Is an Anticompetitive Contract Clause an Ancillary Restraint that will survive Antitrust Scrutiny?

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As a regular reader of The Antitrust Attorney Blog, you understand that setting prices or allocating markets with your competitor is a terrible idea. Doing so is likely to lead to civil litigation and perhaps even criminal penalties.

Price fixing and market allocation agreements are per se antitrust violations. That means they are the worst of the worst of anticompetitive conduct.

There is, however, a limited circumstance in which what would normally be a per se antitrust violation is instead treated by Courts and government antitrust agencies under the rule of reason:

An ancillary restraint.

You shouldn’t put ancillary restraints in your agreements without the help of an antitrust lawyer. That would be like juggling knives that are on fire. You might be able to do it, but if you make a mistake, you won’t like the results.

What is an Ancillary Restraint?

This isn’t an easy question to answer and, in fact, if you can answer it, you will often know whether your restraint will survive antitrust scrutiny.

Let’s back up a little bit.

In a typical situation, if two competitors agree to fix prices or to split a market (perhaps they will agree to limit their competition for each other’s customers), they commit what is called a per se antitrust violation. What that means is that this type of restraint is so consistently anticompetitive that courts won’t even examine the circumstances—it is per se illegal.

Obviously you should avoid committing per se antitrust violations, unless, of course, you want to experience an antitrust blizzard.

Without further context, such a restraint is often called a naked restraint of trade. That doesn’t mean that the cartel meets at a nudist colony; it means that it is an anticompetitive agreement with nothing surrounding it. Such agreements are almost always done to gain greater profits from the restraint itself.

So what does a non-naked restraint of trade look like? Interesting question. I will answer it, but you have to read through most of this article.

Sometimes two or more parties, even competitors, will put together a joint venture or collaboration that creates what antitrust lawyers often call efficiency. You might normally think of efficiency as running more smoothly or at the same or better result with fewer resources.

But when antitrust attorneys use the term “efficiency” or “efficiency enhancing,” they often mean that the venture or combination will create economic value for the marketplace as a whole that wouldn’t exist but for the agreement. The term often comes up in the merger context, as an antitrust analysis of a merger will examine whether the benefits through efficiency and more exceed any potential anticompetitive harm.

An Ancillary Restraint Example

Sometimes it is easier to understand with an example: Let’s say you have a company called Research that is full of people with PhDs that spend all of their days trying to figure out how to make the world a better place. If someone at Research comes up with a good idea, the company will sometimes manufacture and sell the finished product itself.

In this same hypothetical world is a company called Manufacture. They are great at manufacturing products. They have a few of their own products, but their real skill is in manufacturing, so they will often contract with other companies to Manufacture and sell their products.

One day, company Research comes up with a great idea, perhaps even a world-changing idea. They talk internally about manufacturing and selling the product, but come to the realization that they suck at manufacturing. Well, they aren’t terrible, but they aren’t that good either. And since it is a world-changing product, the demand will probably be high, so if they want to sell it for a reasonable price, they will need to manufacture and sell it at a much greater scale than they can do now.

So Research calls up company Manufacture and asks them about manufacturing and selling the world-changing product. Manufacture is interested—it is a big piece of business and if anyone could do it well, it is them. That is why they named themselves “Manufacture.”

At a certain point the lawyers get involved in putting the deal together. And one of the attorneys for Research brings up the concern that Manufacture will take what they learn from this contract with Research—including the trade secrets that they have to pass along so Manufacture can create the machines to produce the product—and create a competing product. The product is world-changing, remember, so there is a lot of potential value in that.

Research is conservative and not about to give up their secrets, even with contractual protection, to someone that could take the secrets with minimal trace to create a competitor product from Research’s IP and trade secrets.

So Research goes back to their labs where they hold their meetings resigned to the idea that they will have to manufacture their great product themselves, even though they suck at manufacturing. They will make money, but not as much.

Company Manufacture is also depressed—that would have been big business, and a lot of fun to sell such a world-changing product. But they understand: As much as they could say they won’t steal the secrets, they know that if they wanted to, they could do it with little likelihood of being traced. So they aren’t mad at Research.

But most of all, the people that want to buy the world-changing product lose. They can still purchase it, eventually, after Research finally figures out how to manufacture it. But the product won’t be as good because the quality of manufacturing makes a big difference in its value. So the product doesn’t change the world after all.

But what if there were an alternative—some way for Manufacture to manufacture the product without Research worrying that their trade secrets and IP will be stolen from them?

Sure, the companies could merge and that might be better than not doing a deal, especially for a world-changing product. But that isn’t an ideal solution as both companies may want to remain independent and there may be good reason for them to do so, as they each have a specific focus. Merging might eliminate that important focus that has led to success for both companies.

There is, in fact, a solution short of merger. Can you figure out what that is?

That’s right, it is an Ancillary Restraint.

In this case, a market allocation agreement is actually the pro-competitive solution to a problem, rather than an anticompetitive evil.

Here is how it would work in this example: Company Research and Company Manufacture would enter into an arrangement whereby Research would license its IP for the world-changing product to Manufacture, who would agree to manufacture and sell the product in exchange for a royalty (fee per product).

To sufficiently eliminate Research’s concerns that Manufacture would steal the IP and create their own product, the parties would include in the IP licensing deal that Manufacture would, for the duration of the contract, agree not to manufacture and sell a competing product.

Research and Manufacture have smart antitrust lawyers, so they draft the restraint—which in other circumstances would be a naked market allocation agreement—to be narrowly tailed to specifically address Research’s reasonable concern. They don’t go any further than is necessary to make the agreement itself possible.

To put this in terms that the antitrust agencies might use, this “efficiency-enhancing integration of economic activity” includes a market allocation agreement that is “reasonably necessary” to the integration.

What that means is that without the agreement by Manufacture not to sell any competing products, the arrangement itself wouldn’t be possible. So the “restraint” is ancillary to a larger pro-competitive agreement.

In this example, consumers greatly benefit from the arrangement between Research and Manufacture as each company is able to contribute their complimentary skills to create and sell a world-changing product. If Research had to do it by themselves, it wouldn’t be nearly as valuable to consumers. And Manufacture, of course, didn’t have the great idea—that came from the PhDs at Research. This is an example of an efficiency-enhancing or pro-competitive agreement

Going back to the question of what does a non-naked restraint look like, it looks like this example. When a naked restraint is surrounded by and reasonably necessary to a larger procompetitive agreement, it may be called an ancillary restraint.

If we are going to keep with the metaphor, for a restraint to not be naked, it has to be clothed in a procompetitive arrangement or structure.

Does this mean that an ancillary restraint is always legal? No. What happens instead is that the courts and government agencies will review the restraint under a different standard. This may not sound like much, but moving from the easy-to-prove per se standard to the rule of reason is a big deal.

Under the rule of reason, the court or agency will actually examine the particulars of the deal to determine whether the pro-competitive benefits exceed the anticompetitive harm. The reality is that a rule of reason case is so much more expensive and resource intensive and so much less likely to prevail that agencies and plaintiffs are unlikely to bring them unless they are strong.

That doesn’t mean that an ancillary restraint won’t be condemned under the rule of reason, but if it is truly ancillary, it is much more likely to survive antitrust scrutiny.

Please consider, however, that when you put what are usually considered naked restraints into your agreements, you are taking a risk. You should only do this with guidance. Even with proper antitrust counseling, you don’t completely eliminate antitrust risk. But you can substantially reduce that risk and perhaps solve a problem that will create lots of revenue, along with value for consumers.

If you are interested, here is my approach to counseling clients on antitrust risk.

Sometimes, of course, companies will try to hide a naked restraint in an agreement that they describe as procompetitive. The issue usually comes down to whether the overall arrangement is, in fact, procompetitive and whether the restraint is reasonably necessary to the procompetitive arrangement.

For example, you can’t just agree to limit how you compete for customers when you are putting together an agreement that doesn’t reasonably need such a limit for its existence. That’s a good way to invite antitrust litigation and government investigations.

Whatever you do, make sure that you find antitrust help if these issues come up. Don’t handle this yourself.

If you are interested in more detail, you should read Antitrust Guidelines for Collaborations Among Competitors, which was put out by the Federal Trade Commission and Department of Justice. If you are a Law360 subscriber, I highly recommend an article that my colleague William Markham wrote on ancillary restraints.

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