COMPETITION LAW & FRANCHISE AGREEMENTS

By Ian Jacobsberg & Nicolene Padayachee • November/December 2017 • Issue 58

Although the Consumer Protection Act, 68 of 2008, and the regulations enacted in terms thereof, are currently the only legislation that expressly regulate franchising in South Africa, the Competition Act, 89 of 1998, also contains several provisions that should be borne in mind when drafting a franchise agreement.

Section 5(1) of the Competition Act (the Act) governs agreements between parties in ‘vertical relationships’ (being the relationship between a firm, its suppliers and its customers). This would include the relationship between a franchisor and franchisee. Section 5(1) provides that ‘an agreement between parties in a vertical relationship is prohibited if it has the effect of substantially preventing or lessening competition in a market, unless a party to the agreement can prove that any technological, efficiency or other pro-competitive gain resulting from that agreement outweighs that effect.’ A number of common provisions in franchise agreements appear, on the surface, to have an anti-competitive effect; at the same time, they can often be justified in terms of the proviso to section 5(1), the so-called ‘rule of reason’. Examples of these terms, and the way in which they may be justified, are discussed herein.

PRESCRIBED PRODUCTS OR SUPPLIERS

It is customary for franchisees to be required to stock specific products, use a specific style of packaging, labelling and decor, and use prescribed ingredients in the preparation of products. In order to enforce this, the franchisor usually requires the franchisee to purchase goods either from the franchisor itself or from prescribed suppliers. By restricting the sources from which the franchisee may purchase its supplies, the franchisor may also be limiting the franchisee’s ability to negotiate better prices. This may adversely affect the franchisee’s ability to compete in the market and may be seen as a prohibited practice in terms of section 5(1). However, it can often be justified on the basis of ‘the rule of reason’. Examples of justifications that will usually be accepted are:

In most franchise systems, it is important that all franchisees offer a standard product range, and it is to the benefit of the franchisor and franchisees that a consistent level of quality be observed across the network. Insistence that the franchisees purchase their supplies from approved suppliers, to the extent that it is necessary to achieve that end, is permitted.

Franchisors are often able to negotiate bulk purchasing deals from suppliers, which is dependent on all the franchisees in the network purchasing their supplies from the supplier concerned. Provided that all franchisees abide by the arrangement, they will be guaranteed efficient deliveries and discounts, which might not be available to them should they procure supplies individually. This will also justify the franchisor’s insistence that franchisees buy supplies from approved suppliers.

DESIGNATED AREAS OF OPERATION

It is also common for franchise agreements to stipulate specific areas in which the franchisee may, or may not, operate. Restricting the franchisee to a territory and customer base in this manner reduces intra-brand competition and therefor raises competition concerns in terms of section 5(1). This can be justified on the basis of ‘the rule of reason’ on various grounds. In addition to encouraging franchisees to invest in their businesses and to ensure that customers receive quality products and services, it also assists franchisees in resisting ‘extra-brand competition‘, i.e. competition from outside the network, and it discourages ‘free-riding’, where a franchisee that has invested in an infrastructure in order to service customers in their territory efficiently, is forced to service the customers of a franchisee in another territory who has not made the investment.

LIMITED PRODUCT RANGE

Franchisors often limit the types of products or services franchisees may supply. Prima facie, this also limits the franchisee’s ability to expand their business by introducing more profitable product lines. However, it is relatively easy to justify this practice on the basis of ensuring standardisation across the network.

RESALE PRICE RESTRICTIONS

Section 5(2) of the Act prohibits ‘minimum resale price maintenance’, in other words, the franchisor may not prescribe a minimum resale price. While this prohibition is not subject to the ‘rule of reason’ of section 5(3), it provides that a supplier or producer of a product may recommend a price, as long as it is clear that it is a suggested price.

Observations with regards section 5(2) of the Competition Act:

Franchisors are only prohibited from prescribing a minimum resale price; prescribing a maximum price is not prohibited. While this may amount to a contravention of section 5(1), it can usually be justified on the ‘rule of reason’ basis, as a limit on the price that can be charged will inevitably benefit consumers. Only if the maximum prices are set so low as to make it unfeasible for the franchisee to sell the product, would it be likely to be unjustifiable.

Franchisors very often do not specify whether the prescribed price is a maximum or minimum, stipulating a fixed resale price instead. As this effectively prohibits the franchisee from selling the product at below the prescribed price, it will amount to a contravention of section 5(2).

The section only prohibits prescribing a minimum price in respect of the ‘resale’ price of the product. It may be argued that where the product sold by the franchisee is not the same as that at which it is bought, e.g. if the franchisee buys ingredients and uses them to make a finished product, section 5(2) will not apply. If the franchisor prescribes a minimum price in those circumstances, it may contravene section 5(1). While it may be more difficult to justify a minimum price, it is not impossible; it can, for example, be argued that it enhances the exclusive reputation of the product.

DOMINANCE PROVISIONS

Some of the practices referred to may also be affected by the abuse of dominance provisions of the Competition Act. A franchisor will be considered dominant in the market for a specific product or service if:

it has at least 45 percent of that market;
it has between 35 percent and 45 percent of that market, unless it can show that it does not have market power; or
it has less than 35 percent of that market, but has market power.

‘Market power’ is defined as the power of a firm to control prices, exclude competition or behave independently of its competitors, customers or suppliers.

Where a franchisor is dominant, section 8(d)(iii) prohibits it from supplying goods or services (‘the tying product’) to franchisees on condition that the franchisees purchase other goods or services (‘the tied product’), which are unrelated to the object of the contract for the tying product. If the franchisor can show a connection between the additional products and services the franchisee is required to buy and the franchise agreement, the arrangement will not amount to a contravention. In addition, the arrangement can be justified, as in the case of section 5(1), if the franchisor can show a technological efficiency or other pro-competitive gain that outweighs the anti-competitive effect of the act.

In light of this discussion it would be advisable for a franchisor, before incorporating any of these provisions into its agreements, to consult a legal practitioner so as to align its operations and agreements with the law.

Disclaimer: SA Franchise Warehouse is not associated in any manner to any of the brands listed on this website apart from listing details of their respective franchise opportunities. We do not underwrite their viability as a business opportunity nor the quality of the service or products offered by their franchisees. Any complaints need to be directed to the franchisors directly.