The Supreme Court Needs to Intervene and Bring Rationality to Tying Law – and It May Wish to Look at Loyalty Discounts as Well

Alden Abbott —  18 November 2015

In Collins Inkjet Corp. v. Eastman Kodak Co. (2015) (subsequently settled, leading to a withdrawal of Kodak’s petition for certiorari), the Sixth Circuit elected to apply the Cascade Health Solutions v. PeaceHealth “bundled discount attribution price-cost” methodology in upholding a preliminary injunction against Kodak’s policy of discounting the price of refurbished Kodak printheads to customers who purchased ink from Kodak, rather than from Collins.  This case illustrates the incoherence and economic irrationality of current tying doctrine, and the need for Supreme Court guidance – hopefully sooner rather than later.

The key factual and legal findings in this case, set forth by the Sixth Circuit, were as follows:

Collins is Kodak’s competitor for selling ink for Versamark printers manufactured by Kodak. Users of Versamark printers must periodically replace a printer component called a printhead; Kodak is the only provider of replacement “refurbished printheads” for such printers. In July 2013, Kodak adopted a pricing policy that raised the cost of replacing Versamark printheads, but only for customers not purchasing Kodak ink. Collins filed suit, arguing that this amounts to a tying arrangement prohibited under § 1 of the Sherman Act, 15 U.S.C. § 1, because it is designed to monopolize the Versamark ink market. Collins sought a preliminary injunction barring Kodak from charging Collins’ customers a higher price for refurbished printheads. The district court issued the preliminary injunction, finding a strong likelihood that Kodak’s pricing policy was a non-explicit tie that coerced Versamark owners into buying Kodak ink and that Kodak possessed sufficient market power in the market for refurbished printheads to make the tie effective.

On appeal, Kodak challenges both the legal standard the district court applied to find whether customers were coerced into using Kodak ink and the district court’s preliminary factual findings. In evaluating the likelihood of success on the merits, the district court applied a standard that unduly favored Collins to determine whether customers were coerced into buying Kodak ink. The court examined whether the policy made it likely that all or almost all customers would switch to Kodak ink, but did not examine whether this would be the result of unreasonable conduct on Kodak’s part. A tying arrangement enforced entirely through differential pricing of the tying product contravenes the Sherman Act only if the pricing policy is economically equivalent to selling the tied product below cost. The record makes it difficult to determine conclusively Kodak’s ink production costs, but the available evidence suggests that Kodak was worse off when customers bought both products, meaning that it was in effect selling ink at a loss. Thus, Collins was likely to succeed on the merits even under the correct standard.  Furthermore, the district court was correct in its consideration of the other factors for a preliminary injunction. Accordingly, the preliminary injunction was not an abuse of discretion.

The Sixth Circuit’s Collins Inkjet opinion nicely illustrates the current unsatisfactory state of tying law from an economic perspective.  Unlike in various other areas of antitrust law, such as vertical restraints, exclusionary conduct, and enforcement, the Supreme Court has failed to apply a law and economics standard to tying.  It came close on two occasions, with four Justices supporting a rule of reason standard for tying in Jefferson Parish, and with a Supreme Court majority acknowledging that “[m]any tying arrangements . . . are fully consistent with a free, competitive market” in Independent Ink (which held that it should not be presumed that a patented tying product conveyed market power).  Nevertheless, despite the broad scholarly recognition that tying may generate major economic efficiencies (even when the tying product conveys substantial market power), tying still remains subject to a peculiar rule of limited per se illegality, which is triggered when:  (1) two separate products or services are involved; (2) the sale or agreement to sell one is conditioned on the purchase of the other; (3) the seller has sufficient economic power in the market for the tying product to enable it to restrain trade in the market for the tied product; and (4) a “not insubstantial amount” of interstate commerce in the tied product is affected.  Unfortunately, it is quite possible for plaintiffs to shoehorn much welfare-enhancing conduct into this multipart test, creating a welfare-inimical disincentive for efficiency-seeking businesses to engage in such conduct.  (The U.S. Court of Appeals for the D.C. Circuit refused to apply the per se rule to platform software in United States v. Microsoft, but other appellate courts have not been similarly inclined to flout Supreme Court precedent.)

Courts that are concerned with the efficient application of antitrust may nonetheless evade the confines of the per se rule in appropriate instances, by applying economic reasoning to the factual context presented and finding particular test conditions not met.  The Sixth Circuit’s Collins Inkjet opinion, unfortunately, failed to do so.  It is seriously problematic, in at least four respects.

First, the Sixth Circuit’s opinion agreed with the district court that “coercive” behavior created an “implicit tie,” despite the absence of formal contractual provisions that explicitly tied Kodak’s ink to sale of its refurbished printheads.

Second, it ignored potential vigorous and beneficial ex ante competition among competing producers of printers to acquire customers, which would have negated a finding of significant economic power in the printer market and thereby precluded per se condemnation.

Third, it incorrectly applied the PeaceHealth standard to the facts at hand due to faulty economic reasoning.  For a finding of anticompetitive (“exclusionary”) bundled discounting, PeaceHealth requires that, after all discounts are applied to the “competitive” product, “the resulting price of the competitive product or products is below the defendant’s incremental cost to produce them”.  In Collins Inkjet, all that was known was that Kodak “stood to make more money if customers bought ink from Collins and paid Kodak’s unmatched printhead refurbishment price than if they bought Kodak ink and paid the matched printhead refurbishment price.”  Absent additional information, however, this merely supported a finding that Kodak’s tied ink was priced below its average total cost, not below its (far lower) incremental cost.  (Applying PeaceHealth, the Collins Inkjet court attributed the printhead discount entirely to Kodak’s ink, the tied product.)  In short, absent this error in reasoning (ironically, the court justified its flawed cost analysis “as a matter of formal logic”), the Sixth Circuit could not have based a finding of anticompetitive conduct on the PeaceHealth precedent.

Fourth, and more generally, the Sixth Circuit’s opinion, in its blinkered search for a “modern” (PeaceHealth) finely-calibrated test to apply in this instance, lost sight of the Supreme Court’s broad teaching in Reiter v. Sonotone Corp. that antitrust law was designed to be “a consumer welfare prescription.”  Kodak’s pricing policy that offered discounts to buyers of its printheads and ink yielded lower prices to consumers.  There was no showing that Collins Inkjet would likely be driven out of business, or, even if it were, that consumers would eventually be harmed.  Absent any showing of likely anticompetitive effects, vertical contractual provisions, including tying, should not be subject to antitrust challenge.  Indeed, as Professor (and former Federal Trade Commissioner) Joshua Wright and I have pointed out:

[T]he potential efficiencies associated with . . . tying . . . and the fact that [tying is] prevalent in markets without significant antitrust market power, lead most commentators to believe that [it is] . . . generally procompetitive and should be analyzed under some form of rule of reason analysis. . . .  [T]he adoption of a rule of reason for tying and presumptions of legality for [tying] . . . under certain circumstances may be long overdue.  

In sum, it is high time for the Supreme Court to take an appropriate case and clarify that tying arrangements (whether explicit or “coerced”) are subject to the rule of reason, with full recognition of tying’s efficiencies.  Such a holding would enable businesses to engage in a wider variety of efficient contracts, thereby promoting consumer welfare.

Finally, while it is at it, the Court should also consider taking a loyalty discount case, to reduce harmful uncertainty in this important area (caused by such economically irrational precedents as LePage’s, Inc. v. 3M) and establish a clear standard to guide the business community.  If it takes a loyalty discount case, the Court could beneficially draw upon Wright’s observation that “economic theory and evidence suggest[s] that instances of anticompetitive loyalty discounts will be relatively rare,” and his recommendation that “an exclusive dealing framework . . . be applied in such cases.”

Alden Abbott

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I am a Senior Legal Fellow at the Heritage Foundation. I write on antitrust, domestic and international regulatory policy, and law and economics. I am an Adjunct Faculty Member at George Mason Law School.