Courts get tough on resale price maintenance
September 10, 2013 | BY
clpstaff &clp articles &In a high-profile case between medical supplies company Johnson & Johnson and a reseller, the Shanghai High Court held that a resale price maintenance agreement was illegal. Businesses in China need to pay close attention to the decision
Resale price maintenance (RPM), otherwise known as vertical price fixing, refers to agreements between business operators at different levels in a distribution chain establishing restrictions on the resale price of products or services. On August 1 2013, the Shanghai High Court, in China Rainbow Medical Equipment & Supplies Co (Rainbow Medical) v Johnson & Johnson, held the RPM agreement concerning distribution of Johnson & Johnson's medical suture products violated the PRC Anti-monopoly Law (中华人民共和国反垄断法) (AML). In this case, after Rainbow Medical won a public bid for a medical suture supply contract with a price lower than the floor price established by the RPM agreement, Johnson & Johnson took an aggressive stance by cutting off the supplies and refusing to renew the distribution agreement despite their 15-year relationship. In a well-crafted decision, the Shanghai High Court held that the RPM agreement at issue was anti-competitive without any apparent pro-competitive effects and thus illegal under the AML.
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Why manufacturers need an RPM policy
To a layperson, RPM seems counterintuitive for the upstream party (mostly the manufacturer) in a vertical relationship, as it does not bring any direct financial benefit to the upstream party, which can achieve this goal by simply raising the wholesale price. On the contrary, it ensures the downstream party (mostly the reseller) a certain profit margin for resale of the upstream party's products. But in many situtations, the manufacturer is the driving force behind many RPM agreements. This is because, from an economic perspective, while both manufacturer and reseller seek higher profits, their interests are not perfectly aligned. The manufacturer is more concerned about the product quality, image and popularity associated with its long-term profitability, whereas the reseller has more immediate needs, which often can be achieved through increased sale volumes in a short period.
Because of the diverse goals of the parties, the manufacturer often imposes requirements and restrictions in the distribution agreement concerning how its product may be marketed or sold by the resellers, and the RPM is viewed as one of these options. Unlike companies in a horizontal price-fixing cartel whose primary goal is to restrict or eliminate inter-brand price competition to the detriment of the consumers, the manufacturer uses an RPM policy not to seek immediate monopoly profit, but to incentivise the resellers to provide the type of customer services that the manufacturer deems adequate. As recognised by the Shanghai High Court in the Johnson & Johnson case, while it is clear that the RPM policy restricts or eliminates intra-brand price competition (competition among resellers of the same product), its effect on inter-brand competition, which is the primary concern of the AML, is not straightforward and requires detailed economic analysis.
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Pro-competitive effects
Supporters often herald RPM as a solution to the so-called “free-rider” problem. For many products, consumers desire certain promotional activities and presale or post-sale services, and the manufacturer and its resellers collectively benefit from such activities and services. Without the RPM and related restraints, one reseller may choose not to invest in any promotional effort, or offer presale and post-sale services, in an attempt to take advantage of investments made by the manufacturer and other resellers. For example, a customer may visit one reseller to have all his questions answered and enjoy demonstrations, and go to another reseller that offers none of the customer services to offer the product at a reduced price. Under this scenario, all resellers will be motivated to cut promotional and customer service expenses, resulting in the general reduction in consumer welfare.
The Shanghai High court in the Johnson & Johnson case dismissed the free rider justification for the RPM agreement at issue. It held that the many non-price restrictions in the distribution agreement (like hospital-specific authorisation) and Johnson & Johnson's strict supervision over the resellers' marketing activities effectively eliminated any possibility for free-riding. But the Shanghai High Court failed to consider that the RPM policy, non-price restrictions, and manufacturer supervision are different mechanisms to deter free-riding, and the effectiveness of one does not necessarily mean the superfluity of another. The analysis by the Shanghai High Court indicates that there may be more leeway to deem an RPM agreement legal if other mechanisms are not sufficient to deter free-riding.
New entrants may also use RPM to establish a foothold in the market. The manufacturer entering the market wants to quickly introduce its products to customers, but resellers that are uncertain about the popularity of the products may take a cautious approach about investing resources into promotion and sales of the products. Through the RPM, the resellers are assured to obtain a premium to recoup their investment. The Shanghai High Court in the Johnson & Johnson case accepted this argument as a valid justification for an RPM agreement, but noted that this argument did not apply to Johnson & Johnson, who has been in the Chinese medical suture market for over 15 years.
A manufacturer may also attempt to maintain its products' image and reputation through an RPM policy. For many customers, the price of a product may be associated with the perceived quality, value and performance of the product. For example, purchasers of women's handbags would expect high-end brands, like Prada or Hermes, to be generally priced higher than handbags of regular brands, because the manufacturers of these high-end brands are perceived to be more dedicated to fabrication techniques, material selection and quality control. Price reduction of these products would run the risk of permanently undermining such perception so that consumers may be no longer willing to accept the products at their regular price. In Johnson & Johnson, the Shanghai High Court took a position that a widely-known product with good reputation does not need RPM to maintain its reputation. This position ignores the fact that product reputation is more than some quantitative measures of the product, and a stable pricing strategy may be required to maintain customers' perception of product image and reputation.
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Anti-competitive effects
In a perfectly competitive market with many substitutable products, the pricing, distribution and management strategies of one market participant have little or no effect on those of others. However, as such markets rarely exist in practice, one market participant's restriction on resale price usually does affect the pricing of its competitors. RPM is often criticised for facilitating price collusion among manufacturers. As the RPM makes the prices of competing products more transparent, competitors can easily monitor any deviance from the explicit or implied price collusion.
In Johnson & Johnson, the Shanghai High Court noted that the evidence did not support the existence of a price-fixing cartel. However, it concluded that the RPM agreement at issue not only prevented the resellers of Johnson & Johnson products from lowering the price, it also kept the price of competing products artificially high. The Shanghai High Court reasoned that because Johnson & Johnson prices its medical suture products higher than its competitors, if Johnson & Johnson allows its resellers to lower the price, the price of competing products will decrease as well, indicating that implied collusion among competing manufacturers may be in place due to Johnson & Johnson's RPM policy.
The Shanghai High Court did not cite any empirical or economic study to support this part of its analysis. As there is no indication that the pricing decision of Johnson & Johnson and its competitors was correlated, it appears to assume that the rival manufacturers or resellers will consciously price their competing products at a certain level below that of Johnson & Johnson products. While each market participant would certainly closely monitor the prices of rival products, how the rival manufacturers may respond to any price decrease of Johnson & Johnson product depends on their own assessment of business reality. If they believe Johnson & Johnson's price decrease is due to poor company management or product quality, they may be tempted to keep the price of their products stable or even raise the price to take over Johnson & Johnson's position as the market leader with regard to both product price and market share. On the other hand, if they believe the price decrease is in response to more fierce competition or lower customer demand, they may lower the price of their product as well. For example, after contaminated milk source and quality issues caused a crisis of confidence in foreign infant formulas, several domestic infant formula manufacturers raised the resale price for their competing products and positioned themselves as the better alternative for consumers.
The deprivation of the reseller's pricing freedom and exclusion of efficient resellers were put forth by the Shanghai High Court as one anti-competitive effect of RPM policies. This is indeed an area where a RPM policy may have a negative effect on inter-brand competition. However, the efficiency of a reseller is not accurately measured by whether it can lower the price and still obtain a profit. A better indicator is whether the reseller can successfully engage in non-price competition against resellers of rival products – this is exactly what the RPM policy is intended to accomplish. To this extent, free-riding and inefficient resellers are two aspects of the same issue associated with the RPM.
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Striking a balance
The balancing economic analysis applied by the Shanghai High Court in the Johnson & Johnson case of the RPM's pro- and anti-competitive effects brings uncertainty to the legality of RPM agreements in general. In this case, Johnson & Johnson's strong market power (even though it may not reach the level of market dominance) was cited as an indication of RPM agreement's anti-competitive effect. While use of the RPM by manufacturers with little or no market power is unlikely to have anti-competitive effects, manufacturers with at least some market power should be careful in crafting RPM agreements after Johnson & Johnson.
Even if the RPM agreements are not per se illegal under Johnson & Johnson, manufacturers that need to discipline their resellers' business activities are advised to first resort to non-price restrictions, such as geographic segmentation, detailed requirements for promotional or service efforts, and close supervisions throughout their relationship. The combination of these may help the manufacturers to eliminate free-riding resellers and at the same time ensure the resellers will take the necessary steps to provide qualified services and preserve product image and reputation.
Manufacturers may also consider adopting the so called “Colgate doctrine” in dealing with resale prices for their products, which distinguishes bilateral or multilateral agreements which set minimal resale price from unilateral policies. Under the Colgate doctrine, the manufacturer would unilaterally set a suggested retail price (SRP) and announce a policy that it would not deal with discounters. The manufacturer would then terminate or refuse to renew the distribution agreement if the resellers offer the product at a price below the SRP. However, by entering into a distribution agreement on these terms, the reseller could be found to have tacitly agreed on the provision. As the legality of the Colgate doctrine under the AML has not been tested in a Chinese court, its future as a valid alternative to the RPM is still uncertain.
Other than being the first appellate decision on the issue of vertical price fixing, Johnson & Johnson is also the first appellate decision in which the defendant was found liable for AML violations, and has received wide attention from legal professionals as well as the general public. In its decision, the Shanghai High Court acknowledged that a RPM agreement is not necessarily illegal under the AML and its impact on market competition should be carefully analysed. Companies should balance the potential pro- and anti-competitive effects of any retail price fixing scheme before they enter into this kind of agreement.
Fang Qi and Haiyan Tao, Fangda Partners, Beijing
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