Manufacturers Have More Freedom to Regulate Distributor Pricing

By Greg Sater and Eric Peterson

You probably know the concept manufacturer's suggested retail price (MSRP). You may even know that the reason it is a "suggested retail price," rather than a "required retail price," is that the U.S. Supreme Court has long held that it is illegal for a manufacturer to try to set the retail price at which its distributors can sell its products.

What you may not know is that, this year, the Supreme Court changed all that. Earlier this year, a divided Supreme Court handed down a landmark decision that will enhance the ability of manufacturers to regulate distributor pricing. It is a bold decision that overturns a long line of legal precedent that dates back to 1911.

The ruling is important to understand for manufacturers and distributors alike. Here are the basics:

DISTINGUISHING THE LEGAL STANDARDS
The Sherman Act (15 U.S.C. § 1) provides that "[e]very contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is hereby declared to be illegal."

Under the Act, there are two analytical standards that courts apply to determine whether a business practice is illegal: the "rule of reason" standard, and the per se rule.

The Rule of Reason - If the rule of reason standard applies, it is difficult and expensive for a plaintiff to prove a violation of the Act. Under the rule of reason, a plaintiff is required to prove that the defendant's practice creates an unreasonable restraint on competition. This means a plaintiff has to prove that the defendant's practice created an anti-competitive effect harmful to the consumer. The plaintiff will have to retain experts and economists and commission market studies for the purpose of defining the relevant geographic boundaries of the competitive market, the parameters of the product market, the market share of the defendant, and the effect on the price paid by the consumer--all of which is expensive and time consuming.

The Per Se Rule - Plaintiffs have a much easier time when the per se standard applies. Under long-standing legal precedent, the per se standard applies to those types of practices that courts regard as always--or almost always--tending to restrict, and thus harm, competition. It is reserved for those narrow categories of business practices, which, due to their destructive effect on competition and general lack of redeeming qualities, are presumed to be unreasonable and therefore, illegal. There's no need for experts and studies; they are deemed unreasonable as a matter of law. As a result, in these cases it's much easier, and a lot cheaper too, for a plaintiff to prove a violation of the Sherman Act than when the rule of reason standard applies.

THE NEW CHANGE IN THE LAW
In 1911, the Supreme Court established that it is per se illegal under the Sherman Act for a manufacturer to contract with its distributors for the maintenance of a minimum price at which the distributor would sell the manufacturer's goods.

In other words, for nearly a century, it's been illegal for a manufacturer to require that its distributors maintain a certain resale price. All that changed, this year.

This year, in Leegin Creative Leather Products, Inc. v. PSKS, Inc., the Supreme Court reversed its 1911 decision and held that manufacturer resale price maintenance agreements will no longer be presumed to be pernicious or destructive to competition.

Now, the rule of reason will apply, rather than the per se rule. That means a distributor wishing to challenge a retail price maintenance agreement will have to prove that the price maintenance agreement unreasonably restrains market competition and is detrimental to consumer interests. It also means that manufacturers that are sued for alleged Sherman Act violations will have the opportunity to try to demonstrate the reasonableness of their resale price agreements. Before, they had no chance to do so, because they were deemed illegal per se.

MANUFACTURERS BEWARE
It's important to note that not all resale price maintenance agreements are OK. The Leegin decision, by simultaneously increasing the potential costs of litigation to a plaintiff, and affording to manufacturers the opportunity to demonstrate the reasonableness of resale price maintenance agreements, will disincentivize plaintiffs from bringing such difficult-to-prove claims. Manufacturers are cautioned, however, not to read more into this new legal regime than is warranted. Though the change in law is significant, it does not completely remove the risk of liability under the Sherman Act, for manufacturers that try to set and maintain their distributors' retail prices. Even under the Leegin decision, not all resale price maintenance agreements will qualify for treatment under the rule of reason.

Under the Sherman Act, business practices such as resale price maintenance agreements are defined in many respects by whether they are "vertical" or "horizontal" arrangements. At its core, a vertical arrangement is one that flows from one level in the supply chain to another--such as from manufacturer to distributor. A horizontal arrangement is one that reflects an agreement between competitors at the same level of distribution. (Think of an agreement between two competing firms to drive a third competitor from the market).

The Leegin case deals with vertical resale price maintenance agreements. Where a manufacturer determines that its best interests are served by compelling those that sell its goods to maintain prices at a certain level, the manufacturer may do so under Leegin.

However, simply because an agreement appears on its face to be vertical does not mean that a court will agree. For instance, were the manufacturer to impose a resale price maintenance requirement on one smaller retailer in response to the request of one or more of its larger retailers, a court could perceive some horizontality in the conduct. By a manufacturer agreeing to take part in and to effectuate the handicapping of a market newcomer, it may find that, in the eyes of the law, it has become a part of what is in essence a horizontal conspiracy to restrain trade at the retail level. In such a situation, a court might still impose the per se standard.

Also, it must be noted, Leegin deals with resale price maintenance agreements. A reseller who is not a party to the agreement (such as a reseller who acquires product from a firm other than the manufacturer, such as an intermediary) may not be bound by the terms. Any attempt by a manufacturer to influence such third parties so that they too will adhere to a pricing policy must be made with extreme caution, if at all.

GOING FORWARD
It remains to be seen how the courts will apply the Leegin decision, but one thing is clear: Leegin represents a significant legal development in favor of manufacturers, which will be extremely helpful to them in maintaining retail pricing and, by extension, maintaining their brands.

In the final analysis, however, manufacturers should be aware that though their freedom to demand that minimum resale price agreements be maintained has been enhanced, such agreements are not going to be completely free of judicial scrutiny. On a case-by-case basis, some still may end up being regarded as violations of the Sherman Act under the rule of reason standard; and, in some circumstances, judges still may find ways to apply the per se standard of illegality (e.g., where there is evidence of a horizontal combination of companies that conspire with the manufacturer to create a disadvantage for one or more others at their level).

With Leegin decided and new case law developing, if you are a party to, or are considering entering into a price maintenance agreement, consider obtaining legal counsel regarding your rights and obligations.

Greg Sater is an attorney with Rutter Hobbs & Davidoff Inc., a law firm based in Los Angeles. He can be reached at (310) 286-1700, or via e-mail at gsater@rutterhobbs.com. Eric Peterson is also an attorney at the law firm. He can be reached at (310) 286-1700, or via e-mail at epeterson@rutterhobbs.com.