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Kolasky: The DOJ and FTC Should Revise Their Proposed Vertical Merger Guidelines to Emulate the EU’s

William J. Kolasky —  6 February 2020

[TOTM: The following is part of a symposium by TOTM guests and authors on the 2020 Vertical Merger Guidelines. The entire series of posts is available here.

This post is authored by William J. Kolasky (Partner, Hughes Hubbard & Reed; former Deputy Assistant Attorney General, DOJ Antitrust Division), and Philip A. Giordano (Partner, Hughes Hubbard & Reed LLP).] 

[Kolasky & Giordano: The authors thank Katherine Taylor, an associate at Hughes Hubbard & Reed, for her help in researching this article.]

On January 10, the Department of Justice (DOJ) withdrew the 1984 DOJ Non-Horizontal Merger Guidelines, and, together with the Federal Trade Commission (FTC), released new draft 2020 Vertical Merger Guidelines (“DOJ/FTC draft guidelines”) on which it seeks public comment by February 26.[1] In announcing these new draft guidelines, Makan Delrahim, the Assistant Attorney General for the Antitrust Division, acknowledged that while many vertical mergers are competitively beneficial or neutral, “some vertical transactions can raise serious concern.” He went on to explain that, “The revised draft guidelines are based on new economic understandings and the agencies’ experience over the past several decades and better reflect the agencies’ actual practice in evaluating proposed vertical mergers.” He added that he hoped these new guidelines, once finalized, “will provide more clarity and transparency on how we review vertical transactions.”[2]

While we agree with the DOJ and FTC that the 1984 Non-Horizontal Merger Guidelines are now badly outdated and that a new set of vertical merger guidelines is needed, we question whether the draft guidelines released on January 10, will provide the desired “clarity and transparency.” In our view, the proposed guidelines give insufficient recognition to the wide range of efficiencies that flow from most, if not all, vertical mergers. In addition, the guidelines fail to provide sufficiently clear standards for challenging vertical mergers, thereby leaving too much discretion in the hands of the agencies as to when they will challenge a vertical merger and too much uncertainty for businesses contemplating a vertical merger. 

What is most troubling is that this did not need to be so. In 2008, the European Commission, as part of its merger process reform initiative, issued an excellent set of non-horizontal merger guidelines that adopt basically the same analytical framework as the new draft guidelines for evaluating vertical mergers.[3] The EU guidelines, however, lay out in much more detail the factors the Commission will consider and the standards it will apply in evaluating vertical transactions. That being so, it is difficult to understand why the DOJ and FTC did not propose a set of vertical merger guidelines that more closely mirror those of the European Commission, rather than try to reinvent the wheel with a much less complete set of guidelines.

Rather than making the same mistake ourselves, we will try to summarize the EU vertical mergers and to explain why we believe they are markedly better than the draft guidelines the DOJ and FTC have proposed. We would urge the DOJ and FTC to consider revising their draft guidelines to make them more consistent with the EU vertical merger guidelines. Doing so would, among other things, promote greater convergence between the two jurisdictions, which is very much in the interest of both businesses and consumers in an increasingly global economy.

The principal differences between the draft joint guidelines and the EU vertical merger guidelines

1. Acknowledgement of the key differences between horizontal and vertical mergers

The EU guidelines begin with an acknowledgement that, “Non-horizontal mergers are generally less likely to significantly impede effective competition than horizontal mergers.” As they explain, this is because of two key differences between vertical and horizontal mergers.

  • First, unlike horizontal mergers, vertical mergers “do not entail the loss of direct competition between the merging firms in the same relevant market.”[4] As a result, “the main source of anti-competitive effect in horizontal mergers is absent from vertical and conglomerate mergers.”[5]
  • Second, vertical mergers are more likely than horizontal mergers to provide substantial, merger-specific efficiencies, without any direct reduction in competition. The EU guidelines explain that these efficiencies stem from two main sources, both of which are intrinsic to vertical mergers. The first is that, “Vertical integration may thus provide an increased incentive to seek to decrease prices and increase output because the integrated firm can capture a larger fraction of the benefits.”[6] The second is that, “Integration may also decrease transaction costs and allow for a better co-ordination in terms of product design, the organization of the production process, and the way in which the products are sold.”[7]

The DOJ/FTC draft guidelines do not acknowledge these fundamental differences between horizontal and vertical mergers. The 1984 DOJ non-horizontal guidelines, by contrast, contained an acknowledgement of these differences very similar to that found in the EU guidelines. First, the 1984 guidelines acknowledge that, “By definition, non-horizontal mergers involve firms that do not operate in the same market. It necessarily follows that such mergers produce no immediate change in the level of concentration in any relevant market as defined in Section 2 of these Guidelines.”[8] Second, the 1984 guidelines acknowledge that, “An extensive pattern of vertical integration may constitute evidence that substantial economies are afforded by vertical integration. Therefore, the Department will give relatively more weight to expected efficiencies in determining whether to challenge a vertical merger than in determining whether to challenge a horizontal merger.”[9] Neither of these acknowledgements can be found in the new draft guidelines.

These key differences have also been acknowledged by the courts of appeals for both the Second and D.C. circuits in the agencies’ two most recent litigated vertical mergers challenges: Fruehauf Corp. v. FTC in 1979[10] and United States v. AT&T in 2019.[11] In both cases, the courts held, as the D.C. Circuit explained in AT&T, that because of these differences, the government “cannot use a short cut to establish a presumption of anticompetitive effect through statistics about the change in market concentration” – as it can in a horizontal merger case – “because vertical mergers produce no immediate change in the relevant market share.”[12] Instead, in challenging a vertical merger, “the government must make a ‘fact-specific’ showing that the proposed merger is ‘likely to be anticompetitive’” before the burden shifts to the defendants “to present evidence that the prima facie case ‘inaccurately predicts the relevant transaction’s probable effect on future competition,’ or to ‘sufficiently discredit’ the evidence underlying the prima facie case.”[13]

While the DOJ/FTC draft guidelines acknowledge that a vertical merger may generate efficiencies, they propose that the parties to the merger bear the burden of identifying and substantiating those efficiencies under the same standards applied by the 2010 Horizontal Merger Guidelines. Meeting those standards in the case of a horizontal merger can be very difficult. For that reason, it is important that the DOJ/FTC draft guidelines be revised to make it clear that before the parties to a vertical merger are required to establish efficiencies meeting the horizontal merger guidelines’ evidentiary standard, the agencies must first show that the merger is likely to substantially lessen competition, based on the type of fact-specific evidence the courts required in both Fruehauf and AT&T.

2. Safe harbors

Although they do not refer to it as a “safe harbor,” the DOJ/FTC draft guidelines state that, 

The Agencies are unlikely to challenge a vertical merger where the parties to the merger have a share in the relevant market of less than 20 percent, and the related product is used in less than 20 percent of the relevant market.[14] 

If we understand this statement correctly, it means that the agencies may challenge a vertical merger in any case where one party has a 20% share in a relevant market and the other party has a 20% or higher share of any “related product,” i.e., any “product or service” that is supplied by the other party to firms in that relevant market. 

By contrast, the EU guidelines state that,

The Commission is unlikely to find concern in non-horizontal mergers . . . where the market share post-merger of the new entity in each of the markets concerned is below 30% . . . and the post-merger HHI is below 2,000.[15] 

Both the EU guidelines and the DOJ/FTC draft guidelines are careful to explain that these statements do not create any “legal presumption” that vertical mergers below these thresholds will not be challenged or that vertical mergers above those thresholds are likely to be challenged.

The EU guidelines are more consistent than the DOJ/FTC draft guidelines both with U.S. case law and with the actual practice of both the DOJ and FTC. It is important to remember that the raising rivals’ costs theory of vertical foreclosure was first developed nearly four decades ago by two young economists, David Scheffman and Steve Salop, as a theory of exclusionary conduct that could be used against dominant firms in place of the more simplistic theories of vertical foreclosure that the courts had previously relied on and which by 1979 had been totally discredited by the Chicago School for the reasons stated by the Second Circuit in Fruehauf.[16] 

As the Second Circuit explained in Fruehauf, it was “unwilling to assume that any vertical foreclosure lessens competition” because 

[a]bsent very high market concentration or some other factor threatening a tangible anticompetitive effect, a vertical merger may simply realign sales patterns, for insofar as the merger forecloses some of the market from the merging firms’ competitors, it may simply free up that much of the market, in which the merging firm’s competitors and the merged firm formerly transacted, for new transactions between the merged firm’s competitors and the merging firm’s competitors.[17] 

Or, as Robert Bork put it more colorfully in The Antitrust Paradox, in criticizing the FTC’s decision in A.G. Spalding & Bros., Inc.,[18]:

We are left to imagine eager suppliers and hungry customers, unable to find each other, forever foreclosed and left languishing. It would appear the commission could have cured this aspect of the situation by throwing an industry social mixer.[19]

Since David Scheffman and Steve Salop first began developing their raising rivals’ cost theory of exclusionary conduct in the early 1980s, gallons of ink have been spilled in legal and economic journals discussing and evaluating that theory.[20] The general consensus of those articles is that while raising rivals’ cost is a plausible theory of exclusionary conduct, proving that a defendant has engaged in such conduct is very difficult in practice. It is even more difficult to predict whether, in evaluating a proposed merger, the merged firm is likely to engage in such conduct at some time in the future. 

Consistent with the Second Circuit’s decision in Fruehauf and with this academic literature, the courts, in deciding cases challenging exclusive dealing arrangements under either a vertical foreclosure theory or a raising rivals’ cost theory, have generally been willing to consider a defendant’s claim that the alleged exclusive dealing arrangements violated section 1 of the Sherman Act only in cases where the defendant had a dominant or near-dominant share of a highly concentrated market — usually meaning a share of 40 percent or more.[21] Likewise, all but one of the vertical mergers challenged by either the FTC or DOJ since 1996 have involved parties that had dominant or near-dominant shares of a highly concentrated market.[22] A majority of these involved mergers that were not purely vertical, but in which there was also a direct horizontal overlap between the two parties.

One of the few exceptions is AT&T/Time Warner, a challenge the DOJ lost in both the district court and the D.C. Circuit.[23] The outcome of that case illustrates the difficulty the agencies face in trying to prove a raising rivals’ cost theory of vertical foreclosure where the merging firms do not have a dominant or near-dominant share in either of the affected markets.

Given these court decisions and the agencies’ historical practice of challenging vertical mergers only between companies with dominant or near-dominant shares in highly concentrated markets, we would urge the DOJ and FTC to consider raising the market share threshold below which it is unlikely to challenge a vertical merger to at least 30 percent, in keeping with the EU guidelines, or to 40 percent in order to make the vertical merger guidelines more consistent with the U.S. case law on exclusive dealing.[24] We would also urge the agencies to consider adding a market concentration HHI threshold of 2,000 or higher, again in keeping with the EU guidelines.

3. Standards for applying a raising rivals’ cost theory of vertical foreclosure

Another way in which the EU guidelines are markedly better than the DOJ/FTC draft guidelines is in explaining the factors taken into consideration in evaluating whether a vertical merger will give the parties both the ability and incentive to raise their rivals’ costs in a way that will enable the merged entity to increase prices to consumers. Most importantly, the EU guidelines distinguish clearly between input foreclosure and customer foreclosure, and devote an entire section to each. For brevity, we will focus only on input foreclosure to show why we believe the more detailed approach the EU guidelines take is preferable to the more cursory discussion in the DOJ/FTC draft guidelines.

In discussing input foreclosure, the EU guidelines correctly distinguish between whether a vertical merger will give the merged firm the ability to raise rivals’ costs in a way that may substantially lessen competition and, if so, whether it will give the merged firm an incentive to do so. These are two quite distinct questions, which the DOJ/FTC draft guidelines unfortunately seem to lump together.

The ability to raise rivals’ costs: 

The EU guidelines identify four important conditions that must exist for a vertical merger to give the merged firm the ability to raise its rivals’ costs. First, the alleged foreclosure must concern an important input for the downstream product, such as one that represents a significant cost factor relative to the price of the downstream product. Second, the merged entity must have a significant degree of market power in the upstream market. Third, the merged entity must be able, by reducing access to its own upstream products or services, to affect negatively the overall availability of inputs for rivals in the downstream market in terms of price or quality. Fourth, the agency must examine the degree to which the merger may free up capacity of other potential input suppliers. If that capacity becomes available to downstream competitors, the merger may simple realign purchase patterns among competing firms, as the Second Circuit recognized in Fruehauf.

The incentive to foreclose access to inputs: 

The EU guidelines recognize that the incentive to foreclose depends on the degree to which foreclosure would be profitable. In making this determination, the vertically integrated firm will take into account how its supplies of inputs to competitors downstream will affect not only the profits of its upstream division, but also of its downstream division. Essentially, the merged entity faces a trade-off between the profit lost in the upstream market due to a reduction of input sales to (actual or potential) rivals and the profit gained from expanding sales downstream or, as the case may be, raising prices to consumers. This trade-off is likely to depend on the margins the merged entity obtains on upstream and downstream sales. Other things constant, the lower the margins upstream, the lower the loss from restricting input sales. Similarly, the higher the downstream margins, the higher the profit gain from increasing market share downstream at the expense of foreclosed rivals.

The EU guidelines recognize that the incentive for the integrated firm to raise rivals’ costs further depends on the extent to which downstream demand is likely to be diverted away from foreclosed rivals and the share of that diverted demand the downstream division of the integrated firm can capture. This share will normally be higher the less capacity constrained the merged entity will be relative to non-foreclosed downstream rivals and the more the products of the merged entity and foreclosed competitors are close substitutes. The effect on downstream demand will also be higher if the affected input represents a significant proportion of downstream rivals’ costs or if it otherwise represents a critical component of the downstream product.

The EU guidelines recognize that the incentive to foreclose actual or potential rivals may also depend on the extent to which the downstream division of the integrated firm can be expected to benefit from higher price levels downstream as a result of a strategy to raise rivals’ costs. The greater the market shares of the merged entity downstream, the greater the base of sales on which to enjoy increased margins. However, an upstream monopolist that is already able to fully extract all available profits in vertically related markets may not have any incentive to foreclose rivals following a vertical merger. Therefore, the ability to extract available profits from consumers does not follow immediately from a very high market share; to come to that conclusion requires a more thorough analysis of the actual and future constraints under which the monopolist operates.

Finally, the EU guidelines require the Commission to examine not only the incentives to adopt such conduct, but also the factors liable to reduce, or even eliminate, those incentives, including the possibility that the conduct is unlawful. In this regard, the Commission will consider, on the basis of a summary analysis: (i) the likelihood that this conduct would be clearly be unlawful under Community law, (ii) the likelihood that this illegal conduct could be detected, and (iii) the penalties that could be imposed.

Overall likely impact on effective competition: 

Finally, the EU guidelines recognize that a vertical merger will raise foreclosure concerns only when it would lead to increased prices in the downstream market. This normally requires that the foreclosed suppliers play a sufficiently important role in the competitive process in the downstream market. In general, the higher the proportion of rivals that would be foreclosed in the downstream market, the more likely the merger can be expected to result in a significant price increase in the downstream market and, therefore, to significantly impede effective competition. 

In making these determinations, the Commission must under the EU guidelines also assess the extent to which a vertical merger may raise barriers to entry, a criterion that is also found in the 1984 DOJ non-horizontal merger guidelines but is strangely missing from the DOJ/FTC draft guidelines. As the 1984 guidelines recognize, a vertical merger can raise entry barriers if the anticipated input foreclosure would create a need to enter at both the downstream and the upstream level in order to compete effectively in either market.

* * * * *

Rather than issue a set of incomplete vertical merger guidelines, we would urge the DOJ and FTC to follow the lead of the European Commission and develop a set of guidelines setting out in more detail the factors the agencies will consider and the standards they will use in evaluating vertical mergers. The EU non-horizontal merger guidelines provide an excellent model for doing so.

[1] U.S. Department of Justice & Federal Trade Commission, Draft Vertical Merger Guidelines, available at https://www.justice.gov/opa/press-release/file/1233741/download (hereinafter cited as “DOJ/FTC draft guidelines”).

[2] U.S. Department of Justice, Office of Public Affairs, “DOJ and FTC Announce Draft Vertical Merger Guidelines for Public Comment,” Jan. 10, 2020, available at https://www.justice.gov/opa/pr/doj-and-ftc-announce-draft-vertical-merger-guidelines-public-comment.

[3] See European Commission, Guidelines on the assessment of non-horizontal mergers under the Council Regulation on the control of concentrations between undertakings (2008) (hereinafter cited as “EU guidelines”), available at https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52008XC1018(03)&from=EN.

[4] Id. at § 12.

[5] Id.

[6] Id. at § 13.

[7] Id. at § 14. The insight that transactions costs are an explanation for both horizontal and vertical integration in firms first occurred to Ronald Coase in 1932, while he was a student at the London School of Economics. See Ronald H. Coase, Essays on Economics and Economists 7 (1994). Coase took five years to flesh out his initial insight, which he then published in 1937 in a now-famous article, The Nature of the Firm. See Ronald H. Coase, The Nature of the Firm, Economica 4 (1937). The implications of transactions costs for antitrust analysis were explained in more detail four decades later by Oliver Williamson in a book he published in 1975. See Oliver E. William, Markets and Hierarchies: Analysis and Antitrust Implications (1975) (explaining how vertical integration, either by ownership or contract, can, for example, protect a firm from free riding and other opportunistic behavior by its suppliers and customers). Both Coase and Williamson later received Nobel Prizes for Economics for their work recognizing the importance of transactions costs, not only in explaining the structure of firms, but in other areas of the economy as well. See, e.g., Ronald H. Coase, The Problem of Social Cost, J. Law & Econ. 3 (1960) (using transactions costs to explain the need for governmental action to force entities to internalize the costs their conduct imposes on others).

[8] U.S. Department of Justice, Antitrust Division, 1984 Merger Guidelines, § 4, available at https://www.justice.gov/archives/atr/1984-merger-guidelines.

[9] EU guidelines, at § 4.24.

[10] Fruehauf Corp. v. FTC, 603 F.2d 345 (2d Cir. 1979).

[11] United States v. AT&T, Inc., 916 F.2d 1029 (D.C. Cir. 2019).

[12] Id. at 1032; accord, Fruehauf, 603 F.2d, at 351 (“A vertical merger, unlike a horizontal one, does not eliminate a competing buyer or seller from the market . . . . It does not, therefore, automatically have an anticompetitive effect.”) (emphasis in original) (internal citations omitted).

[13] AT&T, 419 F.2d, at 1032 (internal citations omitted).

[14] DOJ/FTC draft guidelines, at 3.

[15] EU guidelines, at § 25.

[16] See Steven C. Salop & David T. Scheffman, Raising Rivals’ Costs, 73 AM. ECON. REV. 267 (1983).

[17] Fruehauf, supra note11, 603 F.2d at 353 n.9 (emphasis added).

[18] 56 F.T.C. 1125 (1960).

[19] Robert H. Bork, The Antitrust Paradox: A Policy at War with Itself 232 (1978).

[20] See, e.g., Alan J. Meese, Exclusive Dealing, the Theory of the Firm, and Raising Rivals’ Costs: Toward a New Synthesis, 50 Antitrust Bull., 371 (2005); David T. Scheffman and Richard S. Higgins, Twenty Years of Raising Rivals Costs: History, Assessment, and Future, 12 George Mason L. Rev.371 (2003); David Reiffen & Michael Vita, Comment: Is There New Thinking on Vertical Mergers, 63 Antitrust L.J. 917 (1995); Thomas G. Krattenmaker & Steven Salop, Anticompetitive Exclusion: Raising Rivals’ Costs to Achieve Power Over Price, 96 Yale L. J. 209, 219-25 (1986).

[21] See, e.g., United States v. Microsoft, 87 F. Supp. 2d 30, 50-53 (D.D.C. 1999) (summarizing law on exclusive dealing under section 1 of the Sherman Act); id. at 52 (concluding that modern case law requires finding that exclusive dealing contracts foreclose rivals from 40% of the marketplace); Omega Envtl, Inc. v. Gilbarco, Inc., 127 F.3d 1157, 1162-63 (9th Cir. 1997) (finding 38% foreclosure insufficient to make out prima facie case that exclusive dealing agreement violated the Sherman and Clayton Acts, at least where there appeared to be alternate channels of distribution).

[22] See, e.g., United States, et al. v. Comcast, 1:11-cv-00106 (D.D.C. Jan. 18, 2011) (Comcast had over 50% of MVPD market), available at https://www.justice.gov/atr/case-document/competitive-impact-statement-72; United States v. Premdor, Civil No.: 1-01696 (GK) (D.D.C. Aug. 3, 2002) (Masonite manufactured more than 50% of all doorskins sold in the U.S.; Premdor sold 40% of all molded doors made in the U.S.), available at https://www.justice.gov/atr/case-document/final-judgment-151.

[23] See United States v. AT&T, Inc., 916 F.2d 1029 (D.C. Cir. 2019).

[24] See Brown Shoe Co. v. United States, 370 U.S. 294, (1962) (relying on earlier Supreme Court decisions involving exclusive dealing and tying claims under section 3 of the Clayton Act for guidance as to what share of a market must be foreclosed before a vertical merger can be found unlawful under section 7).

In Antitrust & Competition, Antitrust Division, Barriers to Entry, Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?, European Union, Exclusionary Conduct, Exclusive Dealing, Exemptions, Federal Trade Commission, International, Justice Department, Law & Economics, Market Definition, Merger Guidelines, Truth on the Market, Tying, Vertical Restraints , , , , , , , , , , , , ,
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Kolasky (2) on the Apple e-books case: Coordination, even horizontal coordination, isn’t per se illegal

William J. Kolasky —  16 February 2016

By William Kolasky

Jon Jacobson in his initial posting claims that it would be “hard to find an easier case” than Apple e-Books, and David Balto and Chris Sagers seem to agree. I suppose that would be true if, as Richard Epstein claims, “the general view is that horizontal arrangements are per se unlawful.”

That, however, is not the law, and has not been since William Howard Taft’s 1898 opinion in Addyston Pipe. In his opinion, borrowing from an earlier dissenting opinion by Justice Edward Douglas White in Trans-Missouri Freight Ass’n, Taft surveyed the common law of restraints of trade. He showed that it was already well established in 1898 that even horizontal restraints of trade were not necessarily unlawful if they were ancillary to some legitimate business transaction or arrangement.

Building on that opinion, the Supreme Court, in what is now a long series of decisions beginning with BMI and continuing through Actavis, has made it perfectly clear that even a horizontal restraint cannot be condemned as per se unlawful unless it is a “naked” restraint that, on its face, could not serve any “plausible” procompetitive business purpose. That there are many horizontal arrangements that are not per se unlawful is shown by the DOJ’s own Competitor Collaboration Guidelines, which provide many examples, including joint sales agents.

As I suggested in my initial posting, Apple may have dug its own grave by devoting so much effort to denying the obvious—namely, that it had helped facilitate a horizontal agreement among the publishers, just as the lower courts found. Apple might have had more success had it instead spent more time explaining why it needed a horizontal agreement among the publishers as to the terms on which they would designate Apple as their common sales agent in order for it to successfully enter the e-book market, and why those terms did not amount to a naked horizontal price fixing agreement. Had it done so, Apple likely could have made a stronger case for why a rule of reason review was necessary than it did by trying to fit a square peg into a round hole by insisting that its agreements were purely vertical.

In Antitrust & Competition, Apple, Justice Department, Monopolization, Platforms, Symposium on the Apple E-Books Antitrust Case: Implications for Antitrust and for the Economy, Vertical Restraints , , , , , , , , , , , , , , , , , ,
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Kolasky on the Apple e-books case: Another reminder that “easy labels do not always supply ready answers”

William J. Kolasky —  15 February 2016

By William Kolasky

In my view, the Second Circuit’s decision in Apple e-Books, if not reversed by the Supreme Court, threatens to undo a half century of progress in reforming antitrust doctrine. In decision after decision, from White Motors through Leegin and Actavis, the Supreme Court has repeatedly held—in cases involving both horizontal and vertical restraints—that the only test for whether an agreement can be found per se unlawful under Section 1 is whether it is “a naked [restraint] of trade with no purpose except stifling competition,” or whether it is instead “ancillary to the legitimate and competitive purposes” of a business association. Dagher. The cases in which the Court has consistently applied this test read like a litany of antitrust decisions we all now study in law school: White Motors, Topco, GTE Sylvania, Professional Engineers, BMI, Maricopa, NCAA, Business Electronics, ARCO, California Dental, Dagher, Leegin, American Needle, and, most recently, Actavis. Significantly, more than two-thirds of these cases involved horizontal, not vertical restraints.

In these decisions, the Court has also repeatedly warned that this test cannot be applied by simply asking whether the defendants “have literally ‘fixed’ a ‘price,” or otherwise agreed not to compete. Warning that “[l]iteralness is overly simplistic and often overbroad,” the Court insisted in BMI that courts instead focus on “the effect and, because it tends to show effect…, on the purpose of the practice” to determine whether “the practice facially appears to be one that would always or almost always tend to restrict competition and decrease output… or instead one designed to ‘increase economic efficiency and render markets more, rather than less, competitive.”

In applying this test the Court has also repeatedly emphasized that a court should classify an alleged restraint—whether horizontal or vertical—as per se unlawful “only after considerable experience” with the particular restraint at issue. In addition, the Court has repeatedly emphasized that all that is necessary for a restraint to escape per se illegality is that there be a “plausible” procompetitive purpose behind it. See, e.g., Cal Dental; Business Electronics; Northwest Wholesale Stationers.

By focusing so much attention in their cert. papers on whether the agreements between Apple and the publishers should be characterized as “vertical” or “horizontal,” both Apple and the DOJ seem to have lost sight of the fundamental teachings of this long line of Supreme Court decisions—namely, that even if an agreement is horizontal, it can be found to be per se unlawful only if it is a naked agreement that, on its face, serves no purpose other than to restrict competition and restrain output. This is particularly important where, as in this case, the alleged agreements have both horizontal and vertical elements. In such cases, the right question is not whether the agreements can be labeled a “hub-and-spoke conspiracy,” but instead what the nature and purpose of those agreements were.

In this case, the nature of the arrangement between Apple and the publishers by which they all appointed Apple as their common sales agent is not fundamentally different from the an agreement among a group of competitors to appoint a joint sales agent. While such an arrangement can, in some circumstances, be used to facilitate cartel behavior, it can also serve legitimate pro-competitive purposes by enabling those competitors to market their goods or services more efficiently. The courts and antitrust enforcement agencies have, therefore, recognized—ever since the Supreme Court’s decision in Appalachian Coals—that these joint sales arrangements must generally be evaluated under the rule of reason and cannot in all instances be condemned as per se unlawful. See, e.g., FTC/DOJ, Competitor Collaboration Guidelines. (For those of you who remember the criticisms that used to be directed at that decision by your antitrust professor in law school, I urge you to read Sheldon Kimmel’s excellent revisionist article, How and Why the Per Se Rule Against Price Fixing Went Wrong, showing that the Court’s holding was perfectly consistent with its more recent rulings in BMI and its progeny.

Viewing this as an agreement among the publishers to appoint Apple as their common sales agent might have helped the lower courts to have focused on what should have been the key issues in the case. The first is whether the agency arrangement was a “naked” agreement to “restrict competition and decrease output,” or could “plausibly” have been intended to serve other legitimate pro-competitive business purposes. The second is whether, if so, the restraints that were part of this arrangement—such as price caps and most-favored nation clauses—were ancillary to those legitimate purposes.

Based on the record as I read it, it appears to me that the answers to these two questions are obvious, and that they compel the conclusion that this common sales agent arrangement could not be classified as per se unlawful, but would need to be evaluated under a full-blown rule of reason analysis. Let me address each issue in turn.

Was the common sales agent arrangement between Apple and the five publishers a naked agreement to fix prices and restrict output?

Neither the lower courts nor the parties in their cert papers address this key issue in any detail, choosing instead to spend page after page debating whether the agreement between Apple and the publishers was horizontal or vertical. Fortunately, the amicus briefs that were filed in support of Apple’s cert. petition by ICLE and by a group of antitrust economists do address the issue at considerable length.

Those briefs make a convincing argument that the common sale agent arrangements between the publishers and Apple were designed to serve at least two pro-competitive purposes. The first was to introduce greater competition into the downstream market for the distribution of e-books by ending Amazon’s below-cost pricing of e-books at the retail level. The second was to give the publishers greater control over the downstream pricing of their e-books in order to prevent below-cost pricing of e-books from cannibalizing the sales of their print books.

The common sale agent arrangement served to introduce more competition into the downstream market for the distribution of e-books

This one is easy. No one disputes that before Apple entered, Amazon dominated the downstream market for e-books with a 90% market share, giving it a virtual monopoly. Hopefully, few, if any, would dispute that Amazon’s loss-leader strategy of selling e-books at well below cost served to entrench its near monopoly position in that market. It is easy to understand why publishers of e-books would not want to allow Amazon’s monopoly to continue, leaving them with only a sole distributor for their products.

The record below makes it clear that Apple did not believe it could profitably enter the e-book market so long as Amazon continued to maintain its first-mover advantage by selling e-books below cost. Apple and the publishers therefore had a common interest in moving from the existing wholesale model of e-book distribution to a new agency model under which the publishers, not Amazon, would control the retail pricing of e-books and could set those prices at a level that would enable other competitors, such as Apple, to enter. That seems pro-competitive to me.

The record also makes it clear that this objective could not be accomplished through a simple vertical agency agreement between Apple and one or two individual publishers. In order to enter successfully, Apple needed a critical mass of titles, which it could have only by securing the agreement of most of the leading publishers to appoint it as their common sale agent. Apple, therefore, had a legitimate pro-competitive business reason to facilitate—or, as the Second Circuit charged, “orchestrate” —agreements among the publishers to switch to an agency model and to appoint Apple as their common non-exclusive agent for the sale of their e-books.

The common sales agent arrangement gave the publishers control over the retail prices of e-books, protecting them from harms to their businesses that could otherwise be caused by below-cost pricing by a single dominant retailer.

The Second Circuit and DOJ both make much of the fact that the publishers wanted to control the retail prices of e-books in order to raise those prices above the level set by Amazon’s loss-leader pricing strategy. They both seem to believe that this alone is enough to characterize their conduct as a “naked price fixing scheme.” But it is not. As the Supreme Court held in Leegin, resale price maintenance can be pro-competitive even if it leads to higher prices if it is designed promote competition by creating a more efficient and competitive distribution system.

As Areeda and Hovenkamp teach in their treatise, Fundamentals of Antitrust Law, the same principle applies to agreements among a group of horizontal competitors to appoint a single sales agent. Those competitors will frequently “have to agree with each other that they will not accept less than a certain minimum price, or sometimes may even have to agree on the entire price schedule,” and these prices may sometimes be higher than the prices at which they were previously selling the products individually. See Areeda & Hovenkamp (2015 Supp.), at 19:31-32. But even if these agreements result in an increase in price, they argue that it should not be found illegal if the effect on output is positive. Their argument is supported by the language in BMI, in which the Court focused on the effect of a restraint on output, not price, in describing what was necessary to classify an alleged restraint as a per se illegal naked price-fixing agreement.

Here, although the district court found that prices went up and output went down in the short run after the publishers switched from their wholesale model to an agency model, these immediate, short-term effects do not necessarily show that the switch to the new agency model might not, over the long-term, have resulted in an increase in output. DOJ concedes that since Apple’s entry, e-book sales have grown exponentially, but speculates that this growth might have occurred even if Amazon had continued to maintain its monopoly position in the retail sale of e-books. As someone who reads e-books on my iPad, I doubt that, but this is the type of issue that can only be resolved through a full rule-of-reason analysis, not through the application of a conclusive presumption of illegality under the per se doctrine.

Here, as the amicus briefs argue, there are several ways Amazon’s loss-leader pricing strategy could have depressed the output of both e-book and print books long-term. First, of course, once its monopoly was fully entrenched, Amazon could have sought to recoup its losses by raising its e-book prices above a competitive level. Second, if instead Amazon continued to cannibalize print sales through below-cost e-book pricing, publishers might have been forced to reduce the royalties they pay authors, giving those authors less reason to continue writing, thus reducing the output of all books. Again, these are the types of issues that require a full rule of reason analysis, not summary condemnation under the per se doctrine.

Were the price caps and most-favored nation clauses ancillary restraints that may have been reasonably necessary to the legitimate pro-competitive purposes of the common sales agent arrangement?

The ancillary nature of the terms that were included in Apple’s agency agreements with the publishers, and which the publishers may have agreed among themselves to accept, is equally easy to show.

The price caps on which Apple insisted were obviously designed to protect it from opportunistic behavior by the publishers in charging higher prices for their e-books than what Apple felt the market would accept, thereby preventing it from selling a sufficient volume of e-books to make its entry successful. Such opportunistic behavior by the publishers could also have made it harder to convince consumers to buy Apple’s new iPad, the success of which was critical to its future.

The most favored nation clauses on which Apple insisted, and which the publishers may also have agreed among themselves to accept, were likewise arguably necessary to protect Apple from the risk of having to compete against an established competitor offering lower prices than it could, thereby impeding its successful entry and damaging its goodwill with consumers.

In both cases, these are classic and legitimate reasons for ancillary restraints. Whether or not these particular restraints were reasonably necessary to Apple’s successful entry is a question that could only be decided on the basis of a full rule of reason analysis. All that is needed to avoid per se condemnation is that there be a plausible argument that they were, and that, again, should be something that no one could dispute.

* * *

Given the way the case was litigated, I recognize that it may be difficult to introduce at the Supreme Court level a whole new way of looking at the facts of the case. But if the Court does grant cert., I would hope that Apple and the amici supporting it would try to refocus the Court’s attention away from a sterile argument over whether the restraints in question were vertical or horizontal, and to focus it instead on whether they were a “naked” attempt to fix prices and restrict output or were instead ancillary to a pro-competitive business relationship.

 

 

 

 

 

 

 

In Amazon, Antitrust & Competition, Apple, Justice Department, Monopolization, Platforms, Resale Price Maintenance, Supreme Court, Symposium on the Apple E-Books Antitrust Case: Implications for Antitrust and for the Economy, Vertical Restraints , , , , , , , , , , , , , , , , , , , ,
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Section 2 Symposium: Bill Kolasky on Proving Market Power

William J. Kolasky —  6 May 2009

kolaskyWilliam Kolasky is a partner in WilmerHale’s Regulatory and Government Affairs Department, a member of the firm’s Antitrust and Competition Practice Group, and a former Deputy Assistant Attorney General in the Antitrust Division at the Department of Justice.

The market power section of the Department’s Single Firm Conduct report is one of the strongest sections of the report.  It provides an exceptionally clear discussion of the market power element under Section 2.  It recognizes, in particular, that a violation of Section 2 requires more than mere market power, but rather a finding of substantial and durable market power – “an extreme degree of market power” as the Fifth Circuit expressed it in Beauville v. Federated Dep’t Stores.

In addition, the report make a persuasive argument that agencies and courts should rely principally on market shares and entry conditions as the primary means of evaluating whether a firm has monopoly power or a dangerous probability of achieving it.  As the report notes, courts often say that monopoly power can also be shown through direct evidence, but when one examines those decisions, one finds that courts almost never (and perhaps never) find monopoly power or a dangerous probability in section 2 cases without first finding that the firm has a very large market share.  Even in section 1 cases, while the Supreme Court held in NCAA and Indiana Federation that market power can be shown by direct evidence “without a detailed market analysis,” in both cases the defendants’ market shares of the likely relevant market were very high.

The report explains quite persuasively the problems with relying on direct evidence as a basis for finding monopoly power.  One type of direct evidence that is frequently mentioned are large price-cost margins, but as the report notes the economics literature raises serious doubt as to whether one can infer anything about the presence or absence of monopoly profits from a company’s profits as reported in its accounting records.  Similarly, while some have suggested that the presence of price discrimination might be used to infer monopoly power, most economists now recognize that price discrimination is common in markets in which firms do not have durable, long-run monopoly power.

In this regard, the Justice Department’s views appear consistent with those of the FTC staff, at least as reflected in the FTC staff reports that the FTC has posted on its website.  What both agencies seem to believe is that direct evidence may be useful in addition to, but not as a substitute for, an examination of market structure and entry conditions.

In Antitrust & Competition, Antitrust Division, Justice Department, Law & Economics, Price Discrimination, Section 2 Symposium, Truth on the Market
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Section 2 Symposium: Bill Kolasky on a Stepwise Rule of Reason for Exclusionary Conduct

William J. Kolasky —  5 May 2009

kolaskyWilliam Kolasky is a partner in WilmerHale’s Regulatory and Government Affairs Department, a member of the firm’s Antitrust and Competition Practice Group, and a former Deputy Assistant Attorney General in the Antitrust Division at the Department of Justice.

The most controversial part of the Justice Department’s Single Firm Conduct Report is the Department’s proposed use of what it terms a “substantial disproportionality” test for exclusionary conduct. Under this test, the Justice Department would bring a case only if the harm to consumers and competition caused by a dominant or near-dominant firm’s conduct is “substantially disproportionate” to any legitimate benefits the firm might realize. The Department argues that this test is superior to the three alternative tests it considers—an effects-balancing test, a no-economic-sense test, and an equally-efficient-competitor test—because it is more administrable and because it reduces the risk of false positives (i.e., finding conduct unlawful that does not harm competition ), which the Department views as more serious than that of false negatives (i.e., finding conduct lawful that does harm competition).

Critics of the Department’s report argue that this test places a finger on the scale in favor of monopolists and near-monopolists, leaving consumers and smaller competitors with too little protection, and it is certainly easy to see why the test gives rise to this perception. But there is another, more fundamental problem with the Justice Department’s proposed test – namely, that it perpetuates the outdated view of the rule of reason as an ad hoc balancing test, and does not take into account the extent to which the Supreme Court and the lower courts have given greater structure to rule of reason analysis over the last thirty years. Continue Reading…

In Antitrust & Competition, Antitrust Division, Exclusionary Conduct, Justice Department, Law & Economics, Section 2 Symposium, Truth on the Market
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Kolasky on What Happens with the Section 2 Report

William J. Kolasky —  13 December 2008

William Kolasky (Wilmer Hale, and one of the frontrunners for the DOJ AG spot according to the rumormill) has an interesting piece in the Antitrust Source on the DOJ Section 2 Report arguing that while:

even the objecting Commissioners would probably agree that the Justice Department Report does a good job analyzing particular types of exclusionary conduct, such as price predation, tying, bundled and loyalty discounts, refusals to deal, and exclusive dealing …. The principal focus of the three Commissioners’ objections is not to this part of the Report, but rather to the general standard it proposes for exclusionary conduct. And, in that regard, their concerns appear to have some merit.

The most interesting paragraph in the article, and the one most likely to grasp the attention of the antitrust community, is the closer:

With a new Administration in January, we should have further discussion of the standards the agencies and courts should use in enforcing Section 2. Until then, we should treat the Justice Department’s Report, not as its final word, but rather as a discussion draft, and continue to search for a common standard that both agencies could apply. That was how the European Commission presented its report on Article 82 and abuse of dominance. It is an approach that makes particularly good sense here, so that we do not have the Justice Department applying one, highly laissez-faire standard to single-firm conduct and the FTC a different, more restrictive standard.

There are a couple of ways this might go.  Defenders of the Report might argue that the Section 2 Hearings involved plenty of discussion over the appropriate standards and it is for the FTC to either join the DOJ or offer a better alternative.  Alternatively, the new DOJ could go a bit further than Kolasky’s suggestion here and renounce or reject the Report in some fashion, clearing that path for FTC/DOJ convergence on some new (and presumably more aggressive) standard.  Of course, a third possibility is that the FTC and DOJ continue to apply divergent standards to single firm conduct.  That would be costly.  But if you are of the view that the DOJ Section 2 Report offers a good set of substantive monopolization rules and provides valuable guidance in the area of antitrust law that needs it the most — I hold this view — it is not so clear to me that the uncertainty between agencies is less costly than converging to a yet to be determined and possibly worse set of rules.

At some point, and this goes for the conversation about convergence and divergence between Section 2 and Article 82, we are going to have to have a frank discussion about the optimal monopolization standards.  Yes, institutional design matters here.  The absence of private rights in the EU compared to the high cost of false positives in the United States given treble damages and private actions means that the domestic standards should be less restrictive than those overseas.  But the discussion shouldn’t stop there.  Private rights of action and generous remedies in the U.S. system is only one reason to optimal monopolization standards should under-deter.  The more general point is an Easterbrookian one.  The costs of false positives are higher even without those institutional concerns both because they are self-correcting where as false negatives are not and, importantly but often ignored in this context, we just aren’t very good at distinguishing anticompetitive from pro-competitive conduct in the single firm context yet. That’s as true in Europe as it is in the United States.  It’s the same economics.

Other thoughts on the FTC v. DOJ Section 2 ruckus here and here).

In Antitrust & Competition, European Union, Exclusionary Conduct, Exclusive Dealing, Federal Trade Commission, International, Justice Department, Tying
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