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Today the International Center for Law & Economics (ICLE) submitted an amicus brief to the Supreme Court of the United States supporting Apple’s petition for certiorari in its e-books antitrust case. ICLE’s brief was signed by sixteen distinguished scholars of law, economics and public policy, including an Economics Nobel Laureate, a former FTC Commissioner, ten PhD economists and ten professors of law (see the complete list, below).

Background

Earlier this year a divided panel of the Second Circuit ruled that Apple “orchestrated a conspiracy among [five major book] publishers to raise ebook prices… in violation of § 1 of the Sherman Act.” Significantly, the court ruled that Apple’s conduct constituted a per se unlawful horizontal price-fixing conspiracy, meaning that the procompetitive benefits of Apple’s entry into the e-books market was irrelevant to the liability determination.

Apple filed a petition for certiorari with the Supreme Court seeking review of the ruling on the question of

Whether vertical conduct by a disruptive market entrant, aimed at securing suppliers for a new retail platform, should be condemned as per se illegal under Section 1 of the Sherman Act, rather than analyzed under the rule of reason, because such vertical activity also had the alleged effect of facilitating horizontal collusion among the suppliers.

Summary of Amicus Brief

The Second Circuit’s ruling is in direct conflict with the Supreme Court’s 2007 Leegin decision, and creates a circuit split with the Third Circuit based on that court’s Toledo Mack ruling. ICLE’s brief urges the Court to review the case in order to resolve the significant uncertainty created by the Second Circuit’s ruling, particularly for the multi-sided platform companies that epitomize the “New Economy.”

As ICLE’s brief discusses, the Second Circuit committed several important errors in its ruling:

First, As the Supreme Court held in Leegin, condemnation under the per se rule is appropriate “only for conduct that would always or almost always tend to restrict competition” and “only after courts have had considerable experience with the type of restraint at issue.” Neither is true in this case. Businesses often employ one or more forms of vertical restraints to make entry viable, and the Court has blessed such conduct, categorically holding in Leegin that “[v]ertical price restraints are to be judged according to the rule of reason.”

Furthermore, the conduct at issue in this case — the use of “Most-Favored Nation Clauses” in Apple’s contracts with the publishers and its adoption of the so-called “agency model” for e-book pricing — have never been reviewed by the courts in a setting like this one, let alone found to “always or almost always tend to restrict competition.” There is no support in the case law or economic literature for the proposition that agency models or MFNs used to facilitate entry by new competitors in platform markets like this one are anticompetitive.

Second, the negative consequences of the court’s ruling will be particularly acute for modern, high-technology sectors of the economy, where entrepreneurs planning to deploy new business models will now face exactly the sort of artificial deterrents that the Court condemned in Trinko: “Mistaken inferences and the resulting false condemnations are especially costly, because they chill the very conduct the antitrust laws are designed to protect.” Absent review by the Supreme Court to correct the Second Circuit’s error, the result will be less-vigorous competition and a reduction in consumer welfare.

This case involves vertical conduct essentially indistinguishable from conduct that the Supreme Court has held to be subject to the rule of reason. But under the Second Circuit’s approach, the adoption of these sorts of efficient vertical restraints could be challenged as a per se unlawful effort to “facilitate” horizontal price fixing, significantly deterring their use. The lower court thus ignored the Supreme Court’s admonishment not to apply the antitrust laws in a way that makes the use of a particular business model “more attractive based on the per se rule” rather than on “real market conditions.”

Third, the court based its decision that per se review was appropriate largely on the fact that e-book prices increased following Apple’s entry into the market. But, contrary to the court’s suggestion, it has long been settled that such price increases do not make conduct per se unlawful. In fact, the Supreme Court has held that the per se rule is inappropriate where, as here, “prices can be increased in the course of promoting procompetitive effects.”  

Competition occurs on many dimensions other than just price; higher prices alone don’t necessarily suggest decreased competition or anticompetitive effects. Instead, higher prices may accompany welfare-enhancing competition on the merits, resulting in greater investment in product quality, reputation, innovation or distribution mechanisms.

The Second Circuit presumed that Amazon’s e-book prices before Apple’s entry were competitive, and thus that the price increases were anticompetitive. But there is no support in the record for that presumption, and it is not compelled by economic reasoning. In fact, it is at least as likely that the change in Amazon’s prices reflected the fact that Amazon’s business model pre-entry resulted in artificially low prices, and that the price increases following Apple’s entry were the product of a more competitive market.

Previous commentary on the case

For my previous writing and commentary on the the case, see:

  • “The Second Circuit’s Apple e-books decision: Debating the merits and the meaning,” American Bar Association debate with Fiona Scott-Morton, DOJ Chief Economist during the Apple trial, and Mark Ryan, the DOJ’s lead litigator in the case, recording here
  • Why I think the Apple e-books antitrust decision will (or at least should) be overturned, Truth on the Market, here
  • Why I think the government will have a tough time winning the Apple e-books antitrust case, Truth on the Market, here
  • The procompetitive story that could undermine the DOJ’s e-books antitrust case against Apple, Truth on the Market, here
  • How Apple can defeat the DOJ’s e-book antitrust suit, Forbes, here
  • The US e-books case against Apple: The procompetitive story, special issue of Concurrences on “E-books and the Boundaries of Antitrust,” here
  • Amazon vs. Macmillan: It’s all about control, Truth on the Market, here

Other TOTM authors have also weighed in. See, e.g.:

  • The Second Circuit Misapplies the Per Se Rule in U.S. v. Apple, Alden Abbott, here
  • The Apple E-Book Kerfuffle Meets Alfred Marshall’s Principles of Economics, Josh Wright, here
  • Apple and Amazon E-Book Most Favored Nation Clauses, Josh Wright, here

Amicus Signatories

  • Babette E. Boliek, Associate Professor of Law, Pepperdine University School of Law
  • Henry N. Butler, Dean and Professor of Law, George Mason University School of Law
  • Justin (Gus) Hurwitz, Assistant Professor of Law, Nebraska College of Law
  • Stan Liebowitz, Ashbel Smith Professor of Economics, School of Management, University of Texas-Dallas
  • Geoffrey A. Manne, Executive Director, International Center for Law & Economics
  • Scott E. Masten, Professor of Business Economics & Public Policy, Stephen M. Ross School of Business, The University of Michigan
  • Alan J. Meese, Ball Professor of Law, William & Mary Law School
  • Thomas D. Morgan, Professor Emeritus, George Washington University Law School
  • David S. Olson, Associate Professor of Law, Boston College Law School
  • Joanna Shepherd, Professor of Law, Emory University School of Law
  • Vernon L. Smith, George L. Argyros Endowed Chair in Finance and Economics,  The George L. Argyros School of Business and Economics and Professor of Economics and Law, Dale E. Fowler School of Law, Chapman University
  • Michael E. Sykuta, Associate Professor, Division of Applied Social Sciences, University of Missouri-Columbia
  • Alex Tabarrok, Bartley J. Madden Chair in Economics at the Mercatus Center and Professor of Economics, George Mason University
  • David J. Teece, Thomas W. Tusher Professor in Global Business and Director, Center for Global Strategy and Governance, Haas School of Business, University of California Berkeley
  • Alexander Volokh, Associate Professor of Law, Emory University School of Law
  • Joshua D. Wright, Professor of Law, George Mason University School of Law

On October 7, 2015, the Senate Judiciary Committee held a hearing on the “Standard Merger and Acquisition Reviews Through Equal Rules” (SMARTER) Act of 2015.  As former Antitrust Modernization Commission Chair (and former Acting Assistant Attorney General for Antitrust) Deborah Garza explained in her testimony, “t]he premise of the SMARTER Act is simple:  A merger should not be treated differently depending on which antitrust enforcement agency – DOJ or the FTC – happens to review it.  Regulatory outcomes should not be determined by a flip of the merger agency coin.”

Ms. Garza is clearly correct.  Both the U.S. Justice Department (DOJ) and the U.S. Federal Trade Commission (FTC) enforce the federal antitrust merger review provision, Section 7 of the Clayton Act, and employ a common set of substantive guidelines (last revised in 2010) to evaluate merger proposals.  Neutral “rule of law” principles indicate that private parties should expect to have their proposed mergers subject to the same methods of assessment and an identical standard of judicial review, regardless of which agency reviews a particular transaction.  (The two agencies decide by mutual agreement which agency will review any given merger proposal.)

Unfortunately, however, that is not the case today.  The FTC’s independent ability to challenge mergers administratively, combined with the difference in statutory injunctive standards that apply to FTC and DOJ merger reviews, mean that a particular merger application may face more formidable hurdles if reviewed by the FTC, rather than DOJ.  These two differences commendably would be eliminated by the SMARTER Act, which would subject the FTC to current DOJ standards.  The SMARTER Act would not deal with a third difference – the fact that DOJ merger consent decrees, but not FTC merger consent decrees, must be filed with a federal court for “public interest” review.  This commentary briefly addresses those three issues.  The first and second ones present significant “rule of law” problems, in that they involve differences in statutory language applied to the same conduct.  The third issue, the question of judicial review of settlements, is of a different nature, but nevertheless raises substantial policy concerns.

  1. FTC Administrative Authority

The first rule of law problem stems from the broader statutory authority the FTC possesses to challenge mergers.  In merger cases, while DOJ typically consolidates actions for a preliminary and permanent injunction in district court, the FTC merely seeks a preliminary injunction (which is easier to obtain than a permanent injunction) and “holds in its back pocket” the ability to challenge a merger in an FTC administrative proceeding – a power DOJ does not possess.  In short, the FTC subjects proposed mergers to a different and more onerous method of assessment than DOJ.  In Ms. Garza’s words (footnotes deleted):

“Despite the FTC’s legal ability to seek permanent relief from the district court, it prefers to seek a preliminary injunction only, to preserve the status quo while it proceeds with its administrative litigation.

This approach has great strategic significance. First, the standard for obtaining a preliminary injunction in government merger challenges is lower than the standard for obtaining a permanent injunction. That is, it is easier to get a preliminary injunction.

Second, as a practical matter, the grant of a preliminary injunction is typically sufficient to end the matter. In nearly every case, the parties will abandon their transaction rather than incur the heavy cost and uncertainty of trying to hold the merger together through further proceedings—which is why merging parties typically seek to consolidate proceedings for preliminary and permanent relief under Rule 65(a)(2). Time is of the essence. As one witness testified before the [Antitrust Modernization Commission], “it is a rare seller whose business can withstand the destabilizing effect of a year or more of uncertainty” after the issuance of a preliminary injunction.

Third, even if the court denies the FTC its preliminary injunction and the parties close their merger, the FTC can still continue to pursue an administrative challenge with an eye to undoing or restructuring the transaction. This is the “heads I win, tails you lose” aspect of the situation today. It is very difficult for the parties to get to the point of a full hearing in court given the effect of time on transactions, even with the FTC’s expedited administrative procedures adopted in about 2008. . . . 

[Moreover,] [while] [u]nder its new procedures, parties can move to dismiss an administrative proceeding if the FTC has lost a motion for preliminary injunction and the FTC will consider whether to proceed on a case-by-case basis[,] . . . th[is] [FTC] policy could just as easily change again, unless Congress speaks.”

Typically time is of the essence in proposed mergers, so substantial delays occasioned by extended reviews of those transactions may prevent many transactions from being consummated, even if they eventually would have passed antitrust muster.  Ms. Garza’s testimony, plus testimony by former Assistant Deputy Assistant Attorney General for Antitrust Abbott (Tad) Lipsky, document cases of substantial delay in FTC administrative reviews of merger proposals.  (As Mr. Lipsky explained, “[a]ntitrust practitioners have long perceived that the possibility of continued administrative litigation by the FTC following a court decision constitutes a significant disincentive for parties to invest resources in transaction planning and execution.”)  Congress should weigh these delay-specific costs, as well as the direct costs of any additional burdens occasioned by FTC administrative procedures, in deciding whether to require the FTC (like DOJ) to rely solely on federal court proceedings.

  1. Differences Between FTC and DOJ Injunctive Standards

The second rule of law problem arises from the lighter burden the FTC must satisfy to obtain injunctive relief in federal court.  Under Section 13(b) of the FTC Act, an injunction shall be granted the FTC “[u]pon a proper showing that, weighing the equities and considering the Commission’s likelihood of success, such action would be in the public interest.”  The D.C. Circuit (in FTC v. H.J. Heinz Co. and in FTC v. Whole Foods Market, Inc.) has stated that, to meet this burden, the FTC need merely have raised questions “so serious, substantial, difficult and doubtful as to make them fair ground for further investigation.”  By contrast, as Ms. Garza’s testimony points out, “under Section 15 of the Clayton Act, courts generally apply a traditional equities test requiring DOJ to show a reasonable likelihood of success on the merits—not merely that there is ‘fair ground for further investigation.’”  In a similar vein, Mr. Lipsky’s testimony stated that “[t]he cumulative effect of several recent contested merger decisions has been to allow the FTC to argue that it needn’t show likelihood of success in order to win a preliminary injunction; specifically these decisions suggest that the Commission need only show ‘serious, substantial, difficult and doubtful’ questions regarding the merits.”  Although some commentators have contended that, in reality, the two standards generally will be interpreted in a similar fashion (“whatever theoretical difference might exist between the FTC and DOJ standards has no practical significance”), there is no doubt that the language of the two standards is different – and basic principles of statutory construction indicate that differences in statutory language should be given meaning and not ignored.  Accordingly, merging parties face the real prospect that they might fare worse under federal court review of an FTC challenge to their merger proposal than they would have fared had DOJ challenged the same transaction.  Such an outcome, even if it is rare, would be at odds with neutral application of the rule of law.

  1. The Tunney Act

Finally, helpful as it is, the SMARTER Act does not entirely eliminate the disparate treatment of proposed mergers by DOJ and the FTC.  The Tunney Act, 15 U.S.C. § 16, enacted in 1974, which applies to DOJ but not to the FTC, requires that DOJ submit all proposed consent judgments under the antitrust laws (including Section 7 of the Clayton Act) to a federal district court for 60 days of public comment prior to being entered.

a.  Economic Costs (and Potential Benefits) of the Tunney Act

The Tunney Act potentially interjects uncertainty into the nature of the “deal” struck between merging parties and DOJ in merger cases.  It does this by subjecting proposed DOJ merger settlements (and other DOJ non-merger civil antitrust settlements) to a 60 day public review period, requiring federal judges to determine whether a proposed settlement is “in the public interest” before entering it, and instructing the court to consider the impact of the entry of judgment “upon competition and upon the public generally.”  Leading antitrust practitioners have noted that this uncertainty “could affect shareholders, customers, or even employees. Moreover, the merged company must devote some measure of resources to dealing with the Tunney Act review—resources that instead could be devoted to further integration of the two companies or generation of any planned efficiencies or synergies.”  More specifically:

“[W]hile Tunney Act proceedings are pending, a merged company may have to consider how its post-close actions and integration could be perceived by the court, and may feel the need to compete somewhat less aggressively, lest its more muscular competitive actions be taken by the court, amici, or the public at large to be the actions of a merged company exercising enhanced market power. Such a distortion in conduct probably was not contemplated by the Tunney Act’s drafters, but merger partners will need to be cognizant of how their post-close actions may be perceived during Tunney Act review. . . .  [And, in addition,] while Tunney Act proceedings are pending, a merged company may have to consider how its post-close actions and integration could be perceived by the court, and may feel the need to compete somewhat less aggressively, lest its more muscular competitive actions be taken by the court, amici, or the public at large to be the actions of a merged company exercising enhanced market power.”

Although the Tunney Act has been justified on traditional “public interest” grounds, even its scholarly supporters (a DOJ antitrust attorney), in praising its purported benefits, have acknowledged its potential for abuse:

“Properly interpreted and applied, the Tunney Act serves a number of related, useful functions. The disclosure provisions and judicial approval requirement for decrees can help identify, and more importantly deter, “influence peddling” and other abuses. The notice-and-comment procedures force the DOJ to explain its rationale for the settlement and provide its answers to objections, thus providing transparency. They also provide a mechanism for third-party input, and, thus, a way to identify and correct potentially unnoticed problems in a decree. Finally, the court’s public interest review not only helps ensure that the decree benefits the public, it also allows the court to protect itself against ambiguous provisions and enforcement problems and against an objectionable or pointless employment of judicial power. Improperly applied, the Tunney Act does more harm than good. When a district court takes it upon itself to investigate allegations not contained in a complaint, or attempts to “re-settle” a case to provide what it views as stronger, better relief, or permits lengthy, unfocused proceedings, the Act is turned from a useful check to an unpredictable, costly burden.”

The justifications presented by the author are open to serious question.  Whether “influence peddling” can be detected merely from the filing of proposed decree terms is doubtful – corrupt deals to settle a matter presumably would be done “behind the scenes” in a manner not available to public scrutiny.  The economic expertise and detailed factual knowledge that informs a DOJ merger settlement cannot be fully absorbed by a judge (who may fall prey to his or her personal predilections as to what constitutes good policy) during a brief review period.  “Transparency” that facilitates “third-party input” can too easily be manipulated by rent-seeking competitors who will “trump up” justifications for blocking an efficient merger.  Moreover, third parties who are opposed to mergers in general may also be expected to file objections to efficient arrangements.  In short, the “sunshine” justification for Tunney Act filings is more likely to cloud the evaluation of DOJ policy calls than to provide clarity.

b.  Constitutional Issues Raised by the Tunney Act

In addition to potential economic inefficiencies, the judicial review feature of the Tunney Act raises serious separation of powers issues, as emphasized by the DOJ Office of Legal Counsel (OLC, which advises the Attorney General and the President on questions of constitutional interpretation) in a 1989 opinion regarding qui tam provisions of the False Claims Act:

“There are very serious doubts as to the constitutionality . . . of the Tunney Act:  it intrudes into the Executive power and requires the courts to decide upon the public interest – that is, to exercise a policy discretion normally reserved to the political branches.  Three Justices of the Supreme Court questioned the constitutionality of the Tunney Act in Maryland v. United States, 460 U.S. 1001 (1983) (Rehnquist, J., joined by Burger, C.J., and White, J., dissenting).”

Notably, this DOJ critique of the Tunney Act was written before the 2004 amendments to that statute that specifically empower courts to consider the impact of proposed settlements “upon competition and upon the public generally” – language that significantly trenches upon Executive Branch prerogatives.  Admittedly, the Tunney Act has withstood judicial scrutiny – no court has ruled it unconstitutional.   Moreover, a federal judge can only accept or reject a Tunney Act settlement, not rewrite it, somewhat ameliorating its affront to the separation of powers.  In short, even though it may not be subject to serious constitutional challenge in the courts, the Tunney Act is problematic as a matter of sound constitutional policy.

c.  Congressional Reexamination of the Tunney Act

These economic and constitutional policy concerns suggest that Congress may wish to carefully reexamine the merits of the Tunney Act.  Any such reexamination, however, should be independent of, and not delay expedited consideration of, the SMARTER Act.  The Tunney Act, although of undoubted significance, is only a tangential aspect of the divergent legal standards that apply to FTC and DOJ merger reviews.  It is beyond the scope of current legislative proposals but it merits being taken up at an appropriate time – perhaps in the next Congress.  When Congress turns to the Tunney Act, it may wish to consider four options:  (1) repealing the Act in its entirety; (2) retaining the Act as is; (3) partially repealing it only with respect to merger reviews; or, (4) applying it in full force to the FTC.  A detailed evaluation of those options is beyond the scope of this commentary.

Conclusion

In sum, in order to eliminate inconsistencies between FTC and DOJ standards for reviewing proposed mergers, Congress should give serious consideration to enacting the SMARTER Act, which would both eliminate FTC administrative review of merger proposals and subject the FTC to the same injunctive standard as the DOJ in judicial review of those proposals.  Moreover, if the SMARTER Act is enacted, Congress should also consider going further and amending the Tunney Act to make it apply to FTC as well as to DOJ merger settlements – or, alternatively, to have it not apply at all to any merger settlements (a result which would better respect the constitutional separation of powers and reduce a potential source of economic inefficiency).

Applying antitrust law to combat “hold-up” attempts (involving demands for “anticompetitively excessive” royalties) or injunctive actions brought by standard essential patent (SEP) owners is inherently problematic, as explained by multiple scholars (see here and here, for example).  Disputes regarding compensation to SEP holders are better handled in patent infringement and breach of contract lawsuits, and adding antitrust to the mix imposes unnecessary costs and may undermine involvement in standard setting and harm innovation.  What’s more, as FTC Commissioner Maureen Ohlhausen and former FTC Commissioner Joshua Wright have pointed out (citing research), empirical evidence suggests there is no systematic problem with hold-up.  Indeed, to the contrary, a recent empirical study by Professors from Stanford, Berkeley, and the University of the Andes, accepted for publication in the Journal of Competition Law and Economics, finds that SEP-reliant industries have the fastest quality-adjusted price declines in the U.S. economy – a result totally at odds with theories of SEP-related competitive harm.  Thus, application of a cost-benefit approach that seeks to maximize the welfare benefits of antitrust enforcement strongly militates against continuing to pursue “SEP abuse” cases.  Enforcers should instead focus on more traditional investigations that seek to ferret out conduct that is far more likely to be welfare-inimical, if they are truly concerned about maximizing consumer welfare.

But are the leaders at the U.S. Department of Justice Antitrust Division (DOJ) and the Federal Trade paying any attention?  The most recent public reports are not encouraging.

In a very recent filing with the U.S. International Trade Commission (ITC), FTC Chairwoman Edith Ramirez stated that “the danger that bargaining conducted in the shadow of an [ITC] exclusion order will lead to patent hold-up is real.”  (Comparable to injunctions, ITC exclusion orders preclude the importation of items that infringe U.S. patents.  They are the only effective remedy the ITC can give for patent infringement, since the ITC cannot assess damages or royalties.)  She thus argued that, before issuing an exclusion order, the ITC should require an SEP holder to show that the infringer is unwilling or unable to enter into a patent license on “fair, reasonable, and non-discriminatory” (FRAND) terms – a new and major burden on the vindication of patent rights.  In justifying this burden, Chairwoman Ramirez pointed to Motorola’s allegedly excessive SEP royalty demands from Microsoft – $6-$8 per gaming console, as opposed to a federal district court finding that pennies per console was the appropriate amount.  She also cited LSI Semiconductor’s demand for royalties that exceeded the selling price of Realtek’s standard-compliant product, whereas a federal district court found the appropriate royalty to be only .19% of the product’s selling price.  But these two examples do not support Chairwoman Ramirez’s point – quite the contrary.  The fact that high initial royalty requests subsequently are slashed by patent courts shows that the patent litigation system is working, not that antitrust enforcement is needed, or that a special burden of proof must be placed on SEP holders.  Moreover, differences in bargaining positions are to be expected as part of the normal back-and-forth of bargaining.  Indeed, if anything, the extremely modest judicial royalty assessments in these cases raise the concern that SEP holders are being undercompensated, not overcompensated.

A recent speech by DOJ Assistant Attorney General for Antitrust (AAG) William J. Baer, delivered at the International Bar Association’s Competition Conference, suffers from the same sort of misunderstanding as Chairman Ramirez’s ITC filing.  Stating that “[h]old up concerns are real”, AAG Baer cited the two examples described by Chairwoman Ramirez.  He also mentioned the fact that Innovatio requested a royalty rate of over $16 per smart tablet for its SEP portfolio, but was awarded a rate of less than 10 cents per unit by the court.  While admitting that the implementers “proved victorious in court” in those cases, he asserted that “not every implementer has the wherewithal to litigate”, that “[s]ometimes implementers accede to licensors’ demands, fearing exclusion and costly litigation”, that “consumers can be harmed and innovation incentives are distorted”, and that therefore “[a] future of exciting new products built atop existing technology may be . . . deferred”.  These theoretical concerns are belied by the lack of empirical support for hold-up, and are contradicted by the recent finding, previously noted, that SEP-reliant industries have the fastest quality-adjusted price declines in the U.S. economy.  (In addition, the implementers of patented technology tend to be large corporations; AAG Baer’s assertion that some may not have “the wherewithal to litigate” is a bare proposition unsupported by empirical evidence or more nuanced analysis.)  In short, DOJ, like FTC, is advancing an argument that undermines, rather than bolsters, the case for applying antitrust to SEP holders’ efforts to defend their patent rights.

Ideally the FTC and DOJ should reevaluate their recent obsession with allegedly abusive unilateral SEP behavior and refocus their attention on truly serious competitive problems.  (Chairwoman Ramirez and AAG Baer are both outstanding and highly experienced lawyers who are well-versed in policy analysis; one would hope that they would be open to reconsidering current FTC and DOJ policy toward SEPs, in light of hard evidence.)  Doing so would benefit consumer welfare and innovation – which are, after all, the goals that those important agencies are committed to promote.

Last week concluded round 3 of Congressional hearings on mergers in the healthcare provider and health insurance markets. Much like the previous rounds, the hearing saw predictable representatives, of predictable constituencies, saying predictable things.

The pattern is pretty clear: The American Hospital Association (AHA) makes the case that mergers in the provider market are good for consumers, while mergers in the health insurance market are bad. A scholar or two decries all consolidation in both markets. Another interested group, like maybe the American Medical Association (AMA), also criticizes the mergers. And it’s usually left to a representative of the insurance industry, typically one or more of the merging parties themselves, or perhaps a scholar from a free market think tank, to defend the merger.

Lurking behind the public and politicized airings of these mergers, and especially the pending Anthem/Cigna and Aetna/Humana health insurance mergers, is the Affordable Care Act (ACA). Unfortunately, the partisan politics surrounding the ACA, particularly during this election season, may be trumping the sensible economic analysis of the competitive effects of these mergers.

In particular, the partisan assessments of the ACA’s effect on the marketplace have greatly colored the Congressional (mis-)understandings of the competitive consequences of the mergers.  

Witness testimony and questions from members of Congress at the hearings suggest that there is widespread agreement that the ACA is encouraging increased consolidation in healthcare provider markets, for example, but there is nothing approaching unanimity of opinion in Congress or among interested parties regarding what, if anything, to do about it. Congressional Democrats, for their part, have insisted that stepped up vigilance, particularly of health insurance mergers, is required to ensure that continued competition in health insurance markets isn’t undermined, and that the realization of the ACA’s objectives in the provider market aren’t undermined by insurance companies engaging in anticompetitive conduct. Meanwhile, Congressional Republicans have generally been inclined to imply (or outright state) that increased concentration is bad, so that they can blame increasing concentration and any lack of competition on the increased regulatory costs or other effects of the ACA. Both sides appear to be missing the greater complexities of the story, however.

While the ACA may be creating certain impediments in the health insurance market, it’s also creating some opportunities for increased health insurance competition, and implementing provisions that should serve to hold down prices. Furthermore, even if the ACA is encouraging more concentration, those increases in concentration can’t be assumed to be anticompetitive. Mergers may very well be the best way for insurers to provide benefits to consumers in a post-ACA world — that is, the world we live in. The ACA may have plenty of negative outcomes, and there may be reasons to attack the ACA itself, but there is no reason to assume that any increased concentration it may bring about is a bad thing.

Asking the right questions about the ACA

We don’t need more self-serving and/or politicized testimony We need instead to apply an economic framework to the competition issues arising from these mergers in order to understand their actual, likely effects on the health insurance marketplace we have. This framework has to answer questions like:

  • How do we understand the effects of the ACA on the marketplace?
    • In what ways does the ACA require us to alter our understanding of the competitive environment in which health insurance and healthcare are offered?
    • Does the ACA promote concentration in health insurance markets?
    • If so, is that a bad thing?
  • Do efficiencies arise from increased integration in the healthcare provider market?
  • Do efficiencies arise from increased integration in the health insurance market?
  • How do state regulatory regimes affect the understanding of what markets are at issue, and what competitive effects are likely, for antitrust analysis?
  • What are the potential competitive effects of increased concentration in the health care markets?
  • Does increased health insurance market concentration exacerbate or counteract those effects?

Beginning with this post, at least a few of us here at TOTM will take on some of these issues, as part of a blog series aimed at better understanding the antitrust law and economics of the pending health insurance mergers.

Today, we will focus on the ambiguous competitive implications of the ACA. Although not a comprehensive analysis, in this post we will discuss some key insights into how the ACA’s regulations and subsidies should inform our assessment of the competitiveness of the healthcare industry as a whole, and the antitrust review of health insurance mergers in particular.

The ambiguous effects of the ACA

It’s an understatement to say that the ACA is an issue of great political controversy. While many Democrats argue that it has been nothing but a boon to consumers, Republicans usually have nothing good to say about the law’s effects. But both sides miss important but ambiguous effects of the law on the healthcare industry. And because they miss (or disregard) this ambiguity for political reasons, they risk seriously misunderstanding the legal and economic implications of the ACA for healthcare industry mergers.

To begin with, there are substantial negative effects, of course. Requiring insurance companies to accept patients with pre-existing conditions reduces the ability of insurance companies to manage risk. This has led to upward pricing pressure for premiums. While the mandate to buy insurance was supposed to help bring more young, healthy people into the risk pool, so far the projected signups haven’t been realized.

The ACA’s redefinition of what is an acceptable insurance policy has also caused many consumers to lose the policy of their choice. And the ACA’s many regulations, such as the Minimum Loss Ratio requiring insurance companies to spend 80% of premiums on healthcare, have squeezed the profit margins of many insurance companies, leading, in some cases, to exit from the marketplace altogether and, in others, to a reduction of new marketplace entry or competition in other submarkets.

On the other hand, there may be benefits from the ACA. While many insurers participated in private exchanges even before the ACA-mandated health insurance exchanges, the increased consumer education from the government’s efforts may have helped enrollment even in private exchanges, and may also have helped to keep premiums from increasing as much as they would have otherwise. At the same time, the increased subsidies for individuals have helped lower-income people afford those premiums. Some have even argued that increased participation in the on-demand economy can be linked to the ability of individuals to buy health insurance directly. On top of that, there has been some entry into certain health insurance submarkets due to lower barriers to entry (because there is less need for agents to sell in a new market with the online exchanges). And the changes in how Medicare pays, with a greater focus on outcomes rather than services provided, has led to the adoption of value-based pricing from both health care providers and health insurance companies.

Further, some of the ACA’s effects have  decidedly ambiguous consequences for healthcare and health insurance markets. On the one hand, for example, the ACA’s compensation rules have encouraged consolidation among healthcare providers, as noted. One reason for this is that the government gives higher payments for Medicare services delivered by a hospital versus an independent doctor. Similarly, increased regulatory burdens have led to higher compliance costs and more consolidation as providers attempt to economize on those costs. All of this has happened perhaps to the detriment of doctors (and/or patients) who wanted to remain independent from hospitals and larger health network systems, and, as a result, has generally raised costs for payors like insurers and governments.

But much of this consolidation has also arguably led to increased efficiency and greater benefits for consumers. For instance, the integration of healthcare networks leads to increased sharing of health information and better analytics, better care for patients, reduced overhead costs, and other efficiencies. Ultimately these should translate into higher quality care for patients. And to the extent that they do, they should also translate into lower costs for insurers and lower premiums — provided health insurers are not prevented from obtaining sufficient bargaining power to impose pricing discipline on healthcare providers.

In other words, both the AHA and AMA could be right as to different aspects of the ACA’s effects.

Understanding mergers within the regulatory environment

But what they can’t say is that increased consolidation per se is clearly problematic, nor that, even if it is correlated with sub-optimal outcomes, it is consolidation causing those outcomes, rather than something else (like the ACA) that is causing both the sub-optimal outcomes as well as consolidation.

In fact, it may well be the case that increased consolidation improves overall outcomes in healthcare provider and health insurance markets relative to what would happen under the ACA absent consolidation. For Congressional Democrats and others interested in bolstering the ACA and offering the best possible outcomes for consumers, reflexively challenging health insurance mergers because consolidation is “bad,” may be undermining both of these objectives.

Meanwhile, and for the same reasons, Congressional Republicans who decry Obamacare should be careful that they do not likewise condemn mergers under what amounts to a “big is bad” theory that is inconsistent with the rigorous law and economics approach that they otherwise generally support. To the extent that the true target is not health insurance industry consolidation, but rather underlying regulatory changes that have encouraged that consolidation, scoring political points by impugning mergers threatens both health insurance consumers in the short run, as well as consumers throughout the economy in the long run (by undermining the well-established economic critiques of a reflexive “big is bad” response).

It is simply not clear that ACA-induced health insurance mergers are likely to be anticompetitive. In fact, because the ACA builds on state regulation of insurance providers, requiring greater transparency and regulatory review of pricing and coverage terms, it seems unlikely that health insurers would be free to engage in anticompetitive price increases or reduced coverage that could harm consumers.

On the contrary, the managerial and transactional efficiencies from the proposed mergers, combined with greater bargaining power against now-larger providers are likely to lead to both better quality care and cost savings passed-on to consumers. Increased entry, at least in part due to the ACA in most of the markets in which the merging companies will compete, along with integrated health networks themselves entering and threatening entry into insurance markets, will almost certainly lead to more consumer cost savings. In the current regulatory environment created by the ACA, in other words, insurance mergers have considerable upside potential, with little downside risk.

Conclusion

In sum, regardless of what one thinks about the ACA and its likely effects on consumers, it is not clear that health insurance mergers, especially in a post-ACA world, will be harmful.

Rather, assessing the likely competitive effects of health insurance mergers entails consideration of many complicated (and, unfortunately, politicized) issues. In future blog posts we will discuss (among other things): the proper treatment of efficiencies arising from health insurance mergers, the appropriate geographic and product markets for health insurance merger reviews, the role of state regulations in assessing likely competitive effects, and the strengths and weaknesses of arguments for potential competitive harms arising from the mergers.

On Thursday I will be participating in an ABA panel discussion on the Apple e-books case, along with Mark Ryan (former DOJ attorney) and Fiona Scott-Morton (former DOJ economist), both of whom were key members of the DOJ team that brought the case. Details are below. Judging from the prep call, it should be a spirited discussion!

Readers looking for background on the case (as well as my own views — decidedly in opposition to those of the DOJ) can find my previous commentary on the case and some of the issues involved here:

Other TOTM authors have also weighed in. See, e.g.:

DETAILS:

ABA Section of Antitrust Law

Federal Civil abaantitrustEnforcement Committee, Joint Conduct, Unilateral Conduct, and Media & Tech Committees Present:

“The 2d Cir.’s Apple E-Books decision: Debating the merits and the meaning”

July 16, 2015
12:00 noon to 1:30 pm Eastern / 9:00 am to 10:30 am Pacific

On June 30, the Second Circuit affirmed DOJ’s trial victory over Apple in the Ebooks Case. The three-judge panel fractured in an interesting way: two judges affirmed the finding that Apple’s role in a “hub and spokes” conspiracy was unlawful per se; one judge also would have found a rule-of-reason violation; and the dissent — stating Apple had a “vertical” position and was challenging the leading seller’s “monopoly” — would have found no liability at all. What is the reasoning and precedent of the decision? Is “marketplace vigilantism” (the concurring judge’s phrase) ever justified? Our panel — which includes the former DOJ head of litigation involved in the case — will debate the issues.

Moderator

  • Ken Ewing, Steptoe & Johnson LLP

Panelists

  • Geoff Manne, International Center for Law & Economics
  • Fiona Scott Morton, Yale School of Management
  • Mark Ryan, Mayer Brown LLP

Register HERE

In its June 30 decision in United States v. Apple Inc., a three-judge Second Circuit panel departed from sound antitrust reasoning in holding that Apple’s e-book distribution agreement with various publishers was illegal per se. Judge Dennis Jacobs’ thoughtful dissent, which substantially informs the following discussion of this case, is worth a close read.

In 2009, Apple sought to enter the retail market for e-books, as it prepared to launch its first iPad tablet. Apple, however, confronted an e-book monopolist, Amazon (possessor of a 90 percent e-book market share), that was effectively excluding new entrants by offering bestsellers at a loss through its popular Kindle device ($9.99, a price below what Amazon was paying publishers for the e-book book rights). In order to effectively enter the market without incurring a loss itself (by meeting Amazon’s price) or impairing its brand (by charging more than Amazon), Apple approached publishers that dealt with Amazon and offered itself as a competing e-book buyer, subject to the publishers agreeing to a new distribution model that would lower barriers to entry into retail e-book sales. The new publishing model was implemented by three sets of contract terms Apple asked the publishers to accept – agency pricing, tiered price caps, and a most-favored-nation (MFN) clause. (I refer the reader to the full panel majority opinion for a detailed discussion of these clauses.) None of those terms, standing alone, is illegal. Although the publishers were unhappy about Amazon’s below-cost pricing for e-books, no one publisher alone could counter Amazon. Five of the six largest U.S. publishers (Hachette, HarperCollins, Macmillan, Penguin, and Simon & Schuster) agreed to Apple’s terms and jointly convinced Amazon to adopt agency pricing. Apple also encouraged other publishers to implement agency pricing in their contracts with other retailers. The barrier to entry thus removed, Apple entered the retail market as a formidable competitor. Amazon’s retail e-book market share fell, and today stands at 60 percent.

The U.S. Department of Justice (DOJ) and 31 states sued Apple and the five publishers for conspiring in unreasonable restraint of trade under Sherman Act § 1. The publishers settled (signing consent decrees which prohibited them for a period from restricting e-book retailers’ ability to set prices), but Apple proceeded to a bench trial. A federal district court held that Apple’s conduct as a vertical enabler of a horizontal price conspiracy among the publishers was a per se violation of § 1, and that (in any event) Apple’s conduct would also violate § 1 under the antitrust rule of reason.   A majority of the Second Circuit panel affirmed on the ground of per se liability, without having to reach the rule of reason question.

Judge Jacobs’ dissent argued that Apple’s conduct was not per se illegal and also passed muster under the rule of reason. He pointed to three major errors in the majority’s opinion. First, the holding that the vertical enabler of a horizontal price fixing is in per se violation of the antitrust laws conflicts with the Supreme Court’s teaching (in overturning the per se prohibition on resale price maintenance) that a vertical agreement designed to facilitate a horizontal cartel “would need to be held unlawful under the rule of reason.” Leegin Creative Leather Prods, Inc. v. PSKS, Inc. 551 U.S. 877, 893 (2007) (emphasis added).   Second, the district court failed to recognize that Apple’s role as a vertical player differentiated it from the publishers – it should have considered Apple as a competitor on the distinct horizontal plane of retailers, where Apple competed with Amazon (and with smaller player such as Barnes & Noble). Third, assessed under the rule of reason, Apple’s conduct was “overwhelmingly” procompetitive; Apple was a major potential competitor in a market dominated by a 90 percent monopoly, and was “justifiably unwilling” to enter a market on terms that would assure a loss on sales or exact a toll on its reputation.

Judge Jacobs’ analysis is on point. The Supreme Court’s wise reluctance to condemn any purely vertical contractual restraint under the per se rule reflects a sound understanding that vertical restraints have almost always been found to be procompetitive or competitively neutral. Indeed, vertical agreements that are designed to facilitate entry into an important market dominated by one firm, such as the ones at issue in the Apple case, are especially bad candidates for summary condemnation. Thus, the majority’s decision to apply the per se rule to Apple’s contracts appears particularly out of touch with both scholarship and marketplace realities.

More generally, as Professor Herbert Hovenkamp (the author of the leading antitrust treatise) and other scholars have emphasized, well-grounded antitrust analysis involves a certain amount of preliminary evaluation of a restraint seen in its relevant factual context, before a “per se” or “rule of reason” label is applied. (In the case of truly “naked” secret hard core cartels, which DOJ prosecutes under criminal law, the per se label may be applied immediately.) The Apple panel majority panel botched this analytic step, in failing to even consider that Apple’s restraints could enhance retail competition with Amazon.

The panel majority also appeared overly fixated on the fact that some near-term e-book retail prices rose above Amazon’s previous below cost levels in the wake of Apple’s contracts, without noting the longer term positive implications for the competitive process of new e-book entry. Below-cost prices are not a feature of durable efficient competition, and in this case may well have been a temporary measure aimed at discouraging entry. In any event, what counts in measuring consumer welfare is not short term price, but whether expanded output is being promoted by a business arrangement – a key factor that the majority notably failed to address. (It appears highly probable that the fall in Amazon’s e-book retail market share, and the invigoration of e-book competition, have generated output and welfare levels higher than those that would have prevailed had Amazon maintained its monopoly. This is bolstered by Apple’s showing, which the majority does not deny, that in the two years following the “conspiracy” among Apple and the publishers, prices across the e-book market as a whole fell slightly and total output increased.)

Finally, Judge Jacobs’ dissent provides strong arguments in favor of upholding Apple’s conduct under the rule of reason. As the dissent stresses, removal of barriers to entry that shield a monopolist, as in this case, is in line with the procompetitive goals of antitrust law. Another procompetitive effect is the encouragement of innovation (manifested by the enablement of e-book reading with the cutting-edge functions of the iPad), a hallmark and benefit of competition. Another benefit was that the elimination of below-cost pricing helped raise authors’ royalties. Furthermore, in the words of the dissent, any welfare reductions due to Apple’s vertical restrictions are “no more than a slight offset to the competitive benefits that now pervade the relevant market.” (Admittedly that comment is a speculative observation, but in my view very likely a well-founded one.) Finally, as the dissent points out, the district court’s findings demonstrate that Apple could not have entered and competed effectively using other strategies, such as wholesale contracts involving below-cost pricing (like Amazon’s) or higher prices. Summing things up, the dissent explains that “Apple took steps to compete with a monopolist and open the market to more entrants, generating only minor competitive restraints in the process. Its conduct was eminently reasonable; no one has suggested a viable alternative.” In closing, even if one believes a more fulsome application of the rule of reason is called for before reaching the dissent’s conclusion, the dissent does a good job in highlighting the key considerations at play here – considerations that the majority utterly failed to address.

In sum, the Second Circuit panel majority wore jurisprudential blinders in its Apple decision. Like the mesmerized audience at a magic show, it focused in blinkered fashion on a magician’s sleight of hand (the one-dimensional characterization of certain uniform contractual terms), while not paying attention to what was really going on (the impressive welfare-enhancing invigoration of competition in e-book retailing). In other words, the majority decision showed a naïve preference for quick and superficial characterizations of conduct at the expense of a nuanced assessment of the broader competitive context. Perhaps the Second Circuit en banc will have the opportunity to correct the panel’s erroneous understanding of per se and rule of reason analysis. Even better, the Supreme Court may wish to step in to ensure that its thoughtful development of antitrust doctrine in recent years – focused on actual effects and economic efficiency, not on superficial condemnatory labels that ignore marketplace benefits – not be undermined.

On May 9, 2014, in Horne v. Department of Agriculture, the Ninth Circuit struck a blow against economic liberty by denying two California raisin growers’ efforts to recover penalties imposed against them by the U.S. Department of Agriculture (USDA).  The growers’ heinous offense was their refusal to continue participating in a highly anticompetitive cartel.  In order to understand this bizarre miscarriage of justice, which turns orthodox anti-cartel policy on its head, a bit of background is in order.  

Perhaps the most serious affront to a sound consumer welfare-based American antitrust policy is the persistence of federal government-sponsored agricultural cartels.  In a form of bureaucratic schizophrenia, while the Justice Department works hard to send private cartelists to jail, and grants leniency to informers who undermine cartels, the U.S. Agriculture Department (USDA) seeks to punish individuals who undercut USDA-sponsored cartels created pursuant to Agricultural Marketing Agreement Act marketing orders.  Those orders establish antitrust-exempt government-approved frameworks under which private industry members restrict output and raise the price of specific crops, in the name of ensuring “orderly” markets.  (Various scholars, such as Mario Loyola, have explored the public choice explanations for the private-public collusion that leads to marketing orders and other government-supported cartels.)    

A particularly notorious USDA cartel is the California Raisin Marketing Order (“Raisin Order”), in operation since 1949, which establishes a Raisin Administrative Committee (“RAC”).  The RAC is comprised almost entirely of self-interested raisin growers and packers (it is comprised of 47 growers and packers, plus a public member).  The RAC sets annual raisin “reserve tonnage” requirements as a percentage of the overall crop, with the remainder comprising “free raisins.”  “Reserve raisins” are diverted from the market but may be released when supplies are low.  Under the Raisin Order, raisin producers convey their entire crop to raisin packer-distributors known as “handlers,” with producers receiving a pre-negotiated price for the free tonnage.  Handlers sell free tonnage raisins on the open market, and divert the RAC-required percentage of each producer’s crop to the account of the RAC.  The RAC tracks how many raisins each producer contributes to the reserve pool, and has a regulatory duty to sell them in a way that maximizes producer returns.  The RAC finances its activities from reserve raisin sales proceeds, and disburses whatever net income remains to producers.  Reserve raisins are diverted to “low value” markets, such as the export sector, while American consumers typically buy free raisins.  The Raisin Order imposes substantial harm on American consumers:  for example, in 2001 free raisins sold for $877.50 per ton compared to $250 per ton for reserve raisins, and the free raisins/reserve raisins price ration approached 10/1 in 1984 and 1991

California raisin producers Marvin and Laura Horne sought to evade these cartel strictures by handling their own raisin crop, rather than selling it to traditional handlers, against whom the reserve requirement of the Raisin Order clearly operated.  Similarly, by buying and handling other producers’ raisins for a per-pound fee, the Hornes believed that they could avoid the Raisin Order’s definition of “handler” with respect to those purchased raisins.  A USDA judicial officer disagreed, finding the Hornes liable for numerous Order violations and fining them over $695,000, including an assessment of nearly $484,000 for the dollar value of the raisins not held in reserve. 

The Hornes challenged this USDA order in federal district court, arguing that they were not “handlers” within the meaning of the Raisin Order and that the order violated the Fifth Amendment’s Takings Clause and the Eighth Amendment’s prohibition against excessive fines.  The district court granted summary judgment for USDA on all counts.  On appeal, the Ninth Circuit affirmed the application of the Raisin Order and the denial of the Eighth Amendment claim, but held that the Court of Federal Claims rather than the district court had jurisdiction over the takings claim.  The U.S. Supreme Court granted certiorari on the jurisdictional issue only, holding that the Hornes could assert their takings claim in district court.  The Supreme Court remanded for a determination of the merits of the takings claim, and on May 9 the Ninth Circuit, applying de novo review, affirmed the district court’s rejection of that claim.

The Ninth Circuit acknowledged that USDA linked a monetary exaction (the penalty imposed for failure to comply with the Raisin Order) to specific property (the reserved raisins) and that the Hornes faced a choice – give the RAC the raisins or face a penalty.  Because the government did not literally seize raisins from the Holmes’ land or remove money from their bank account, the court held that the USDA’s action had to be analyzed as a potential regulatory taking.  The court then noted that the Takings Clause affords less protection to personal property than to real property, and that the Hornes did not lose all economically valuable use of their property.  The court asserted that the Hornes’ rights with respect to the reserved raisins were not extinguished because they retained a claim on certain future proceeds from reserved raisin sales (even though, as the Hornes pointed out, the “equitable distribution” of reserved sales might be zero).  The court reasoned that even though the Hornes might not receive cash distributions in some years, the reserved raisins were not “permanently occupied,” and that the RAC’s diversion of reserved raisins inured to the Hornes’ benefit by stabilizing raisin prices.  The court viewed the raisin diversion program as granting a conditional government benefit in exchange for an exaction.  In short, by smoothing price fluctuations in the raisin industry, the Raisin Order made “market conditions predictable” and thereby bore a “sufficient nexus” to a legitimate interest the government sought to protect.  (The court never asked why the reduction of consumer welfare and the imposition of deadweight losses through industry cartelization is a legitimate government interest.)  Moreover, the RAC’s imposition of a reserve requirement on all producers was roughly proportional to the USDA’s market stabilizing goal as reflected in the Raisin Order.  Thus, applying the nexus/proportionaliy test of Nollan v. California Coastal Commission and Dolan v. City of Tigard, the Ninth Circuit held that the application of the Marketing Order to the Hornes’ activities did not constitute a taking.

Stripped of its convoluted reasoning and highly selective application of Supreme Court precedents, the Ninth Circuit’s holding indicates that industrious and entrepreneurial individuals will not be allowed to avoid and thereby undermine agricultural cartels through creative commercial innovations.  It means that individuals engaging in a legitimate business activity who wish not to contribute their product to a cartel that is imposed on them may suffer loss of their property, merely because the government approves of the cartel and wishes to protect it by punishing “cheaters.”  But when the government is the ringmaster, odious cartels are miraculously transformed into praiseworthy citizens who promote the public interest by “stabilizing” markets. 

Whatever the ultimate outcome of the Hornes’ legal saga, the Ninth Circuit’s crabbed analysis highlights the absurdity of imposing government financial exactions on private commercial conduct that unequivocally raises consumer welfare and enhances competition.  The egregiousness of this conduct is amplified when the government penalizes a business for refusing to transfer some of its property to a third party (here, the RAC), without assurance of being compensated.  Whether the business chooses to incur the penalty or instead accedes to the transfer, basic logic demonstrates that its property is being taken.  Hopefully, future courts will keep this in mind and be willing to apply the Takings Clause to analogous scenarios. 

If faced by a serious possibility of having to pay “just compensation” under the Takings Clause, the USDA may become less willing to sanction cartel avoiders through overly expansive interpretations of its agricultural marketing orders.  That in turn could encourage additional businesses to seek creative ways to opt out of these arrangements.  The end result could be the gradual weakening and ultimate dismantling of the marketing order framework.  Even better, the USDA could choose to act unilaterally tomorrow and move to rescind marketing order regulations.  (That might be asking too much, of course.)

I have a new article on the Comcast/Time Warner Cable merger in the latest edition of the CPI Antitrust Chronicle, which includes several other articles on the merger, as well.

In a recent essay, Allen Grunes & Maurice Stucke (who also have an essay in the CPI issue) pose a thought experiment: If Comcast can acquire TWC, what’s to stop it acquiring all cable companies? The authors’ assertion is that the arguments being put forward to support the merger contain no “limiting principle,” and that the same arguments, if accepted here, would unjustifiably permit further consolidation. But there is a limiting principle: competitive harm. Size doesn’t matter, as courts and economists have repeatedly pointed out.

The article explains why the merger doesn’t give rise to any plausible theory of anticompetitive harm under modern antitrust analysis. Instead, arguments against the merger amount to little more than the usual “big-is-bad” naysaying.

In summary, I make the following points:

Horizontal Concerns

The absence of any reduction in competition should end the inquiry into any potentially anticompetitive effects in consumer markets resulting from the horizontal aspects of the transaction.

  • It’s well understood at this point that Comcast and TWC don’t compete directly for subscribers in any relevant market; in terms of concentration and horizontal effects, the transaction will neither reduce competition nor restrict consumer choice.
  • Even if Comcast were a true monopolist provider of broadband service in certain geographic markets, the DOJ would have to show that the merger would be substantially likely to lessen competition—a difficult showing to make where Comcast and TWC are neither actual nor potential competitors in any of these markets.
  • Whatever market power Comcast may currently possess, the proposed merger simply does nothing to increase it, nor to facilitate its exercise.

Comcast doesn’t currently have substantial bargaining power in its dealings with content providers, and the merger won’t change that. The claim that the combined entity will gain bargaining leverage against content providers from the merger, resulting in lower content prices to programmers, fails for similar reasons.

  • After the transaction, Comcast will serve fewer than 30 percent of total MVPD subscribers in the United States. This share is insufficient to give Comcast market power over sellers of video programming.
  • The FCC has tried to impose a 30 percent cable ownership cap, and twice it has been rejected by the courts. The D.C. Circuit concluded more than a decade ago—in far less competitive conditions than exist today—that the evidence didn’t justify a horizontal ownership limit lower than 60% on the basis of buyer power.
  • The recent exponential growth in OVDs like Google, Netflix, Amazon and Apple gives content providers even more ways to distribute their programming.
  • In fact, greater concentration among cable operators has coincided with an enormous increase in output and quality of video programming
  • Moreover, because the merger doesn’t alter the competitive make-up of any relevant consumer market, Comcast will have no greater ability to threaten to withhold carriage of content in order to extract better terms.
  • Finally, programmers with valuable content have significant bargaining power and have been able to extract the prices to prove it. None of that will change post-merger.

Vertical Concerns

The merger won’t give Comcast the ability (or the incentive) to foreclose competition from other content providers for its NBCUniversal content.

  • Because the merger would represent only 30 percent of the national market (for MVPD services), 70 percent of the market is still available for content distribution.
  • But even this significantly overstates the extent of possible foreclosure. OVD providers increasingly vie for the same content as cable (and satellite).
  • In the past when regulators have considered foreclosure effects for localized content (regional sports networks, primarily)—for example, in the 2005 Adelphia/Comcast/TWC deal, under far less competitive conditions—the FTC found no substantial threat of anticompetitive harm. And while the FCC did identify a potential risk of harm in its review of the Adelphia deal, its solution was to impose arbitration requirements for access to this programming—which are already part of the NBCUniversal deal conditions and which will be extended to the new territory and new programming from TWC.

The argument that the merger will increase Comcast’s incentive and ability to impair access to its users by online video competitors or other edge providers is similarly without merit.

  • Fundamentally, Comcast benefits from providing its users access to edge providers, and it would harm itself if it were to constrain access to these providers.
  • Foreclosure effects would be limited, even if they did arise. On a national level, the combined firm would have only about 40 percent of broadband customers, at most (and considerably less if wireless broadband is included in the market).
  • This leaves at least 60 percent—and quite possibly far more—of customers available to purchase content and support edge providers reaching minimum viable scale, even if Comcast were to attempt to foreclose access.

Some have also argued that because Comcast has a monopoly on access to its customers, transit providers are beholden to it, giving it the ability to degrade or simply block content from companies like Netflix. But these arguments misunderstand the market.

  • The transit market through which edge providers bring their content into the Comcast network is highly competitive. Edge providers can access Comcast’s network through multiple channels, undermining Comcast’s ability to deny access or degrade service to such providers.
  • The transit market is also almost entirely populated by big players engaged in repeat interactions and, despite a large number of transactions over the years, marked by a trivial number of disputes.
  • The recent Comcast/Netflix agreement demonstrates that the sophisticated commercial entities in this market are capable of resolving conflicts—conflicts that appear to affect only the distribution of profits among contracting parties but not raise anticompetitive concerns.
  • If Netflix does end up paying more to access Comcast’s network over time, it won’t be because of market power or this merger. Rather, it’s an indication of the evolving market and the increasing popularity of OTT providers.
  • The Comcast/Netflix deal has procompetitive justifications, as well. Charging Netflix allows Comcast to better distinguish between the high-usage Netflix customers (two percent of Netflix users account for 20 percent of all broadband traffic) and everyone else. This should lower cable bills on average, improve incentives for users, and lead to more efficient infrastructure investments by both Comcast and Netflix.

Critics have also alleged that the vertically integrated Comcast may withhold its own content from competing MVPDs or OVDs, or deny carriage to unaffiliated programming. In theory, by denying competitors or potential competitors access to popular programming, a vertically integrated MVPD might gain a competitive advantage over its rivals. Similarly, an MVPD that owns cable channels may refuse to carry at least some unaffiliated content to benefit its own channels. But these claims also fall flat.

  • Once again, these issue are not transaction specific.
  • But, regardless, Comcast will not be able to engage in successful foreclosure strategies following the transaction.
  • The merger has no effect on Comcast’s share of national programming. And while it will have a larger share of national distribution post-merger, a 30 percent market share is nonetheless insufficient to confer buyer power in today’s highly competitive MVPD market.
  • Moreover, the programming market is highly dynamic and competitive, and Comcast’s affiliated programming networks face significant competition.
  • Comcast already has no ownership interest in the overwhelming majority of content it distributes. This won’t measurably change post-transaction.

Procompetitive Justifications

While the proposed transaction doesn’t give rise to plausible anticompetitive harms, it should bring well-understood pro-competitive benefits. Most notably:

  • The deal will bring significant scale efficiencies in a marketplace that requires large, fixed-cost investments in network infrastructure and technology.
  • And bringing a more vertical structure to TWC will likely be beneficial, as well. Vertical integration can increase efficiency, and the elimination of double marginalization often leads to lower prices for consumers.

Let’s be clear about the baseline here. Remember all those years ago when Netflix was a mail-order DVD company? Before either Netflix or Comcast even considered using the internet to distribute Netflix’s video content, Comcast invested in the technology and infrastructure that ultimately enabled the Netflix of today. It did so at enormous cost (tens of billions of dollars over the last 20 years) and risk. Absent broadband we’d still be waiting for our Netflix DVDs to be delivered by snail mail, and Netflix would still be spending three-quarters of a billion dollars a year on shipping.

The ability to realize returns—including returns from scale—is essential to incentivizing continued network and other quality investments. The cable industry today operates with a small positive annual return on invested capital (“ROIC”) but it has had cumulative negative ROIC over the entirety of the last decade. In fact, on invested capital of $127 billion between 2000 and 2009, cable has seen economic profits of negative $62 billion and a weighted average ROIC of negative 5 percent. Meanwhile Comcast’s stock has significantly underperformed the S&P 500 over the same period and only outperformed the S&P over the last two years.

Comcast is far from being a rapacious and endlessly profitable monopolist. This merger should help it (and TWC) improve its cable and broadband services, not harm consumers.

No matter how many times Al Franken and Susan Crawford say it, neither the broadband market nor the MVPD market is imperiled by vertical or horizontal integration. The proposed merger won’t create cognizable antitrust harms. Comcast may get bigger, but that simply isn’t enough to thwart the merger.

On July 10 a federal judge ruled that Apple violated antitrust law by conspiring to raise prices of e-books when it negotiated deals with five major publishers. I’ve written on the case and the issues involved in it several times, including here, here, here and here. The most recent of these was titled, “Why I think the government will have a tough time winning the Apple e-books antitrust case.” I’m hedging my bets with the title this time, but it’s fairly clear to me that the court got this case wrong.

The predominant sentiment among pundits following the decision seems to be approval (among authors, however, the response to the suit has been decidedly different). Supporters believe it will lower e-book prices and instigate a shift in the electronic publishing industry toward some more-preferred business model. This sort of reasoning is dangerous and inconsistent with principled, restrained antitrust. Neither the government nor its supporting commentators should use, or applaud the use, of antitrust to impose the government’s (or anyone else’s) preferred business model on industry. And lower prices in the short run, while often an indication of increased competition, are not, by themselves, sufficient to determine that a business model is efficient in the long run.

For example, in a recent article, Mark Lemley is quoted supporting the outcome, noting that it may spur a shift toward his preferred model of electronic publishing:

It also makes no sense that publishers, not authors, capture most of the revenue from e-books, when they do very little of the work. I understand why publishers are reluctant to give up their old business model, but if they want to survive in the digital world, it’s time to make some changes.

As noted, there is no basis for using antitrust enforcement to coerce an industry to shift to a particular distribution of profits simply because “it’s time to make some changes.” Lemley’s characterization of the market’s dynamics is also seriously lacking in economic grounding (and the Authors Guild response to the suit linked above suggests the same). The economics of entrepreneurship has an impressive intellectual pedigree that began with Frank Knight, was further developed by Joseph Schumpeter, Israel Kirzner and Harold Demsetz, among others, and continues to today with its inclusion as a factor of production. (On the development of this tradition and especially Harold Demsetz’s important contribution to it, see here). The implicit claim that publishers’ and authors’ interests (to say nothing of consumers’ interests) are simply at odds, and that the “right” distribution of profits would favor authors over publishers based on the amount of “work” they do is economically baseless. Although it is a common claim, reflecting either idiosyncratic preferences or ignorance about the role of content publishers and distributors in the e-book marketplace and the role of entrepreneurship more generally, it is nonetheless mistaken and has no place in a consumer-welfare-based assessment of the market or antitrust intervention in it.

It’s also utterly unclear how the antitrust suit would do anything to change the relative distribution of profits between publishers and authors. In fact, the availability of direct publishing (offered by both Amazon and Apple) is the most likely disruptor of that dynamic, and authors could only be helped by an increase in competition among platforms—in other words, by Apple’s successful entry into the market.

Apple entered the e-books market as a relatively small upstart battling a dominant incumbent. That it did so by offering publishers (suppliers) attractive terms to deal with its new iBookstore is no different than a new competitor in any industry offering novel products or loss-leader prices to attract customers and build market share. When new entry then induces an industry-wide shift toward the new entrants’ products, prices or business model it’s usually called “competition,” and lauded as the aim of properly functioning markets. The same should be true here.

Despite the court’s claim that

there is overwhelming evidence that the Publisher Defendants joined with each other in a horizontal price-fixing conspiracy,

that evidence is actually extremely weak. What is unclear is why the publishers would need a conspiracy when they rarely compete against each other directly.

The court states that

To protect their then-existing business model, the Publisher Defendants agreed to raise the prices of e-books by taking control of retail pricing.

But despite the use of the antitrust trigger-words, “agreed to raise prices,” this agreement is not remotely clear, and rests entirely on circumstantial evidence (more on this later). None of the evidence suggests actual agreement over price, and none of the evidence demonstrates conclusively any real incentive for the publishers to reach “agreement” at all. In actuality, publishers rarely compete against each other directly (least of all on price); instead, for each individual publisher (and really for each individual title), the most relevant competition for this case is between the e-book version of a particular title and its physical counterpart. In this situation it should matter little to any particular e-book’s sales whether every other e-book in the world is sold at the same price or even a lower price.

While the opinion asserts that each publisher

could also expect to lose substantial sales if they unilaterally raised the prices of their own e-books and none of their competitors followed suit,

it also states that

there is no evidence that the Publisher Defendants have ever competed with each other on price. To the contrary, several of the Publishers’ CEOs explained that they have not competed with each other on that basis.

These statements are difficult to reconcile, but the evidence supports the latter statement, not the former.

The only explanation offered by the court for the publishers’ alleged need for concerted action is an ambiguous claim that Amazon would capitulate in shifting to the agency model only if every publisher pressured it to do so simultaneously. The court claims that

if the Publisher Defendants were going to take control of e-book pricing and move the price point above $9.99, they needed to act collectively; any other course would leave an individual Publisher vulnerable to retaliation from Amazon.

But it’s not clear why this would be so.

On the one hand, if Apple really were the electronic publishing juggernaut implied by this antitrust action, this concern should be minimal: Publishers wouldn’t need Amazon and could simply sell their e-books through Apple’s iBookstore. In this case the threat of even any individual publisher’s “retaliation” against Amazon (decamping to Apple) would suffice to shift relative bargaining power between the publishers and Amazon, and concerted action wouldn’t be necessary. On this theory, the fact that it was only after Apple’s entry that Amazon agreed to shift to the agency model—a fact cited by the court many times to support its conclusions—is utterly unremarkable.

That prices may have shifted as well is equally unremarkable: The agency model puts pricing decisions in publishers’ hands (who, as I’ve previously discussed, have very different incentives than Amazon) where before Amazon had control over prices. Moreover, even when Apple presented evidence that average e-book prices actually fell after its entrance into the market, the court demanded that Apple prove a causal relationship between its entrance and lower overall prices. (Even the DOJ’s own evidence shows, at worst, little change in price, despite its heated claims to the contrary.) But the burden of proof in such cases rests with the government to prove that Apple caused prices to rise, not for Apple to explain why they fell.

On the other hand, if the loss of Amazon as a retail outlet were really so significant for publishers, Apple’s ability to function as the lynchpin of the alleged conspiracy is seriously questionable. While the agency model coupled with the persistence of $9.99 pricing by Amazon would seem to mean reduced revenue for publishers on each book sold through Apple’s store, the relatively trivial number of Apple sales compared with Amazon’s, particularly at the outset, would be of little concern to publishers, and thus to Amazon. In this case it is difficult to believe that publishers would threaten their relationships with Amazon for the sake of preserving the return on their newly negotiated contracts with Apple (and even more difficult to believe that Amazon would capitulate), and the claimed coordinating effects of the MFN provisions is difficult to sustain.

The story with respect to Amazon is questionable for another reason. While the court claims that the publishers’ concern with Amazon’s $9.99 pricing was its effect on physical book sales, it is extremely hard to believe that somehow $12.99 for the electronic version of a $30 (or, often, even more expensive) physical book would be significantly less damaging to physical book sales. Moreover, the evidence put forth by the DOJ and found persuasive by the court all pointed to e-book revenues alone, not physical book sales, as the issue of most concern to publishers (thus, for example, Steve Jobs wrote to HarperCollins’ CEO that it could “[k]eep going with Amazon at $9.99. You will make a bit more money in the short term, but in the medium term Amazon will tell you they will be paying you 70% of $9.99. They have shareholders too.”).

Moreover, as Joshua Gans points out, the agency model that Amazon may have entered into with the publishers would have been particularly unhelpful in ensuring monopoly returns for the publishers (we don’t know the exact terms of their contracts, however, and there are reports from trial that Amazon’s terms were “identical” to Apple’s):

While Apple gave publishers a 70 percent share of book sales and the ability to set their own price, Amazon offered a menu. If you price below $9.99 for a book, Amazon’s share will be 70 percent but if you price above $10, Amazon only returns 35 percent to the publisher. Amazon also charged publishers a delivery fee based on the book’s size (in kb).

Thus publishers could, of course, raise prices to $12.99 in both Apple’s and Amazon’s e-book stores, but, if this effective price cap applied, doing so would result in a significant loss of revenue from Amazon. In other words, the court’s claim—that, having entered into MFNs with Apple, the publishers then had to move Amazon to the agency model to ensure that they didn’t end up being forced by the MFNs to sell books via Apple (on the less-attractive agency terms) at Amazon’s $9.99—is far-fetched. To the extent that raising Amazon’s prices above $10 may have cut royalties almost in half, the MFNs with Apple would be extremely unlikely to have such a powerful effect. But, as noted above, because of the relative sales volumes involved the same dynamic would have applied even under identical terms.

It is true, of course, that Apple cares about price differences between books sold through its iBookstore and the same titles sold through other electronic retailers—and thus it imposed MFN clauses on the publishers. But this is not anticompetitive. In fact, by facilitating Apple’s entry, the MFN clauses plainly increased competition by introducing a new competitor to the industry. What’s more, the terms of Apple’s agreements with the publishers exactly mirrors the terms it uses for apps and music sold through the iTunes store, as well. And as Gordon Crovitz noted:

As this column reported when the case was brought last year, Apple executive Eddy Cue in 2011 turned down my effort to negotiate different terms for apps by news publishers by telling me: “I don’t think you understand. We can’t treat newspapers or magazines any differently than we treat FarmVille.” His point was clear: The 30% revenue-share model is how Apple does business with everyone. It is not, as the government alleges, a scheme Apple concocted to fix prices with book publishers.

Another important error in the case — and, unfortunately, it is one to which Apple’s lawyers acceded—is the treatment of “trade e-books” as the relevant market. For antitrust purposes, there is no generalized e-book (or physical book, for that matter) market. As noted above, the court itself acknowledged that the publishers “have [n]ever competed with each other on price.” The price of Stephen King’s latest novel likely has, at best, a trivial effect on sales of…nearly every other fiction book published, and probably zero effect on sales of non-fiction books.

This is important because the court’s opinion turns on mostly circumstantial evidence of an alleged conspiracy among publishers to raise prices and on the role of concerted action in protecting publishers from being “undercut” by their competitors. But in a world where publishers don’t compete on price (and where the alleged agreement would have reduced the publishers’ revenues in the short run and done little if anything to shore up physical book sales in the long run), it is far-fetched to interpret this evidence as the court does—to infer a conspiracy to raise prices.

Meanwhile, by restricting itself to consideration of competitive effects in the e-book market alone, the court also inappropriately and without commentary dispenses with Apple’s pro-competitive justifications for its conduct. Put simply, Apple contends that its entry into the e-book retail and reader markets was facilitated by its contract terms. But the court ignores these arguments.

On the one hand, it does so because it treats this as a per se case, in which procompetitive effects are irrelevant. But the court’s determination to treat this as a per se case—with its lengthy recitation of relevant legal precedent and only cursory application of precedent to the facts of the case—is suspect. As I have noted before:

What would [justify per se treatment] is if the publishers engaged in concerted action to negotiate these more-favorable terms with other publishers, and what would be problematic for Apple is if its agreement with each publisher facilitated that collusion.

But I don’t see any persuasive evidence that the terms of Apple’s deals with each publisher did any such thing. For MFNs to perform the function alleged by the DOJ it seems to me that the MFNs would have to contribute to the alleged agreement between the publishers, just as the actions of the vertical co-conspirators in Interstate Circuit and Toys-R-Us were alleged to facilitate coordination. But neither the agency agreement itself nor the MFN and price cap terms in the contracts in any way affected the publishers’ incentive to compete with each other. Nor, as noted above, did they require any individual publisher to cause its books to be sold at higher prices through other distributors.

Even if it is true that the publishers participated in a per se illegal horizontal price fixing scheme (and despite the court’s assertion that this is beyond dispute, the evidence is not nearly so clear as the court suggests), Apple’s unique role in that alleged scheme can’t be analyzed in the same fashion. As Leegin notes (and the court in this case quotes), for conduct to merit per se treatment it must “always or almost always tend to restrict competition and decrease output.” But the conduct at issue here—whether somehow coupled with a horizontal price fixing scheme or not—doesn’t meet this standard. The agency model, the MFN terms in the publishers’ contracts with Apple, and the efforts by Apple to secure broad participation by the largest publishers before entering the market are all potentially—if not likely—procompetitive. And output seems to have increased substantially following Apple’s entry into the e-book retail market.

In short, I continue to believe that the facts of this case do not merit per se treatment, and there is a good chance the court’s opinion could be overturned on this ground. For this reason, its rejection of Apple’s procompetitive arguments was inappropriate.

But even in its brief “even under the rule of reason…” analysis, the court improperly rejects Apple’s procompetitive arguments. The court’s consideration of these arguments is basically summed up here:

The pro-competitive effects to which Apple has pointed, including its launch of the iBookstore, the technical novelties of the iPad, and the evolution of digital publishing more generally, are phenomena that are independent of the Agreements and therefore do not demonstrate any pro-competitive effects flowing from the Agreements.

But this is factually inaccurate. Apple has claimed that its entry—and thus at minimum its development and marketing of the iPad as an e-reader and its creation of the iBookstore—were indeed functions of the contract terms and the simultaneous acceptance by the largest publishers of these terms.

The court goes on to assert that, even if the claimed pro-competitive effect was the introduction of competition into the e-book market,

Apple demanded, as a precondition of its entry into the market, that it would not have to compete with Amazon on price. Thus, from the consumer’s perspective — a not unimportant perspective in the field of antitrust — the arrival of the iBookstore brought less price competition and higher prices.

In making this claim the court effectively—and improperly—condemns MFNs to per se illegal status. In doing so the court claims that its opinion’s reach is not so broad:

this Court has not found that any of these [agency agreements, MFN clauses, etc.]…components of Apple’s entry into the market were wrongful, either alone or in combination. What was wrongful was the use of those components to facilitate a conspiracy with the Publisher Defendants”

But the claimed absence of retail price competition that accompanied Apple’s entry is entirely a function of the MFN clauses: Whether at $9.99 or $12.99, the MFN clauses were what ensured that Apple’s and Amazon’s prices would be the same, and disclaimer or not they are swept in to the court’s holding.

This effective condemnation of MFN clauses, while plainly sought by the DOJ, is simply inappropriate as a matter of law. In order to condemn Apple’s conduct under the per se rule, the court relies on the operation of the MFNs in allegedly reducing competition and raising prices to make its case. But that these do not “always or almost always tend to restrict competition and reduce output” is clear. While the DOJ may view such terms otherwise (more on this here and here), courts have not done so, and Leegin’s holding that such vertical restraints are to be assessed under the rule of reason still holds. The court’s use of the per se standard and its refusal to consider Apple’s claimed pro-competitive effects are improper.

Thus I (somewhat more cautiously this time…) suggest that the court’s decision may be overturned on appeal, and I most certainly think it should be. It seems plainly troubling as a matter of economics, and inappropriate as a matter of law.

Trial begins today in the Southern District of New York in United States v. Apple (the Apple e-books case), which I discussed previously here. Along with co-author Will Rinehart, I also contributed an  essay to a discussion of the case in Concurrences (alongside contributions from Jon Jacobson and Mark Powell, among others).

Much of my writing on the case has essentially addressed it as a rule of reason case, assessing the economic merits of Apple’s contract terms. And as I mention in this Reuters article from yesterday on the case, one of the key issues in this analysis (and one of the government’s key targets in the case) is the use of MFN clauses.

But as Josh pointed out in a blog post last year,

my hunch is that if the case is litigated its legacy will be as an “agreement” case rather than what it contributes to rule of reason analysis.  In other words, if Apple gets to the rule of reason, the DOJ (like most plaintiffs in rule of reason cases) are likely to lose — especially in light of at least preliminary evidence of dramatic increases in output.  The critical question — I suspect — will be about proof of an actual naked price fixing agreement among publishers and Apple, and as a legal matter, what evidence is sufficient to establish that agreement for the purposes of Section 1 of the Sherman Act.

He’s likely correct, of course, that a central question at trial will be whether or not this is a per se or rule of reason case, and that trial will focus in significant part on the sufficiency of the evidence of agreement. But because this determination will turn considerably on the purpose and function of the MFN and price cap terms in Apple’s agreements with the publishers, I don’t think there should (or will) be much difference. Nor do I think the government should (or will) win.

Before the court can apply the per se rule, it must satisfy itself that the conduct at issue “would always or almost always tend to restrict competition and decrease output.” But it is not true as a matter of economics — and certainly not true as a matter of law — that MFNs meet this standard.

After State Oil v. Kahn there can be no question about the rule of reason (if not per se legal) status of price caps. And as the Court noted in Leegin:

Resort to per se rules is confined to restraints, like those mentioned, “that would always or almost always tend to restrict competition and decrease output.” To justify a per se prohibition a restraint must have “manifestly anticompetitive” effects, and “lack any redeeming virtue.

As a consequence, the per se rule is appropriate only after courts have had considerable experience with the type of restraint at issue, and only if courts can predict with confidence that it would be invalidated in all or almost all instances under the rule of reason. It should come as no surprise, then, that “we have expressed reluctance to adopt per se rules with regard to restraints imposed in the context of business relationships where the economic impact of certain practices is not immediately obvious.” And, as we have stated, a “departure from the rule-of-reason standard must be based upon demonstrable economic effect rather than . . . upon formalistic line drawing.”

After Leegin, all vertical non-price restraints, including MFNs, are assessed under the rule of reason.  Courts neither have “considerable experience” with MFNs, nor can they remotely “predict with confidence that they would be invalidated in all or almost all instances under the rule of reason.” As a recent article in Antitrust points out,

The DOJ and FTC have brought approximately ten cases over the last two decades challenging MFNs. Most of these cases involved the health care industry and all were resolved by consent judgments.

Even if the court does take a harder look at whether a per se rule should govern, however, as a practical matter there is not likely to be much difference between a “does this merit per se treatment” analysis and analysis of the facts under the rule of reason. As the Court pointed out in California Dental Association,

The truth is that our categories of analysis of anticompetitive effect are less fixed than terms like “per se,” “quick look,” and “rule of reason” tend to make them appear. We have recognized, for example, that “there is often no bright line separating per se from Rule of Reason analysis,” since “considerable inquiry into market conditions” may be required before the application of any so-called “per se” condemnation is justified. “[W]hether the ultimate finding is the product of a presumption or actual market analysis, the essential inquiry remains the same–whether or not the challenged restraint enhances competition.”

And as my former classmate Tom Nachbar points out in a recent article,

it’s hard to identity much relative simplicity in the per se rule. Indeed, the moniker “per se” has become somewhat misleading, as cases determining whether to apply the per se or rule of reason become as long as ones actually applying the rule of reason itself.

Of course that doesn’t end the analysis, and the government’s filings do all they can to sidestep the direct antitrust treatment of MFNs and instead assert that they (and other evidence alleged) permit the court to infer Apple’s participation as the coordinator of a horizontal price-fixing conspiracy among the publishers.

But as Apple argues in its filings,

The[ relevant] cases mandate an inquiry into the possibility that the challenged contract terms and negotiation approach were in Apple’s independent economic interests. The evidence is overwhelming—not just possible—that Apple acted for its own valid business reasons and not to “raise consumer prices market-wide.”…Plaintiffs ask this Court to infer Apple’s participation in a conspiracy from (1) its MFN and price cap terms and (2) negotiations with publishers.

* * *

What is obvious, however, is that Apple has not fixed prices with its competitors. What is remarkable is that the government seeks to impose grave legal consequences on an inherently pro-competitive act—entry—accomplished via agency, an MFN, and price caps, none of which is per se unlawful.

The government’s strenuous objection to Apple’s interpretation of the controlling Supreme Court authority, Monsanto v. Spray-Rite, notwithstanding, it’s difficult to see the MFN clauses as evidence of Apple’s participation in the publishers’ alleged conspiracy.

An important point supporting Apple’s argument here is that, unlike the “hubs” in the other “hub and spoke” conspiracies on which the DOJ bases its case, Apple has no significant leverage over the alleged co-conspirators, and thus no power to coordinate — let alone enforce — a price-fixing scheme. As Apple argues in its Opposition brief,

The only “power” Apple could wield over the publishers was the attractiveness of a business opportunity—hardly the “make or break” scenarios found in Interstate Circuit and [Toys-R-Us]. Far from capitulating to Apple’s requested core business terms, the publishers fought Apple tooth and nail and negotiated intensely to the very end, and the largest, Random House, declined.

And as Will and I note in our Concurrences article,

MFNs are essentially an important way of…offering some protection against publishers striking a deal with a competitor that leaves Apple forced to price its ebooks out of the market.

There is nothing, that we know of, in the MFNs or elsewhere in the agreements that requires the publishers to impose higher resale prices elsewhere, or prevents the publishers from selling through Apple at a lower price, if necessary. Most important, for Apple’s negotiated prices to dominate in the market it would have to enjoy market power – a condition, currently at least, that is exceedingly unlikely given its 10% share of the ebook market.

The point is that, even if everything the government alleges about the publishers’ price fixing scheme were true, it’s extremely difficult to see Apple as a co-conspirator in such a scheme. The Supreme Court’s holding in Monsanto stands for nothing if not the principle that courts may not infer a vertical party’s participation in a horizontal price-fixing scheme from the existence of otherwise-legal and -defensible interactions between the vertically related parties. Because MFNs have valid purposes outside the realm of price-fixing, they may not be converted into illegal conduct on Apple’s part simply because they might also “sharpen [a publisher’s] incentives” to try to raise prices elsewhere.

Remember, we are in a world where the requisite anticompetitive conduct can’t be simply the vertical restraint itself. Rather, we’re evaluating whether the vertical restraint was part of a broader anticompetitive scheme among the publishers. For the MFN clauses to be part of that alleged scheme they must have an identifiable place in the scheme.

First of all, it is unremarkable that Apple might offer terms to any individual publisher (or to all publishers independently) that might be more favorable to the publisher than terms it is getting elsewhere; that’s how a new entrant in Apple’s position attracts suppliers. It is likewise unremarkable that Apple would seek to impose terms (like the MFN) that would preserve its ability to offer a publisher’s books for the same price they are offered elsewhere (which is necessary because the agency agreements negotiated by Apple otherwise remove pricing authority from Apple and confer it on the publishers themselves). And finally it is unremarkable that each publisher would try to negotiate similarly favorable terms with other distributors (or, more accurately, continue to try: bargaining over distribution terms with other distributors hardly started only after the agreements were signed with Apple). What would be notable is if the publishers engaged in concerted action to negotiate these more-favorable terms with other publishers, and what would be problematic for Apple is if its agreement with each publisher facilitated that collusion.

But I don’t see any persuasive evidence that the terms of Apple’s deals with each publisher did any such thing. For MFNs to perform the function alleged by the DOJ it seems to me that the MFNs would have to contribute to the alleged agreement between the publishers, just as the actions of the vertical co-conspirators in Interstate Circuit and Toys-R-Us were alleged to facilitate coordination. But neither the agency agreement itself nor the MFN and price cap terms in the contracts in any way affected the publishers’ incentive to compete with each other. Nor, as noted above, did they require any individual publisher to cause its books to be sold at higher prices through other distributors.

On this latter point, the DOJ alleges that the MFNs “sharpen[ed publishers’] incentives” to raise prices:

If a retailer were allowed to remain on wholesale terms, and that retailer continued to price new release e-books at $9.99, the Publisher Defendant would be forced to lower the iBookstore price to match the $9.99 price

Not only does this say nothing about the incentives of the publishers to compete with each other on price (except that it may have increased that incentive by undermining the prevailing $9.99-for-all-books standard), it seems far-fetched to suggest that fear of having to lower prices for books sold in Apple’s relatively trivial corner of the market would have an apreciable effect on a publisher’s incentives to raise prices elsewhere. For what it’s worth, it also seems far-fetched to suggest that Apple’s motivation was to raise prices given that e-book sales generate only about .0005% of Apple’s total revenues.

Beyond this, the DOJ essentially argues that Apple coordinated agreement among the publishers to accept the terms being offered by Apple, with the intent and effect that this would lead to imposition by the publishers of similar terms (and higher prices) on other distributors. Perhaps, but it’s a stretch. And if it is true, it isn’t because of the MFN clauses. Moreover, it isn’t clear to me (maybe I’m missing some obvious controlling case law?) that agreement over the type of contract used amounts to an illegal horizontal agreement; arguably in this case, at least, it is closer to an ancillary restraint or  justified agreement (as in BMI, e.g.) than, say, a group boycott or bid rigging. In any case, if the DOJ has a case at all turning on this scenario, I think it will have to be based entirely on the alleged evidence of direct coordination (i.e., communications between Apple and publishers during dinners and phone calls) rather than the operation of the contract terms themselves.

In any case, it will be interesting to see how the trial unfolds.