The Law of Loyalty Discounts: Two and a Half Theories
This is the latest in a series of columns by O’Melveny & Myers attorneys, focusing on key legal issues specific to a variety of U.S. industries.
Loyalty discounts are everywhere, some formally labeled as such (“Buy 10 cups of coffee and get one free”) and some a function of volume packaging (a six-pack of soda yields a lower per-unit price than buying a single can).
Less obvious to consumers, but important to business relationships, are upstream loyalty discounts: those that occur, for instance, between a component manufacturer and consumer-product manufacturer or between the consumer-product manufacturer and a distributor.
For in-house counsel in industries where loyalty discounts are used often, recent developments in antitrust theory raise important considerations, particularly for companies that enjoy market power in a particular product. (A speech given on June 3, 2013 [PDF], by Federal Trade Commissioner Joshua Wright, offers important insight on this topic.)
Start with this example: Company A manufactures a component that is installed into Manufacturer B’s end product. Manufacturer B allows customers to select the brand of component and offers a number of choices.
Company A has substantial market power in the component market: a dominant share of customers prefer and will select Company A’s component over others. Manufacturer B will have to buy components from Company A to satisfy that customer demand. Manufacturer B, however, can influence customers that do not have a component brand preference. To incentivize Manufacturer B to exercise that influence in its favor, Company A offers Manufacturer B a long-term contract with conditional rebate provisions under which rebates are received only if Manufacturer B purchases 100 percent of its component requirements from Company A.
To further illustrate, say that Manufacturer B uses 100 components a year. Ninety customers prefer and select Company A’s component. Under the conditional rebate provisions, Manufacturer B can buy those 90 components for $10 per unit. But if Manufacturer B buys all 100 from Company A, the price on the component drops to $9.50 for all units. This is an example of a so-called “first-dollar rebate.” It’s not a straight volume discount (buy more than 90 and the price for the additional units goes down) because it applies backward to previous purchases.
And here’s the issue with this example of a first-dollar rebate: Manufacturer B can buy 90 units and pay $900 (90 x $10), or buy 100 units and pay $950 (100 x $9.50). This makes the effective price to Manufacturer B for the last 10 components $5 per unit. So to compete for those units, Company A’s competitors can only charge $5. But Company A, by capturing all of the market, is effectively getting an average per component price of $9.50.
Let’s say now that you represent Company C, a competitor to Company A. The head of sales tells you that the only way you can possibly compete for the final 10 units is to offer them to Manufacturer B for $5 per unit, a price at which Company C cannot achieve sufficient profitability to attain minimum viable scale in the component market. This must be an unfair business tactic, she says, to force competitors from the market. “What’s the antitrust answer?” she asks.
Good question. You have two big theoretical choices, plus a third option that provides a jurisdictional alternative.
Standard monopolization law under Section 2 of the Sherman Act requires a plaintiff to show that a defendant has monopoly power and that the defendant has acquired, maintained, or enhanced that power through exclusionary conduct that “impair[s] competition in an unnecessarily restrictive way.” Aspen Skiing Co. v. Aspen Highlands Skiing Corp., 472 U.S. 585, 605 (1985). (Section 2 also bars attempted monopolization.)
Consider exclusive-dealing claims: the assertion that a monopoly has used its power to foreclose a competitor from the marketplace in a manner that harms competition. Exclusive-dealing cases can be complicated; after all, companies can point to plenty of pro-competitive reasons for exclusive deals. The underlying theory, however, is straightforward: A monopolist may not protect its monopoly by unreasonably depriving its competitors of a market opportunity for its goods (e.g., by requiring an agreement from customers that they will not do business with its competitors).
Pricing is different. The U.S. Supreme Court, skeptical of claims that lower prices are bad for consumers, created a special rule for predatory pricing in Brooke Group v. Brown & Williamson Tobacco Corp. To make out a predatory-pricing claim, the plaintiff must show that a monopoly defendant set a price below an appropriate measure of its costs (the so-called “price-cost” test) and, in addition, that there is a dangerous probability that future competition will be sufficiently lessened so that the defendant will be able to recover its below-cost losses over time.
To answer the antitrust question asked by the head of sales at Company C, you’ll need decide whether Company A’s conduct should be analyzed as a problem of predatory pricing or exclusive dealing.
1. The Price-Cost Test
Company A will argue that the purpose of Brooke Group was to ensure that low pricing is not treated as anticompetitive unless it is part of a scheme where a company is intentionally pricing below cost in order to drive competitors out of the market and then gobble up the monopoly profits that follow in the wake of their departure. Company A would say that lower pricing is, of course, the most pro-consumer means of meeting threats from competition.
And that’s the approach that the Ninth Circuit has taken.
In Cascade Health Solutions v. PeaceHealth, the Ninth Circuit considered a “bundled” discount—where two products are sold together for a single price that was lower than the total of their standalone prices (such as a bundled cable TV/Internet offer). The plaintiff in Cascade Health, a hospital, alleged that its competitor, the defendant, used its advantage in its monopoly market for sophisticated medical services to offer insurance companies discounts of 35 to 40 percent, but only if those companies used the defendant for all medical services, including in the markets in which the plaintiff competes.
But the Ninth Circuit was not swayed. Its 2007 opinion held that “the exclusionary conduct element of a claim arising under [Section 2] cannot be satisfied by reference to bundled discounts unless the discounts result in prices that are below an appropriate measure of the defendant’s costs.” PeaceHealth, 515 F.3d 883, 903 (9th Cir. 2008). The court went on to explain that, in a bundling case, such pricing can be considered exclusionary only if discounts (the 35 to 40 percent in the monopoly market) are fully allocated to the competitive product and such allocation results in the price of the competitive product dropping below the defendant’s incremental cost of production.
2. Exclusive Dealing
In its 2012 decision in ZF Meritor, LLC v. Eaton Corp, the Third Circuit questioned the relevancy of a price-cost test to loyalty discounts that were part of a larger set of anticompetitive acts. Meritor, an entrant into the heavy-duty transmission market, alleged that the defendant, longtime transmission manufacturer Eaton Corp., had entered into contracts that improperly harmed Meritor’s ability to compete, including Eaton’s use of rebates conditioned on truck manufacturer customers pledging purchase of a high percentage of their requirements from Eaton. Meritor also alleged a series of other exclusionary actions, including the claim that Eaton used its monopoly power to induce manufacturer customers to list its products as the “standard offering” in their retail catalogs, while requiring two of them to remove listings of competitive transmissions.
Ultimately, in a split decision, the Third Circuit decided that “price itself was not the clearly predominant mechanism of protection” and, consequently, that the Brooke Group price-cost test was inapplicable. ZF Meritor, 696 F.3d 254, 277 (3d Cir. 2012). The facts presented the “rare case” that should be analyzed as a matter of exclusive dealing because “this is not a case in which the defendant’s low price was the clear driving force behind the customer’s compliance with purchase targets . . ..” Id. at 278. The court emphasized both the allegations of a wide scope of anticompetitive acts and that the customers had no practical alternative but to carry Eaton products, which would be threatened if they failed to meet the market-share requirements.
In Commissioner Wright’s recent public speech, he built on the analysis in ZF Meritor. Wright asserted that courts should analyze loyalty discounts, whether or not the only mechanism of exclusion, “under the same legal rubric as exclusive dealing.” Simple but Wrong or Complex but More Accurate? The Case for an Exclusive Dealing-Based Approach to Evaluating Loyalty Discounts 20, Bates White 10th Annual Antitrust Conference (June 3, 2013). He explained that “a monopolist may be able to use exclusive contracts to raise its rivals’ costs” (id. at 22), and that the kind of loyalty discount described above can also be viewed as a monopoly tax that has “the effect of forcing rival manufacturers to charge substantially lower prices in order to convince manufacturers to forgo the all-units discount . . ..” Id. at 8, fn. 11.
Any analysis of loyalty discounts should keep in mind that exclusive dealing can often be pro-competitive, and therefore an exclusive-dealing claim must be judged under the rule of reason. Consider, for example, a small startup company that wants to bring its first product to market. Without a brand name or a track record, it will have difficulty finding distributors. But by giving a distributor the exclusive opportunity to sell its product, the startup is also giving the distributor an incentive to invest in the new product’s success.
And it can work the other way: A distributor may wish to offer rival suppliers the chance to bid for an exclusive deal by offering the lowest price.
Courts will weigh such pro-competitive benefits against potential anticompetitive impact when a monopolist engages in exclusive dealing. The rule of reason calls on courts to decide “whether the questioned practice imposes an unreasonable restraint on competition, taking into account a variety of factors, including specific information about the relevant business, its condition before and after the restraint was imposed, and the restraint’s history, nature, and effect.” State Oil v. Khan, 522 U.S. 3, 10 (1997).
2.5. Section 5 of the FTC Act
Why a “half” theory? Because Section 5 of the FTC Act, barring “[u]nfair methods of competition,” offers an alternative jurisdictional basis. A Section 5 theory might be important if, for example, the Supreme Court resolved to apply the price-cost test to the kind of conduct alleged in ZF Meritor. (The Court, in 2013, denied certiorari in that case.)
A Section 5 theory would not resurrect private claims, but it would permit civil enforcement actions by the FTC. Commissioner Wright’s speech reviewed a number of FTC actions—most notably its 2009 administrative complaint against Intel—that he views as consistent with the exclusive-dealing theory. (And, of course, state unfair-competition laws need not reflect the limits of Section 2.)
The in-house counsel asked about the proprietary of loyalty discounts from either a seller’s or buyer’s perspective is put in a difficult situation: yes, loyalty discounts are ubiquitous in commercial arrangements, but their treatment under the law is still uncertain, at least where they involve products in which the seller enjoys substantial market power. Avoiding uncertainty is the obvious solution; a company offering only volume discounts, for instance, is unlikely to face antitrust questions.
When the issue has to be faced directly, however, in-house counsel should (i) carefully evaluate the potential net effect of discounts on competition, should they ever be assessed under a rule-of-reason analysis, and (ii) recognize that the federal judiciary’s willingness to consider the aggregate impact of the alleged acts of a monopolist, as in US v. Microsoft, requires a careful evaluation of all circumstances, not just the impact of pricing alone.
Jon Sallet and Katrina Robson are members of the Antitrust and Competition Practice Group of O’Melveny & Myers.