Ninth Circuit Provides New Cost-Based Rule For Antitrust Cases

September 2007

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In McKenzie-Willamette Hospital vs. PeaceHealth (no. 05-35627, September 4, 2007), the Ninth Circuit established a new test regarding whether bundled transactions were a violation of §2 of the Sherman Act. The case is important because of the prevalence of bundled transactions, and because it establishes a split with the Third Circuit.

Bundled transactions are everywhere

According to the Opinion,

“Bundling is the practice of offering, for a single price, two or more goods or services that could be sold separately. A bundled discount occurs when a firm sells a bundle of goods or services for a lower price than the seller charges for the goods or services purchased individually. … Bundled discounts are pervasive, and examples abound. Season tickets, fast-food value meals, all-in-one home theatre systems – all are bundled discounts … The varied and pervasive nature of bundled discounts illustrates that such discounts transcend market boundaries. On the one hand, the world’s largest corporations offer bundled discounts as their product lines expand with the convergence of industries. On the other hand, a street-corner vendor with a food cart - a merchant with limited capital – might offer a discount to a customer who buys a drink and potato chips to compliment a hot dog. The fact that such diverse sellers offer bundled discounts shows that such discounts are a fundamental option for both buyers and sellers.”

As the Court noted, bundled transactions occur almost everywhere. Companies bundle goods and services for a variety of sound economic reasons that have nothing to do with anticompetitive behavior, such as:

1. improved capabilities from integration,
2. convenience to customers,
3. economies of scale in manufacturing, distribution, or selling,
4. packaging savings,
5. advertising savings from introducing a new product by selling it with an established product, and
6. reduced transaction costs by combining what would otherwise be multiple purchases.

These reasons benefit consumers. Consumers get lower prices, useful information regarding what is being purchased, and an easier purchase of coordinated products.

Previous law involving bundled transactions

Before this case, the Third Circuit’s LePage decision provided guidance as to how to treat bundled transactions. The Ninth Circuit described the issue as follows:

“In the case, the district court based its jury instruction regarding the anticompetitive effect of bundled discounting on the Third Circuit’s en banc decision in LePage’s Inc. vs. 3M, 324 F.3d 141 (3d Cir. 2003). In that case, the plaintiff, LePage’s, was the market leader in the sales of ‘private label’ (i.e., store brand) transparent tape. As LePage’s market share fell and its profitability declined, it brought suit asserting that 3M, who manufactured Scotch tape, some private label tape, and many other products that LePage’s did not produce (like healthcare products and retail automotive products), leveraged its monopoly over Scotch brand tape to monopolize the private label tape market. Specifically, LePage’s alleged that 3M’s multi-tiered bundled rebate structure was anticompetitive. The bundled rate structure offered progressively higher rebates when customers increased purchases across 3M’s different product lines – discounts LePage’s could not offer because it did not sell the same diverse array of products as 3M. A jury found that 3M’s conduct violated §2 of the Sherman Act and 3M appealed. … 3M argued that its bundled rebate structure was legal as a matter of law because it never priced below cost…. [citations omitted]”

Several courts have followed the LePage decision, no doubt aided by the U.S. Supreme Court denying certiorari of the LePage’s decision. Assisting this, the Office of the Solicitor General filed an amicus brief urging the U.S. Supreme Court to deny certiorari because:

"Although the business community and consumers would benefit from clear, objective guidance on the application of Section 2 to bundled rebates, this case does not present an attractive vehicle for this Court to attempt to provide such guidance. Furthermore, there is no pressing need for the Court to address the matter at this time. While bundled rebates may be a common business practice, it is not clear that monopolists commonly bundle rebates for products over which they have monopolies with products over which they do not. The United States submits that, at this juncture, it would be preferable to allow the case law and economic analysis to develop further and to await a case with a record better adapted to development of an appropriate standard."

The Ninth Circuit noted the district court’s reliance on LePage’s as follows:

“In this case, the district court used LePage’s to formulate its jury instruction. Specifically, the district court instructed the jury that:

>‘Plaintiff … contends that the defendant has bundled price discounts for its primary, secondary, and tertiary acute care products and that doing so is anticompetitive. Bundled pricing occurs when price discounts are offered for purchasing an entire line of services exclusively from one supplier. Bundled price discounts may be anti-competitive if they are offered by a monopolist and substantially foreclose portions of the market to a competitor who does not provide an equally diverse group of services and who therefore can not make a comparable offer.’

Notably, the above instruction does not require the jury to perform any analysis whatsoever once the jury determines that the competitor is not in a position to match the offering. The Ninth Circuit concluded that this was incorrect because, as 3M argued in the LePage case, the instructions do not consider the cost of what is being bundled.

The Ninth Circuit’s new standard

The Ninth Circuit instead adopted a more lenient standard that allows one to provide a bundled package that competitors cannot duplicate if certain requirements are met. Specifically, the Court determined:

“Given the endemic nature of bundled discounts in many spheres of economic activity, we decline to endorse the Third Circuit’s definition of when bundled discounts constitute the exclusionary conduct proscribed by §2 of the Sherman Act. Instead, we think the course safer for consumers and our competitive economy to hold that bundled discounts may not be considered exclusionary conduct …unless the discounts result in prices that are below an appropriate measure of the defendant’s costs. …”

“We adopt what amici refer to as a ‘discount attribution’ rule. Under this standard, the full amount of the discounts given by the defendant on the bundle are allocated to the competitive product or products. If the resulting price of the competitive product or products is below the defendant’s incremental cost to produce them, the trier of fact may find that the bundled discount is exclusionary for the purpose of §2. This standard makes the defendant’s bundled discounts legal unless the discounts have the potential to exclude a hypothetical equally efficient producer of the competitive product.” …

The Ninth Circuit standard is not as lenient as other possible standards. The Court recognized that there is "limited judicial experience with bundled discounts", which is perhaps why the new standard is still not “defendant-friendly”.

The Ninth Circuit’s test provides practical challenges for bundling discounters, particularly when numerous products are involved with a different set of competitors of each product in the bundle. One would expect that, the larger the bundle, the greater the discount. However, larger bundles and the resulting larger discounts are at greater risk because the entire bundle’s discount will be allocated to a single product at issue. Consequently, a seller could be selling “below cost” for a single product in the bundle, even though (i) the entire transaction is quite profitable, and (ii) the discount the seller attributed to a single product is relatively modest. The analysis gets more complicated as the bundle size gets larger, since each would-be plaintiff will attribute the entire discount to the part of the bundle with which they compete.

How does one measure “Cost”?

The Ninth Circuit noted that the definition of cost is an open question in both the Ninth Circuit and elsewhere. Although describing incremental cost as the proper standard (for example, see quote above), the Court declined to provide additional guidance regarding how to measure this incremental cost. Under the Ninth Circuit’s current ruling, as before, “cost” means average variable cost.

Variable costs are those that change with the amount of output. Variable costs exclude fixed costs, which do not change with volume. This is a issue that requires accounting analysis, and almost always generates disagreement between competing experts.

Fulcrum Inquiry performs forensic accounting in support of litigation. We are experienced in performing cost analyses required by this Ninth Circuit decision.