Problematic clauses in franchise agreements
- 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.
- 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.
- 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.
- 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 perse prohibitions in the Act.
- 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)
4.1 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.
4.2 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 1 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.
4.3 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.
4.4 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.
4.5 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.
4.6 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
6.1. 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.
6.2 Franchise agreements usually contain such provisions and the immediate competition concern is that they reduce intra-brand 3 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.
6.3 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.
6.4 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.
6.5 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.
6.6 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 4 competition to also venture into the area concerned.
C. Exclusive Dealing
8.1 Exclusive dealing is a very common commercial practice 5. 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.
8.2 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.
8.3 It is to be noted, however, that sometimes exclusive dealing provisions may also be efficient and pro-competitive 6 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 7 effects.
8.4 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
10.1 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 8 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.
10.2 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.
10.3 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
12.1 Intellectual Property Rights (IPRs) such as trademarks, patents, registered designs, the know-how, technical assistance are normally included in franchising agreements.
12.2 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 9. 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.
12.3 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.
12.4 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 10.
- This refers to competition among dealers/franchisees of the same brand.
- www.comptrib.co.za; Case 08/CR/Feb01: Competition Commission and Federal Mogul Aftermarket Southern Africa (Pty) Ltd & Others.
- The effect of this is that franchisees are being protected from competition.
- This refers to competition among dealers for different labels, brand and products.
- Manual on the Formulation and Application of Competition Law, UNCTAD, page 14
- Competition Law SG 2/2004, page 7.
- The free riding problems arise in many situations where no individual is willing to contribute towards the cost of something when that person hopes that someone else will bear the cost instead. See Penguin Directory of Economics (7th edition) – Free-rider problem.
- This refers to a situation where a franchisor requires a franchisee to buy products which he/she would not otherwise buy.
- Martin Brassy (Competition Law, page 316)
- Competition Law SG2/2004, page 8.