ARTICLE
19 November 2019

The Importance Of Vertical Restraint In Franchising Agreements

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K Singhania & Co

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Franchising has often been referred to as one of the most novel methods of business expansion in today's world.
India Corporate/Commercial Law
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INTRODUCTION

Franchising has often been referred to as one of the most novel methods of business expansion in today's world. Simply put, it refers to a contractual arrangement whereby the owner of a product, service or even a method of production, secures the distribution of its offerings through one or more affiliations (franchisee). The franchisor offers a licensed privilege to the franchisee to do business under its name and to use the technical know-how provided by the franchisor in return for a negotiated monetary exchange.

Franchising's many advantages include significant benefits to both the contractual parties involved and has an enormous success rate1 which makes it a widely adopted form of business. Its diluted sense of risk comes from the fact that the franchisee doesn't have to worry about creating a well-known brand name and the franchisors are able to take advantage of the distribution as well as the economies of scale2.

Franchising emerged as a response to the rapid and fast paced industry evolution in the modern era where technological advancements, an orientation towards service economy and the need for an increased market penetration all played a role for its gaining traction. Moreover, in an emerging economy like India a rise in disposable middle-class income and increasing brand recognition could allow a greater number of companies with varied products and services to set up successful franchise businesses across the country3.

FRANCHISING LAWS IN INDIA AND THE COMPLEXITIES INVOLVED

In some jurisdictions, there are specific franchising laws and statutes that regulate the core functioning of franchising and the regulatory issues peripheral to it. However, there is no specific statute for franchising regulation in India and a plethora of legislations collectively regulate it.

Although there is no central legislation in place, the Franchising sector in India is not arbitrarily governed and is influenced by a coalescence of enactments spread across different statutes like the Indian Contract Act 1872; the Consumer Protection Act, 1986; the Trade Marks Act, 1999; the Copyright Act, 1957; the Patents Act, 1970; the Design Act, 2000; the Specific Relief Act, 1963 and various other statutory enactments. Primarily, a Franchising agreement is incumbent on the involvement of two or more parties. Therefore, the Indian Contract Act 1872 and Specific Relief Act 1963 are one of the most prominent legislations which directly deal with the actual enforcement of the covenants in the agreement as well as the provision of appropriate damages for any breach whilst keeping in mind the balance of conveniences and interests of the parties involved.

Another huge aspect which is subjected to regulation in franchise agreements is the competition implications of such agreements. A franchise agreement provides the franchisor with an easier route for effective distribution of their products. However, certain stipulations can become a threat to a sense of fair competition in the market. For instance, the franchisee agreeing to certain obligations or restrictions on their activities like restriction on selling of products from other brands. Such requirements can cause competition concerns under Competition Act 20024 which seeks to prevent 'Appreciable Adverse Effect' in the market economy.

Laws relating to taxation, property, insurance and labor also apply to franchise transactions and in case the goods and services provided by the franchise entity falls under specific regulations, the same shall apply to them depending on the  specific sector.

The aforementioned regulations and their influence makes it arguable to propose that perhaps a singular comprehensive enactment may be desirable for the Indian scenario and that the coalescence of multiple regulations makes it more complex, time consuming and at times ambiguous. This also lays bare the resultant complexities which are involved while getting into such agreements and the restrictions which ensue between firms at different levels of marketing chain.

VERTICAL RESTRAINTS

Given the complex legal landscape it is of upmost significance to protect one's interests while participating as a contracting party in any Franchising marketing model. Vertical Restraints and their peculiar importance in franchising models are yet another part of such a complex relationship.

These restraints could be referred to as an economic imposition used in manufacturer/distributor relationship for controlling certain aspects of the trade (resale price maintenance, quantity fixing, tie-ins) or softening competition (exclusive dealing, franchising, exclusive territories). The importance of vertical restraint for franchising models is apparent from its very inherent features. The economic rationale behind their usage stems from the fact that they offer significant benefits to a brand in the form of protecting their brand image, increasing their presence and enhancing service qualities5.

It has been the outcome of numerous studies that manufacturers and at times even small and medium sized-businesses (SMEs) adopt vertical restraints as a business strategy to prevent free-riding6.

There are numerous types of covenants and agreements which come under the domain of Vertical Restraints. Covenants like 'Resale Price Maintenance' as well as 'Exclusive Dealing are the most frequently used in Franchising agreements. These covenants have routinely invited scrutiny and criticism as they have anti-competitive implications. For example, Exclusive Dealing is where the manufacturer/franchisor puts an obligation on the retailer/franchise not to stock on any of their competitor's products. Therefore, exclusive dealing affords the Franchisor to exercise greater autonomy over the distribution chains and thereby, not only softens the competition but also grants the business a more dominant presence in the market. Such a market foreclosure has anti-competitive consequences in the form of increased barriers to trade. However, the economics of vertical restraints and its relationship can cause us to re-scrutinize whether they are desirable or not7.

VERTICAL RESTRAINTS IN INDIA

Owing to the nature of Vertical Restraints and the varying scope of their restrictive implications, it is considered desirable to put them under regulations so as to preserve the fair competitive spirit which the government seeks to uphold in the market. The anti-trust potential of these covenants in India is covered through Competition Act 2002 which primarily deals with issues restrictive agreements and trade practices.

Section 3(4) deals with vertical restraints in different stages or levels of production enumerated as 'tie-in arrangements' 'exclusive supply agreement', 'refusal to deal' etc. Likewise, the enactment prohibits the imposition of any such agreement which would reasonably cause an 'appreciably adverse effect on competition' i.e. AAEC which is the guiding philosophy of competition legislation. A strengthened competition policy in this regard is an essential component for the creation of a fair and 'democratic market economy'8.

It is furthermore informed and guided by the Section 27 of the Indian Contract Act which expressly prohibits any agreement in restriction of trade. Even the overarching constitutional principles take a dim view of any imposition which impedes the fair and free flow of trade and commerce within the country. It has often times influenced a number of decisions when it comes to negative covenants.9

Moreover, as we know the digital revolution in this era has also added newer dimensions to the breadth of the legal landscape pertaining to the franchising business. In a string of precedents like Mohit Manglani v. Flipkart 10 and All India Online Vendors Association v. Flipkart India11, the Competition Commission of India has acknowledged the distinctiveness of online platforms and the unique implications they have on the legal climate of competition policy and chains of distribution and has laid out that the touchstone of 'Appreciable Adverse Effect' has to be extended to such online platforms and at times have even held that vertical restraints could be pro-competitive and consumer friendly12.

THE CASE FOR VERTICAL RESTRAINT

It is not to be disputed that if allowed to be unregulated and unhindered, an arbitrary usage of such negative covenants could run amok and cause a disruption in the kind of free and fair market that Competition legislation seeks to secure. However, modern economic theories and even some recent legislations have arguably opened up to the possibility of a revised understanding wherein a regulated way to these covenants could do more good than harm.

ECONOMIC RATIONALE

In a report made by OECD13, it was observed that it is not a determinate principle that the presence of vertical restraints could either increase or decrease economic efficiency. The effects of vertical restraints and their economic desirability were considered to be extremely contextual. For example, a territorial restriction could cause unfair barriers to trade in certain contexts while on the other hand in certain contexts it can protect brand quality and prevent extensive free riding thereby not only protecting the brand image but also increasing product quality and consumer surplus.

Secondly, another crucial factor which is often overlooked is the presence of inter-brand competition and its influence on the economic justification for vertical restraint. Where there is extreme competition in the markets like India, the presence of inter-brand and intra-brand competition is more likely to produce an efficiency in supply of services and promote competition.

India's market suffers from debilitating issues relating quality control and authenticity. Therefore, the objective of prevention of loss from counterfeit products could be solved by their deployment by filling the void of information asymmetry between the creator of the product or a service and ultimately the end consumer.

JUDICIAL ACKNOWLEDGMENT

Recently, adjudicating authorities have opened up to the idea of accepting the commercial viability of vertical restraints where it is due. In a recent precedent, Jasper v. Kaff14, the CCI has laid out that vertical agreements do protect the interests of the end consumer and are pro-competitive.

It is not disputed that covenants like RPM may affect the fair price competition and market equilibrium between retailers/distributors, these covenants do become a commercially justifiable option and desirable from the perspective of both manufacturers/retailers and consumers when there is intra-brand price competition between different distribution channels.

Particularly in case of online vertical restraints the problem of free-riding could be easily curbed and regulated. It is highly probable for instance that a particular retailer may end up free- riding on the investment of another. If a marketing manufacturer spends money on the upkeep of a retailer's premises used for the sale of their product or service, it would be particularly unfair to such a manufacturer if a competing manufacturer or a brand takes advantage of such an upkeep. This is where the need to vertical restraints come into the domain of a financially reasonable business strategy.

CASE STUDIES

In addition to judicial pronouncements and economic theory, the fact there are more nuances to vertical restraints in franchising agreements has not been missed by certain experiences of businesses where their economic advantages were duly noted. On this front, empirical studies have drawn interesting conclusions and linkages. In a study carried out in Ippolito and Overstreet15 tried to draw conclusions by rescinding the application of Re-sale Price Maintenance in a particular market. The result showed that following the withdrawal of RPM as a business tool, the company suffered losses and also put on a dismal performance at the share market while their rival firms gained from such a circumstance. Therefore, the study acknowledged that agreements like RPM come from a place of improving product distribution and brand image rather than any other ulterior anti-competitive motive.

Lessons learned from the Hyundai case also indicated that it is erroneous to draw determinate linkages between vertical restraints and its supposed anti-trust implications. NCLAT has re-directed the discussion on anti-competitive vertical restraints, holding that conclusions and pronouncements should be drawn through analysis of relevant evidence, identifying the competition concerns and checking whether it could be actually linked to an appreciable adverse effect on competition or could it distinguished as an authentic business adoption.

INTERNATIONAL STANDARDS AND LEARNINGS

Indian jurisprudence follows the 'rule if reason' for adjudication on the implications of vertical restraints similar to the US usage. However, it has often been repeated that India needs to formulate its own sense of jurisprudence on this matter whilst keeping in mind the international standards and their consonance.

For example, the European Communities (EC) competition policy which proposes a balance between all the objectives ranging from ensuring a fair market space to upping customer satisfaction. A host of such objectives is found under the overarching ideal of a 'social market economy' where economic progress is reconciled with social and consumer welfare. EC has also had its share of problems in identifying threshold tests for regulating vertical restraints. It's well documented doctrine of 'economic freedom' failed to distinguish between anti-competitive agreements and justifiable agreements.

Regulation 2790/1999, Regulation 330/201016 however upholds a safe harbour for vertical restraints if the market share of the supplier does not exceed 30 percent in the market in which it sells the contract goods or services: -

It can be presumed that, where the share of the relevant market accounted for by the supplier does not exceed 30%, vertical agreements which do not contain certain types of severely anti-competitive restraints generally lead to an improvement in production or distribution and allow consumers a fair share of the resulting benefits.

Therefore, it wouldn't be unreasonable for India to take advantage of international jurisprudence and its benefit of hindsight to create a consistent jurisprudence of precedents which seeks the perfect balance between competition and regulation which is suited to the Indian market sensibilities. Some precedents have already started doing it in case of online vertical restraints.

While India has borrowed from the US's rule of reason it has had the consequence of borrowing its problems as well. 'Rule of reason' is a flexible doctrine, however it is also open-ended and susceptible to inconsistent application. A problem faced by the US jurisdiction. Therefore, India needs to strengthen its legislation by defining 'relevant market'17 in the competition Act to produce clarity as well as pass comprehensive guidelines for courts to consider in reference to different types of vertical restraints.

Footnotes

1. India's Franchise Industry: The Road so Far and Beyond, IBEF, Knowledge Centre, August 28 2018, available at: https://www.ibef.org/blogs/india-s-franchise-industry-the-road-so-far-and-way-forward

2. Barim, Menekse & Salar, Orkide. (2014). Determining Pros and Cons of Franchising by Using Swot Analysis. Procedia - Social and Behavioral Sciences. 122. 515-519. 10.1016/j.sbspro.2014.01.1385.

3. Advantages of Taking Up a Franchise, Shahnaz Husain, Franchising Aspects, 2009-10-09, Franchise India Holding Ltd, Available at: https://www.franchiseindia.com/content/Advantages-of-taking-up-a-Franchise.3

4. Competition Act 2002, Parliament of India, Act No. 12 of 2003, 31 March 2003.

5. Vertical Agreements: Motivation and Impact in 3 Issues in Competition Law and Policy 1813, Chapter 72, Vincent Verouden, 2008)

6. Why Vertical restraints? New evidence from a business survey, April 2016, Oxera, Available at: https://www.oxera.com/agenda/why-vertical-restraints-new-evidence-from-a-business-survey/

7. Vertical Agreements: Motivation and Impact in 3 Issues in Competition Law and Policy 1813, Chapter 72, Vincent Verouden, 2008)

8. State of Competition in the Indian economy, Economic Advisor CCI, Augustine Peter, Available at: https://www.cci.gov.in/sites/default/files/workshop_pdf/14peter.pdf

9. M/s Gujurat Bottling Co. Ltd & Ors v. The Coca Cola Co. & Ors, 1995 SCC(5) 545.

10. 2015 SCC Online CCI 61

11. 2018 SCC Online CCI 97

12. 2014 SCC Online CCI 150

13. OECD Report on Competition Policy and Vertical Restraints: Franchising Agreements, Dr Steven Brenne, Available at: https://www.oecd.org/competition/abuse/1920326.pdf

14. 2014 SCC Online CCI 150

15. Vertical Agreements: Motivation and Impact in 3 Issues in Competition Law and Policy 1813, Chapter 72, Vincent Verouden, 2008)

16. Raad, Puya. "Effectiveness of EU Law and Policy on Vertical Restraints at Protecting Competition." Wroclaw Review of Law, Administration & Economics 3.1 (2013): 119-125.

17. Raychaudhuri, Tilottama. "Vertical restraints in Competition Law: The Need to Strike the Right Balance Between Regulation And Competition." NUJS L. Rev. 4 (2011): 609.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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