THOUGHTS ON THE EC'S GREEN PAPER
ON VERTICAL RESTRAINTS
Prepared Remarks of
DEBRA A. VALENTINE
Assistant Director
International Antitrust Division
FEDERAL TRADE COMMISSION
BEFORE
ABA ANTITRUST SECTION AND
IBA ANTITRUST AND TRADE LAW COMMITTEE
Managing the Antitrust Risks of
Multinational Distribution
The Plaza Hotel
New York City, New York
June 10, 1997
The views expressed here are those of the author, and not necessarily of the Federal Trade Commission or any Commissioner.
I have never thought of myself as a Don Quixote figure, but rather as somewhat pragmatic and level-headed. But I am going to make a quixotic attempt today to try to convince the EC to think big and aspirationally in reevaluating its approach to vertical restraints. This project could not be more timely.
Dramatic changes in recent decades have broken down national barriers. Deregulation of transportation sectors has led to falling transportation costs. Those costs historically had posed significant barriers to entry and often were an important factor in defining geographic markets. Yet the 1980 deregulation of U.S. road transport and the 1987 deregulation of French road transport both triggered a 20% fall in the prices of road freight services. The 1994 deregulation of this sector in Germany caused a price fall of some 30%.(1) Airline transportation deregulation in the U.S. unleashed a price decrease of about 33% between 1976 and 1993, while privatization and deregulation of the UK airline industry caused BA's fares to fall by about 25% in the 1985-1990 period.(2) And the EU should benefit from similar price savings when its deregulation of this sector is completed in 1998.
Innovation is also driving cost decreases in communications, and developments in information technology are transforming the distribution sector.(3) Computers, scanning machines at check out counters and bar codes on products have increased the power of retailers by shifting control over inventories from wholesalers to retailers. With immediate access to point of sale information, retailers can calibrate the number of green shirts in size 6 and pink shirts in size 10 sold on a daily, if not hourly, basis.(4) The ability to forecast demand with a high degree of accuracy allows large retailers to reduce stock levels, fine-tune their inventories and insist on smaller and more frequent shipments of exactly what they need. Innovation also is enabling new forms of distribution and marketing, a proliferation of long-distance selling and the rise of sales through the Internet.(5)
And as transportation and communication costs tumble, firms are going global, whether through mergers, joint ventures, franchising, or foreign direct investment. The Coca Cola Company has eliminated the labels "international" and "domestic" in its organizational hierarchy; what most people would call its domestic sales now represent only 21% of the company's total sales. Ford is moving to global sourcing and currently is exporting 68% of its sales from its Mexican plants to North American markets.(6) And Benetton has linked its franchise outlets and suppliers worldwide via computer.(7) Finally, the EU should have a common currency by 1999, thus removing another cause of price differentials in national markets and an impediment to parallel trade.(8)
Simultaneously, successive rounds of trade negotiations have dramatically reduced tariff barriers in goods. They have also attacked nontariff barriers such as standards and subsidies. And trade negotiators are now addressing services, procurement, trade-related aspects of intellectual property, investment and competition.(9) The OECD just concluded an agreement to combat bribery in international business transactions and should soon have one that liberalizes investment. These forces, many of which are acknowledged in the Green Paper, all trend toward the dissolution of national boundaries. Cumulatively, they do far more to integrate markets and allow non-nationals to enter new territory than any single nation's or region's competition policy on vertical restraints.
This is not news to the EC. Chris observes that since the early 1960s, many EU product and service markets have evolved considerably (10) and the markets in which competition is intense have both increased and continue to do so.(11) The Green Paper also notes that price convergence is occurring in the Single Market.(12) I suspect that the EC does not attribute all that market evolution and increased competition to DG IV's current stance on parallel imports. Now, I am not trying to diminish the significance of competition policy. Indeed, as government barriers to market integration disappear, we can expect that private anticompetitive practices will assume increased importance. And vertical restraints will be an important and complicated issue for competition enforcers. But the importance of vertical restraint policy does not lie in simply prohibiting bans on parallel imports. Absolute territorial restrictions may at times promote competition or contribute to integration.(13) Rather, an effective and economically attuned vertical restraint policy is important because vertical restraints can produce both substantial harm and substantial good.
This Janus-faced potential of vertical restraints leads me to the second reason why the EC should have the courage to change its approach under Article 85(1). Our economic understanding of vertical restraints has evolved a great deal. Indeed, I think the Green Paper's chapter on the economic analysis of vertical restraints fairly reflects an emerging economic consensus. The good part of vertical restraints is clear -- they can be used to enable small firms to enter markets, promote interbrand competition, protect intellectual property rights, encourage optimal amounts of pre-sale information and after-sale service, and prevent free-riding. But it is equally clear, contrary to the comforting simplifications of the Chicago School, that vertical restraints can also be used to raise prices to consumers and to create or enhance market power by allowing firms to raise rivals' costs or facilitate collusion. As the Green Paper puts it, vertical restraints normally have a positive effect when they are introduced to solve co-ordination problems; their negative effects tend to prevail in the presence of weak upstream and/or downstream competition.(14) It is thus exceedingly important that we get our approach to and analysis of vertical restraints right.
This logically suggests a narrower, more focused application of Article 85(1) in the vertical area. A nuanced, economics-based interpretation of 85(1) would allow the Commission to devote its resources where it should -- to those instances where a restraint is likely to harm competition by raising prices or reducing output.
Assuming such a focused approach, addressing vertical minimum price restraints is straightforward. The EC, U.S., and virtually every competition authority I know, view vertical minimum price fixing as pernicious and per se illegal. There should be no question that Article 85(1) applies per se to this conduct. Likewise, the draft revised de minimis notice is correct in withholding from RPM situations the safeharbor bestowed when firms have 10% or less of market share.
One interesting qualification in the vertical price area, at least on the U.S. side, is the news that the FTC and DOJ filed an amicus brief urging the Supreme Court to overturn the per se rule against vertical maximum price fixing and instead adopt a rule of reason approach. The government's brief draws on a statement from an earlier case in which the Supreme Court noted that "the manufacturer's decision to fix a maximum resale price may actually protect consumers against exploitation by the dealer acting as a local monopolist."(15) Thus, our thinking about vertical issues continues to evolve as well. Interestingly, the same type of thinking appears in the EC's proposed Option II and Option IV. With Option II, which suggests wider block exemptions, the Green Paper proposes that the "block exemption for franchising agreements could be extended to cover maximum resale price maintenance as an exception to the general principle that resale price maintenance will not be exempted."(16) In Option IV, the rebuttable presumption of compatibility with Article 85(1) for parties with less than a 20% market share would not be available for restraints relating to minimum resale prices. There is silence concerning maximum RPM.
But the more intriguing arena is the vertical nonprice area, where restraints can both create efficiencies and impede them. I hope we can all agree that (1) production efficiency occurs when goods are produced using the most cost-effective combination of resources available under existing technology; (2) innovation efficiency involves the invention, development, and diffusion of new products and production processes that increase social wealth; and (3) allocative efficiency occurs when the existing stock of goods and productive output are allocated through the price system to those buyers who value them most, in terms of willingness to pay.(17)
I think we also all agree that innovation efficiency is the most important factor in the growth of output in the industrialized world. The U.S. Congress recognized the importance of innovation efficiencies in the National Cooperative Research Act of 1984 and the National Cooperative Research and Production Act of 1993.(18) The Green Paper seems to recognize this implicitly when it suggests treating vertical restraints more favorably in circumstances involving significant material or immaterial investment or risk.(19)
Next comes production efficiency, which is more important than allocative efficiency for two reasons. First, production efficiency increases wealth over the whole range of output. Allocative efficiency increases wealth only at the margin. Second, because the gains from lower production costs are recurring and cumulative, production efficiency affects the growth of future wealth. In contrast, allocative efficiency, which is achieved when goods are priced at marginal or incremental cost, maximizes wealth at a fixed point in time.
If competition enforcers pursue only cartels and collusion with the aim of forcing prices closer to marginal cost, we will be focusing largely on allocative efficiency. That is why it is also important to pursue exclusionary behavior. That conduct reduces production and innovation efficiency by raising the costs and lowering the return of rival firms without offsetting social benefit.(20) And because vertical restraints can be both a way of realizing these production and innovation efficiencies and of preventing other firms from realizing them, our analysis of these restraints must be sensitive to the market context in which they occur. An overregulatory or blanket approach to vertical restraints leads one to sacrifice important efficiencies. So again I plead for a more rigorous economic analysis to define Article 85(1)'s application. It should apply only when a restraint is likely to restrict competition, such as when a restraint forecloses market access to competitors.(21)
A third reason for getting the analysis of vertical restraints right is that competition systems are converging. I shudder to think of firms around the world notifying their non-price vertical restraints to, and seeking exemptions from, the proliferating numbers of competition agencies. Both Chris and the Green Paper concede that neither the large Member States nor the U.S. nor Canada employ a notification system.(22) Moreover, the U.S., Canada, Germany, the U.K., France and Italy rely on an economics-based analysis of the market effects of various vertical restraints, rather than legalistic rules and categories of exemptions to determine whether a violation exists.(23) As we begin to work on competition issues in the WTO, the EC should seriously consider whether its formalistic structure for categorizing vertical restraints is an appropriate model for the world. While the EC has done a serious piece of analysis in its Green Paper, its final conclusions still resonate with the thinking of past decades, rather than aspiring to be a vertical competition policy for the 21st century.
You will not be surprised to hear that I find Option IV to be the most promising of the proposed options in the Paper. It moves in the direction of applying an economic analysis to vertical restraints and of providing more flexible treatment of vertical arrangements between parties with no significant market power. But while urging the EC to be even more daring, I fear that a professed concern with legal certainty may be invoked to limit any ambitious attempt at change.(24)
Legal certainty can have value insofar as it minimizes parties' transaction costs and saves enforcement resources. But legal certainty is useful only when government draws the right line; this usually is when it reflects commonly accepted principles. Correct and clear line-drawing is feasible in the antitrust context for hard core restraints among competitors, such as price-fixing, bid rigging and market allocation. Those types of agreements are virtually always pernicious and virtually never have any redeeming value. Thus, most antitrust systems prohibit them absolutely. Certainty in the vertical nonprice restraint area is difficult because there are no simple rules that define when a particular restraint, even an absolute territorial restraint, may be harmful. It all depends on the economic circumstances, including the parties' market power, the degree of interbrand competition, the ease of entry, the cumulative impact of parallel networks of vertical agreements in the relevant market and so forth. Any attempted certainty created in the face of this factual specificity and complexity will by definition create overbroad and underbroad rules. I would argue that flexibility, even if accompanied by a degree of uncertainty, is better here than certainty, particularly if it is based on false assumptions that yield wrong answers.
Moreover, the EC system has exacerbated the inherent uncertainty about the virtues and vices of vertical arrangements. The EC has generated uncertainty by drawing the ambit of Article 85(1) too widely and assuming that all vertical arrangements are potentially harmful, when in fact the majority are not. A system of block and individual exemptions was erected in an attempt to address this uncertainty. But those exemptions reflect no consistent economic rationale and when competition law is not tethered to economics, it loses its compass. Lacking any coherent analysis by which to predict whether a restraint is lawful, the block exemptions' rigid lines only created more uncertainty.
It is only natural that whenever a legal system tries to draw clear or rigid lines, escape valves appear and human ingenuity creates some wiggle room. Because Article 85(1) applies too broadly to vertical restraints, the courts were forced to invent theories as to why Article 85(1) did not apply. One concept was that of "appreciability." By finding that exclusive purchasing agreements do not appreciably restrict competition, the Court of Justice concluded that they do not fall within Article 85(1) unless they have the effect of foreclosing market access to competitors.(25) Another possible escape is in how to define agreement, as Jim Venit's paper suggests. Indeed, the pressure arising from attempts to conform a complicated world to simple rules often escapes in the vertical area in debates over the meaning of "agreement."
On the U.S. side, the question of whether an agreement exists has long been an important part of the analysis of vertical price restraints. This is because the Colgate doctrine establishes the right of a manufacturer to deal or not deal with a distributor based on the latter's pricing activities. The manufacturer may also communicate its views on resale prices, for example by providing suggested price lists. But the manufacturer must do so unilaterally, and the dealer's acquiescence in following the suggested resale price must be the result of its independent decision.(26) Consequently, our courts have struggled to distinguish unilateral conduct that is legal from concerted action that is not.
Determining whether an agreement exists became even more important after the Supreme Court concluded that nonprice vertical restraints are not per se illegal.(27) This is because if one defines what constitutes an agreement on vertical price-fixing too broadly and infers agreement too easily from highly ambiguous evidence, one risks injuring rather than promoting competition by eroding the rule of reason approach to nonprice vertical restraints, in addition to undermining the manufacturer's right to deal with whom he chooses. Consequently, the Supreme Court required that a per se rule apply only if there is "direct or circumstantial evidence that reasonably tends to prove that the manufacturer and others 'had a conscious commitment to a common scheme designed to achieve an unlawful objective'."(28) To show a "common scheme" dealer compliance with the suggested price is insufficient. Evidence must be presented "both that the distributor communicated its acquiescence or agreement, and that this was sought by the manufacturer."(29)
Interestingly, Jim Venit's paper makes me think that the EC is now facing the same definitional dilemma over what constitutes an agreement, particularly in the area of parallel imports. This may reflect a concern that if the Commission defines agreement too broadly in its commitment to prohibit restraints on parallel imports, it will sacrifice efficiencies and penalize justifiable business practices. I have learned, based on press coverage of what we do, never to opine about a case unless one knows the actual facts, which I do not with respect to Adalat. But it is certainly questionable whether dealers who actively sought to evade the manufacturer's export restriction by seeking additional supplies for export from other unsuspecting dealers can be deemed to have agreed or acquiesced to the manufacturer's demand. And it is interesting that the price differential between France, Spain and the U.K. that was causing the exports was largely attributable to a regulatory cap that the French and Spanish governments had placed on the price of this pharmaceutical product. This circles back to my original point which was that the removal (or leveling) of government restraints and barriers will likely contribute most to the free flow of trade.
What I think may be different on the U.S. and the EC sides is that in the U.S. we struggle with whether an agreement on price exists in an effort not to mix apples, oranges and pears. There are sound economic reasons for viewing vertical price agreements differently from vertical nonprice agreements and both differently from unilateral action on prices. In the EC, the box of apples may be too big. Not all vertical nonprice restraints are harmful and not all territorial restraints are anticompetitive or antithetical to integration goals.(30) Because the underlying rule is not drawn between procompetitive and anticompetitive restraints, any effort to define the term agreement so as to locate a vertical restraint on one or the other side of the 85(1) line will look somewhat disingenuous.
What the Adalat case suggests is that the EC should consider taking a more economic approach to its analysis of vertical territorial restraints. Why not analyze territorial restraints just as other nonprice vertical restraints should be analyzed, in terms of whether they reduce output or raise prices? This could be done under Article 85(1). Then, if need be, the EC could reevaluate and potentially prohibit certain restrictions under Article 85(3) if they were found to impede market integration unduly. But if the economic analysis is done properly in the first step the second safety valve may often be redundant. For if a territorial restraint promotes competition and allows new entry, it should tend to further integration as well.
1. OECD Paper, "The Economy-Wide Effects of Regulatory Reform," DAFFE/CLP/WP2(96)9/07 at 51 (unpublished draft).
2. Ibid at 38, 39.
3. See EC Green Paper at 41.
4. EC Green Paper at 20, 232, see also Exec. summ. at 34; Deacon, "Vertical Restraints Under EU Competition Law: New Directions," 1995 Fordham Corp. L. Inst. at 320.
5. EC Green Paper at 43, 44.
6. FTC Staff Report, "Competition Policy in the New High-Tech, Global Marketplace," at 7-8 and Chap. 1 generally (May 1996).
7. Deacon, supra, at 315.
8. EC Green Paper at 45.
9. A similar process has occurred and is occurring in the Single Market. See EC Green Paper at 55, cf. 73.
10. Jones Paper at 1 (draft).
11. Jones Paper at 8.
12. EC Green Paper at 74, exec. summ. at 12.
13. Jones at 6.
14. EC Green Paper at 57.
15. Amicus Brief for the United States, State Oil Co. v. Khan, No. 96-871, cert. granted, __ U.S.L.W. __(1996), citing Atlantic Richfield Co. v. USA Petroleum, 495 U.S. 329, 343 n.13 (1990).
16. EC Green Paper at 284.
17. Brodley, "The Economic Goals of Antitrust: Efficiency, Consumer Welfare, and Technological Progress," 62 N.Y.U. L.Rev. 1020, 1025 (1987).
18. 15 U.S.C. 4301-06.
19. EC Green Paper at 81; exec. summ. at 12.
20. Brodley, supra note 17, at 1025.
21. Cf. Demilitis v. Henninger Brau AG, [1991] ECR 935.
22. The Green Paper implies that non-notification indicates a belief that vertical restraints are a priori legal. That is not the case in the U.S. A non-notification system has co-existed with a per se (illegal) approach to vertical price fixing as well as a per se approach to vertical territorial restrictions. See United States v. Arnold Schwinn & Co., 388 U.S. 365 (1967).
23. Green Paper, Exec. summ. at 32; 194-218.
24. The FTC intends to provide comments to the EC on its Green Paper and thus we will be making more specific suggestions at a later date.
25. Delimitis v. Henninger Brau AG, [1991] ECR 935.
26. United States v. Colgate & Co., 250 U.S. 300, 307 (1919); FTC v. Beech-Nut Packing Co., 257 U.S. 441 (1922); United States v. Parks, Davis & Co., 362 U.S. 29 (1960).
27. Continental T.V., Inc. v. GTE Sylvania, Inc., 433 U.S. 36 (1977).
28. Monsanto Co. v. Spray-Rite Service Corp., 456 U.S. 752 (1984). Moreover, ". . . something more than evidence of complaints is needed. There must be evidence that tends to exclude the possibility that the manufacturer and nonterminated distributors were acting independently." Id. at 764.
29. Id., 456 U.S. at 764 n.9.
30. Indeed, if a restraint does not restrict competition, it is difficult to understand how it can impede parallel imports that are of any economic significance.