This past September in Kaufman v. Time Warner,[1] the Second Circuit upheld the dismissal of an action on behalf of a putative class of cable subscribers claiming that Time Warner improperly tied the sale of its premium cable services to the leasing of cable boxes, in violation of Section 1 of the Sherman Act. In a split decision, the Second Circuit upheld the dismissal on two grounds. First, the majority found that the plaintiffs had failed to establish that there were separate markets for premium cable services and cable boxes. Second, the majority concluded that the plaintiffs had not properly alleged that Time Warner had market power over the tying product—premium cable services. Circuit Judge Droney dissented, declaring that the majority had applied too strict a standard to the plaintiffs’ complaint and contending that when all facts were construed in the plaintiffs’ favor, as required when considering a dismissal motion under Rule 12(b)(6), plaintiffs had sufficiently alleged separate markets and market power.

Background

The Time Warner case was originally filed by a proposed class of cable subscribers in August 2008. The case was consolidated into a Multidistrict Litigation in the Southern District of New York later that year. After the plaintiffs’ first amended complaint was dismissed, they filed a complaint that further amended their claims. The plaintiffs alleged that Time Warner had violated the Sherman Act by tying the sale of its premium cable services to the required leasing of set-top cable boxes. Premium cable services were defined as “digital cable services incorporating interactive functions,” which referred to a consumer’s ability to view program guides, restart programs from the beginning, and order on-demand programs.[2] The tied product was specifically defined as “bi-directional cable boxes,” meaning set-top boxes that can transmit signals from users Time Warner in addition to transmitting signals from Time Warner to subscribers.[3] The plaintiffs alleged that Time Warner forced subscribers to lease the bi-directional cable boxes when they subscribed to Time Warner premium cable services, and then return the boxes when their subscription ended. This meant that subscribers were not able to keep their cable boxes and use them with different cable providers. Time Warner did not manufacture its own cable boxes, instead purchasing them from several third-party manufacturers.

Time Warner moved to dismiss the plaintiffs’ amended complaint and the District Court granted the motion, ruling that the plaintiffs had not sufficiently pled that Time Warner had market power in each of the geographic markets at issue in the complaint.[4] The plaintiffs’ appeal to the Second Circuit followed.

The Second Circuit Decision

In a split decision, the Second Circuit upheld the dismissal of the complaint on the grounds that: (1) the plaintiffs had failed to allege sufficient plausible facts to support a conclusion that there were separate markets for premium cable services and cable boxes, and (2) the allegations of the complaint were insufficient to support the claim that Time Warner had market power in the market for premium cable services. In his dissent, Judge Droney disagreed on the grounds that the plaintiffs had sufficiently pled their claims.

The panel majority began with an explanation of the nature of tying arrangements and the circumstances in which they are illegal. The majority explained that tying arrangements should be stricken when they allow a seller with market power in one market to use that power anticompetitively in a second market. The court explained that for the plaintiffs to plead a tying claim adequately, they would have to show that: (1) the sale of premium cable services was conditioned upon the purchase (or lease) of a separate product—in this case bi-directional cable boxes; (2) Time Warner had forced subscribers to lease the cable boxes through “actual coercion”; (3) Time Warner had sufficient power in the market for premium cable services to coerce subscribers into leasing the cable boxes; (4) the tying arrangement had “anticompetitive effects in the tied market”; and (5) “a not insubstantial amount of interstate commerce [was] involved in the tied market.”[5]

Separate Markets

The panel majority first emphasized that a showing of separate product markets is necessary to a tying claim because without separate markets, there can be no concern that a monopoly in one market is being used in an anticompetitive manner in a second market. In analyzing whether separate markets existed for cable services and cable boxes, the court explained that cable providers programmed codes into cable boxes to tie them specifically to the signals that the providers put out to their subscribers, making the boxes provider-specific. The “core issue” in the case, then, according to the majority, was “a cable provider’s right to refuse to enable cable boxes it does not control to unscramble its coded signal.”[6]

The plaintiffs argued that several allegations were sufficient to show that there were separate markets for premium cable services and bi-directional cable boxes:

"(i) existing technology permits the sale of remotely programmable bi-directional cable boxes at retail; (ii) Time Warner does not manufacture its own bi-directional cable boxes; (iii) Time Warner separately itemizes charges for leasing bi-directional cable boxes and providing cable television services on consumers’ bills; (iv) bidirectional cable boxes are sold separately at retail in markets outside of the United States, for example, in South Korea; and (v) modems are sold separately from internet services in the United States.[7]"

The court ultimately found these arguments unpersuasive. It reasoned that the first two allegations related to “supply-side considerations,” but they said nothing about whether there was consumer demand to purchase cable boxes independently of premium cable services. The court dismissed the third allegation as implausible because an FCC regulation required the charges to be itemized separately.[8] The court next ruled that the fourth allegation was insufficient because the plaintiffs had not presented any arguments demonstrating that the South Korean market was similar enough to the United States market to allow the court to adopt any inferences about what the demand for cable boxes would be in the United States absent Time Warner’s tying. The court also dismissed the comparison to cable modems, as internet signals are not provider-specific in the way that premium cable services are, so there is no need for an internet provider to tie a modem to its services. Importantly, the court stressed that the complaint lacked any allegations that cable boxes had ever been sold separately from cable services in the United States. Given these deficiencies, the majority concluded that the plaintiffs had failed to adequately allege there were separate markets for bi-directional cable boxes and premium cable services, which also meant that the plaintiffs had not sufficiently alleged that Time Warner had coerced subscribers into leasing cable boxes.

In addition to these conclusions, the majority analyzed how the regulatory framework surrounding cable boxes made the plaintiffs’ allegations of separate markets implausible. First, the court emphasized that while the FCC had made efforts to develop a market for cable boxes separate from cable services, those efforts had proven unsuccessful due in large part to cable providers’ need to ensure the security of their programming.[9] The court further concluded that FCC regulations that controlled the amount cable providers could charge for cable box leasing made it unlikely that Time Warner would attempt to monopolize that market, as the potential profits were capped by regulation.[10]

Market Power

In addition to finding fatal deficiencies in the plaintiffs’ allegations regarding separate product markets, the panel majority concluded that the plaintiffs had failed to sufficiently allege that Time Warner had sufficient power over premium cable services to force consumers to lease the cable boxes. The plaintiffs had alleged that: (1) cable providers generally do not compete within local markets; (2) Time Warner had market power over basic cable services in the markets where it provides such services; (3) premium cable services rely on the same infrastructure as basic cable services; and (4) as a result, Time Warner “naturally” had market power over premium cable services.[11]

The panel majority concluded that these allegations were inadequate to show that Time Warner had market power over premium cable services, the alleged tying product. According to the majority, the allegations about infrastructure said nothing about the market for premium cable services. The court further ruled that the plaintiffs had not presented any allegations regarding the non-cable competitors that Time Warner faced in 22 of the 53 separate geographic markets at issue in the complaint. As a result, the majority concluded that the complaint should also have been dismissed for the independent reason that it did not adequately plead that Time Warner had market power in the market for premium cable services.

The Dissent

In his dissent, Judge Droney disagreed with the majority’s conclusions regarding the plaintiffs’ allegations as to both separate markets and market power. He believed that the majority had placed “too high a bar” for the plaintiffs, and that when all reasonable inferences were drawn in the plaintiffs’ favor, as required when a court considers a motion to dismiss, the allegations had plausibly demonstrated that separate markets for premium cable services and cable boxes existed.[12] Judge Droney emphasized that the majority had improperly credited Time Warner’s contention that security concerns prevented consumers from being able to purchase cable boxes directly from manufacturers and securely receive providers’ programming, because the plaintiffs had alleged that cable providers could in fact program the boxes remotely—an allegation not acknowledged by the majority. The dissent also took issue with the majority’s conclusion regarding the plaintiffs’ failure to allege that cable boxes have historically been purchased separately from cable services in the United States. According to Judge Droney, the absence of such separate purchases was arguably caused by the cable providers themselves, which had for many years uniformly required subscribers to lease their cable boxes in conjunction with purchasing cable services.

Similarly, Judge Droney reasoned that the FCC’s inability to separate cable boxes from cable services led to the opposite conclusion of the one drawn by the majority—the various regulations cited by the majority showed that the FCC viewed the markets as separate, but the failure of the FCC to separate the market was caused by cable providers’ resistance to efforts to treat them as separate. Lastly, Judge Droney disagreed with the majority’s conclusions regarding the FCC regulation capping the lease price of cable boxes. Not only did the regulation allow leasing charges to be tied to the “average annual unit purchase cost”—a cost which could be artificially inflated because there has been little competition in the market, since manufacturers do not sell directly to consumers—but the cap also provides for “a reasonable profit.”[13] Moreover, Time Warner had previously warned investors that cable box competition could lower the significant profits obtained from leasing cable boxes, demonstrating that Time Warner considered the cable boxes to be a separate market with profits worth pursuing.

As to the market power issue, Judge Droney viewed the undisputed fact that Time Warner had market power over basic cable to logically mean that it also had market power over premium cable services in the geographic markets in which it operated. Judge Droney emphasized that this conclusion was supported by specific allegations regarding the significantly higher numbers of premium subscribers Time Warner had compared to its competitors. Lastly, he concluded that the plaintiffs’ allegations regarding Time Warner’s far greater number of premium subscribers was sufficient at the motion to dismiss stage to imply market power across all relevant geographic markets, making the majority’s scrutiny of the 53 separate markets unnecessary.

The Significance of the Second Circuit’s Decision

The majority’s holding in Kaufman v. Time Warner ultimately serves as a reminder that plaintiffs must plausibly allege each required element of a tying claim before a court will rule that a tying action can go forward. Plaintiffs should clearly emphasize that the facts alleged plausibly support a tying claim, even if other possibilities may be more plausible. This should be sufficient, since courts are supposed to credit all factual inferences in favor of plaintiffs at the motion to dismiss stage.

Time Warner involved the particular characteristics of a highly regulated market. It remains to be seen how significant an effect the case will have upon antitrust suits that do not involve regulations dealing with the specific practices at issue in the suit. In the meantime, the FCC and the White House continue to push for increased competition in the cable box market, meaning that change could come soon even with the dismissal of the Time Warner suit.[14]