Sellers as diverse as the world’s largest corporations with expanding product lines that want to induce customers to try new products, and street vendors with food carts offering a discount for customers buying a drink and chips with their hot dog, offer bundled discounts. The use of bundling is pervasive, transcends market boundaries, and clearly is a useful option for buyers and sellers.1 However, the antitrust standard for bundling remains elusive in the United States. A different antitrust standard in Europe only adds to the antitrust risk and uncertainty facing a dominant seller offering a worldwide bundled pricing program. So, what is a seller to do?
The legal terrain in the United States and the EU lacks uniformity with respect to bundled pricing programs. Further, U.S. courts analyzing antitrust challenges to bundled pricing programs have applied conflicting standards. In 2007, the Antitrust Modernization Commission Report and Recommendations (the “AMC Report”)2 proposed a standard, but neither the courts, the Department of Justice (“DOJ”), nor the Federal Trade Commission (“FTC”) has adopted the AMC proposal in its entirety.3 In September 2008, the DOJ offered some guidance in its report, Competition and Monopoly: Single-Firm Conduct Under Section 2 Of The Sherman Act (hereinafter “DOJ Section 2 Report”). It set forth standards to apply to determine whether to take enforcement action regarding bundled discounts.4 The DOJ adopted the use of a price-cost “safe harbor,” and for bundles that fall outside the safe harbor, the application of a “disproportionality” test.5 However, on May 11, 2009, the DOJ’s new antitrust chief, Christine Varney, announced that the DOJ was withdrawing, effectively immediately, the DOJ Section 2 Report, stating that the Antitrust Division would be aggressively pursuing cases of unlawful unilateral conduct.6 Further, FTC Commissioners Harbour, Leibowitz (now the FTC Chairman) and Rosch had criticized the DOJ Section 2 Report in a published statement (hereinafter the “FTC Commissioners’ Statement”) issued at the time the DOJ Section 2 report was released.7 In their strongly worded statement, the FTC Commissioners criticized the price-cost safe harbor, stating that “no Supreme Court decision has ever blessed the use of any price-cost rules of legality.” As to the disproportionality test, the Commissioners said that “the Department is the sole author and authority for the use of the ‘disproportionality’ safety net.”8 After the change in administration in Washington, there were questions regarding whether the DOJ would in fact apply the standards described in the DOJ Section 2 Report under the stewardship of its new Chief, Christine Varney. That question was answered May 11 and should come as no surprise. Ms. Varney had made clear during her confirmation hearing that her initial goals for the DOJ include “rebalanc[ing] legal and economic theories in antitrust analysis and vigorously enforc[ing] the law.”9
To add to the thicket, the European Court of Justice (“ECJ”) and the Court of First Instance (“CFI”) have long applied a foreclosure test that does not require price-cost evidence in cases not involving predation or margin squeeze. However, the Commission of the EC (the “Commission”) recently issued guidance on enforcement priorities and set forth a full foreclosure analysis that it intends to apply, which includes a price-cost test. Significantly, the definition of “cost” that the Commission will use in its analysis to determine whether a bundled discount is predatory, is broader than the definition of cost that U.S. courts have applied and that the DOJ had stated that it would use in its price-cost test in the DOJ Section 2 Report. As a result, a bundled discount that is lawful in the United States may not be permissible in the EU.
Forms of Bundling
Bundling can take a number of forms. Some bundles are technological—i.e., the consumer must use the individual items in the bundle together to achieve functionality. Other bundles are financial. In a financial bundle, the seller offers a discount if the buyer purchasers an array of products from the seller, rather than purchasing the products a la carte from multiple sellers. In a bundled program, the buyer is free to purchase less than all of the products in the bundle. In that respect, it is unlike a tying arrangement in which the buyer must purchase the tying product and the tied product from the seller (which refuses to sell the products separately at any price). It also is not like an exclusive dealing arrangement, which requires that the buyer purchase particular products only from a particular seller. A bundled pricing program merely provides a financial incentive to the buyer to purchase the entire bundle from a supplier, by charging a price for the entire bundle that is less than the sum of its parts if purchased separately. The courts, FTC, DOJ and commentators recognize that there are legitimate business justifications for bundled pricing.10 Efficiencies derived from economies of scale and scope can be achieved through bundled offerings. On the other hand, there is recognition that under certain circumstances, a monopolist’s bundled program can be anticompetitive and can harm consumers if it eliminates competition that restrains the surviving seller’s ability to raise prices above competitive levels.
Rivals compete with bundled discounts in different ways. In some instances, a rival may be able to offer consumers a similar bundle of products, either by itself or in combination with other suppliers. In that event, there is competition for the bundle. However, in other instances, competitors are unable to offer a competing bundle. If rivals cannot offer a “must have” product in the bundle, it may be difficult to compete on price for sales of the competitive products in the bundle. A hypothetical described in Ortho Diagnostic Systems, Inc. v. Abbott Laboratories, Inc. demonstrates the coercive aspects of a bundled program in such cases.11 In the hypothetical, only A makes conditioner, but A and B make shampoo, and consumers need to use both products. A’s average variable costs are $2.50 for conditioner and $1.50 for shampoo (for a combined average variable cost of $4), whereas B’s average variable cost for shampoo is $1.25 (which may infer that B is more efficient). A prices conditioner at $5 and shampoo at $3 if purchased separately, but offers a price of $5.25 if conditioner and shampoo are purchased together. The bundle generates a combined profit for A of $1.25 ($5.25 – $4.00). In order to induce consumers to purchase shampoo from B (while purchasing conditioner from A at $5), B cannot charge the consumer more than $ 0.25 for shampoo in order to compensate consumers for the lost discount made available by the bundled discount. This is below both B’s average variable cost of $1.25 and A’s average variable cost for shampoo of $1.50. But because A is charging a price that is above average variable cost for the bundle, its price for the bundle is not predatory. Moreover, consumers benefit from the lower prices. As a result, consumers will purchase the bundle from A, and B may be forced to exit the market. The question faced by courts and government enforcers is whether consumers will remain better off in the long run when B exits the market. Certainly, one alternative is for B to start selling conditioner and offering a competitive bundle. However, that is not always possible. In some instances, competitors cannot offer a “must have” product because there are significant barriers to entry. These are the types of fact patterns that provide the greatest challenge for enforcement agencies and the courts, and create all kinds of policy considerations.12
U.S. Judiciary Standards
As indicated above, the U.S. judiciary has not applied a consistent standard across jurisdictions. In some circuits (Second, Eighth, Ninth), bundled discounts are not considered to be anticompetitive unless the effective price of one or more products in the bundle is below some measure of cost (i.e., is predatory).13 Echoing the Supreme Court, the Eighth Circuit, in Concord Boat Corp. v. Brunswick Corp., stated: “’Low prices benefit consumers regardless of how those prices are set, and so long as they are above predatory levels, they do not threaten competition. Hence, they cannot give rise to antitrust injury.’”14 Quoting the Supreme Court opinion in Brooke Group Ltd. v. Brown & Williamson Tobacco Corp.—the U.S. Supreme Court’s definitive statement on single-product price discounting—the Eighth Circuit warned: “Because cutting prices in order to increase business often is the very essence of competition, which antitrust laws were designed to encourage, it ‘is beyond the practical ability of a judicial tribunal to control [above cost discounting] without courting intolerable risks of chilling legitimate price cutting.’”15
However, in Eastman Kodak Co. v. Image Technical Servs., Inc., the Supreme Court cautioned that “[l]egal presumptions that rest on formalistic distinctions rather than actual market realities are generally disfavored in antitrust law.”16 Antitrust claims are to be resolved on a “case-by-case basis, focusing on the particular facts disclosed by the record.”17 Thus, the Concord Boat court recognized that, while above-cost pricing might create a presumption of lawful conduct, a case might exist (however remote) where factors other than price might demonstrate anticompetitive impact: “If a firm has discounted prices to a level that remains above the firm’s average variable cost, ‘the plaintiff must overcome a strong presumption of legality by showing other factors indicating that the price charged is anticompetitive.’”18
In contrast to the Eighth Circuit, the Third Circuit has not required a showing of predatory pricing to conclude that bundled discounts can constitute anticompetitive behavior. In SmithKline Corp. v. Eli Lilly and Co.19, the court held that a bundled discount was anticompetitive, even though there was no allegation of predatory pricing. There, defendant Eli Lilly & Co. (“Lilly”) had a monopoly on a certain strain of antibiotic (cephalosporin) that it sold under the brand name Kerflin. Lilly also manufactured additional forms of the same antibiotic and had patents on all of them, except one product sold under the name Kefzol. The plaintiff, SmithKline, began producing a generic form of Kefzol and sold it under the name Ancef. In response to the competition from SmithKline and to preserve its market position in the Keflin brand, Lilly developed a rebate program under which hospitals that purchased certain quantities of any three of Lilly’s antibiotics received a discount. The rebate program effectively combined the purchases of Lilly’s market leader, Keflin, with its generic version, Kefzol, thereby giving Kefzol a competitive advantage over SmithKline’s generic equivalent Ancef. The court found that the effect of the rebate was to force SmithKline to give rebates on one product, Ancef, that was equal to the rebates that Lilly paid on three products. The court held that Lilly’s rebate program was anticompetitive and violated Section 2 of the Sherman Act without requiring any evidence of predatory pricing. The court stated: “On the basis of expert testimony, …SmithKline’s prospects for continuing in the cephalosporin market under these conditions to be poor.”20
Again, more than 25 years later, in LePage’s Inc. v. 3M, the Third Circuit concluded that a bundled discount program violated § 2 of the Sherman Act without requiring any price-cost evidence.21 3M offered discounts to certain customers in the form of rebates that were conditioned on purchases of products that spanned six of 3M’s diverse product lines. If a customer failed to meet 3M’s target for any one product, it would lose the rebates across the board, thereby creating “a substantial incentive for each customer to meet the targets across all product lines to maximize its rebates.”22 Although LePage’s did not allege that 3M was selling any of the products below cost, the Third Circuit concluded that the discount program was anticompetitive: “The principal anticompetitive effect of bundled rebates…is that when offered by a monopolist they may foreclose portions of the market to a potential competitor who does not manufacture an equally diverse group of products [and] who therefore cannot make a comparable offer.”23 The court went on to say that “if 3M were successful in eliminating competition from LePage’s second-tier or private label tape, 3M could exercise its monopoly power unchallenged” and later recoup lost profits resulting from the discounts, because entry into the market was difficult.24
The Third Circuit rejected 3M’s legal theory that “after Brooke Group, no conduct by a monopolist who sells its product above cost—no matter how exclusionary the conduct—can constitute monopolization in violation of § 2 of the Sherman Act.”25 The Third Circuit noted that even if Brooke Group could be read to hold that a company’s pricing is legal if its prices are above its costs, “nothing in the decision suggests that its discussion of the issue is applicable to a monopolist with its unconstrained market power… A monopolist is not free to take certain actions that a company in a competitive (or even oligopolistic) market may take, because there is no market constraint on a monopolist’s behavior.”26 The court pointed out that in the decade following the Brooke Group decision, the Supreme Court had not suggested that Brooke Group diluted the “Court’s consistent holdings that a monopolist will be found to violate section 2 of the Sherman Act if it engages in exclusionary or predatory conduct without a valid business justification.”27
In Cascade Health Solutions v. PeaceHealth28, the Ninth Circuit expressly rejected the standard adopted by the Third Circuit in LePage’s. Significantly, after oral argument in the appeal, the Ninth Circuit invited all interested parties to submit amicus briefs on whether a price-cost test should be applied to bundled discounts, and if so, what that standard should be. Numerous companies and scholars filed briefs, almost all of which supported some form of price-cost test. Many endorsed the discount attribution standard recommended in the AMC Report, which was issued after oral argument in the PeaceHealth appeal.
The AMC Report had criticized the Third Circuit standard in LePage’s, noting that that standard did notrequire the fact finder to consider whether the plaintiff was as efficient a producer as the defendant. Consequently, the LePage’s standard might shield a less efficient producer to the detriment of consumer welfare. The AMC proposed a three-part test, which asks: (1) whether, after allocating the entire discount on the bundle to the competitive products, the defendant sold the competitive products at prices that were below incremental cost; (2) whether the defendant is likely to recoup its losses from the discounts; and (3) whether the defendant’s bundled discount is likely to have an anticompetitive effect on competition. According to the AMC, the price-cost element of the test provided a standard that businesses could apply easily to monitor their conduct, and it would protect efficient producers from liability.
The Ninth Circuit adopted a price-cost standard in PeaceHealth. In doing so, the Ninth Circuit relied heavily on the Supreme Court opinion in Brooke Group.29 The Ninth Circuit emphasized that “the Supreme Court has forcefully suggested that we should not condemn prices that are above some measure of incremental cost.”30 The Ninth Circuit noted that the reasoning and conclusions in Brooke Group shows “a measured concern to leave unhampered pricing practices that might benefit consumers, absent the clearest showing that an injury to the competitive process will result.”31 The Ninth Circuit observed: “A bundled discount, however else it might be viewed, is a price discount on a collection of goods. The Supreme Court has undoubtedly shown a solicitude for price competition.”32 Therefore, the Ninth Circuit held that a bundled discount is not exclusionary “unless the discounts result in prices that are below an appropriate measure of the defendants’ cost.”33
In considering what “an appropriate measure of the defendants’ cost” should be, the Ninth Circuit considered numerous suggestions proposed by the Amici briefs. The court acknowledged that marginal cost (i.e., the cost to produce one incremental unit of product) is the most appropriate measure of cost; however, it recognized that the incremental cost of producing an additional unit of product is not readily determinable from conventional business records, which typically do provide average variable costs. Noting that other circuits have adopted average variable cost as a surrogate for marginal cost as the unit of measure, the Ninth Circuit held that a bundled discount constitutes exclusionary conduct only if, after allocating the entire discount to the competitive products in the bundle, the seller sold the competitive products at prices that were below average variable cost. This standard has been referred to as the “discount attribution” standard.34 Of course, even among the circuits that require proof of predatory pricing, disagreement remains over the appropriate measure of cost, be it avoidable cost, average variable cost or average total cost.35
The PeaceHealth court rejected the second and third elements of the AMC test. With respect to the recoupment test, the court noted that the test did not fit well with multi-product bundles, because the seller likely profited on the bundle as a whole.36 Thus, the seller’s losses on the competitive products are contemporaneously recouped by the profits on the other products in the bundle. The court rejected the third element of the test, concluding that it was redundant with the antitrust injury element of a Sherman Act claim.37
The DOJ Section 2 Report
Although the DOJ has now withdrawn its Section 2 Report, it is instructive to note its position on bundling, because it is unclear whether that particular portion the Report represents a clear departure from what the DOJ is likely to follow. In the Report, the DOJ had recognized that even though bundled discounts may benefit consumers in the short run by providing lower prices, such discounts offered by a monopolist may harm competition in certain instances.38 The DOJ noted in its Section 2 Report that no Supreme Court decisions have analyzed bundled discounts under Section 2 of the Sherman Act. The United States recommended against granting certiorari in LePage’s, asserting that “it would be preferable to allow the case law and economic analysis to develop further.”39 In its Section 2 Report, the DOJ noted that LePage’s represented a departure from the decisions of other courts that analyzed bundled discounts by applying a price-cost test. Further, although other cases applied a cost-based standard, they did not apply the same measure of cost.
The DOJ, after analyzing the cases and the AMC Report recommendations, concluded that a cost-based test is appropriate. The DOJ concluded that where “bundle-to-bundle competition is reasonably possible…[t]he price-cost safe harbor should mirror the predatory pricing safe harbor” for single products.40 Bundled discounts would be considered exclusionary only if the bundle as a whole was priced below marginal cost for the bundle. Further, “[w]here bundle-to-bundle competition is not reasonably possible,” the DOJ Section 2 Report states that “a discount allocation safe harbor is appropriate” (i.e., the standard that the Ninth Circuit adopted in PeaceHealth).41 The DOJ Section 2 Report stated that the risk of false negatives that might result by applying the safe harbor is insufficient to justify enforcement consideration of conduct that falls within the safe harbor. Where conduct falls outside of the safe harbor, the DOJ Section 2 Report stated that the discount still has to be analyzed for competitive effects.42 If competitors have not exited the market because of the bundled discounts and if exit is not reasonably imminent, the DOJ Section 2 Report stated that courts “should be especially demanding as to the showing of harm to competition.”43 The DOJ concluded that “when actual or probable harm to competition is shown, bundled discounting by a monopolist that falls outside the discount-allocation safe harbor should be illegal only when (1) it has no procompetitive benefits, or (2) if there are procompetitive benefits, the discount produces harm substantially disproportionate to those benefits.”44 Based on the recent withdrawal of the DOJ Section 2 Report, it is likely that the DOJ will take a more aggressive stand on bundling and analyze such pricing under a more traditional rule of reason foreclosure analysis, rather than on a price-cost test. In particular, Ms. Varney’s policies on single-firm conduct appear to be more closely aligned with the European Commission, which is discussed more fully below.
The FTC Commissioners’ Statement
As stated above, the FTC Commissioners’ Statement was strongly critical of the DOJ Section 2 Report, noting that it lacks Supreme Court sanction. The Commissioners stated that “the Report does not mention the possibility of analyzing bundled discounts as a form of exclusive dealing instead of affording them the protection of price-cost ‘safe harbors’ and requiring proof of ‘disproportionality,’ despite the [DOJ’s] recognition of the kinship between bundled discounts and ‘first dollar’ loyalty discounts ….”45 Thus, the FTC Commissioners asserted that bundled discounts should be analyzed under a traditional rule of reason foreclosure analysis. Mr. Leibowitz, one of the authors of the Statement, is now Chief of the FTC.
EU Treatment of Bundling
The European judiciary has treated bundled discounts as a potential abuse of a dominant position in violation of Article 82 of the European Community Treaty and its predecessors. Although in cases involving predation or margin squeeze, the European Community’s courts have applied price-cost analyses, they have not hitherto done so in relation to other forms of abuse such as exclusivity, fidelity rebates, or bundling. Two cases have often been cited as stating the rationale for this treatment—Hoffman-LaRoche v. Commission46 and N.V. Nederlandsche Banden-Industrie Michelin v. Commission.47 In neither of these cases (although not classic bundling cases) did the courts apply a price-cost analysis. On December 3, 2008, the European Commission issued written guidance on its enforcement priorities in applying Article 82 EC Treaty to exclusionary conduct by dominant undertakings. With respect to bundled discounts, the Commission stated that, inter alia, it would apply a price-cost approach. With respect to multi-product rebates, the Commission will apply the “as efficient competitor” analysis to determine whether there is potential harm to consumers.48 In that regard, the Commission will consider prices below long-run average incremental cost (“LRAIC”) as being capable of foreclosing competition from an as efficient competitor.49 The Commission’s use of LRAIC in its price-cost test in the EU, while some U.S. courts have used marginal cost in their price-cost test in the United States, can result in a bundled discount being permissible in the United States, but not in the EU. Therefore, sellers using worldwide pricing must satisfy the lowest common denominator (i.e., the Commission’s standard) or offer different pricing in the United States and the EU.
In situations where competitors cannot offer the identical bundle, “[i]f the incremental price…for each of the dominant undertaking’s products in the bundle remains above the LRAIC of the dominant firm…, the Commission will normally not intervene since an equally efficient competitor with only one product should in principle be able to compete profitably against the bundle.”50 If, however, competitors offer identical bundles, or could do so in a timely manner without significant additional cost, the Commission will analyze whether the cost of the bundle as a whole is predatory.51 The Commission will consider efficiency justifications offered by the dominant undertaking, such as whether the practice produces economies of scale, reduces customers’ transaction costs or results in savings on packaging and distribution.52
Sellers offer bundled discounts for a host of pro-competitive reasons. It is widely recognized that such discounts can result in efficiencies that can be passed on to consumers. However, any seller offering, or considering offering, bundled discounts should understand that within the United States, courts have applied conflicting standards to determine whether the discounts are anticompetitive. Further, now that the DOJ has withdrawn its Section 2 Report, it is unclear how the DOJ will analyze bundling programs. While most U.S. courts and the DOJ Section 2 Report analyzed bundled discounts applying a price-cost test, other courts and the FTC have applied a more traditional rule of reason foreclosure test. Further, a particular bundled discount program may be permissible in the United States and impermissible in the EU. The EU Judiciary has long applied an analysis that does not include a price-cost test (except in cases involving predation or margin squeeze). In contrast, the Commission recently stated that it will apply a price-cost test in its enforcement decisions. Finally, the measure of cost applied by the Commission makes it more likely to find predatory pricing than the different cost measures applied by the U.S. courts (which also disagree on the appropriate measure of cost). Therefore, it behooves any seller considering bundled discounts to consult with counsel.