Navigating Hong Kong's Competition Law – Competition Issues In Franchise Agreements

Franchise agreements are commonplace in Hong Kong across many industries and must comply with the competition rules in the Competition Ordinance (Ordinance). Franchise agreements will inevitably impose restrictions on how a franchisee can do business in order to legitimately protect the franchisor's brand, know-how and expertise. However excessive control by the franchisor, which has the object or effect of harming competition, can breach a number of competition rules. This alert considers a number of key issues for parties to a franchise agreement to consider.

What is a franchise agreement?

A franchise agreement is a contract by which a business (franchisor) consents to provide its brand, operational model and necessary support to an independent business (franchisee) to run a similar business usually in exchange for a fee or royalty. The franchisor benefits from faster expansion, scalability and more effective market penetration and a franchisee which has limited resources benefits from quick market entry and the right to use and operate an established brand and business.

What competition laws do franchisors and franchisees need to have front of mind?

The Ordinance recognises that franchisors may take measures necessary to maintain the identity and reputation of the franchise network and which are essential to protect the franchisor's IP and know-how. Any measures that are directly related to and necessary for the implementation of the franchise agreement will not breach the Ordinance.

Excessive restrictions, and those that are not directly related to the franchise agreement, risk breaching the competition rules. We have identified some of the most common restrictions that can fall foul of the competition law rules if not carefully considered from a competition law perspective:

1. Resale Price Maintenance

Resale Price Maintenance (RPM) arises when a franchisor requires a franchisee to resell goods or services at a fixed or minimum resale price. RPM falls under the Ordinance's First Conduct Rule (FCR), which prohibits an agreement or arrangement between two parties that has the object or effect of harming competition in Hong Kong (more on RPM and this competition rule here and here). There is no exception from the prohibition against RPM for franchise agreements. The Commission's guidelines indicate that it will take a hard line on RPM and therefore any control a franchisor exercises over a franchisee's ability to set prices is at high risk of breaching the FCR. A franchisor is not prevented from providing franchisees with a recommended price list and is permitted to set a maximum price for goods or services.

2. Obligation to not-compete during a franchise agreement or once it has ended

The Ordinance acknowledges that restrictions which have the objective of maintaining the identity and reputation of the franchise network, such as restricting a franchisee's operations to a particular territory or preventing the franchisee from selling competing goods, will not breach the FCR. A franchisor may also impose a non-compete that prevents the franchisee from competing once the franchise agreement has ended. A non-compete that is overzealous in scope and/or duration, and goes further than is reasonably necessary to protect the franchisor's legitimate business interests, is, however, likely to breach the FCR.

3. Restricting from whom franchisees can source supply or to whom they can sell

A franchisor may require franchisees to purchase goods or services from the franchisor, a related company, a particular supplier or a list of nominated suppliers. The Ordinance does not prohibit such arrangements unless they have the object or effect of harming competition in Hong Kong. You can find out more on exclusive dealing here.

Franchisors, especially those with large market shares, who seek to restrict the parties with whom franchisees can deal should always seek specialist competition law advice to ensure that such restrictions will not breach the Ordinance by reason of their impact on competition.

Consequences of breaching the Ordinance

All franchisors need to be aware of Hong Kong's competition laws as any restriction that is illegal will be unenforceable. Further, the Competition Commission may bring proceedings before the Competition Tribunal, and if the franchisor is found to have breached the Ordinance, it may be required to pay pecuniary penalties and damages to an affected person if a private follow-on action is also brought.

Interested in other aspects of Hong Kong's Competition Law?

You may be interested in reading other related fact sheets in this series, such as those that cover the First Conduct Rule, the Second Conduct Rule, Resale Price Maintenance, Exclusive Dealing, the Role of the Competition Commission vs the Role of the Competition, Penalties, Damages and Remedies, and Follow-on Actions.