Still Unclear Path Forward – Resale Price Maintenance under the AML and Recommendations for Companies

By Liu Cheng Swita Gan Yu Zhenzhen King&Wood Mallesons’ M&A Group

Since the Anti-monopoly Law of the People’s Republic of China[1] (“AML”) came into effect, there has been much debate about the circumstances in which minimum resale price maintenance (“RPM”) will constitute a vertical monopolistic agreement prohibited by Article 14 of the AML. In the debate, the most contentious issue is whether RPM should be regarded as per se illegal or if the “rule of reason” doctrine[2] should be adopted to assess on a case-by-case basis, whether the RPM is illegal.

In reviewing the AML, it can be seen that RPM is one kind of vertical monopolistic agreement, as categorized by Article 14 of the AML. Article 13 of the AML defines monopolistic agreements as “agreements, decisions or other concerted practices that eliminate or restrict competition”. This definition apparently covers vertical monopolistic agreements listed in Article 14. However, opinions differ when it comes to assessing the illegality of RPM. The different opinions can be simplified into two distinct lines of thought: (i) whether the act of RPM is a monopolistic agreement that eliminates or restricts competition definitely with no need to further decide its effect on competition (i.e. to adopt the per se illegal rule) or (ii) whether the act of RPM itself should not be deemed as illegal and a rule of reason approach should be adopted to comprehensively evaluate its effect on market competition, to determine whether or not it constitutes an illegal monopolistic agreement.

I. Application of Rule of Reason to RPM in Judicial System

Despite the debate, the tendency of applying the rule of reason doctrine to determine the legality of RPM appears to be clear on the judicial side. On August 1, 2013, being the AML’s fifth anniversary since it came into effect, the Shanghai Municipal High People’s Court (“High Court”) made its second-trial judgment on the case Rainbow Technology and Trading Co., Ltd (“Rainbow”) v. Johnson & Johnson (Shanghai) Medical Devices Co., Ltd and Johnson & Johnson (China) Medical Devices Co., Ltd (collectively “Johnson & Johnson”) (the “Johnson Case”), in which the High Court clarified that the effect of eliminating or restricting competition must be proved to determine RPM constitutes a vertical monopolistic agreement. It further summarized several factors used in analyzing the anti-competitive effect of RPM (these are outlined below). This judgment confirmed the view that RPM should be analyzed with respect to the rule of reason principle in China. Based on our knowledge, the High Court has taken the advice from China’s Supreme People’s Court (“Supreme Court”) regarding certain key issues in the Johnson Case. Therefore, it is very likely that the High Court’s Judgment reflects the opinions of the Supreme Court on the key legal issues in the case and will be important references for other local courts dealing with similar cases in the future.

Indeed, the first-trial court of the Johnson Case expressed the opinion that determining whether a monopolistic agreement was prohibited by Article 14 of the AML should not merely be based on the fact that a company concludes an agreement for fixing or maintaining resale prices with trading counterparties. Determining instead, the effect of eliminating or restricting competition should be considered for such a determination. [3]

In the second trial of the Johnson Case, the High Court stated that the anti-competitive effect should be considered to determine whether RPM constitutes a monopolistic agreement as prohibited by Article 14 of the AML. The following factors should therefore be comprehensively assessed for such a determination: 1) whether competition in the relevant market is sufficient, 2) whether the company conducting RPM has a strong market position, 3) whether the company has a motive to restrict competition, and 4) whether the conduct has an adverse impact on competition in the market.

1. The Competition Status in the Relevant Market

The High Court considered that insufficient competition in the relevant market is the first and foremost condition to determining whether RPM is a relevant violation.

In a fully competitive market, customers must have plenty of choices when purchasing products. With such a scenario in mind, a company engaging in RPM may affect customers who buy its products. However, it will not hinder customers who choose to buy substitute products from other companies. Accordingly, the consumer welfare and social and economic efficiency is unlikely to be harmed by one company engaging in RPM in a fully competitive market. Further, RPM may otherwise force distributors to promote sales services. In respect of this, the efficiency brought by RPM can, in most cases, offset and surpass its adverse impact on competition.

In contrast, in a market with insufficient competition with a lack of adequate alternative products, customers normally rely on one brand or a few brands. In such cases, maintaining the resale price of one brand will not only weaken the intra-brand price competition, but will facilitate tacit understandings between producers of different brands on pricing, or make them lose their motive for price competition. This may lead to increasing of prices or the maintenance of prices at relatively high levels which, in turn, may damage customers’ interests and economic efficiency.

2. The Market Position of the Company Conducting the RPM

The High Court’s judgment also made it clear that a company’s market position is another factor to be considered when assessing the illegality of RPM.

The High Court ruled: a company’s power in a market is the basis for its pricing activities affecting market competition. If a company has no advantage in respect of market share, the supply of raw materials, key techniques, distribution channels or brand influence, this company cannot be regarded as having the power to affect market competition.  Consequently, RPM behavior by the company is unlikely to affect market competition, or it may have some adverse influence in a short period and within a limited scope but the competition status will be adjusted by the market itself within a short time.

The High Court adopted the “strong market position” criterion for the determination of illegal RPM. It is ambiguous whether this criterion is the same as or different to the “dominant market position” standard. However, in general, we consider this criterion will be easier to meet than the “dominant market position” criterion under the AML because “strong” seems to imply a lower threshold than “dominant”. According to the AML, a company having a dominant market position normally means that that company has a market share of no less than 50%. While the High Court concluded that if a company has relatively strong pricing power in the market, has an absolute advantage over purchasers in price negotiations and is able to not follow the market price, that company can be regarded as having a sufficiently strong market position to enable it to affect competition. Adopting that rationale, a company with a market share of less than 50% may be found to have a strong market position.

3. The Motive for Restricting Competition

The third factor to be considered is the motive for restricting competition. The High Court explained that, when a company has a strong market position, the motive for restricting competition is another significant factor in determining whether RPM has anti-competitive effects. This is because, as mentioned by the High Court, a company with a strong market position normally has advantages in respect of finance, technology or information, and usually has strong power to control the upstream or downstream industries. If such a company conducts RPM for the purpose of eliminating or restricting competition, it is highly likely that its conduct will adversely impact competition.

4. The Adverse Impact on Competition in the Market

The fourth factor for the determination of RPM constituting a violation is whether it has an adverse impact on market competition. Based on the rule of reason principle, the High Court held that RPM has both pro-competitive and anti-competitive effects. With regard to the anti-competitive effects, some of them can be quickly adjusted by the market itself, while others can be off-set by pro-competitive effects. The High Court therefore concluded that it is only when the anti-competitive effects generated from RPM are difficult to be adjusted by the market or off-set by pro-competitive effects that RPM should be deemed as an illegal monopolistic agreement.

It is the first time that the High Court’s decision clarified the anti-competitive and pro-competitive effects of RPM. Anti-competitive effects include effects of restricting intra-brand price competition, restricting the freedom of distributors to set their prices and facilitating price cartels, resulting in excessive advertisement and services, etc. The first and second effects, the latter of which may facilitate price cartels that limit inter-brand price competition, are the key elements in determining whether competition in the market is materially impacted.

The pro-competitive effects of RPM include the prevention of distributor “free-riding”, facilitating new brands or products entering the market, promoting the competition of product quality, safeguarding goodwill, providing unified price information to customers, improving the development of distributors and building distribution channels and protecting against discount sales of competitors, etc. Among these effects, the first, second and third ones are the key elements for determining the pro-competitive effects of RPM, as concluded by the High Court.

II. NDRC’s Attitude on RPM

On the other hand, in contrast to the clear interpretation by the High Court on the judicial side, the attitude of the National Development and Reform Commission (“NDRC”)[4], the administrative enforcement agency against price-related monopolistic behaviors, is still vague on which doctrine (i.e. per se illegal or rule of reason) shall be used to assess RPM.

Early 2013, NDRC’s local counterparts in Sichuan Province (“SDRC”) and Guizhou Province respectively announced their decisions to impose fine on two famous Chinese liquor companies, Maotai and Wuliangye, for RPM. SDRC announced in its decision that Wuliangye had set the minimum price for distributors reselling its brands of alcohol to customers by taking advantage of its strong market position. Such actions had the effect of eliminating and restricting competition in the relevant market, harming customers’ interests and thus constituted a violation of Article 14 of the AML. Although the reasoning is relatively brief, it reflects SDRC’s consideration of Wuliangye’s strong market position as a factor in determining the violation by Wuliangye.  Instead of directly determining Wuliangye’s RPM as per se illegal, SDRC analyzed the impact of Wuliangye’s activity on market competition, and found the violation after considering the strong market power of Wuliangye and the anti-competitive facts of its conduct. This seems to indicate that a rule of reason approach will also be adopted when NDRC (including its authorized agencies) determine the illegality of RPM.

However, the public information available about the more recent investigation by NDRC of Beingmate, Dumex and other milk powder companies (the “Milk Powder Case”), do not include the NDRC’s detailed reasoning for the penalty decision (i.e. the publically available information does not include analysis of the effects on competition of milk powder companies’ illegal activities, or estimates of their market shares in China, their market positions or their ability to control their distributors, etc.).  It is unclear to us, based on the publically available information, whether NDRC had adopted the similar rule of reason approach in this case.

However, the Milk Powder Case involved a number of milk powder companies, and from an ordinary consumer’s perspective, it seems that not each of those companies has a “market position” that enables them to affect competition in the market.  If a rule of reason assessment were to be applied to every single company punished in the Milk Powder Case, it is questionable whether they would have engaged in a violation.

If we follow this logic, it seems that NDRC may not have adopted a rule of reason approach to determine the illegality of every single company in the Milk Powder Case and, instead, adopted an approach which is more like regulating the pricing conduct across the whole industry.  Of course, this is just conjecture on our part, based on information available on the public record.  We see benefit in the AML enforcement agencies providing further clarity about how they intend to interpret the legal rules during future investigations, so that companies may better participate in market competition while taking steps to ensure they comply with the Law.

III. Comments and Recommendations

Given the potential different principles between judicial interpretation and NDRC’s enforcement practices in relation to when RPM will be illegal, companies, especially those with a relatively large presence in markets in China, may wish to adopt a relatively conservative approach to reduce the risk of violations of Article 14 of the AML.

In general, under the current regime, we recommend that a company avoid engaging in RPM.  RPM is not limited to explicitly agreeing minimum resale prices in distribution agreements or dealings with distributors, and also includes fixing or restricting the amount of profit the manufacturers/suppliers can gain from the sale, agreeing the formula for calculation of resale prices, limiting discounts offered by distributors or charging distributors fees which are higher than the average amount.

Some large manufacturers/suppliers include a “suggested retail price” clause in their distribution agreements, including to protect the value of their brand, and at the same time, impose “penalties” on distributors who do not apply the “suggested retail price.” The “penalties” may include reducing commissions, suspending supply or threatening to cease co-operating with the distributor in question.  All these activities may be deemed to be resale price maintenance under Article 14 of the AML, especially where the activities amount to “industry practice.”

Considering the High Court’s decision in the Johnson Case, the following factors may be available to companies as defenses when being investigated for RPM:

a)    The relevant market is fully competitive, as evidenced by 1) a relatively large numbers of suppliers of the product and fierce competition between them; 2) the distribution market is fully competitive, i.e. there is an adequate number of distributors for suppliers to access and the distributor management systems designed by suppliers will not hinder free competition between distributors; and 3) clients or customers can alter or choose different brands or distributors freely.

b)    The company does not have a strong market position in the relevant market. Although the High Court has not clarified the method for deciding whether a company has a strong market position, we believe there is a high possibility that a company may be found to have such a market position if that company ranks No.1 or No.2 in the relevant market or industry in terms of its market share, has strong controlling or bargaining power over distributors, has a relative wide brand influence and customers who have a high degree of reliance on its products.

c)    The activity is not engaged in for an anti-competitive purpose. It is suggested that a company should be clear on the purpose of its RPM activity before implementing RPM. The purpose should be legitimate with regard to legal and commercial considerations and not directed at hindering competition. It would be more persuasive if the company can prove that the purpose of maintaining minimum resale prices is to facilitate product or technology innovation, promote operational efficiency, save energy or protect the environment.

d)    The RPM has pro-competitive effects and is good for consumer welfare. According to the judgment of the High Court, these effects may include the prevention of distributor “free-riding”, facilitating new brands or products entering the market, providing unified price information to customers, improving the development of distributors and building distribution channels and protecting against discount sales of competitors, etc.

It should be noted that conclusive guidance is not available at this point in time as to whether the rule of reason doctrine will be applied to determine the legality of RPM by the NDRC in its enforcement actions.  If a company is investigated by NDRC for suspected RPM, especially when similar RPM practices are prevalent across the company’s industry, the above defenses may not be able to save the company from an investigation and being fined by the NDRC for having violated Article 14 of the AML.

We recommend that companies create appropriate competition compliance policies and undertake periodic audits of compliance with the policies. The compliance policies should set out the frequency with which employees should receive training (preferably, on an annual basis as well as on an as-needs basis), identify those employees who should receive the training (especially management and sales and marketing teams as well as anyone involved in pricing decisions), prescribe regulations and codes of conduct to make all officers and employees of the company aware of their responsibilities under the AML and the company’s protocols and be endorsed by senior representatives of the company, such as the Chairman and Chief Executive Officer, so that compliance is truly “top down.” In addition, companies should conduct periodic audits of their contracts and communications with distributors from time to time.  If they are aware of any suspicious clauses or behaviors, they should not hesitate to contact their legal counsels for advice to control and minimize the potential risks.