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Understanding Antitrust and Related Regulatory Aspects of Building Distribution Channels

Andrew J. Sherman, Partner, Dickstein Shapiro Morin and Oshinsky LLP

Many entrepreneurs dream of achieving a level of growth and market share that would put them on the radar screen of a potential antitrust action - but those dreams would quickly fade if they considered the time and expense of reporting to regulatory inquiries or that a proposed transaction could be held up for months by government attorneys. Even if they are never on the defending end of an antitrust dispute, it is also critical that entrepreneurs understand the basics of the antitrust laws as a potential plaintiff - just in case their efforts to expand are being restricted by the anticompetitive practices of the dominant player in the marketplace. This article provides a brief overview of the federal antitrust laws, as well as selected related laws, that may affect certain types of business growth strategies and the building of distribution channels. Entrepreneurs should also bear in mind that each state has its own set of antitrust laws, which may be even broader than federal laws and that, depending upon the political views of a given governor or attorney general, a state could more aggressive about enforcing the laws as part of its consumer protection policies.

The federal antitrust laws -- beginning with the Sherman Act of 1890, the Clayton Act of 1914, the Robinson-Patman Act of 1936, and the Federal Trade Commission Act of 1914 -- were designed to promote a free-market system and protect against restraints of trade. Conflicts have arisen, however, between the two themes at the heart of antitrust policy. On one hand, political theory supported a body of law that promoted equality and fair play among businesses. Under this view, the interests of the entrepreneur are paramount, even if the end result is economic inefficiency, which essentially puts the entrepreneur's interests ahead of that of the consumer. On the other hand, antitrust laws have also been developed based upon economic theory. Economists viewed antitrust as a body of law designed to protect competition and production efficiency, with the emphasis on the consumer and not the interests of individual competitors. No matter which theory is currently at the forefront, owners and managers of growing companies adopting aggressive strategies in order to expand market share must be aware of the pricing, customer relations, marketing practices and distribution methods that will not be tolerated.

There are two general categories of restraints prohibited by antitrust laws. Vertical restraints are those placed by a manufacturer on a distributor or by a wholesaler on a retailer. These are restraints on trade that develop between firms at different levels in the production and distribution network and are relevant when building distribution channels. Examples include: resale price maintenance, such as an attempt to fix the prices at which the retailer could offer its products; geographic and customer limitations, such as limiting a distributor to an exclusive territory; exclusive dealing arrangements, such as forcing a distributor to sell only a particular line of products; tying, which forces a distributor to buy products A and B when all he really wants is B; and price discrimination, such as selling to one wholesaler in a given area under terms and conditions designed primarily to drive out regional competition. In certain cases, these arrangements are contractual and voluntary, such as in a franchise agreement, or are necessary to protect against so-called "free-riders" that threaten product quality and pricing formulas. However, if it is determined that an entrepreneur is implementing these restraints merely to protect and expand market share in bad faith, antitrust violations are likely to be triggered.

The second category of practices, which are of antitrust concern, is horizontal restraints. Here the law is concerned with practices by firms operating at the same level in the distribution chain and generally doing business in the same markets. The laws are designed to protect against large portions of market strength and market share being concentrated in the hands of one or only a few firms, and may be relevant when implementing certain types of growth strategies, such as mergers and acquisitions. Monopolistic practices falling under the category of horizontal restraints include: predatory pricing, or underselling rivals in order to acquire or preserve market share; price fixing among market leaders designed to squeeze out smaller firms and create greater barriers to market entry; production and output agreements and other forms of collusion among market leaders; and restrictions on mergers and acquisitions.

The penalties for failure to obey the federal antitrust laws can be severe, and in the past have included criminal sanctions, injunctive relief, damages for lost profits, and in certain cases triple damages. Set forth below is a more detailed discussion of specific antitrust issues that should be of interest, not only to the growing company seeking to avoid sanctions, but also to the entrepreneur who feels injured by a competitor's employing such practices.

  • Monopolistic Practices - It may seem ironic that a capitalistic society that fosters entrepreneurship and business growth also has laws that penalize companies that manage to acquire substantial market power. Nonetheless, the antitrust laws have struggled over the last century to draw a line between those practices which were permissible because market power was achieved due to a superior product or business skill and those practices which must be condemned as being anticompetitive and harmful to our economy and society because market power was achieved due to a conscious effort by a growing company to reduce output and raise prices. The current approach for striking this balance involves the application of the so-called "rule of reason" test to the conduct in question. The "rule of reason" test examines all relevant facts and circumstances in an attempt to determine whether the particular act by an entrepreneur or growing company was exclusionary and harmful to competition or whether the act should be permitted as actually fostering and promoting competition. A wide variety of acts could be deemed to be monopolistic in nature, such as price discrimination, a refusal to do business with a given customer or supplier (often referred to as a "refusal to deal"), certain customer and territorial restrictions, mergers of rivals, tying arrangements and conspiracies among competitors, some of which will be discussed in greater detail below. Courts have consistently stated that size and growth alone, even at the expense of competitors, is not enough to determine guilt under the antitrust laws. Rather there must be some wrongful intent or illegal conduct by which the company seeks either to obtain or sustain market power.
  • Price-Fixing - The Sherman Act specifically prohibits "contracts, combinations or conspiracies" which are in restraint of trade. Under the Sherman Act, if two or more competitors conspire to fix prices or methods of price computation at a certain level, then such conduct per se is illegal. This means that such practices will not be tolerated by the courts regardless of the facts and circumstances, even if prices are fair, reasonable and in the best interests of all competitors within the industry or geographic area. This per se approach not only affects any agreements among competitors as to price, but also covers any term and condition of sale, such as credit terms, shipping policies or trade-in allowances. Another practice closely related to horizontal price-fixing is known as "conscious parallelism," by which companies follow the acts of a dominant market leader, by changing prices or sales terms, even in the absence of a formal agreement to fix prices among competitors. Similar legal principles apply to price-fixing attempts in the vertical chain of distribution, generally known as resale price maintenance, or RPM. Attempts by a company to impose RPM policies on its distributors and retailers are also illegal per se, with a few limited exceptions for non-price vertical restraints, such as unilateral refusals to deal, customer restraints, and the designation of exclusive territories. Perhaps the most noted exception to the per se illegality of vertical price-fixing is the unilateral refusal to deal rule, which allows an objective decision by a manufacturer that it will not deal with distributors who cut prices below suggested levels, provided that the decision to refuse to deal is both truly unilateral - for example, not at the urging of another distributor -- and is not the result of threats or intimidation. The only other well-recognized exception to the per se rule against RPM policies involves a situation in which a manufacturer essentially retains ownership of the product by distributing on a consignment basis. These consignment arrangements make the reseller a mere "agent" of the manufacturer and thus create a legal and business justification for controlling prices.
  • Price Discrimination - Most price discrimination issues arise under the Robinson-Patman Act when a seller offers its otherwise uniform products at different prices due to size or geographic location of the buyer. The Robinson-Patman law is designed to ensure both fair pricing among the various buyers of the seller's products, as well as to protect against pricing strategies intended to drive out local competition. Here again, the antitrust laws attempt to draw a line between competitive practices that are encouraged and anticompetitive practices that are prohibited. For example, the Robinson-Patman Act does not expressly prohibit a seller from charging a lower price to a customer if its actual costs of the sale are lower due to the quantities purchased by the buyer or the geographic proximity of the buyer. Similarly, a seller is permitted to drop its prices under certain circumstances if needed to meet changing market conditions -- for example, in order to compete with a rival's equally low price -- as long as products are not sold below cost. As with certain related monopolistic practices, Robinson-Patman issues must be considered not only for direct pricing issues, but also for non-price considerations, such as promotional allowances and credit terms.
  • Vertical Non-Price Restraints - Manufacturers may attempt to implement a variety of restraints affecting distribution channels that trigger antitrust considerations. The three most common forms are tying, exclusive dealing, territorial and customer restrictions.
  • Tying is an arrangement by which the sale or lease of Product X, which the buyer wants, is conditioned on the buyer also purchasing Product Y, which the buyer does not necessarily want. Recent cases have set forth a clear test for distinguishing when a tie-in arrangement is permitted and when it is prohibited, although the exact elements of the test vary among the jurisdictions. A threshold condition to finding an illegal tying arrangement has always been that the seller have sufficient market power and exercise enough coercion to truly force the buyer to purchase Product Y as a condition to getting Product X.
  • Exclusive dealing involves a situation in which a buyer contracts to purchase all of its requirements for a given product exclusively from a particular seller. When the buyer is entering into such an arrangement merely to protect its requirements for the product in a period of market supply uncertainty, it would clearly be wrong to classify such an agreement as anticompetitive. However, if the exclusive dealing contract is designed to suppress competition, then the court will examine the exclusive dealing contract in light of all relevant facts and circumstances under the "rule of reason" test.
  • Territorial and Customer Restrictions usually involve attempts by sellers to divide the targeted market into distinct territorial segments and grant geographic or customer exclusivity to a given buyer. Courts have struggled with the antitrust implications of such arrangements primarily because of the dual effect on competition that territorial and customer restraints tend to have. Specifically, so-called interbrand competition -- among different manufacturers -- is generally increased at the same time that intrabrand competition -- among different retailers of the same manufacturer -- is generally adversely affected. The courts have attempted to balance this conflicting effect on competition by analyzing all of the surrounding facts and circumstances in analyzing a territorial or customer restraint under the "rule of reason" test.

As a company's growth leads it into the establishment of new distribution channels, expanded geographic territories and increased market share, the need for the development and maintenance of a formal antitrust compliance program becomes increasingly important to avoid antitrust problems and penalties. Implementation of such a program should begin with an antitrust audit, which consists primarily of circulating a legal and strategic questionnaire to all key employees responsible for marketing, distribution and pricing decisions. The purpose of the questionnaire is to identify existing company policies, objectives, activities, contracts, practices, and even attitudes that could create problems under the antitrust laws. The audit should address the following issues:

  • Does the company have an oral or written understanding with any direct or indirect competitor regarding pricing, warranties, discounts, shipping and credit terms, promotional contributions or service policies in connection with any of its products?
  • What are the exact product and geographical markets in which the company competes? What is its respective market share in each of these markets?
  • Has the company experienced any actual or threatened antitrust litigation or investigation in the past? What were the specific company practices upon which these claims were based? What steps, if any, were taken to resolve any of the previously identified problems?
  • How are the company's pricing policies developed? Is the same product ever sold to different customers at different prices? What is the rationale or justification for such a price disparity?
  • What distribution channels have been selected for marketing the company's products and services? What oral or written agreements have been developed with wholesalers and retailers? Do any of these agreements include specific provisions or understandings as to price, territory or customer restrictions? Does the company engage in dual distribution? Are any of the company's customers forced to purchase unwanted products and services as a condition to dealing with the company?
  • To what trade associations does the company belong? What types of information is exchanged among members? Why?

The company's CEO and key managers should provide the answers to these questions. Then the company's legal counsel needs to determine whether a change in policy or practice should be implemented.

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