To: MassApparal, Inc



To: MassApparal, Inc.

From: Greg Albert, Alex Engelhart, Kyle Farnam, Cosme Hozven, and John Nourse

Date: November 20, 2007

Re: Legality of Mass’ “Marketing Discipline” Provisions under Antitrust Law

New Facts

Many of the new facts in this case dealt with market shares. Mass has 25% of the MLB cap and jacket market nationally, and SU has 10% of the same market in Las Vegas and Salt Lake City through selling Mass’ apparel there. Mass does appear to have a much stronger market share of the MLB apparel market in the southwestern U.S., including perhaps a 75% market share in the MLB cap and jacket market in Las Vegas and Salt Lake (the retailers complaining about SU there have a 25% market share). However, the other MLB cap and jacket manufacturers still have one or two retailers apiece in these cities. Overall, Mass uses 120 retailers.

Other new facts in this case showed that there is not very much consistency between the four MLB licensees. The four manufacturers’ products have prices “across the board,” and Mass produces the highest quality and priced apparel. Three of the four manufactures use “marketing discipline” contracts, but they are not the same. There is no evidence that these contracts have affected the price or output of MLB caps and jackets. Likewise, there is no indication that manufacturers or retailers agreed with one another to use “marketing discipline” contracts, and otherwise do not conduct information sharing.

None of the provisions or terms in Mass’ retailer contracts are defined more precisely.

Issues Presented

1. Are Mass’ five “marketing discipline” provisions (location requirement, end consumer requirement, training requirement, and minimum/maximum price requirements) valid under antitrust law?

2. May Mass terminate its contract with SU?

3. May Mass legally change its retailer contracts to prevent retailers from advertising outside of their designated markets?

Brief Answer

All vertical restraints are subject to a rule of reason analysis, which weighs the anticompetitive effects of such restraints with procompetitive justifications for them. Under such an analysis, Mass’ five “marketing discipline” provisions are very likely to be found valid under antitrust law. Generally speaking, these provisions seek to maintain the “high-quality” image of Mass’ products, prevent free riding, and foster a strong customer-salesman relationship. Likewise, there is no evidence that these justifications are countered by any strong anticompetitive effects—nothing indicates a manufacturer or retailer cartel, and the “marketing discipline” contracts do not appear to have affected the price or output of MLB caps and jackets. Because its retailer contract is valid, Mass may enforce it against SU, and terminate its relationship if it so chooses. Finally, because procompetitive justifications support its territorial restraints, Mass may likely be able to prevent retailers from advertising outside of their designated markets.

Analysis

A. Vertical Restraints are Subject to the Rule of Reason

Although it was not the case until 2007, all vertical restraints are now subject to the rule of reason. Leegin Creative Leather Products, Inc. v. PSKS, Inc., 551 U.S. ____ (2007) (minimum resale price maintenance); State Oil Co. v. Kahn, 522 U.S. 3 (1997) (maximum resale price maintenance); Continental T.V., Inc. v. GTE Sylvania Inc., 433 U.S. 36 (1997) (territorial restraints). In a rule of reason analysis, anticompetitive effects are weighed against procompetitive justifications. See Leegin, 522 U.S. ____. Vertical restraints are often justified with arguments that controlling intrabrand competition fosters interbrand competition—that consumers are given more options, barriers to market entry are reduced, and retailers are encouraged to offer services that would not be provided even absent free riding. Id. However, these justifications must be weighed against anticompetitive effects that may be present in vertical restraints, such as facilitating a manufacturer or retailer cartel. Id. The U.S. Supreme Court has offered factors to consider when conducting a rule of reason analysis in the vertical restraint context, including the number of manufacturers that use the restraints, whether retailers were the impetus of the restraint, and whether the relevant entity possesses market power. Id.

The following analysis will address the market power of the relevant entities, and consider each of Mass’ five “marketing discipline” restraints under a rule of reason analysis. Finally, it will offer advice to Mass on how it may proceed with its relationship with SU and its territorial restraint provision of its retailer contracts.

B. Market Power

The U.S. Supreme Court has noted that both manufacturer and retailer market power are relevant considerations when analyzing vertical restraints under the rule of reason. Leegin, 522 U.S. ____. Without possessing market power, the Leegan Court reasoned, retailers cannot force manufacturers from selling through competitors, and manufacturers cannot force competitors out of its distribution outlets. Id. While there is no bright-line rule for what market share is suspect in the vertical restraint context, the Court has noted that retail market power is rare. Continental T.V., 433 U.S. at 54.

Depending on the definition of relevant market, Mass may have significant market power. If the relevant market is defined as the MLB cap and jacket market, Mass has a quarter share. However, in Salt Lake City and Las Vegas, Mass may have a much higher share of the MLB cap and jacket market, perhaps as high as 75% (complaining retailers in these cities have a 25% share of the MLB cap and jacket market). While Mass has three approved retailers in each of these cities, competitors only have one or two. However, even though Mass’ market power in the MLB cap and jacket market is much more substantial in these cities, it still competes with other manufacturers.

It appears highly unlikely that SU may be construed as having market power under any definition of relevant market. In Salt Lake City and Las Vegas, SU accounts for only 10% of the MLB cap and jacket market through selling Mass apparel. As noted above, Mass uses two other retailers in these cities. Overall, Mass has 120 retailers. Therefore, it appears that SU has a great deal of competition from other retailers.

In conclusion, even if Mass or SU was considered to have significant market power, they both face competition within any definition of a relevant market. Because it does not enjoy a monopoly, it is reasonable for Mass to consider using “marketing discipline” provisions in order to enhance the desirability of its products.

C. Mass’ Territorial Restriction

1. Territorial Restrictions are Subject to the Rule of Reason

Mass’ territorial restriction issue is similar to that in Continental T.V., Inc v. GTE Sylvania Inc., 433 U.S. 36 (1977). In that case, the supplier held a small minority of the television market but a complete monopoly over its brand. It agreed with a retailer that the retailer would distribute from a specific geographic location. The Continental T.V. Court held that there are enough procompetitive effects inherent in this kind of arrangement that it should automatically pass a per se analysis and be scrutinized under the rule of reason.

Like in Continental T.V., Mass requires a retailer to restrict their sales to be “from” a specific geographic location. Also like Continental T.V., Mass is concerned that its supplier is breaching the contract by selling products outside of its designated territory. Therefore, a rule of reason analysis is proper for Mass’ territorial restriction.

2. Procompetitive Justifications of Territorial Restrictions

The Continental T.V. enumerated several procompetitive effects that may justify a geographic restriction case. Most of the justifications fit within the umbrella of whether the geographic location was intended to restrict intrabrand distribution or interbrand distribution. The procompetitive effects are: (1) inducing retailers to make a larger capital and labor investment to secure a contract, (2) inducing retailers to further promote the product, (3) inducing retailers to provide service and repair so that goodwill is increased, and (4) eliminating free riders from the market.

Continental T.V. also established that a plaintiff of a vertical restraint antitrust claim bears the burden of showing that the restraint has a demonstrable anticompetitive economic effect on the market. Structural line-drawing between types of transactions will not suffice to demonstrate this. Mass may be able to argue several of these factors

The Continental T.V. Court applied its first procompetitive justification, inducing capital and labor investments, to suppliers who are new to a market, but it may apply to Mass as well. From the facts, we know that Mass faces an avalanche of efforts by distributors to violate the geographic restriction agreement if they do not hold firm on the agreement with SU. This means that they will lose the power to negotiate with new retailers in new markets where Mass still does not enjoy any marketability. If this happens, a decentralization of supply will come about where every retailer will be free to sell from another retailer’s territory. As these retailers advance into new territories, Mass will have less ability to negotiate for retailers to commit labor and capital because the retailers will face greater competition in the market of completely fungible, intrabrand products. This will stymie their ability to supply the existing demand in those markets procompetitively.

Continental T.V.’s second procompetitive justification, inducing retailers to promote products, applies more directly to Mass. When a territorially-restricted retailer advances into another market with an expansive advertisement-scheme, Mass loses the ability to negotiate with the retailers who are already in that market to continue promoting their goods. The existing retailers may find it too cost-prohibitive to comparably advertise or it may give up the market altogether. While this may not be a problem if the outside-retailer was able to satisfy all of the market demand, presumably, this is not the case here. First, it is a sound presumption that if SU were able to more thoroughly satisfy demand in the satellite cities than the existing retailers, Mass would award SU the contract to those cities. Second, SU only advertises for its San Diego store out of ‘satellite’ stores, it does not distribute directly from those locations. Consumers who go to these satellite stores cannot purchase the items directly off the shelves. Since prices are largely uniform throughout Mass’ market, it is reasonable to think that at least a few consumers would prefer to purchase the items immediately.

The third procompetitive justification in Continental T.V., inducing retailers to provide services and repairs to increase customer goodwill, may also apply in Mass’ case. While sport-memorabilia stores may not conduct maintenance or repairs on the goods they sell, the may offer services like free shipping for goods not in stock, liberal return policies, and replacing faulty products. More importantly, Mass is seeking a strong customer-salesman relationship in its retail stores (also seen in the salesman training requirement). By requiring retailers to inventory and sell locally, Mass is encouraging local retailers to establish a relationship with local customers, and interact with Mass’ products in a face-to-face setting. In this case, SU is undercutting Mass’ sought relationship because customers are buying products in stores where those products are not present—salesman cannot show customers the products in person, and point out why they should be purchased.

Continental T.V.’s final procompetitive justification, eliminating free riders, is perhaps Mass’ strongest claim for why territorial restrictions are valid. Even though SU is marketing in the satellite cities, other considerations should apply here. First, by expanding its sales territory, SU may not be doing its share of customer service. In that case, a consumer may spend a significant amount of time working with one of the already-established retailers’ sales representative to determine the product that they wish to purchase. The consumer may also benefit from product demonstration. But they may still go to the SU satellite store to make their purchase. That could raise the cost to the territorial incumbent while reducing their sales. With smaller profits, the territorial incumbent may find it difficult to satisfy the demand of its territory. Second, SU’s own commitment to advertising and marketing could be compromised by free-riders if Mass permits retailers to intrude on one-another’s markets. SU is the second-largest retailer that Mass and spends a significant amount on marketing. Smaller retailers may be able to enter SU’s market to benefit from its marketing efforts while undercutting them on prices.

Although territorial restrictions affect intrabrand competition, there is no reason why these controls would harm interbrand competition. Mass’ competitors are still free to compete wherever they choose—there is no evidence of any agreement by other manufacturers to stay out of Mass’ markets. Because interbrand competition is still in tact, and because all four of Continental T.V.’s procompetitive justifications may be elicited by Mass, its territorial restraint provision is valid under a rule of reason analysis.

D. Mass’ End Consumer Requirement

As noted above, in the context of vertical restraints, courts have focused on the tension between interbrand and intrabrand competition – many restraints put explicit limits on intrabrand competition but have the effect of fostering interbrand competition. See Continental T.V. Inc.; Business Electronic Corp. In order to compete against other manufacturers, a manufacturer will often want its retailers to provide extra services to consumers because “[t]he availability and quality of such services affects a manufacturer’s goodwill and the competitiveness of his product.” Continental T.V. Inc. And since “[b]ecause of market imperfections such as the so-called “free rider” effect, these services might not be provided by retailers in a purely competitive situation,” id., there are strong interbrand procompetitive benefits to upholding the legality of some non-price vertical restraints. Restraints on the locations where retailers may sell a manufacturer’s goods have been upheld. Continental T.V., Inc. And in light of the Supreme Court’s explicit overruling of Schwinn, and its observation that “[i]n intent and competitive impact, the retail-customer restriction in Schwinn is indistinguishable from the location restriction in the present case,” it is safe to assume that most restrictions on a retailer’s right to resell goods to other retailers would be upheld under current law.

Provision (2) of the Mass MLB retailer contract “provides that the retailer may only sell MLB merchandise to end consumers and not resellers.” This is a classic non-price vertical restraint, not unlike the one at issue in the overruled Schwinn case. Under current law, this restraint is evaluated under the rule of reason – we must balance its procompetitive benefits against its anticompetitive effects. Specifically, we should examine the extent to which it fosters interbrand competition, and weigh this against its explicit intrabrand restriction on the ability of selected retailers to resell to other retailers.

Provision (2) is very likely to be upheld under this analysis. We know that Mass has a reputation for providing the highest-end, most expensive MLB merchandise of the four manufacturers. It has a very strong, legitimate interest in protecting its reputation and good will. Mass’s ability to charge high prices and succeed in its market depends on the consumer perception that its products are superior and higher-end than the products of the other three manufacturers. Restriction (2) is designed to protect this reputation for quality by ensuring that all retailers of Mass merchandise maintain a certain level of decorum and customer service. If retailers were allowed to resell Mass merchandise to other retailers, these secondary retailers could sell the merchandise in ways that would negatively impact Mass’s goodwill and reputation, thereby seriously damaging its ability to compete with other brands.

This fear is not hypothetical. We know that “SU has sold discontinued or dated MLB merchandise to unauthorized “ma and pa” retailers in the satellite markets, some of whom heavily discount the merchandise at all times and others of whom charge ‘insanely’ high prices for ‘Hot-team’ merchandise.” These “ma and pa” retailers run the gamut from solo guys selling out of their trucks to fancy strip stores. They often sell at 30% of cost, just to dump old Mass merchandise. Clearly, these “ma and pa” retailers are low-end discounters – their ability to sell Mass merchandise clashes sharply with Mass’s reputation for quality and high-end products. In fact, some of these low-end retailers could even be involved in counterfeiting Mass merchandise. Under these circumstances, Mass is justified in contractually barring its selected retailers from selling to these unapproved “ma and pa” outfits. Interbrand competition is fostered through Mass’s ability to maintain its reputation and prevent counterfeiting of its products. Under the rule of reason analysis, this should outweigh provision (2)’s acknowledged limitation on intrabrand competition.

E. Mass’ Training Requirement

Under a rule of reason analysis, Mass can almost assuredly justify its requirement that retailers train their staff on MLB merchandise and adopt a comprehensive advertising plan in their markets. As noted above, consistent with antitrust law, businesses may selectively use retailers that offer high-quality services in order to prevent free riding on their products. Continental T.V., 433 U.S. at 36. Likewise, the U.S. Supreme Court has noted that vertical restraints may have a procompetitive justification of encouraging retailer services that would not be provided even absent free riding. Leegin, 522 U.S. ____. In this case, Mass is simply explicitly requiring its retailers to offer high quality service and advertising to support Mass’ products. This requirement may be justified as an attempt to better its products’ image, attract and serve customers, and prevent free riding. On the other hand, it seems hard to characterize such a requirement as anticompetitive—it certainly does not appear to be a pretext or scheme to drive up prices or limit output. Finally, it is helpful for Mass that they supply representatives to visit retailers and help train their staff, therefore absorbing some of the costs associated with this requirement.

F. Mass’ Maximum Price Requirement

The fourth provision of Mass’ MLB retailer contract is a maximum price fixing provision, subject to the rule of reason under Khan. Consequently, the key issue is whether this provision leads to net anti-competitive conduct. The maximum pricing provision prevents any retailer from abusing its regional monopoly resulting from Mass’s retailing contract. Without such a provision, the retailer would have the power to charge an extremely high price because it is the only outlet for the specific product. MLB has issued only four licenses permitting a particular manufacturer to sell caps and jackets bearing the logos of all major league teams. Each of these four manufacturers concentrates its efforts within a particular region of the United States—Mass in the southwest, one in the Midwest, one in the south, and one in the east. While Mass’s retailers retail for the other manufacturers as well, those retailers carry small amounts of non-Mass MLB products. Consequently, there exists minimal competition in these four MLB cap and jacket markets between these manufacturers. Further, because Mass controls 25% of the entire MLB cap and jacket market, and Mass is subject to minimal competition from the other manufacturers in its southwest market, Mass’s retailers have virtual monopolies in its southwest MLB cap and jacket market. A manufacturer may restrain intrabrand competition and impose maximum price restraints in order to promote interbrand competition and curtail the negative effects associated with product price increases. Sylvania; Khan.

By keeping prices within a profitable yet attractive bracket, Mass’s restraint benefits the consumers and maintains greater competitive strength for its products in the market.

Demand for the majority of Mass’s MLB products is elastic. Consequently, price increases over the limit indicated by Mass would tend to harm both Mass and its consumers, by reducing demand and increasing consumers’ price for the products. By imposing a maximum price constraint, Mass is able to regulate its retailers and prevent them from negatively impacting its image and customer base. While price ceilings below a competitive level could theoretically lead to narrower margins for a retailer thus reducing its ability to invest in marketing or services, the facts indicate that such is not the case here. Under Mass’s maximum pricing provision, Mass’s retailers’ margins are: supra keystone, above the other manufacturers’ 50% cost/price average, and “not uncommon for specialized logo merchandise.” Thus, sufficient revenue can be allocated to providing for point-of-sale services at the retailer level, without compromising Mass’s desirable point-of-sale services. Were this not so, Mass’s attempt to “squeeze [its] dealers’ margin below a competitive level […] would just drive the dealers into the arms of a competing supplier.” Khan, 93 F.3d 1358, at 1362. Thus, regulating intrabrand competition by imposing a maximum price constraint guarantees both Mass’s and its retailers’ long-term success and viability.

The maximum price provision creates beneficial safeguards that benefit the consumer and the competitive strength of Mass’s products in the market, which greatly outweigh any anti-competitive effects on the retailers’ ability to market the products. The provision will, therefore, survive a rule of reason analysis.

G. Mass’ Minimum Price Requirement

Mass’ provision requiring retailers to use their best efforts not to sell below recommended retail prices during the season does not violate the Sherman Act or the Clayton Act. Although price restraints have historically been treated as per se illegal, Leegin overturned the per se rule set out in Dr. Miles and stated that rule of reason is the proper mode of analysis for such provisions. Leegin is now the controlling case for price based vertical restraints.

Arguably, the provision is too soft to rise to the level of a minimum price requirement. The term “best efforts” is not defined, but by its use, the contract does not require pricing at the suggested retail price level, nor has Mass threatened to stop supplying to enforce compliance with their suggested retail prices. However, it is unnecessary for us to determine whether or not the provision is sufficiently forceful constitute a price based restraint. Even assuming it is, under the rule of reason analysis required by Leegin, the provision’s pro-competitive effects outweigh their anti-competitive effects.

As noted above, under rule of reason analysis, the validity of a vertical restraint is deciding by weighing of pro- and anti-competitive effects. Leegin recognized that setting minimum prices for a product may benefit interbrand competition in various ways, including encouraging retailer investment in product promotion, facilitating market entry, giving consumers more options, and encouraging retailers to offer services that would not be provided even absent free riding. Leegin, 522 U.S. at 2715. Many of these justifications may apply to Mass, which is known as a manufacturer of high quality merchandise. Maintaining a certain price level allows them to continue that image. Likewise, controlling resale prices allows them to prevent discount sales to “ma and pa” stores that will sell their merchandise at discount prices alongside pirate merchandise. Protecting the image that Mass Appeal has built encourages competition by rewarding their work and encouraging them to maintain high quality.

Leegin also lays out a number of anticompetitive effects that may result from minimum retail price agreements. The primary concerns are the use of such provisions to gain monopoly power and enhance profits; that such provisions will encourage either retailer or manufacturer cartelization; and that a powerful retailer or manufacturer might use them to keep others out of the market. Id. at 2716-2717.

Nothing in the discovered facts suggests that Mass’ retailer contracts are were designed to foster a manufacturer cartel. There is no evidence of parallel action by the manufacturers, and the differences among their products buttress this conclusion. First, the quality of MLB caps and jackets among the four manufacturers is different, and their prices are “all over the board” (according to Professor Drake’s response to a question). Although three of the four manufacturers use “marketing discipline” contracts, their included provisions are not the same. Likewise, the fact that one manufacturer does not use a contract may be significant—it would be difficult for four manufacturers to maintain a cartel if one of them was not placing restrictions on retailers. Finally, there is no evidence that the price or output of MLB caps and jackets was altered by any of the manufacturer’s retailer contracts.

Similarly, there is no evidence suggesting a cartel on the retailer level. The terms of the agreement originated with Mass, not the retailers, and Mass is the only manufacturer to use a minimum pricing provision. In Leegin, the court points out that “a retailer cartel is unlikely when only a single manufacturer in a competitive market uses resale price maintenance. Interbrand competition would divert consumers to lower priced substitutes and eliminate any gains to retailers from their price-fixing agreement over a single brand.” Id. 2719. Neither is there any evidence of less efficient retailers using the minimum pricing to maintain profits in the face of more efficient competitors. SU’s fellow Mass distributors brought complaints to Mass about SU’s failure to follow the terms of the distribution contract. The evidence suggests not that SU’s competitors are trying to free ride on SU’s efforts in advertising, but that they are trying to keep SU from creating intrabrand competition by invading their geographical market. Therefore, the evidence does not support the fear of a retailer cartel.

In the final weighing, there are many pro-competitive effects of the pricing provision: the protection of the image that Mass has built in competition with manufacturers; the differentiation of quality and price allowing for consumer choice; the reduction of intrabrand competition in favor of interbrand competition; the protection of Mass’s image by reducing the likelihood of the sale of its goods side by side with pirated goods. Furthermore, although there may be anticompetitive concerns with such price restraints, they do not appear to apply in Mass’ case. The evidence clearly weighs in favor of pro-competitive effects, thereby making the provision allowable under a rule of reason analysis as supplied by Leegin.

H. Taken Together, Mass’ Five Restrictions on Retailers are a Valid Vertical Restraint

The preceding has analyzed each of Mass’ five vertical restraints that it has imposed on retailers through its “marketing discipline” contracts. In each case, it appears the restraints are valid under a rule of reason analysis. Taken as a whole, Mass appears to be using these contracts to maintain a “high quality” image for their brand, prevent free riding, and foster a strong customer-salesman relationship. Most importantly, Mass does not appear to be using the retailer contracts to harm competition—nothing indicates a cartel on either the manufacturer or retailer level, and the contracts have not affected product price or output of any MLB caps and jackets. Therefore, consistent with antitrust law, Mass may continue to use their “marketing discipline” contracts.

I. Advice to Mass

1. Mass May Terminate Its Contract with SU

As the above demonstrates at length, Mass’ retailer contracts are very likely to be considered valid under antitrust law. SU has violated at least one provision, the end-consumer requirement, and appears to be going against the spirit of what Mass wants from its retailers. Therefore, assuming the contract allows for its termination in the event of a party’s violation, Mass may choose to end its relationship with SU. Because deciding whether to terminate SU is therefore a business decision rather than a cause for liability, it will not be discussed furthermore herein.

2. Mass May Strengthen Its Territorial Restraint Provision

Mass has expressed concern that SU’s sales in satellite cities has violated the “spirit of the deal” between them, and has expressed a desire to bolster its territorial restriction on retailers by prohibiting advertising outside of a retailer’s designated territory. The above factors indicate that they will be able to do this without violating any antitrust laws. First, the new contract will enjoy the same rule of reason analysis rather than a strict per se condemnation. Under that analysis, just as with the above-analyzed territorial restriction, a court would probably find enough procompetitive effects to eclipse the anticompetitive ones. Mass would still be using the territorial restriction to encourage all of its retailers to use their own advertising, and to promote a strong local relationship between retailers and their customers. The fact that sports memorabilia is a non-essential good means that it requires substantial capital for advertisement and marketing. Allowing a retailer like SU to market outside of its territory could undercut Mass’ ability to induce other firms in those territories to invest in their own marketing, which may lead to free riding. Simply put, a territorial restriction dealing with advertising, as opposed to just sales and inventory, does not appear to have significantly different procompetitive justifications or anticompetitive effects—therefore, it is likely a valid vertical restraint.

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