Competition Economics

Competition law, its enforcement and the role of economic analysis in that process, varies widely across the Asia-Pacific, and is experiencing a period of rapid evolution. Of particular interest for 2016 will be the enforcement of Hong Kong’s new Competition Ordinance, the advancement of competition law within the Association of Southeast Asian Nations (ASEAN), and progress in the review of Australia’s competition law.

Within this landscape, the treatment of vertical agreements has emerged as particularly topical, with competition authorities grappling not only with the assessment of such agreements but also the need to distinguish clearly when an agreement between parties involves a vertical, rather than horizontal, commercial relationship.

Vertical agreements are endemic in many industries and often – but not always – in the best interests of consumers. Their assessment often requires a detailed and situation-specific analysis of the associated benefits and detriments to the competitive process. In this review, we survey the range of potential effects of vertical restraints on competition, and discuss how to determine whether the parties to an agreement are in a vertical or horizontal relationship. We also discuss the treatment of resale price maintenance (RPM), and the recent upsurge in interest in most favoured nation (MFN) clauses.

Recognising vertical agreements

Horizontal agreements involve cooperation between two or more competing firms operating within a market. In contrast, vertical agreements are those between firms operating at different levels of a supply chain and include, for example, arrangements between manufacturers and their distributors or retailers. Although it is usually straightforward to determine whether companies are competitors or vertically related, these boundaries can become blurred when firms operate across more than one functional level of a supply chain. In these circumstances, determining the appropriate classification of an agreement as horizontal or vertical may require an assessment of ‘competition’ and what it means for firms to be ‘competitors’.

Competition is a process of rivalry, whereby individual firms attempt to supply customers, or purchase inputs, at the expense of other firms. The competitive process leads to better outcomes for consumers, because it encourages firms to offer lower prices or more desirable products in order to attract customers. Firms can be said to be ‘in competition’ with one another if the price and output decisions of one firm are likely to constrain the other. For this to be the case, the products supplied by the firms must be sufficiently close substitutes in the minds of consumers. In other words, they must be in the same market. Markets are typically defined by their product, functional, and geographic dimensions, such that they include all the goods and services that are regarded as substitutes by consumers given the products’ characteristics, intended use and location.

When the nature of an arrangement between firms is uncertain, achieving clarity as to its economic substance often requires an assessment of: the definition and features of the relevant market or markets, the characteristics of the products offered by each firm, the location at which supply takes place, the sales channels, and the way in which customers make their purchase decisions, as well as the precise terms and conditions of the relevant agreement.

The prospect for uncertainty as to whether two firms are competitors is well illustrated by two recent Australian cases, Flight Centre¹ and ANZ Bank.² The fundamental nature of these cases was similar – both involved upstream suppliers providing services to distributors as well as directly to consumers. In each case, the characterisation of the arrangements hinged critically on whether the involved firms were found to be in competition with one another. Despite similarities in the economic relationships, the Federal Court reached conflicting decisions at first instance, finding that ANZ Bank had entered into a vertical arrangement with mortgage brokers, whereas Flight Centre was in competition with airlines and had therefore entered into a presumptively anticompetitive horizontal pricing agreement. On appeal, the Full Federal Court upheld the ANZ Bank decision and, consistently, found that Flight Centre’s agreement was also vertical in nature.

In reaching its decisions, the Full Federal Court recognised the need for making a case-by-case assessment, firmly rooted in the facts. The court strongly emphasised the need to consider the specifics of each case and for market definitions to be grounded in, among other things: a careful evaluation of the nature and character of the relevant goods or services, the circumstances in which they were supplied or acquired, and the interactions between, and perceptions of, the relevant suppliers and acquirers of the product.

Vertical agreements: a friend or foe to competition?

Recognising an agreement as between parties in a vertical relationship is a critical first step in assessing its implications, since the nature of the agreement will necessarily influence the way in which it affects competition or any ‘theory of harm’ that may be proposed. The vast majority of vertical arrangements should not be of concern to competition authorities; however, those that contain ‘vertical restraints’, and so restrict the conduct of one or more party, may be problematic. These can take many forms and include, for example, arrangements whereby manufacturers specify retail prices (RPM), limitations on the ability of parties to buy from or sell to third parties (exclusive dealing), or requirements for customers to purchase additional products (tying).

Vertical restraints are not uncommon in contracts between parties at different levels of a supply chain and, in many cases, will benefit end customers by lowering prices, improving quality and increasing choice. For example, vertical restraints may:

• improve design or production coordination by improving manufacturers’ understanding of the preferences of end customers and demand trends;
• improve the incentives for producers to invest in retail-related assets to support the quality of their product (for example, ice cream producers that provide retail freezers and breweries that provide beer dispensing systems) – producers are less likely to make such investments if there is a risk they will then be used by competitors (so-called ‘free-riding’);
• improve the incentives for investment in significant, long-lived, sunk assets that are required to support downstream activities (for example, electricity generators or gas pipelines) – without long-term contractual arrangements, suppliers may be unwilling to take the risk of their asset being supplanted early in its lifespan and so may not invest (investment ‘hold up’); or
• reduce end customer prices directly – in supply chains characterised by weak competition at more than one functional level, pricing arrangements may enable firms to increase profits by coordinating a reduction in prices (reducing ‘double marginalisation’) in order to increase demand.

These types of effects are ‘pro-competitive’ – they enhance the degree of rivalry in the market and, ultimately, benefit consumers. However, in some industries vertical restraints may work to limit rivalry between firms and thereby harm consumers by increasing prices, reducing quality or reducing choices.

Anticompetitive effects are much more likely when a vertical restraint involves a firm (or group of firms) that is dominant or holds substantial market power. Market power involves the ability to raise and maintain the price of a good or service above the competitive price. Firms with enduring market power are able to set prices above competitive levels with little concern of losing sales to rivals. A vertical restraint that allows such a firm to influence outcomes in a second market, or ‘leverage’ its power from one market into another, is more likely to reduce rivalry and be detrimental to consumers. Examples of such effects include:

• a supplier imposing tying or exclusivity arrangements to require customers purchasing a product, for which the supplier has a degree of market power, also to purchase complementary products, for which it would otherwise face competition;
• a supplier reducing competition between distributors or retailers by allocating geographic territories or specifying retail prices; and
• a retailer with purchasing power demanding preferential treatment from its suppliers in order to secure a competitive advantage over other retailers or potential entrants.

In most instances, vertical restraints will entail both pro-competitive and anticompetitive effects. Determining whether the net effect involves a ‘substantial lessening of competition’ (or similar) therefore requires the weighing up, or balancing, of countervailing influences to assess the net effect on consumer outcomes (prices, choice, quality, etc). Ultimately, whether a vertical agreement lessens competition substantially will be case-specific and will depend on the nature of the agreement, the conditions of competition in the relevant markets, and the involved parties’ power in those markets.

The need to consider offsetting effects in the context of the particular facts of the case is reflected in the treatment of vertical agreements in most competition laws. With the frequent exception of RPM arrangements, vertical agreements are almost always subject to rule-of-reason assessments rather than being condemned per se. Some competition law regimes – for example, in Brunei, the Philippines, Singapore, Taiwan and Vietnam – go one step further and exclude vertical arrangements from their anticompetitive agreement provisions, but not those concerning the abuse of dominance. This approach is consistent with the theory that the presence of dominance, or enduring market power, is a necessary condition for vertical agreements to be anticompetitive.

RPM: the shift away from per se illegality

The traditional exception to the assessment of vertical relationships by rule-of-reason analysis has been RPM arrangements, which have often been treated as per se or presumptively anticompetitive, and so illegal. RPM may harm competition by directly reducing (or eliminating) competition between retailers or distributors or by facilitating collusion. It may also facilitate collusion among wholesalers by reducing the incentive to withdraw from a cartel, since undercutting competitors would not affect retail prices and so would not increase the demand for their products, and would ultimately reduce profits. RPM agreements may therefore reduce both intrabrand and interbrand competition.

However, there is increasing recognition that RPM arrangements may in certain circumstances be pro-competitive. For example, RPM agreements may allow producers to provide signals to consumers regarding the quality of their products. In some industries, such as for high-tech products, RPM may be used to encourage retailers to provide presales services – for instance, informing customers as to the use and features of products. In the absence of RPM arrangements, retailers in these industries may be reluctant to provide such services if customers then have the option of shopping around for lower prices from limited service retailers with lower costs. In industries in which consumer information is particularly important, RPM arrangements may be especially useful to support the introduction of new products.

Increasing recognition of the potential competition benefits of RPM arrangements is being reflected in a number of competition regimes. In 2007, the United States moved away from the per se prohibition in the Leegin ruling³and, in December 2014, the Australian Competition and Consumer Commission (ACCC) authorised an RPM agreement for the first time, recognising that the supplier had limited market power and that the arrangement benefited consumers.⁴ EU guidelines also state that parties to an RPM agreement have the ‘possibility to plead an efficiency defence’ under certain circumstances.⁵ In a number of jurisdictions in the region, RPM agreements are not singled out for per se treatment, but are subject to the same test as other vertical agreements.

The debate surrounding the treatment of RPM is well illustrated by the approach taken by Chinese competition authorities and courts. China’s Anti-Monopoly Law (AML) does not clearly specify whether RPM should be treated as a per se violation or analysed under the rule-of-reason approach.

In August 2013, the Shanghai Higher People’s Court reinforced the role of rule-of-reason analysis in RPM cases in the private action brought by Beijing Ruigang Yonghe Science and Technology Trade Company (Rainbow) against Johnson & Johnson subsidiaries in Shanghai. The Intermediate People’s Court had previously found that RPM was not per se illegal but that three conditions must be met; namely, anticompetitive behaviour, injury and causality between the two. Although the Intermediate People’s Court finding that there had been no violation of the AML was overturned, the Higher People’s Court confirmed the rule-of-reason approach that had been adopted, and further emphasised that four factors should be taken into account:

• whether there is sufficient competition in the relevant market, considering such factors as market definition, bargaining power of buyers and barriers to entry;
• whether the defendant has a strong market position, taking account of market shares, power in price negotiation and brand importance;
• the motivation of the defendant; and
• the anticompetitive and pro-competitive effects arising from the arrangement.

The fact that these two courts arrived at different conclusions, in spite of the application of a similar standard to the same facts, reinforces the challenges that are inherent in determining the net impact of many vertical arrangements on competition.

More recently, China’s National Development and Reform Commission (NDRC) has investigated and imposed sizeable fines on several auto manufacturers for vertical restraints, including RPM, in relation to the prices of cars as well as auto parts and vehicle maintenance in the aftersales market. It is less clear whether the NDRC applied a per se or rule-of-reason standard for these cases. The NDRC is currently drafting detailed implementation rules regarding the enforcement of Article 15 of the AML that grant exemptions in antitrust investigations, including on the grounds of economic efficiency. It is also in the process of drafting antitrust guidelines for the automobile industry. Both of these documents are expected to provide further guidance on the treatment of RPM arrangements.

Most favoured nation clauses: the shift out of favour

Vertical restraints under which one party agrees to provide terms and conditions to another that are no less favourable as those provided to any other party and known as most favoured nation (MFN) arrangements. MFN clauses can take several forms, for example:

•     most favoured customer, licensee or supplier clauses;

•     commitments not to sell at a better price on other platforms – so-called retail-price MFNs; and

•     MFN-plus clauses that commit to providing preferential terms and conditions.

In contrast to RPM agreements, until relatively recently MFN arrangements were typically treated as pro-competitive, but have come under increasing scrutiny by competition authorities over the past few years, particularly in the context of e-commerce. Competition authorities in Europe and the United States have investigated allegations of anticompetitive conduct involving MFN clauses in industries such as e-books, online hotel portals, cinemas, tobacco, private motor insurance and health insurance. Authorities in the ASEAN region are also showing an increasing interest in their evaluation.

As for other vertical arrangements, the assessment of MFN clauses is complicated by the fact that they are often efficiency-enhancing and their net effect on the competitive process may be unclear. MFN clauses offer the potential to reduce negotiation costs, as contract terms and conditions are automatically reviewed to meet the most current, or ‘market’ terms. They may also encourage firms to reach agreements sooner by reducing the risk that a better deal could be struck in the future. Accordingly, MFN clauses (but not MFN-plus clauses) preclude the ability of one party to establish discriminatory terms and conditions that favour certain counter-parties. Non-discriminatory pricing in upstream markets is generally considered pro-competitive since it is more consistent with allowing downstream rivals to compete on their merits for end customers.

However, in some circumstances MFN clauses may lessen competition, for example, by providing a mechanism to fix prices or by reinforcing the effectiveness of anticompetitive RPM policies. MFN clauses may also reduce the incentive on resellers to bargain with suppliers, since there is less reason to seek favourable terms and conditions if these will automatically be offered to competitors. Further, MFN clauses can facilitate collusion – if a significant proportion of supply is sourced from a given supplier, ensuring that all distributors pay the same price makes it easier for a (tacit or explicit) pricing agreement to be reached. MFN clauses may also be used to maintain or reinforce market positions, to raise barriers to entry, and to prevent new entrants from seeking to enter or expand by negotiating lower prices with suppliers.

The anticompetitive effects of MFN clauses are likely to be of particular concern when they are structured as MFN-plus arrangements. By their very nature, MFN-plus clauses make it difficult for an equally efficient competitor to compete and may preclude entry or result in firms withdrawing from markets, thereby reducing the degree of rivalry.

Retail-price MFNs may also be used to reduce rivalry if they limit competition between retailers or enable firms to set prices without fear of a competitive response. For example, in April 2015, French, Italian and Swedish competition authorities investigated Booking.com and found that its retail-price MFN clauses were likely to reduce competition by allowing Booking.com to increase its commission rate without the risk of losing customers to competing platforms. The competition authorities also found that the clauses were likely to make it more difficult for competitors to enter or expand by offering lower room prices.

Similar to other vertical agreements, the potential for MFN clauses to be anticompetitive depends on the facts of the case, including whether any of the parties have enduring market power, the nature of the market, and the particular terms of the contract.

Conclusion

Vertical agreements are pervasive throughout many industries and are often a necessary and efficient means by which to organise business interactions. But under certain circumstances, vertical restraints within those agreements may limit rivalry and, ultimately, harm consumers. Recognising the uncertainty surrounding their effect on competition, vertical agreements are frequently subject to rule-of-reason assessments rather than being condemned per se. Even forms of agreement for which the competitive effects were previously taken to be clear-cut, such as RPM and MFN clauses, are increasingly being subjected to rule-of-reason assessments. The scrutiny of vertical arrangements by competition authorities within the Asia-Pacific region is likely to continue to increase, particularly as younger competition authorities gain experience and confidence, the ASEAN free trade agreement is put into effect, and e-commerce becomes yet more pervasive.

In this evolving context, economic analysis plays a critical role in guiding competition authorities and the courts to reach sound decisions regarding:

•     the definition and boundaries of the relevant markets;

•     whether the firms in question are competitors or vertically related;

•     the means by which the agreement in question affects competition, in both anticompetitive and pro-competitive terms; and

•     on balance, whether the net effect of the agreement enhances or hinders the competitive process, and so whether consumers are made better or worse off.

Notes

1. Flight Centre Limited v Australian Competition and Consumer Commission [2015] FCAFC 104 and Australian Competition and Consumer Commission v Flight Centre Limited (No 2) [2013] FCA 1313.
2. Australian Competition and Consumer Commission v Australia and New Zealand Banking Group Limited [2015] FCAFC 103 and Australian Competition and Consumer Commission v Australia and New Zealand Banking Group Limited [2013] FCA 1206.
3. Leegin Creative Leather Products Inc v PKKS Inc, 551 US 877 (2007).
4. ACCC (5 December 2014) ACCC authorises minimum retail prices on Festool power tools.
5. European Commission (2010) Commission Notice – Guidelines on Vertical Restraints, page 63.