Manufacturers Must Follow "Rule of Reason" In Setting Floor Prices

July 31, 2007
Mandatory arbitration clause in contracts may help protect companies.

The United States Supreme Court has just cracked 100 years of antitrust jurisprudence in a decision that may profoundly affect the way consumer goods are priced in the future. This decision holds great promise -- but not without danger -- for manufacturers of virtually any type of consumer product.

On June 7, 2007, in Leegin Creative Leather Products, a sharply divided Supreme Court ruled that pricing behavior which, in the past, had been considered so pernicious that it was always per se illegal -- i.e., under no circumstances would it be permitted -- might now, under the right circumstances, be OK. The subject is minimum resale price maintenance, and the potential commercial impact is vast.

Here's how it happened: Leegin is a small California manufacturer of women's shoes and other fashion accessories that it sold under the "Brighton" label. Leegin prided itself on the quality of its products, and sought to extend its reputation for quality to the store environment by providing its customers with exceptional professional service, pleasant sales surroundings, and a knowledgeable staff. These features cost money, so Leegin's prices were always a bit higher than the competition. Its customers didn't seem to mind, however, and were apparently willing to pay a price premium for the overall satisfying experience of buying Brighton products.

Leegin sold its goods through a network of independent sales outlets, each of which was required to adhere to Leegin's high standards of resale quality. To cover the cost of providing Leegin's "quality purchasing atmosphere," the retailers also had to agree that they wouldn't sell Brighton products below Leegin's unilaterally set resale prices. In Leegin's case, the phrase "MSRP" didn't mean "suggested;" it was mandatory.

Kay's Kloset was a small retailer in Texas. It enjoyed a large book of business selling Brighton products, but didn't think much about Leegin's minimum price floor. Using commercial logic, Kay's Kloset figured that it could sell more Brighton products if its prices were below the other stores in the area selling the same thing, so it regularly undercut Leegin's minimum resale price. Not surprisingly, this generated substantial additional business for Kay's. When Leegin discovered this conduct, however, it cut off Kay's supply of Brighton products. Kay's sued, and the Texas trial court, applying established federal antitrust principles, found Leegin in violation of the law. The trial court held that a 1911 Supreme Court case prohibiting "vertical price maintenance" -- the Dr. Miles case -- meant that Leegin's conduct was per se illegal, and awarded Kay's $3.6 million in antitrust damages. In so doing, the trial court rejected Leegin's argument that its pricing structure, when analyzed under a "rule of reason" approach, was actually pro-competitive. The court refused Leegin's offer to prove the economics behind its point.

Leegin appealed, but the 5th Circuit Court of Appeals also looked to Dr. Miles, found that the "per se" rule applied, and affirmed the trial court. The Supreme Court agreed to review the case and, last month, sent Dr. Miles packing: "Vertical agreements establishing minimum resale prices can have either pro-competitive or anticompetitive effects, depending upon the circumstances in which they are formed." Justice Anthony Kennedy, speaking for the 5-4 majority, ushered the "rule of reason" into resale price maintenance analyses.

What does the "rule of reason" mean in terms of pricing decisions? A lot. Initially, it means that a manufacturer's decision to establish minimum resale prices is not automatically going to put it in violation of the antitrust laws. This is a big deal, because antitrust damages are automatically tripled and your opponent's attorneys' fees are always awarded. The dollars involved are huge. But it's not a Get Out of Jail Free card, either. It doesn't mean that you can establish resale prices at some profitable level just because you think it's a good idea to do so. Remember that the antitrust laws exist to protect competition, not competitors. So if you're going to establish a sales floor for your products, you're going to have to justify that decision on some economically defensible basis. That is, your decision must be "reasonable."

It will be a long time before the courts are in a position to provide much guidance on what factors are "reasonable" to consider when setting retail price floors. The Supreme Court acknowledged as much: "As courts gain experience considering the effects of these restraints by applying the rule of reason over the course of decisions, they can establish the litigation structure to ensure the rule operates to eliminate anticompetitive restraints from the market and to provide more guidance to businesses." In other words, the Court is saying something like, "we may not be able to define it, but we'll know it when we see it." Not a whole lot of comfort. And the fact that the Supreme Court decided Leegin on the narrowest possible margin -- robustly underscoring the likelihood that future courts will disagree on what is and what is not "reasonable" -- can not add to your sense of well being.

What can you do to protect yourself? Consider adding a mandatory arbitration clause to your sales contracts. Since the courts aren't going to have much guidance in the near future, you may have a better chance of getting all your evidence before an arbitrator -- without having to deal with those pesky rules of evidence -- than you would before a "bound by tradition" judge. Beyond that, do your homework! Make sure you get all the facts relevant to your decision. Bring in the economists, marketing people, and legal staff. Run the "reasonableness" analysis yourself to see if your decision really is justifiable. (Remember, this analysis is going to be Exhibit A, regardless of whether you're in arbitration or in court.) And don't overreach. Minimum resale prices can ensure that you are compensated for the efforts you put into designing, manufacturing and marketing your product, but don't use them just to increase your profit margin. There's no antitrust analysis in the world that will find that "reasonable."

Hon. James L. Warren (Ret.) is a full time mediator and arbitrator with JAMS, The Resolution Experts, based in Northern California. Prior to his appointment to the San Francisco County Superior Court in 1994, Judge Warren worked for almost 20 years with a large, multinational law firm, where he provided antitrust and intellectual property advice to clients such as Chevron, Safeway, Pacific Telesis, Ford, IBM, General Instrument, and the Estate of Andy Warhol. He can be reached at 415-982-5267 or [email protected]

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