Competitive Intelligence / Competitive Strategy, by Arik Johnson
by Arik Johnson

Tying Arrangements:
llegal tying is one of the most common antitrust claims

I. Introduction

II. Standard of Analysis

III. Basic Requirements

IV. The Kodak Case

V. Defenses

I. Introduction

Illegal tying is one of the most common antitrust claims. Although the Supreme Court and the lower courts have regularly addressed the merits of tying claims and much has been written about the basic requirements needed to establish a tying claim, tying claims still remain somewhat unpredictable in nature. Most of the confusion stems from the nomenclature. Tying is often referred to as per se, or automatically, illegal. Nevertheless, tying arrangements may sometimes be justified or subject to rule of reason analysis.

Simply put, a tying arrangement is an agreement by a party to sell one product but only on the condition that the buyer also purchases a different product (often known as a positive tie), or at least agrees that he will not purchase that product from any other supplier (often known as a negative tie). The product that the buyer is required to purchase in order to get the product the buyer actually wants is called the tied product. The product that the buyer wants to purchase is called the tying product. In the most basic sense, the seller has tied two products together, as if in a knot. The only way the buyer can get the one product is to also purchase another product that he or she may or may not want. The purpose of this EXECUTIVE LEGAL SUMMARY is to discuss the basic elements of tying and the analysis applied to tying arrangements.

II. Standard of Analysis

Tying arrangements can violate a number of antitrust laws. The confusion surrounding tying arrangements has arisen not because such arrangement might violate a number of different antitrust laws, but because the courts use confusing language when analyzing tying arrangements.

The antitrust laws are designed to protect competition. In antitrust law, there are some arrangements or restrictions that have such a deleterious effect on competition that courts have ruled them per se or automatically illegal. What this means is that if the basic elements of the antitrust violation are established, the court will consider the arrangement illegal and will not examine any justifications or reasons as to why the arrangement might actually benefit competition in some manner. Tying arrangements are often considered per se illegal. The basic requirements that must be met for tying to be per se illegal are as follows:

1. There must be two separate products or services.

2. There must be a sale or an agreement to sell one product (or service) on the condition that the buyer purchase another product or service (or the buyer agrees not to purchase the product or service from another supplier).

3. The seller must have sufficient economic power with respect to the tying product to appreciably restrain free competition in the market for the tied product.

4. The tying arrangement must affect a "not insubstantial" amount of commerce.

Courts are nearly unanimous in agreeing that these are the basic requirements of a tying claim. The problem is that even though the Supreme Court has called tying a per se violation, the Supreme Court -- and other courts -- have actually followed a standard of analysis known as the rule of reason. Under the rule of reason, courts will use a balancing test, or a "look at all the facts" approach. The courts will examine both the positive and negative effects of the arrangement to see if one outweighs the other. This type of analysis is not used for per se violations. The third requirement for an illegal tying arrangement, however, requires the courts to examine the degree of market power that the seller has in the various markets. This type of market analysis is used in the rule of reason. Thus, even though courts call tying arrangements per se violations, they typically look at the market and balance the procompetitive and anticompetitive effects of the arrangement before determining whether it violates the antitrust laws or not.

III. Basic Requirements

A. Two Separate Products

In order to have a tying arrangement in the first place, there must be two products that the seller can tie together. It would seem easy to determine whether there are two distinct products capable of being tied together, but the actual analysis of the two separate products (or services) issue has proven much more complex in practice. The nature of the problem is easily illustrated by examining the sale of a pair of shoes. Theoretically, the seller could sell each shoe separately and require the buyer of a left shoe to purchase a right shoe in order to get the left shoe. Do the left and right shoes constitute two distinct, separate products? Courts have created and utilized various tests to determine whether, in fact, certain products are actually two separate products that have been tied together by the seller.

The Supreme Court finally created a standard for analyzing whether there are two separate products, known as the "character of the demand" test. Under this test, the focus is not on how the two products are functionally related to each other (i.e., shoes go together) but on the character of demand by consumers for the two products. That is, would consumers typically demand that the two products be sold together or separately?

Some courts, prior to the character of the demand test, essentially asked if the products (or services) are generally sold together or whether they are generally sold separately. These courts also asked whether there is a separate charge for the products. Other courts often consider whether a packaging of the items or a combining of the products leads to efficiencies or improved quality of the products. These courts still consider these issues and many courts now apply the character of the demand test to determine if there are two separate products that can be tied together.

We should note that in the distribution/franchise situation, the separate product requirement becomes much more involved. While this discussion only focuses on tying generally, we think you should know that tying in the franchise situation raises another set of problems.

B. Coercion or Conditioning

The second element typically required for a per se tying violation is the existence of a tie. That is, the plaintiff in a tying case will try to establish that his purchase of a good was conditioned upon the purchase of another good. This requirement is referred to in many different ways. Some courts try to determine if there was a conditioning of the purchase of one product on the purchase of another product. Many courts refer to this requirement as the requirement of coercion. These courts reason that for an unlawful tying arrangement to exist, the plaintiff must establish some level of forcing or leverage exerted by the seller upon the buyers that amounts to coercion. In essence, the tying arrangement is not illegal unless the buyer is forced to purchase the one product in order to get the other product.

Courts have struggled with the terminology to apply to this requirement and the level of proof required to establish coercion or conditioning. Nevertheless, there are a few basic principles that arise from cases considering this requirement. For example, when there is an express condition that the buyer must purchase an additional product to get the product it wants, the existence of conditioning or coercion is fairly easy to establish. Likewise, when there is no express condition of any kind, such as when the buyer is free to purchase either product separately, the arrangement poses no problem. The complex cases do not involve express conditions or the lack of express conditions, but fall somewhere in between. The courts often struggle with the level of conditioning or coercion required in these cases and the result will depend upon the facts in each individual case.

C. Market Power

Arguably the most analyzed requirement for a per se tying violation is the requirement of market power. In the tying context, the seller must have sufficient economic power in the tying market to leverage into the market for the tied product. That is, the seller has to have such power in the market for the tying product that it can force the buyer to purchase the tied product. The requirement of market power is crucial to a per se violation. Once again, however, the requirement proves to be extremely complex. Various courts, including the Supreme Court, have struggled to determine exactly what type of market power must be shown.

The courts have concluded that a showing of market power in the tying market does not require a showing of monopoly power in that market. Rather, the vague test seems to be that the seller must have "sufficient economic power" in the tying market (the product or service that the buyer actually wants) to be able to impose a restraint in the tied product market (the product that the buyer presumably does not really want). In one case, the Supreme Court examined detailed data about market share conditions -- like a typical rule of reason analysis -- and concluded that a 30 percent share of the relevant market was not enough power for the seller to be involved in an automatically illegal tying arrangement.

Other aspects of products or services may lead the courts to consider that sufficient market power exists for a per se tying violation. For example, unique products, such as real estate, are often considered to confer a unique advantage upon their owner. For some courts, such products are unique enough to confer market power on the seller.

The real point to bear in mind is that the issue of whether the seller has sufficient market power to impose a tying arrangement makes the courts' analysis of per se tying arrangements different from other per se violations where the courts will not go into complex details about market shares and market power. These kinds of inquiries are used under the rule of reason analysis. We need to remember, however, that even though tying might be automatically illegal, the courts are likely to look at all the facts of the situation, including market power, before determining whether such arrangements are illegal.

D. Effect on "Not Insubstantial" Amount of Commerce

The fourth requirement for a per se tying violation is a showing that a "not insubstantial" amount of commerce in the tied product market be affected by the tying arrangements. Although the courts could have stated this in a different way, by requiring a showing that a substantial amount of commerce be affected, they have relied on this language.

Thus, tying arrangements are unreasonable when a "not insubstantial" amount of interstate commerce is affected. This has been clarified so that "substantial" means substantial enough in terms of dollar-volume so as not to be merely de minimis.

When the courts have limited their analysis to whether a "not insubstantial" amount of commerce was affected, the analysis has proven relatively easy, even if somewhat anomalous results have been reached by different courts. Courts have relied on absolute dollar amounts in determining whether the requisite amount of commerce has been affected. The dollar amount has varied from case to case. Determining what dollar amounts affect a "not insubstantial" amount of interstate commerce is largely a factual question for the courts.

Much like the market power requirement, the courts have seemingly made the effect on commerce requirement much harder than it should be. In one case, the Supreme Court appeared to add another element to the effect on commerce in stating that there "must be a substantial potential for impact on competition" before a tying arrangement will be considered automatically illegal. This additional element would require more detailed proof that the tying arrangement affects competition generally. Some courts have followed this reasoning and require a separate showing of an impact on competition while other courts have concluded only that a showing that a "not insubstantial" effect on commerce is required.

E. Economic Interest

Even though most courts agree on the basic elements needed to establish an illegal tying arrangement, there are a few courts that require a showing that the seller has an economic interest in the sale of the tied product -- the product the buyer presumably does not want to purchase. This requirement has arisen to deal with situations where the seller of the tying product requires the buyer to purchase a product that the seller has no financial interest in.

In this situation, the element of leveraging or forcing is there, but it does not help the seller expand its power in one market into another market. By requiring the buyer to purchase a product from a third party in order to get the seller's product, the seller does use leverage, but not to its advantage since it does not receive any economic value from the purchase of a product from a third party. Because a few courts require a showing of the seller's economic interest in the tied product, buyers trying to claim that the seller illegally tied two products together must be aware of this additional requirement.

IV. The Kodak Case

No discussion of tying would be complete without mentioning the case of Eastman Kodak Company v. Image Technical Services, Inc. Although this case dealt with numerous aspects of tying law, the case focused on the requirement of market power in the tying market.

Kodak manufactures and sells photocopiers and micrographic equipment and also sells replacement parts and service for its equipment. Independent service organizations (ISOs) also provide service for Kodak equipment, typically at a lower price than that offered by Kodak. Customers of Kodak equipment could buy the replacement parts themselves and hire the ISOs to service the machines or they could hire the ISOs to provide both the replacement parts and the service. Or, customers could use Kodak to obtain the replacement parts and service.

Kodak eventually instituted a policy of selling the replacement parts only to those buyers of Kodak equipment who purchased Kodak services to repair their machines. Kodak tried to limit the access the ISOs had to replacement parts for Kodak machines. This effectively limited the ability of the ISOs to repair Kodak machines for their customers. A number of ISOs finally filed suit, claiming that Kodak unlawfully tied the sale of service for Kodak machines to the sale of parts. Thus, the tying arrangement was allegedly between Kodak's repair service and its parts.

In Kodak, the issue was whether Kodak had sufficient economic power in the tying product market (for Kodak parts) to appreciably restrain competition in the tied product market (Kodak service). Kodak claimed that while it might have a monopoly share of the parts market, it could not actually exercise market power because there was competition in the equipment market, the primary market. Thus, Kodak argued that its lack of market power in the primary equipment market precluded a finding that it had power in a derivative aftermarket, i.e., the market for services for that equipment. The Court rejected this presumption, finding no basic economic reality which dictates that competition in the equipment market cannot coexist with market power in the derivative aftermarket.

Instead, the Court adopted the reasoning of the ISOs, that there were significant information and switching costs that would affect the behavior of consumers seeking to purchase either equipment or services. For example, there is an information cost that purchasers must understand when they purchase the equipment. In order for consumers to fully consider their servicing needs, they must be able to engage in "lifecycle" pricing, or pricing that takes into account not only the initial cost of the equipment, but also the costs of services needed after the purchase. Likewise, switching costs also affect the market. Consumers who have already purchased one type of equipment are more likely to accept an increase in price for the servicing of that equipment before they will switch to another piece of equipment. Under Kodak, then, market imperfections -- or "market realities" as the Supreme Court called them -- can provide the necessary economic power in the tying market required for a per se tying violation.

V. Defenses

Another way in which the per se rule for tying arrangements is not really a true per se rule is that there are defenses to tying arrangements. Under a true per se rule, once the required elements of the offense have been established, the conduct automatically violates the antitrust laws. With a true per se rule, the defendant cannot attempt to justify his conduct on any grounds. Tying law, however, recognizes a few -- albeit very limited -- defenses to an otherwise illegal tying arrangement.

Of the two recognized defenses to a per se tying violation, the more common is the business justification defense, also sometimes called the business necessity defense. In cases involving the business justification defense, the court may find ample evidence of an illegal tying arrangement. Courts that recognize the business necessity defense, however, may rule that there are sound business interests which justify the otherwise illegal tie. A common illustration used to explain this principle is a one- legged man. As one court put it, it does not seem reasonable that a seller would have to sell only one shoe (out of a pair) to a one-legged man. Rather, the sound business interests of the seller practically require that the shoes be sold as a pair.

Another defense to a per se tying violation is known as the fledgling industry defense. The fledgling industry defense arises when there is a new industry and where to require separate sales of products or services would simply destroy the company and/or the new industry. In this circumstance, the courts may allow the seller to engage in otherwise unlawful tying in order to protect the fledgling industry. This defense is very difficult to establish and is very limited. Companies need to show that they could not achieve the same result as the illegal tying arrangement through less intrusive means and also must demonstrate that the tying arrangement was reasonable throughout the entire period of the tying arrangement. If a company in a fledgling industry engages in a tying arrangement long past the time needed to protect the industry or company, that time period will not be protected by the fledgling industry defense.

Arik R. Johnson is Managing Director of the Competitive Intelligence (CI) outsourcing & support bureau Aurora WDC. Learn more about Arik at his firm's Web site