The legalities of fair competition

To avoid being liable to pay massive fines, it's vital for franchises to stay on the right side of competition law

The legalities of fair competition

Henry Ford allegedly said that competition is the keen cutting edge of business. Certainly UK legislators are all for promoting competition – we have one of the toughest competition regimes in the world. The Competition and Markets Authority (CMA) is the primary body responsible for enforcement of competition law in the UK. The CMA has substantial powers including making midnight raids to collect evidence on organisations, imposing restrictions on potentially suspect behaviour whilst a full investigation is carried out and, if a business or franchise is found guilty, imposing fines of up to 10% of global annual turnover.

Even if the CMA doesn’t come knocking, there is still a risk that agreements that breach competition law could be invalid and unenforceable. In addition, individuals have the right to bring private actions for compensation if they have suffered loss as a result of breach of competition law. And even if the legal ramifications don’t worry you – and they should – there’s always the risk of bad publicity and reputational damage if a franchise gets it wrong and breaches competition restrictions.

Pro-competition prohibitions

The core of the UK’s Competition Act is closely based on European requirements. Two key prohibitions are against agreements between businesses that could affect or distort competition in the UK – known as “the Chapter 1 prohibition” – and against the abuse of a dominant market position – known as “the Chapter 2 prohibition”.
The Chapter 1 prohibition is extremely wide. For a breach, there must be an agreement, decision or practice between two or more businesses or organisations. This doesn’t have to be an agreement in writing. Any form of contact or practice between organisations could be sufficient, as could a decision made by a trade body. Furthermore, the event doesn’t have to actually distort competition, it merely has to have the potential of doing so. Nor does it need to impact the whole of the UK: something that affects part of the UK is sufficient. The one limiting factor is that the impact on competition does have to be “appreciable”.

The legislation gives examples of the sorts of agreements that would be considered anti-competitive, although the list isn’t exhaustive and each individual arrangement will be considered in light of its own specific facts and circumstances.

There can also be complex questions around defining what the market actually is and therefore whether an event has an “appreciable” impact on that market. For example, a joint agreement between cauliflower producers may have a significant impact on the market for fresh cauliflowers but will have less of an impact if the market is considered to include fresh vegetables as a whole and an even lesser impact if the market includes fresh, frozen and canned vegetables.

Impact for franchise agreements

On the face of it, all franchise agreements could easily breach competition law. However, there is an exemption that means many networks fall outside the regulations. The exemption is for networks where the combined turnover of franchisor and all franchisees is less than £20m. Although many franchise networks will fall within this, it is not an absolute exemption: some practices and clauses are prohibited no matter how big or small the network. For those franchises that fall outside this exemption, the franchisor must ensure that none of the franchise agreement, manual or its general practices infringes upon competition.

Blacklisted and greylisted clauses

One common area for competition consideration in franchise agreements is in relation to pricing clauses. Franchisors are allowed to recommend prices and set maximum ones but clauses that allow the franchisor to fix retail prices across the network or to set minimum retail prices would be an unlawful breach of competition law.
Some clauses, like this price fixing, are blacklisted and prohibited in all circumstances but some clauses are less clear-cut.

A typical example would be restrictive covenants that seek to restrict the franchisee’s ability to be involved in other, competing businesses during the term of the franchise agreement or for a period of time following termination. It is clear that a clause that prevents a person from being involved in a rival business is likely to have a detrimental impact on competition in the wider market but, equally, this must be balanced against the franchisor’s need to protect their knowledge and system. It would be unfair if a franchisee was allowed to operate a competing business so that trade generated through the franchisor’s brand and system could be diverted into another business, depriving the franchisor of licence fees that would otherwise be paid on that trade.

A restricted covenant that lasts for more than five years will be blacklisted and prohibited but restrictions that last for less than this fall into the category of greylisted clauses. These greylisted clauses are not prohibited outright but instead it is necessary to consider all of the individual circumstances and balance the impact on competition against the legitimate interests of all the parties.

Most franchise agreements limit the post-termination restrictions to periods of no more than 12 months and so are easily below the five-year threshold. However, a difficulty can arise in relation to in-term restrictions. Since most franchise agreements contain restrictions that apply during the term of the contract, the trend in the UK is to make the term of the agreement no more than five years. This ensures that the in-term restrictions will remain valid – provided they are reasonable and justifiable in all the circumstances. If the term of the agreement is for more than five years, then any in-term restrictions that apply for the term of the agreement would also last more than five years and risk being invalid as a breach of competition law.

While understanding the subtleties of competition law isn’t always easy, franchisors that successfully do so can focus on growing their business” without risking huge fines.

Kate Legg
Kate Legg