Non-compete clauses in franchise agreements
Updated: Jun 4, 2019
Despite its name the competition law does not entirely prohibit including non-compete obligations in agreements between undertakings. Because as it turns out they may actually be somewhat beneficial for competition. Therefore let’s consider the extent to which EU competition law allows invoking non-compete obligations in franchise agreements.
Non-compete obligations under the EU competition law
According to EU competition law applicable to vertical agreements between undertakings (including franchise agreements), a non-compete obligation includes any direct or indirect obligation causing the buyer not to manufacture, purchase, sell or resell goods or services which compete with the contract goods or services (see full definition under Article 1(d) of the Vertical Block Exemption Regulation, VBER). Typical examples of agreements including non‑compete obligations are exclusive distribution agreements, agreements concerning mergers and franchise agreements.
Additionally, Article 101(3) of the Treaty on the Functioning of the European Union (TFEU) must be taken into account. It allows imposing non-compete obligations in agreements between undertakings, if they contribute “to improving the production or distribution of goods or to promoting technical or economic progress, while allowing consumers a fair share of the resulting benefit” and provided that these obligations are (1) indispensable to the attainment of these objectives and (2) they do not afford the possibility of eliminating competition in respect of a substantial part of the products in question.
Thereby, the general rule of EU competition law is that the non-compete obligations need to be evaluated on a case to case basis taking into account the nature of the agreement and the extent of the non-compete obligation. But there also exist some rules which are applicable specifically to franchise agreements.
Non-compete obligations in franchise agreements
Franchise agreement enables a franchisee to operate as an independent business while using the name and know-how of the franchisor in an allocated territory. For this purpose the franchisor not only allows the franchisee to use franchisor’s trademarks, know-how and other intellectual property, but also provides trainings and commercial or technical assistance to the franchisee throughout the term of the franchise agreement. In turn the franchisor receives from the franchisee a royalty fee, which usually is calculated as a percentage of franchisees turnover.
Because of the nature of the franchise business and the relationship between the franchisee and franchisor it is essential to have non‑compete obligations in franchise agreements. Otherwise the franchisees, once they have learned everything they need from the franchisor, may reap the fruits of franchisor’s know-how by opening and operating a competing business alongside the business operated under the franchise. This in turn will affect the amount of royalty fee payable to the franchisor for its efforts and therefore it may impede further development or even existence of the franchise business and thus its benefits to consumers.
At the same time non-compete obligations in franchise agreements may not be so extensive that they restrict competition unnecessarily. Otherwise such non‑compete obligations will be unenforceable and the parties to the agreement will be subject to a fine, which depending on the circumstances may be imposed by the European Commission (EC) or national competition authorities.
The most certain way to ensure compliance with EU competition law is to benefit from the exemptions of the VBER. Vertical agreements are deemed compliant with EU competition law provided that the market share of the parties to the agreement does not exceed 30 % of the relevant market on which the contract goods or services are purchased or sold.
If this is the case, according to the VBER, the parties to a vertical agreement are allowed to invoke a non-compete obligation, that does not exceed the duration of five years, and they can be assured that such an obligation will be deemed as in line with the EU competition law.
However, such limited non-compete obligation would not make much sense for franchise agreements considering their nature. Therefore the Guidelines on Vertical Restraints (paragraph 148) adopted by the EC (Guidelines) explain that non-compete obligations in franchise agreements may be valid for the entire term of the franchise agreement (which may exceed the duration of five years), because of the “transfer of substantial know-how”. Even though VBER does not explicitly provide for such an exception, according to the EC this is nevertheless in line with EU competition law.
Similarly, in Latvia Cabinet Regulations No. 797 on vertical agreements, that are analogous to VBER, explicitly provide that the 5 year limitation to non-compete obligations does not apply to “franchise agreements where a non-compete obligation is objectively necessary to maintain the overall brand identity and reputation of the franchise network”.
To sum up
A franchise agreement may invoke a non-compete obligation during the whole term of the agreement provided that it is necessary for the protection of substantial know-how, that is transferred to the franchisee under the franchise agreement. Know-how is “substantial”, if it includes information which is significant and useful to the franchisee for the use, sale or resale of the contract goods or services (Guidelines, paragraph 68; see full definition of “know-how” under Article 1(1)(g) of VBER).
You can read about the requirements for invoking non-compete obligations in franchise agreements after their termination here.