THE CHAINS THAT BIND

What franchise buyers need to know about supply-chain rules, particularly those that apply within their franchise system.

What you need to know about supply-chain rules.

Franchise businesses are all about the supply of goods and services to end customers, but there are also supply chains within the franchise system – a franchisee may have goods and services supplied from the franchisor, related companies and third-party “approved” suppliers.

If you are assessing a potential franchised business, you need to be aware of how these supply relationships work and what rules apply to the supplies you receive and the supplies you make.

Competition law is a complex issue, but here are some simple explanations of common concepts. Particular situations may need more investigation and advice.

Regarding the supply of goods and services from the franchisor, many franchise systems require franchisees to buy goods or services from the franchisor or a related company.

There are several reasons for this. Firstly, it allows franchisors to have a separate supply business with its own income stream, or it gives the franchisor company an extra income stream. `

FAIRLY RARE

For example, in a coffee franchise your franchisor may supply you with the branded coffee beans and require you to only use those in the business. The franchisor would be reasonably expected to charge a margin on the cost price of manufacturing and supplying the beans. This margin might be another cost on top of royalties or other fees payable to the franchisor, and while there are some purely “product-based” franchises where the margin on sales to the franchisee is the franchisor’s only revenue, this is fairly rare.

As well as extra revenue, a reason for forcing franchisees to use the franchisor’s product may be that the supply of that product is the essence of the franchise system. The franchise business is identified with the supply of the particular product to customers.

Finally, franchisors may prefer to control the supply directly to franchisees as it allows for them to harness greater buying power from their suppliers and to

ensure quality.

As well as stock, franchisors commonly supply and require franchisees to accept specified training and business support or advice. The forced supply by franchisors to franchisees of the franchisor’s own goods and services is completely legal even if the supplier is a related company such as a holding company of the franchisor.

THIRD-LINE FORCING

Most commonly franchisors require their franchisees to buy goods and services from unrelated suppliers they approve. In the cafe example, this might be the coffee beans but it also might include the coffee cups, the coffee machine or POS software. It could cover business services such as bookkeeping, the payroll or equipment maintenance.

Where the franchisor is not supplying the goods and services but requires its franchisees to buy from a third party it is usually known by lawyers as “thirdline forcing”. This concept has had a difficult history in Australian franchising. Originally it was completely prohibited, although many considered it central to the very concept of franchising. How would McDonald’s ensure its Big Mac was the same worldwide if it did not force the franchisees to all buy the same buns, meat patties and other ingredients? Ensuring quality and consistency is the usual reasoning for these requirements.

The ACCC has permitted franchisors to impose third-line forcing where it has been formally notified of the proposed conduct. This led to most franchisors submitting multiple formal notifications to the ACCC for this permission. Under these notifications, the franchisors must justify their use of third-line forcing.

These notifications can be accessed on the public register on the ACCC website, and by searching the franchisor name you may find considerable information about the suppliers and supply requirements of the system.

At the end of last year the law was amended to prohibit only thirdline forcing where it has the purpose or effect of “substantially lessening competition”.

PRECAUTION

In many cases, this will mean a notification to the ACCC is no longer needed to impose third-line forcing. In our hypothetical cafe franchise, requiring the franchisees to buy coffee beans from a particular roaster is unlikely to substantially lessen competition in the wholesale roasted coffee bean market. If the franchisor has any doubt as to the competitive effect it can always just notify the ACCC as was previously the case. In fact, many will still do this as a precaution.

Many franchisees question the practice of suppliers paying rebates to franchisors based on the purchases of stock by the franchisees. The law permits this practice provided information is given in the franchise disclosure document (item 10). The name of the supplier and whether the franchisees will benefit from the rebates must be advised, but the actual details of the rebate paid does not have to be disclosed.

The rebate may be kept by the franchisor as another form of revenue toward its general business costs, or it may choose to pay it to a marketing fund or allocate it for particular expenditure. Approved suppliers are also often called upon to pay amounts to help fund conferences or promotional or training expenses.

Prospective franchisees should query the franchisor about how the rebates work in their system.

TO BE ENCOURAGED

Generally in Australia it is illegal for a supplier to require its business customer to sell the supplied goods at a fixed or minimum price. This is known as “resale price maintenance”. You should be able to offer your customers a discount even if the price at which you sell your goods is less than what you paid for them. It is in the interests of Australian consumers that discounting among competitors be encouraged.

For the same reason, business competitors are not allowed to conspire to agree to the same prices. This is price fixing and it means the consumer has to pay artificially high prices.

Franchisors will usually set maximum prices (not minimum), which is lawful even if they are the supplier or where they compete with their franchisees. It also allows them to advertise a price that is consistent across the system (or at least not lower than that being charged by franchisees).

Overall, this is a simple explanation of a complex area of law, but intending franchise buyers should examine the documents provided, seek legal advice and ask questions as to the processes and requirements for obtaining supplies and setting prices.