Vertical Restraints: An Introduction Elisa Holmes Monckton Chambers London eholmes@monckton.com 1-2 Raymond Buildings, Gray’s Inn, London, WC1R 5NR, UK +44 (0)20 7405 7211

The EC definition Vertical restraints are agreements or concerted practices entered into between two or more companies each of which operates, for the purposes of the agreement, at a different level of the production or distribution chain, and relating to the conditions under which the parties may purchase, sell or resell certain goods or services.

The basic concept Vertical agreements arise because people who manufacture goods are not the same people who sell them to the ultimate consumer. There is, therefore, usually at least one agreement in relation to the goods in between manufacture and ultimate sale. Almost always there are many more.

Content of vertical agreements What are the things which people might wish to regulate? Number of goods sold Quality of goods or services sold Price at which goods are sold or services are provided Type of outlet at which goods are sold or services are provided Etc Competition law is concerned with agreements or terms of agreements concerned with purchase conditions, sale and re-sale.

Vertical and Horizontal agreements Growers Agents / wholesalers Retailers Ultimate Consumers

Basic Concepts (1) Different levels of the production or distribution chain In order to qualify as a vertical agreement, the parties must operate at different levels of the production or distribution chain. Generally, therefore, excludes agreements between competitors. Independent Economic Operators We are concerned with agreements between independent economic operators. This means they must be capable of making their own decisions, setting their own prices and so on. Different branches of the same company, for example, are often not regarded as independent economic operators if they are ultimately controlled by the same person or company. Different levels of the production or distribution chain may be found within each of the broad categories mentioned above. Within manufacturing, for example, one undertaking may manufacture a component part of a final product (such as a light bulb) and make an agreement to sell that part to a second undertaking which uses that part in its manufacture of the final product (such as a car). Although each of these undertakings is a manufacturer (one of light bulbs and one of cars), they would be regarded as operating at different levels of the production or distribution chain when they entered into an agreement for the supply of light bulbs to be incorporated into a car. Such an agreement may, therefore, benefit from the Block Exemption.

Basic Concepts (2) Intra-brand competition Inter-brand competition Competition between suppliers which sell the same product or the same brand – eg retailers selling same type of coffee Inter-brand competition Competition between different but interchangeable brands or products – eg different types of coffee The concern is always with the ultimate consumer Inter-brand competition – usually at the first two levels. Intra-brand competition at the third level, because consumers have lots of choices of places to buy the same product, eg from where to buy a can of Coke

Negative Effects Negative effects which competition law aims to prevent foreclosure of other suppliers or other buyers by raising barriers to entry; reduction of inter-brand competition between the companies operating on a market; reduction of inter-brand competition between distributors; limitations on the freedom of consumers to purchase goods or services in a particular geographic area.

Positive Effects Vertical restraints often promote non-price competition and improved quality of services one distributor may "free-ride" on the promotion efforts of another distributor; a manufacturer wants to enter a new geographic market, for instance by exporting to another country for the first time. This may involve certain "first-time investments" by the distributor to establish the brand in the market; certain retailers in some sectors have a reputation for stocking only "quality" products; client-specific investments have to be made by either the supplier or the buyer, such as in special equipment or training; know-how, once provided, cannot be taken back, and the provider of the know-how may not want it to be used for or by his competitors; in order to exploit economies of scale and thereby see a lower retail price, the manufacturer may want to concentrate the resale of his product on a limited number of distributors; the usual providers of capital (banks) provide capital sub-optimally when they have imperfect information on the quality of the borrower or there is an inadequate basis to secure the loan; a manufacturer increases sales by imposing a certain measure of uniformity and quality standardisation on his distributors. This may enable him to create a brand image and thereby attract consumers. This can be found, for instance, in selective distribution and franchising.

Analysing Vertical Agreements (1) Analyse the relevant market Establish the market share of the supplier (or sometimes the buyer), the relevant product market (which comprises any goods or services which are regarded by the buyer as interchangeable) and the relevant geographic market (which comprises the area in which the companies concerned are involved in the supply and demand of the relevant goods and services) are taken into account

Analysing Vertical Agreements (2) Determine the kind of restraint Single branding - an obligation or incentive which makes the buyer purchase practically all his requirements on a particular market from only one supplier. He will not be permitted to buy and resell or incorporate competing goods or services. The possible competition risks are foreclosure of the market to competing and potential suppliers, facilitation of collusion between suppliers in cases of cumulative use and, where the buyer is a retailer selling to final consumers, a loss of in-store inter-brand competition. Exclusive distribution - the supplier agrees to sell his products only to one distributor for resale in a particular territory. At the same time, the distributor is usually limited in his active selling into other exclusively allocated territories. The possible competition risks are mainly reduced intra-brand competition and market partitioning, which may in particular facilitate price discrimination. Exclusive customer allocation - the supplier agrees to sell his products only to one distributor for resale to a particular class of customer. At the same time, the distributor is usually limited in his active selling into other exclusively allocated classes of customer. The possible competition risks are mainly reduced intra-brand competition and market partitioning, which may in particular facilitate price discrimination. When most or all of the suppliers apply exclusive customer allocation, this may facilitate collusion, both at the suppliers' and the distributors' level. Selective distribution - restrict the number of authorised distributors, on the one hand, and the possibilities of resale on the other. The difference vis-à-vis exclusive distribution is that the restriction of the number of dealers does not depend on the number of territories but on selection criteria linked in the first place to the nature of the product. Another difference vis-à-vis exclusive distribution is that the restriction on resale is not a restriction on active selling to a territory but a restriction on any sales to non-authorised distributors, leaving only appointed dealers and final customers as possible buyers. Selective distribution is almost always used to distribute branded final products. The possible competition risks are a reduction in intra-brand competition and, especially in cases of cumulative effect, foreclosure of a certain type or types of distributor and facilitation of collusion between suppliers or buyers.

Analysing Vertical Agreements (3) Franchising - Franchise agreements contain licences of intellectual property rights relating in particular to trade marks or signs and know-how for the use and distribution of goods or services. In addition to the licence of IPRs, the franchiser usually provides the franchisee during the life of the agreement with commercial or technical assistance. The licence and the assistance are integral components of the business method being franchised. The franchiser is in general paid a franchise fee by the franchisee for the use of the particular business method. Franchising may enable the franchiser to establish, with limited investments, a uniform network for the distribution of his products. From the competition viewpoint, in addition to provision of the business method, franchise agreements usually contain a combination of different vertical restraints concerning the products being distributed, in particular selective distribution and/or non-compete and/or exclusive distribution or weaker forms thereof. Exclusive supply - there is only one buyer inside the Community to which the supplier may sell a particular final product. For intermediate goods or services, exclusive supply means that there is only one buyer inside the Community or that there is only one buyer inside the Community for the purposes of a specific use. The main competition risk of exclusive supply is the foreclosure of other buyers. Tying - the supplier makes the sale of one product conditional upon the purchase of another distinct product from the supplier or someone designated by the latter. The first product is referred to as the tying product and the second is referred to as the tied product. If the tying is not objectively justified by the nature of the products or commercial usage, such practice may constitute an abuse of a dominant position. Agreements of this type, which are designed to make the sale of one product conditional upon the purchase of another distinct product, may be incompatible with the competition rules. Recommended and maximum resale prices - recommending a resale price to a reseller or requiring the reseller to respect a maximum resale price. The possible competition risk of maximum and recommended prices is that they will work as a focal point for the resellers and might be followed by most or all of them. They may then facilitate collusion between suppliers.

Analysing Vertical Agreements (4) 3. Determine any negative effects on competition The important issue is generally not the form of the vertical restraint but its effect on competition. Usually, the first step in the analysis of a vertical restraint is to assess whether one or more parties to the agreement has market power. Where this is the case, the restraint may have anti-competitive effects if its (likely) effect is to foreclose (a substantial part of) a market to competition or to dampen competition. Determine whether there are any positive effects eg efficiencies, non-price competition, investment and innovation.

Method of Regulating Vertical Agreements in the EC (1) Article 81 of the EC Treaty provides for a general prohibition on agreements between undertakings which may affect trade and which have as their object or effect the prevention, restriction or distortion of competition. Some particular types of agreements such as price fixing, limit or control of production and markets, are then specified.

Method of Regulating Vertical Agreements in the EC (2) 2. Vertical Agreements, however, are generally exempted from this prohibition, largely as an acknowledgment of the general positive effects. It provides that: ‘Article 81(1) shall not apply to agreements or concerted practices entered into between two or more undertakings each of which operates, for the purposes of the agreement, at a different level of the production or distribution chain, and relating to the conditions under which the parties may purchase, sell or resell certain goods or services.’ This is the definition of vertical agreements we have discussed.

Method of Regulating Vertical Agreements in the EC (3) 3. There are two key limits to the scope of the Block Exemption. The Block Exemption will not apply to a vertical agreement where: • the market share of the supplier exceeds 30 percent of the relevant market or • the agreement contains one or more of the five ‘hardcore’ restrictions listed in the Block Exemption, including price-fixing. The main hardcore restriction is price-fixing, but there are four others. If the hardcore restriction applies, the agreement must then be analysed as not being subject to the exemption.

Method of Regulating Vertical Agreements in the EC (4) Even if the exemption does not apply, Article 81(3) provides another opportunity to avoid the illegality. It provides that the prohibition in Article 81(1) is inapplicable in respect of any agreement: ‘which contributes 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 which does not: (a) impose on the undertakings concerned restrictions which are not indispensable to the attainment of these objectives (b) afford such undertakings the possibility of eliminating competition in respect of a substantial part of the products in question.’ All of these really aimed at the general principles and objectives discussed earlier.