24
Paper to be presented at the EMNet Conference on
“Economics and Management of Franchising Networks”
Vienna, Austria, June 26-28, 2003
The economics of restricted distribution.
Jeny Marekova
PHD candidate, Central European University, Budapest, Hungary
Mladost 1, Bl.24, entr. 1, apt.19
1187, Sofia, Bulgaria
Tel: +35988-817528
Fax: +3592-9711159
email:
Abstract:
The paper examines generally the interrelation between the existing legal regimes regulating franchising and the business realities influencing the process. Franchising is viewed as an organizational choice for distribution of goods and services and as a commercial relationship created by contract. The main two groups of regulatory techniques used internationally in the context of franchising are discussed. Attempts for regulation of franchising relationship at supranational level is surveyed as well a discussion on the competition law as a second tire regulation is studied on the example of the recent EC regulation of vertical restraints. On the basis of economic analysis of the nature of the vertical restraints, the paper argues that the relevant area of competition may be the inter-brand competition between chains (networks) of producers and distributors across a number of functional levels, rather than between particular legal entities at a single functional level (intra-brand competition).
In the context of the contemporary legal and economic environment there are some terms that exist and which acknowledge something materially existent and self - explanatory. A few others create what otherwise does not exist, or could be called fictitious[1]. In between lie notions that simultaneously describe and invent reality. Franchise is one of these.
Franchising is one of the most interesting contemporary economic and legal phenomenons. Thus a conference on “Economics and Management of Franchising networks” not only provides perfect field for theoretical, conceptual or empirical analysis, but is a forum perfectly suited for cross-disciplinary and cross-cultural exchange of ideas and generation of new creative practices.
The study of the interrelation between the Law and Economics is broad enough to encompass the essence of all research topics invited by the present conference. From practical or theoretical point of view the discussion about the Economics and Management will not be complete without the underlying legal analysis covering all possible areas: beginning with the basic theoretical concepts and the empirical studies; looking through the problems related to the ownership and the exercise of control through the different structural forms; identification of the relevant regulatory environment, up to identification of the ultimate goals – the achievement of particular economic benefit or vice versa, avoidance of certain negative impacts of the surrounding market developments or structure.
Respectively, the present paper will basically follow the above structure of the discussion.
The notion.
For a quite long period of time the common perception of “franchise” is associated with a pure business operation and it is still not easy to provide a precise, scientific definition.
The usual association is related to a chain shop or fast food restaurant, but we all know that it is much more than this. This public perception represents a good starting point for our discussion. The confusion related to the mere definition of franchising is obviously created by people like us – lawyers, economists and other business practitioners or commentators, who created those public impressions by compiling “manuals” or “guides” to franchisors and franchisees, usually offering nothing more than mere comparisons and differentiations.
How would we define franchising and franchising networks from an economic and legal point of view?
No doubt about the fact that today’s customers have little demand for products at supplier’s factories, rather they want products or services to be available in convenient locations and at convenient time. The distribution chain serves exactly that purpose: it is a complex set of services involved in moving the product from the supplier to the hands of the user. There are great varieties of approaches: some suppliers own their distribution channels; others use independent agents, wholesalers, distributors, or dealers.
As a redefined form of distribution, the franchising network is characterized by operation of a business strongly identified with the supplier’s (franchisor’s) trademarks or trade-names, marketing plan or system, and significant control or assistance and ultimately by payment of some consideration in exchange to the right to do the business under the prescribed formula.
From the other perspective, Franchising is an organizational choice for distribution of goods and services. As a form of business organization, franchising is seen as occupying the middle between the two poles of the organizational complexity[2]. From one side is the internal vertical integration - for example of a producer who owns its own retail outlets. At the other end is the single commercial transaction - a producer that makes a one-time sale to a retailer. In franchising the vertical relationship, often between a supplier and a retailer, is continuous and usually very intense.
Apart of being a method of distribution, franchising networks are commercial relationships and are creatures of a contract and the parties’ freedom to contract, allowing them the right to chose the most suited way for allocation of their economic resources, risks and benefits to the ultimate advancement of their best interests. By drafting rights and obligations, which forms the essence of a contract, commercial or non-commercial, it already restricts the parties’ freedom.
At the same time, the ideal of unrestrained interaction of competitive forces and the freedom to contract does not mean a “rule of jungle”.
These are the basic underlying concepts making the “full and rich” blend of the phenomenon “franchising”.
There are various public and private goals that may put significant restraints on franchise relationship.
Regulation of franchising.
In the initial stage of franchise development, due to the existing disparities between franchisors and franchisees in terms of knowledge about the franchise specifics, a small number of countries have enacted rules or statutes either requiring presale disclosure about significant aspects of franchise relationship, or containing restrictions on termination and other substantive aspects of distribution relationship.
And still there are not so many countries in the world known to have specific laws related directly to franchising. According to the official information of the International Institute for Unification of Private Law[3] (UNIDROIT) those states are Albania, Australia, Belarus, Brazil, several provinces in Canada, China, Croatia, France, Indonesia, Japan, Kazakhstan, Korea, Lithuania, Malaysia, Mexico, Romania, The Russian federation, Spain and the United States of America.
Despite of the similarities and differences in the regulatory regime – one thing has been always certain: the importance to understand different definitions of the term franchise is more than academic. For example, in some states in the US, if a supplier of a branded product merely requires a distributor to maintain a 90- day inventory and participate in a promotional program, a "franchise" under the applicable statutory definition may exist; respectively subject the franchisor to extensive disclosure and registration requirements and extensive rights available under the law to the distributor. Subsequently, failure to abide those disclosure and registration proceeding may result in imposition of significant fines and may give rise to civil suits by “injured” parties.
The laws can be generally divided in two main groups – the ones that lay down the rules according to which a franchise may be offered and sold and the second group is the one containing rules governing the relationship between the franchisor and franchisee.
The first group received significant regulatory attention is the area of disclosure of relevant material facts to the potential franchisees. Such is the example of US regulatory regime where the federal law and a number of state laws impose strict requirements on the minimal information regarding the required investment, necessary work, chances of success and similar data needed for an evaluation of the business opportunity, and the timing of this disclosure, thus considering franchising laws at equal footing as securities laws.
The underlying theory of those disclosure or registration laws is that franchising is a vehicle for investment, and it should be greater transparency and legal certainty in the process of offering, negotiating and concluding franchising agreements. Therefore the franchisee must be given essential information regarding what is considered to be his business investment. The rationale behind the anti-termination laws is that a franchisee, who have invested in franchisor’s brand and has built up a market should be protected from supplier’s arbitrary decision to take the business from him by giving the already developed market to another franchisee or taking it over directly.
In the second group that received regulatory attention are provisions of franchise agreements related to termination, cancellation, non-renewal or amendments of the franchise agreement and which proved to be capable of conveying abuse from franchisors; restrictions on the franchisor's ability to terminate a franchisee without cause and also laws containing restrictions on the transfer of the franchise, especially by inheritance. Finally some rules are enacted that prohibit franchisors from so called ‘encroaching’, i.e. establishing new franchises in close proximity to the existing ones without any compensation to the franchisees concerned.
Within this second group a special place occupy some purely antitrust and industry specific statutes which address the franchise relationship from the perspective of the antitrust (competition) concerns on which we are going to focus our discussion further in this paper.
US is the only example with well developed regulations of both types at federal and state level. In France there is only one law reflecting similar concerns which is applicable to all agreements having as its subject the grant of a right to use a trade mark, trade name or logo – franchise, distribution and licensing agreements[4]. Enacted in 1989 the law was labeled as the “first initiative undertaken by a government outside the US and the Province of Alberta in Canada to regulate franchising”[5] and contains disclosure requirements viewed as “mild” by “North American Standards”. In another EU member country – Spain - In Spain, some body of provisions regulating franchising were introduced by the Law No. 7/1996[6] relating to the retail trade and requiring centralized registration and disclosure.
An interesting regulatory phenomenon represents the Australian experience, which initially could not fall under the definition of legislation. The adopted in 1993 Franchising Code of Practice was a voluntary and self-regulatory, allowing the choice to franchisors and other “related” parties to comply or not with the Code based on “moral and commercial pressures[7]”. Only 18 months after the implementation of the Code, The Federal Minister for Small Business, Customs and Construction, Senator Chris Schact, commissioned an independent review of the code. The review was conducted by Mr.Gardini and was made public in 1995.
As result of the fact that the majority of the franchisors had chosen not to register under the Code, respectively not to follow its standards of conduct, Mr. Gardini recommended that the mandatory self-regulation or co-regulation be introduced so as to provide for universal coverage for all franchisors[8]. Few years later – in 1998 in Australia was adopted a mandatory Franchising Code of Conduct introducing prior disclosure regime but also regulating certain aspects of the franchising relationship. In this sense, the Australian practice, evolving from an ‘alternative’ solution to standard regulatory technique is worth to study in greater detail.
The idea of broad “universal coverage” is also not isolated at the international arena. Within the context of globalization of the commercial practices, we might soon witness a strong trend toward “harmonization” of the regulatory tools at supranational level.
Universal regulation of franchising?
In 1993, a sub-committee of the Governing Council of the Institute for the Unification of Private Law (“UNIDROIT”) met in Rome to consider the direction future work of this organization would take in regulation of franchising. The sub-committee recommended that a “study group on franchising be set up with the task of examining different aspects of franchising and, in particular, disclosure of information between the parties before and after a franchise agreement has been concluded and the effects of master franchise agreements on some franchise agreements”. The Governing Council accepted these recommendations, and as a result the Study Group prepared a Guide to International Master franchise agreements, and educational instrument published in 1998 addressed to franchisors, sub-franchisors, their lawyers and consultants.
The interest towards franchising didn’t stop here. In recognition “that franchising is playing an ever greater role in a wide range of national economies[9]”, on 25 September 2002 the Governing Council of UNIDROIT adopted the Model Franchise Disclosure Law[10]. Whether this new Model law will be welcomed by franchise community is to be learned soon.
On a more narrow regional scale, the parliamentary Assembly of the Council of Europe demonstrated an increased interest in franchising in 1993, when a Committee Ministers issued a report in which it expressed concerns with “the problem of the equilibrium between the right of the franchisor and those of the franchisee, it being given that few of the States have specific legislation dealing with franchising”.
The report of the Committee of Ministers acknowledged that “Franchise agreements involve domains (contract law, business law, tax law, intellectual property law, …) where national rules, sometimes even international ones, already exist. It is not sure that it can be realistically envisaged that a uniform legislation in such heavily regulated domains can be adopted. On the other hand, other domains will be more favourable to international regulation: the information that must be furnished by the franchisor to the potential franchisee; questions relating to Master franchise agreement, notably concerning their end (resiliation, expiration of term); the choice of applicable law and the competent jurisdiction, all while paying attention to the international instruments that already exist; elaboration of a uniform definition of a universally acceptable definition of franchising.”
Thus the report adds more confusion as to the question whether and how much regulation is needed in the context of franchising relationship.
Obviously this short overview of the fragmentary legal regulation of franchising is not capable of providing satisfactory answer to the heaviest problem whether a special legislation on franchising is necessary and on what legal or economic principles it should be based upon?