Wednesday, July 31, 2013

Supreme Court Fails to Defend "Competition on the Merits"

Standing Alone (and Wrong)

This most recent term, the Supreme Court passed up a significant opportunity both to clarify an important facet of antitrust doctrine and to correct an erroneous decision of the Third Circuit Court of Appeals.    See ZF Meritor v. Eaton, 696 F.3d 254 (3d Cir. 2012).  The result will be antitrust doctrine that discourages the most efficient allocation of resources, at least by those enterprises potentially subject to litigation in the Third Circuit.

Eaton was an admitted monopolist of the market for heavy duty ("HD") transmissions, an important feature of tractor trailers manufactured by Volvo, Freightliner and two other firms, so-called "Original Equipment Manufacturers" or "OEMs."  ZF Meritor, a joint venture between Meritor and Germany's  ZF Friedrichshafen AG,  entered the market, vying for sales to OEMs.   After ZF Meritor's entry, Eaton adopted a new pricing policy, a policy that promised significant discounts to OEMs that purchased a stipulated share of their HD transmission requirements from Eaton.  OEMs repeatedly met these market share targets, purchasing up to 92 percent of their requirements from Eaton, and Eaton provided the promised discounts.  ZF Meritor's share of the market shrunk accordingly, and, unable to earn a profit while meeting Eaton's prices, the venture exited the market.

After exiting the market, ZF Meritor filed an antitrust suit against Eaton.  The suit claimed, among other things, that Eaton's policy of granting market share discounts to OEMs constituted unlawful exclusionary conduct contrary to Section 2 of the Sherman Act.  Importantly, ZF Meritor did not allege that Eaton's prices were below any measure of cost.  Nor did the firm claim that Eaton had entered exclusive dealing agreements with any of the OEMs.  Instead, ZF Meritor essentially conceded that it could not match Eaton's prices and remain profitable because the latter had achieved significant efficiencies and thus lower unit costs than ZF Meritor, perhaps because of its large scale.  In other words, ZF Meritor sought damages from Eaton because the latter employed fewer resources to build HD transmissions than ZF Meritor, thereby freeing up resources for use elsewhere and enhancing national productivity. 

This brief amicus curiae, signed by this blogger and several other antitrust scholars, explained how ZF Meritor's failure to allege below-cost pricing should have doomed its case under long-standing precedent.   Both the Supreme Court and various lower courts have repeatedly held that "competition on the merits" is lawful per se, even if such competition results in or protects a monopoly and ultimately results in higher prices.  The realization of efficiencies and resulting above-cost pricing is the paradigmatic example of such lawful competition.   (See pp. 690-715 of this article for an exegesis of the case law on this topic.)  As Justice Brennan explained for the Supreme Court more than two decades ago, "[i]t is in the interest of competition to permit dominant firms to engage in vigorous competition, including price competition."  See Cargill v. Monfort, 479 U.S. 104, 116 (1986).   Banning such pricing at the behest of less efficient competitors would preserve inefficient rivals and  prevent firms from realizing productive efficiencies and thereby making more effective use of the nation's scare resources.   It's no surprise, then, that both mainstream schools of antitrust thought, Harvard and Chicago, have rejected antitrust rules that would condemn above-cost pricing. 

In the face of such precedent, the Third Circuit nonetheless sustained a jury verdict against Eaton.  In particular, the Third Circuit held that Eaton's pricing practices, described above, constituted "de facto exclusive dealing" and thus excluded ZF Meritor from the marketplace on some basis other than efficiency.  The court admitted, as it had to, that no OEM was legally obligated to purchase a single HD transmission from Eaton, let alone bound to purchase HD transmissions exclusively from the firm.  Nonetheless, the court opined that no OEM could survive without purchasing some transmissions from Eaton and that Eaton had the contractual right to refuse to sell such transmissions to any or all OEMs.  See Eaton, 696 F.3d at 282-83 (observing that Eaton had the contractual right to refuse to sell HD transmissions to each OEM and that  “no OEM could satisfy customer demand without some Eaton products.”)   Moreover, as the Third Circuit conceded, Eaton never declined to deal with any OEM or threatened to do so.  See Eaton, 696 F.3d at 282-83 and n. 15.  Nonetheless, the Third Circuit held that the mere possibility that Eaton might do so, combined with the prospect of obtaining market share discounts, effectively coerced OEMs into purchasing most of their requirements from Eaton and thus constituted the economic equivalent of an actual exclusive dealing agreement.  See id.  As a result, the court affirmed the jury's verdict, which rested upon a finding that the defendant's conduct had an unreasonable impact on competition, even though Eaton never priced below cost.  In so doing, the court ignored the Harvard/Chicago consensus described above.

The Third Circuit's equation of Eaton's conduct with actual exclusive dealing, subject to a rule of reason analysis, contravenes both Supreme Court precedent and sound antitrust policy.  As explained in this article,  "competition on the merits" depends upon the recognition of strong property rights.  Thus, for instance, a firm that realizes efficiencies need not share its know-how or facilities with others and must be allowed to charge what the market will bear.  It's no surprise, then, that t
he Supreme Court has repeatedly held that manufacturers may generally refuse to sell their products to others and that such a refusal  does not thereby establish a contractual restraint between the manufacturer and those who wish to purchase the manufacturer's products.  See e.g.  Verizon Communications, Inc. v. Law Offices of Curtis Trinko, 540 U.S. 398 (2004); United States v. Colgate, 250 U.S. 300, 307-308 (1919).  A fortiori, Eaton's right to refuse to deal, which it never exercised or threatened to exercise, did not thereby transform its unilateral pricing policy into an exclusive dealing agreement, de facto or otherwise, as each OEM remained contractually free to purchase as many transmissions from Eaton’s rivals as it wished.  Such contractual freedom constituted the very antithesis of an unreasonable contractual restraint.

To be sure, a monopolist’s unilateral refusal to deal can, in narrow circumstances, violate Section 2 of the Sherman Act, despite the absence of any accompanying agreement.  See Trinko   (rejecting such a claim).     Not surprisingly, ZF Meritor did not argue that Eaton’s conduct satisfied the stringent test for establishing an unlawful refusal to deal, as such a claim would have been baseless.  Instead, both ZF Meritor and the Third Circuit sought to transform two purely lawful practices — above cost pricing and an unexercised right to cease dealing — into one unlawful practice, called “de facto partial exclusive dealing.”  

The Third Circuit’s doctrinal alchemy would, if consistently applied, sweep too broadly and undermine antitrust law’s strong preference for price-based “competition on the merits.”  Under this test, any monopolist that offered discounts that disadvantaged rivals could be subject to liability for "de facto exclusive dealing."    After all, every monopolist is (by definition)  a “dominant supplier,” without whose products some firms might not survive.  As Thom Lambert has explained at Truth on the Market, reliance on this basic economic truism to support a finding of “de facto exclusive dealing” would necessarily require courts to condemn each and every system of market share discounts that prevented rivals from penetrating a monopolist’s market, unless, perhaps, the monopolist could establish, at trial, that the practice was the least restrictive means of generating efficiencies. Such a result would contravene the Supreme Court’s repeated pronouncements that antitrust laws protect competition — including price competition by monopolists — and not individual competitors.

To be sure, monopoly sellers may employ discounts to induce purchasers to enter exclusive dealing contracts, be they beneficial, harmful, or some combination of both.  Indeed, as explained in this article, sellers with little or no market power often employ cost-based discounts to induce acceptance of non-standard agreements, many (but not all) of which produce significant benefits.  However, a rule that subjects a monopolist's discounts to fact-intensive Rule of Reason scrutiny would ignore a critical distinction between market share discounts and other forms of discounts, on the one hand, and actual exclusive dealing, on the other.  After all, competitive rivalry does not take place in a vacuum, but instead reflects the influence of various background rules of contract, property and tort, rules that form what Ronald Coase called the Institutional Structure of Production.   As Coase explained, different sets of background rules can induce different allocations of resources and thus alter the content of society's output.  It therefore stands to reason that courts should take account of these background rules when fashioning antitrust doctrine.

In particular, attention to these rules reveals that actual exclusive dealing agreements have legal consequences that prevent a monopolist’s rivals from themselves engaging in merits-based competition.  For instance, a customer that breaches an exclusive dealing contract would have to pay a monopolist damages caused by such a breach.  Moreover, a new entrant or incumbent rival that knowingly employs discounts to induce customers to breach their exclusive dealing contracts with a monopolist thereby commits tortious interference with contract, exposing itself to liability for compensatory and even punitive damages.  See Restatement (Second) of Contracts, Section 766.  Thus, actual exclusive dealing agreements between Eaton and the OEMs could have solidified Eaton's monopoly for reasons unrelated to efficiency and thus, perhaps, prevented the most efficient allocation of resources.

Where there is no such agreement, however, rivals are perfectly free, as was ZF Meritor, to offer their own discounts in an effort to wrest customers away from the monopolist.  If successful, such a strategy would have no legal consequences whatsover, as substituting ZF Meritor's products for those produced by Eaton would not breach any obligation, contractual or otherwise.  (Any suit by Eaton for tortious interference with prospective economic advantage would fail, as ZF Meritor's discounts would not have resulted in breach of an actual agreement and would not otherwise constitute "improper" means of interference with Eaton's ability to retain OEMs' patronage.)  See Restatement (Second) of Contracts, Section 767.)   That is how competition is supposed to work.  Given these background rules, ZF Meritor's failure to do wrest more business from Eaton, far from reflecting the binding force of an exclusionary contract (backed up by the threat of tort liability), is instead  prima facie evidence that Meritor's costs were higher than those of the Eaton.  Imposition of liability in such circumstances will necessarily thwart the result of legitimate competition and destroy wealth.