10 vertical restraints to optimise entrance into a new contract
Vertical restraints are anti-competitive measures used by firms at different levels of the supply chain within an agreement. Alinea outlines the 10 vertical restraints which are most commonly used within contracts, as a guide for business owners and contractors to consider when negotiating a new or existing deal.
Vertical restraints can be particularly relevant for an emerging brand, or for a company releasing a new product range, as they provide leverage, in addition to the pricing and the scale of distribution, and may assist in aiding the recoup of an initial investment.
Detailed knowledge of how to use the vertical block exemption rules outlined by the European Commission [1] to a company's advantage will enable the principal with the additional tools across the supply chain to optimise entrance into a new contract or market.
In most circumstances, vertical restraints may be applied when neither of the contractors own more than 30% of the market share, and may be combined with other non hard-core restraints such as a non-compete clause and exclusive distribution. In certain circumstances such as single branding the agreement is subject to a limitation of 5 years.
As a disclaimer, in all circumstances it is advisable to seek legal advice subject to the individual requirements of your business. Please schedule a consultation with Geoff Caesar to discuss further, email [email protected] (co-director & PA).
1. Single Branding
A non-compete clause - based on an obligation or initiative scheme which makes the buyer purchase more than 80% of requirements from only one supplier. It does not mean that the buyer can only buy directly from the supplier, but that the buyer will not buy or resell or incorporate competing goods and services. Quantity forcing is a weaker form or non compete, where incentives or obligations agreed between the supplier and buyer make the buyer concentrate his purchases to a larger extent with just one supplier. An 'English clause' the buyer must report a better offer, and be allowed only to accept such an offer when the supplier does not match it. In order to accept single branding restraints, suppliers may have to make a competitive offer to the buyer, or compensate them in whole or part, for the loss in competition resulting from the exclusivity, this may include offers such as financing and equipment provided at favourable rates.
2. Exclusive distribution
The supplier agrees to sell his products to only one distributor for resale in a particular territory. The distributor is usually limited in actively selling into other territories. The wholesaler may be responsible for marketing - this includes the promotion and sponsorship of local events and explaining and promoting the new product to retailers. As technology evolves, pre-sales advice to retailer and consumers plays a vital role. In very large territories, the exclusive distributor may become the exclusive buyer for the whole market, for example, a supermarket chain which becomes the only supplier of a leading food product throughout the nation. A coordinated approach to purchasing, which examines the marketing schedule and advertising campaigns of the producer, potentially addressing an advertising schedule such as a nationwide advertising campaign and a strong brand image within an indemnity clause, could lead to aggrandised market development.
3. Exclusive customer allocation
In an exclusive customer allocation agreement, the supplier agrees to sell his products only to one distributor for resale to a particular group of customers, this will generally occur in business-to-business contracts within a supply chain.
Exclusive customer allocation may lead to efficiencies, especially when distributors are required to make an investment in specific equipment, skills or know-how to adapt to the requirements of their group of customers. The depreciation of these investments indicates the justified duration of an exclusive customer allocation system. In general, the case is strongest for new or complex products, and for products requiring adaptation to the needs of the individual customer. Identifiable differentiated needs are more likely for intermediate products, such as products sold to professional buyers. Allocation of final buyers is unlikely to lead to efficiencies.
4. Selective distribution agreements
Selective distribution agreements restrict sales to non-authorised distributors, and the possibilities of resale, leaving only appointed dealers and final customers as possible buyers. Quantitative selective distribution adds further criteria for selection that limits the number of dealers by requiring minimum or maximum sales, or fixing the number of dealers to avoid over saturation of the market.
Selective distribution is widely used in the luxury industries as a tool against free riding, for instance, Prada recently issued a ‘cease or desist’ notice to online luxury discount store ‘Italist’, who was not authorised to distribute or sell Prada’s goods, and was benefiting from geographical differentiations in VAT pricing to sell in season products to overseas customers at reduced prices.
A benefit of a selective distribution agreement is an optimised customer experience, with branding in-store, a high level of staff training, and experienced after-sales care.
5. Franchising
Franchising occurs within a contractual arrangement where the owner of a product, service, or method of production licenses the distribution of its offerings to an affiliate, a ‘franchisee’ to conduct business using their name and goodwill. Franchiser and franchisee together form some single level of production, the decisions of this production determine the nature and quality of product or service, costs of production, market pricing, and determine the offerings economic efficiency.
Franchising agreements usually contain licenses of intellectual property in relation to trade marks or signs, or know how for the manufacturing, use and distribution of goods or services. In addition to the IPRs, the franchiser usually provides the franchisee during the life of the agreement with commercial and technical assistance. The franchiser is generally paid a franchise fee for the use of a particular business network. Franchising may enable the franchisor, with limited investment, with access to a uniform network for distribution and increased market penetration.
Vertical restraints used within franchising contracts include resale-price maintenance, quantity fixing and tie-ins controlling certain aspects of the trade, or softening competition (exclusive dealing, exclusive territories). The rationale behind applying the vertical restraints includes the protection of brand image and reputation, increasing market presence and enhancing customer service. Exclusive dealing will occur where the franchisee is required not to stock any of a competitor’s products. Exclusive dealing enables the Franchisor with greater autonomy over the distribution chain, thereby softening competition and granting the business a more dominant position in the market. The OECD [1] has published a report addressing competition policy and vertical restraints in franchising agreements. Larger operators will often have a depth of knowledge and resources to keep up with rapidly moving technology.
6. Exclusive supply
Within an exclusive supply agreement, the supplier is obliged to sell the contracted products only to one buyer, in general, or for a particular use.
This may also take the form of quantity forcing, where incentives are agreed between the supplier and buyer, which make the former concentrate sales mainly with one buyer. For intermediate goods and services, exclusive supply is known as industrial supply.
The countervailing power of suppliers is relevant, as important suppliers will not usually allow themselves to be cut off from alternative buyers. The purchasers’ market share will usually be important, as will be the duration of the supply obligation, any entry barriers and the level of trade affected.
7. Upfront access payments
Upfront access payments are fixed fees that suppliers pay to distributors in the framework of a vertical relationship at the beginning of a relevant period, in order to receive access to their distribution network and remunerate services provided by suppliers to retailers. [1]
This category includes various practices such as slotting allowances, pay-to-stay fees and payments to have access to a distributor’s promotional campaign. Certain retailers employ tariffs that combine slotting allowances; negative upfront payments made by the manufacturer even if the retailer does not purchase anything; with two part tariff where the supplier pays wholesale fees and the retailer pays conditional fixed fees dependent on actual trade; in order to achieve a monopolistic outcome and reduce retail competition.
Slotting allowances allow firms to maintain monopoly prices in situations where competing manufacturers offer contracts to alternative retailers. [3] Retailers profits are raised through the elimination of incentives for aggressive downstream pricing.
Dominant suppliers may wish to optimise their shelf space to impose the barriers to entry to potential upstream consumers. Payments provide a tacit method of enhancing market dominance as an instrument to leverage power over competitors. Dominant firms may prefer to use slotting allowances for confirmed visibility over wholesale price concessions as the former is directed straight to the retailer’s bottom line, whereas concessions are mitigated by retail price competition. Slotting allowances may minimise the risk of new product launches through an efficiency rationale. They also provide a means for manufacturers to introduce promotional or incremental sale to customers that would not occur otherwise.
8. Category management agreements
Category management agreements are agreements by which, within a distribution agreement, the distributor entrusts the supplier with the marketing of a category of products including in general not only the supplier’s products but also the products of its competitors. The supplier “category captain” may have an influence on the product placement and product promotion in-store. In these agreements, confidential information is shared between manufacturers and retailers to reduce costs in distribution and increase the profit margin for both parties.
The category captain will present a POG - a visual representation of the store’s products to the retailer, proposing a layout and promotional plan for the entire category. In certain agreements, the category captain will have responsibility will the retailer for the category development and is trusted with all retail divisions, to situations where the role of the category captain is in advisory alongside other consultants. Category management enhances efficiency, it reduces the retailer's risk of being out of stock or having excess inventories, it optimises the delivery and fulfilment timing and enables retailers to fulfil their promotional schedule. Suppliers and retailers receive complimentary information on consumers buying habits and needs, which is also of benefit to consumers. It is an efficient method for the distributor to confirm sufficient visibility and level of promotion to the supplier. Category management is a substitute contractual device to a limited exclusivity provision is a distribution contract; however there is a limitation on the degree of exclusivity as the category captain is required to place rival brands on the POG, the final decision is up to the retailer who will also take the decision of which promotional campaigns to run. The suppliers may incentive their position with the retailers, either by reducing their wholesale prices or paying upfront access fees or through a premium earned by the retailers through the inclusion of a Resale Price Maintenance clause. Category Management has been identified by the European Commission to have a positive effect on optimising economies of scale by allowing retailers to anticipate demand and tailor their promotions accordingly.
9. Tying
Tying refers to situations where customers that purchase one product (the tying product) are required also to purchase another distinct product (the tied product) from the same supplier or someone designed by the latter. Tying may be used with or in the place of copyrights and patents to protect the market entrance and discourage innovation. Tying is often used when suppliers seek to encourage sales of less established products, by placing them tied to more popular products, and is increasingly used within digital technology and the purchasing of software platforms. It may also be used within service-based industries as a sales requirement to optimise brand loyalty.
10. Resale price restrictions
Resale price maintenance (RPM) – agreements or concerted practices having as their direct or indirect object the establishment of a fixed or minimum resale price or a fixed or minimum resale price level to be observed by the buyer are considered a hardcore restriction and are not permitted. However, the practice of recommending a resale price (RRP) to a reseller or requiring the reseller to respect a maximum resale price is covered by the Block Exemption Regulation, provided that it does not amount to a minimum or fixed sale price as a result of pressure or incentives offered by any of the parties. In consideration of pricing management, there are various aspects to consider. A lower price may increase the quantity of products purchased by a consumer and market demand, whereas a higher price point may infer quality to the consumer and optimise brand reputation - a lower price might disrupt the product valuation and brand reputation.
References
- European Commission, 2010 ‘COMMISSION NOTICE Guidelines on Vertical Restraints {C(2010) 2365} {SEC(2010) 413} {SEC(2010) 414}’, European Commission, Brussels SEC (2010) 411, Available at: https://ec.europa.eu/competition/antitrust/legislation/guidelines_vertical_en.pdf
- OECD, Brenner, Dr Steven, Charles River Associates, Rey, Professor Patrick, ‘Competition Policy and Vertical Restraints: Franchising Agreements’, OECD, Available at: https://www.oecd.org/competition/abuse/1920326.pdf
- Liannos, Ioannis, ‘Upfront Access Payments Category Management’, Research Gate, p. 178, Available at: https://www.academia.edu/1334107/UPFRONT_ACCESS_PAYMENTS_CATEGORY_MANAGEMENT_AND_THE_NEW_REGULATION_OF_VERTICAL_RESTRAINTS_IN_EU_COMPETITION_LAW_IMPORTING_THE_RETAIL_SIDE_OF_THE_STORY
- Bibliography
Verouden, Vincent ‘Vertical Agreements: Motivation and Impact, In 3 Issues in Competition Law and Policy 1813, Chapter 72, Vincent Verouden, 2008, Available at: https://www.researchgate.net/publication/254868119_Vertical_Agreements_Motivation_and_Impact