Dictating or Encouraging Franchisee Pricing

The More Aggressive Approach: Dictating Prices Through Resale Price Setting

One primary method of setting resale prices is by agreement, something that was historically per se illegal under Section 1 of the Sherman Antitrust Act. However, two Supreme Court decisions have turned the traditional federal standard upside down, so that all vertical agreements that set a minimum, maximum or exact resale price are now subject to the more franchisor-friendly rule of reason. See, Leegin Creative Leather Prods. v. PSKS, Inc., 551 U.S. 877 (2007) (minimum prices); State Oil Co. v. Khan, 522 U.S. 3 (1997) (maximum prices). While the Khan case was not controversial, the Leegin decision was. In fact, several states have taken the position that, regardless of the federal approach, minimum resale price agreements remain illegal on their face under state law. These include California, New York, Michigan and Illinois, while Maryland enacted a post-Leegin statute expressly outlawing such agreements.

However, the courts long have recognized another way of establishing resale prices that is outside the price-fixing proscriptions of Section 1. Because this provision covers “every contract, combination ' or conspiracy” in restraint of trade, unilateral actions on the supplier's part are beyond its reach. This principle was established by the Supreme Court in U.S. v. Colgate & Co., 250 U.S. 300 (1919), and various other decisions by the Court have endorsed this approach, including, most recently, Leegin. So far, no state has taken a contrary position, as all state activity in this area has focused on resale price agreements.

As a result, a franchisor or other supplier may announce a price at which one or more of its products must be resold (in the form of a ceiling, floor or exact price policy) and refuse to sell to any franchisee or other reseller which does not comply, as long as there is no agreement between the supplier and the reseller on resale price levels. Even where resellers adhere to the policy, there is no unlawful agreement. Due to the latitude provided by the law, many suppliers of desirable branded products successfully have discouraged the discounting of their products by using policies.

Minimum- or exact-price policies permit suppliers sufficient margin to provide services and other aspects of the selling environment (such as ample inventory) that are consistent with the supplier's objectives, including requirements of the franchise. Such policies are aimed at avoiding the “free-rider effect” or “showrooming,” where some discounting resellers take a free ride on the efforts of others.

Pricing policies may be used to cover everything from a single product to all of the supplier's offerings. In each case, a policy violation requires that the supplier stop selling to the offending reseller. This denial of product access could cover each product involved in the policy violation or an entire product line or all of the supplier's products.

Note that the supplier's pulling all of its products sold to the offender is tantamount to termination and could run afoul of reseller protection laws, so it may be better to stop supplying only some key products, assuming this more limited reaction is practical. In any event, the decision whether to resume selling is the supplier's choice alone, although some cases indicate that warnings, threats and probation are troublesome, because they support the inference that some form of prohibited agreement has been reached.

To make a resale pricing policy work, the supplier must have brand power. If not, the ready availability of substitutes makes the policy toothless. At the same time, highly desirable products are likely targets for discounting anyway, so the necessary power is often present. Indeed, a successful franchisor likely has such power, as otherwise no one would be willing to pay its franchise fees.

While such policies are powerful, the rules for designing, implementing and enforcing them must be carefully followed or the narrow exception to the price-fixing prohibitions of the Sherman Act is lost. This means that any form of agreement must be avoided, so there can be no resale pricing contracts or assurances of compliance. This also means that careful training of supplier personnel who interact with resellers is essential. Just as important, the supplier must be prepared to enforce the policy against its most important customers.

The Less Aggressive Approach: Resale Price Encouragement

Rather than dictating resale prices, some suppliers choose to encourage desirable pricing behavior by providing financial incentives or penalizing violators by denying them access to products. In other words, there is no restriction on the reseller's selling price, only on the price it promotes. These practices are judged under the rule of reason when an agreement is present (e.g., Lake Hill Motors, Inc. v. Jim Bennett Yacht Sales, Inc., 246 F.3d 752, 757 (5th Cir. 2001)), but they also can be imposed by unilateral policy, exempting them from coverage under Sherman Act Section 1. (No state has taken a contrary position.) Of course, regardless of how implemented, the provision of financial incentives is subject to the Robinson-Patman Act, codified at 15 U.S.C. '13 (prohibiting certain forms of discriminatory pricing to competing resellers).

If financial incentives are used, the rational reseller will decide whether it can fare better economically by taking the incentive or foregoing the incentive and selling more product. Therefore, it is essential that the incentive be of sufficient value to result in the supplier's desired effect, although, even then, there may still be leakage, as some resellers may choose to be price disruptors. For this reason, many contemporary price encouragement programs penalize violators by denying product access, much like resale price policies.

A common practice in the area of price advertising is to employ a Minimum Advertised Price (MAP) program, although the same concept could be used for maximum or exact prices. When MAP programs are based on financial incentives, the reseller receives a promotional allowance (e.g., co-op advertising funds) in return for adhering to the appropriate price in advertising, whether in a catalog, over the Internet or otherwise. Many suppliers pay an explicit allowance (e.g., 80% of the cost of an ad); others use an implicit allowance, where failure to follow the program results in increased future prices for the covered products.

Of course, MAP programs that go too far are still subject to attack, as in In re Sony Music Entm't. Inc., No. 971-0070, 2000 WL 689147 (FTC May 10, 2000) and related cases. There, five suppliers of consumer audio recordings each agreed to drop its MAP program when faced with Federal Trade Commission (FTC) enforcement proceedings. Because these cases were settled by consent orders, neither the facts nor binding legal precedent was established. Nevertheless, they provide some guidance, particularly in the rare situation where virtually identical MAP programs are widely used in an industry, they suppress almost all forms of price communication, they have a demonstrated adverse effect on industry pricing and they lack any pro-competitive justification.

Similar to a MAP program is group or shared-price advertising, where the supplier sponsors an ad, but resellers may be listed in it only if they agree to sell at the advertised price during the period indicated. Because resellers may decline participation, this activity also is judged under the rule of reason.

Conclusion

U.S. antitrust law provides suppliers, including franchisors, with powerful tools to control or encourage resale price levels, including resale price policies and minimum advertised price (MAP) programs. Astute adoption, implementation and enforcement are essential to controlling legal risk and enhancing the likelihood of business success.

Author's Note: The analysis for pricing by franchises regarding the sale of services depends on whether the franchisee is performing the services (e.g., residential real estate brokerage) or acting as an agent for franchisor-provided services (e.g., truck and trailer rental). The former is subject to the same standards for pricing as those for the sale of goods, while there is considerably more leeway in this area regarding the latter. This is because, as an agent of the supplier, the law views the sale as occurring directly between the supplier and the end-user. Consequently, the supplier is only setting its own selling price, something that always has been its prerogative.

Eugene F. Zelek is a Partner in the Corporate and Litigation Practice Groups at Freeborn & Peters. He also serves as the Co-Leader of the firm's Antitrust and Trade Regulation Practice Group. He can be reached at 312-360-6777 and [email protected].

A price charged by a franchisee that is too low can adversely affect other franchisees and the franchisor by discouraging the provision of pre- and post-sale services, eroding brand image and jeopardizing the ability to introduce new products by depressing price points. Although relatively rare, a franchisee also may cause marketplace problems by charging too high a price for an attractive, new product in great demand. In addition, wide variations in resale prices among franchisees may make it difficult to implement effective national or regional price advertising.

In the United States, there are two primary methods to address concerns over prices that are outside a desired range ' resale price setting and resale price encouragement.

A key question in each situation (and beyond the scope of this article) is whether there are any specific regulatory parameters ' apart from the general antitrust concerns discussed here ' that limit a supplier's ability to take action on vertical pricing issues. For example, are there franchisee, distributor or dealer protection statutes that limit supplier flexibility? (See, e.g., the Wisconsin Fair Dealership Law (WIS. STAT. '135), which prohibits termination or a change in competitive circumstances of a franchisee, distributor or dealer without cause and opportunity for cure.) Or do federal or state statutes otherwise regulate pricing in the industry involved? While not a regulatory matter, are there limitations in the franchise or distribution contract that ban or inhibit resale price initiatives?

The More Aggressive Approach: Dictating Prices Through Resale Price Setting

One primary method of setting resale prices is by agreement, something that was historically per se illegal under Section 1 of the Sherman Antitrust Act. However, two Supreme Court decisions have turned the traditional federal standard upside down, so that all vertical agreements that set a minimum, maximum or exact resale price are now subject to the more franchisor-friendly rule of reason. See, Leegin Creative Leather Prods. v. PSKS, Inc., 551 U.S. 877 (2007) (minimum prices); State Oil Co. v. Khan, 522 U.S. 3 (1997) (maximum prices). While the Khan case was not controversial, the Leegin decision was. In fact, several states have taken the position that, regardless of the federal approach, minimum resale price agreements remain illegal on their face under state law. These include California, New York, Michigan and Illinois, while Maryland enacted a post-Leegin statute expressly outlawing such agreements.

However, the courts long have recognized another way of establishing resale prices that is outside the price-fixing proscriptions of Section 1. Because this provision covers “every contract, combination ' or conspiracy” in restraint of trade, unilateral actions on the supplier's part are beyond its reach. This principle was established by the Supreme Court in U.S. v. Colgate & Co., 250 U.S. 300 (1919), and various other decisions by the Court have endorsed this approach, including, most recently, Leegin. So far, no state has taken a contrary position, as all state activity in this area has focused on resale price agreements.

As a result, a franchisor or other supplier may announce a price at which one or more of its products must be resold (in the form of a ceiling, floor or exact price policy) and refuse to sell to any franchisee or other reseller which does not comply, as long as there is no agreement between the supplier and the reseller on resale price levels. Even where resellers adhere to the policy, there is no unlawful agreement. Due to the latitude provided by the law, many suppliers of desirable branded products successfully have discouraged the discounting of their products by using policies.

Minimum- or exact-price policies permit suppliers sufficient margin to provide services and other aspects of the selling environment (such as ample inventory) that are consistent with the supplier's objectives, including requirements of the franchise. Such policies are aimed at avoiding the “free-rider effect” or “showrooming,” where some discounting resellers take a free ride on the efforts of others.

Pricing policies may be used to cover everything from a single product to all of the supplier's offerings. In each case, a policy violation requires that the supplier stop selling to the offending reseller. This denial of product access could cover each product involved in the policy violation or an entire product line or all of the supplier's products.

Note that the supplier's pulling all of its products sold to the offender is tantamount to termination and could run afoul of reseller protection laws, so it may be better to stop supplying only some key products, assuming this more limited reaction is practical. In any event, the decision whether to resume selling is the supplier's choice alone, although some cases indicate that warnings, threats and probation are troublesome, because they support the inference that some form of prohibited agreement has been reached.

To make a resale pricing policy work, the supplier must have brand power. If not, the ready availability of substitutes makes the policy toothless. At the same time, highly desirable products are likely targets for discounting anyway, so the necessary power is often present. Indeed, a successful franchisor likely has such power, as otherwise no one would be willing to pay its franchise fees.

While such policies are powerful, the rules for designing, implementing and enforcing them must be carefully followed or the narrow exception to the price-fixing prohibitions of the Sherman Act is lost. This means that any form of agreement must be avoided, so there can be no resale pricing contracts or assurances of compliance. This also means that careful training of supplier personnel who interact with resellers is essential. Just as important, the supplier must be prepared to enforce the policy against its most important customers.

The Less Aggressive Approach: Resale Price Encouragement

Rather than dictating resale prices, some suppliers choose to encourage desirable pricing behavior by providing financial incentives or penalizing violators by denying them access to products. In other words, there is no restriction on the reseller's selling price, only on the price it promotes. These practices are judged under the rule of reason when an agreement is present ( e.g. , Lake Hill Motors, Inc. v. Jim Bennett Yacht Sales, Inc. , 246 F.3d 752, 757 (5th Cir. 2001)), but they also can be imposed by unilateral policy, exempting them from coverage under Sherman Act Section 1. (No state has taken a contrary position.) Of course, regardless of how implemented, the provision of financial incentives is subject to the Robinson-Patman Act, codified at 15 U.S.C. '13 (prohibiting certain forms of discriminatory pricing to competing resellers).

If financial incentives are used, the rational reseller will decide whether it can fare better economically by taking the incentive or foregoing the incentive and selling more product. Therefore, it is essential that the incentive be of sufficient value to result in the supplier's desired effect, although, even then, there may still be leakage, as some resellers may choose to be price disruptors. For this reason, many contemporary price encouragement programs penalize violators by denying product access, much like resale price policies.

A common practice in the area of price advertising is to employ a Minimum Advertised Price (MAP) program, although the same concept could be used for maximum or exact prices. When MAP programs are based on financial incentives, the reseller receives a promotional allowance (e.g., co-op advertising funds) in return for adhering to the appropriate price in advertising, whether in a catalog, over the Internet or otherwise. Many suppliers pay an explicit allowance (e.g., 80% of the cost of an ad); others use an implicit allowance, where failure to follow the program results in increased future prices for the covered products.

Of course, MAP programs that go too far are still subject to attack, as in In re Sony Music Entm't. Inc., No. 971-0070, 2000 WL 689147 (FTC May 10, 2000) and related cases. There, five suppliers of consumer audio recordings each agreed to drop its MAP program when faced with Federal Trade Commission (FTC) enforcement proceedings. Because these cases were settled by consent orders, neither the facts nor binding legal precedent was established. Nevertheless, they provide some guidance, particularly in the rare situation where virtually identical MAP programs are widely used in an industry, they suppress almost all forms of price communication, they have a demonstrated adverse effect on industry pricing and they lack any pro-competitive justification.

Similar to a MAP program is group or shared-price advertising, where the supplier sponsors an ad, but resellers may be listed in it only if they agree to sell at the advertised price during the period indicated. Because resellers may decline participation, this activity also is judged under the rule of reason.

Conclusion

U.S. antitrust law provides suppliers, including franchisors, with powerful tools to control or encourage resale price levels, including resale price policies and minimum advertised price (MAP) programs. Astute adoption, implementation and enforcement are essential to controlling legal risk and enhancing the likelihood of business success.

Author's Note: The analysis for pricing by franchises regarding the sale of services depends on whether the franchisee is performing the services (e.g., residential real estate brokerage) or acting as an agent for franchisor-provided services (e.g., truck and trailer rental). The former is subject to the same standards for pricing as those for the sale of goods, while there is considerably more leeway in this area regarding the latter. This is because, as an agent of the supplier, the law views the sale as occurring directly between the supplier and the end-user. Consequently, the supplier is only setting its own selling price, something that always has been its prerogative.

Eugene F. Zelek is a Partner in the Corporate and Litigation Practice Groups at Freeborn & Peters. He also serves as the Co-Leader of the firm's Antitrust and Trade Regulation Practice Group. He can be reached at 312-360-6777 and [email protected].