January 2010 Franchising World
It is not possible in the EU to create a system of exclusive franchised territories in which each franchisee is protected from competition from other franchisees of the same brand outside its territory.
By Nick Pimlott and Martin Mendelsohn, Ph.D.
The European Union antitrust rules on the distribution of goods are under reform. For years the rules have been criticized both for imposing a straightjacket on business behavior and for outlawing practices that are not obviously anticompetitive.
Many years ago, franchising had its own set of rules in a specific regulation issued by the European Commission, the institution responsible for the implementation of antitrust law in the EU. This was one of a number of regulations applying to different forms of distribution structure: exclusive distribution, exclusive purchasing and so on. In 1999, the commission issued a new general regulation which provides a “safe harbor” from the application of antitrust law in the EU for all types of “vertical” agreement provided that the supplier’s (franchisor’s) market share did not exceed 30 percent (the Vertical Agreements Block Exemption Regulation).
The application of the safe harbor is also conditional on agreement containing no “hardcore” restrictions of competition. Hardcore restrictions include those which have, at least until recently, been regarded as per se infringements in the United States, such as resale price maintenance. They also include–controversially–many kinds of sales restrictions that are commonly found in exclusive or selective distribution systems and in franchising agreements. Because of this, it is not possible in the EU to create a system of exclusive franchised territories in which each franchisee is protected from competition from other franchisees of the same brand outside its territory.
The reason for this approach is the goal of single market integration in the EU. From the early days of the European Economic Community in the 1950s and 1960s, it was recognized by the commission and other European institutions that territorial restrictions in distribution and licensing agreements between private parties could undermine the free circulation of goods and services in the community. Thus it was established that restrictions which created “absolute territorial protection” were impermissible. Over time the commission, through its decisions and regulations, has refined this concept into detailed rules. Of these, the most important is that restrictions which prevent franchisees (or other distributors) directly or indirectly from making “passive sales” (meeting unsolicited orders) are prohibited.
Inclusion of restrictive provisions in agreements carries the risk both that the provision is unenforceable and that the parties might be fined. Hardcore restrictions usually carry a high risk of fines. The maximum fine that may be levied in the EU is 10 percent of group worldwide turnover.
Franchising Under EU Antitrust Rules
Franchising, because of its unique combination of trademark licensing, know-how and distribution, has always struggled to fit in with European Commission’s proscriptions. Although restrictions that are designed to control the franchisee’s use of the brand and to protect the franchisor’s know-how give rise to no antitrust problem, restrictions on the customers to whom, or the territories in which, the franchisee may market and sell the franchised products need careful consideration from an antitrust point of view; likewise any restriction on franchisee’s resale price. This places franchising at a disadvantage compared to vertically-integrated businesses which can, through the mechanism of corporate governance, control their subsidiaries’ pricing and sales activity.
Non-compete clauses in a franchising agreement normally give rise to no antitrust concerns. However, post-term noncompetes must be limited to the premises from which the franchisee operated, effectively enabling ex-franchisees to open up competing premises next to or in the vicinity of franchised premises.
Proposals for Reform
The current VABER expires May 31, 2010. The commission has issued a consultation on revisions to the VABER and the lengthy guidelines which accompany it. The revised draft is intended to reflect changes in markets and the law in the past 10 years, such as the increases in large distributors’ market power and sales on the Internet. However, they herald little real change in the way that the EU competition rules apply to distribution and franchising agreements.
Key Changes Affecting Franchisors
• Internet sales–a major issue that has arisen in recent years has been the application of the EU antitrust rules to Internet sales. The current guidelines treat Internet selling as a form of “passive” sales. This means that franchisees cannot typically be prevented from using the Internet as a sales channel. They can, however, be required to operate any Web site in accordance with the franchisor’s brand guidelines. The amended draft guidelines accompanying the revised VABER do not change this basic position but provide more information on what kind of restrictions on Internet selling would be considered restrictions on passive selling. For example, requiring a franchisee to prevent customers located in another territory from viewing its Web site or completing transactions online would be a restriction on passive selling and therefore prohibited. Franchisors can impose minimum sales restrictions on franchisees’ sales from their brickand-mortar shops but cannot require them to limit overall sales over the Internet. Imposing criteria for online sales which do not pursue the same objective as the criteria imposed for sales from brick-and-mortar shops would also be a form of passive sales restriction.
• Resale price maintenance–Requiring a buyer to observe minimum or fixed price levels set by the supplier remains a hardcore restriction under the new draft VABER. However, there is an acknowledgement that RPM may lead to efficiencies and may be justified in some cases. Examples given are where a manufacturer introduces a new brand or enters a new market and RPM is used to encourage distributors to increase promotional efforts and expand overall demand for the product; or where fixed resale prices are necessary to organize a short term (two to six weeks) low-price campaign in a franchise network. This shows willingness by the commission to assess RPM on a case-by-case basis rather than just presume the likely negative effects. This softening of the commission’s stance on RPM is probably in recognition of the abolition of the per se rule for RPM by the U.S. Supreme Court decision in Leegin Creative Leather Products. However, the current proposals fall short of applying a full “rule of reason” approach to RPM in the EU. This is likely to create considerable legal uncertainty for franchisors who would like to adopt some form of RPM in the EU.
• The market share threshold–The new draft VABER provides that both the buyer and supplier must have a market share below 30 percent to fall within its safe harbour. The current VABER provides that it is the supplier’s market share which has to fall below 30 percent (except in the case of exclusive supply arrangements), so this represents a higher hurdle for businesses wishing to rely on the safe harbor. The competition aspects of current agreements going beyond May 31, 2010 may therefore need to be reconsidered if the buyer’s market share might be above 30 percent.
Given that the rules on vertical agreement are only reviewed once every 10 years, it is disappointing that the commission has not taken a more radical look at the way the rules operate in practice. This may be because, outside the areas of resale price maintenance and restriction on crossborder trade, there has been little case law on vertical agreements either at the EU level or in member states’ national courts, in the past 10 years. It is perhaps easy for the commission to conclude, as it does in the preamble to the new draft regulation, that the current rules are “working well;” the practical reality for parties to franchising agreements and their advisers is anything but. The rules, much of which appear in loosely drafted guidelines, are both over-prescriptive and unclear. The commission has in particular failed to address in a significant way the major changes that the Internet has brought about in the distribution of goods and services in the 10 years since the current VABER came into force–issues on which the commission has received detailed submissions in another recent consultation on online selling. The softening of the commission’s stance on RPM, while likely to be welcome to franchisors, does not go far enough toward the U.S. model of a full rule-of-reason approach to be of significant practical utility.
The commission’s consultation period on the revised draft closed on Sept. 28, 2009. The new VABER and guidelines will come into force May 31, 2010.
Nick Pimlott is a partner of the Competition and EU Regulatory Law Group and Martin Mendelsohn, Ph.D. is a consultant of business and franchising advice for Field Fisher Waterhouse, LLP. Pimlott can be reached at +44 (0)20 7861 4073 or email@example.com and Mendelsohn at +44 (0)20 7861 4000 or firstname.lastname@example.org .