9th Circuit Rules on Application of Antitrust Law to Bundling Discounts
September 4, 2007. The U.S. Court of Appeals (9thCir) issued its opinion [58 pages in PDF] in McKenzie v. PeaceHealth, vacating the key parts of the judgment of the District Court, and rejecting its analysis, as well as that of the 3rd Circuit en banc in LePage's v. 3M.
Introduction. This is an antitrust dispute between hospitals regarding health care services. However, since the dispute centers around bundling of services at discount prices, which is also characteristic of large companies with large market shares in the telecommunications and information technology sectors, this case may be of interest to telecom and tech sector companies, and the companies and consumers with whom they do business.
In short, the Court of Appeals vacated the jury's verdict in favor of McKenzie on the attempted monopolization, price discrimination, and tortious interference claims. It also vacated the District Court's summary judgment in favor of PeaceHealth on the tying claim. It also vacated the District Court's award of attorneys' fees, costs, and expenses. Finally, it remanded for further proceedings.
More to the point, this Court of Appeals (the 9th Circuit) rejected the approach to bundled discounts taken by the District Court, and the approach to bundled rebates taken by the 3rd Circuit in its en banc opinion [PDF] in 2003 in LePage's v. 3M, upon which the District Court relied. The 9th Circuit adopted a cost based standard for bundling discounts.
One hospital company, formerly known as McKenzie, filed a complaint against another hospital company, known as PeaceHealth, alleging, among other things, a violation of Section 2 of the Sherman Act in connection with PeaceHealth's offering to insurers of bundled discounts. While there are a number of issues on appeal in this case, the application of Section 2 to bundled discounts may have far reaching affects for the telecom and tech sectors, as well as health care.
Telecom companies are providing consumers an ever wider array of services and products. One company might offer a triple play of voice, broadband, and video. Companies are also bundling electronic devices with services. It is common for tech and telecom companies to offer bundles, and at a total price for the bundle that is lower than the sum of the prices for the components of the bundle, when purchased one by one.
Even though this is a health care case, the Court of Appeals wrote in a footnote that "in the telecommunications field, it is common for companies to offer not only phone service, but also Internet access and television service, and many of these companies offer bundled discounts to customers who purchase their entire package".
Companies use discounted bundles to compete with other companies. Competition benefits. Consumers benefit too from lower prices.
However, there is an opportunity for anti-competitive conduct when several conditions are present. For example, if there are two or just a few providers, their bundled product and/or services lines are not the same, and one company has market power with respect to one product or service that it offers as part of a discounted bundle, this company might hypothetically be able to abuse its market power via bundled discounts.
Telecom and IT companies are already offering bundled discounts. Yet, some telecom and IT sectors are characterized by consolidation, overlapping but not identical product mixes, and companies with market power with respect to some products or services. This is increasing the potential for these conditions to be met.
This opinion reflects an attempt by one Court of Appeals to set a precedent that does impose antitrust liability upon the rare anti-competitive bundled discounts, while not also enabling antitrust plaintiffs to prevail in Section 2 cases where the complained of conduct is actually pro-competitive. The approaches of the District Court in this case, and the Third Circuit en banc opinion in LePage's, arguably, and theoretically, enable plaintiffs to prevail against some providers of bundled discounts in the absence of anti-competitive conduct.
However, this 58 page opinion, as long and detailed as it is, recognizes that the topic is complex, that the underlying economic analysis is still developing, and that it will take some time for this area of antitrust law to "percolate" in the courts. This opinion rejects LePage's, offers the foundation for a cost based approach, but leaves many questions unanswered.
Statute and Precedent. Section 2 of Sherman Act, which is codified at 15 U.S.C. § 2, is the applicable statute. However, it provides little, if any, guidance.
Section 2 provides, in part, that "Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony, and, on conviction thereof, shall be punished by fine ..."
Rather, the law in this areas derives from economic analysis of bundled discounts, and courts' application of this analysis on a case by case basis to build up a body of judicially created principles.
The present opinion follows, and rejects, LePage's, an unfortunate opinion of the U.S. Court of Appeals (3rdCir) applying Section 2 to bundling practices. (It is also reported at 324 F.3d 141.)
That case was a bundled rebate case brought by LePage's against 3M involving 3M's multiple product lines of transparent adhesive tape. LePage's alleged that 3M unlawfully maintained a monopoly in the market for transparent tape, in violation of Section 2 of the Sherman Act through the use of its bundled rebate program for retailers that sold 3M products. The trial jury returned a verdict for LePage's on the monopoly maintenance count. The District Court entered judgment. The divided three judge panel of the U.S. Court of Appeals (3rdCir) reversed the District Court's judgment on that count. However, an en banc panel of the Court of Appeals granted rehearing, and affirmed the judgment of the District Court on the monopoly maintenance count.
The 3rd Circuit held that below cost pricing and a probability of recoupment should not be required when the defendant is a monopolist whose behavior will be unconstrained by the market after it eliminates its lone rival.
The Supreme Court of the U.S. (SCUS) denied certiorari.
In addition, the Office of the Solicitor General filed an amicus brief urging the SCUS to deny certiorari. It wrote that "although the business community and consumers would benefit from clear, objective guidance on the application of Section 2 to bundled rebates, this case does not present an attractive vehicle for this Court to attempt to provide such guidance. Furthermore, there is no pressing need for the Court to address the matter at this time. While bundled rebates may be a common business practice, it is not clear that monopolists commonly bundle rebates for products over which they have monopolies with products over which they do not. The United States submits that, at this juncture, it would be preferable to allow the case law and economic analysis to develop further and to await a case with a record better adapted to development of an appropriate standard."
The views of the Antitrust Modernization Commission (AMC) are also pertinent. The AMC has completed its study, released its report, and terminated. See, story titled "Antitrust Modernization Commission Releases Report", story titled "AMC Addresses Innovation" and story titled "AMC Seeks End to Duplicative FCC Antitrust Merger Reviews" in TLJ Daily E-Mail Alert No. 1,560, April 4, 2007.
The AMC's views are addressed by the Court of Appeals in the just released opinion. The AMC recommended that "Courts should adopt a three-part test to determine whether bundled discounts or rebates violate Section 2 of the Sherman Act. To prove a violation of Section 2, a plaintiff should be required to show each one of the following elements (as well as other elements of a Section 2 claim): (1) after allocating all discounts and rebates attributable to the entire bundle of products to the competitive product, the defendant sold the competitive product below its incremental cost for the competitive product; (2) the defendant is likely to recoup these short-term losses; and (3) the bundled discount or rebate program has had or is likely to have an adverse effect on competition." (Parentheses in original.)
Litigants. McKenzie and PeaceHealth were the only two providers of hospital care in Lane County, in the state of Oregon.
The Court of Appeals summarized that the "relevant market in this case is the market for primary and secondary acute care hospital services in Lane County. Primary and secondary acute care hospital services are common medical services like setting a broken bone and performing a tonsillectomy. Some hospitals also provide what the parties call “tertiary care,” which includes more complex services like invasive cardiovascular surgery and intensive neonatal care."
McKenzie provided primary and secondary acute care in one hospital, but did not provide tertiary care. PeaceHealth was much larger, operated three hospitals, and provided primary and secondary acute care, as well as tertiary care. PeaceHealth offered health insurance companies bundled and discounted primary, secondary, and tertiary services.
McKensie was a financially failing company. It has since merged with another hospital company.
District Court. McKenzie filed a complaint in U.S. District Court (DOre) against PeaceHealth alleging federal law claims of monopolization, attempted monopolization, conspiracy to monopolize, tying, and exclusive dealing, and state law claims of price discrimination and intentional interference with prospective economic advantage.
In formulating a jury instruction on anti-competitive effects, the District Court followed the 3d Circuit's en banc opinion in LePage's.
The jury instruction contained the following: "plaintiff ... contends that defendant has bundled price discounts for its primary, secondary, and tertiary acute care products and that doing so is anticompetitive. Bundled pricing occurs when price discounts are offered for purchasing an entire line of services exclusively from one supplier. Bundled price discounts may be anti-competitive if they are offered by a monopolist and substantially foreclose portions of the market to a competitor who does not provide an equally diverse group of services and who therefore cannot make a comparable offer."
Notably, this instruction contains no requirement that the jury engage in any cost analysis.
In addition, before commencement of the trial, the District Court granted summary judgment to PeaceHealth on McKenzie's tying claim. Then, the trial jury rendered a verdict in favor of PeaceHealth on McKenzie's claims of monopolization, conspiracy to monopolize, and exclusive dealing. It rendered a verdict in favor of McKenzie on McKenzie's claims of attempted monopolization, price discrimination, and tortious interference.
The jury awarded McKenzie $5.4 Million in damages, which the District Court trebled. The District Court also awarded McKenzie $1,583,185.57 in attorneys’ fees, costs, and expenses.
The present appeal and cross-appeal followed. In addition, the Court of Appeals solicited and received amicus curiae briefs. Microsoft, Verizon, AT&T and Visa all participated as amici.
Court of Appeals. The Court of Appeals addressed in detail the economic theories, and effects upon competition and consumer welfare, of bundled discounts. It wrote that "it is possible, at least in theory, for a firm to use a bundled discount to exclude an equally or more efficient competitor and thereby reduce consumer welfare in the long run."
"For example, a competitor who sells only a single product in the bundle (and who produces that single product at a lower cost than the defendant) might not be able to match profitably the price created by the multi-product bundled discount." (Parentheses in original.)
"This is true even if the post-discount prices for both the entire bundle and each product in the bundle are above the seller’s cost." The Court of Appeals continued that "a bundled discounter can exclude rivals who do not sell as great a number of product lines without pricing its products below its cost to produce them. Thus, a bundled discounter can achieve exclusion without sacrificing any short-run profits."
"McKenzie asserts it could provide primary and secondary services at a lower cost than PeaceHealth. Thus, the principal anticompetitive danger of the bundled discounts offered by PeaceHealth is that the discounts could freeze McKenzie out of the market for primary and secondary services because McKenzie ... does not provide the same array of services as PeaceHealth and therefore could possibly not be able to match the discount PeaceHealth offers insurers."
The Court of Appeals concluded that "bundled discounts, while potentially procompetitive by offering bargains to consumers, can also pose the threat of anticompetitive impact by excluding less diversified but more efficient producers. These considerations put into focus this problem: How are we to discern where antitrust law draws the line between bundled discounts that are procompetitive and part of the normal rough-and-tumble of our competitive economy and bundled discounts, offered by firms holding or on the verge of gaining monopoly power in the relevant market, that harm competition and are thus proscribed by § 2 of the Sherman Act?"
After a lengthy analysis of the purposes of antitrust law, and the economics of bundling discounts, the Court of Appeals determined to draw the line differently from the 3rd Circuit.
It held that "Given the endemic nature of bundled discounts in many spheres of normal economic activity, we decline to endorse the Third Circuit’s definition of when bundled discounts constitute the exclusionary conduct proscribed by § 2 of the Sherman Act. Instead, we think the course safer for consumers and our competitive economy to hold that bundled discounts may not be considered exclusionary conduct within the meaning of § 2 of the Sherman Act unless the discounts resemble the behavior that the Supreme Court in Brooke Group identified as predatory. Accordingly, we hold that the exclusionary conduct element of a claim arising under § 2 of the Sherman Act 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." (Footnotes omitted.)
See, the SCUS's 1993 opinion in Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., which is also reported at 509 U.S. 209.
The Court of Appeals continued that the "next question we must address is how we define the appropriate measure of the defendant's costs in bundled discounting cases and how we determine whether discounted prices fall below that mark."
The Court of Appeals rejected the aggregate discount rule, advocated by AT&T and others. (See, summary of amicus curiae briefs below). The Court explained that "A competitor who produces fewer products than the defendant but produces the competitive product at or below the defendant's cost to produce that product may nevertheless be excluded from the market because the competitor cannot match the discount the defendant offers over its numerous product lines. This possibility exists even when the defendant’s prices are above cost for each individual product and for the bundle as a whole." Thus, "Under a discount aggregation rule, anticompetitive bundled discounting schemes that harm competition may too easily escape liability."
Instead, the Court of Appeals adopted a "discount attrition" standard. It wrote that "Under this standard, the full amount of the discounts given by the defendant on the bundle are allocated to the competitive product or products. If the resulting price of the competitive product or products is below the defendant’s incremental cost to produce them, the trier of fact may find that the bundled discount is exclusionary for the purpose of § 2. This standard makes the defendant’s bundled discounts legal unless the discounts have the potential to exclude a hypothetical equally efficient producer of the competitive product." (Footnote omitted.)
The Court of Appeals wrote that another advantage of this "discount attribution standard" is that it "provides clear guidance for sellers that engage in bundled discounting practices. A seller can easily ascertain its own prices and costs of production and calculate whether its discounting practices run afoul of the rule we have outlined."
However, it also conceded that "liability under the discount attribution standard has the potential to sweep more broadly than under the aggregate discount rule ..."
The Court of Appeals also wrote that there is "limited judicial experience with bundled discounts", so it would be best to "allow these difficult issues to further percolate in the lower courts". So, it concluded that "Pending further judicial and academic inquiry into the prevalence of anticompetitive bundled discounts, we think it preferable to allow plaintiffs to challenge bundled discounts if those plaintiffs can prove a defendant's bundled discounts would have excluded an equally efficient competitor."
The Court of Appeals summarized: "the primary anticompetitive danger posed by a multi-product bundled discount is that such a discount can exclude a rival is who is equally efficient at producing the competitive product simply because the rival does not sell as many products as the bundled discounter. Thus, a plaintiff who challenges a package discount as anticompetitive must prove that, when the full amount of the discounts given by the defendant is allocated to the competitive product or products, the resulting price of the competitive product or products is below the defendant’s incremental cost to produce them. This requirement ensures that the only bundled discounts condemned as exclusionary are those that would exclude an equally efficient producer of the competitive product or products."
The Court of Appeals then proceeded to the next question, the "appropriate measure of incremental costs in a bundled discounting case".
It observed that "In single product predatory pricing cases, the appropriate measure of incremental costs is an open question in this circuit. ... The Supreme Court has likewise refused to decide the matter."
The Court of Appeals held that "the appropriate measure of costs for our cost-based standard is average variable cost."
That is, variable costs are those that vary with the amount of output, as opposed to fixed costs, which do not. A firm's total costs are the sum of fixed and variable costs. The Court of Appeals suggested that the best measurement would be the marginal cost (that is, "the cost to produce one additional unit and the price that would obtain in the market under conditions of perfect competition") but that this cannot readily be inferred, so average variable cost should be used as the available surrogate for marginal cost.
Hence, with respect to bundled discounts, the Court of Appeals concluded with this. "In summary, we hold the following: To prove that a bundled discount was exclusionary or predatory for the purposes of a monopolization or attempted monopolization claim under § 2 of the Sherman Act, the plaintiff must establish that, after allocating the discount given by the defendant on the entire bundle of products to the competitive product or products, the defendant sold the competitive product or products below its average variable cost of producing them. The district court’s jury instruction on the attempted monopolization claim, which built on the holding of LePage’s that we have rejected, thus contained an error of law." (Footnote omitted.)
The opinion then goes on to address at length the issues of harmless error, price discrimination, and intentional interference with prospective economic advantage.
The Court of Appeals also addressed the District Court's summary judgment for PeaceHealth on McKenzie’s claim that PeaceHealth illegally tied primary and secondary services to its provision of tertiary services in violation of § 1 of the Sherman Act, which is codified at 15 U.S.C. § 1. The Court of Appeals vacated.
Amicus Curiae Briefs. The Court of Appeals received nine amicus curiae briefs. Verizon and Caterpillar filed one, Microsoft filed another, and Pacific Bell and Visa filed a third. A group of five law professors also filed a brief.
The professors argued in their brief [26 pages in PDF] that "Bundled discounts are ubiquitous in our national economy and are almost always procompetitive". They wrote that "the Court should require plaintiff challenging a bundled discount scheme to show -- at minimum -- that the competitive product was priced below average variable cost after discounts are reallocated to the competitive product from non-competitive products."
They added that "care should be taken in framing liability rules for the rare instances were bundled discounts could be anticompetitive. Amici submit that bundled discounts should never be unlawful unless, at minimum, the seller has charged a below-cost price in the competitive market after discounts given in the non-competitive market are reallocated to the competitive market. In determining what costs should be included in ascertaining whether the seller priced below cost, Amici urge the adoption of the average variable cost test."
The five professors were Daniel Crane (Cardozo School of Law), Thomas Lambert (University of Missouri School of Law), Thomas Morgan (George Washington University School of Law), Daniel Sokol (University of Wisconsin School of Law), and Richard Squire (Fordham Law School).
Pacific Bell (with is now part of AT&T) and Visa jointly filed an amicus brief [34 pages in PDF] in which they disclosed that "AT&T frequently bundles its services and offers them at prices discounted from their prices if purchased separately. These bundled discounts are sought after by AT&T's customers and play an important role in fostering competition in the rapidly evolving communications industry."
They urged the Court of Appeals to adopt the "aggregate rule", which "measures anti-competitive effect by examining whether the discounted price of the entire bundle exceeds the monopoly firm's cost of producing the entire bundle", rather than the "conflated discount rule", which "compares the price of a single good or service in the bundle (the same one produced by the plaintiff-rival) reduced by the discount for the entire bundle with the monopoly firm's cost of producing that individual product or service". (Parentheses in original)
They concluded that "This Court should rule that a plaintiff challenging bundled discounts under the Sherman Act must prove (1) that the aggregate price of the bundle is less than the defendants' cost of producing the bundle and (2) that the defendant has a dangerous probability of recouping it losses from those below-cost sales."
Verizon and Caterpillar wrote in their amicus brief [PDF] the 3rd Circuit's en banc opinion in LePage's "poses the risk that antitrust liability for bundled pricing by dominant firms will hinge on a court's or jury's ad hoc intuitions, unhinged from any reasonable application of antitrust law and economics, discouraging the availability of bundled discounts. Amici and other companies would benefit from use of sensible and predictable rules in this area that do not punish dominant firms because of their ability to offer consumers a broad product line at a discount price." (Footnote omitted.)
This case is Cascade Health Solutions fka McKenzie-Willamette Hospital v. PeaceHealth,
et al., U.S. Court of Appeals for the 9th Circuit, App. Ct. Nos. 05-35627, 05-35640,
05-36153, and 05-36202, appeals from the U.S. District Court for the District of Oregon, D.C.
No. CV-02-06032-HA, Judge Ancer Haggerty presiding. Judge Ronald Gould wrote the opinion
of the Court of Appeals, in which Judges Richard Paez and Johnnie Rawlinson joined.