Managing Your Channel under the PRC Antimonopoly Law By Lefan  GONG 2009-09-16

With the new Antimonopoly Law (AML) effective on August 1, 2008, manufacturers, distributors and others are now subject to new rules that may significantly change their existing ways of doing businesses. Some of the automakers in China reportedly have already started making changes to agreements with their dealers to be in full compliance with the new law. Antimonopoly lawsuits were filed just within a few days after the AML took effect, marking a start of a likely new wave of litigations in China against large corporations, trade associations and even government agencies.

In particular, the AML will likely have a profound impact on channel management. For instance, Article 14 the AML prohibits “monopoly agreements” that fix resale prices or specify minimum resale prices. Now a host of questions emerge: can a company use methods other than “agreements” to impose minimum resale prices on its distributors? Can a company suggest and advertise minimum retail prices for its products? Can it terminate those distributors that fail to obey such “suggested retail prices”? Can a franchisor continue to impose price and territorial restrictions on its franchisees?

Apparently, many currently existing supply chain and distribution practice would need to be reevaluated and probably modified or adjusted in light of the AML. Some may now be illegal, while the other may appear problematic on the surface but would require analysis to determine whether they are legal under the AML.

The challenge is, purely looking at the black letter text of the AML can hardly lead to any conclusive observations to practical questions and issues companies are faced with, such as those mentioned above. The 57-article AML only lays out the principles of the new antimonopoly regime and leaves many questions unanswered. Although many may be anxiously awaiting any implementation rules to provide better guidance, companies may not have much time left to delay the process of reevaluating their current channel arrangement and distribution policy especially when facing possible antimonopoly litigations.

This article discusses commonly used vertical restraints in China and provides observations how they may be viewed in light of the AML, with the aim to ease the burden on companies speculating how they should adjust their strategies without substantially compromising their competitive advantages and legitimate business interests.

Rule of Reason?

The AML does not clearly distinguish the concepts of interbrand competition vis-à-vis intrabrand competition, and “illegal per se” vis-à-vis the rule of reason doctrine. Manufacturer-imposed requirements can benefit consumers by increasing competition among different brands (i.e., interbrand competition) while reducing competition among distributors or dealers in the same brand (i.e., intrabrand competition). Agreements among competitors to limit price or allocate territories (also known as horizontal restraints) represent a form of interbrand competition and are almost always reducing competition and therefore illegal. Reasonably limiting intrabrand competition, however, may foster better services rendered to the customers, higher quality marketing efforts for the products and ultimately stronger position in the competition with the other brands. This is why in countries like the U.S. many courts often adopt a “rule of reason” approach when weighing the benefits of vertical restraints against any reduction in competition from the restrictions.

For example, if some of the retailers furnish quality services to customers, the discounting retailers may free ride on those retailers by capturing such increased demand that those high quality services providers have helped generate. Conversely, if any distributors or retailers can freely lower the price without any restrictions, a nasty price war could implode within the same brand undermining the incentives for distributors and retailers to invest in product promotion and service quality and ultimately jeopardize the brand image in the market.

So does the AML also adopt or embed a “rule of reason” principle? It is not expressly provided, but appears to be embedded in some of the provisions. Article 15 sets out a non exhaustive list of exemptions for horizontal and vertical restraints prohibited under Articles 13 and 14. For instance, if a company can prove that the [price-fixing] agreements are “for purposes of enhancing product quality, reducing costs, increasing efficiency, unifying the product specs and standards, or specialization”, then Articles 13 and 14 will not apply.

It is important to fully understand such embedded principle when a company is evaluating its channel arrangement and distribution policy. Unlike some of the other laws and regulations, “overdoing” your compliance efforts under antimonopoly law is unnecessary and onerous, and could risk eroding your competitive edge on the market.

Non-price Vertical Restraints

It is interesting that none of the non-price restraints, such as restraints on customers and territories, areas of primary responsibility, exclusive dealership, are included in article 14 as illegal “monopoly agreement” on the “vertical” food chain, while some of those activities are expressly prohibited under article 13 as illegal “horizontal” monopoly agreement.

The legislator might have decided to leave it out and let the antimonopoly authorities to decide through one or more implementation rules of the AML. A more likely reason may be many of those non-price vertical restraints will pass muster of the “rule of reason” analysis as they are often beneficial for promoting efficiency and interbrand competition.

As a result, vertical restraints often seen in franchised operations may not be treated under the AML as prohibited “monopoly agreements”. Even if the franchised operations impose minimum resale prices or service prices, it might be exempted pursuant to article 15 as it is applied for purposes of “enhancing product quality, reducing costs, increasing efficiency, unifying product specs and standards”.

Resale vis-à-vis Consignment

Article 14 of the AML prohibits fixing resale price or specifying minimum resale price through monopoly agreements. In practice, however, there are activities such as consignment and sale through agents, which bear resemblance to resale but essentially distinctive from resale. From the legal perspective, a seller under a consignment arrangement supplies his product or commodity to a dealer while actually retaining title and control. Since such seller remains the legal owner, there is no “sale” from the supplier to the dealer or agent, and as a result no “resale” from the dealer or agent to the ultimate customers. In other words, the final sale is between the supplier and the final customers.

The relationship between airline and travel agency is another good example of such agent arrangement. The airline may legally fix the price at which the travel agent resells the tickets to customers if such travel agent acts as a representative for and on behalf of the airline.

Although this may be subject to further clarification through implementation rules, it appears reasonable for us to conclude consignment or agent arrangement should not be treated as “resale” for purposes of article 14 and therefore supplier may fix price as it sees fit.

Agreement Requiring Minimum Resale Price

In the context of horizontal restraints agreed to by competitors, requiring minimum resale price is illegal per se under the U.S. antitrust law. Article 13 of AML prohibits such agreements of fixing or changing commodity prices, limiting product output or sales, dividing sales markets or supply sources of raw materials, group boycotts and so on. Although a party to such agreement may cite one or more exemptions under Article 15 to rebut the applicability of Article 13, it would usually be hard to argue such horizontal restraints would NOT impair competition and would benefit consumers – a requirement imposed under Article 15.

For vertical restraints, the rule of reason principle would be more relevant in evaluating a requirement of minimum resale price is legal or not. As discussed above, this is largely due to the fact that reasonably limiting intrabrand competition among the distributors or retailers may help increase the competitiveness of the products and enhance the service quality rendered by the distributors or retailers. So if a company can successfully make a good argument under Article 15, its agreement fixing minimum resale price may not be viewed as violation of Article 14.

So what would be “unreasonable” limitation of intrabrand competition which might run afoul of article 14? There is no clear answer solely from the reading of article 14 and 15. Under the US law, it is illegal to enter into an anticompetitive agreement between an entity and other firms (such as its distributors) that provides for termination or exclusion of any firms that sell products under the agreed minimum resale price(s). A manufacturer is often under pressure and even coercion of dealers and distributors to “cut off” those that sell a product below agreed minimum price or suggested retail price. Lawsuits are often filed by those terminated entities against such manufacturer and assertive dealers for violation of antitrust law, and the courts tend to support the plaintiffs under such circumstances.

Unilateral Action to Require Minimum Resale Price

The reading of both article 13 and 14 indicates that only monopoly agreement that requires minimum resale prices is illegal. This could be interpreted that a unilateral act or a single firm conduct that sets a minimum resale price rule or policy may be legal so long as such act or conduct does not otherwise violate Article 17, which prohibits abusive activities by dominant market players. A good example is manufacturer setting a “suggested retail price” or publicizing a “pricing guideline” for the distributors to follow.

Under the U.S. law, a fundamental tenet under the Shearman Act is that there must be an agreement between two independent entities which restrain trade. In other words, an agreement on pricing must exist for a court to rule whether the alleged resale price maintenance is unreasonable.

This means if the supplier unilaterally sets a minimum resale price, and the distributor voluntarily decides to follow such pricing policy, there is no “monopoly agreement” between the two parties. But if the supplier acts in concert with one or more distributors on pricing, an “agreement” could be deemed in existence.

Under the U.S. law, it is clear that a manufacturer can announce its resale prices in advance and refuse to deal with those who fail to comply. And a distributor is free to acquiesce in the manufacturer’s demand in order to avoid denial of business or future termination. It may also be legal for the manufacturer to terminate the disobeying distributor if such termination is not the product of an anticompetitive agreement with other firms or part of a predatory or exclusionary strategy to acquire or maintain monopoly.

However, if the supplier goes beyond such unilateral conduct and uses threats of termination and other “coercive” tactics that interfere with the distributor’s pricing independence, it runs the risk that a “coerced” agreement between the two will be found, resulting in a finding of an “agreement” and antitrust violation.

It is unclear whether the Chinese courts and antimonopoly authorities would take a similar approach and rule that unilateral announcement of minimum resale price plus supplier’s coercion on distributors are equal to an “agreement” of monopoly.

Promotional Allowance and Resale Prices

Can a supplier grant a temporary reduction in the wholesale prices in conjunction with a policy of suggested retail prices? Is it permissible under AML for a supplier to tie marketing allowance for distributors with their obedience to the “suggested retail price”? Can a supplier deny a distributor’s request for reimbursement of advertisement available for all distributors, due to such distributor’s failure to sell products above “suggested retail price” or failure to avoid statements in the advertisement suggesting price competition?

A common wholesale pricing practice is to grant a temporary reduction in the supplier’s wholesale price to enable the distributor to respond to local retail price competition. Often such reduction of wholesale price comes with a policy of suggested retail prices. Under the US law, there could be issues of possible violation of antitrust law if such “dealer assistance” support is denied by the supplier as punishment for a distributor’s failure to charge the suggested resale price. Again, the AML is not clear on the practice of suggested retail price and how it views “coercive” method and unilateral conduct on applying minimum resale price. However, providing allowance as a quid pro quo for sticking to a (minimum) retail price suggested by the supplier arguably constitutes an agreement under article 14 of the AML, unless it is subject to exemptions under article 15.

For promotional allowance, if the supplier requires that distributors must include “suggested retail price” or otherwise avoid statements suggesting price competition, such requirement in and of itself does not amount to a monopoly agreement “specifying minimum resale price” under article 14 of the AML.

Conclusive Observations

As proven in countries with longer history of competition law, the practice of antimonopoly law is often much more complex than the text body appeared in the statute. This may be a reason why the Supreme People’s Court issued a notice on July 28, 2008 on “studying and implementing” of the AML, stressing that antimonopoly cases are “highly complex, with both economic and legal issues intertwined, requiring highly specialized expertise and bearing significance to both enterprises and industries”. Recognizing the available [AML] rules are fairly simple, the notice goes on to exhort courts at all levels to “get well prepared” to handle antimonopoly cases and report new issues to the Supreme People’s Court.

Channel management has widespread implications for companies, and it is an area where the antimonopoly legal reasoning often intersects with economic rationalization. Most of the examples and analyses on channel operations as discussed in this article are not clearly written in the body of the law, but will likely crop up when companies try to comply with the new requirements of the AML.

Because of the involvement of economic elements such as the balancing of intrabrand competition and interbrand competition, the antimonopoly rules must leave adequate breathing room for reasoning. Although many are holding their breath for the implementation rules of the AML, chances are, due to the nature of the antimonopoly law itself, none of the statutory and regulatory rules would likely provide cookie cutter answers. It is unrealistic to expect that those implementation rules would be granular or precise enough for anyone to solve problems without in-depth analysis of balancing all the elements under the principles reflected in the AML. Companies should consult antimonopoly specialists to reformulate their channel management strategies. Although they should watch out for compliance issues under the AML, they should also take note that unwarranted strict and broad application of the text of AML without fully understanding the embedded principles could be an onerous burden for a company and undermine its business goals and competitive edges.