Price-Cost Tests in Antitrust Analysis of Single Product Loyalty Contracts

• Date: 01 March 2016

PRICE-COST TESTS IN ANTITRUST ANALYSIS OF

SINGLE PRODUCT LOYALTY CONTRACTS

B

ENJAMIN

K

LEIN

A

NDRES

V. L

ERNER

*

There is substantial disagreement regarding whether predatory pricing or

exclusive dealing principles should be the controlling antitrust legal standard

for the evaluation of single product loyalty discount contracts.

1

The Third Cir-

cuit in ZF Meritor v. Eaton Corp.

2

resolved this issue by focusing on whether

price discounts were “the clearly predominant mechanism of exclusion” in the

loyalty contract.

3

Eaton, which had about an 80 percent share of sales of

heavy-duty truck transmissions, introduced loyalty contracts in 2000 that pro-

vided upfront payments and price rebates to the four major truck manufacturer

buyers if they met a sliding scale of minimum purchase shares, generally set

between 85 and 95 percent.

4

Eaton urged the court in evaluating these con-

tracts to adopt a Brooke Group

5

price-cost test and to conclude that Eaton had

not engaged in anticompetitive conduct “because Plaintiffs did not prove—or

even attempt to prove—that Eaton priced its transmissions below an appropri-

* The authors are, respectively, Professor Emeritus of Economics, UCLA, and Executive

Vice President, Compass Lexecon. The research in this article has not been sponsored or paid for

by any organization and neither author has consulted on any of the cases analyzed in this article.

We have benefited from comments and discussions with Leah Brannon, George Cary, Dan

Crane, Don Hibner, Kelly Fayne, Kevin Murphy, Richard Steuer, Mike Waldman, and Josh

Wright. Valuable research assistance was provided by Steve Stanis and editorial assistance pro-

vided by Adam Sieff, Francesca Pisano, and Karen Otto.

1

Sean P. Gates, Antitrust by Analogy: Developing Rules for Loyalty Rebates and Bundled

Discounts, 79 A

NTITRUST

L.J. 99 (2013) (provides recent survey of the case law and the current

ongoing debate).

2

696 F.3d 254 (3d Cir. 2012).

3

Id. at 275.

4

Id. at 265. The minimum purchase shares for Freightliner ranged between 86.5% and 92%;

for International between 87–97.5%; for PACCAR between 90–95%; and for Volvo, which man-

ufactured a significant quantity of its own transmissions, between 70–78%. Id. The contracts

were instituted after Meritor, Eaton’s primary rival, announced plans to expand through a joint

venture it entered in mid-1999 with a large German company, ZF Friedrichshafen. Id. at 264.

5

Brooke Grp. Ltd. v. Brown & Williamson Tobacco Corp., 509 U.S. 209 (1993).

631

632

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OURNAL

[Vol. 80

ate measure of its costs.”

6

The court rejected this argument, holding that, con-

sistent with previous antitrust case law regarding single product loyalty

contracts, “predatory pricing principles, including the price-cost test, would

control [only] if this case presented solely a challenge to Eaton’s pricing

practices.”

7

The court emphasized that, in addition to price discounts contingent on the

purchase of a minimum share of Eaton products, the Eaton loyalty contracts

included other terms that required truck manufacturers to favor Eaton prod-

ucts, specifically that Eaton transmissions be listed in truck manufacturer cat-

alogues (or “data books”) as the standard, lowest price offering.

8

Furthermore,

two of the four contracts required the truck manufacturer to remove competi-

tors’ products from its data book entirely.

9

The court also found that truck

manufacturers faced the risk of contract termination or reduced availability of

supply if they failed to meet Eaton’s minimum purchase share and preferred

distribution contract terms.

10

This led the court to conclude that “price itself

was not the clearly predominant mechanism of exclusion.”

11

Hence, the court

determined that the Eaton loyalty contracts should not be evaluated in terms

of a price-cost test but on a rule-of-reason exclusive dealing standard, under

which the contracts were found to violate antitrust law.

12

This article clarifies the Meritor framework of analysis by, first, examining

what it means for price to be “the predominant mechanism of exclusion” in a

loyalty contract. It is essential to distinguish between two types of contract

terms in a loyalty contract: (1) contract terms that specify buyer performance

conditions, such as minimum purchase share; and (2) contract terms that in-

centivize buyers to meet these performance conditions, such as the loss of

price discounts if the performance conditions are not fulfilled. More complex

loyalty contracts include contract terms that may specify additional buyer per-

formance conditions, such as Eaton’s preferential listing and pricing distribu-

tion requirements, or specify additional buyer incentives, such as Eaton’s

ability to terminate or restrict supply to buyers who fail to meet contract per-

formance conditions.

Use of a price-cost test requires price to be “the predominant mechanism of

exclusion” in a loyalty contract in the sense of the second type of contract

term, namely that the contractual incentive mechanism by which buyers are

6

Meritor, 696 F.3d at 269.

7

Id. at 273–74.

8

Id. at 277–78.

9

Id. at 265–66.

10

Id. at 277–78.

11

Id.

12

Id. at 281.

2016]

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induced to meet contractually specified performance conditions consists

predominantly of the loss of price discounts. When price discounts are the

mechanism that incentivizes buyers to meet loyalty contract performance con-

ditions, equally efficient rivals can compete for sales as long as price is

greater than cost, a condition that holds independent of the contract terms that

are used to specify performance conditions. A loyalty contract, for example,

may include preferential distribution requirements in addition to minimum

purchase share performance conditions. However, as long as price is the “pre-

dominant mechanism of exclusion” and price is greater than cost, buyers can

reject all the contract performance conditions because the only consequential

cost they bear is the loss of price discounts that equally efficient rivals can

meet. On the other hand, when significant non-price incentive mechanisms

also are present in a loyalty contract, such as the termination and supply risks

present in the Eaton loyalty contracts, the essential insight of Meritor is that

price greater than cost cannot be used as a test of liability because the ability

of equally efficient rivals to compete will depend upon the sum of price and

non-price incentive mechanisms in the loyalty contract.

When price is “the predominant incentive mechanism,” a price-cost test can

be used to evaluate single product loyalty contracts. However, both economics

and previous loyalty contract case law indicate that a simple Brooke Group

average price-cost test is applicable only when all sales are “contestable,” in

the sense that rivals can compete for all of a buyer’s purchases. More gener-

ally, consumer preferences for an established firm’s products may imply that

some of the established firm’s sales are “incontestable” sales for which rivals

are not able to economically compete. In that case the Brooke Group antitrust

safe harbor test must be modified, with loyalty discounts applied only to the

contestable sales. If the discount attributed price of contestable sales, defined

by allocating all discounts to contestable sales, is above costs, equally effi-

cient rivals then can compete for contestable sales.

An important insight of this article is that consumer product preferences

that create incontestable sales also provide a procompetitive motivation for

loyalty discounts. Because individual firm demand curves as a consequence of

consumer preferences are negatively sloped, the single competitive price will

be greater than marginal cost, often substantially greater than marginal cost in

high fixed cost, high margin industries. For example, the first case to apply

the Third Circuit Meritor reasoning, Eisai v. Sanofi-Aventis,

13

dealt with Sa-

nofi’s loyalty contracts on sales of its pharmaceutical products to hospitals

where the single, profit-maximizing price was substantially greater than mar-

ginal cost. In this circumstance firms have a competitive incentive to use loy-

alty contracts to offer buyers contingent price discounts in return for increased

13

No. 08-4168 (MLC), 2014 U.S. Dist. LEXIS 46791 (D.N.J. Mar. 28, 2014).