Vertical restraints are agreements made between persons operating at different levels in the market, such as manufacturers and distributors. Vertical agreements come in a variety of forms including franchising agreements, distribution agreements and single branding agreements. There may be a mixture of different elements in particular types of agreements.
Vertical agreements typically contain restraints which may have anticompetitive effects, but may nonetheless be justifiable in terms of the economic benefit that they bring. Competition rules in this area involve a balancing of the potential benefits of the restrictions in such agreements with the potential risk to competition involved.
An exclusive distributor may be appointed within a territory. The extent of exclusivity will depend on the terms of the agreement. The effect will be to reduce or eliminate competition within the brand concerned, as only one distributor is available. EU law principles require that passive sales into another state should be allowed, although active marketing into those states may be restricted. This arises from the strong objection to the compartmentalisation of the EU single market.
Distribution agreement may bring gains the efficiency of the overall distribution system. Economies of scale may bring benefits to customers. Distributors may be unwilling to promote products unless they are given some form of exclusivity. The restriction of competition within a brand may lead to healthier or more rigorous competition between similar and competing brands.
The free rider problem refers to the risk that entities who have undertaken considerable investment in building up distribution channels, brands and marketing run the risk that they are undercut by retailers who have avoided these costs. Selective distribution may seek to protect the brand by restricting its sale to certain retailers. The justification for exclusivity may be the investment in human, physical and intellectual capital. However, the restraints are potentially harmful where a party has significant market power an where competition between brands is weak.
The EU has amended its approach significantly in the 2010 Vertical Agreement Regulation, Block Exemption Regulation. Under the earlier EU approach, a significant number of vertical agreements were required to be notified and exempted article 101(3). This was regarded as an inefficient and overly formalistic. Considerable delays might ensue during the process. This process was regarded as unduly restrictive and in particular, might prevent innovation and investment through technology licensing.
The EU Court of Justice has taken a more flexible attitude to vertical restraints in recent decades. Where ancillary restraints are necessary from a commercial perspective, they will not generally infringe the substantive prohibition at all. The restrictions must be limited in space and time and must be proportionate. The court has to some extent taken a rule of reason approach, similar to the US approach, particularly in the context of IP rights licensing and exclusive distribution agreements. They have weighed whether particular investment and innovation justifies restrictions on competition, what would otherwise constitute restrictions on competition.
In 2007, the US Supreme Court overturned its traditional long-established rule that retail price maintenance was illegal in itself. It introduced the possibility of the rule of reason, in respect of resale price maintenance (i.e. that it could potentially be justified on objective grounds in some, presumably highly unusual cases). The rule of reason considers whether they are reasonable or justifiable circumstances. In the case of agreements which are illegal in themselves, no further inquiry arises. In other cases, a reasoned economic analysis of the restraint and market conditions is required, in order to weigh the pro-competitive and anti-competitive effect.
The 2010 EU Regulation on Vertical Agreements significantly changed the approach of previous block exemptions. It provides exemptions on more general terms, which in effect allows more restraints to be permissible in principle unless prohibited. It adopts a so-called blacklist of prohibited terms and a white list of permissible terms. It gives greater flexibilities in vertical agreements.
A safe haven is created where the relevant entities do not have significant market power. This is generally measured at 30% of the relevant market. The Commission recognises certain type of vertical agreements may improve economic efficiency within a chain of production or distribution by facilitating better coordination between participating undertakings. This may lead to a reduction in transaction and distribution costs to the parties and an optimisation of their sales and investment levels.
Vertical Agreements under the Block Exemption
Vertical agreements are agreements or concerted practices entered between two or more undertakings, each of which operates, for the purpose of the agreement or the concerted practice, at a different level of production or place in the distribution chain which relates to the conditions under which the parties may purchase, sell or resell certain goods or services.
Many vertical agreements will not fall within the scope of this definition at all, under general principles. Agreements that fall within the definition may be exempted under other provisions such as the Technology Transfer Regulation. An assignment of intellectual property rights may be exempt where it is ancillary to the main objective of the agreement, for example, in the case of the establishment of an efficient system of distribution.
The Regulations applies a market share threshold. Where the market share held by the supplier does not exceed 30% of the relevant market on which it sells the relevant goods or services, and the market share of the buyer does not exceed 30% of the relevant market in which it purchases the relevant goods or services, the Regulation does not apply. The European Commission has published notes on the definition of a market for the purpose of market share.
The blacklisted or so-called hard-core restraints which are prohibited, are set out in the Regulation. They are not capable of being exempted. The most significant types are resale price maintenance and territorial restrictions.
Resale price maintenance may arise directly by fixing a minimum resale price. It may arise indirectly by fixing discount levels or indirect action which imposes penalties or practical obstacles in order to ensure the maintenance of a recommended minimum price. Maximum prices are not restricted in themselves. Although resale price maintenance is almost invariably regarded as objectionable, there may be highly exceptional circumstances in which it can be justified.
Clauses which restrict passive sales into excluded EU territories or customer groups are excluded from the exemption. This is based on the EU requirements for an integrated market and the long-standing objection to the compartmentalisation of the single market.
The Commission has published guidelines on the distinction between active and passive sales. The use of the internet in itself does not comprise an active sale, if it is a reasonable means of marketing. Provided the website is not aimed at specific customers, primarily located in another state, it does not comprise an active sale. The language on the website is not determinative. Apart from e-commerce marketing, passive selling would include catalogue selling and responding to unsolicited orders.
The guidelines allow for a restriction of passive sales in limited cases. Where the distributor is first in the market selling a new brand or first to bring an established brand into a new market, the significant investment may justify a restriction on passive sales for up to two years.
There are restrictions of the use of non-compete obligations arising after the term of the agreement and obligations regarding competing products in selective distribution networks. They are restricted, irrespective of market share. They may be severed from an agreement, so that the remainder may be capable of benefiting from the exemption.
The Commission has published guidelines on vertical restraints. This assist it the interpretation of the Regulations and sets out the Commission’s policy in order to assist businesses to undertake a self-assessment of the agreements. There is a four stage test for analysis. The party should first and analyse the relevant market and ascertain the relevant market share. If the shares are each below 30%, then the agreement may be within the exemption.
If the market share is less than 30%, then the hard-core prohibitions must be considered. If the parties have a share of more than 30%, the agreement must be considered from the perspective of whether it falls within the prohibition and if it does so, whether it falls within the exemption.
A key issue is whether the agreement is such that it leads to insufficient competition between brands. A reduction between brands is generally more harmful than a reduction of competition within the brand. A combination of restraints may increase the harmful effect on competition and less easily justified.
Restraints that are required in order to justify a bilateral investment in the context of a specific type of relationship are more easily justified. Restraints imposed in the context of seeking to open up new products or geographic markets are similarly more easily justified.
The Commission emphasise the market position of competitors, the existence and extent of barriers to entry and the maturity of the product markets. The Commission is of the view that negative effects are more likely to follow in a mature market than in an emerging or dynamic market.
Exclusive Distribution Agreements
There may be justification for exclusive distribution agreements in terms of economic efficiency. The Commission has sought to balance the restrictions on competition arising from exclusive distribution agreements with features that enhance competition between brands. Distribution agreements typically provide for exclusive distribution in a particular territory. This will be often recognised as necessary for start-up goods entering onto a new market
The Vertical Agreements Regulation restricts the types of territorial exclusivity which is permissible. Territorial exclusivity may be permissible, but not all territorial restrictions are allowed. Complete obstruction of parallel imports is not usually permitted, even where agreements grant absolute territorial protection which could be justified on the basis of an increase of inter-brand competition. There is a strong presumption that parallel trading should be permitted from outside the relevant territory, subject perhaps to restrictions for a short period, such as the first year, where a significant investment is necessary.
The EU Guidelines on Vertical Restraints take account of the effect of e-commerce. It restricts practices such as dual pricing by which online products are sold at a higher rate.
While an exclusive distribution agreement breaches the substantive prohibition in Article 101(1), it may still be upheld under Article 101(3). The Article 101(3) defences are unlikely to justify absolute territorial exclusivity or resale price maintenance.
Single Branding Agreements
The Vertical Agreement Guidelines refer to single branding agreements as non-compete obligations, the main element of which is that that the buyers are obliged to concentrate their orders for a particular type of product with one supplier. This runs the risk of closing the market to actual or potential competitors. If the participants have less than 30% market share, and the agreement is for less than five years, then the block exemption applies. The exemption applies to direct and indirect non-compete obligations. This includes exclusive purchasing obligations.
The Commission may withdraw the benefit of the exemption, where the agreement does not fulfil the criteria in Article 101(3). The guidelines indicate that the exemption may be withdrawn where a number of major suppliers enter into single branding agreements with a significant number of buyers in the market, causing a cumulative effect. The Commission may exclude from the exemption, parallel networks of similar vertical agreements where the networks cover more than 50% of the relevant market.
Where the block exemption is not applicable, the guidelines set out considerations for the analysis of whether the single branding agreement is caught by the substantive prohibition. They include the supplier’s market position, the length of non-compete obligations and the likelihood of significant foreclosure of the market.
The guidelines emphasise the possibility of a reduction in inter-brand competition for final products at the retail level. Significant anticompetitive effects may start to arise if 30% or more of the relevant market is tied. Guidance is given in relation to cumulative foreclosure effects.
Selective distribution agreements typically involve the restriction of branded products based on criteria related to the products. In order to be eligible to join the network of distributors, resellers must meet certain standards provided by the manufacturer. In contrast to exclusive distribution agreements, the number of distributors is not necessarily limited.
Qualitative criteria, such as staff training or service quality requirements based on the nature of the product, without restriction on the number of dealers, is regarded as low risk in respect of anticompetitive effect. The Commission recognises that in some product cases, non-price factors are a significant competitive force. The enhancement of quality through selective networks with provisions which seek to eliminate free riders who damage the brand by lower standards, is generally permissible.
The 2010 Regulation allows both qualitative and quantitative restrictions. Restrictions on the number of outlets in an area are usually allowed, provided that the market share is below 30% and there are no hard-core restrictions, including in particular restrictions on active selling by distributors to each other and to end-users.
Where there is not significant market power, inter-brand restrictions in selective distribution agreements are generally acceptable on the basis that that there is competition from other brands. The Commission may withdraw the exemption, if over half the market is subject to similar restrictions.
The internet raises difficult questions for selective distribution. There is a risk of free riders who compete unfairly with high quality retailers who have invested in physical infrastructure. Selective distribution agreements may be justified in imposing proportionate restrictions, requiring minimal infrastructural investment.