THE STANDARD FOR DETERMINING THE LEGALITY OF VERTICAL PRICE RESTRAINTS

Transcription

1 THE STANDARD FOR DETERMINING THE LEGALITY OF VERTICAL PRICE RESTRAINTS Magaldi, Arthur, M. Pace University Le Vine, Saul S. Pace University Magaldi, Jessica A. Adjunct Professor, Pace University, ABSTRACT Section I of the Sherman Act condemns and declares illegal every restraint, combination in form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States. Under the Sherman Act, agreements to fix prices between natural competitors, e.g., retailers or manufacturers, are illegal per se. So-called horizontal price-fixing agreements of this nature do not require analysis by courts to determine whether or not they damage competition because they have been declared illegal by their very nature, i.e., per se. Vertical price-fixing and vertical price restraints, e.g., agreements between manufacturers and distributors which set a minimum price at which a product can be sold, were similarly declared illegal per se in 1911 by the United States Supreme Court in the famous Dr. Miles case. Generally, most other agreements or actions which are not illegal per se but are alleged to be in violation of the Sherman Act are judged by what is known as the rule of reason. Basically, the rule of reason doctrine requires analysis of an alleged violation and the weighing of all circumstances and factors to determine whether a restriction on trade or competition unreasonably restrains competition. Those that do not unreasonably restrain competition are permitted. In 2007, ninety-six years after they established the Dr. Miles rule for vertical restraints, the Supreme Court considered again the question of how agreements between manufacturers and distributors setting minimum prices should be viewed, i.e., under the rule of reason or per se illegal. The following article analyzes the landmark decision. INTRODUCTION The anti-trust laws are designed to encourage competition and to prevent unreasonable restraints on competition which hurt businesses and consumers. The foundation statute of the anti-trust laws is the Sherman Act which sets forth in Section 1 that every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States. is forbidden. The Sherman Act which established the basic policy of protecting competition and avoiding restraints on

2 competition has been augmented by the Clayton Act, the Robinson-Patman Act, and a long line of court decisions. The birth of the anti-trust movement may be traced to the passage of the Sherman Act in Sherman declared every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States to be illegal. As anti-trust law evolved, a certain few acts or actions were considered to be so clearly detrimental to competition and commerce that they are absolutely forbidden and are considered illegal per se, i.e., there is no need for courts or juries to analyze them. They are considered so serious and so likely to cause harm that they are automatically declared illegal. When an act is a per se violation, there is no need for the courts to engage in an extended analysis in order to determine whether they actually are seriously anti-competitive because they are absolutely condemned as illegal by the law. The most notable example of per se violations is an agreement to fix prices by those who would naturally be competitors. For example, an agreement to fix prices by manufacturers or retailers of automobiles would be illegal on its face. Agreements among competitors to fix prices are known as horizontal price-fixing arrangements. It should be noted that in all cases, of course, the restraint on competition must be meaningful to be unlawful. The agreement of two children competing and selling lemonade on the same block who agree that they will both charge twenty-five cents per glass of lemonade would clearly be insignificant. Most alleged violations of the anti-trust laws are not viewed as simply as horizontal price-fixing agreements and are not automatic violations of the law. Alleged violations of the anti-trust law which are not per se violations of the law are judged by what is known as the rule of reason. Under the rule of reason, restrictions on trade and competition are looked at in the context in which they occur in order to determine whether the alleged violation imposes an unreasonable restraint on competition. So in rule of reason cases which constitute the great majority of anti-trust litigation, the courts must determine the actual effect of the restraint and the courts do not have the certainty or assurance of simply declaring agreements or practices illegal without further inquiry. An analysis is necessary in a trial of a rule of reason type case and all the circumstances of the case are weighed. On a case by case basis, the courts must determine whether an alleged violation poses an unreasonable restraint on competition. In rule of reason cases, restraints which are held harmful to competition and consumers are declared illegal, but restraints which are benign or beneficial to competition are allowed. VERTICAL RESTRAINTS/RESALE PRICE MAINTENANCE AGREEMENTS Vertical restraints on competition, generally agreements between manufacturers and retailers, have presented a thorny and long-running issue for Congress and the courts. The setting of minimum prices by a manufacturer coupled with the threat of refusing to deal with a retailer who fails to charge at least the minimum prices established by the manufacturer is the prime example of a vertical restraint on competition. Manufacturers attempt to enforce minimum prices on their goods by refusing to supply goods to retailers who do not adhere to the minimum prices agreed upon with the manufacturer. The threat of cutting off the flow of goods to a retailer is a serious matter. The fixing of minimum prices by the manufacturer known as resale price maintenance has been the subject of important legislation and litigation. The first landmark case dealing with an agreement between a manufacturer and distributor to set minimum resale prices, Dr. Miles Medical Co. v. John D. Park & Sons Co., was decided in Factually, the Dr. Miles case involved a manufacturer of medicine and sleep relaxants which sued a distributor for selling at prices below the minimum prices which the distributor had agreed upon with the manufacturer. In that case, the United States Supreme Court set forth that vertical price restraints were a per se violation of the Sherman Act and likened the agreement to a price-fixing cartel. The Court reasoned that large scale use of minimum resale price maintenance agreements could have the same negative effect on competition as horizontal price fixing imposed by a cartel.

3 In 1937, the United States Congress stepped into the vertical price maintenance controversy and passed fair trade legislation. During the Depression, members of Congress became concerned that big retailers were underpricing goods in an effort to drive smaller retailers out of business. Thereafter, with competition out of the way, the larger stores would have been free to raise prices. The Miller-Tydings Act, also known as The Fair Trade Law, which was passed by Congress, did not expressly declare resale price maintenance agreements to be legal, but it gave the power to the to the individual states to make the decision. The legislation allowed the individual states to permit resale price maintenance agreements where they felt it appropriate. The Fair Trade Law effectively rolled back the Dr. Miles per se rule in those states which, in effect, opted out of that doctrine. But in 1975, the Congress repealed the Fair Trade Law on the theory that the free market was endangered by resale price maintenance agreements. Studies showed that minimum-pricing pacts under Fair Trade boosted prices by 19% to 27% in states allowing them. (Pereira, Wall Street Journal) Following the repeal, The United States Supreme Court ruled in 1980 in California Liquor Dealers v. Midcal, that a resale price maintenance agreement was illegal. This, in effect, reinstated the Dr. Miles rule. In 1980, however, the Supreme Court reviewed another vertical restraint, but this one did not involve minimum prices. Instead, the restraint in question pertained to the concept of granting exclusive territories to one distributor. In such agreements, the manufacturer will sell to only one distributor or retailer in a given area. The Court noted the possible anti-competitive aspects of such agreements, but decided that the claimed violations of the Sherman Act due to these type restrictions should be judged in context under the less restrictive rule of reason concept. PROS AND CONS OF RESALE PRICE MAINTNENACE AGREEMENTS The most obvious criticism of vertical price-fixing agreements/resale price maintenance agreements is that they cause consumers to pay more for goods. Discounting or marking down of the goods in question is prohibited and a whole segment of sellers, i.e., discounters, are not in a position to do that which they are most known for, selling below the ordinary retail price. A retailer may not run a sale on goods of this nature. This poses a particular problem for internet retailers who are often price-cutters. There is clearly a broad range of retail approaches. Many retailers are known for providing good service and various amenities to customers, while others may be light on service but also low on prices. Ordinarily the consumer is free to choose the type of retailer which fits the consumer s needs, but this is effectively negated by the fixing of minimum prices by the manufacturer, since the no-frills retailer will be forced to charge the minimum set by the manufacturer. Since no markdowns are permitted, the likelihood is that those consumers who would have chosen the lower price, lower service retailer, will be forced to pay more if they buy the goods in question. Manufacturers who favor minimum prices often feel that their products require that the retailer provide a high level of service for the product to be successful, e.g., demonstrations, explanations, and product promotions. The fear is that discounters will not provide those services perceived by the manufacturer to be vital for the ultimate success of the product. Additionally, many manufacturers enjoy the image of high quality which is often associated with higher prices. Lower prices do not support the image of the manufacturer s products which the manufacturer desires. Where the manufacturer is able to set a minimum price, the retailer generally has to market the goods more vigorously and creatively since the retailer cannot draw customers through lower prices. This helps to attain the goal of the manufacturer to sell goods which consumers will associate with a high level of service. Those favoring the setting of minimum prices also want to avoid disappointing consumers who purchase their goods and then later see them being sold elsewhere at a lower price. They want potential customers to believe that the goods are high quality and selling for the same price everywhere thereby

4 providing no incentive to put off purchase in the hope of finding a better price at another location. Resale price maintenance agreements help to achieve these goals. LEEGIN CREATIVE LEATHER PRODUCTS V. PSKS, INC., DBA KAY S KLOSET In 2007, a dispute based on resale price maintenance between a retailer, PSKS, a company also known and doing business as Kay s Kloset and Kay s Shoes, and a manufacturer, Leegin Creative Leather Products, had worked its way through the federal district court and the federal Court of Appeals. The United States Supreme Court granted certiorari in order to decide the now-famous Leegin Creative Leather Products, Inc., Petitioner v. PSKS, Inc., DBA Kay s Kloset Kays Shoes case. The dispute in the case centered on the fact that Kay s Kloset had been selling Brighton products manufactured by Leegin since 1995, but in 1997 Leegin instituted a policy of refusing to sell their goods to any retailer who did not maintain certain minimum prices. Brighton products were a major part of the gross sales and profits of Kay s Kloset. When Leegin discovered that Kays s was discounting Brighton products, it ultimately stopped selling goods to Kay s which suffered a substantial loss of business and ultimately brought suit in the federal district court for damages. The district court applied the Dr. Miles per se illegality rule when it was established that the manufacturer had imposed a vertical restraint to fix prices. The damages that Kay s established at trial amounted to $1.4 million. In accordance wtth the statute calling for treble damages, the damages were finally set at almost $4 million including attorneys fees and costs. The defendant-manufacturer offered at trial to present expert testimony of pro-competitive aspects of vertical price-fixing, but the court excluded the testimony on the ground that the matter was per se illegal. The Federal Court of Appeals for the fifth circuit affirmed that holding. Justice Kennedy wrote the opinion of the Court in a 5-4 decision overturning the rule that vertical pricefixing/resale price maintenance is illegal per se and replaced it with the rule of reason. Justice Kennedy began by stating that the legal issue of the case was whether the Court should overrule the Dr. Miles standard and replace it with the rule of reason for resale price maintenance agreements. The Court reviewed the facts of the case and was sensitive to the fact that defendant Leegin wanted its goods sold in small stores where customers received better services and shopping was more personal. Leegin felt that its products would be received more favorably in such a setting. The minimum prices were set at a level high enough that retailers would obtain reasonable margins to offer the services Leegin deemed essential to the creating of the appropriate brand image. The manufacturer never denied demanding vertical pricefixing agreements, but claimed they were necessary for its ends and not anti-competitive. The Court noted that although the statute condemned every contract in restraint of trade, in reality the Court had previously held that it condemned only unreasonable restraints and cited its 1997 decision in State Oil Co. v. Khan. The Court reviewed anti-trust theory and summarized some important holdings. The standard for deciding whether, in fact, a practice, standard, or agreement unreasonably restrained trade or competition was generally the rule of reason. In rule of reason cases, all factors are weighed and the matter is viewed in the context of its history, nature, and effect. The market power of the businesses involved is also an important factor. Rule of reason analysis differentiates between restrains that aid competition and those that harm competition. Per se rules were restricted to cases in which restraints would always or almost always tend to restrict competition and decrease output. In support of this premise, the Business Electronics case was cited as precedent. In short, the per se rule is the exception or the unusual and is applied only in very clear-cut cases, while the rule of reason is the theory more often applied. It was further noted that although Dr. Miles viewed the vertical restraint as similar in effect to a horizontal restraint, the Court relying on more economic analysis noted differences in the economic effects of the two different restraints. The two types of restraints were not viewed as having the same economic effects on competition and consumers.

5 Justice Kennedy reviewed the positions of economists which held that resale price maintenance may, in fact, have pro-competitive effects. They can encourage inter-brand competition. The theory is that resale price maintenance encourages manufacturers selling different brands of the same product to compete by curtailing intra-brand competition. This is a key factor because the purpose of the anti-trust laws, as stated by the Court, is the protection of competition. Intra-brand competition is prevented by resale price maintenance, but it encourages retailers to invest more in the services necessary to promote the goods. This protects the manufacturer against competing manufacturers selling similar goods. In effect, by eliminating intra-brand competition, you may stimulate inter-brand competition. It also gives consumers choices the higher price, higher service or the lower priced, lower service goods of competing manufacturers. The Court gave great respect to those who favor resale price maintenance as a means of preventing freeriding. Free-riding may occur when price cutting, discount retailers capture some of the good will generated by other retailers who provide services to promote the goods while the discounters do not make a similar investment of time and money. Preventing discounters from charging less than the enhanced service provider effectively cancels out what may be viewed as the discounter s unfair advantage. The retailers then must compete on a more level field on the basis of services. According to the Court, resale price maintenance may help bring new firms and brands into the market because manufacturers can use these restrictions to encourage retailers to invest in their products and help make the product known to the public. Investment in services and promotion go a long way to the success of new products. The Court stated, New products and new brands are essential to a dynamic economy, and if markets can be penetrated by using resale price maintenance there is a procompetitive effect. Further, the aspect of providing a relatively high margin to retailers by resale price maintenance coupled with the threat of the cutoff of supply may help a manufacturer gain market share by, in effect, forcing the retailer to heavily market the goods. The Court did acknowledge that resale price maintenance might cause prices to be higher. But it viewed as more important, the idea that they might enhance interbrand competition saying, For, as has been indicated already, the antitrust laws are designed primarily to protect interbrand competition, from which lower prices can later result. It was felt to be unlikely that a manufacturer would impose unnaturally high minimum prices since such conduct would lead consumers to purchase the goods of other manufacturers. It was also acknowledged that agreements of this type could pose a danger, as in the case a group of retailers imposing minimum prices on a manufacturer or where a powerful cartel of manufacturers imposed minimum prices. In Leegin the restraint was, of course, imposed by the manufacturer not a group of retailers. But the Court felt that issues of this nature could be dealt with on a case-by-case basis in the trial courts using the rule of reason as a guideline. Economic analysis had found that, when available in fair trade states, not more than one percent of manufacturers made use of the opportunity to vertically fix prices. In sum, the conclusion was that resale price agreements could be pro or anti-competitive, a decision best left to the triers of the facts applying the rule of reason. Hereafter, these matters will be dealt with by applying the rule of reason in the trial courts. Vertical price restraints are to be judged according to the rule of reason. The principle known as stare decisis holds that legal precedent once established is to be applied in similar type cases. Accordingly in Leegin, the retailer argued that since the legal precedent that resale price maintenance provisions were per se illegal had been in place since 1916, the Court should continue to follow it. The Court rejected such reasoning quoting one of their former decisions, Dickerson v. United States, We have overruled our precedents when subsequent cases have undermined their doctrinal underpinnings. The Court also rejected the argument that the per se rule made for administrative clarity indicating that it was more important to have the law correct even if administratively more difficult to administer. The Court acknowledged that the case-by-case approach of the rule of reason would provide

6 challenges for the lower courts which would apply the law, but felt that over time they would begin to form guidelines to apply to vertical price maintenance cases. The Court also noted that Congress could have enacted the Dr. Miles rule in a statute which would have settled the issue, but Congress never chose to do so. Congress could have set the Dr. Miles rule in stone, but it chose a more flexible option. We respect its decision by analyzing vertical price restraints, like all restraints, in conformance with traditional Section 1 principles, including the principle our antitrust doctrines evolve with new circumstances and new wisdom. It cited the Business Electronics case to support this approach. CONDITIONS IN THE AFTERMATH OF LEEGIN A great deal of time has not passed since the Leegin decision, so it is difficult to state with certainty the economic results of the new ruling. But an article in the Wall Street Journal on August 18, 2008, (Pereira, Price Fixing Makes Comeback After Supreme Court Ruling) attempted to evaluate the situation. The writer noted that manufacturers are embracing the opportunity to set minimum prices and, In May, attorneys general from 35 states including New York, California, Massachusetts and Pennsylvania wrote to Congress urging passage of a law to make policies like these illegal. As the chief antitrust enforcers in our respective States, we know all too well the harm that can be caused by pricing pacts. The writer also quoted Lino A. Graglia, a law professor who concluded that it would be difficult to prove resale price maintenance agreements to be anti-competitive. The article contained numerous quotes from retailers indicating how difficult they felt it was to operate under the new prices fixed by manufacturers. REFERENCES Sherman Act, 15 U.S. Code, Section 1 Pereira, Joseph (2008) Price-Fixing Makes Comeback After Supreme Court Ruling,Wall Street Journal, August 18, D1-3. Labaton, Stephen (2007), Justices End 96-Year-Old Ban on Price Floors, New York Times, June 29, Al, A18. Savage, David G. (2007), High court appears split on price fixing, Los Angeles Times, March 27, C-2. Graglia, Lino A. (2007), Leegin Creative Products, Inc. v. PSKS Inc.: The Strange CareerOf the Law of Resale Price Maintenance,University of Texas, Law and Economic Research Paper No. 115 Dr. Miles Medical Co. v. John D. Park & Co., 220 U. S. 373, United States Supreme Court (1916). Dickerson v. United States, 530 U.S. 428, 443, United States Supreme Court(1910). State Oil Co. v. Khan, 522 U. S. 3, 10, United States Supreme Court (1997).. Business Electronics v. Sharp Electronics, 485 U.S. 717, 723, United States Supreme Court (1988).