MEMORANDUM - University of Washington



CASE STUDY 6 - KEY TEAM MEMORANDUM

TO: Roger Davis

FROM: Team 6: Tim DeFors, Mario Gandara, Brendan Grady, Miles Hawks, Christine Lee, Faye Park

DATE: November 12, 2008

RE: Antitrust exposure of the Quad Cities private school coordination

Purpose

The purpose of this memorandum is to discuss the potential antitrust liability of the coordinated program between the five private schools in the greater Quad Cities area.

Issue

The primary question is whether the coordinated program between the five private schools in the greater Quad Cities area violates Sections 1 or 2 of the Sherman Act, 15 U.S.C. §§ 1-2, or Section 5 of the Federal Trade Commission Act, 15 U.S.C. § 45. If there is antitrust exposure, the second question is what actions can be taken to reduce or eliminate that exposure but still achieve the commendable goals of the program.

Analysis

Introduction

Although the coordinated program between the five private high schools in the Quad Cities area has a commendable social goal of increasing diversity within the private school system, some of the means by which the schools intend to do this could unwittingly violate the American antitrust laws. The most problematic are the agreements to equalize tuition between the schools, to coordinate teachers’ salary, and to restrict competitive advertising. Less problematic is the system for exchanging information and pooling scholarship funds. While it could be argued that the social and educational utility of increased diversity will have a procompetitive effect, this effect is likely outweighed by the strong anticompetitive effects of the different elements of the proposal. The agreement between the private schools must be overhauled or at least extensively modified in order to reduce or eliminate the destructiveness of the potential antitrust liability.

Defining the Relevant Market and Market Power

Essentially, a “market is composed of products that have reasonable interchangeability for the purposes for which they are produced—price, use and qualities considered.” United States v. E.I. du Pont De Nemours & Co., 351 U.S. 377, 404 (1956). The “product” for this case is the provision of high school education, and the relevant issue here is whether the Quad Cities area private schools are within its own market or whether they exist within the broader secondary school market (private and public). Thus, in order to accurately define the market in this case, we need to determine the extent of interchangeability/cross-elasticity between private high schools and—the other alternative—public high schools. The facts indicate that there is likely insufficient interchangeability between private schools and public schools. First, the obvious price difference (free public schools versus $13,000-$24,000 for private school) demonstrate low interchangeability. Also, the differences in quality of education provided indicate low interchangeability. For example, the additional facts reveal that the public schools lack the reputation and ability to place as many students in quality colleges, as well as a substantially higher percentage of students who do not aspire to academic success. Additionally, the private schools have smaller classes and better ability to attract high quality teachers.

Further, the Court in du Pont, with respect to cellophane, noted that “an element for consideration as to cross-elasticity of demand between products is the responsiveness of the sales of one product to price changes of another.” E.I. du Pont, 351 U.S. at 400. The Court found that there was sufficient interchangeability between cellophane and other similar flexible wrappings. Id. In this case, however, public school is already free, yet those students who intend to attend private school do so. Additionally, a slight decrease in private school tuition, given its substantial cost, will not likely lead to a significant influx of public school students to private schools. Overall, there is low interchangeability between private and public schools. Therefore, the relevant market here is the market for the services of private high school education in the Quad Cities and surrounding areas. Because the five private schools within the agreement comprise the entire market, their market power when they act together is unchallenged.

Procompetitive Benefits of Diversity as a Social Welfare Justification

There may be procompetitive benefits of diversity, along with public interest justifications, that may allow an entity to survive a full rule of reason analysis. The court in United States v. Brown University, 5 F.3d 658 (3rd Cir. 1993), noted that “[a] trade-off may need to be made between providing financial aid to a large number of the most needy students or allowing the free market to bestow the limited financial aid on the very few most talented who may not need financial aid to attain their academic goals.” Id. at 677. The court then concluded that conduct aimed at increasing diversity (or other legitimate institutional goals) may actually override concerns regarding the limitation of choices for the most talented students. Id. at 678. In a similar vein, the court also found that “institutions of higher education [may] require that a particular practice, which could properly be viewed as a violation of the Sherman Act in another context, be treated differently” and that “[higher education] is a common good that should be extended to as wide a range of individuals from as broad a range of socio-economic backgrounds as possible.” Id (inside quotations omitted).

The court also distinguished its case from certain other cases that rejected specific procompetitive and noneconomic justifications for anticompetitive conduct. For instance, as noted above, the court found that increasing diversity may be sufficient to overcome concerns involving limitation on choice for certain consumers, as it may actually enhance choice for many other consumers—something that did not occur in cases such as Professional Engineers and Indiana Dentists. Brown University, 5 F.3d at 677. Additionally, these two cases also involved agreements that demonstrated strong economic self-interest of the parties, whereas such self-interest did not exist in Brown University; the court implied that such lack of self-interest may help buttress claims of procompetitive benefits. Id. at 677.

The instant case bears several similarities to Brown University, particularly the goal to increase diversity by establishing a fixed tuition (this case) fixed-award scholarship program (Brown) among several relatively comparable schools. Although Brown specifically addresses higher education, it is likely that courts may apply the opinion to secondary schooling as well, particularly in light of (1) the increasingly competitive nature of college admissions and the fact that the quality of secondary school that a student attends may often have substantial influence on the quality of the student’s college application; and (2) the importance of increasing diversity at all levels of education and beyond. As such, courts may find that the procompetitive and noneconomic justification of increasing diversity in secondary schooling are also significant enough to overcome what might normally be a violation of the Sherman Act. Therefore, a court may find that the Davis Plan—with its purpose of increasing diversity and also its lack of economic self-interest—offers sufficient procompetitive/social benefits to survive a full rule of reason analysis and escape antitrust liability.

Unfortunately, this social benefit theory is untested. The Court in Brown suggests it is possible, but does not say it is an automatic winner. Rather than relying on the social and educational benefits of increased diversity as a justification to questionable behavior, a more prudent course of action would be to examine the problems with each of the agreement’s elements and to see if they are problematic under the antitrust laws, and if so, analyze how they could be modified to come into compliance.

Equalizing Tuition is a Per Se Antitrust Violation

An oligopoly is a market characterized by only a few sellers. According to E.I. du Pont De Nemours & Co. v. Federal Trade Commission, 729 F.2d 128 (2nd Cir. 1984), section 5 of the FTC Act is not violated by “non-collusive, non-predatory, independent conduct.” The court held “The mere existence of an oligopolistic market structure in which a small group of manufacturers engage in consciously parallel pricing of an identical product does not violate the antitrust laws.” du Pont De Nemours at 139. The court then concluded that in order to find an unfair method of competition under section 5 of the Act, in absence of an agreement, there must be some indication of oppression such as “(1) evidence of anticompetitive intent or purpose . . ., or (2) the absence of an independent legitimate business reason for the conduct.” Id. Furthermore, the court, in du Pont De Nemours, found that there was no violation of section 1 of the Sherman Act because the court did not find that there was an express agreement between the competitors. Id. at 143.

The private school district in the Quad Cities area consists of five private schools, which means that there are only a few “sellers” within this market. Prior to the Davis plan, the five private schools appear to be an oligopoly. Unlike in du Pont De Nemours, where the court found that the defendants did not violate the any antitrust laws, the Davis plan requires a tacit agreement amongst competitors. The Davis plan includes fixing tuition for all schools at $18,500 per year and agreeing not to advertise or dispense any literature that states, suggests, or implies that it is any better than the other private schools in the area.

The Court in Arizona v. Maricopa County Medical Soc., 457 U.S. 332 (1982), stated that “ . . . once an agreement has been labeled as ‘price fixing’ it is to be condemned per se.” Id. at 361. According to the facts given, it is clear that the Davis plan includes price fixing and therefore a court would “ . . . determine whether it is a ‘naked restrain[t] of trade with no purpose except stifling of competition.’” Maricopa County, 457 U.S. at 362.

Prior to the Davis plan, private schools differentiated themselves from one another through advertising and pricing. For example, Bushwood always said it is the best while the other schools emphasized their virtues, such as sports programs and special classes. One of the major competitive factors between the schools was price. Price is a major concern for parents when deciding where to place their child. Implementation of the Davis plan would mean that all of the participating private schools would be uniformly priced, thus effectively eliminating any competitive edge one school might have over the other. By setting tuition at a fixed price, it is likely that schools will have little or no incentive to improve or provide services that would differentiate themselves from the other institutions. Therefore, the consumers would likely lose out on those benefits due to the anticompetitive nature of the Davis plan. It is highly likely that a court would find that the Davis plan violates the Sherman Antitrust Act due to the tacit agreement amongst schools not to promote themselves over other private schools and setting their tuition at a fixed level. It is doubtful that the possible procompetitive, social welfare, and educational benefits that may flow from increased diversity can justify and outweigh this significant violation.

No Antitrust Liability due to the Information Exchange

An additional aspect of the agreement that must be analyzed for antitrust liability is the information sharing between the competing schools. As part of the program, the schools will make their own independent admissions decisions, but will regularly exchange data on their admissions decisions and the diversity of their student bodies. This information sharing will be controlled by a central administrator who will be hired to manage the new scholarship program. A long line of cases have considered whether or not information sharing can rise to the level of a restraint of trade under the Sherman Act. While the sharing of information is not a per se antitrust violation, it may become a restraint of trade if the information allows the competitors to significantly affect the pricing mechanism.

The first major Supreme Court case considering the effects of information exchange was American Column & Lumber Co. v. United States, 257 U.S. 377 (1921). In that case, an association of hardwood mills began sharing information through a system of reports and newsletters in order to stabilize and harmonize prices. Each mill was required to submit reports to the secretary of the association including detailed daily sales and shipping reports, monthly production and stock reports, price lists, and inspection reports. In turn, the secretary would disseminate the information to the members in a monthly market report letter, along with tips as to how to harmonize the price. A typical tip admonished the members that “Overproduction will spell disaster,” since the capacity of the nations mills exceeded the demand for lumber. Id. at 403. The Court found that the only element of the plan missing was an overt agreement to fix the price of lumber. Finding that the association was akin to a price fixing scheme, the Court held the association liable. Id. at 411-412.

The Court revisited the topic of information sharing in the lumber market only four years later in Maple Flooring Manufacturers’ Ass’n v. United States, 268 U.S. 563 (1925). At issue in that case was the practice of a trade association distributing information booklets containing the average cost to association members of all dimensions and grades of flooring, freight rates around the country, and quantity, kind of flooring sold, prices, and amount of stock on hand. However, this information was collected by the secretary of the association and provided to members without revealing the identity of the member in any specific transaction. In contrast to American Column, the Court found that this practice did not lead to an antitrust violation. There was no concerted effort by the association to use the information to restrict price. The dissemination of general knowledge about the market is not in itself a restraint on trade unless the market players use that knowledge in a concerted anticompetitive action.

A more modern analysis of information sharing is found in United States v. Container Corp. of America, 393 U.S. 333 (1969). In that case, competing box manufacturers would exchange information regarding specific sales to identified customers. Although there was no agreement to fix prices, after exchanging price information competitors would tend to match each others prices for a particular customer. In reversing the district court’s dismissal of the complaint, the Court found that this particular market was highly susceptible to price fixing. The industry is dominated by a few sellers, the product is fungible and competition occurs on price, and the demand for the product is inelastic. Given these factors, the Court reasoned that the exchange of price information was at least evidence enough of anticompetitive behavior to survive a motion to dismiss.

In sum, these cases provide a succinct picture as to how competitors can incur liability when exchanging information. Any exchange of information that can affect the pricing mechanism of a competitor bears further review. An exchange of raw data is preferable to an exchange plus advice on how to use that data. Information in average form is preferable to individual sales data. Information gathered and distributed by a neutral party is preferable to direct exchanges. Finally, an agreement will warrant extra scrutiny when the market is already primed for price fixing, because of the lack of competitors, fungibility of product, and inelastic demand.

In applying these principles to the proposed program, it becomes clear that an exchange of information regarding admissions decisions and school diversity is one of the aspects of the program least likely to incur antitrust liability. At first blush, the market seems like it is the sort that is readily susceptible to price fixing. The market currently consists of only five competitors. Although the market is currently meeting demand, there are large barriers to entry. A new school would face several millions of dollars in start-up costs and compete for a limited number of students. Thus, a new school is unlikely to enter the market and force prices downward. Also, while there is some competition in quality between the schools, private school education is largely fungible. Especially for students attending neither Bushwood nor West Private, the educational experience is largely the same at any school. Also, education is almost by definition an inelastic product. At the margins some students will be unable to afford private school and switch to public. But the majority of families with the means to afford private school will continue to send their children regardless of cost. Because this closed market is subject anticompetitive behavior, a closer analysis is warranted.

However, despite a proclivity towards price fixing, it does not seem that the information being traded is the type that would lead to such anticompetitive behavior. First of all, the information exchanged seems to be of a general sort, applicable to the schools as a whole, not information related to individual students. Second, the data does not include any additional advice about how to manipulate the market. Third, the information is collected by a neutral third party, the administrator of the fund. But most importantly, it is difficult to see how such information would affect the pricing mechanism of the schools. Knowledge of a competing schools admissions and diversity would not lead to anticompetitive behavior in absence of the tuition setting agreement. Additionally, the information sharing seems to offer significant procompetitive benefits by allowing the schools to gauge how accurately they are addressing diversity concerns. Thus, under a rule of reason analysis, the program of information sharing itself does not warrant a finding of antitrust liability.

However, concern over this element of the plan seems to ignore the elephant in the room. Courts are wary of competitors exchanging information because it can have the effect of price fixing through parallel conduct. But here, other elements of the program have already fixed the price of tuition between the schools, and removed the ability of the schools to compete through scholarships. Faced with these blatant efforts to eliminate competition based on price, the fact that the schools also share admissions data seems to be of little consequence. Put another way, if a court finds that the procompetitive effects of the tuition setting program are valid in this case, it would be illogical to then condemn the schools for exchanging diversity and admissions data. However, it could be the case that the tuition setting scheme is found to be a restraint on trade. If so, then the schools may still wish to share information as a safer way to address a lack of diversity. As explained above, the sharing of such information by itself should not incur antitrust liability.

Pooling and Appropriate Distribution of Scholarship Funds Must be Emphasized

Related to the proposal to share information is the proposal to pool scholarship funds and to distribute scholarships based on true need. This particular proposal is at the very heart of the whole intent of the program; it is the main vehicle through which the schools hope to increase diversity. An analysis of this proposal is similar to that of the information exchange due to the required intercommunications and will not be repeated. By itself, the scholarship proposal certainly has a tremendous social welfare justification that should easily outweigh any possible anticompetitive effects under Brown University. But combined with the other elements, the scholarship proposal loses some of its beneficial effects. Therefore, this single proposal must be emphasized as the most important element of the whole plan, meaning that the other proposals must be formulated so that they add to or secure the benefits that stem from this proposal. This sort of emphasis will greatly reduce the antitrust exposure of the Davis Plan.

Coordinating Teachers’ Salaries Leads to Antitrust Exposure

An additional issue raised by Davis’ proposed arrangement relates to the effect it would have on the salaries of private school teachers in the Quad City area. Whereas teachers’ salaries are currently based on merit, Davis’ plan, hoping to combat dollar-chasing, school switching, private deals and high turnover, would base teachers’ salaries on length of service and graduate education completed. The plan also allows participating schools to award teachers trophies and certificates based on merit. These trophies arguably have reputational value, but are of little economic value. Although other benefits, such as health care, vacation time and the aforementioned trophies and certificates may be used in negotiating with teachers, until this point money has been and, in the absence of this arrangement, would have been the primary factor used to entice good teachers to teach at the schools.

It seems quite clear that in order to set the teachers’ salaries at the same level at the participating schools each school would be required to share information regarding its teachers’ past and current salaries and educational background. They will also most likely need to share information regarding future salaries in order to set the future pay scales. In addition, the schools will probably need to meet on a somewhat regular basis; both to make sure that teachers’ salaries are set at 5% above the current public school salary for a teacher of equal tenure having an equal educational background and to make sure that each school is complying with the requirements of the arrangement. This information exchange is subject to attack by the affected teachers as a §1 Sherman Act violation based on an unlawful information exchange.

The case of Todd v. Exxon Corp., 275 F.3d 191 (2nd Cir. 2001), where the plaintiff accused oil company defendants of colluding to set the salaries of certain employees across the industry, is illustrative in determining the schools’ potential liability under §1 of the Sherman Act. In Todd the Second Circuit recognized the validity of a claim against employers sharing salary information where a plaintiff can allege a “plausible market, a market structure that is susceptible to collusive activity, a data exchange with anticompetitive potential, and antitrust injury.” Id. at 195. The court further stated in dictum that “if plaintiff…could allege that defendants actually formed an agreement to fix [teachers’] salaries,” it would likely rise to the level of per se price fixing.” Id. at 198. Based on Davis’ current proposal it is quite possible that a court could find per se price fixing in this situation and the schools would be liable in antitrust. Even if the current proposal does not rise to the level of a per se antitrust violation, it is still subject to a rule of reason analysis, under which a court would look at the aforementioned factors. Based on Todd it seems likely that a court would find antitrust liability under a rule of reason analysis as well as, other than the relevant market, the factors the court relied on in Todd in finding a basis for a claim, are substantially similar in this instance.

As noted above, the relevant market in this case would be the combined public and private school market in the Quad Cities. Although the teachers’ market is arguably anywhere where the teacher is licensed to teach, due to the importance of reputation in commanding an appropriate salary, the limitation to the Quad Cities area is plausible. That being the case, the participating schools represent 100% of the private side of the market. Note, however, that the Todd court stated that if a plaintiff could prove that the schools engaged in an anticompetitive information exchange that resulted in an anticompetitive effect, such as artificially driving down the salaries of teachers, market power would be irrelevant. As in Todd, colluding on salaries results in oligopsonistic behavior and creates inelastic demand, because the demand for teachers at a school will not change. The schools must have teachers in order to operate. As noted above, in order to set salaries for now and maintain them in the future the schools will need to exchange information regarding current and future salaries, and most likely refer to the salaries that specific teachers are receiving. All of these factors were relevant in the Todd court’s analysis and all were deemed to have a dangerously anti-competitive effect. Finally, although setting salaries under the plan will not negatively affect all teachers, it does have the tendency to affect teachers in the upper salary brackets negatively by artificially limiting their salaries at a level lower than what they would have received were it not for the participating schools’ anticompetitive practices.

Due to the anticompetitive dangers involved in the arrangement, as it pertains to the setting of teachers’ salaries, the schools would be wise to avoid exchanging information about current and future salaries and to avoid exchanging the information by direct, personal contact. However, as noted above, exchange of current and future salary information is critical to setting a standard pay scale for its teachers. Even if the schools did not exchange the information directly, but instead used an independent third party to receive and compile the data, they would still face liability based on the nature of the information. If it could be demonstrated that the salary setting has more pro-competitive effects than anticompetitive effects, the schools might escape liability, but this is unlikely. In addition to the direct anticompetitive effect on teachers’ salaries created by their inability to negotiate for higher pay, the salary setting has the indirect effects of driving good teachers to the public schools where benefits could potentially make up for the 5% salary differential or driving good teachers out of the Quad Cities area entirely.

Advertising Restrictions are Dangerously Anticompetitive

The aspect of the coordinated program whereby the private schools agree to extreme limits on competitive advertising between themselves likely leads to antitrust exposure due to the agreement’s anti-competitive nature. Agreements between horizontal competitors to place restrictions on their nondeceptive advertising have been disfavored in American antitrust jurisprudence. Courts routinely recognize that advertising facilitates competition by “informing consumers of the nature and prices of the goods or services available in a market, and thus creating an incentive for suppliers or the products and services to compete along those dimensions . . .” Matter of Polygram Holding, Inc., 5 CCH Trade Reg. Rep. ¶ 15,451 (FTC, 2003). “Restrictions on truthful and nondeceptive advertising harm competition, because they make it more difficult for consumers to discover information about the price and quality of goods and services, thereby reducing competitors’ incentives to compete with each other with respect to those features. . . . These principles apply not just to price advertising, but also to information about qualitative aspects of goods and services.” Id.; see also National Soc. of Prof. Engineers v. United States, 435 U.S. 679, 695 (1978) (“[A]ll elements of a bargain – quality, service, safety, durability – and not just immediate cost, are favorably affected by the free opportunity to select among alternative offers.”). These cases and others demonstrate that agreements to withhold information a consumer needs to make a meaningful choice between competitors may incur antitrust liability due to the anticompetitive effects of such restrictions.

Yet advertising restrictions are not per se illegal, and it may be possible for some restraints to have procompetitive effects that outweigh the negatives. See California Dental Ass’n v. Federal Trade Association, 526 U.S. 756 (1999). In California Dental the Court seems amenable to the suggestion that a professional association’s advertising restrictions are only designed to avoid false or deceptive advertising, and therefore may have no effect on competition or even have a procompetitive effect. Id. at 771. The Court admonishes the Court of Appeals’ quick look analysis of the advertising restrictions and holds that on remand the restrictions must be examined under a rule of reason to determine if they are “nothing more than a procompetitive ban on puffery . . .”, id. at 779, or if they tend to limit the delivery of services.

As applied to the facts of the agreement between the private schools, the various authoritative pronouncements indicate that the agreed advertising restrictions are dangerously anticompetitive and may lead to antitrust liability. The schools’ pre-agreement advertising efforts trumpeted the virtues of each school in such areas as student-teacher ratio, price, sports programs, special classes, study aboard programs, etc. The schools were effectively saying that they were better than others in those areas. But under the Davis plan a school is not allowed to advertise that they are better than another private school, meaning that individual schools could not trumpet their own virtues. This directly violates the rule that decided Polygram Holding and Prof. Engineers because the agreement withholds information that consumers need to make a meaningful choice between competitors. Further, the restrictions are not protected by the more generous test offered in California Dental because the specific areas of advertisement at issue here – student-teacher ratio, special classes, study abroad programs, etc – are easily quantifiable and do not amount to “puffery”. Only one school, Bushwood, seems to advertise that it is the “best”, and California Dental says that banning this sort of claim may be permissible. But the other private schools point to specific factors upon which a consumer can make an informed choice.

Prohibitions on this sort of information from reaching the consumer and therefore affecting the market are definitely condemned in American antitrust law because it will destroy incentives for the schools to actually they quality of product (educational services) in the specific areas in which they formerly competed. If one of the private schools cannot advertise that it offers, for example, fifteen different Advanced Placement classes while the other schools all offer less than ten, that first school would have much less incentive to have fifteen Advanced Placement classes. This definitely injures the competitive process, will lead to a lower-quality product across all of the schools, and will ultimately hurt the consumer. Additionally there is no apparent connection between the advertising restrictions and the socially-commendable desire to increase diversity within the public schools. This makes it difficult to argue that these restrictions are ancillary to a legitimate purpose and not simply a naked restraint on trade. See United States v. Addyston Pipe & Steel Co., 85 F. 271 (6th Cir. 1898), modified and aff’d, 175 U.S. 211 (1899). Thus, they are likely illegal and must be changed. The fact that the restriction is limited to other private schools and not against public schools is irrelevant to the antitrust analysis (and the potential for liability) because that falls into a wholly different market.

Every indication says that the proposed advertising restrictions create antitrust liability. The best recommendation is that they be totally removed from the agreement. As they stand now, they do not promote diversity and they do not have any apparent procompetitive effects. It may be possible to salvage the restrictions by modifying them to only prohibit unverifiable claims in advertisements, but even that would need to be justified – and those justifications are lacking.

Conclusion

The coordinated program between the five private high schools in the Quad Cities area is rife with antitrust liability. Despite the commendable social goal of increasing diversity within the private school system, some of the agreements within the program expose the schools to antitrust violations and must be modified. The most problematic are the agreements to equalize tuition between the schools, to coordinate teachers’ salary, and to restrict competitive advertising. Less problematic is the system for exchanging information and pooling scholarship funds. While it is possible that the social and educational benefits of increased diversity within the private schools could justify and outweigh the anticomepetitive effects of the agreement, it would be unwise to rely on this theory. If the schools still intend to pursue greater diversity, they must review and modify their means to this end or else could face destructive antitrust liability.

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