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Asian Antitrust

Chinese Court’s Roadmap on Vertical Monopoly Analysis: Some Comments on the Final Judgment on Rainbow vs. Johnson & Johnson Case

Zhan Hao, China Law Vision blog, August 2013.

See Zhan Hao's resume

On August 1 2013, Shanghai People’s High Court (the Court) handed down judgment on the first private antitrust action involving vertical agreements under the minimum resale price maintenance (RPM) clause of China’s Anti-monopoly Law (AML). The Court rescinded the judgment of the first instance court and ordered the US-headquartered health care giant Johnson & Johnson Medical (China) Ltd. and its Shanghai branch (collectively J&J) to pay their Beijing-based former distributor Rainbow Medical Equipment & Supply Co. (Rainbow) RMB 530,000.

This judicial decision was made against the backdrop that the recent high-profile luxury liquors case and baby formula case handled by antitrust implementing agencies of China have demonstrated a new trend of striking both horizontal and vertical monopolies, but the agencies used to invest much more efforts in investigating horizontal monopolies. The Court’s judgment marks the first official deliberation of the Chinese judicial bodies over vertical monopoly agreements. Meanwhile, the judgment has also helped to mitigate the lack of transparency of how to deal with vertical monopoly agreements by the government bodies, as the ruling has clarified the Court’s attitudes towards vertical monopolies, in particular vertical price agreements, and the analytical approach. In this sense, the judgment is of great importance.

This article aims to make comments on the J&J case from five perspectives: the divergence of the decisions of the first instance court and the appellate court, the consistent attitudes of the Court and NDRC, the application of the rule of reason, the reinforced role of the expert witness, and the calculation of damages.

I. Divergence of Two Courts’ Decisions

The final judgment is a far cry from the first instance court’s decision that was made by the Shanghai First Intermediate People’s Court on May 18 2012. The salient divergence of the two courts’ rulings is few and far between in the five-year history of the Chinese antitrust regime.

The first instance court held that for a business operator to be accountable for its conducts under the AML, there are three necessary elements: monopoly behaviors, damages, and the causation between the monopoly behaviors and the damages. In the present case, it is true that the distribution agreement between J&J and Rainbow included RPM clauses; however, to decide whether the agreement falls within the category of a monopoly agreement, one has to consider whether the agreement has eliminated or restricted competition. With regard to the competition effect of the challenged vertical monopoly behaviors, Rainbow was unable to provide persuasive evidences regarding the market share of the products in the distribution agreement in relevant market, the competition conditions and other key information; in contrast, J&J had successfully proved that there were multiple suppliers of similar products in the upstream market, which implied a decent amount of competition. Therefore, there is no compelling evidence to prove the existence of monopoly behaviors in the present case.

Has the contended RPM resulted in eliminating or restricting competition? The appellate court approached the question chiefly from four perspectives: 1) whether there is sufficient competition in the relevant market, 2) whether J&J possesses overwhelming market position, 3) what is the underlying incentive of J&J to execute RPM, and 4) what is the impact of RPM on competition. After taking all the four elements into consideration, the Court concluded that J&J’s RPM practice had directly restricted price competition in the relevant market.

Admittedly, the Court’s comprehensive analysis on the economic impact of J&J’s vertical price-fixing has not only officially confirmed the application of the rule of reason as opposed to the per se rule to vertical price agreement, but also further made clear the appropriate methodology of the rule of reason.

II. Consistent Approaches of the Court and NDRC

The decisions made by the National Development and Reform Commission (NDRC) and local Development and Reform Commissions (LDRC) and the judgment of the Court have suggested consistent approaches to vertical monopoly agreements. The antitrust agency and the Court both apply the rule of reason.

In the Notice of administrative punishment on Wuliangye, for instance, Sichuan Development and Reform Commission (Sichuan DRC) presented an analysis on the illegality of Wuliangye’s conducts primarily from the following aspects:

First, whether or not the conduct can lead to the effect of eliminating or restricting intra-brand competition? In this regard, Sichuan DRC pointed out that Wuliangye had fixed the minimum resale price and meanwhile established strict supervision, assessment and punishment measures to guarantee the implementation of minimum resale price. This practice had led to the effect of eliminating price competition between downstream distributors and undermined the economic efficiency.

Second, whether or not the conduct can lead to the effect of eliminating or restricting the inter-brand competition? Sichuan DRC dropped the answer “yes” by illustrating that the company’s behavior has played a negative role model within the industry. Some followers of Wuliangye imposed similar restrictive and punitive measures on downstream distributors. The restriction of and detriment to competition that Wuliangye had generated was worsened.

Third, are consumers’ interests and welfare compromised? Sichuan DRC held that the liquor maker had stripped consumers of opportunities to buy lower-priced goods via RMP. Especially, considering Wuliangye’s important position in Luzhou where consumers have a strong preference for white spirits and the low product substitutability, the consumers’ interests had been significantly infringed upon.

From the above-mentioned Notice, instead of determining relevant conduct’s illegality simply by the existence of relevant monopoly agreements, Sichuan DRC analyzed the harm that relevant monopoly conduct caused from the angles of market competition, economic efficiency and consumer welfare. Hence, this case is a typical example of the application of “rule of reason” in antitrust enforcement of China.

The Court’s approach of embracing “rule of reason” in vertical price monopoly case is in line with the practices in advanced antitrust regimes.

For example, in a 1977 landmark case, Continental TV, Inc. v. GTESlyvania, the U.S. Supreme Court overturned the "per se rule" but rather set up the "rule of reason” as the rule of thumb in the antitrust analysis of non-price vertical agreements. In the State Oil v.Kham case, the Court further overturned the application of the "per se rule" in maximum resale price fixing.

In the following Leegin Creative Leather Products Inc. V. PSKS, Inc. case, the U.S. Supreme Court stepped forward by holding that “rule of reason” was also applicable in the antitrust analysis on retail price fixing and minimum resale price fixing.

A couple of cases disclosed by NDRC involve vertical monopoly agreements, such as such as the luxury liquors case and the more recent milk power case. Some ongoing antitrust investigations also relate to vertical monopoly agreements. Unfortunately, the public enforcement agencies have not presented a detailed reasoning of the law application as the Court did in the judgment of the J&J case. In this sense, the principles established in the judgment may serve as a quasi-case law thanks to the case guidance system of China, notwithstanding China is not a member of the case law system.

III. Establishment of Analytical Approach for the “Rule of Reason”

The question of whether the “rule of reason” should be applied in the determination of vertical monopoly agreements has long been disputed. The Court’s judgment in this case has clarified this issue from the practical point. On top of that, the judgment has further created a set of fundamental principles for the application of the “rule of reason” in cases involving vertical monopoly agreements, which is praiseworthy.

In the second trial, the Court found that the following considerations are the most important in analyzing the nature of minimum resale prices fixing, and could be treated as a fundamental approach in assessing such conducts: (1) If competition in the relevant market is adequate; (2) If the defendant has a strong market position; (3) What’s the motivation of the defendant for fixing the minimum resale prices; (4) Competitive effect of fixing minimum resale prices. Among the aforesaid considerations, the first one is the most fundamental inquiry and only when the answer is no, should any further analysis be required.

It should be recognized that the analytical approach above established by the Court combined objective and subjective elements, by taking into account not only the motivations and market position, but also the characteristics of the relevant market, market competition environment and other macroeconomic factors. If this method is applied in the competition analysis, it can be expected that a decent “competitive effect model” could come up.

For example, in examining the market position of J&J in the relevant market, the Court conducted analysis from multiple angles, including market share, pricing power, brand influence, and control over distributors. In assessing the net competitive effect incurred by fixing minimum resale price in this case, the Court considered the obvious negative anticompetitive effects on the one hand, and examined whether obvious pro-competitive effect existed on the other hand, such as improvement on product quality and safety, mitigation of "free rider" problem, and facilitation of new entrance into the relevant market.

I am delighted to see that the courts have paid more attention to economic analysis in antitrust litigation, and this can be expected to enhance the quality and professionalism of private antitrust litigation to a significant degree.

IV. Strengthened Role of Expert Witness

Antitrust law does not only bear upon legal issues, but also economics ones. The particularity of antitrust legal practice is largely rooted in the dependency on economic analysis; or put it in another way, the economic analysis has a great influence on the antitrust analysis. In particularly, in the circumstance where the "rule of reason" is applied, there comes higher and more requirements for economic knowledge and even the knowledge about relevant industries and markets.

The characteristics of antitrust civil litigations have determined the large demands for special knowledge. 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 Conducts (Judicial Interpretation) which came into force on June 1 2012 has recognized this the reality mention above from the court’s point of view.

Article 12 of the Judicial Interpretation provides that the parties may ask for one or two professionals with relevant background to appear before the court, and present the explanations with regard to specific issues. Additionally, as per Article 13 provides, the parties may apply for the court to entrust professional agencies and professionals to conduct market surveys or provide economics analysis reports. With the permission of the court, the two parties can make an agreement on the determination of professional agencies and professionals. If no agreement is reached, the court shall make the decision. The court shall review the foregoing surveys or reports and make judgment by referring to the Civil Procedure Law and relevant judicial interpretations.

In the second trial, the appellant commissioned the Foreign Economic and Trade University Professor Gong Jiong as the expert witness. Prof. Gong participated in the second and third hearing and provided professional opinions. Although Professor Tan Guofu of Shanghai University of Finance commissioned by the two appellees as an expert witness did not participate in the hearing, he provided written opinions.

The high-profile antitrust private damage actions, including the Qihoo 360 v. Tencent case and the present case, have demonstrated the significance and full application of the expert witness mechanism, an institution established in the Judicial Interpretation. It should be recognized that the introduction of expert witness has played a crucial role in both facts finding and antitrust analysis in the second trial of the J&J case.

V. Preliminary Determination on Damage Calculation

How to calculate the damage caused by monopolistic behavior has always been a technical problem in the judicial practice of antitrust laws. The J&J case is ​​a valuable attempt for calculating the compensation of damages caused by vertical monopoly, especially in cases filed by downstream firms.

In the J&J case, Rainbow contended that in order to ensure the fulfillment of vertical monopoly agreements, J&J had implemented several punitive measures, including deducting cash deposit and terminating the distribution agreements regarding some products or even all products. The measures led to high-priced purchases, overstocked inventories, costly personnel severance pay, the loss of expected profits of 2008 and 2009 as well as the loss of 15 years’ sunk promotional costs, and many other losses. For these losses, J&J shall pay the compensation. However, the J&J denied both the charge of monopolistic behavior and the legitimacy of the antitrust damage claims made by Rainbow.

After accepting that the compensation claims related to the profits loss of suture products had an antitrust ground under the AML, the Court stated that it could not calculate the amount of damages on the basis of contract law, i.e. the damage could not be based on the profit acquired with normal performance of the contract in 2008 because this would lead to the absurd logic according to which monopoly profits is to be pursued through judicial remedies. Rainbow is only able to claim the loss of profit suffered in the case of free competition without a monopoly agreement. Because of different views of people on the economic models applied to estimation of profits in the case of free competition, and the complex realities of the market, how to calculate the amount of losses in the counterfactual scenario remains an open question even in advanced countries. The judge of the J&J case rendered an economics-based and practicable answer.

First, the court held that according to past sales records, if J&J had not stopped supplies to Rainbow in 2008, the latter would have completed its sales target.

Second, in the profitability considerations, the Court compared the prices between stitching products of J&J and the same or similar products of other brands, and found that the prices of J&J’s products were higher than the prices of other brands’ products by around 15%. Hence, the Court believed that the sales prices and profits of J&J’s products in the scenario without vertical monopoly agreements should be comparable to the prices and profits of other brands’ products, and should be adjusted accordingly.

Thirdly, given that Rainbow bears the tax burden in transactions with J&J, this cost shall be adjusted in the amount of compensation.

Considering the above factors, the Court concluded that Rainbow could acquire normal profit equivalent to 16% of unachieved sales with tax included, and accordingly the normal profit losses suffered by Rainbow due to monopoly behavior of J&J should be RMB 530,000. As for the claims made by Rainbow for the profits loss of anastomat products’ sales, loss of margin arising from high-priced purchases, and loss of anastomat products’ price subsidies, the court did not support because such losses were not caused by monopolistic behavior of J&J. To be frank, I think that the Court’s ruling is commendable even in relation to advanced antitrust regimes, as it reflects the judges’ remarkable carefulness and maturity.

The application of vertical price agreements is a widely spread practice in an array of industries in China. The setback that the practice encountered in the J&J case has spurred people’s curiosity. Will the conclusion of the J&J case prompt significant reforms of the current sales model in relevant firms? Will the anti-monopoly agencies apply the same analytical approach? We look forward to any ensuing development.

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