Predatory Innovation

Sophie Lawrance of Bristows has written a post on the US Department of Justice investigation into high frequency trading, a practice most recently brought into public view by Michael Lewis’s book Flash Boys.

In addition to saying nice things about this blog, Sophie drew my attention to the US Ninth Circuit Allied Orthopedic case which, although it came out a few months before my publication deadline for Competition Law and Regulation of Technology Markets, I’m afraid I missed at the time.

A Per Se Test for Legality

It’s an interesting case: the Ninth Circuit applied a per se legality test to issues of product redesign, an approach which was roundly – and rightly – criticised in this article by some very savvy tech lawyers (Jacobson, Sher and Holman).

My book has some other cases of predatory innovation where per se legality would clearly have led to the wrong results: Bard v M3, for example, is a particularly interesting US case, at least for EU lawyers. A manufacturer of surgical syringe guns redesigned its guns so that competitor needles would no longer work. The product redesign replaced the need for behavioural conduct of the kind employed by Hilti in the EU case involving nail guns and nails.

But a Balancing Test is Better

Overall, I can’t better the conclusion of the above article criticising Allied Orthopedic:

“While innovation is appropriately granted deference under the antitrust laws because of its ability to generate significant procompetitive benefits, courts must be wary of anticompetitive conduct dressed up as “innovation” that harms competition while providing no material benefit to consumers. When confronted with allegations of predatory innovation, courts should apply the D.C. Circuit’s consumer welfare balancing test in Microsoft, and not the per se rule protecting redesign established by the Ninth Circuit in Allied Orthopedic. While other tests also exist, such as the “profit sacrifice test” and the “no economic sense test,” both suffer from encouraging either over- or underenforcement. The Microsoft test applies a time-tested approach to ensuring that the focus of the inquiry is appropriately on consumer welfare, and thus should be applied to ensure that the significant potential benefits of innovation are appropriately weighed against any alleged competitive harms.”

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Speaking Engagements

I have two speaking engagements in April, both on cartels.

The first is for the American Bar Association: Slicing the Pie: Defining the Scope of an International Cartel: April 28, 2014 12:00PM to 1:30PM (EST) / 6:00PM to 7:30PM (CET)

The second is at the IBC Advanced EU Competition Law event in London on 29 & 30 April, where I’ll be speaking with Johan Ysewyn on recent cartel developments. IBC bills the conference as “The ultimate review of key developments in EU competition law.” If anyone is organising a penultimate review of developments, please let me know.

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Faull & Nikpay, Third Edition, has just been published.

The third edition of Faull and Nikpay: The EU Law of Competition has just been published.

This is a significantly expanded edition:

Fully updated in this third edition, the work includes full coverage of the latest legislation, case law and guidance, giving competition lawyers a comprehensive commentary on recent developments. It includes new material on industries of growing importance in the competition field, including Pharma and High Tech. It also analyses the R&D and Specialisation Block Exemption Regulations, the revised Verticals Block Exemption Regulation, and the Technology Transfer Block Exemption. Key cases covered in this edition include Telefonica, Microsoft, Intel, Rambus, RWE, and GdF.

 

The Communications chapter that I co-wrote in the first and second editions has been replaced with separate telecoms and media chapters written by two great DG COMP experts. (After completing my own book on technology – Competition Law and Regulation of Technology Markets – I didn’t feel I had enough original to say to give the Communications chapter the complete rewrite it needed.)

I continued to contribute to the IP chapter, together with Luc Peeperkorn and Lars Kjolbye.

Get it while it’s hot.

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It’s not only essential facilities that need limiting principles

A post in another place about Areeda’s article on essential facilities – “an epithet in need of limiting principles” – reminded me that limiting principles are not only needed to decrease the risks of over-enforcement. Areeda’s legitimate concern about nuance being lost in the application of precedent applies also to precedents which limit liability. They are relevant to under-enforcement as well.

From hard cases to bad law

Areeda wrote:

“As with most instances of judging by catch-phrase, the law evolves in three stages: (1) An extreme case arises to which a court responds. (2) The language of the response is then applied -often mechanically, sometimes cleverly- to expand the application. With too few judges experienced enough with the subject to resist, the doctrine expands to the limits of its language, with little regard to policy. (3) Such expansions ultimately become ridiculous, and the process of cutting back begins“

How do you solve a problem like predation?

Although Areeda would very likely disagree, I think you can see the same evolution in the US case law on predation. I wrote about this in the pricing chapter of Competition Law and Regulation of Technology Markets:

4.32 Current predation test In Brooke Group:⁠ [fn: Brooke Group Ltd v Brown & Williamson Tobacco Corp 509 US 209 (1993).] the Supreme Court combined the cost-based element of the Barry Wright case with the structural elements of the Matsushita case to create an overall test for predation requiring:

- prices below an appropriate measure of costs (though the court did not specify whether the appropriate measure should be average variable or average total cost); and

- a ‘dangerous probability’ of recoupment of its below-cost pricing.

4.33 Prices below costs: In applying the first of these limbs, US courts have generally adopted the Areeda Turner test for predation,⁠[fn: Philip Areeda and Donald F. Turner, ‘Predatory Pricing and Related Practices under Section 2 of the Sherman Act’, 88 Harv L Rev 697 (1975).] whereby only prices below average variable cost are seen as predatory. Although criticized,⁠[fn: See, eg, Oliver E. Williamson, ‘Predatory Pricing: A Strategic and Welfare Analysis’, 87 Yale LJ 284 (1977); Janusz A. Ordover and Robert D. Willig, ‘An Economic Definition of Predation: Pricing and Product Innovation’, 91 Yale LJ 8 (1981).] it is often seen as the best alternative to provide legal certainty and avoid enforcement errors.

4.34 Recoupment: In Brooke Group, the plaintiff (Liggett) had introduced a cut-price unbranded range of cigarettes onto the market in 1980. By 1984, unbranded cigarettes had taken 4 per cent of the market from branded cigarettes. The defendant, Brown & Williamson, had entered the cut-price segment of the market, beating the defendant’s price, sparking a price war, with allegations of predation. However, the defendant sold only 11.4 per cent of the market’s branded cigarettes. For a recoupment strategy to succeed, it would be dependent on the reactions of RJ Reynolds with about 28 per cent of the market and Philip Morris with about 40 per cent of the market. Given these facts, the Supreme Court found that recoupment was unlikely given the risks of defection during the recoupment period. Brooke Group therefore involved a relatively unconcentrated market—at least compared to simpler monopoly cases—and to argue that a predatory strategy seems doomed to failure in these circumstances seems uncontroversial.

4.35 It seems less justifiable, however, to use the case as a precedent for the difficulty of demonstrating recoupment in cases with—say—a single company with monopoly power and a market share of 80 per cent. Looking at the case against Intel, for example, put forward by the European Commission⁠ and the Federal Trade Commission,⁠ a company with a 70–80 per cent market share carried out a range of activities designed to undermine and exclude its only serious rival on the market: no concern with the need for a collusive practice or the risks of defection need reduce the likelihood of recoupment in such a case.

…

4.37 Recoupment as a screening device One factor that helps explain the focus of the US courts on recoupment is its role as a useful screening device, a means of quickly identifying cases that lack merit. Often it will be, ‘much easier to determine from the structure of the market that recoupment is improbable than it is to find the cost a particular producer experiences’.⁠[fn: A.A. Poultry Farms, Inc v. Rose Acre Farms, Inc 881 F.2d 1396, 1401 (7th Cir. 1989) (Easterbrook J).] This is particularly important in a system with substantial private enforcement.

…

4.122 EU and US law on recoupment The absence under EU law of the need for a recoupment analysis contrasts markedly with the need, under US law, for a ‘dangerous probability’ of recoupment. The gap between EU and US could be narrowed, if the original Brooke Group rationale of recoupment as a simple screen for unmeritorious cases were brought more to the fore: there seems little scope for that, however.

… particularly in high fixed costs industries

So I argue in the book that there is nothing wrong with a recoupment test in itself, but there is a risk that an overly formulaic application of the rule can lead to under-enforcement. This is particularly the case when you combine overly formulaic ideas of recoupment with overly formulaic applications of the relevant cost test…

4.123 Difficulties of the AAC/AVC test in certain cost structures In the Article 102 Enforcement Priorities Guidance,⁠1 the Commission refers to pricing below average avoidable costs in relation both to predation⁠2 and to rebates.⁠3 However, firms cannot survive on a market if they only recover their marginal costs. The Department of Justice’s now withdrawn report on s 2 of the Sherman Act recognized that marginal cost pricing would be unlikely in high fixed cost industries: ‘Depending on the size of the firm’s fixed costs, even a significant margin between price and short-run marginal cost may be insufficient to earn even a normal return.’ It did so in a section highlighting that pricing above marginal costs should not, without more, be an indicator of market power,⁠4 but the point remains true as a description of the economic realities in high fixed cost industries.



1 Guidance on the Commission’s enforcement priorities in applying Article 82 of the Treaty [now Article 102 TFEU] to abusive exclusionary conduct by dominant undertakings, 24 February 2009, 2009 OJ C 45, p 7.
2 At paragraph 64: ‘The Commission will take AAC as the appropriate starting point for assessing whether the dominant undertaking incurred or is incurring avoidable losses. If a dominant undertaking charges a price below AAC for all or part of its output, it is not recovering the costs that could have been avoided by not producing that output: it is incurring a loss that could have been avoided. Pricing below AAC will thus in most cases be viewed by the Commission as a clear indication of sacrifice.’
3 At paragraph 44: ‘W here the effective price is below AAC, as a general rule the rebate scheme is capable of foreclosing even equally efficient competitors.’
4 US Dept of Justice, ‘Competition and monopoly: single-firm conduct under section 2 of the Sherman Act’ (2008) (now withdrawn), 29: ‘Indeed, a firm should not be found to possess monopoly power simply because it prices in excess of short-run marginal cost and hence has a high price-cost margin (footnote: See Mar. 7 Hr’g Tr., supra note 6, at 13–14 (Nelson); id. at 97 (Katz); see also CARLTON & PERLOFF, supra note 8, at 93 (distinguishing monopoly from market power on the basis that more than just a competitive profit is earned when a firm with monopoly power optimally sets its price above its short-run marginal cost).)’

…

4.126 In high fixed and low variable cost industries, the use of average avoidable costs by itself will operate to favour dominant companies at the expense of their competitors and, ultimately, of consumers.⁠ [fn: The problems with ignoring fixed costs are discussed in H. Hovenkamp, The Antitrust Enterprise (Harvard University Press, 2006).]

When I drafted the book, I put Hovenkamp’s criticisms rather mildly. In the Antitrust Enterprise he said:

“the AVC test works very poorly in industries that have high fixed costs and relatively low marginal costs, such as airlines and public utilities, and perhaps some markets that have a large intellectual property component in their value…
[In such industries, e.g. airlines] …the AVC test amounts to a virtual license to engage in predatory pricing.”

Though I perhaps mischaracterised the criticism slightly in the footnote as Hovenkamp focusses more on the problem of ignoring opportunity costs.

So I think – although as I say I’m sure that Areeda wouldn’t – that current US law on predation provides a very good example of Areeda’s concern quoted at the beginning: “(1) An extreme case arises to which a court responds. (2) The language of the response is then applied -often mechanically, sometimes cleverly- to expand the application. With too few judges experienced enough with the subject to resist, the doctrine expands to the limits of its language, with little regard to policy. (3) Such expansions ultimately become ridiculous, and the process of cutting back begins.”

More work required

Though notwithstanding Hovenkamp’s highlighting of the problems, I’m not sure that the cutting back has yet truly begun.

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Bananas to Chillin Competition

Alfonso Lamadrid on Chillin Competition, commented earlier today on an interesting paper by Javier Berasategi bringing together issues of competition law, supermarkets and technology.

In passing he noted that I’d already brought groceries and tech together with my “exploding banana hypothesis.” I’m grateful to him for highlighting my valuable contribution to the jurisprudence on perishable fruit and cross border trade. For the curious, here are the relevant paragraphs from my book on competition law and regulation of technology markets:

7.07 Are there circumstances where product design can achieve what would otherwise be unlawful under the competition rules?

7.08 For example, EU competition law prohibits many vertical restraints that restrict parallel trade. In the United Brands case the Commission, in a decision upheld by the Court of Justice, found United Brands to have abused its dominant position by imposing a restriction on its distributors that prevented them from reselling bananas while they were still green. As bananas perish quickly once they have turned yellow, a ban on resale while green effectively prevented cross-border trade. A colleague once speculated as to what the European Commission’s approach would have been if, instead of imposing restrictions on its banana distributors, United Brands had instead created a banana that exploded when it crossed frontiers (the ‘exploding banana’ hypothesis).


The point was to highlight – assuming market definition and dominance – whether the design of such a banana could be abusive. In the book I then go on to talk about predatory innovation – a slightly more formal way of expressing the issue. Those curious can:
* buy the book;
- beg, borrow or steal a copy of a lecture I gave at Kings in London a couple of years ago which looked at product design and interoperability in more detail; or
- for the more patient, wait for me to write up that lecture. And this gives me yet more incentive to do so.

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Asking the right question

Too often we tend to assume that if we can write down a question – in a request for information – then business can write down the answer just as simply.

(This is the second article in what I hope will be a series covering “Mistakes the Other Side Make”. For an introduction to the series see here. It says a lot about the European Commission that they allow me to publish articles that admit that not everything is perfect about how we work.)

I’m guilty of this assumption. A few years ago I wrote a request for information to a company asking for a map of their entire corporate structure, together with background information on each company. The lawyer receiving the request turned – so I now imagine – white with horror and then red with anger. I had, so she explained at high – but justified – volume, asked for more information than would be covered in a due diligence exercise. My request was, according to her, wholly disproportionate. She was likely right.

When I explained what I was trying to unearth – what actual or potential overlaps there were between this particular undertaking’s corporate group, and another undertaking involved in the same joint venture – the conversation turned to how this legitimate question could be answered more briefly and effectively. My mistake was having this conversation after sending the request for information rather than before.

DG Competition has gotten better.

The move to a sectoral organisation in the mid 2000s helped capture more sectoral knowledge helping units formulate their requests for information more accurately. The Chief Economist Team also routinely sit down with the other side to discuss what information is needed and how it can be provided, before finalising a request for information.

But this is still an area where we can improve.

However, there are real problems getting in the way of improvement:

- the revolving door between public and private sector  revolves rather slowly in the EU. DG Competition does not have theprivate sector experience which characterises – for example – the US Department of Justice;

- given an inevitable lack of detailed knowledge of the company under investigation, it is easy to ask for information in a form not easily mappable onto business systems;

- we may easily formulate our queries poorly and end up asking for too much information.

All of these argue in favour of frequent discussion of potentially complex requests for information before the requests are sent. This happens increasingly often, but there’s an inevitable gap between best practice and… less than best practice.  We could improve.

[Update on 5 February 2014, to change the title from "Limited business knowledge" to "Asking the right questions" which better sums up the post. With credit to Peter Willis for suggesting the title could be better.]

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Inability to pay and significant loss of asset value

The European Commission’s positions on inability to pay competition fines, and on the failing firm defence under the merger regulation are superficially different, but the underlying policy concern is the same.

The Commission’s 2006 Fining Guidelines envisaged the possibility that some fines ought to be reduced if a firm is unable to pay:

“35. In exceptional cases, the Commission may, upon request, take account of the undertaking’s inability to pay in a specific social and economic context. It will not base any reduction granted for this reason in the fine on the mere finding of an adverse or loss-making financial situation. A reduction could be granted solely on the basis of objective evidence that imposition of the fine as provided for in these Guidelines would irretrievably jeopardise the economic viability of the undertaking concerned and cause its assets to lose all their value.” (emphasis added)

This last element, that a fine should not cause the assets “to lose all their value” was clarified in an Information Note jointly agreed by Commissioners Almunia and Lewandowski:

“8. With respect to the condition that the company’s assets have to lose “all their value”, it has become apparent that a literal interpretation of this wording would rather lead to a systematic rejection of all ITP claims since individual assets practically never lose completely their value, even if the company that participated in the anticompetitive practice goes bankrupt (because the assets normally will retain a certain operational and resale value). The Commission therefore interprets this condition as requesting that the fine would not only be likely to lead to the bankruptcy of an undertaking as such, but also that it would cause its productive assets to lose “significantly” their value. This would be the case if the bankruptcy would lead to the disappearance of the undertaking as a going concern (because of dismantling and/or closure), its jobs being lost and the assets (property, buildings, machinery etc.) being sold separately at substantially discounted prices. Conversely, there would be no significant asset loss if there are clear indications that the undertaking will be acquired and its business will be continued as a going concern (i.e. without job losses, etc.) by another company, even if the infringing undertaking as a legal entity would declare bankruptcy.” (emphasis added)

This makes clear that bankruptcy in itself is not a reason for reducing or eliminating a fine. Only if the undertaking would not continue as a going concern should the Commission accept an inability to pay application. If a competition fine would lead to the removal of the firm as a competitive force on the market, then competition on the market may best be served by reducing or not imposing the fine.

The Commission may be faced with a similar problem under the Merger Regulation. If a merger would lead to a significant impediment to effective competition, but one of the firms may – absent the merger – fail, then competition on the market may best be served by allowing the merger. This is usually referred to as the failing firm defence.

However, the wording of the failing firm defence under the Merger Regulation is a little different to the wording in relation to a firm being unable to pay a competition fine. In the Horizontal Merger Guidelines, the Commission sets out three criteria which must be fulfilled for the failing firm defence to be met:

“The Commission considers the following three criteria to be especially relevant for the application of a “failing firm defence”. First, the allegedly failing firm would in the near future be forced out of the market because of financial difficulties if not taken over by another undertaking. Second, there is no less anti-competitive alternative purchase than the notified merger. Third, in the absence of a merger, the assets of the failing firm would inevitably exit the market.” (emphasis added) (at paragraph 90).

The Commission points out in the next paragraph that this isn’t an exception to the merger control rules, but rather an application of the principle that there has to be, “causality between any given merger and any deterioration of competitive conditions in the market that can be expected to occur.’ You could also see this as an application of the principle that the competition rules should not decrease competition on a market. The Commission should not prohibit a merger – or impose a cartel fine – that would weaken competition on a market.

Notwithstanding this common aim, the criteria set out are rather different.

In the inability to pay scenario, the Commission refers to causality plus the potential loss of asset value; in the failing firm scenario, the Commission mentions causality, the lack of alternative solutions (not relevant to a cartel or other antitrust fine) and the exit of productive assets from the market. The latter formulation with its focus on the exit of productive assets from the market seems better aligned with what the public policy should be: if productive assets are being lost to society, then society is worse off; if a shareholder of a company that has been involved in a cartel simply loses the value of its investment, then that is a problem for the shareholder, not for society. That an undertaking goes bankrupt is not in itself a loss of productive assets to society; an undertaking ceasing to be a going concern is more likely to lead to a loss of productive assets to society; better yet, however, would be an explicit recognition that the policy objective underlying inability to pay is the loss of productive assets, for which an undertaking ceasing to be a going concern is at best an imperfect proxy.

This is certainly hinted at in the emphasised section above in the Almunia / Lewandowski information note that the underlying concern is in fact the loss of productive assets – in the reference to the undertaking not surviving as a going concern or the assets being sold separately – and this is a useful clarification of the 2006 Fines guidelines.

Perhaps if there is ever to be a revision to the Fines Guidelines, this hint could be taken up more fully, and the language on inability to pay aligned more closely with the language on failing firm.

[Update: 18 April 2014: this post has been slightly rewritten to - hopefully - make the flow of the argument clearer. No change of substance or argument was intended.]

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Alfonso Lamadrid (Chillin Competition) on the Commission’s Android case

Most press comment has been on the Commission’s investigation into Google’s search practices. The Commission has another pending case, however, into Google’s handling of the Android operating system. Alfonso Lamadrid of Garrigues (disclosure: a friend) has written an excellent three part analysis of the complaints against Android lodged with the European Commission.
Without commenting on any of his tentative conclusions, the articles highlight the issues to be considered better than anything else you’re likely to read unless and until the Commission makes a decision. (And I know that some will say “even after any Commission decision…”)
Post 3 on the bundling allegations
There’s then a guest post by Pablo Ibanez, and the exchange between Pablo and Alfonso in the comments is also well worth reading.
(And if you’re wondering why this post has appeared so long after Alfonso’s original post, read this.)
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Complicity and Compliance Redux: Two Years On

Two years ago I wrote a short article (which I recently republished here) on why reducing competition fines because a company had a compliance policy would be a mistake. Since then, I’ve changed my mind. But only on the reasoning, not the result. At least for now. And I may change it again.

There is fairly profound disagreement on this point between the Commission and many companies (and their advisers). The Commission does not want to give fines reductions for companies that have a compliance programme in place; companies believe that investing in a compliance programme should be recognised by the Commission by a reduction in fines.

The disagreement could be simply because companies that have put in place a compliance programme know that there is a risk that it will fail, so they are trying to reduce potential future fines. This would be a rational argument but would be somewhat self-serving and I don’t believe it’s the main reason for companies’ disagreement with Commission policy.

It could also be because it might make it easier for  inhouse and external counsel to “sell” an expensive compliance programme to the CEO. Though as I noted at the end of my last article, if the compliance programme avoids just one antitrust infringement, that will almost certainly be far more effective than a fine reduction or damages for any infringement that does occur. So if that avoidance of cartel behaviour isn’t enough of a sell to the CEO, it’s hard to see why a reduction in a potential future fine would be more persuasive. (There may be an argument here that the fines reduction is somehow perceived as more proximate or significant and therefore has a bigger impact on CEO decision-making but I don’t really see it.)

Rather than the above reasons, I wonder if the difference in view on rewarding compliance programmes by reducing the fine is in part driven by the lack of successful damages actions in Europe.

I admit the link may not be immediately obvious.

Let’s look at the basics of what a fine has to achieve. Any fine has to punish and to deter.

From the perspective of a company that has put a lot of time, effort and money into creating a comprehensive compliance programme, it may feel that there is little more that it can do to increase compliance. It already has no intention of breaking the competition rules – it does not need to be deterred further – and it has already gone to great efforts to avoid such infringements – so any punishment should recognise these efforts.

From the perspective of the Commission, on the other hand, for a fine to deter, any revenue generated by the cartel and not paid out in damages has to be taken into account. This has been recognised by the Court:

‘profit which the undertakings were able to derive from their practices is one of the factors to be considered in assessing the gravity of the infringement’, Cases C-189/02P, etc, Dansk Rørindustri v Commission [2005] ECR I-5425, para 211.

This idea is also picked up in the European Commission’s 2006 Fining Guidelines which refers to:

‘the need to increase the fine in order to exceed the amount of gains improperly made as a result of the infringement where it is possible to estimate that amount.’Fining Guidelines, OJ 2006 C210/2, para 31

Let’s call this the unjust enrichment resulting from the cartel.

For a cartelist to be forced to disgorge the unjust enrichment leaves the cartelist in a neutral position – neither worse nor better off than if the cartelist had never engaged in the cartel in the first place.

Given the lack of damages actions in Europe, disgorgement of this unjust enrichment by these means almost never takes place.  Although the number of damages actions is increasing – and the Commission is proposing legislative changes to make such actions more likely to succeed – the starting assumption in looking at the fine has to be that damages are not being paid.

As an aside, this does not mean that if damages actions take off then cartel fines will, or should, go down – there is plenty of economic evidence to suggest that cartel fines are currently too low: estimates of cartel uplifts are often high, the detection rate can never be 100% so a deterrent fine has to take account of undetected cartels, and so on.

But an increase in successful damages actions might alter the terms of the debate about the relevance – for example – of compliance programmes.

Faced with a case where damages had been paid (so there was no question of unjust enrichment), an authority might then want to look at issues such as efficacy of compliance programmes when deciding what the appropriate punishment should be.

If, for example, the company has an extensive compliance programme in place, the infringement was committed by someone knowingly circumventing that programme, and the victims have been compensated, then a fine could perhaps take that into account without it being any less deterrent.

Before people seize on this as a sign that the Commission may be thinking of changing its cartel policy, a couple of points:
- first, have you read the disclaimer? These are just my thoughts;

- second, being able to assume that damages will deal with the unjust enrichment is not something that the European Commission will be able to do for the foreseeable future;

- third, the difficulties of distinguishing between the moral culpability of different types of companies highlighted in my first article will remain. Whether or not a company has a compliance programme would seem to be only one potentially relevant factor amongst several;

- finally, the question “why should we reward a failed compliance programme?” will remain.

So don’t expect a change anytime soon. But I think that focussing on the separate elements of unjust enrichment and punishment is helpful in framing the debate about fining policy and compliance programmes, and potentially other areas as well.

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