Routes to Market Series: Competition

When appointing a distributor, it is vital to ensure that the distribution agreement complies with competition law. Getting this wrong can result in significant fines and lead to reputational harm.

Vertical agreements

In competition law parlance, a distribution agreement is what is known as a ‘vertical agreement’. This is because it is made between a supplier and a distributor operating at different levels of the supply chain. The supplier sells down to the distributor and the distributor sells on to retailers or consumers further down the chain.

Distribution arrangements can be complex. A supplier may operate an exclusive distribution system, a selective distribution system, an open distribution system, or a combination of these. If it has granted some degree of territorial exclusivity to a particular distributor, it will want to limit other distributors’ access to that territory. It will also want to protect its brand by ensuring that its distributors are meeting certain quality standards and by restricting how its distributors may work with competitor brands or other, unauthorised distributors.

However, certain obligations and restrictions can go too far and breach competition law. So, it is important to ensure that the contractual obligations and restrictions are drafted carefully to ensure they are compatible with applicable competition laws. This has been complicated somewhat by Brexit because suppliers appointing a distributor in the UK may need to take into account both the UK and the EU competition law regimes.

There are some red lines that cannot be crossed, such as granting absolute territorial protection to a distributor or imposing fixed or minimum resale prices. These are examples of practices that competition authorities consider so injurious to competition as to justify significant fines, regardless of their actual effects on competition. Fines for breaching UK competition law can be up to 10% of worldwide turnover for the previous business year.

Safe harbour

Helpfully, competition law takes into account that some vertical agreements may have little or no real impact on competition. Under both UK and EU regimes, there is a ‘safe harbour’ available where the parties involved do not have a significant share of the relevant market and where the agreement between the parties does not contain certain ‘hardcore’ or ‘excluded’ restrictions.

In the UK, this safe harbour is set out in the Competition Act 1998 (Vertical Agreements Block Exemption) Order 2022 (‘VABEO’). To fall within the scope of the UK safe harbour, the parties and the agreement must meet certain cumulative conditions. The conditions are set out in the VABEO but are explained in more detail in the CMA Guidance on the Vertical Agreements Block Exemption Order (‘CMA Guidance’). Although the CMA Guidance is non-binding, it is nevertheless a very important aid to understanding whether an agreement may be protected by the VABEO and should always be considered alongside the VABEO.

Broadly, the conditions are as follows:

1. The market share of each party must not exceed 30%

This means that the supplier’s share of the market on which it sells the goods must not exceed 30% and the distributor’s share of the market on which it buys the goods must not exceed 30%. Below the 30% level, there is a presumption that the parties lack market power and that the agreement between them will not affect competition. Assessing a party’s market share can be a complex process because this requires a detailed analysis of the relevant product and geographic markets and it often requires input from econometrists.

It must also be remembered that the VABEO is only intended to apply to ‘vertical agreements’, i.e. between parties operating at different levels of the supply chain. Consequently, it would not apply to an agreement between competitors as that would be treated as a ‘horizontal agreement’. However, subject to certain conditions, the VABEO can apply to ‘dual distribution’, which is where a supplier sells both through its own sales outlets and through independent distributors. The VABEO will only apply to dual distribution in certain non-reciprocal situations, such as where the supplier is either a manufacturer, wholesaler or importer and is also a distributor of goods, while the buyer is only a distributor that does not compete with the manufacturer, wholesaler or importer at the relevant upstream level.

2. The agreement must not contain ‘hardcore restrictions’

If the agreement contains so-called hardcore restrictions, the entire agreement loses the benefit of the safe harbour. Hardcore restrictions would include resale price maintenance obligations which require a distributor to sell at prices specified by the supplier and total export bans preventing a distributor from selling to customers outside their designated territory. There are some significant watchouts to be aware of:

Price fixing or resale price maintenance: The VABEO treats resale price maintenance as a hardcore restriction. This will apply to any agreement or practice requiring a distributor to adhere to price levels set by the supplier. A supplier may impose a maximum resale price or a recommended resale price, as long as these don’t equate to fixed prices – the distributor must always be free to set its own prices.

Territorial/customer restrictions: The general principle is that a distributor must be free to decide where and to whom it sells the contract goods and any restriction on this is considered a hardcore restriction. However, the VABEO provides certain exceptions to this principle which vary depending on whether the supplier is operating an exclusive, selective or open distribution system. For example, where a supplier operates a selective distribution system, it can prohibit a distributor from making active sales or passive sales to unauthorised distributors located in the geographical area where the supplier operates the selective distribution system. In an exclusive distribution system, where a supplier has reserved a territory to one or more exclusive distributors, it can restrict other distributors from making active sales into the reserved territory but it cannot restrict passive (i.e. unsolicited) sales into that territory. Generally speaking, there are very few circumstances in which it is lawful to restrict distributors from making passive sales so, if an agreement contains a restriction on passive sales, this will require very careful consideration.

Parity obligations: The VABEO defines a ‘wide retail parity obligation’ as a restriction ensuring that the prices (or other terms) at which a supplier sells its goods on a sales channel (online or offline) are no worse than those offered by the supplier on another channel. The VABEO treats wide retail parity obligations as hardcore restrictions. By contrast, narrow retail parity obligations which apply only to the supplier's direct sales channels (e.g. its own website) can benefit from the safe harbour.

3. The agreement must not contain ‘excluded restrictions’ that cannot be severed

If the agreement contains excluded restrictions, these restrictions will fall outside the safe harbour but the rest of the agreement can still benefit. In the UK, non-compete clauses that are tacitly renewable beyond five years will be considered ‘excluded restrictions’ and will fall outside the scope of the safe harbour. This is because they are deemed to be concluded for an indefinite period.

Excluded restrictions also include obligations preventing a distributor from dealing in any goods after termination and obligations preventing a member of a selective distribution system from selling the brands of particular competing suppliers.

If the conditions set out in the VABEO are met, an agreement can benefit from the safe harbour. However, it is important to remember that vertical agreements that do not satisfy the conditions are not automatically in breach of competition law. Instead, they must be considered on a case-by-case basis to assess their pro-competitive and anti-competitive effects by reference to all the relevant circumstances.

Finally, even when appointing a distributor in the UK, it is essential to consider whether the agreement might have an effect on trade in the EU. This is because EU competition law has extra-territorial effect. If so, it will be necessary to factor in EU competition law – which is stricter in some areas and less so in others – and, if possible, to draft the agreement to comply with the requirements of the EU safe harbour.