Cartel Risks in Dual-Distribution Models – Too Soon to Tell?

Introduction

Consider a typical supply chain – in the market for supply and sale of plastic bottles, for example, the manufacturer procures raw materials from upstream suppliers to manufacture bottles of various colors and sizes. Depending on the size and scale of its business, the manufacturer then engages a distributor or a network of distributors to facilitate downstream sales to the ultimate consumers. While there may be a network of players (such as distributors, sub-distributors, wholesalers, franchisee networks, etc.) to cover the “last mile” to the ultimate consumer, from a competition law perspective, the relevant point is the one at which economic activity occurs between any two given legal entities.

Under competition rules, these legal relationships
can either be categorized as “horizontal” (where they occur between entities
operating at the same level of the supply chain) or “vertical” (where they
occur between entities operating at different levels of the supply chain).
Across jurisdictions, horizontal agreements such as cartels are treated more
severely than vertical restraints, and are considered to be illegal per se.
In India, cartels are presumed to cause an appreciable adverse effect on
competition (but this presumption is rebuttable).² On the
other hand, testing the legality of vertical restraints requires a balancing
test between their efficiency-enhancing, pro-competitive effects and their
anti-competitive effects (a so-called “rule of reason” approach).

But what happens when in a typical supply chain, a
manufacturer operates at both the manufacturing level and the distribution
level (alongside independent distributors), such that, from a demand-side
perspective, consumers regard them as two alternative sources of supply for the
same product or brand?

In antitrust parlance, such hybrid distribution
models are commonly known as dual-distribution models. On the one hand, the
manufacturer acts as a supplier of the product to its independent distributors
(with whom it has vertical relationships). On the other hand, the manufacturer
also distributes the product directly to consumers and therefore operates at
the same level in the supply chain as its independent distributors (and
therefore also has horizontal relationships with them).

Over decades, the fundamental quandary for courts
has always been (and continues to be) whether restraints imposed by a dual
distributor on its independent distributors should be viewed as being
horizontal or vertical in nature. A further question is whether the “source” of
the restraint (i.e. whether it was imposed by the manufacturer, or by the
independent distributors) is a determining factor, or whether the purpose and
economic effect of the restraint is more relevant for a meaningful assessment.

It is important to note that a routine exclusive
distribution or supply restraint in a pure-play distribution arrangement is
typically assessed under a straightforward and settled rule of reason test.
This is because, as described above, vertical agreements can have both pro- and
anti-competitive effects. On the one hand, they can result in benefits to
consumers, and improve production and distribution processes. But on the other
hand, they can create entry barriers, foreclose competition, etc.³
As such, a blanket per se prohibition should not be applied to such
agreements, since this type of rule is best limited to restraints that always
(or almost always) restrict competition and/or decrease output of goods or
services.⁴

However, would the rules of the game change simply
because a manufacturer doubles up as a distributor? Against this background,
this article seeks to briefly outline case law trends in the treatment of such
hybrid distribution restrictions in other jurisdictions and queries their
implications for Indian enforcement.

Exploring International
Jurisprudence

Historically, both vertical price- and non-price
restraints were tested under a per se rule in most jurisdictions. One of
the earliest cases concerning dual distribution was United States v.
McKesson & Robbins, Inc. (“McKesson”).⁵
McKesson was one of the largest manufacturers of drugs in the U.S. It
distributed drugs through independent wholesalers, but also operated as a
wholesaler itself. McKesson had entered into so-called “fair trade” agreements
with independent wholesalers to set the resale price of drugs. The U.S. Supreme
Court held that these agreements were horizontal in nature. The Supreme Court
reasoned that, in essence, McKesson, as a dual distributor, competed with each
of the wholesalers with which it had agreements. Thus, the arrangement was
horizontal rather than vertical.

Progressively, following authoritative rulings in
the U.S., which held that vertical restraints required assessment under the
rule of reason approach,⁶
the trend gradually shifted towards assessing vertical restraints (or at least
non-price vertical restraints) in dual distribution models under the rule of
reason approach.⁷
In this regard, one of the earliest and most significant cases was Norman E.
Krehl, et al. v. Baskin-Robbins Ice Cream Co., et al. (“Baskin Robbins”).⁸
Baskin-Robbins had a dual distribution model, whereby it licensed its
trademarks and formulae to independent ice cream manufacturers (which
exclusively operated as area franchisors in assigned territories), and also
operated as an area franchisor itself in certain reserved territories. It was
held that this arrangement could not be assessed under the per se rule
in the absence of evidence of collusion between Baskin-Robbins and its area
franchisors to allocate or fix territories. The Court held that the allocation
of territories was a unilateral decision by Baskin-Robbins, without any
coercion or requests by the other area franchisors, and without any hindrance
to inter-brand competition. Notably, an increase in inter-brand competition was
a relevant factor in the Court’s assessment. It noted that Baskin-Robbins’
distribution system had in fact resulted in the expansion of its business to
new territories and had increased the promotion and availability of its
products.

Similar rulings were also given in the context of price-related restraints. For instance, in Jacobs v. Tempur-Pedic Int’l, Inc. (“Jacobs”),⁹ the defendant (“TPX”) was a mattress manufacturer that sold its products on its own website, but also through third-party distributors. Interestingly, TPX sold the mattresses at the same price as its distributors. It was alleged that TPX had entered into price-fixing agreements with its distributors, containing both vertical and horizontal restraints. It was argued that the restraints completely foreclosed price competition in the downstream market, and that there was barely any price variance between mattresses sold either through third-party distributors’ brick-and-mortar stores or on TPX’s own website.

In its ruling, the Court held that although TPX (as a dual distributor)
used vertical minimum resale price agreements, both TPX and its third-party
distributors nonetheless independently set their own prices. The fact that
these prices were similar was because TPX’s direct sales (through its website)
acted as a sort of “enforcement mechanism” to keep a check on prices charged by
distributors. Thus, if distributors raised their prices above the minimum
resale price set by TPX, consumers would automatically shift and purchase
almost exclusively from TPX’s website, thereby driving the distributors out of
business.

In the same vein, it was economically advantageous for TPX to sell
(through its website) at the agreed minimum price, as any
price reduction would affect its distributors’ business. As such, the
commercial significance of maintaining distributor showrooms for consumers to
test the mattresses before purchasing was crucial for TPX to maintain price
parity. Put another way, the court noted that the allegations raised competing
inferences of conscious parallelism and independent business judgment/economic
interest. Given that price parallelism by itself was not sufficient to
establish horizontal price fixing, the court dismissed the complaint in the
absence of additional evidence to demonstrate that, somehow, TPX and its
distributors signaled to each other and coordinated price adjustments.

The ruling in Jacobs is significant in the context of the
growing trend for manufacturers to rely on e-commerce channels, given that
having both a conventional physical store and an online sales channel has now
become the “new normal.”

Cartel Risks – How Can
They Arise?

While the case law cited above demonstrates a
progressive trend towards adopting a rule of reason approach in assessing dual distribution restraints,
the primary dilemma of sorting dual distribution arrangements into the
“horizontal” and “vertical” categories continues to confound antitrust
authorities worldwide.

In 2016, in stark contrast to the case law
trend analyzed above, the High Court of Australia (“High Court”) in ACCC v.
Flight Centre Limited (“Flight Centre”)¹⁰
held that Flight Centre, a travel agent for international airlines/carriers
(that offered air ticket booking services to customers) had attempted to
collude with carriers (dual distributors of air tickets through direct website
sales) by inducing them not to offer price discounts through their direct sales
channels. Despite the presence of an agency relationship, the High Court
observed that Flight Centre and the international carriers operated in the same
market (i.e. the market for supply of international airline tickets) and
directly competed with one another. As such, from a consumer perspective, both
were competitors in the same relevant market, and the attempt to collude on
price impeded competition.

To arrive at this conclusion, the High Court
primarily focused on two crucial aspects: (i) the fact that Flight Centre
exercised pricing discretion over the tickets it sold to customers; and (ii)
the scope of the authority given to Flight Centre by the international carriers
insofar as it was free to act/operate in its own best interests.

A 2016 consent order by the U.S. Federal Trade
Commission (“FTC”) involving a dual
distribution model follows in a similar vein. Fortiline LLC (“Fortiline”), a U.S. ductile iron pipe distributor,¹¹
was charged with “invitation to collude” with its competitor (a
manufacturer/dual distributor). In short, Fortiline distributed iron pipes from
several players including those of a certain company (“Manufacturer “A”), which
was also a direct distributor in the market. While the FTC recognized the
importance of market and price-related communications between a manufacturer
and its distributor(s), it noted that Fortiline’s invitation to collude with
Manufacturer A was an attempt to fix prices across the board, and therefore
impeded horizontal competition. As such, any pro-competitive benefits or
improvement in inter-brand competition emanating from Fortiline’s vertical
relationship with Manufacturer A could not shield it from a finding of price
collusion contrary to Section 5 of the U.S. FTC Act.

Ultimately, the FTC approved a consent
agreement whereby Fortiline, among other things, was prohibited from entering
into or soliciting agreements with competing distributors to fix prices or
allocate markets. The agreement contained an exception permitting
communications between Fortiline and manufacturers to the extent necessary to
achieve the pro-competitive benefits of a lawful manufacturer-distributor
relationship, and for negotiating/entering into sale/purchase agreements.

These rulings show that antitrust risks in
dual distribution models depend on the facts, and a case-by-case assessment is required to assess their legality. The
cases also emphasize that the presence of an agency relationship may not
necessarily immunize parties from the applicability of antitrust principles if
the principal and the agent are found to compete in the downstream market.

The Indian Position

While there has been no Indian case law thus far dealing specifically
with the issue of dual distribution, it may be worthwhile to briefly discuss the CCI’s recent
decision in In Re: Anticompetitive
conduct in the Dry-Cell Batteries Market in India (the “Batteries Case”).¹²

Here, the CCI held that Panasonic Energy India Company Limited (“Panasonic India”) and Godrej
and Boyce Manufacturing Co. Ltd. (“Godrej”) (jointly, the “Parties”) were engaged in a price fixing cartel. The
Parties had entered into a product supply agreement (“PSA”) for institutional sales of dry cell
batteries from Panasonic India to Godrej, pursuant to which Godrej would
rebrand the batteries under its own name for resale. The PSA required both
Parties to maintain price parity between their respective brands, and not to
jeopardize each other’s market interests. Additionally, the PSA also stipulated
that both Parties were “independent principals,” and that it did not create a
joint venture, partnership, or agency agreement. The Parties argued that they
were not cartelizing, given that the PSA was a supply arrangement and should
therefore be considered (at most) to be a “vertical” agreement.

However, the CCI dismissed these arguments,
and held that the Parties were engaged in a price-fixing cartel. To this end,
the CCI observed that, from a demand-side perspective, Panasonic’s distribution
arm and Godrej were in a horizontal relationship and acted as independent
competitors with separate brands, even though the products were manufactured by
the same party (i.e. Panasonic India). Therefore, the PSA, which created price
parity between two different brands, could not be viewed as vertical resale
price maintenance between a buyer and a seller.

The Batteries Case is significant, in that the
CCI arguably “pierced the veil” of an ostensibly vertical relationship by
examining it as a horizontal agreement based on its substance and intent. The
distinctive feature of this case is the presence of two separate market-facing
brands competing with each other, as opposed to a typical dual distribution
model where the product or brand remains the same – but is merely available to
consumers via both the manufacturer (directly) and independent distributors.
However, another school of thought suggests that the CCI’s reasoning in the
Batteries Case may have muddied the waters by treating a vertical pricing
restraint as a cartel.

The Road Ahead

Today, e-commerce has made it extremely convenient
for manufacturers to reach out directly to their consumers. Businesses now
routinely adopt dual-distribution and multi-distribution models where the
primary manufacturer has a direct presence in the downstream market through
company-owned outlets, or online channels. This metamorphosis has rendered
previously straightforward relationships between stakeholders and business
partners complex. Such redefined roles have also obscured the lens under which
such relationships were traditionally viewed.

Based on the evolving jurisprudence, it appears that while engaging in dual distribution in itself is not prohibited, direct competition between a manufacturer and its distribution channels requires scrutiny under competition rules to ascertain the intent behind certain restraints and the true character of seemingly harmless arrangements. Typically, the competition assessment of distribution restraints takes into account the effects of the restraint on inter-brand competition, considering its direct impact on and relevance to consumers. Whether or not the same principle should be extended to intra-brand competition is a material question for dual distribution. Although trends in recent case law suggest that the relationship between a manufacturer and an independent distributor in a dual distribution model is primarily vertical in nature (requiring a rule of reason assessment), there is no bright-line test to govern all types of seemingly innocuous vertical agreements. As such, until clarity is provided by antitrust regulators on the treatment of dual distribution models, it is too soon to foretell their definitive fate. Given the rapidly changing business environment, it is recommended that an assessment of dual- or multi-channel distribution models be undertaken to evaluate the efficiencies and potential threats they present. It is small wonder that an increased number of distribution channels can enhance customer reach and result in tangible efficiencies. That said, lack of sufficient care in entering into such arrangements without an adequate rationale, and without putting in place appropriate safeguards, could compromise their legality, and raise antitrust risks for manufacturers and distributors alike.

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1 Anisha Chand is a Partner in the
Competition law practice group of Khaitan & Co., Mumbai. She is reachable
at anisha.chand@khaitanco.com, and Anmol Awasthi is an
associate in the Competition law practice group of Khaitan & Co., Mumbai.
She is reachable at anmol.awasthi@khaitanco.com.

2 Section 3(3), Competition Act, 2002 (the “Act”).

3 For example, see Section 19(3) of the Act.

4 Business Electronics Corp. v. Sharp Electronics Corp., 485 U. S. 717 (1988).

5 351 U.S. 305 (1956).

6 Continental T V, Inc. v. GTE Sylvania, Inc.; 433 U.S. 36, (1977);
Leegin Creative Leather Products, Inc. v. PSKS, Inc., 551 U.S. 877
(2007).

7 Red Diamond Supply v. Liquid
Carbonic Corp., 637 F.2d 1001 (5th Cir.
1981); H & B Equip. Co. v. Int’l Harvester Co., 577 F.2d 239, 245 (5^th
Cir. 1978).

8 664 F.2d 1348 (9^th Cir. 1982).

9 626 F.3d 1327 (11th Cir. 2010).

10 2016 [HCA] 49.

11 In the Matter of Fortiline, LLC,
FTC File No. 151 0000, Docket No. C-4592, FTC (September 23, 2016).

12 Suo motu Case No. 3 of 2017, CCI (January 15, 2019).