Franchise systems: ad campaigns with low prices can come costly!

Franchisors may run ad campaigns with low prices. Such campaigns, however, can come costly if they have an anticompetitive effect, especially if they factually force the franchisees to offer the products for the low prices.

Best example: pricing campaigns for the “burger of the week”, as decided by the Munich Regional Court in its decision of 26 October 2018 (Case No. 37 O 10335/15).

The situation

The plaintiffs are franchisees of the defendant’s franchise network, a restaurant chain. In addition to the obligation to pay “royalties” in return for the use of the franchise systems and its trade marks (5%), the franchise agreements also obliged the franchisees to pay a sales-related advertising fee. The defendant and franchisor used the advertising fees of the franchisees, among others, to advertise products from the plaintiffs’ menu at low prices, e.g. under the slogan “King of the Month“. By participating in the advertising campaigns and its low prices, the sales of the franchisees increased and thus the franchise fee they had to pay. After some time, the franchisees decided that this advertising campaign caused them financial damage – because the products offered for a low price affected the sale of products offered at a normal price (“cannibalism effect”). They no longer participated in the campaign and demanded an appropriate reduction of their advertising fee. Among other things, they brought an action for an injunction against the use of the advertising fee for the campaign complained of and for a declaratory judgment of the liability to pay damages. The Regional Court granted both motions.

The main reason. The advertising campaigns had the effect of restricting competition, namely the franchisees’ ability to determine their sale prices (contrary to sec. 1 and 2 (2) German Act against Restraints of Competition and Art. 2 (1), Art. 4 a) Vertical Block Exemption Regulation). After all, the franchisor set – so the court – the resale price through the de facto binding effect of the ad campaign.

The decision stands in line with the previous case law, especially of the German Federal Court’s decisions on low-price campaigns by franchisors of

• self-drive rental vehicles (“Sixt ./. Budget”, 02.02.1999, Case No. KZR 11/97, para.30),
• pet food (“Fressnapf”, 04.02.2016, Case No. I ZR 194/14, para. 14), and
• glasses within a dual distribution system where the franchisor sold the products through its own branches and through franchisees without differentiating between branch and franchise operations (“Apollo Optik”, 20.05.2003, Case No. KZR 27/02, para. 37).

Practical tips

1. Obligations that are essential for running the franchise system do not restrict competition for the purposes of the EU antitrust rules (similar to the US law’s “ancillary restraints doctrine”). In particular, the following restrictions are typically indispensable components of a functioning franchise agreement:

• Restrictions of the transfer of know-how;
• Non-compete obligations (during and after the term of the agreement), prohibiting the franchisee from opening a shop of the same or similar nature in an area where he may compete with other members of the franchise network;
• Obligations of the franchisee not to transfer his shop without the franchisor’s prior approval.

(cf. EU Court of Justice, 28.01.1986, Case “Pronuptia”, Case No. 161/84 para. 16. 17).

2. However, franchise systems are not per se exempted from the prohibition of restricting competition. Therefore, watch out to comply with the EU antitrust rules to avoid painful fines and ensure that the franchise agreement can be enforced.
3. The prohibition of price-fixing (or Resale Price Maintenance) applies to the relationship between franchisor and franchisee if the franchisee bears the economic risk of its enterprise. To avoid that an ad campaign with recommended resale prices constitutes an anticompetitive price-fixing, the concrete situation needs to be assessed thoroughly. What helps to avoid also any factual binding effect:

• Add a clarifying note: “Only at participating restaurants in … . As long as stocks last.”
• Ensure that such note is clearly visible, e.g. by adding an asterisk “*” to the price.
• Avoid any measures that could be interpreted as pressure or incentive for the franchisees and which would turn the recommended price into a fixed price (e.g. because other pricing would otherwise lead to negative evaluations).

4. Such ad campaigns may work, as a UK court’s decision shows: According to the BBC, Burger King franchisees sued the franchisor in 2009 “because a corporate promotion required franchisees to sell a double cheeseburger for $1 that cost a $1.10 to make. The court ruled for Burger King.” Under the above circumstances and also for short-term promotions, franchisors may even impose the resale price – such campaigns just need to be well prepared.
5. For an overview on resale price maintenance, see the Legalmondo article Resale Price Maintenance and Exceptions for short-term promotions.
6. Resale Price Maintenance can come costly – in 2018, the European Commission imposed fines of EUR 111 million in total on four consumer electronics manufacturers – Asus, Denon & Marantz, Philips and Pioneer – for fixing online resale prices (cf. the Press release of 24 July2018).