After judicial proceedings spanning three years, Johnson & Johnson Medical (China) Ltd. and Johnson & Johnson Medical (Shanghai) Ltd. (collectively, “J&J”) lost the antitrust action brought by Beijing Ruibang Yonghe Science and Technology Trade Company, one of their distributors in China (the “Distributor”). This is the first antitrust civil action in China involving vertical anti-competitive agreements.

Appellate court reverses decision

On Aug. 1, 2013, Shanghai Higher People’s Court (the “Higher Court”), the appellate court in this case, granted final judgment in favor of the Distributor, by ruling that minimum resale price provisions in the distribution agreements between J&J and the Distributor constitute vertical anti-competitive agreements. The Higher Court rejected the trial court’s decision, which found the evidence insufficient to hold J&J liable for anti-competitive conduct. 

The Distributor partnered with J&J for 15 years for the distribution of medical staplers and sutures, and the distributorship was renewed each year. In 2008, J&J discovered that the Distributor broke its covenants by tendering bids to a hospital at a price lower than the minimum resale price set forth in the distribution agreements. For this and other reasons, J&J terminated the distributorship. The Distributor claimed RMB 14,399,300 for economic compensation. The Higher Court finally ordered J&J to pay RMB 530,000, representing the lost profit of the Distributor in 2008.

NDRC probe into milk powder industry and liquor industry

While there was still a heated discussion about the rulings of the Higher Court in the action against J&J as introduced above, on Aug. 7, 2013, the National Development and Reform Commission of the People’s Republic of China (“NDRC”) published the results of its antitrust probe into the milk powder industry in China, which was launched a few months ago by the Price Supervision, Inspection and Anti-Monopoly Bureau of NDRC. Heavy fine tickets were issued to six foreign-headquartered and Chinese domestic milk-powder companies, including Mead Johnson Nutrition, Abbott Laboratories, Danone (Dumex), Royal FrieslandCampina, Fonterra, and Biostime, in an amount up to RMB 670 million in total. Each company is subject to penalties ranging from 3 percent to 6 percent of its annual sales last year. Wyeth, Meiji and Beingmate were also subject to NDRC’s antitrust investigation, but were exempted from monetary punishment due to their active cooperation. All nine companies were charged with vertical anti-competitive conduct including fixing resale prices and setting minimum resale prices with their distributors.

In February 2013, NDRC penalized two well-known Chinese liquor companies—Maotai and Wuliangye—for vertical price restraints. The two companies were subject to penalties in an aggregated amount of RMB 247 million, around 1 percent of their annual sales of 2012.

Vertical Anti-competitive agreements in the Chinese Anti-monopoly Law (“AML”)

Vertical anti-competitive agreements are set forth in Article 14 of the AML, which expressly include the following two categories:

  • Fixing resale prices.
  • Setting minimum resale prices.

According to the AML, a company is liable for third party losses arising from its anti-competitive conduct, determined by a competent court in civil actions. In addition, if a company is found by the enforcers of the AML, such as NDRC, to have entered into and performed anti-competitive agreements, the company could be subject to penalties ranging from 1 percent to 10 percent of its annual sales from the last year. Simply entering into anti-competitive agreements without any performance could still be subject to penalties up to RMB 500,000. However, if a company actively cooperates with enforcers by reporting the details in the anti-competitive agreements and provides important evidence, the penalties may be mitigated or exempted. Therefore, NDRC has great discretion in dealing with vertical price restraints.

Interpretations of vertical anti-competitive agreements by the Higher Court

The Higher Court clarified, among other matters in the action against J&J, that “eliminating or restricting competition” is an essential element of vertical anti-competitive agreements, and that the burden of proof regarding such elimination or restriction lies with the plaintiff —points which are both unclear in the AML and the Provisions of the Supreme People’s Court on Several Issues Concerning the Application of Law in the Trial of Civil Dispute Cases Arising from Monopolistic Conduct (the “Supreme Court Interpretation”). Although the Higher Court has no legislative power under the law, its rulings are significant. The rulings and the substantial reasoning of the Higher Court are summarized as follows: 

  1. Application of AML

The Higher Court ruled that although the distribution agreements between J&J and the Distributor were entered into prior to Aug. 1, 2008, the effective date of the AML, they should still be subject to AML as the performance of the distribution agreements was not terminated after the effective date.

  1. Competent plaintiff

While the Distributor is a participant in anti-competitive activities, it might still be a victim and suffer losses due to the restrictions imposed on resale prices, and therefore should have the right to sue. According to a broad definition in the Supreme Court Interpretation, any individual, legal person or organization who suffers losses due to any anti-competitive conduct or violation of AML is eligible to file antitrust actions.

  1. “Eliminating or restricting competition” – an element of vertical anti-competitive agreements 

There were debates, due to the ambiguity in the AML, as to whether simply fixing resale prices or setting minimum resale prices could directly lead to a violation of AML, or whether such practices should be combined with the proof of “eliminating or restricting competition” for overall consideration.

The Higher Court made it clear that although the phrase “eliminating or restricting competition” appears in Article 13 of the AML—an article specifically introducing the categories of horizontal anti-competitive agreements—it should also cover Article 14 (categories of vertical anti-competitive agreements) and the remaining content of the AML where anti-competitive agreements are applicable. The court gave reasons, stemming from the nature of monopolies, that since horizontal anti-competitive agreements, which are more likely to cause anti-competitive results, require the proof of “eliminating or restricting competition,” it is unreasonable to not list the same for vertical anti-competitive agreements.  

  1. Burden of proof lies with plaintiff

Article 7 of the Supreme Court Interpretation provides that in an action relating to horizontal anti-competitive agreements, the burden of proof regarding the elimination or restriction of competition lies with the defendant. However, the Supreme Court Interpretation does not specify which party should bear the burden of proof if the dispute is related to vertical anti-competitive agreements. Therefore, the Higher Court concluded that as no law provides otherwise, the plaintiff should bear the burden of proof in vertical price restraint cases, according to the general principles in the Civil Procedure Law.

  1. Factors in evaluating economic effects of setting minimum resale price

The Higher Court found the following the most important factors in evaluating the economic effects of setting minimum resale prices:

  1. Whether the market is sufficiently competitive

The Higher Court considered this factor a primary condition, and reasoned that there is no need to further evaluate the economic effects, unless the market has been deemed as lacking in sufficient competition. The Higher Court reviewed the facts and evidence regarding the replaceability of the products, bargaining power, and brand loyalty of the customers, market entry barriers for potential competitors, and the pricing power of J&J, and concluded that the suture products market of mainland China was not sufficiently competitive.  

  1. Whether the possible monopolist has dominant market position

The Higher Court indicated that if a company has no advantages on market share, supply of raw materials, key technologies, distribution channels, or brand images, it certainly has no power to interfere with the market competition, and thus its price control activities may not be in violation of the AML. Evidence showed that J&J had a large market share, brand influences, effective control over distributors, and strong pricing power (such as maintaining the prices of its suture products in the China market for fifteen years without fluctuation). Therefore, J&J was deemed as having dominant market position.

  1. Whether the motive is avoiding price competition

The Higher Court reasoned that it would be comparatively much easier for a company with a dominant market position to create an anti-competition environment, if it has motive to do so. The motive of J&J was evidenced by its strategies toward competition. The Higher Court pointed out that when faced with competition, J&J would rather try various possible means—such as improving the quality of service, upgrading products, and maintaining good client relationships—and would instruct the distributors to do the same, instead of lowering the prices of its products. In the Higher Court’s view, this signaled J&J sought to avoid price competition.

  1. Whether anti-competitive effects can be offset by pro-competitive effects

Article 15 of the AML indicates that certain anti-competitive agreements are meant to create benefits to customers, while not substantially restricting market competition. Those anti-competitive agreements are not prohibited.

The Higher Court found that the minimum resale price restrictions imposed by J&J were in fact detrimental to the customers’ interest, because they eliminated the rights and initiatives of distributors and other brand competitors to lower the prices of products. Furthermore, price restraints were not meant to cause pro-competitive effects such as improving the quality and safety of products, improving the service of distributors, or promoting and marketing new products. Therefore, Article 15 was not applicable in this case.

  1. Civil compensation

The Higher Court affirmed the profit losses of the Distributor in 2008. The amount of compensation (RMB 530,000) is much lower than the claimed amount of profit, partly because the distribution agreement was executed on an annual basis where there was no expected profit for next year. Another factor is that the Higher Court calculated the losses based on the fair profit margin in the market, rather than the profit margin derived from the distribution agreements that contained minimum resale prices.

Other losses claimed by the Distributor, such as the expected profit after the renewal of the distribution agreements, employee severance fees, losses due to unsold inventory, marketing expenses, and damages to business reputation, were not supported by the Higher Court due to the lack of legal basis or evidence.

Alert of potential legal risks

In summary, vertical anti-competitive agreements are only rendered in violation of the AML if the effects of eliminating or restricting market competition are affirmed, after scrutiny, by competent court or enforcers of the AML, such as NDRC. Certain singular or combined customary practices in treating distributors, such as giving warnings, imposing fines or disguised forms of fines, deducting rebates, limiting supplies, and terminating distributorship, when the distributors violate fixed resale price or minimum resale price covenants, may give rise to vertical price restraint disputes or investigations. Although the burden of proof lies with the plaintiff in a civil case, active cooperation might be wise if NDRC initiates the investigation.

The intense investigations of NDRC and the huge penalties also signal that the regulatory authorities in China are paying more attention to vertical anti-competitive agreements. It is time for market leaders doing business in China to review and revise their price restraint policies and practices to prevent intentional or unintentional anti-competitive conduct.