FTC:WATCH NO. 531
THE aai COLUMN Franchise antitrust claims: the vacuum in federal leadership
by Warren Grimes*
Franchise antitrust law is in disarray. Maintaining competitive discipline in franchising is a matter of consequence because, according to the Franchise Annual, more than 1/3 of all consumer dollars flow through franchised outlets.
Franchisors often have market power - the power to raise and maintain prices above a competitive level - in dealings with franchisees. This power can arise because of the franchisee's sunk investment and the franchisor's power to confer benefits and impose costs on franchisees.
Abuses of this power can distort competition and injure the franchisee, efficient suppliers of the franchisee, and the consuming public. Over the past 80 years, antitrust claims have provided a measure of protection against these abuses. But a number of recent lower court decisions have summarily dismissed antitrust claims against franchisor abuses. Some courts have reasoned that because a franchisor has no market power over a franchisee before the franchise contract is signed, post-contractual competitive abuses should be governed exclusively by contract law. As Judge Becker wrote in a 1997 dissent, if this theory is accepted, "the franchisor/franchisee relationship is rendered virtually immune from antitrust scrutiny."
Consider a simple competitive abuse that can occur in franchising. The franchisor requires the franchisee to buy an input product from a designated vendor (a sourcing requirement). Such requirements may assure the uniformity and quality of franchise offerings, maintaining or enhancing the good will of the system.
But the favored vendor, in order to win the business, may rebate to the franchisor a percentage of each franchisee purchase. The franchisor now has an incentive to ignore the competition-enhancing interests of the franchisee. Instead of searching for the best price/quality mix, the franchisor may look to the size of the rebate that it receives from the vendor.
Even if the vendor is reputable and offers initially competitive terms, a substantial degree of competitive discipline is now lost. Over time, the vendor may raise its price or become sloppy in quality or service. If the input product is durable equipment (such as a computerized cash register), the vendor may give low priority to servicing, knowing that the franchisee can go nowhere else. Indeed, the aggrieved franchisee may be told: "We won't service that cash register - replace it with a new one."
Franchisee complaints to the franchisor may fall on deaf ears. The franchisor knows that it receives a rebate with each purchase so it, like the vendor, may favor replacement over servicing.
In this example of a franchisor-imposed sourcing control, the franchisee is denied a choice fundamental to our market system: the freedom to respond to a supplier's poor performance by picking a new one. Instead, the franchisee is locked into an unsatisfactory supply arrangement that distorts competition. The franchisee must pay supracompetitive prices for sub-par performance; efficient rivals of the supplier are deprived of business that could fairly be won under competitive conditions; and consumers are likely to be harmed in a variety of ways. The franchisee's increased costs may be passed on through higher prices to consumers or through cut-backs in service or quality that consumers might prefer. If such sourcing abuses become pervasive, franchising may be underutilized, depriving consumers of an efficient method of distribution.
All these harms might be avoided without compromising the franchisor's legitimate interest in protecting the good will of the franchise system. The franchisor might provide each franchisee with a list of approved vendors that could supply and service acceptable cash registers, restoring the franchisee's ability to choose a supplier that performs competitively.
Franchisor-imposed sourcing requirements have often been attacked as unlawful tie-ins or exclusive dealing arrangements. During the 1960s, the FTC brought high profile cases against petroleum companies that imposed a sourcing requirement on service station purchases of tires, batteries and accessories. Although some judicial decisions of this era lacked disciplined economic analysis, the Supreme Court implicitly and correctly recognized (for example in FTC v. Texaco (1968)) that franchisors can exercise market power over franchisees.
In 1992, the Court provided a more refined basis for the economic analysis of franchisor market power in Eastman Kodak Co. v. Image Technical Services, a case involving an original equipment supplier's market power over purchases of aftermarket products and services. The supplier's market power can arise from a buyer's pre-purchase information deficiencies and post-purchase lock-in.
The pre-contract information problems confronting many franchisees far surpass any difficulties confronting the buyers of Kodak's micrographic equipment. After signing the franchise contract, franchisees may be locked in by substantial sunk investment and subjugated by the franchisor's ability to impose costs or confer benefits.
Although Kodak offered a sound paradigm for determining a franchisor's market power, many post-Kodak lower court decisions have rejected this paradigm. Some decisions interpret Kodak narrowly and insist that the franchisor's market power be assessed before the franchisee signs the franchise contract. This approach has found support in a strand of academic literature (compare Benjamin Klein's article with my article in Volume 67, No. 2 of the Antitrust Law Journal).
Judge Becker is quite correct that a pre-contract analysis of franchisor market power will eliminate meaningful antitrust protection. A mechanical pre-contractual approach is inconsistent with the words of Section 1 of the Sherman Act (condemning "contracts . . . in restraint of trade").
The pre-contract approach also conflicts with the policy of antitrust (to prevent injury to competition, particularly when that injury flows to consumers or less powerful market participants such as many franchisees); with a substantial line of court decisions recognizing that market power may exist and be abusively exercised in franchise relationships; and with the competition laws of the European Union and member states such as Germany (that expressly recognize the possibility of market power abuses in enduring supplier relationships such as franchising).
The FTC has brought no recent franchise antitrust cases, inactivity probably linked to the agency's sparse resources and a sense that franchise abuses can be addressed in private litigation. But franchise antitrust law is now in disarray and in need of federal policy leadership. That leadership should be exercised to restore a balance to federal antitrust law to protect against traditional franchise antitrust abuses such as tie-ins, exclusive dealing, and vertical maximum price fixing when those practices injure competition without offsetting competitive benefits. The restoration of this balance would ensure that franchising is an efficient and fair method of distribution that serves consumers and market participants alike.