September 27, 2004

Vertical Restraints and Distribution: Complying with the Antitrust Laws

7 min

Hypothetical A:  A procurement officer with the federal government posts an RFP for 100 copies of a well known training manual that is used in both the public and private sectors.  Fifteen resellers submit bids – all at exactly the same price.  The procurement officer thinks this is strange, and calls several bidders to see if they will lower their initial bids.  None will, and one reseller tells him that the bids are all the same because the pricing is controlled by the publisher.  How does the procurement officer respond?

  • Does he accept the explanation, reasoning that the publisher owns the copyright in the training manuals, and has the right to control the price charged by its sales agents? or
  • Does he call his contacts at the Department of Justice and suggest that they may want to open an investigation into whether there is price-fixing going on in the publishing industry?

Hypothetical B:  What if a few of the resellers did decide to offer lower prices to the procurement officer?  Could the publisher do anything?

I. Vertical Restraints:  An Introduction

While the classic portrayal of an antitrust conspiracy is a group of competitors gathered in a smoke-filled room to set the prices to be charged in their industry – a horizontal conspiracy –  the antitrust laws are also concerned with conduct that is vertical in nature, that is, conduct involving the relationship between a seller and its distributors and retailers.  The primary focus of the antitrust laws in the vertical arena is on resale price maintenance, promotional advertising, and territorial and customer restraints.

II. Resale Price Maintenance

A. Resale price maintenance is also known as vertical price fixing.  It occurs when a supplier (or publisher) and its distributors or resellers agree on a resale price or range of prices for product or services.  Often, there are good reasons for the desire to control price – encouragement of advertisement and promotions, discouragement of free riding, maintaining of profit margins, etc.

B. Naked agreements to set prices or price levels are per se, or automatically, illegal because they are inherently anticompetitive.  To the extent that any supplier attempts to obtain any understanding or agreement – whether formal or informal, express or implied – concerning the minimum prices for resale by the reseller on the resale price of the product, such conduct would likely be per se illegal.  Price-fixing is illegal whether it involves horizontal competitors discussing the price they will charge, as was the case in the Archer-Daniels-Midland case, or a manufacturer setting the minimum resale price at which its dealers may sell its product.  Agreements to set maximum resale prices, however, are no longer per se illegal under established case law.

C. Permissible Means to Control Downstream Pricing – Although true vertical resale price maintenance is typically per se illegal, there are several factual scenarios under which a supplier may be able to exercise some degree of control over the pricing of its products without violating the antitrust laws.

1.Suggested Retail Prices –  Suppliers are always permitted to suggest resale prices to resellers.  It is then up to the reseller, using its independent business judgment, to unilaterally decide whether to follow the supplier's suggestions.  However, there must be no requirement that the reseller adhere to the supplier's suggestions – continued dealings with the reseller cannot depend on adherence to the suggestions, lest there be an "agreement" to price at the suggested retail price.

a. The supplier may also consider incenting adherence to suggested retail prices by offering cooperative advertising funds, perhaps in conjunction with a minimum advertised price program.

2. Unilateral Refusals to Deal and Colgate –  A Colgate policy often goes hand-in-hand with a suggested retail price policy.  A seller will announce that resellers must advertise above suggested retail price, subject to the penalty of unilateral termination if they failed to follow the policy.  This type of termination is legal, but because of the danger that a lawful termination on the seller's part could become an unlawful resale price maintenance agreement, the termination must be unilateral and final – a seller may not reinstate resellers who fail to comply with the price list, it may not accept complaints from other resellers about others’ pricing, and it may not discuss any violations and/or termination decisions with its current or former resellers.  This type of policy is notoriously difficult to enforce.

3. Agency/Consignment Arrangements and Joint Ventures – Suppliers are also permitted to set the price for their products when the party that is “reselling” it is actually acting as an agent for the supplier, or is selling for the supplier on a consignment basis.  This may also be true to the extent that the producer and the reseller are acting in partnership – as joint venturers, with each party contributing resources to the creation and marketing of the product and sharing risk.

4. Other Arrangements/Rebates and Pass-Throughs, Promotional Allowances, and Cooperative Advertising – Suppliers might also consider using certain other arrangements intended to ensure that the ultimate consumer receives the lowest price possible without violating the antitrust laws, such as rebates and pass-throughs and promotional allowances.  Under these scenarios, it may be possible for the supplier to structure its relationships with its partners so as to exert some control over the ultimate price charged to consumers.

III. Customer, Territory and Location Restraints

A. Territorial/Customer Restrictions place restraints on a distributor or dealer with respect to the resale of the supplier's products.

1.Types of restrictions:

  • Territorial allocations restrict the geographic area or territory where the distributor can sell the product.
  • Customer restrictions restrict a seller to certain customers or classes of customers.
  • In an exclusive dealership agreement, the supplier appoints an exclusive distributor for a given time and cannot appoint another dealer in that territory for that time.
  • An area of primary influence, also referred to as "zone of influence," is a type of territory clause.  It requires a distributor to operate primarily in the assigned area and meet all quotas and goals set by the manufacturer in that area.  The dealer can sell anywhere else as long as it adequate services its primary area.
  • Profit passover clauses require a dealer to remit a certain amount to other dealers if it sells outside of its assigned area.

2. Rule of reason analysis –Territorial/Customer Restrictions are analyzed under the rule of reason.  Although such restrictions may be anticompetitive and violate the Sherman Act (or the FTC Act), they may also be procompetitive to the extent they promote interbrand competition (i.e., they may promote competition between suppliers).

  • For example, in one case involving Anheuser-Busch, the court held that the brewer's territory restrictions caused wholesalers to distribute more efficiently, reducing free riding and increasing competition between brewers.
  • Important factors may be the market share of the supplier (less is better) and the type of restriction.
  • Clauses establishing areas of primary responsibility are typically less suspect than other types of local restrictions because they are less restrictive.

B. While nonprice vertical restraints are analyzed under the rule of reason this does not mean they are per se legal.  You still need to look at the procompetitive and anticompetitive factors.

  1. The market share the supplier controls is very important, because it determines how much of the market is foreclosed, particularly with exclusive dealing.
  2. Before implementing a nonprice restriction on its dealers, a seller should determine:
    1. The vitality of interbrand competition in the market.
    2. The effects the restraint might have on the market.
    3. The availability of less restrictive alternatives.

IV. Some Final Notes

  1. Keep in mind that vertical conduct can have horizontal implications as well, particularly when your distributors are "vertically integrated" (i.e., they produce their own videos and are therefore your competitors too) – this could mean more trouble!
  2. Examine the business realities behind the form agreements.
  3. "We've always done it that way and it's been OK" or "everybody does it" does not mean it is legal under the antitrust laws.  And the penalties for violating the antitrust laws can be severe – stiff fines, treble damages and even jail sentences for the directors and officers of the company and/or the individuals who participated in the antitrust violation.