The Single Entity Defense in Antitrust Law: Understanding Control

1. Organization, Control, and the Single Entity Defense in Antitrust Dean V. Williamson US Department of Justice Antitrust Division May 2006

2. Observation: • Antitrust outsiders and even some insiders might be surprised to know that antitrust insiders could not tell them what a firm is. • Economists are the worst offenders. They’ve been puzzling over “The Theory of the Firm” since the 1930’s, but delineating “the boundaries of the firm” remains a challenge.

3. Observation: • Economists have good company. With the advent of antitrust legislation in 1890, lawyers have been pressed to consider what constitute antitrust “conspiracies.” • This motivated efforts to circumscribe conspiracies by negation – that is, by sorting out what they affirmatively are not. The law might insulate certain types of “business arrangements” from antitrust scrutiny by extending to them the status of “single entity.”

4. Section 1 of the Sherman Antitrust Act (1890): • “Every 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 declared to be illegal.”

5. Clarence Thomas in Texaco v. Fouad N. Dagher et al. 126 S.Ct. 1276 (February 28, 2006): • “This Court has not taken a literal approach to this language, however. See, e.g., State Oil Co. v. Khan (1997) (‘[T]his Court has long recognized that Congress intended to outlaw only unreasonable restraints.’)”

6. Problem: • Neither the law nor economics offer an operationally significant concept of “control,” and yet … • “Control” seems to be at the heart of efforts to characterize “firms” or “single entities.”

7. This matters, because??? • “Single entity” status may provide a useful safe-harbor in the law. “Per se Illegal” “Safe Harbor” “Rule of Reason”

8. This also matters, because the “single entity” question shows up! • Hospital “networks” have been proliferating over the last 15 years. (See, for example, the Evanston Northwestern Healthcare Corporation matter.) • Healthcare constitutes one-sixth of U.S. GNP and continues to grow.

9. Air Liquide Group (2003): • In 2003 the French Competition Council ruled that two subsidiaries of the Air Liquide Group, CFPO and Carboxyque Francaise, “rigged” bids for contracts to supply hospitals with “medical gas.”

10. A Swedish “Asphalt Cartel?” (2003): • A buyer of asphalt organized collaboration between competing asphalt suppliers: • “The Swedish National Road Administration has acted both as purchaser and supplier (Vägverket Produktion) in many of the procurements which the Swedish Competition Authority has cited in its petition. This is the reason that the participating companies have claimed that the Competition Act can not be applied.”

11. Does the “Safe Harbor” concept work? The Dagher matter was argued in the Supreme Court just this year. Wasn’t the Texaco-Shell joint venture the kind of “legitimate business arrangement” that might have been spared scrutiny?

12. Or does the Single Entity concept incorporate both a “safe harbor” concept and a truncated rule-of-reason analysis? Applications have included “vertical” relationships (e.g., franchising, patent licensing, exclusive contracts), sports leagues, etc…

13. Another observation: • The “single entity” case law offers a broad array of “tests.” • Some tests have proven to be more robust. Others have prompted confusion, e.g., the “unity of interests” test. • (1) Even members of a cartel may share a “unity of interests.” • (2) Chicago Professional Sports (1996): “[The] Copperweld [opinion of the Supreme Court] does not hold that only conflict-free enterprises may be treated as single entities.”

14. I suggest that the robust tests … • can be lined up in a two-stage sequence of tests, and • line up with what economics does have to offer with respect to control in organizations.

15. Control is Concentrated? Yes No Parties contribute complementary inputs? ACCEPT Yes No ACCEPT REJECT

16. Some Background in the Case Law United States v. General Motors (1941): General Motors complained that jurors should have been instructed that “if they find that the defendant corporations [various General Motors subsidiaries] together constitute a single co-operative enterprise, in the course of which defendants corporations do not compete with one another, that there is and can be no unlawful agreement among them to restrain trade and commerce among the states, in automobiles.” The Seventh Circuit Court of Appeals disagreed.

17. United States v. Yellow Cab (1947): “[A] restraint [on interstate commerce] may result as readily from a conspiracy among those who are affiliated or integrated under common ownership as from a conspiracy among those who are otherwise independent... The corporate interrelationships of the conspirators … are not determinative of the applicability of the Sherman Act. That statute is aimed at substance rather than form.”

18. Kiefer-Stewart Co. v. Joseph E. Seagram and Sons (1951) Even if commonly owned or controlled units of a firm may constitute “mere instrumentalities of a single manufacturing merchandising unit … common ownership and control does not liberate corporations from the impact of the antitrust laws.”

19. Joseph E. Seagram and Sons et al. v. Hawaiian Oke and Liquors (1969) “It is now settled law that if a corporation chooses to conduct parts of its business through subsidiary or affiliated corporations, and conspires with them to do something that independent entities cannot conspire to do under section 1 of the Sherman Act, it is no defense that the corporations are, in reality a single economic entity. The Supreme Court has said that ‘common ownership and control does not liberate corporations from the impact of the antitrust laws.’ … [Yet] [t]he Court has never indicated what, if any, are the limits of this [intracorporate conspiracy] doctrine.” “[Intracorporate conspiracy] doctrine hands to plaintiffs, on a silver platter, an automatically self proving conspiracy.”

20. Copperweld Corp. v. Independence Tube Corp. (1984) The Supreme Court severely circumscribed intracorporate conspiracy doctrine when it held that “[defendants] Copperweld and its wholly owned subsidiary Regal are incapable of conspiring with each other for purposes of § 1 of the Sherman Act. To the extent that prior decisions of this Court are to the contrary, they are disapproved and overruled.”

21. Copperweld expressly limited its inquiry to the “narrow issue” of “whether a parent and its wholly owned subsidiary are capable of conspiring in violation of § 1 of the Sherman Act.” It explicitly left open for further consideration other types of business arrangements such as those under which “a parent may be liable for conspiring with an affiliated corporation it does not completely own.” Fraser v. Major League Soccer (2002): “Once one goes beyond the classic single enterprise, including Copperweld situations, it is difficult to find an easy stopping point or even decide on the proper functional criteria for hybrid cases.”

22. There are many incantations of “ownership” and “control” in the case law and in economics, but it is not obvious how ownership and control are related. To fix ideas, let’s consider four types of “business arrangements” …

23. 1. An Electricity Marketing Contract Two parties, an electricity generator and an electricity “marketer,” commit to a 20-year contract. The marketer pays for the right to dispatch electricity from the generator’s generating units. The contract features a veto provision according to which the marketer can veto proposals by the generator to add or withdraw capacity during the 20-year term. Is the veto provision anticompetitive? Do the parties constitute a “single entity?”

24. 2. Two Electricity Marketing Contracts Two competing generators contracting with one and the same marketer.

25. 3. Hospital Networks A number of hospitals incorporate a new entity and assign governance of the entity to a board of directors. The hospitals appoint members to the board. They assign to the new entity rights to veto proposals by any one hospital to expand, upgrade or withdraw services or capacity (e.g., “hospital beds”). The new entity aggregates profits from each hospital so that it may propose and finance plans to expand, upgrade or withdraw service capacity. Each hospital maintains a veto over proposals by the new entity to expand, upgrade or withdraw services or capacity at any of its sites.

26. 4. A traditional corporate hierarchy A hierarchical tree of “parents” and subsidiaries. A “parent” anywhere in the hierarchy may delegate managerial functions to any its own subsidiaries or indirect subsidiaries, and any parent reserves the right to take back functions it had previously delegated.

27. (Apocryphal?) Q&A with Alfred Sloane, Jr. on Delegation and Control Q: How can you run GM with only 100 people? A: Delegate! Q: Then what do you do all day? A: Manage the exceptions.

28. “Delegation” indicates a point of contact between the law and the economics of organization: Economics does not offer an affirmative concept of control but does offer concepts of adaptation and “control rights.” Williamson (1971): Adaptation to (unforeseen) contingencies can pose an important economic problem. If adaptation is not a problem, then “control” amounts to nothing more than exercising the right to script a complete, state-contingent production plan.

29. Who gets to change the “script” when and if an uncontracted-for contingency arises? Grossman & Hart (1986): Parties who own the assets engaged in production get to decide how to redeploy those assets in the event uncontracted-for contingencies arise. These parties reserve “residual control rights.”

30. “Control rights” suggests how “ownership” and “control” are related. But, ownership does not imply all “control rights.” It implies rights that are residual in that parties may have signed away the most important control rights. Consider veto provisions in the electricity marketing contracts. One party owns the asset, but that party has signed away important control rights.

31. I add a concept here: “nexus of control” • Let “party” indicate any person or entity capable of assuming control rights. • Algorithm: • For each asset engaged in production, identify the parties that reserve control rights with respect to that asset. • Let this collection of parties indicate the nexus of control with respect to that asset.

32. “Nexus of control” will lend itself to a nested sequence of single entity criteria. • Criterion 1 > Criterion 2 > Criterion 3 • > Criterion 4 > Criterion 5 > Criterion 6

33. A A A > > > A B B B

34. Criterion 1 – All nexuses of control within the candidate single entity are identical. Mathematically speaking: the cluster of parties who constitute the union of all nexuses is identical to cluster of parties who constitute the intersection of all nexuses of control.

35. Criterion 2 – Encapsulated nexuses of control. All nexuses constitute a nested sequence of nexuses. Example: The Electricity Marketing Contract

36. Criterion 3 – A unique nexus of control belongs to all other nexuses of control

37. Criterion 4 – A unique cluster of parties belongs to all nexuses of control Criterion 5 – The agglomeration of intersecting nexuses of control

38. Criterion 6 – The agglomeration of all nexuses of control Note: If “>” indicates the ordering “is more demanding than,” then Criterion 1 > Criterion 2 > Criterion 3 > Criterion 4 > Criterion 5 > Criterion 6

39. Examples: Criterion 1 > Electricity Marketing Contract > Criterion 2 Criterion 2 > Two Marketing Contracts > Criterion 3 Criterion 3 > Hospital Network > Criterion 4

40. In other words … • Electricity Marketing Contract • > Two Electricity Marketing Contracts • > Hospital Network

41. What does the ordering “>” leave out? For one thing, it says nothing about how to evaluate the prospect that erstwhile “subsidiaries” appoint members to the board of a “parent” entity. Consider the “hospital network” example.

42. In Fraser v. Major League Soccer (2002), the court suggested that “the analogy to a single entity is weakened, and the resemblance to a collaborative venture strengthened, by the fact that the operator/investors are not mere servants of [Major League Soccer]; effectively, they control it, having the majority of votes on the managing board.” What the Fraser court declined to do, however, was suggest how board participation informs “control.”

43. Two forks in the road: Navigating single entity tests in the case law

44. “Economic Unity” Seagram and Sons (1969): “[S]ound management demands extensive delegation of authority within the organization. Yet, under the trial court's ruling, the more delegation there is, the more danger there will be that the holders of such delegated authority will be found by a court to be capable of conspiring with each other in carrying on the corporation's business, as in this case, where the trial court so held as a matter of law.”

45. “Economic Unity” Arleen Freeman v. San Diego Association of Realtors (2003): “The theme in these cases is economic unity. Where there is substantial common ownership, a fiduciary obligation to act for another entity's economic benefit or an agreement to divide profits and losses, individual firms function as an economic unit and are generally treated as a single entity.”

46. Single entity defenses failed tests of economic unity in: Freeman (2003), New York v. Saint Francis Hospital, Vassar Brothers Hospital and Mid-Hudson Health (2000) 94 F.Supp.2d 399, Robert M. Bogan v. Northwestern Mutual Life Insurance Company (1997) 953 F.Supp. 532, Malcolm Weiss v. York Hospital et al. (1984) 745 F.2d 786, SMMS v. United States (1982) 1 Cl.Ct. 188, National Society of Professional Engineers v. United States (1978) 435 U.S. 679. The court accepted a single entity defense on the basis of economic unity in Seagram and Sons v. Hawaiian Oke (1969) at 83.

47. “Complementarity” What about cases in which economic unity is less than complete? The Freeman court observed “[I]n the absence of economic unity, the fact that firms are not actual competitors is also usually not enough, by itself, to render them a single entity. Absence of actual competition may simply be a manifestation of the anticompetitive agreement itself, as where firms conspire to divide the market … Cases have required instead that the constituent entities be neither actual nor potential competitors.“

48. “Complementarity” Single entity defenses have failed some version of an “actual or potential competitors” test in Freeman (realtor associations), Maricopa County (medical associations), Professional Engineers (another professional association), and Citizen Publishing Company v. United States (1969) 394 U.S. 131 (a joint operating agreement).

49. Complementarity and Sports Leagues Two types of complementarity: (1) Demand-side network effects: Just as a phone network that features only one phone is worthless to users, so to a sports league that features only one team is useless. Need more than one team to produce “games.”

50. Complementarity and Sports Leagues (2) Supply-side network effects: But who needs a formally-organized league to produce “games?” The league may contribute complementary inputs: the brand name, rule-making standards Chicago Professional Sports: “[T]he NBA has no existence independent of sports. It makes professional basketball; only it can make ‘NBA Basketball’ games.”