Arzinger | View firm profile
I. INTRODUCTION
Vertical integration can become a powerful strategy for businesses aiming to enhance innovation, streamline operations, and expand their market reach.
By consolidating different stages of production or distribution, companies can respond more swiftly to market changes, maintain a competitive edge, and even anticipate evolving customer demands. For some organizations, vertical integration is often necessary to get to the next level of growth.
Franchising can serve as a strategic pathway for businesses seeking to expand their presence at the different levels of the supply chain. By using the franchise model, a company can extend its control over downstream or upstream operations without bearing the full operational or financial burden of direct ownership. For instance, a manufacturer may use franchising model to enter the retail market, ensuring consistent product distribution while benefiting from the distributors’ expertise and investment of franchisees.
However, this process is not without its challenges and risks, particularly in the area of antitrust. Expanding into new levels of the supply chain can blur the lines between permissible business strategies and practices that may attract regulatory scrutiny. Franchisors must strike a balance between maintaining control of their brand and operations without engaging in practices that could be perceived as anti-competitive, making regulatory uncertainty a key concern.
This article examines the problematic aspects of vertical integration in franchise systems, focusing on the antitrust risks that businesses face when moving across different levels of the supply chain and the inadequate regulation that complicates the process.
II. THE VARIETY OF FRANCHISING
Franchising typically involves a business entity (franchisor) that has developed a particular way of doing business expanding its business by giving other existing or would-be entrepreneurs (franchisees) the right to use the franchisor’s proven business model in another location for a defined period of time in exchange for payment of initial and ongoing fees. Along with the right to use the business model, the franchisor permits the franchisee to use the franchisor’s intellectual property and know-how and provides both initial and ongoing training and support. In essence, a successful business is replicated and run by the franchisee under the supervision and control of, and with the assistance of, the franchisor[1].
But let’s look into the vertical integration in franchise systems through the following example.
A company named X, a food products manufacturing business, currently sells its products to intermediaries such as distributors. These distributors in turn supply the products to retail networks and stores, where they are ultimately sold to end consumers.
In a strategic move, Company X (franchisor) plans to establish a franchise system consisting of retail outlets managed by franchisees. These outlets will operate under a single brand name and business system but will not be limited to selling only Company X’s products. Instead, they will function as multi-brand outlets, allowing franchisees to sell both the franchisor’s products and competing ones. In addition, Company X plans to impose certain conditions and obligations on its franchisees that would provide the franchisor with valuable access to market and commercial information about its competitors. This could include insights into pricing strategies, promotional campaigns, marketing efforts and their respective effects on consumer behaviour.
By implementing such a system, Company X aims to strengthen its presence in the retail sector. In the long term, this forward integration strategy could position Company X to enhance its market influence and potentially secure a competitive advantage by controlling both the production and the retail stages of the supply chain.
Given that Company X (franchisor) is a manufacturer of products and does not have its own outlets, while the franchisees are not manufacturers, i.e. the parties operate at different levels of the supply chain, the conclusion of agreements or decision-making (in any form) by such parties is considered to be vertical concerted action from the perspective of antitrust legislation.
The EU antitrust legislation provides certain guidelines for the assessment of vertical agreements and restrictions in vertical agreements, including franchise ones, which takes into account the distinction between anti-competitive and pro-competitive effects[2]. It also suggests that vertical agreements between undertakings operating at different levels of the production or distribution chain are generally less harmful than horizontal agreements between competing undertakings supplying substitutable goods or services[3].
However, the example described above implies that Company X is indirectly entering a lower-level market (similar to vertical integration) and demonstrates its influence over two markets – the production of products and their distribution in the retail market. This influence in the retail market is achieved through the franchising mechanism, by establishing rights and obligations for franchisees. Given this dual-market presence, evaluating the impact on competition requires a broader regulatory perspective and focusing solely on franchising relations may not be sufficient.
In practical terms, there are models with similar features – in which a business entity operates simultaneously in two markets of different levels and in one of which (the sales market) it has the ability to influence its competitors from the other market (the production market) – vertical business integration (also vertical concentration), dual distribution (a situation in which a supplier sells its goods or services directly to end consumers, thus competing with its suppliers at the retail level) and private label (a situation in which a retailer sells its own goods or services to end consumers, thus competing with its suppliers at the production level).
III. SETTING THE BOUNDARIES
The EU Guidelines aim to provide an overview of the various reasons and justifications for applying certain vertical restraints in commercial agreements[4].
As such, franchise agreements involve the licensing of intellectual property rights (IPRs) and the transfer of know-how for the use and distribution of goods or the provision of services. In addition to licensing IPRs, franchisors often provide commercial and technical assistance to franchisees, including procurement services, training and advice on real estate and financial planning. These licences and related assistance are an integral part of the franchising business model.
As franchising typically has certain specific characteristics, such as the use of a uniform business name, uniform business methods (including the licensing of IPRs) and the payment of royalties in return for the benefits granted, certain restrictive practices and provisions are generally permitted[5]. However, it is crucial that these practices are aligned and structured in a way that is compatible with competition law.
Firstly, there are specific conditions for vertical agreements containing IPR provisions to be fulfilled:
- the IPR provisions must be part of a vertical agreement, that is, an agreement with conditions under which the parties may purchase, sell or resell certain goods or services;
- the IPRs must be assigned to or licensed for use by the buyer;
- the IPR provisions must not constitute the primary object of the agreement;
- the IPR provisions must be directly related to the use, sale or resale of goods or services by the buyer or its customers. In the case of franchising where marketing forms the object of the exploitation of the IPRs, the goods or services are distributed by the master franchisee or the franchisees;
- the IPR provisions, in relation to the contract goods or services, must not contain restrictions of competition having the same object as vertical restraints that are not exempted under Regulation (EU) 2022/720 (hardcore restrictions).
The above conditions ensure that the exemption applies where the use, sale or resale of goods or services can be performed more effectively because IPRs are assigned to or licensed for use by the buyer (as long as the primary focus of the agreement is on the distribution or purchase of goods and services) [6].
Further, the EU Guidelines outline certain IPR-related obligations that are typically necessary to safeguard the franchisor’s IPRs:
- an obligation on the franchisee not to disclose to third parties the know-how provided by the franchisor as long as such know-how is not in the public domain;
- an obligation on the franchisee to communicate to the franchisor any experience gained in exploiting the franchise and to grant the franchisor and other franchisees a non-exclusive licence for the know-how resulting from that experience;
- an obligation on the franchisee to inform the franchisor of infringements of licensed IPRs, to take legal action against infringers or to assist the franchisor in any legal actions against infringers;
- an obligation on the franchisee not to use know-how licensed by the franchisor for purposes other than the exploitation of the franchise;
- an obligation on the franchisee not to assign the rights and obligations under the franchise agreement without the franchisor’s consent[7].
In view of the above, the assessment of commercial terms of cooperation between a franchisor and a franchisee requires an analysis of whether the vertical restraints go beyond the legitimate scope of protection of IPRs and are strictly necessary for the functioning of franchising systems.
For many distribution models, such as exclusive or selective distribution systems, regulators have already established clear approaches and guidelines regarding permissible practices that comply with antitrust laws. As a result, the various vertical restraints within the franchising systems are usually assessed using the principles applicable to the distribution system that most closely corresponds to the particular franchise agreement[8].
At the same time, many practices that franchisors may wish to implement for their franchisees fall into a grey area regarding whether they meet the criterion of being “strictly necessary for the functioning of franchising systems.” This concept, being inherently evaluative, leaves room for interpretation and necessitates careful analysis.
1. Uniform pricing policy
Maintaining brand consistency across a single network is critical to franchising, however, antitrust law strictly prohibits price-fixing. This means that franchisors must avoid imposing restrictions that limit a franchisee’s ability to determine its sale prices. Exceptions do exist, allowing franchisors to recommend or establish maximum sale prices, as long as these do not amount to fixed or minimum prices, which would violate competition law[9]. However, it is also worth analysing the general commercial law applicable to franchise agreements, which may impose additional restrictions on price control mechanisms in particular countries.
It is also important to understand that price-fixing extends beyond the direct price control but also to include indirect mechanisms that can influence pricing levels. These involves mechanisms such as discount or loyalty programs designed to incentivize specific purchasing behaviour or sanctions penalizing the respective non-compliance.
To navigate these constraints, franchisors must find legitimate ways for encouraging pricing strategies and exercise caution to avoid engaging in pricing activities that could violate the law.
2. Assortment control
Control over the product assortment, including the requirement to maintain a minimum share of the franchisor’s products or the need for prior approval of competing products, is considered a form of a non-compete obligation for franchisees.
As a general rule, a non-compete obligation may be permissible if its duration does not exceed five years. For franchise agreements, it is further stipulated that the duration of such non-compete clauses is irrelevant, provided that it does not exceed the duration of the franchise agreement. However, these obligations should be viewed as relating to goods or services acquired by the franchisee, which are essential for maintaining the consistent identity and reputation of the franchise network[10].
The EU practice also demonstrates that a franchisor is allowed to take measures necessary to preserve the identity and reputation of a network that bears the name or symbols of its company. As such, requiring franchisees to source goods related to the primary object of the franchising business exclusively from the franchisor or suppliers designated by the franchisor can be considered a justified practice[11].
Alongside maintaining a uniform system, methods of assortment control may be employed to eliminate competitors’ products or dictate their market share. In order to assess such effects, certain approaches have been developed to help participants in such coordinated actions navigate the introduction of non-compete obligations.
Firstly, the market share of the franchisor (supplier) is of a great importance when assessing the anti-competitive effects of non-compete, often referred to as single branding[12] requirements that can create significant risks by potentially foreclosing the market to competing suppliers and new entrants[13]. If the franchisor holds a substantial share of the market, such restrictions may reduce competition, as franchisees are bound to sell only the franchisor’s products and not those of competing suppliers. This can limit the variety of goods available to consumers and diminish the opportunities for other suppliers to gain market access. The EU Guidelines also suggest that foreclosure is more likely at the retail level due to significant barriers for manufacturers to establish independent retail outlets. In addition, at the retail level such agreements may reduce in-store inter-brand competition[14].
At the same time, the EU practice shows that the risks of eliminating or restricting competitors’ access to the market as a result of assortment restrictions and their anti-competitive effects also depend on the market share of the hypothetical buyers. For example, in the Heineken/Punch case[15], which concerned vertical concentration, the antitrust authority concluded that, due to the small share of pubs owned by Punch, the concentration would not limit access to the retail market (pubs). This was because it was not a key channel for that market, and brewers had a wide range of alternatives for selling their products.
The above findings demonstrate that the impact of assortment control and non-compete obligations in franchise agreements on market competition depends on several factors and while the intention behind non-compete clauses may be to protect the brand identity and reputation of the franchisor, it is crucial to balance this with the need to maintain healthy competition.
3. Marketing activities
Since the franchising involves the licensing of IPRs, management of marketing activities by a franchisor typically would be required considering the need to protect IPRs and ensure compliance with the conditions of use for the granted rights. For marketing activities, the franchisor may provide guidelines and/or approve marketing actions taken by franchisees to ensure compliance with IPRs related to the franchisor’s licensed trademarks, including conditions for using the trademark in advertisements and maintaining the franchisor’s business reputation. For example, in practice, a franchisor may provide advertising templates, signage for both external and internal store design, and marketing materials for display in franchisees’ stores.
Antitrust legislation also recognizes the legitimate rights of intellectual property holders and allows restrictions on franchisees to protect know-how and goodwill, or to maintain the overall identity or reputation of the franchise network.
However, there are many marketing activities that are not directly linked to intellectual property (such as registered trademarks) and are not derived from IPRs but are related to the sale of goods (e.g., promotions/discounts). It is also important to note that such marketing practices can be either price-related or non-price-related. In this context, in the absence of specific regulation applicable to franchise systems these activities should be assessed as regular commercial practices with due consideration of the antitrust regulation and its restrictions.
To this end, since in the vertically integrated franchising system marketing activities occur at the retail level, these practices may not only be unfair to business partners but also effectively target eliminating competitors and reducing market competition, as recognized at the European level[16].
Access foreclosure may occur through the following practices:
- Misuse of confidential business information provided by competitors for the benefit of one’s own products;
- Introduction of access fees that hinder the spread of competing brands;
- Abrupt termination of access that undermines the viability of competing brands;
- Upfront access refusal for products or innovations competing with one’s own.
Unfair non-price activities can include:
- Degradation of in-store services;
- Better shelf positioning or disproportionate space allocation for the franchisor’s products in stores.
There are also price-related marketing activities that may indicate control over pricing, such as requiring or encouraging franchisees to sell products at specific prices, which, as mentioned earlier in the article, is prohibited.
In practice, EU regulatory authorities may consider unfair marketing activities by franchisees, not linked to IPRs, and which grossly violate fair business principles, as unfair commercial practices[17].
In view of the above, directing and overseeing franchisees’ marketing activities can take various forms – from those directly related to intellectual property (e.g. use of trademarks in advertising and maintaining the franchisor’s business reputation) to those related to product and pricing, which can take the form of risky practices, such as foreclosure of competitors, and have a high potential to violate competition law.
4. Commercial information exchange
The nature of the franchise agreement and the franchise model itself requires the exchange of information between its participants. At the same time, the scope, nature and content of the information that may be exchanged varies according to competition law rules and practice, depending on whether such information contributes to the coordination of behaviour between competitors, market control or other forms of distortion or restriction of competition, or is merely intended to ensure the application of a single business model throughout the network.
The EU Guidelines suggest that the information exchange between a supplier and buyer can contribute to the pro-competitive effects of vertical agreements, in particular the optimization of production and distribution processes[18]. In the context of a franchise agreement, such exchanges may be essential for implementing a consistent business model throughout the franchise network[19].
However, in the vertically integrated franchising system the franchisor may wish and even need to obtain information on its competitors’ products (for example, to calculate royalty) and such information can indeed be “directly related to the implementation of the vertical agreement”, as suggested by the EU Guidelines.
Undoubtedly, obtaining information about prices, marketing activities, and other data related to products from other manufacturers (the franchisor’s competitors) carries significant antitrust risks, particularly when the shared information reduces uncertainty regarding a competitor’s recent or future market behaviour. A franchisor receiving information about competitors through its franchisees can lead to an uneven distribution of market information and grant a franchisor an informational advantage concerning external and internal market dynamics and participants, enabling making strategic decisions.
These risks of uneven distribution of market information have been confirmed by the EU practice in the retail sector in the private label scenario. In the Kesko/Tuko case[20] the European Commission noted that, given the “buyer power”, the retailer has access to commercially sensitive information about product launches and promotion strategies of the producers of goods and this privileged position increases the influence of retailers on product manufacturers.
As a result, antitrust regulation admits that in certain distribution models, in particular in dual distribution, the exchange of certain types of information may raise horizontal concerns. In such cases, only the exchange of information that is both strictly necessary for implementing the vertical agreement and essential for optimizing the production or distribution of the contracted goods or services is exempt from regulatory scrutiny[21].
Although the EU Guidelines contain illustrative lists of information exchanges that are “more likely to be acceptable ” and “more likely to be unacceptable”[22], they also provide a disclaimer stating that these examples cannot replace a thorough evaluation of the particular facts of vertical agreement. Moreover, the guidelines lack examples that sufficiently account for the diverse structures and practices within various franchising systems, limiting their applicability to such arrangements.
IV. CONCLUSION
Vertical integration in franchise systems offers significant opportunities for growth, market expansion, and operational efficiency. However, it also presents complex legal challenges, particularly in navigating antitrust regulations. While the franchise model inherently relies on control and coordination, these practices must be carefully aligned with competition laws to avoid anti-competitive effects.
The analysis highlights key risks and regulatory considerations, such as pricing policies, assortment control, marketing practices and information exchange, all of which require a delicate balance between the franchisor’s operational needs and legal compliance. While the EU Guidelines are intended to provide a useful legal framework, companies need to be cautious and aware of the inadequacy of existing legislation when dealing with the diversity of distribution systems.
Authors: Lana Sinichkina, Partner at Arzinger Law Office, Valeriia Odarchenko, Senior associate at Arzinger Law Office
Footnotes
[1] World Intellectual Property Organization (WIPO), In Good Company: Managing Intellectual Property Issues in Franchising.
[2] Commission Regulation (EU) No 2022/720 of 10 May 2022 on the application of Article 101(3) of the Treaty on the Functioning of the European Union to categories of vertical agreements and concerted practices; Communication from the Commission: Commission Notice Guidelines on Vertical Restraints 2022/C 248/01.
[3] Communication from the Commission: Commission Notice Guidelines on Vertical Restraints 2022/C 248/01, p.10.
[4] ibid, p. 16.
[5] ibid, pp. 165-166.
[6] ibid, pp. 72-73.
[7] ibid, p. 87.
[8] ibid, p. 167.
[9] Article 4(a) of Commission Regulation (EU) No 2022/720 of 10 May 2022 on the application of Article 101(3) of the Treaty on the Functioning of the European Union to categories of vertical agreements and concerted practices.
[10] Communication from the Commission: Commission Notice Guidelines on Vertical Restraints 2022/C 248/01, p. 167.
[11]ECJ Decision dated 28.01.1986 Pronuptia de Paris GmbH v Pronuptia de Paris Irmgard Schillgallis, C-161/84, EU:C:1986:41.
[12] The main element of a single branding agreement is that the buyer is obliged or induced to concentrate its orders for a particular type of product with one supplier.
[13] Communication from the Commission: Commission Notice Guidelines on Vertical Restraints 2022/C 248/01, p. 299.
[14] ibid, p. 309.
[15] CMA Decision Heineken/Punch (2017).
[16] Enforcement of competition policy in the retail sector: Competition issues in the food retail chain. Note by the UNCTAD secretariat, 2016, pp. 8-9.
[17] European Parliament resolution of 5 July 2011 on a more efficient and fairer retail market (2010/2109(INI));
European Parliament Briefing Unfair Trading Practices in the Business-to-Business Food Supply Chain.
[18] Commission Regulation (EU) No 2022/720 of 10 May 2022 on the application of Article 101(3) of the Treaty on the Functioning of the European Union to categories of vertical agreements and concerted practices, p. 13.
[19] Communication from the Commission: Commission Notice Guidelines on Vertical Restraints 2022/C 248/01, p. 98.
[20] Commission Decision Kesko/Tuko (Case IV/M784) 97/277/EC [1997] OJ L110/53.
[21] Commission Regulation (EU) No 2022/720 of 10 May 2022 on the application of Article 101(3) of the Treaty on the Functioning of the European Union to categories of vertical agreements and concerted practices, p. 13.
[22] Communication from the Commission: Commission Notice Guidelines on Vertical Restraints 2022/C 248/01, pp. 99-100.