Over a year and a half ago, with some fanfare, the U.S. Supreme Court overruled a 1911 decision, Dr. Miles Medical Company v. John D. Park & Sons Company.1 Dr. Miles held that it was illegal per se under Section 1 of the Sherman Act2 for manufacturers to require their distributors to adhere to minimum resale prices. This practice is known as resale price maintenance, and in the lexicon of antitrust law, a practice is illegal per se only when it is so inherently pernicious that no explanation will save it. Justice Kennedy, writing for the Court in Leegin Creative Leather Products, Inc. v. PSKS, Inc,3 ruled that minimum resale price agreements would no longer be illegal per se but would be judged on a case-by-case basis under the rule of reason.4
The 5-4 decision in Leegin split down ideological lines, ending a century-old article of faith for liberal antitrust scholars. For many, the demise of Dr. Miles--the last bulwark against vertical price fixing--will sound the death knell for discounters. Since Leegin, forces on both sides of the issue have been vocal.
Tim Craig, writing in Retailing Today, suggested that the end of Dr. Miles would have a convulsive effect on retailing, forcing millions of businesses to close.5 University of North Florida marketing professor Gregory Gunlach--an expert witness for the plaintiff in Leegin--said, "What we're seeing here is the potential for a reshaping of the retail landscape in America."6
Are these theories plausible? The day after Leegin was decided, Cendant Corporation, parent of Avis and Budget Rent-a-Car, successfully moved the U.S. District Court in Alaska to dismiss a vertical price-fixing case brought against it by one of its franchisees. Citing Leegin, the district court found that while the challenged agreement might reduce competition between Avis and Budget, Avis remained competitive with Hertz and National.7
Jacob Weiss, the owner of Baby-Age.com, a seller of maternity items, said that since Leegin, 100 of his company's 465 suppliers now require minimum pricing, and a dozen suppliers no longer deal with his company. Weiss said that if the trend continues it will put him out of business.8 Brian Okin, founder of online retailer WorldHomeCenter.com Inc., said, "[I]t's becoming a nightmare operating a business."9 Okin is suing lighting supplier L.D. Kichler on grounds that its minimum price policy caused WorldHomeCenter to forego substantial profits.10 In response, Kichler states that it has no policy against discounting, so long as prices are not advertised. Okin claims that the policy selectively discriminates against online retailers because the practice of online retailing requires price posting.11
In May 2008, the attorneys general of 35 states wrote Congress asking that legislation be enacted to reverse Leegin.12 Even consumers have been dragged into the fray. In April 2008, the president of Old Mother Hubbard Dog Food Company threatened to cut off a retailer if it did not cease selling Mother's 30-pound bags at 20 cents below the minimum price of $39.99. The retailer, Morris Sussex Pet Supply, put up signage asking its customers to boycott Old Mother Hubbard Dog Food. A full 85 percent of Old Mother Hubbard customers switched brands.13
When a century-old precedent is overruled, it is cause for comment and controversy among the legal community. But in some quarters there was more than that--a reaction approaching shock. Whatever result one might have desired in Leegin,14 it is curious that Justice Breyer in his dissent should suggest that Dr. Miles ought to have been maintained on grounds that it is a "well-established...statutory precedent."15 At its conception, Dr. Miles was so tenuous a ruling that the Supreme Court tried, in effect, to undo it as early as 1919. For 70 years after that, its reasoning and validity were whipsawed from decision to decision. By the late 1980s it was clear to all but those still believing that the antitrust laws were enacted to further populist and sociopolitical aims that Dr. Miles would not survive. On June 28, 2007, Justice Kennedy pulled the plug.
Dr. Miles began with an actual Dr. Miles--a maker of "secret medicines" who was, in truth, a snake oil salesman. He controlled his business through agreements requiring wholesalers and retailers to resell at minimum prices. When a wholesaler refused to comply and inveighed other wholesalers to do the same, Dr. Miles sued for tortious interference with contract.
He was denied relief because the contracts constituted illegal restraints of trade.16 The 1911 opinion, authored by Justice Hughes, rests on two pillars. First, the agreements at issue in the case were substantially no different than horizontal agreements between dealers, and thus they had an effect akin to that produced by a cartel. Second, they constituted an impermissible restraint on alienation.17
Less than a decade later, the Supreme Court tried to undo the mischief of Dr. Miles by--as it so often does--creating more mischief. In United States v. Colgate & Company,18 the Court held that while resale price maintenance was illegal, a manufacturer could announce to the world the terms on which it would do business, including resale prices, and simply refuse to deal with those unwilling to comply. This, said the Court, was mere unilateral conduct and not subject to the antitrust laws.19 However, this was a fiction. A dealer who agreed to distribute the product of a manufacturer that had announced its price terms to the world had, at a minimum, consummated an implied contract that was per se illegal under Dr. Miles.20
The conundrum remained unresolved for decades. In opinions stretching from 1920 to 1960, the Court restricted Colgate's already limited utility, culminating in United States v. Parke, Davis & Company.21 In that case, the Court held that while a manufacturer could announce the price terms on which it would do business, under no circumstances could it do more than that, such as enforce the terms. Parke, Davis & Company, a national distributor of pharmaceuticals, decided not only to exercise its Colgate rights but to enforce them. Justice Brennan held that in so doing, the company had "put together a combination in violation of the Sherman Act."22 This was because enforcement goes beyond the mere "unilateral act" of refusing to deal with those who refuse to comply. So, after Parke, Davis & Company, a manufacturer could announce its terms, sign up wholesalers and retailers and, if they failed to comply, take one of two steps: 1) do nothing, or 2) seek enforcement and risk a private, treble damages antitrust suit. Justice Brennan and the majority effectively overruled Colgate. But this did not restore Dr. Miles to good health.
Case Law Presaging the End of Dr. Miles
The death of Dr. Miles lies not in the law of resale "price" restraints but resale "nonprice" restraints. "Resale nonprice" restraints--such as territorial restrictions--are a subset of what are called vertical restraints. Five decisions chart their course.
In 1963 the Supreme Court decided White Motor Company v. United States.23 White, a maker of custom-built trucks, sought to maximize sales through franchise agreements employing territorial and customer allocation restrictions. The justice department claimed the restraints were per se illegal under the Sherman Act, but the Court disagreed. Adumbrating modern antitrust analysis, Justice Douglas opined, "[T]his [Court]...know[s] too little of the actual impact of... that restriction...to reach a conclusion on the bare bones of the documentary evidence before us."24 Justice Douglas was effectively saying that the form of a restraint (in this case, vertical) will not necessarily doom it if its actual impact is not anticompetitive. But what the Court giveth, the Court taketh away. And four years later it did just that.
In United States v. Arnold, Schwinn & Company25 Justice Fortas delivered a tangled opinion holding certain resale nonprice restraints illegal per se. Schwinn sold to wholesale distributors both outright and on consignment, employing territorial restrictions and confining sales to franchised Schwinn dealers. Fortas's reasoning was formalistic--a stark counterpoint to that of Justice Douglas in White Motor Company. In a nod to Dr. Miles, Fortas hung his hat on alienation. Where Schwinn departed "with title, dominion, or risk with respect to the article," the restraint was illegal per se. But in all other circumstances he declined "to introduce the inflexibility which a per se rule might bring if it were applied to prohibit all vertical restrictions of territory...where the manufacturer retained ownership of the goods...."26 This reasoning may have something to do with property rights; it has nothing to do with competition and antitrust law.
In 1977 Schwinn was overruled in Continental T. V., Inc. v. GTE Sylvania Inc.27 The Continental decision marks the Court's final and decisive rejection of per se illegality in the area of resale nonprice restraints. The case emerged when Sylvania sought to increase its market share by selling to franchised retailers bound by location clauses under which they could sell only from certain locations. When Continental was forbidden to sell Sylvania products through one of its new outlets, it claimed the location clause was illegal per se under Schwinn. Justice Powell, writing for the majority, disagreed.
The Continental opinion is groundbreaking. It rejects Schwinn's formalistic distinctions and relies instead on economic reasoning and business efficiency as key elements in antitrust analysis. And while Justice Powell conceded that certain vertical restraints may restrain "intrabrand" competition (that is, competition among retailers selling the same brand), he recognized that they may also create fierce "interbrand" competition (competition among retailers selling different brands), thus mitigating anticompetitive dangers.28
Continental was the beginning of the end for Dr. Miles. The ensuing decision in Monsanto Company v. Spray-Rite Service Corporation29 is illustrative. Spray-Rite claimed it was terminated following complaints of price cutting by fellow distributors. Spray-Rite alleged a vertical price-fixing conspiracy between Monsanto and its other distributors. Monsanto said Spray-Rite was terminated because it failed to hire a trained staff and promote sales. Monsanto moved that the case be dismissed outright, citing no evidence of a price-fixing scheme. Prior to Monsanto, the mere fact of a complaining competitor followed by termination would have been enough to proceed to trial. In Monsanto, Justice Powell declared that plaintiffs would henceforth be required to adduce "evidence that tends to exclude the possibility of independent action by the manufacturer and distributor." Moreover, "there must be...evidence that reasonably tends to prove...a conscious commitment to a common scheme designed to achieve an unlawful objective."30 Monsanto ensures the gains made in Continental. It protects manufacturers using procompetitive nonprice restraints (such as requiring retailers to maintain trained staff) from the threat of treble damage awards when there is no evidence of collusion.
Finally, in 1988 the Court held in Business Electronics Corporation v. Sharp Electronics Corporation31 that it is not illegal per se for a manufacturer to terminate a discounting dealer at the insistence of a premium dealer, even if it means higher consumer prices, so long as the vertical agreement between the manufacturer and premium dealer does not contain an actual agreement on price. Business Electronics was terminated by Sharp after Sharp received complaints from a rival dealer about price cutting. Business Electronics claimed the real reason was a price-fixing agreement between Sharp and the rival dealer, but the agreement between Sharp and the rival dealer had no price component. Instead, the agreement required servicing, repair, and product demonstration.
Justice Scalia, writing for the majority, opined that "a vertical restraint is not illegal per se unless it includes some agreement on price or price levels."32 Under Justice Scalia's analysis, Sharp could exercise its unilateral Colgate rights and terminate Business Electronics for discounting to ensure the premium dealer's financial ability--through higher prices--to engage in nonprice activity essential to brand integrity. While the entire arrangement could lead to a higher price, it was not illegal per se under Dr. Miles.
After Business Electronics, the writing was on the wall: All vertical restraints would eventually be decided under the rule of reason.33 To understand why, it is necessary to survey the economic debate that allowed the Leegin Court to do what it did.
The Economics of Vertical Restraints
Settled law holds that restraints of trade having no effect other than to decrease output and increase price should under no circumstance be tolerated.34 Thus, price fixing and divisions of territories, when effected horizontally, are justly deemed illegal per se.35 But in the area of vertical restraints the analysis is different.
Horizontal arrangements exist between parties who compete for market share at the same level of distribution. They are usually implemented with the intent and effect of decreasing output while raising costs to consumers.36 In contrast, vertical arrangements are not typically between competitors. Rather, manufacturer and retailer may be cast as partners or joint venturers, together seeking optimum sales and distribution of a product. In this light, vertical restraints are but a tool in the distribution process. Whether a manufacturer places restraints on independent retailers or integrates forward, building its own retail network, it has no apparent incentive to restrict output.37
However, can it justly be said that because a manufacturer builds its own distribution and retail network it should also have unrestricted control over independent distributors? An independent retailer obtains efficiencies through its own business decisions; for example, how it structures its financial base, its choice of employees, its policies on customer service, its product-line decisions, where it will locate, and its choice of target customers. Wise choices create efficiencies leading to greater distribution and lower prices, thus stimulating competition. But when pricing and distribution are determined solely at the manufacturing level, efficiencies may go unrealized. This is not easy to rationalize.38
For example, a low markup policy will generate increased sales. Increased sales not only enhance retail profits but create efficiencies upstream at the manufacturing level. Perhaps, then, the integrated manufacturer is likely to take advantage of efficiencies in its own retail operations in order to maximize sales.39 Assuming this to be true, it is fair to ask why a manufacturer would forego these benefits when its distributor or retailer is independent. Indeed, some have argued that because the manufacturer's natural concern is to maximize return, it will often seek retailers and distributors who can market and distribute its product at less cost than the manufacturer can on its own. Arguably, when this benefit is achieved, the manufacturer's interest will not lie in requiring the retailer to increase the price of the product. The natural consequence of this action would be a reduction in sales to the retailer and ultimately in revenue to the manufacturer as requests for orders falter.40
Nevertheless, the commercial reality is that few manufacturers distribute through a single source. Moreover, discord among retailers can wreak havoc upon a manufacturer's business. Intense intrabrand competition may drive a price down to a point at which distributors and retailers, themselves unable to sustain a return, demand that the manufacturer cut its wholesale price.41 This may be feasible in some cases, but not if the manufacturer operates on a thin margin. Resale price maintenance can alleviate this situation by stabilizing retail prices.
Indeed, broad-based assumptions about vertical restraints are imperfect and unwise. For example, a major objection to vertical restraints is that they facilitate cartelization at both the dealer and manufacturing levels.42 A cartel of retailers can deter holdouts from the cartel by enlisting manufacturers to impose resale price maintenance. Thus, in this argument, resale price maintenance stabilizes the cartel, and defection--in the form of price cutting--becomes more difficult.43 Resale price maintenance also is said to effectuate manufacturer cartels because it removes the incentive to cheat and, if cheating occurs, makes it more readily apparent. A manufacturer will not defect from a cartel unless its cut in price can be passed on to consumers--and this is impossible when resale price maintenance is in place. Moreover, policing the cartel becomes easier because a cut in price at the point of sale is likely due to a defection.44
These arguments, however, are ill-conceived. They rely on naked horizontal restraints. It makes no sense to condemn horizontal restraints and vertical restraints if, standing alone, the latter is found to enhance efficiency. Joint ventures may facilitate a "conspiracy," yet joint ventures are not so readily condemned.
The question of cartelization has been addressed directly by Robert Bork, who shows that when retailers carry a multiplicity of brands, an effective cartel would generally require fixed prices for all or most of them, necessitating the cooperation of numerous manufacturers in the resale price scheme. Not only would such an arrangement be almost impossible to manage,45 but it is illogical to assume that manufacturers will be easily seduced into participating in dealer conspiracies designed to restrict output.46 A high markup, low volume program is not in a manufacturer's best interest.
Bork believes that resale price maintenance is not a necessary means of policing manufacturer cartels. Dealers usually carry more than a single brand of any given product and "continually play one supplier off against another...." Thus, when a manufacturer cheats on the cartel, cutting its price to dealers, the dealers are likely to demand similar cuts from other manufacturers--and thus, in the process, exposing the defector.47
The most widely offered justification for vertical restraints (and resale price maintenance) is that they prevent "free riding." In the typical free-ride situation, dealer A has invested a substantial sum in maintaining adequate sales staff, repair services, and promotional devices, all desired by the manufacturer. Dealer B, selling the same product, is a discounter and provides no point-of-sale services. In this scenario, potential customers may learn about the product through Dealer A's advertising, partake of A's demonstration program, and educate themselves with A's brochures, but the purchase will be through Dealer B, the discounter.48
This is anticompetitive because, eventually, the point-of-sale services and promotional devices employed by Dealer A are necessary to provide proper product reliability and to engender goodwill among the manufacturer's target customers. Dealers will not long incur the costs of maintaining necessary point-of-sale services when discounting rivals, constrained neither by resale price maintenance nor the costs of providing such services, consistently underbid them.
The result is that ultimately no dealer provides these services, product reliability and appeal falter, and sales are lost, leading to reduced output and decreased interbrand competition.49 Proponents of resale price maintenance argue that it prevents this unfair result by not only foreclosing discounters but also providing retailers with increased profits, enabling them to engage in service and promotional activity that will actually increase demand and output.50
But is this a universal truth? Professor Robert Pitofsky has argued persuasively against resale price maintenance as a viable remedy for free riding. He cites not only what he sees as the pernicious cartel-like effects of resale price maintenance, but that it is probably incapable of inducing the activity that its proponents applaud. Pitofsky questions whether increased profits with respect to any given item will cause a retailer, selling perhaps thousands of items, to increase the level of its service or promotional activity.51 Moreover, assuming less than perfect nonprice competition, what is to prevent the retailer from simply pocketing increased profits?52 Pitofsky argues that since retailers form the front line in customer contact, it is they who are best able to determine what services are needed to achieve optimum sales. When services are necessary, they can easily be contracted for separately between retailer and customer.53
This sampling of competing perspectives suggests at least some, or perhaps much, justification for the Leegin Court's decision, which is focused almost entirely on traditional retailing. Curiously absent from the Court's analysis was a consideration of whether the advent of online retailing will affect the arguments for or against resale price maintenance.
While online retailing remains relatively new, several themes have emerged regarding the issue of vertical restraints. Generally, online retailing can be said to have three laudable characteristics: lower operating costs, the instant availability of price comparison, and broad and immediate product advertising and distribution, well beyond even catalog mailings.54 Is it a forum ripe for free riding and hence a justification for resale price maintenance? There is evidence to suggest this is so.
The classic example is the shopper who visits brick-and-mortar establishments to check out a product firsthand but who buys the product online at a reduced price. One study suggests that over a quarter of online buyers investigate their purchases at brick-and-mortar establishments before buying online.55 In effect, these purchasers are free riding on the investments of shop retailers in their establishments.
Still, some have suggested that free riding can work both ways in the world of e-commerce. For example, a potential buyer can sample music or books online, read online reviews and ratings, and eventually drive to the local music or bookstore to make the purchase.56
Yet another issue arises when a manufacturer sells its product through both brick-and-mortar specialty retailers and online catalogs. The services offered by the online retailer are static and represent fixed costs57--no shop need be leased nor expenditures made for a trained sales staff or expensive décor, not to mention upkeep. But the costs of actually running a store--such as hiring employees and training them to explain luxury goods or to demonstrate specialty electronics--constitute a variable cost well beyond what the online retailer must bear.58 When a manufacturer decides to dual-track its retailing, the existence of the specialty shop remains essential to maintaining brand perception and, consequently, sales. In these cases, resale price maintenance may be an appropriate means of protecting brick-and-mortar retailers and, in the process, ensuring brand integrity.59
The broader question is the future of traditional retailing. The continued existence of the retail shop does not seem in doubt. First, a large segment of the population enjoys the traditional, physical experience of shopping. Second, buyers who simply will not purchase a good they have not first touched and examined will remain a contingent with which retailers must reckon.
Nevertheless, an increasing number of manufacturers of consumer goods of all kinds are vertically integrating, selling online and only through their own specialty outlets. These firms need not deal with independent wholesalers or retailers; they can dual-track sales online and at the mall, all the while controlling point-of-sale pricing without regard to vertical pricing agreements. This is even more true for those manufacturers that have decided to forego all independent forms of distribution and sales, selling to and servicing the public directly and exclusively online.
Thus, the overruling of Dr. Miles was long overdue, since commercial realities rendered its utility questionable. For the massive discount retail industry that has emerged over the last generation, the end of Dr. Miles and the per se rule will likely have little effect.