State Auto Dealer Regulation: One Man's Preliminary View

The International Franchise Association 34th Annual Legal Symposium

Washington, D.C.

Date:
By: 
Thomas B. Leary, Former Commissioner

The title of this speech should be taken literally. The reference to one man emphasizes that I am just speaking for myself. This is the standard disclaimer from people in a federal agency, but I flag it here because this article addresses something that I have not even discussed with my colleagues in the Commission. State auto dealer regulation is a subject that I have been thinking about recently, but thus far I have been doing so in isolation.

I refer to preliminary views because, even though I do have a background in the auto industry and was once familiar with the issue, it is not something that I have had occasion to consider for almost twenty years. I am now looking at this whole issue anew and from a different perspective. Some of these preliminary views may seem provocative, but my mind is still open and I welcome the reaction of practitioners and their clients.

A number of things have stimulated this renewed interest in state dealer legislation. First, the Commission has recently been focusing on a variety of issues involving e-commerce and the potential of the Internet, both for business-to-business and business-to-consumer transactions. This potential has apparently prompted a lot of activity at the state level. There has been an explosion of proposals to regulate further the already highly regulated interactions between automobile dealers and manufacturers, and there is already a suit,Alliance of Auto Manufacturers v. Hull,(2) challenging a particularly far-reaching law recently enacted in Arizona. This case is still in the preliminary stages, but is likely to attract much attention as it moves through the courts.

Significance of the Issue

The issue is important because it lies at the boundary between antitrust and other forms of regulation. For a lot of antitrust lawyers and economists, it has always seemed anomalous that the most effective and most durable restraints on competition are restraints mandated by government at various levels. Some say that the only durable and effective restraints on competition are those imposed by government, but even people who do not go that far will recognize that government restraints on competition are of great potential concern. And yet, government restraints on competition are antitrust immune under various doctrines announced in cases like Parker v. Brown(3) and its progeny. Moreover, even concerted efforts to induce competitive restraints by government on behalf of private interests can be antitrust immune under the Noerr(4) case and its progeny. That is something that has nagged at the back of my mind for decades.

The issue is also important because e-commerce can promise massive efficiencies involving direct communication across multiple levels, a close match between manufacturing activities and ultimate consumer demand, and substitution of a consumer "pull" strategy for a product "push" strategy.(5) Those who are familiar with this area know that the potential dollar savings are enormous. The potential to improve consumer satisfaction in other ways is also huge.

At the same time, this potential for direct, virtually costless communication with ultimate consumers has a very serious impact on the role of so-called middlemen like automobile dealers. I do not suggest that a free and open competitive system in the e-commerce environment would eliminate the need for automobile dealers, but it might very much change what automobile dealers do. It might also quite dramatically change the bargaining interface between automobile dealers and their customers, quite dramatically, and it is not surprising that dealers do not like that prospect. Like so many other interest groups in our society, they are doing what they can to enlist the aid of government to preserve present relationships.

The FTC's Role

There is an initial question about the appropriate role of the Federal Trade Commission in connection with the activities of state legislatures around the United States. The Commission has a role to play in protecting competition but obviously there is a tremendous difference between private restraints and the actions of sovereign states. State legislatures are free to take into consideration noncompetition values. The Federal Trade Commission does not run the world. At the same time, however, the Commission has a compelling responsibility to advocate competitive values. That is part of our job.(6) If we point out the potential costs of restrictions on competition, those who may decide to go down a particular regulatory path for other reasons will at least know the price of their decision.

Take an example involving a different issue in a different field. The Commission recently issued an extensive report on the factors that led to the highly publicized spike in gasoline prices in the Midwest in early summer 2000.(7) This is still an important issue because it is likely to happen again in various parts of the United States. That report stated that we had found no evidence of law violations by the oil refiners. This was a significant finding by itself, but we also went on to identify a lot of factors that contributed to the price spike, including government regulations that mandate the sale of numerous different kinds of gasoline and other government regulations that slow the construction or modification of refineries. These are big-ticket items that account for a substantial share of last year's price increases and likely future increases.

It was presumptuous for the Commission to discuss these factors, even though there are other considerations involved. There are environmental concerns that are very serious and not our responsibility. But nevertheless, when evaluating what government is going to do, people should be aware of the price that they will pay for it. If government regulation is going to have an adverse effect on the operation of normal market forces, it is proper for the Commission to point that out.

In 1986, the Commission's Bureau of Economics conducted a study that actually attempted to estimate the impact of then-existing state dealer laws on the prices of new automobiles. The study concluded that laws restricting "the ability of auto manufacturers to establish new dealerships may have increased the amount consumers paid for new cars by about $3.6 billion per year in the 36 states that had such laws."(8)

It is also part of the Commission's job to point out that competitive conditions may be changing, so that what appeared to be sensible legislation at one period of time may not be sensible at another. Market facts change, and there may have been some fundamental changes in the traditional relationships between automobile manufacturers and their dealers.

Changes In Auto Dealer Relationships

Federal regulation of the dealer relationship goes back 45 years - to a federal law that is popularly known as The Auto Dealers Day in Court Act.(9) There were two principal policy rationales for that law and the myriad state laws that have followed. One was the perceived imbalance in bargaining power between the big auto manufacturers and the dealers, which were assumed to be relatively small. The second was the notion that preservation of independent automobile dealers was an important value in and of itself - not only because of a general predilection in favor of small business but also because local dealers might have greater sensitivity to local consumer preferences and provide better overall service.(10) However, there have been some big changes in the intervening years.

Consider the supposed imbalance in bargaining power. The relative size of parties to a contract is probably a lot less significant than the availability of competitive alternatives. (Free-agent athletes and entertainers, who are highly talented, can command immense salaries from much larger enterprises.) The automobile industry is a great deal less concentrated today than it was 45 years ago when the first federal law was passed,(11) and there are also relatively fewer exclusive dealerships. This means that there is a great deal more competition at the manufacturer level to sign up particular dealers and establish a franchise relationship.

At the same time, there have been substantial changes at the dealer level. Dealers have never been considered fungible; that is the reason auto manufacturers wanted independent dealers in the first place. There has also been a proliferation of massive chain dealerships, including some entities that own hundreds of outlets across multiple product lines. On the bargaining power issue, the facts have shifted in 40 plus years and are continuing to shift.

These extensive changes also effect the consumer service argument. The original idea was to have a local entrepreneur with hands-on responsibility for the dealership and direct contact with consumers. In many areas today, the absentee owners of chain dealerships have no more local presence than absentee owners in a company-owned dealership. The person in charge is no longer there every day looking after the store. The unique personal service relationship is, to some degree, fading away. Finally, consider the potential of electronic communication. To a degree unheard of 45 years ago, there is the potential for a more direct and efficient communication between the manufacturer and the ultimate consumer. And, at the same time, electronic communication may make it easier for manufacturers to monitor dealership operations directly.

It is obvious that these factors may cut in opposing directions. Some dealers may have increased bargaining power and some may have less in the new environment. Some manufacturers might decide, in a free market, to experiment with different distribution methods. State dealer laws will, of course, inhibit these experiments.

In addition to these factual changes in the competitive dynamic, there have also been advances in economic theory. This is not the place to elaborate on the economic insights that prompted the Sylvania decision(12) and its successors, except to say it is no longer assumed that a manufacturer's control over its dealer network is harmful to consumers.

All of these things have combined to change the competitive environment and to make strict regulation of the auto dealer relationship arguably less justified today than it used to be. At the same time, state regulation appears to be becoming more and more restrictive. Whether these observations are true, and I emphasize that there may be arguments that can persuade me they are not true, I think it may be the Commission's job to at least to study the subject.

Countervailing Arguments

There may well be countervailing factors that should be openly debated. There is, for instance, a very big difference between anticompetitive laws passed by states and anticompetitive private restraints. So-called substantive due process has been largely dead for 65 years in the courts, and courts do not ask whether state legislation is wise or unwise. The test is much more deferential than that. Absent other constitutional issues, courts are likely to uphold legislation if there is some conceivable rational basis for it. This is a high burden for anyone mounting a challenge. At the same time, however, the potentially restrictive impact on e-commerce introduces additional issues that were not necessarily present in previous cases. It introduces arguments relating to free speech and serious interference with interstate commerce that may not have been available to people who were arguing these issues years ago.

The previously mentioned case, Alliance of Auto Manufacturers, promises to bring these issues to the fore.(13) This case involves a challenge to a new Arizona statute that, among other things, bars manufacturers from marketing directly to consumers - not only vehicles, but also parts, services, and financing. There is case law upholding state statutes that prevent manufacturers from selling vehicles directly to consumers, but it is something else to extend the ban to all of these ancillary activities.

The Arizona law also prevents manufacturers from "influencing" retail sales prices. Influencing is an extraordinarily broad word. If, for example, manufacturers want to publish information on dealer sales prices to ultimate consumers on the Internet, so that consumers no longer have to go from one dealership to another, this is arguably "influencing" the ultimate price, not because manufacturers dictate dealer prices but because the information will enhance the bargaining power of more knowledgeable consumers. If this is indeed what the law is intended to do and what it is interpreted to mean, there might be First Amendment arguments available as well.

The Arizona court is considering these matters. The court refused to enjoin enforcement of the statute before a trial on the facts. It did say, however, that some of the challengers' claims "may hold merit upon the development of a more comprehensive factual record."(14)That is something that the parties will presumably proceed to do.

In addition to these arguments of a constitutional dimension, there are arguments in defense of this kind of legislation that go to the merits. One of the most interesting is a free-riding claim that echoes some of the arguments many manufacturers have made in order to justify vertical restrictions on dealers. Dealers can assert that there will be an enormous potential for free-riding if people visit a dealership, tour the showroom, question the sales people, kick the tires, and test drive the cars (literal free-riding), then go on the Internet and buy at a lower price directly from the manufacturer or from some other dealer who undertakes no sales effort. This looks like a standard justification for vertical restraints, but there are important differences.

There may be a free-riding concern if consumers go to the dealer first and avail themselves of the dealer's sales efforts, and then buy from someone else on the Internet.(15) It is quite another thing if the consumer interaction is reversed, that is, if the consumer gathers information from the Internet first, gets armed with comparative information, and then goes to the dealer. This is not free-riding and state legislation that inhibits this kind of activity simply reduces consumer bargaining power.

A second distinction arises from the fact that the legislation is overtly designed to promote dealer interests. In other words, the restraints are horizontal in origin, rather than vertical. In the private context, restraints are particularly suspect if they are the result of horizontal action by dealers.(16) The legal test applied to state action is, of course, different, but the anticompetitive potential is the same.

In fact, state-imposed restraints may be much more anticompetitive because they apply across all product lines and to all competitors (or to all competing dealers). Absent collusion among manufacturers or dealers that handle different brands, private vertical restraints do not eliminate the potential for competition among different distribution systems. Manufacturers that employ vertical restraints that are not ultimately proconsumer can be disciplined by the competition of manufacturers that do not and intrabrand dealer collusion will be disciplined in the same way. That potential competition is eliminated with state-imposed vertical restraints.

To make matters worse, manufacturers that do not believe it makes sense to continue with this present system of distribution cannot really change their minds either. They are locked in because they cannot sell to consumers directly. In addition, there are all kinds of restrictions on terminating dealers. Unlike private vertical restraints that may or may not be procompetitive, but that are individual and subject to change, these state restraints are imposed across the board and tend to freeze present relationships.

Conclusion

In my preliminary view, this is a matter that should concern the Commission as a government agency with a responsibility to champion competition and consumer welfare. The FTC's 1986 staff study indicated that then-existing dealer regulation had a seriously adverse consumer impact. That potential still exists. The methodology of the 1986 study was criticized,(17) and it is possible the critics had valid points. There may haves been offsetting consumer benefits that were not taken into consideration then that still exist today. But we should develop the facts and try to determine who is right because the stakes are so high.

Endnotes:

1. This text is adapted from a speech delivered on May 8, 2001 at the International Franchise Association 34th Annual Legal Symposium in Washington, D.C. I would like to acknowledge the assistance of Attorney Advisor Holly Vedova, but accept sole responsibility for the opinions expressed.

2. No. CIV 00-1324-PHX-PGR (D. Ariz. Apr. 30, 2001).

3. 317 U.S. 341 (1943).

4. Eastern R.R. Presidents Conference v. Noerr Motor Freight, Inc., 365 U.S. 127 (1961).

5. In other words, instead of attempting to sell products that they have already made, manufacturers will increasingly be able to make products that they have already sold.

6. The Commission's Office of Competition Advocacy was abolished in 1993, but the activity has continued. The Office of Policy Studies (formerly Policy Planning), for example, has coordinated public comments on energy deregulation issues and has also sponsored public workshops for the exchange of views on competition issues.

7. Final Report of the Federal Trade Commission, Midwest Gasoline Price Investigation, Mar. 29, 2001, (available at: <www.ftc.gov/os/2001/03/mwgasrpt.htm>).

8. Robert P. Rogers, The Effect Of State Entry Regulation On Retail Automobile Markets, Bureau of Economics Staff Report to the Federal Trade Commission, 11 (Jan. 1986). A report issued by the Consumer Federation of America lists thirteen studies, all finding that vertical restrictions imposed by states on automobile dealerships result in higher prices to consumers. The report concludes that the result is a markup of approximately six to eight percent per vehicle in markets where restrictions are in force. See Mark Cooper, Consumer Federation of America, A Roadblock On The Information Superhighway: Anticompetitive Restrictions On Automotive Markets, 20-22 (Feb. 2001) [hereinafter CFA Report].

9. Federal Automobile Dealers' Franchise Act, 15 U.S.C. §1221 et seq.

10. This perceived advantage of local, independent dealers was an article of faith when I worked for an auto company in the 1970s, and I suspect that it still has strong support in the industry today. It is quite another thing, of course, to say that relationships based on this preference should be frozen by law.

11. The 1992 U.S. Department of Justice and Federal Trade Commission Horizontal Merger Guidelines measure concentration levels by what is known as the Hirschman-Herfindahl Index (HHI). The HHI is calculated by summing the squares of the individual market shares of all the participants in the market. Measured by the number of competing auto manufacturers, the automobile industry HHI has declined dramatically in the past three decades. In 1967, it was at almost 3,000, which is deemed a highly concentrated market by the Merger Guidelines. By 1997, it declined to slightly below 1,600, which is considered moderately concentrated by the Merger Guidelines. If the HHI is measured by the number of competing divisions or models, the concentration levels are much lower. See CFA Report, supra note 8, at 31-32.

12. Continental T.V., Inc. v. GTE Sylvania Inc., 433 U.S. 36 (1977).

13. No. CIV 00-1324-PHX-PGR (D. Ariz. Apr. 30, 2001).

14. Alliance of Auto Manufacturers, Slip Op. at 21.

15. Manufacturers can, of course, mitigate this problem in a variety of ways (i.e., by paying a promotional fee to a local dealer for each car delivered in the dealer's area of responsibility).

16. See, e.g., United States v. General Motors Corp., 384 U.S. 127, 144-45 (1966) (horizontal agreement among dealers along with vertical agreement between dealers and a supplier to boycott another dealer constituted per se illegal horizontal restraint); Denny's Marina, Inc. v. Renfro Prods., 8 F.3d 1217, 1220 (7th Cir. 1993) (dealer conspiracy to exclude competing dealer was per se illegal horizontal agreement notwithstanding the fact that it was joined in by operators of the Fairgrounds boat shows); ES Dev., Inc. v. RWM Enters., 939 F.2d 547, 556-57 (8th Cir. 1991) (agreement between car dealers to oppose rival car dealer's entry through concerted campaign of vertical communications with manufacturers was per se illegal), cert denied, 502 U.S. 1097 (1992).

17. See Wharton Economic Forecasting Associates, Inc., An Evaluation Of The FTC's Analysis Of The Effects Of RMA Laws On Auto Markets, (National Automobile Dealers Ass'n 1987).