Product Design and Product Bundling: Evolving Monopolization Standards in the U.S. Courts

1. Product Design and Product Bundling:Evolving Monopolization Standards in the U.S. Courts Mark S. Popofsky, Co-Head, Antitrust Practice Group April 2010

2. Introduction Monopolization law in the United States is in flux. Outside of certain discrete areas, the applicable legal tests are literally “up for grabs.” One source of instability is the quite different tone struck by the seminal Microsoft decision, on the one hand, and the U.S. Supreme Court’s subsequent decisions in Trinko, linkLine, and Twombly on the other. Today, I will explicate this tension and demonstrate how it plays out in two areas of monopolization law: Bundled Discounts. Product Design.

3. Background: The Microsoft Revolution U.S. courts decided relatively few monopolization cases in the U.S. courts in the years leading up to United States v.Microsoft Corp., 253 F.3d 34 (D.C. Cir. 2001) (en banc) (per curiam). Many cases involved conduct that presented “easy” judgments. For example: Courts held above-cost pricing per se legal. Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., 509 U.S. 209 (1993) (“[A] plaintiff seeking to establish competitive injury resulting from a rival’s low prices must prove that the prices complained of are below an appropriate measure of its rival’s costs.”). Barry Wright Corp. v. ITT Grinnell Corp., 724 F.2d 227 (1st Cir. 1983) (refusing to condemn above-cost pricing even when such pricing has no purpose except to exclude rivals and raise prices).

4. Background: The Microsoft Revolution Courts condemned termination of dealings with rivals only when unprofitable in the short term and lacking any justification. CompareAspen Skiing Co. v. Aspen Highlands Skiing Corp., 472 U.S. 585 (1985) (sustaining liability under Section 2 when monopolist discontinued joint marketing program with rival without legitimate business justification) with Olympia Equip. Leasing Co. v. W. Union Tel. Co., 797 F.2d 370 (7th Cir. 1986) (Section 2 liability rejected when monopolist pointed to legitimate reasons for ceasing to sell rival’s product). Courts permitted new product introductions that created options for consumers. Berkey Photo Inc. v. Eastman Kodak Co., 603 F.2d 263 (2d Cir. 1979) (holding, among other things, that company did not contravene Sherman Act merely by simultaneously introducing new film and new camera).

5. Background: The Microsoft Revolution These decisions, broadly, led to a view in the U.S. antitrust community that Section 2 only condemned conduct that lacked any legitimate justification. Put differently, these decisions generally led to a view that if a monopolist’s unilateral conduct (i) enhanced its own output, and (ii) would have been taken even absent market power, then (iii) the conduct was per se legal.

6. Background: The Microsoft Revolution United States v. Microsoft Corp. changed all that. Microsoft held that monopolization analysis involves “balancing” pro- and anticompetitive effects. See 253 F.3d at 58-59. Thus, under Microsoft,a monopolist cannot avoid liability merely because its conduct improved its own product and the improvement would have been undertaken even if the defendant lacked monopoly power. Notably, the D.C. Circuit in Microsoft condemned certain “product design” decisions (comingling browser code with operating system code; removing Internet Explorer from the “Add/Remove Programs” function). See 253 F.3d at 67. And, just as notably, the court held that Microsoft’s intellectual property was not an absolute defense to the monopolization charge. See 253 F.3d at 63.

7. Background: The Trinko Counter-Revolution Since Microsoft, the U.S. Supreme Court has issued a number of opinions that made it more difficult for plaintiffs to sustain viable antitrust claims in the U.S. federal courts. Verizon Communications Inc. v. Law Offices of Curtis V. Trinko, LLP, 540 U.S. 398 (2004), held that it was not unlawful monopolization to refuse to deal with a rival even when a regulatory framework compelled such dealing. Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007), held that antitrust plaintiffs must plead facts in their complaint that plausibly suggest liability, rejecting the Supreme Court’s prior statement that a complaint suffices “unless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief.” Pacific Bell Telephone Co. v. linkLine Communications, 129 S. Ct. 1109 (2009), held that a company that has no antitrust duty to deal with rivals at the wholesale level, and sells its product above-cost at retail, cannot be liable to its rivals for “price-squeeze.”

8. Background: The Trinko Counter-Revolution The impetus for the Supreme Court’s recent antitrust activism does not lie principally in concerns rooted with the substance of antitrust law, but rather with the coercive impact of U.S. private treble damages actions. The Court made clear in Twombly that rigorous pleading standards are necessary to prevent antitrust plaintiffs from coercing settlements from innocent firms that fear the extraordinary expenses associated with discovery. See 550 U.S. at 558-59. The Court expressed similar concerns in Trinko. See 540 U.S. at 414 (noting the danger that mistaken condemnation of legitimate, competitive conduct may “chill the very conduct the antitrust laws are designed to protect”).

9. Background: The Trinko Counter-Revolution But the message of the Trinko trilogy is that narrowing substantive antitrust laws is one solution to the problem. For instance, linkLine narrowed substantive antitrust law by refusing to endorse a new, “price-squeeze” theory of liability. 129 S. Ct. at 1122. Narrowing substantive law, of course, is not the only response to what is perceived as an excess of private treble damages class actions. Twombly effectively raised pleading standards (and expressly acknowledged that tightening pleading standards would reduce plaintiffs’ leverage over defendants in hold-up suits). U.S. courts have tightened the standards for class certification. See, e.g., In re Hydrogen Peroxide Antitrust Litig., 552 F.3d 305 (3d Cir. 2008) (holding that trial courts must conduct a “rigorous analysis” to ensure that the Rule 23 requirements for a class action are met, including resolving any relevant legal or factual disputes).

10. Implications? Yet, in solving the antitrust class action problem through narrowing substantive antitrust law, the Trinko trilogy creates a potential “spillover” issue: Is “narrowing” substantive antitrust law desirable if the problem with treble damage class actions can be solved other ways? What are the implications of the Trinko trilogy where substantive antitrust doctrine is unsettled? As courts address these questions, they confront the very different messages sent by Microsoft on the one hand and the Supreme Court on the other: Microsoft: balance pro- and anticompetitive effects to determine whether conduct is unlawful. Trinko: Section 2 does not give courts “carte blanche” to force businesses to operate differently merely because an alternative course might create more competition. Two areas involving U.S. monopolization law – bundled discounts and product design – illustrate how U.S. courts are reacting to these mixed messages.

11. Bundled Discounts What is a bundled discount? Most simple form: a seller offers a discount on Product A only if the customer purchases a certain quantity of Product B. An example: a tape manufacturer might give a $10 million year-end discount on tape if customers increase their purchases of other products by 10% over the prior year’s purchases. What are the antitrust concerns? Roughly, there are two opposing views in the U.S.: Benign unless predatory: Bundled discounts are a form of price competition. Thus, this point of view runs, bundled discounts ought not be condemned unless “predatory” – i.e., unless the discounts result in products being sold at prices below cost where the seller can recoup its investment in below-cost prices. Potentially exclusionary cost-raising conduct: Bundled discounts can disadvantage single-product rivals. Under this paradigm, it is argued, bundled discounts ought to be subjected to Rule of Reason “balancing” of effects.

12. Bundled Discounts These two views find expression in a circuit split in the American federal courts. LePage’s Inc. v. 3M, 324 F.3d 141 (3d Cir. 2003) (en banc): Strongly influenced by Microsoft, one court of appeals condemned a bundled discount and expressly rejected the argument that such arrangements are legal unless predatory. However, the court did not articulate a clear test. The court appeared to impose liability because (i) a monopolist weakened a rival; and (ii) without legitimate justification. LePage’s created significant backlash. The presidentially-appointed Antiturst Modernization Commission (“AMC”) strongly disagreed with LePage’s, and suggested a cost-based screen.

13. Bundled Discounts Cascade Health Solutions v. PeaceHealth, 515 F.3d 883 (9th Cir. 2008): Another court of appeals parted ways with LePage’s and largely adopted the AMC-suggested predatory pricing approach. Cascade applied a modified predatory pricing test: is the “competitive” product (i.e., the product that a hypothetical competitor also sells) in the package sold below cost, taking into account any “discount” on other products. This is called the attribution test. This standard is designed to make the defendant’s bundled discounts legal unless the discounts “have the potential to exclude a hypothetical equally efficient producer of the competitive product.” 515 F.3d at 906 (emphasis omitted).

14. Bundled Discounts • For example: • Suppose a defendant sells its products, M and C (with C as the “competitive” product), for $5 each on a stand-alone basis. • Further suppose C costs $4 to produce. • And suppose the seller offers M and C together for $8. • Under the attribution test, there is a $2 implied discount for taking C from the defendant, making the sale below cost: • The incremental revenue from C is $3 (if M were sold alone, revenue would be $5; and revenue from the package is $8). • The incremental cost of C is $4. • Such bundles can be anticompetitive under certain conditions, the theory goes, because a hypothetical competitor that produced C just as efficiently (at a cost of $4), but did not produce M, could be excluded. • As a practical matter, it is hard to demonstrate below-cost pricing under this test, and thus hard to demonstrate that a bundled discount is anticompetitive, particularly for a high-fixed cost, low variable-cost industry.

15. Bundled Discounts • Although addressed by a few district courts since, the Cascade approach appears to be prevailing over that of LePage’s; and the reason may reflect, in part, the influence of the Trinko trilogy. • Indeed, the same court that decided Cascade (the 9th Circuit) recently applied linkLine to hold conduct that effectively took the form of a bundled discount, but was challenged as unlawful “monopoly leveraging,” lawful. • See John Doe 1 v. Abbott Labs., 571 F.3d 930 (9th Cir. 2009) (company that offered a standalone product to its competitors at a high price, while selling a combination of that product and another product at a low price, did not violate Section 2 absent allegations of below-cost pricing).

16. Bundled Discounts • Nonetheless, it is unclear how the conflict ultimately will be resolved, particularly with a new administration that is committed to litigating these issues. • The FTC’s suit against Intel, In re Intel Corp., No. 9341 (F.T.C. filed Dec. 16, 2009), challenges bundled and market share discounts under Section 5 of the FTC Act. • The Intel case will be tried before an ALJ in the Fall of 2010; it will eventually be reviewed by a federal court of appeals.

17. Bundled Discounts • European Union law has undergone a parallel development. • EU Courts held that discounts designed to induce loyalty to the monopolist required efficiency justification. See, e.g., Case T-203/01, Manufacture Française des Pneumatiques Michelin v. Comm’n, 2003 E.C.R. II-4071 (Ct. First Instance) (condemning loyalty-inducing rebates to dealers based on sales targets); Case C-95/04, British Airways plc v. Comm’n, 2007 E.C.R. I-2331 (Ct. Justice) (condemning airline’s loyalty-inducing reward system for travel agents). • Recently, however, the European Commission adopted an approach that focuses on whether a discount can exclude an equally-efficient rival. See European Comm’n, Guidance on the Commission’s Enforcement Priorities in Applying Article 82 of the EC Treaty to Abusive Exclusionary Conduct by Dominant Undertakings, COM (2009) 864 final ¶ 59 (Feb. 9, 2009) (multi-product rebates are likely illegal if they are “so large that equally efficient competitors offering only some of the components cannot compete against the discounted bundle”).

18. Bundled Discounts • European Union law has undergone a parallel development (con’t): • In the Intel matter, the Commission both applied the quasi-per se rule of the case law and concluded that Intel’s loyalty discounts were anticompetitive because they could exclude an equally efficient rival. Case COMP/C/3-37990, Intel (May 13, 2009) (Intel’s market-share rebate scheme condemned because an equally-efficient rival would need to offer its product below average avoidable costs to compete for contestable units and because Intel evidenced no justification).

19. Product Design • Product design is yet another area where Microsoft and the themes expressed by the Trinko trilogy lead courts in opposite directions. • Some courts appear to apply a balancing test (as suggested by Microsoft) in assessing “product design” decisions – for instance, Abbott Laboratories v. Teva Pharmaceuticals USA, Inc., 432 F. Supp. 2d 408 (D. Del. 2006). • Abbott introduced a new formulation of a drug while simultaneously withdrawing the existing formulation. • Abbott, the court found, thereby impeded generic rivals, whose medication only could be prescribed if identical to the marketed branded drug. • The court upheld the plaintiff’s complaint challenging the conduct as unlawful monopolization and articulated a test of balancing pro- and anticompetitive effects. 432 F. Supp. 2d at 422-23.

20. Product Design • Other courts apply a more lenient approach: • Allied Orthopedic Appliances Inc. v. Tyco Health Care Group LP, 592 F.3d 991 (9th Cir. 2010). • Allied Orthopedic involved an antitrust challenge to redesign of pulse oximetry monitors and sensors. • The new monitors no longer worked with existing sensors, including generic sensors. • The new monitor/sensor system produced benefits while lowering transition costs by enabling use of existing monitors with new sensors. • The Ninth Circuit held the conduct was lawful, without balancing its pro- and anticompetitive effects.

21. Product Design • Like other courts, however, Allied Orthopedic recognized that a monopolist’s discontinuation of old technology could violate Section 2 if it “effectively forces consumers to adopt its new technology.” 592 F.3d at 1002. • Berkey Photo had previously suggested that a monopolist’s withdrawal of an old product when introducing a new one could be an anticompetitive use of monopoly power. 603 F.3d at 287 n.39. • Indeed, Walgreens Co. v. AstraZeneca Pharmaceuticals L.P., which rejected a challenge to a new product introduction, suggested that cases such as Microsoft and Abbott concerned the elimination of consumer choice. 534 F. Supp. 2d 146, 151 (D.D.C. 2008).

22. Product Design • A number of high-profile product design cases are currently in litigation in the U.S. courts, where we can expect to see the debate between these approaches play out: • In re Intel Corp., No. 9341 (F.T.C. filed Dec. 16, 2009) (FTC alleges that Intel unlawfully reduced the interoperability of its interfaces so as to harm its rivals). • Datel Holdings Ltd. v. Microsoft Corp., No. CV 09-5535 (N.D. Cal. filed Nov. 20, 2009) (alleging that Microsoft deployed a software update to Xbox 360 so as to disable a rival’s memory cards). • In re Apple iPod iTunes Antitrust Litig., No. C-05-00037 (N.D. Cal. filed Jan 26, 2010) (alleging that Apple software unlawfully creates incompatibility between iTunes and non-Apple MP3 players and unlawfully advantages iTunes in connecting with iPods).

23. Product Design • The Commission’s Microsoft decision demonstrates that distribution strategies that also could be labeled product-design decisions are not immune from scrutiny under European Community law. • See Case T-201/4, Microsoft Corp. v. Comm’n, 2007 E.C.R. II-3601 (Ct. First Instance).

24. THE END QUESTIONS? Contact Information Ropes & Gray LLP One Metro Center Washington, DC 20005 (202) 508-4624 Mark.Popofsky@ropesgray.com