Thursday, May 27, 2010

South Africa’s competition authorities are threatening to undermine the very essence of the nation’s highly successful franchise business model.
The franchise business model is a popular vehicle for opening up markets for small and medium businesses. Not only does the model help create jobs; it is also an efficient method for distribution of goods.
The foundation for the model is that the franchisor permits the franchisee to make use of the franchisor’s trademark or patent, distribution network and commercial knowledge in return for a royalty fee attached to a license. The central principle is uniformity, whereby the franchisor provides a complete business plan for the franchisee, including standardisation of stock, promotional prices, preferred suppliers and layout.
The bad news is that standardisation, such as uniformity in prices, has been identified by the competition authorities as problematic. They have accordingly prohibited the centrally setting of on-sale prices by the franchisor.
It is an action that exposes the franchisor to the risk of a competition law violation; one that stems from the essence of the franchise business model, in the process eroding the value of the business model.
The franchisor and franchisee are generally not competitors. Rather, their activities fall under section 5 of the Competition Act no. 89 of 1998, as amended, which regulates the vertical relationships between a firm and its suppliers or customers, or both.
The practice of setting on-sell prices is known as resale price maintenance (RPM), and is per se prohibited under section 5(2) of the Competition Act. Where a conduct is per se prohibited, it is outright illegal and no contrary economic efficiency arguments can be considered.
In contrast, the rule of reason approach applied in other sections of the Competition Act evaluates the pro-competitive features of a restrictive business practice against its anticompetitive effects in order to decide whether or not the practice should be prohibited.
Examples of RPM include:

fixing the maximum level of a discount that can be offered on the product;
making the granting of rebates or sharing of promotional costs conditional on adhering to a given resale price; or
the use of delays or suspensions of deliveries as a means of fixing the prices charged for the on-sale of goods by the customer.

If a firm is found guilty of RPM, it may incur an administrative penalty of up to 10% of the firm’s annual turnover in South Africa – and exports from South Africa – in the firm’s preceding financial year. 
Under a strict reading of the Competition Act, circumstances where the franchisor centrally sets prices would constitute RPM. The Competition Commission stated in its Note on Franchise Agreements that the use of RPM in a franchise agreement was a problematic clause that risked violating competition laws.
To establish the existence of a practice of RPM, the competition authorities will examine:

if the reseller or distributor knows the price at which they are expected to on-sell the product; and
if there is a penalty (direct or indirect) for not complying with the expected price.

The prohibition against RPM has been applied in several competition cases to franchise arrangements.
As an alternative to centrally setting prices and risking a RPM violation, franchisors can set a recommended minimum resale price on products to comply with the requirements of section 5(3) of the Competition Act. If it opts for such an approach, the franchisor must make it clear that the recommendation is not binding and if the product has a stated price, the words “recommended price” must appear next to the stated price. In addition, the franchisor should not sanction or penalise the franchisee that resells the product at a different price than the recommended one.
Because of the principles of uniformity and standardisation inherent in a franchise relationship, it has been argued that the franchisor and franchisees should be treated as a single firm. This would eliminate the vertical relationship between the franchisor and its franchisees and permit the franchisor to centrally set prices as a chain of stores in the market with uniform products and prices. However, the competition authorities have not viewed the franchise relationship as a single firm. Instead, they argue that the franchise relationship should be analysed as a vertical integration. This is because:

the franchisee is the owner of his/her business;
he/she invests his/her own capital into the business and pays the operating expenses; and
therefore operates somewhat independently from the franchisor.

Yet even though each franchise is individually owned and managed, the public is not aware of the particular franchise ownership structure. The public’s perception is that the franchisees and franchisors are a single firm with a chain of stores and that the price of a product in every franchisee should be the same. The public is likely to become confused as to whether the franchisee is a genuine part of the franchise if the prices are not standardised. Such confusion would surely erode the franchisor’s trademark.
Franchisors have justifiably argued that the franchise is a unique form of organisation with its own brand of economic efficiencies. Hence there should be a blanket exemption from the Competition Act. The Competition Commission was clear in its Note on Franchise Agreements that there would be no such blanket exemptions for franchises.
Beyond a blanket exemption, section 10(3)(b) of the Competition Act prescribes four circumstances where an individual firm can apply for an exemption from the prohibitions of the Competition Act. But the only one of the four relevant to the franchise relationship would be section 10(3)(b)(ii) – if the practice promotes the ability of small businesses, or firms controlled or owned by historically disadvantaged persons to become more competitive. The franchise business model affords individuals, including previously disadvantaged persons, an ideal opportunity to own their own small business supported by the franchisor.
Yet even if an exemption from the prohibitions of the Competition Act was granted, it would only be for a specified period because once a firm’s ability to compete is sufficiently enhanced, it could not continue to claim the benefit of an exemption. An individual franchise exemption may not, therefore, be a viable long-term solution for the franchise business model.
Another option would be to alter legislation such that RPM would not be per se prohibited and economic efficiencies could be considered under a rule of reason approach.
In the United States, RPM was also deemed to be per se illegal until the Supreme Court of Appeal overruled the principle and considered RPM under a rule of reason approach. The South African courts have already considered the US jurisprudence and decided that it is not applicable to the RPM provisions of our law.
In the European Union, RPM is a “hardcore” prohibition comparable to the per se prohibition in our law. The EU Commission has, however, recognised the economic efficiencies in RPM and allowed individual firms to apply for an exemption for RPM from the competition laws.
The EU Commission has also commented on the implication for RPM in franchises, thus “… fixed resale prices… may be necessary to organise in a franchise system or similar distribution system applying a uniform distribution format a coordinated short term low price campaign (two to six weeks in most cases) which will also benefit the consumers.”
Common to the value added in a franchise relationship is a national advertising campaign launched by the franchisor that advertises promotional products available at all franchisees.  Although the EU, as in South Africa, adopts a per se approach, it has recognised the pro-competitive gains that RPM may offer firms, including the franchise business model. It would consider individual firms’ applications for exemption on this basis, with no prescribed time limit.
RPM limits competition in a number of ways, including:

The restriction of competition among retailers or distributors of the same brand;
precluding retailers from setting lower prices for customers, especially when the market requires price segmentation for different customers to facilitate affordability; and
by preventing price competition amongst distributors, RPM may prevent more efficient retailers from entering the market and acquiring sufficient scale with lower prices.

Be that as it may, RPM offers pro-competitive gains in cases where a manufacturer introduces a new product and the set retail price will induce the distributor to charge a fair price for the product when promoting it to stimulate demand. RPM may also allow retailers to use the extra margin to provide additional pre-sale services. As mentioned, RPM is particularly useful to the franchisor in a promotional price national advertising campaign which will benefit consumers by offering lower prices.
Whichever way one looks at it, the current law on RPM leaves the future of the franchise business model in South Africa in a precarious position.
That’s because, in short, the law on RPM restricts the very nature of the franchise business model and leaves the franchisor in the untenable position of not being able to offer a standardised franchise product.
Of particular concern to the franchise model is the risk inherent in a franchisor launching a national advertising campaign on behalf of its franchisees.
Possible solutions include:

A strategy of developing our competition law to a “rule of reason” approach to RPM as opposed to the current per se approach – a change that would allow the economic efficiencies of RPM in a franchise system to be taken into account;
A blanket RPM exemption for franchises to permit certain useful practices, such as a national promotional price advertising campaign;
Enable franchisees to apply for individual exemption under the Competition Act but only for a limited time period – which may be useful for a short-term national advertising campaign but will only be on a once-off basis.

Currently franchisors can reduce their competition law risk exposure by setting recommended prices. But any other form of price setting may expose them to such risk.
Kerry Kopke is a Candidate Attorney at Bowman Gilfillan.