Vertical Issues : The Federal View

Remarks before The American Law Institute-American Bar Association (ALI-ABA), Product Distribution And Marketing Meeting

Scottsdale, Arizona

Date:
By: 
Sheila F. Anthony, Former Commissioner

Good afternoon. I'm very pleased to be here again. This is my third year in a row participating in this program. I always enjoy meeting with all of you and having a chance to tell you about some of the FTC's recent activities relating to distribution and marketing. This afternoon, we focus on antitrust issues arising in the context of vertical business relationships.

I've provided an outline of vertical issues that you will find beginning on page 235 of your materials. You should note that the outline does not correspond to my remarks here today. The outline covers a broad range of issues and is intended to serve as a general reference. Rather than attempt to describe the entire vertical landscape in 15 minutes, my remarks today will focus on just a few of the Commission's most recent vertical cases.

Introduction

Let me first make the standard disclaimer that the opinions I express here today are my own and do not necessarily reflect those of the Commission or any other individual Commissioner.

In the midst of the sea of mergers raising only horizontal issues that annually floods the Commission, I look forward to the occasional vertical case. The vertical cases often present competitive threats equal to or greater than those in the typical horizontal case, and they're usually extremely intellectually interesting as well.

At the most basic level, vertical antitrust theory focuses on integrations of different levels of the supply chain - from those who gather and supply the raw materials, to those who manufacture the products, and on to those who distribute and sell those products to the consumers. Often the integrations are pro-competitive. For example, they might allow more products to come to market faster and cheaper. Other times, however, integrations can stifle competition. They might create bottlenecks, freeze out competition, limit product choices, result in higher prices, or have other anticompetitive effects. That's where the antitrust law enforcers, like the FTC, come in.

Today, I will describe three vertical cases recently addressed by the Commission -- one involves electric power, another pharmaceuticals, and the last, books. While the industries may not be at all similar to those you deal with in your day-to-day practices, I believe the legal issues involved have a broad application.

One common thread running through all three cases is the concept of foreclosure. Foreclosure occurs when a vertical integration closes off some or all of a market to competitors thereby permitting the exercise of market power. Foreclosures can occur upstream, such as by cutting off rivals' access to necessary supplies or inputs, or downstream, such as by cutting off access to sales outlets or customers. Some of the ways foreclosures can harm competition include: forcing rivals out of the market; raising entry barriers; and raising rivals' costs, which all, in turn, can result in higher prices for consumers.

My goal here today is to help you spot issues and identify the enforcement risks your clients might face when they contact you about a plan to integrate different levels of production or distribution through a contract or merger. Hopefully, my description of how the FTC approached these three cases will give you some insight into how we might view your case.

Dominion Resources, Inc.

I'm sure many of you live in states that are considering, or have implemented, electricity deregulation, and the rest of you have surely heard about it in the news. Opening electricity markets to competition is an exciting prospect. In the Dominion Resources case, the Commission faced a vertical merger that threatened this competition before it even had a chance to develop.

In Dominion, the principal electric power supplier for the State of Virginia, who I'll refer to here as Virginia Power, sought to acquire Consolidated Natural Gas Company. Overall, this merger promised several synergies that will likely be beneficial to consumers.

However, one portion of the deal was problematic. Natural gas is the fuel of choice in Southeastern Virginia for running turbines that generate electrical power. One of the gas company's subsidiaries, Virginia Natural Gas, is the primary distributor of natural gas in southeastern Virginia. In simple terms, we have the primary electricity supplier buying the primary natural gas supplier.

Virginia will begin to implement electric utility deregulation in 2002. As deregulation occurs, independent electric generators are expected to enter the market and compete with Virginia Power. If Virginia Power's merger with the gas company had gone forward as proposed, Virginia Power would have controlled a critical input needed by the independent generators. Faced with a situation where their competitor controlled their gas supply, potential entrants might have stayed out of the market, or if they did enter, have faced higher production costs. Either way, the result would have been higher prices for electricity.

The Commission considered whether new gas distributors might come into the market and keep Virginia Power in check. Such entry, however, faced huge barriers. It would take a lot of time and money to extend pipelines into the region. Also, other companies with nearby pipelines lack sufficient excess capacity to supply a new pipeline into southeastern Virginia.

Working with the State of Virginia, the Commission obtained a consent agreement from the merging parties whereby the gas company subsidiary at issue will be divested. This remedy makes it possible for new generators to deal with an independent supplier rather than one owned and operated by their largest competitor.

Mylan

Let me now move from electricity to prescription drugs. In December 1998, the Commission sued Mylan Laboratories and three other companies, alleging that their exclusive vertical supply agreements violated the antitrust laws. The case is presently in the discovery stage with a trial expected to occur next year.

Before I describe the facts in Mylan, I'd like to stress two procedural issues. First, the forum. In most antitrust matters, the Commission either proceeds administratively or goes to federal court only to obtain a preliminary injunction needed to maintain the status quo during an administrative trial. In Mylan, the Commission is proceeding under Section 13(b) of its Act to obtain a permanent injunction; in other words, the case will start and finish in the federal court.

The second issue is the relief. Along with a permanent injunction, the Commission is seeking disgorgement of ill-gotten gains and restitution of money to injured consumers. The Commission has often sought and obtained disgorgement in consumer protection cases brought in district court, but this remedy has rarely been pursued in antitrust cases. The typical relief in most antitrust cases before Mylan has been limited to injunctions.

The Mylan defendants filed motions to dismiss challenging both the Commission's authority to bring an action for a permanent injunction in federal court and to obtain disgorgement. Last July, the court ruled in the Commission's favor on both these issues. The court held that it did have the power to issue a permanent injunction and also that the Commission could seek disgorgement. The judge's opinion is available on the Commission's website: FTC dot GOV.

Let me now tell you a little more about the conduct at issue in Mylan. In late 1997, Mylan Laboratories entered into several exclusive supply agreements with effectively the only supplier of the active pharmaceutical ingredient for two generic drugs it produced. These exclusive supply agreements were part of an overall scheme by Mylan to dramatically raise the prices of the two generic drugs.

Because these two drugs are used to treat chronic anxiety, they are heavily prescribed in nursing homes and hospices, and users tend to stay on them for long periods of time. The agreements prevented Mylan's competitors from having access to supply and thereby made it easier for Mylan to raise prices. As a result of these exclusive agreements, Mylan was able to raise the prices of the drugs by 2,000 to 3,000 percent, costing consumers over $120 million. Can you imagine what an impact such drastic price increases had on consumers who depend on these medications on a daily basis? Especially, when many of those consumers are elderly and most likely on fixed incomes!

Because this case is currently pending in the Federal District Court for the District of Columbia, it remains to be seen whether a Federal Judge will agree with the allegations contained in the Commission's complaint and issue a permanent injunction or order monetary relief. Nonetheless, I hope that this case sends a strong message to businesses that if you engage in anticompetitive conduct that has a clear negative effect not just on competition, but consumers as well, I as a Commissioner will seek relief that goes beyond a mere slap on the wrist. I will be looking for strong injunctive relief, and, in appropriate cases, disgorgement as well.

Barnes & Noble

Now, let's shift gears again; this time from drugs to books. Last year, Barnes & Noble, Inc., the largest book retailer in the United States, proposed to merge with Ingram Book Group, the largest book wholesaler in the United States. After an extended Commission investigation, and following press reports that the Commission would seek an injunction, the parties abandoned the deal last June.

Although Barnes & Noble was mainly a vertical case, it also raised a couple of horizontal issues that relate to distribution and marketing.

Barnes & Noble had its own distribution centers and, therefore, to some extent acted as its own wholesaler. Barnes & Noble had announced publicly that it was considering providing such wholesale services to other bookstores. Therefore, it was a potential direct competitor of Ingram's.

Understandably, Ingram wanted to prevent Barnes & Noble from growing its wholesale operation - quite simply, it wanted to maintain this large customer -- and so it offered better prices, more titles, and improved service. All of Ingram's customers, including independent bookstores, were beneficiaries of this competition.

Ingram is the dominant wholesaler. The gap between Ingram and the next largest wholesaler, Baker and Taylor, is very large. There were also indications that Ingram is even more important to the bookselling industry in a qualitative sense than its quantitative dominance suggests - that is, it simply does a better job of distribution. The combination of Ingram with Barnes & Noble's internal distribution center may well have increased the already high concentration in the overall book wholesaling market with the result being higher costs for retail competitors.

The main vertical theory in the case was that the merger threatened to "raise rivals' costs." This theory predicted that, after the merger, Barnes & Noble could raise the costs borne by rivals such as independent book stores and Internet retailers. Through this acquisition, Barnes & Noble would acquire the power to foreclose its retail competitors from access to an important upstream supplier.

The "raising rivals' costs" theory has been developed in the economic literature of the last decade or so, and focuses on the actual impact on competition from foreclosure. Under this theory, a vertical merger has the potential to cause anticompetitive results only when the remaining alternatives (upstream or downstream) are either inferior, inadequate, or more costly, thus imposing higher costs on the rivals of the integrating firm and permitting it to raise its own prices. It is important to note that absolute foreclosure is not required. Rather, competitive concerns are raised if rivals are forced to use more costly or less efficient alternatives.

The analysis is of course a lot more sophisticated than just concluding that if vertically related companies combine they are going to freeze out companies that aren't vertically integrated. The question we ask is whether the newly vertically-integrated company will have an incentive (and, of course, the ability) to raise rivals' costs. That is, will it be profitable to do so?

Post merger, a number of strategies would have been available to the merged company. For example, it might have chosen to (1) sell to competing bookstores at higher prices; (2) slow down book shipments t rivals; (3) restrict access to hot titles; (4) restrict access to Ingram's extended inventory or back list; or (5) price services higher or simply discontinue or reduce these services. While the merged company might have lost wholesale business byimplementing some of these strategies, it might also have gained additional retail business at higher margins, with the net result being higher profits. The ability of a merged company to raise rivals' costs would have depended to a great extent on how good the wholesaler alternatives to Ingram were, or could become. I was concerned that the answer was, "not very good." Even the largest of them, Baker & Taylor, was far smaller than Ingram. Ingram had several warehouses, efficiently placed throughout the U.S. The other wholesalers would have been more costly to use; they don't offer the title selection, speed, services or fill rate that Ingram does.

Of course, retailers do purchase some books directly from publishers. While retailers could have been expected to consider increasing their direct purchases from publishers in an effort to compensate for the loss of Ingram's services, that strategy seemed unlikely to be successful. The key service provided by wholesalers is next day replenishment of fast selling books. Publishers take two to four weeks, or even months, to deliver books, and customers generally will not wait that long. Also, of course, ordering books from each individual publisher rather than from a single wholesaler would greatly increase transaction costs.

I was concerned about the impact of this transaction on all segments of retailing: chains, Internet retailers, and independent booksellers. The largest threat, however, seemed to be to independent booksellers. The independents, as a group, serve as a sort of third national presence - along with large chains and Internet retailers - and a reduction of the significance of one of three national competitive forces posed a threat to consumers' interests.

Another concern I had was that the merged firm, through a subsidiary that deals with firms that are otherwise rivals, might obtain competitively sensitive information about the rivals. This sort of concern has led us to obtain protective order provisions - so-called "firewall" provisions - in other cases.

I was concerned that Barnes & Noble would gain access to two types of such information that the rivals provide to Ingram: the financial information they supply to obtain credit, and the titles and quantities of books they purchase from Ingram. The concerns was that Barnes & Noble might use this information for such purposes as targeting promising store locations, identifying competitors' weaknesses, and reaping the fruits of others' marketing efforts. Whether the fears were realistic or not, the fact that they were out there could have had its own dampening effect on competition. For example, independents may have less incentive to develop a market for special interest books if they believe Barnes & Noble would simply free-ride on their efforts. The question remains as to whether a firewall could have been designed to solve these problems.

I hope that my discussion of these cases has alerted you to potential issues that your clients may face when they embark upon vertical integrations. I also hope that I have impressed upon you the serious enforcement implications your clients may face if these issues are ignored. As you review a proposed integration, think about potential foreclosures and the market power implications they present. Also, don't hesitate to contact the enforcement agencies for guidance if you are not sure about how the authorities will view an integration