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The Importance Of Vertical Restraint In Franchising Agreements

Given the complex legal landscape it is of upmost significance to protect one’s interests while participating as a contracting party in any Franchising marketing model.

By News Editor
The Importance Of Vertical Restraint In Franchising Agreements

Franchising has often been referred to as one of the most novel methods of business expansion in today’s world. Simply put, it refers to a contractual arrangement whereby the owner of a product, service or even a method of production, secures the distribution of its offerings through one or more affiliations (franchisee). The franchisor offers a licensed privilege to the franchisee to do business under its name and to use the technical know-how provided by the franchisor in return for a negotiated monetary exchange.

Franchising’s many advantages include significant benefits to both the contractual parties involved and have an enormous success rate which makes it a widely adopted form of business. Its diluted sense of risk comes from the fact that the franchisee doesn’t have to worry about creating a well-known brand name and the franchisors are able to take advantage of the distribution as well as the economies of scale.

Franchising emerged as a response to the rapid and fast-paced industry evolution in the modern era where technological advancements, an orientation towards a service economy and the need for an increased market penetration all played a role for its gaining traction. Moreover, in an emerging economy like India, a rise in disposable middle-class income and increasing brand recognition could allow a greater number of companies with varied products and services to set up successful franchise businesses across the country. 

FRANCHISING LAWS IN INDIA AND THE COMPLEXITIES INVOLVED

In some jurisdictions, there are specific franchising laws and statutes that regulate the core functioning of franchising and the regulatory issues peripheral to it. However, there is no specific statute for franchising regulation in India and a plethora of legislations collectively regulate it.

Although there is no central legislation in place, the Franchising sector in India is not arbitrarily governed and is influenced by a coalescence of enactments spread across different statutes like the Indian Contract Act 1872; the Consumer Protection Act, 1986; the Trade Marks Act, 1999; the Copyright Act, 1957; the Patents Act, 1970; the Design Act, 2000; the Specific Relief Act, 1963 and various other statutory enactments.

Primarily, a Franchising agreement is incumbent on the involvement of two or more parties. Therefore, the Indian Contract Act 1872 and Specific Relief Act 1963 are one of the most prominent legislation which directly deals with the actual enforcement of the covenants in the agreement as well as the provision of appropriate damages for any breach whilst keeping in mind the balance of conveniences and interests of the parties involved.

Another huge aspect that is subjected to regulation in franchise agreements is the competition implications of such agreements. A franchise agreement provides the franchisor with an easier route for the effective distribution of their products. However, certain stipulations can become a threat to a sense of fair competition in the market. For instance, the franchisee agreeing to certain obligations or restrictions on their activities like restriction on the selling of products from other brands. Such requirements can cause competition concerns under Competition Act 2002, which seeks to prevent the ‘Appreciable Adverse Effect’ in the market economy.

Laws relating to taxation, property, insurance, and labor also apply to franchise transactions and in case the goods and services provided by the franchise entity fall under specific regulations, the same shall apply to them depending on the specific sector.

The aforementioned regulations and their influence make it arguable to propose that perhaps a singular comprehensive enactment may be desirable for the Indian scenario and that the coalescence of multiple regulations makes it more complex, time-consuming and at times ambiguous. This also lays bare the resultant complexities which are involved while getting into such agreements and the restrictions which ensue between firms at different levels of the marketing chain.

VERTICAL RESTRAINTS

Given the complex legal landscape, it is of utmost significance to protect one’s interests while participating as a contracting party in any Franchising marketing model. Vertical Restraints and their peculiar importance in franchising models are yet another part of such a complex relationship.

These restraints could be referred to as an economic imposition used in manufacturer/distributor relationship for controlling certain aspects of the trade (resale price maintenance, quantity fixing, tie-ins) or softening competition (exclusive dealing, franchising, exclusive territories). The importance of vertical restraint for franchising models is apparent from its very inherent features. The economic rationale behind their usage stems from the fact that they offer significant benefits to a brand in the form of protecting their brand image, increasing their presence and enhancing service qualities.

It has been the outcome of numerous studies that manufacturers and at times even small and medium-sized businesses (SMEs) adopt vertical restraints as a business strategy to prevent free-riding.

There are numerous types of covenants and agreements which come under the domain of Vertical Restraints. Covenants like ‘Resale Price Maintenance’ as well as ‘Exclusive Dealing’ are the most frequently used in franchising agreements. These covenants have routinely invited scrutiny and criticism as they have anti-competitive implications. For example, Exclusive Dealing is where the manufacturer/franchisor puts an obligation on the retailer/franchise, not to stock on any of their competitor’s products. Therefore, exclusive dealing affords the Franchisor to exercise greater autonomy over the distribution chains and thereby, not only softens the competition but also grants the business a more dominant presence in the market. Such a market foreclosure has anticompetitive consequences in the form of increased barriers to trade. However, the economics of vertical restraints and their relationship can cause us to re-scrutinize whether they are desirable or not.

VERTICAL RESTRAINTS IN INDIA

Owing to the nature of Vertical Restraints and the varying scope of their restrictive implications, it is considered desirable to put them under regulations so as to preserve the fair competitive spirit which the government seeks to uphold in the market. The anti-trust potential of these covenants in India is covered through Competition Act 2002 which primarily deals with issues relating to restrictive agreements and trade practices.

Section 3(4) deals with vertical restraints in different stages or levels of production enumerated as ‘tie-in arrangements’ ‘exclusive supply agreement’, ‘refusal to deal’ etc. Likewise, the enactment prohibits the imposition of any such agreement which would reasonably cause an ‘appreciably adverse effect on competition’ i.e. AAEC which is the guiding philosophy of competition legislation. Strengthened competition policy in this regard is an essential component for the creation of a fair and ‘democratic market economy’.

Furthermore, Section 27 of the Indian Contract Act expressly prohibits any agreement in restriction of trade. Even the overarching constitutional principles take a dim view of any imposition which impedes the fair and free flow of trade and commerce within the country. These legal principles have many a time influenced a number of decisions when it comes to negative covenants.

Moreover, the digital revolution is adding newer dimensions to the breadth of the legal landscape pertaining to the franchising business. In a string of precedents like MohitManglani v. Flipkart and All India Online Vendors Association v. Flipkart India, the Competition Commission of India has acknowledged the distinctiveness of online platforms and the unique implications they have on the legal climate of competition policy and chains of distribution and has laid out that the touchstone of ‘Appreciable Adverse Effect’ has to be extended to such online platforms and at times have even held that vertical restraints could be pro-competitive and consumer-friendly.

 

This article is written by Krrishan Singhania, Managing Partner & Sarjana Pandey, Associate, Singhania & Co.

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