Potential Antitrust Implications of Most Favored Nation Clauses

30 March 2016 Manufacturing Industry Advisor Blog

In the manufacturing industry, parties have turned to most favored nation (MFN) clauses—or clauses having the same effect—as a means to assure the lowest possible input costs. MFN clauses offer pro-competitive, cost-saving benefits including efficiencies in negotiations; buyers need not haggle for the last nickel in cost reduction when an MFN clause guarantees the best available price. Despite these pro-competitive benefits, MFN clauses have drawn increased scrutiny for their possible misuse and potential for creating antitrust exposure.

DOJ’s Growing Concerns

Our last article regarding MFN pricing provisions reviewed the growing debate among antitrust practitioners over whether such provisions are pro-competitive or anticompetitive. We noted the Department of Justice Antitrust Division’s (DOJ) concerns over such provisions when imposed by a buyer with a large market share. Indeed, the DOJ had filed several antitrust actions alleging that particular MFN clauses violated Sherman Act § 1 and caused anticompetitive effects.

A more recent action offers a cautionary tale of how MFN clauses signed by several competitors can draw DOJ scrutiny: U.S. v. Apple, Inc., 952 F. Supp. 2d 638 (S.D.N.Y. 2013), aff’d, 791 F.3d 290 (2d Cir. 2015). In Apple, MFN provisions allegedly were used to affect a conspiracy among sellers to raise prices rather than reduce costs. We set forth the DOJ allegations in Apple below, but a principal lesson of Apple is that MFN clauses and other contract terms cannot be used as a means to ensure that competitors agree not to compete with one another.

A Cautionary Tale: U.S. v Apple, Inc.

According to the published court decisions, the facts of Apple are as follows. In 2009, Apple was on the verge of releasing its new tablet computer, the iPad. In connection with the release, Apple wanted to create an ebook marketplace, which came to be known as the iBookstore. At the time, however, Amazon, and its Kindle e-reader, controlled 90% of the ebook marketplace. Amazon’s market position was attributed to its “loss-leading strategy” whereby it purchased ebooks from publishers at a given wholesale price, and then sold those ebooks at or below wholesale price. This strategy was most pronounced with new releases and New York Times bestsellers, which Amazon sold for one invariable figure: $9.99.

Apple knew of Amazon’s aggressive pricing, and it knew that if it set similarly low prices, its iBookstore would be unprofitable. But Apple also knew that the book industry’s major publishers—the “Big Six”—were decidedly unhappy with Amazon’s pricing. Apple allegedly leveraged the Big Six’s discontent during contract negotiations. Apple’s publisher contracts adopted agency model pricing under which each publisher retained pricing authority within a range of price caps while agreeing to pay Apple a fixed percentage of each sale. The agency agreements each included an MFN clause requiring publishers to set ebook prices in Apple’s iBookstore no higher than any of the publishers’ other retailers.

By way of example, under the MFN clause, if a publisher charged $15 for Book-X in the iBookstore, but Amazon sold the book for $10, the publisher would be required to lower the price of Book-X in the iBookstore to no more than $10. Thus, not only would the publisher be required to lower the price to $10, but after paying Apple its 30% fee, the publisher would only receive $7 from the sale—even less than its wholesale prices. Therefore, in order for agency pricing to be viable from a publisher’s perspective, the publisher needed to move its Amazon contract to the agency model or otherwise cause Amazon to price at a higher level. Otherwise, the MFN clause would not only perpetuate the $9.99 price point, but it would cause the publisher to lose even more money. The DOJ alleged that the Big Six knew that any one publisher acting alone could not coerce Amazon into renegotiations—but if they collectively insisted upon an agency model, Amazon would comply.

Ultimately, five of the Big Six agreed to terms with Apple (after Apple allegedly assured each publisher that the others were agreeing to the same terms), and shortly thereafter each publisher moved its respective contract with Amazon to agency model pricing. Accordingly, Apple successfully entered the market and the price of ebooks rose.

Apple and the publishers never agreed to set particular ebook prices, but the DOJ contended that they conspired to eliminate Amazon’s $9.99 price point and increase prices generally. Thus, although the MFN was arguably “pro-competitive” insofar that it facilitated Apple’s entrance into the ebook marketplace, thereby de-concentrating Amazon’s near monopoly, the MFN clauses also provided the means, as well as the motivation, to effect a conspiracy among the publishers to raise ebook prices. In the antitrust jargon of a “hub and spoke” conspiracy, the DOJ in effect alleged that Apple served as the hub of a conspiracy among five publishers.

The district court held that Apple orchestrated a conspiracy among the publishers to eliminate price competition and to raise ebook prices, and the Second Circuit affirmed. The Supreme Court recently denied Apple’s petition for a writ of certiorari, putting an end to yet another interesting demonstration of how MFN clauses can attract DOJ scrutiny and lead to potential antitrust liability. Unlike previous DOJ actions, which challenged parties’ alleged use of MFN clauses to prevent smaller competitors from entering a given market, the MFN clause in Apple was used by a party that possessed no market share whatsoever.  It was only after Apple allegedly rallied the publishers together—emboldened by the MFN clause—that it became possible to raise ebook prices.

Key Takeaway

The lesson for manufacturers is that MFN clauses—like other restrictions in supply agreements—need to be considered not only in the context of how they may reduce input costs but also for what potential anticompetitive effects they may have in the market. When the effect or intent of using an MFN clause may be to limit competition or preclude competition by a competitor, a closer look at the MFN clause is warranted.

This article originally appeared on the Dashboard Insights blog.

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