets for small and medium-sized enterprises (hereinafter “SMEs”) and the historically disadvantaged persons to participate in the mainstream economy of the country.

2.4 Whilst franchising is a successful, common and often efficient method of distribution or manufacture of goods and services in the country, it is important to realize that at the same time it may be problematic from a competition law perspective.

2.5 This notice thus highlights the various aspects of franchising that may be affected by the Act. However, this should not be interpreted to exhaust all instances or activities in franchising arrangements that could be affected by the Act. For easy understanding and clarity, decided cases and approaches adopted in other international jurisdictions have been considered.

3. OBJECTIVES OF FRANCHISE AGREEMENTS

3.1 Franchising is described as a method of structuring a productive relationship between two parties in which both contribute to the production or distribution of the product and service. It is a contractual relationship between a franchisor and a franchisee whereby a franchisor would permit a franchisee to make use of his/her trademark or patent, distribution network and commercial know-how in return for a royalty fee attached to a license.

3.2 The franchisor may also provide the marketing image as well as technical assistance for the duration of the agreement. Franchising does offer the perfect opportunity for expanding a franchisor’s business while retaining his/her competitive edge.

3.3 In order to ensure uniformity in the presentation and selling of goods/ services, the franchisor may insist on certain requirements amongst its franchisees, such as requiring them to obtain stock from him/her or from selected suppliers or to produce the stock in accordance with the franchisor’s specifications. In addition to the need to protect intellectual property rights such as trademark, the franchisor also supervises the location, the décor, and may arrange premises in accordance with the distinctive layout/format associated with the franchise. Despite all of these, it is important to realize that the franchisee’s business is an independent business to that of the franchisor.

3.4 Inasmuch as this industry is described as a specialized sector with all the good intentions, it is also a business concept or model whereby the franchisors and the franchisees are engaged in an economic activity. Therefore, in terms of section 3(1), the competition legislation does apply to franchising agreements, as they constitute an economic activity within or having an effect within the Republic.

4. PROBLEMATIC CLAUSES IN FRANCHISE AGREEMENTS

4.1 The Commission was established to investigate, control and evaluate restrictive practices and abuse of dominance. Chapter 2 of the Act stipulates specifically the types of agreements and conduct that could be deemed to be anti-competitive.

4.2 Section of 4(1) of the Act prohibits a conduct by parties in a horizontal relationship that would have the effect of substantially lessening competition in a market or relate to price fixing, market division or collusive tendering.

4.3 Section 5(1) of the Act prohibits agreements between firms in a vertical relationship that would have the effect of substantially preventing or lessening competition in a market or that relate to minimum resale price maintenance. The Act further prohibits the abuse of dominance.

4.4 Chapter 2 makes provision for rule of reason prohibitions and per se prohibitions. The former allows for justification of prohibited conduct whereas the latter does not. Price fixing, collusive tendering and market division as well as minimum retail price maintenance are thus per se prohibitions in the Act.

4.5 Typical restraint provisions applicable to franchising, which may have possible competition implications, are discussed below. It must be noted though that the extent to which competition concerns may arise would depend largely on market definition, which the Commission will do on a case-by case basis, taking into account both geographic and product dimensions.

A. Use of Resale Price Maintenance (RPM)

4.6 This is a form of price fixing that occurs when a franchisor imposes a minimum resale price on a franchisee, thereby limiting or even excluding a franchisee’s ability to offer discounts or to sell at lower prices than what the franchisor imposes.

4.7 Section 5(2) of the Act prohibits the practice of minimum resale price maintenance (RPM). RPM is bad because it not only prevents consumers from enjoying lower prices but also undermines intra-brand competition. Worse still, it could possibly facilitate collusion on prices and trading conditions among the franchisees, practices that are also not allowed in terms of the Act.

4.8 The Tribunal imposed a fine of R3 million on Federal Mogul Aftermarket for setting a minimum resale price in respect of spare parts. Toyota SA also paid an administrative penalty of R12 million for dictating maximum discounts that dealers were allowed to give to customers in respect of certain models of cars that Toyota manufactures .

4.9 Franchisors should therefore realize that the Act does not allow them to dictate to franchisees/dealers/retailers minimum prices at which to resell goods or to determine the maximum discount that can be given to customers.

4.10 The franchisor can in terms of section 5(3) recommend a price if he/she feels that it gives weight to the value and quality of the product or service, but should never bind the retailer or dealer to that price, as this will be a violation of section 5(2) of the Act.

4.11 In order to comply with section 5(3), franchisors must therefore revise their pricing clauses in the agreements and state clearly that their prices are only recommended. They must also ensure that there is no sanction, penalties or disincentives meted out to franchisees that resell the products at different prices to the recommended ones. Franchisees should also be allowed to freely give discounts to their customers when and if they so wish without fear of being victimized.

B. Exclusive territories for the franchise businesses

4.12 Arrangements for exclusive territories occur when a franchisor imposes limitations on a franchisee by specifying an area or areas where a franchisee may operate or supply goods. What happens is that areas are divided between the franchisor and the franchisees or between the franchisees themselves with the purpose of restricting the franchisee to a territory or a particular group of customers.

4.13 Franchise agreements usually contain such provisions and the immediate competition concern is that they reduce intra-brand competition. The other danger is that other franchisors may be unable to find suitable outlets for their products in those areas. Other competition concerns may be that allocation of territories could have an effect of not only creating monopolies in a market, but might also stifle competition. If this is allowed to happen consumer choice and competitive pricing will be compromised. Section 5(1) of the Act may be infringed if there is an arrangement, which involves exclusive territories between a franchisor and a franchisee. For such an infringement to occur, the effect of such an arrangement must substantially prevent or lessen competition in that market.

4.14 However, a franchisor is allowed to raise a defense for engaging in exclusive territories arrangements. One such defense could be that the aim was to achieve efficiencies in distribution, such as better information flows, which not only benefits the consumers but also allows the franchisor to become competitive. If such a defense is acceptable by the competition authorities, the agreement or arrangement would not be deemed to be a contravention of the Act and hence no action may be taken against the franchisor.

4.15 Alternatively, if the franchisor is unable to raise a defense based on efficiency, technology or other pro-competitive gains, but would still want to engage in allocation of territories to the franchisees, he/she must apply to the Commission for an exemption. The Commission will then evaluate the application on a case-by-case basis and may grant or refuse the application.

4.16 Sections 8(c) and 8(d) deals with exclusionary acts by a dominant firm. In the context of franchising, exclusive territorial restrictions by a dominant franchisor could also be found to be anti-competitive, unless the franchisor concerned can show that pro-competitive or efficiency gains outweigh the anti-competitive effects of the exclusionary act.

4.17 Despite what has been mentioned above, allocation of territories by the franchisors to the franchisees may sometimes have positive spin offs for competition. It may lead to pro-competitive benefits, as it tends to invite or encourage inter-brand competition to also venture into the area concerned.

C. Exclusive Dealing

4.18 Exclusive dealing is a very common commercial practice . In franchising an exclusive dealing arrangement would involve a situation where a franchisor requires a franchisee to purchase all its requirements of a particular kind of product from the franchisor or selected suppliers. In essence, the franchisor insists that franchisees buy goods from him/her and not from a competing franchisor/supplier. This amounts to the franchisee being limited to the business of the franchisor whereby the franchisee may not undertake business operations that compete directly with the franchisor’s business.

4.19 Exclusive dealing arrangements may lessen or exclude competition if the goods/services supplied by the franchise do not face effective competition from other competitors. It is important to know that if the effect of such an exclusive dealing arrangement substantially lessens or prevents competition in a market, this may amount to an infringement of the Act in terms of section 5(1). It may also lead to contravention in terms of section 8(d)(i) which prohibits a dominant firm from requiring or inducing a supplier or customer not to deal with a competitor.

4.20 It is to be noted, however, that sometimes exclusive dealing provisions may also be efficient and pro-competitive in that they protect the franchisor’s know-how, intellectual property and other skills while simultaneously providing an incentive to the franchisor to invest in the franchise without the fear of free-riding effects.

4.21 Nevertheless, a franchisee should not, without good reason, be prevented from purchasing goods or services from a third party if such goods are of an acceptable quality and would not harm the trademark or reputation of the franchisor. For instance a franchisee should be able to source a similar product or service elsewhere of like grade or performance as long as he/she does not compromise the image, quality and goodwill of the franchisor.

D. Tying of products

4.22 Under a tying arrangement, a dominant franchisor sells one product (the tying product) on condition that the franchisee purchases another product (the tied product). Such provisions require the franchisee to purchase all their immediate requirements (tying products) from the franchisor as well as other inputs not critical to the maintenance of the franchise. These purchases could be exclusive to the franchisor or a franchisor appointed supplier. Sometimes a full-line forcing occurs where the franchisee is compelled to purchase the franchisor’s entire range of products in order to obtain the one or two that are really needed.

4.23 Tying arrangements may contravene section 8(d)(iii) if a franchisor has enough market power in the tying product market to substantially lessen competition in the tied product market. A dominant franchisor should not force its franchisee to buy products that have no relation to the goods or services rendered by the franchise unless there are valid justifications.

4.24 On the other hand, it should be noted that tying arrangements may be justified by the nature of the products concerned. Such arrangements may enhance efficiency by preventing inefficient substitution of input products by the franchisee and by protecting the quality and goodwill of the franchise network. Again franchisors that make use of tying arrangements may raise as a defense the question of efficiency, technology and other pro-competitive gains.

E. Intellectual property rights

4.25 Intellectual Property Rights (IPRs) such as trademarks, patents, registered designs, the know-how, technical assistance are normally included in franchising agreements.

4.26 Inasmuch as these rights need to be protected in order to encourage innovation and creativity in terms of section 10(4) of the Act, they also present special problems for competition law . If these rights as contained in the franchising arrangements are exempted due to the fact that exclusivity and protection for the owners are of utmost importance, this might tend to undermine the aims of competition law.

4.27 A holder of an IPR who wants to exercise such right may need to apply to the Commission to be granted exemption. The Commission would deal with such applications on a case-by-case basis under the rule of reason. It is likely that such applications may be granted because vertical restraints linked to IPRs often enhance efficiency and are imposed to protect the know-how or the investment incurred by the franchisor.

4.28 What could be a competition concern could be the conduct that stems from the IPR. An example of such a conduct would be where, a monopolistic franchisor that holds IPR refuses to license intellectual property to a third party or if there is an alleged excessive pricing of the product or service that is the subject of the IPR .

5. COMPARATIVE STUDY

5.1 In most jurisdictions no particular law that is dedicated to franchising exists and thus franchising agreements are subjected to the same competition law and policy, as it is applicable to all economic activities.

5.2 In Australia Part IV of their Trade Practices Act of 1974 as amended, applies and prohibits any anti-competitive agreements and practices that could substantially lessen competition in vertical relationships and the rule of reason is applied in such cases. Price fixing, RPM, collective boycott and in certain instances exclusive dealing are regarded as per se prohibitions. Recommended prices are, however, allowed and do not constitute a contravention of the Act. The ACCC also makes use of the Franchising Code of Conduct to deal with franchising problems through mediation. However, in a case where a franchisor abuses its power to the disadvantage of the franchisee or does not abide by the rules of the code, the ACCC may intervene and take action on behalf on the franchisee.

5.3 In Canada the provisions of their Competition Act of 1985 as amended, also govern franchising agreements. An agreement or conduct is assessed on a case-by-case basis to determine whether competition is or is likely to be lessened substantially. Exclusive dealing and tied selling are judged under the rule of reason. Their Tribunal may make an order prohibiting a supplier from continuing to engage in an exclusive dealing or tied selling. It may also stipulate any other requirements that, in its opinion, are necessary to overcome the effects thereof in the market or to restore or stimulate competition in the market. Cases of abuse of dominance are also dealt with under the rule of reason or on the substantial lessening of competition test. RPM is treated as an outright prohibition by the authority but price recommendation is allowed.

5.4 In Japan the Anti-monopoly Act, 1947 as amended, applies to franchising agreements and most practices are judged under the rule of reason. Business activities by parties through contracts, agreements or any other concerted actions are prohibited if they would be contrary to the public interest and result in substantial restraint of competition in any particular field of trade. RPM applies only in circumstances where the conduct would have an adverse effect on consumers and was imposed on the reseller. However, it does not apply in legitimate acts performed by an entrepreneur who produces or sells a commodity. The Japanese franchising guideline document cautions franchisees and franchisors to abide by the law and to take heed of the Anti-monopoly Act when contracting.

5.5 In the United Kingdom (“UK”) the Fair Trading Act, Restrictive Trade Practices Act, Resale Prices Act and the Competition Act of 1998 are all relevant in the investigation of anti-competitive and restrictive practices agreements as they relate to franchising. They also follow the principles of Article 81(1) of EC Competition Law, which prohibits agreements that will have an appreciable anti-competitive effect on competition. Chapter 1 of their Competition Act prohibits agreements whose object or effect is to prevent, restrict or distort competition within the UK. Vertical agreements are considered not to raise competition issues except when imposed by a firm with market power. RPM is, however, considered as a ‘hardcore’ restriction and seen as capable of having an appreciable effect on competition. Maximum pricing and recommended pricing are allowed provided they do not result in price fixing and reduction of price competition.

5.6 In the United States the Anti-trust laws subject all competition concerns to the same legal standards and analytical process with no distinction between franchising and other distribution systems. Agreements and practices relating to IPRs are dealt with on a case-by-case basis under the rule of reason.

5.7 In the European Commission the legislation shows a move towards a more economic approach in the assessment of vertical agreements under the EU competition rules. In the absence of market power, vertical agreements that contain restrictions to competition may be considered to improve the production and distribution of goods and services. However, notwithstanding the efficiencies generated, the accepted view is that vertical agreements can also have anti-competitive effects, particularly if they result in market foreclosure, restrict price competition or result in the partitioning of markets. Whether or not the franchise agreement might raise competition concerns, depends on its nature or formulation, or on the structure, market size or market power. Article 81(1) of the EC Competition Law, prohibits agreements that will have an appreciable effect on competition, and would apply in franchise agreements if it is shown that harm is caused to third parties, especially where there are no alternatives. RPM would apply if parties have market power. In the E.U the court found in the Pronuptia de Paris GMbh v Pronuptia de Paris Irsmgard Schillgalis case that price fixing was per se illegal in respect of franchising. Individual or group exemptions can be granted if there are overriding countervailing benefits such as an improvement in efficiency or the promotion of research and development.

5.8 It appears therefore that there is a lot of similarities in the way franchise agreements are dealt with in the different jurisdictions. For example, it is accepted that although vertical agreements are efficiency enhancing they can also have anti-competitive effects. It is also evident that in most of these jurisdictions, the use of the rule of reason is more prominent when dealing with franchise agreements. A developing country like South Africa is likely to continue to treat RPM as a per se offence whereas in developed countries the trend seems to indicate that RPM may be authorized when there are demonstrable public benefits. Recommended prices are acceptable to most competition authorities in that they communicate information (e.g. quality, brand image, etc.) to consumers and franchisees. Furthermore, on the issue of vertical restraints linked to IPRs, most jurisdictions tend to accept that these not only enhance efficiency but are imposed to protect the know-how or the investment incurred by the franchisor

6. CONCLUSION

6.1 It is without doubt that franchise agreements facilitate entry of new firms and/or products and have efficiency enhancing benefits. Franchising is good for economic development and for ensuring that historically disadvantaged individuals and SMEs are able to participate in the mainstream economy. It appears that most jurisdictions do not differentiate between franchising agreements and other distribution channels in their application of their competition law and policy. This is a similar approach in South Africa where franchising is seen as an economic activity over which the Act applies.

6.2 Franchising agreements are as such not necessarily anticompetitive. They are used to establish a distribution network and this creates opportunities and benefits to both parties. The franchisor exploits expertise in other markets without substantial capital investment in setting up a retail network. The franchisee, on the other hand, also gets access to trading methods, which have been tried and tested. Therefore, any agreement that is necessary to support the essential features of the franchise relationship should not raise competition concerns, for example, the protection of the know-how, protection of network reputation, or selective distribution clauses which are normally introduced for efficiency reasons.

6.3 Despite the potential infringements highlighted above, the structure of franchising has a potential of creating collusion among competitors (franchisees) on price and market allocation and may also substantially lessen competition and cause harm to consumers. There may therefore be anti-competitive practices that are a result of franchising agreements, which the competition authorities should be concerned about.

6.7 It is anticipated that this notice has clarified matters on franchise agreements so that parties are able to ensure that their agreements are in line with the Act to avoid possible prosecutions, alternatively, to apply for exemption from some of the provisions of the Act.



REFERENCES AND SUGGESTED READING

Legislation
Competition Act 89 of 1998 – South Africa
Trade Practices Act of 1974 - Australia
Competition Act (R.S. 1985, c. C-34) – Canada
Antimonopoly Act of 1953 – Japan

Books
• Corones, SG: Restrictive trade practices law: The Law Book Company Ltd: 1994
• Koran, Valentine: Cases & Materials on EC Competition Law; Second Edition: 2001: Hart Publication
• Martin Brassey: Competition Law, 1st Edition: 2002: Juta

Case
• Case 08/CR/Feb01: Competition Commission and Federal Mogul Aftermarket Southern Africa (Pty) Ltd & Others
• Pronuptia v Schillgali (1996) ER 353: Pronuptia de Paris GMbh v Pronuptia de Paris Irsmgard Schillgalis

Publications
• ABSA Franchising Booklet
• Competition Commission: South Africa, Annual Report (2004)
• Dingley, D and Legh, R: Competition Law: Sibergramme 2/2004
• Glossary of Industrial: Organisation Economics And Competition Law: OECD
• UNCTAD: Manual on the formulation and application of Competition Law, 2004

Websites
• www.comptrib.co.za
• www.compcom.co.za
• http://www.oecd.org/dataoecd/34/53/1920326: Competition policy & vertical restraints: franchising agreements: OECD
• http://www.accc.gov.au
• http://www2.jftc.go.jp/: (Fair trade Commission of Japan): legislation: Antimonopoly Act
• http://scaleplus.law.gov.au/: ScalePlus: Law Resource: Department of Justice, Australia
• http://laws.justice.gc.ca/en: Department of Justice, Canada: Competition Act (R.S. 1985, c. C-34), Part VIII, Restrictive Practices
• http://oft.gov.uk/: Guidelines