Distribution and Franchising Committee: ABA Section of Antitrust Law

Resale Maintenance and Dual Distribution

by Reuben Arnold, Neill Norman, and Daniel Schmierer 1

Several recent antitrust cases brought by both direct and focus on RPM as it applies dual distribution although indirect purchasers have challenged minimum resale price the analysis applies to multi-channel distribution as well, maintenance (“RPM”) policies imposed by manufacturers except where noted. engaged in dual distribution or multi-channel distribution.2 These cases are frequently dismissed Dual distribution and multi-channel distribution are because plaintiffs fail to establish a relevant or common practices across many industries, including fail to demonstrate that the defendant has information technology, consumer electronics, cosmetics, in that market.3 While these are appropriate threshold apparel, and home furnishings, among many others. tests, dismissal on these grounds means that the court As one Harvard Business School case study puts it, does not reach the central economic issue in the case, “[i] practice, most producers and resellers are usually namely whether the procompetitive benefits of an members of multiple—often, competing—channels RPM policy that supports dual distribution outweigh systems. Producers often sell through a number of any harm to competition. In this article, we discuss the intermediaries, while resellers often carry the products positive impact of dual distribution and multi-channel of competing manufacturers as well as the lines of many 4 distribution on interbrand competition, review the other suppliers in different product categories.” economic analysis of RPM, and demonstrate that RPM For example, Levi Strauss, a manufacturer of blue plays a key role in facilitating the competitive benefits jeans and other clothing, sells a variety of product lines that can arise from dual distribution and multi-channel through different channels targeting different segments distribution. of the market, including its own retail stores, high-end “Dual distribution” describes the distribution strategy stores like Neiman Marcus, department stores like Macy’s 5 of a manufacturer that sells to customers both directly and Sears, and discount retailers like Wal-Mart. Coach, and through third-party distributors or retailers. “Multi- a manufacturer of luxury handbags and accessories, channel distribution” describes a distribution strategy markets products to its consumers through a variety of in which a manufacturer sells through multiple types of channels, such as retail stores, factory outlets, concession retailers, such as online vs. bricks-and-mortar stores, or counters within larger stores (shop-in-shops), online 6 big box stores vs. specialist stores, etc. In this article we channels, and specialty stores.

1 Reuben Arnold is a senior analyst, Neill Norman is a principal, and Daniel Schmierer is a manager at Cornerstone Research. The opinions expressed are those of the authors, who are responsible for the content, and do not necessarily reflect the views of the Cornerstone Research. 2 See, e.g., Complaint, Costco Wholesale Corp. v. Johnson & Johnson Vision Care, Inc., 3:15-cv-00941 (N.D. Cal. Mar. 2, 2015); Corrected Consolidated Class Complaint, In re: Disposable Contact Lens Antitrust Litig. 1:15-md-2626-HES (M.D. Fla. Nov. 23, 2015); People of the State of New York v. Tempur-Pedic Int’l, Inc., 916 N.Y.S.2d 900 (N.Y. Sup. Ct. 2011); Jacobs v. Tempur-Pedic Int’l, Inc.,No. 4:07-cv-02-RLV (N.D. Ga. Dec. 11, 2007); and House of Brides, Inc. v. Alfred Angelo, Inc., No. 11 C 07834 (N.D. Ill. Dec. 4, 2014). 3 In House of Brides, Inc. v. Alfred Angelo, Inc., the plaintiff failed to allege facts that plausibly suggested that a single wedding dress brand constituted a cognizable product market. In People of the State of New York v. Tempur-Pedic Int’l Inc; the state court ruled that RPM provisions are unenforceable but not unlawful under New York state law. In Jacobs v. Tempur- Pedic International, Inc., the federal court concluded that plaintiffs had not identified a relevant market as required under the standard that had to be applied after Leegin Creative Leather Prods., Inc. v. PSKS, 551 U.S. 877 (2007). Costco Wholesale Corporation v. Johnson & Johnson Vision Care Inc., and In Re: Disposable Contact Lens Antitrust Litigation are ongoing.

4 Frank V. Cespedes, Channel Management, Harvard Business School Case Study No. 9-590-045, 3–6, 8 (rev. Nov. 2006).

5 S. C. Jain and G. T. Haley, Marketing Planning and Strategy 339 (8th ed. 2009).

6 P. Kotler and K. L. Keller, Marketing Management 495 (15th ed. 2016).

March 2016 8 Distribution and Franchising Committee: ABA Section of Antitrust Law

I. Competitive Benefits from Dual and Multi- urban area and to sell through a distributor in a more Channel Distribution thinly-populated rural area.11 Again, this distribution strategy has a pro-competitive impact: a supplier Dual distribution and multi-channel distribution can reaches certain market segments at a lower cost than it expand a manufacturer’s output, reduce distribution can attain on its own, and thereby increases the degree costs, and thereby yield pro-competitive benefits that of competition between brands in the marketplace. would not be realized under single-channel distribution. Additionally, the nature of a given product or market First, multi-channel and dual-channel distribution segment may require a company to take direct control may allow suppliers to reach a wider array of demand of a particular channel, while other channels are more segments within a broad market. In markets for many efficiently shared with intermediaries.12 For example, if a differentiated consumer goods, preferences for point- manufacturer of auto parts sells some proportion of its 7 of-sale service vary. By providing a product through a product to an auto manufacturer that uses the product variety of channels that offer differing levels of service as an intermediate input, the auto parts manufacturer at the point of sale, a manufacturer can cater to a wider may wish to control distribution directly to minimize range of consumer preferences and penetrate different the possibility of supply interruption. In contrast, 8 market segments. This expands output, and increases the parts manufacturer may find it simpler to allow an competition between brands. For example, a consumer intermediary to distribute that same part to its auto parts purchasing a computer may value the ability to use the store and auto mechanic customers. product on a trial basis buying it and or the transfer of their data and settings from an old computer to the Second, and relatedly, multi-channel distribution allows new computer; a small business purchasing the same different channels to focus on marketing and selling computer may value the availability of local repair efforts in which they have a comparative advantage. services and procurement advice; and a large corporation In many cases, local retailers have an informational with dedicated IT staff purchasing the computer may advantage that allows them to more effectively engage need none of these services. Different distribution in local advertising and selling efforts than a national channels tailored to different demand segments allow manufacturer. However, a national brand may be a manufacturer to efficiently satisfy these varied needs able to run large advertising campaigns and target and desires. In many cases, this segmentation would not market segments that are difficult for a local retailer be possible were a manufacturer to sell entirely through to reach. For example, a local HVAC retailer that distributors or entirely directly to consumers, or entirely sells Trane products likely has a better strategy for through a single type of reseller.9 targeting and selling to local small businesses than Trane does. However, Trane itself can produce and run Aside from product and service specifications, dual and large advertising campaigns more effectively, and can multi-channel distribution also allow manufacturers compete for large corporate procurements. This sort of to optimize across location and delivery method while dynamic exists in many areas; distributors provide many 10 minimizing costs. For example, it may be most efficient services such as order processing, customer support, and for a company to sell directly to consumers in a dense

7 See Frank Mathewson and Ralph Winter, The Law and Economics of Resale7 Price Maintenance,” 13 Rev. Indus. Org. 67 (1998) (“Additional demand factors include: the number of outlets or availability of the product, the convenience of the outlet’s location, the information provided to customers at the point of sale, the sales effort and talent of dealers, the reputation of the product for quality, the prominence of the display of the product and so on.”).

8 Jain, supra note 5 at 338. 9 Id.

10 Kotler, supra note 6 at 494.

11 Jain, supra note 5 at 340. 12 “Channel Management,” Cespedes, supra note 4 at Harvard Business School, Case Study No. 9-590-045, pp. 3–6, 8.

March 2016 9 Distribution and Franchising Committee: ABA Section of Antitrust Law

customer education that a manufacturer may be well- combination of distribution methods increases the positioned to deliver to some segments of the market but manufacturer’s competitiveness in the market which, in poorly-positioned to deliver to other segments.13 Indeed, turn, promotes inter-brand competition and improves in many cases, manufacturers add channels when they consumer welfare. realize there are customers or market segments that they cannot effectively satisfy with existing channels.14 II. Can Facilitate Dual - and Multi-Channel Distribution and While product distribution through third-party Enhance Interbrand Competition retailers may be the most efficient solution for many manufacturers, others choose to integrate forward into As part of a dual or multi-channel distribution strategy, direct sales to consumers for a number of reasons. manufacturers frequently impose vertical restraints, i.e., First, a manufacturer-operated retail store allows the policies that limit the conduct of both the manufacturer manufacturer to shape its brand image by controlling and its downstream trading partners. These include the shopping experience more closely and providing policies such as resale price maintenance, minimum a broader selection of its goods. Nike and Apple are advertised , exclusive territories, and exclusive 20 notable examples of this approach.15 Many large firms dealing. Minimum resale price maintenance (RPM) in and brands have also decided to manage Internet sales particular can play a key role in facilitating successful of their products for the same reason. Estee Lauder, for dual and multi-channel distribution, as it provides the example, decided to launch an Internet channel for its manufacturer with an instrument with which it can elicit Clinique products as an alternative distribution method the level of retail promotion services consistent with its to traditional sales via department store cosmetics objectives for its brand. 16 counters. Similarly, Apple manages its own online First, manufacturers may use RPM to correct a well- storefront and prohibits its bricks-and-mortar resellers known market failure — the free rider problem — that 17 from selling over the Internet. can otherwise frustrate attempts to elicit competition in Second, a manufacturer that integrates forward into retail retail services to promote its products. A free rider is an may be able to generate higher profit margins and expand economic agent who appropriates the benefits of another output by eliminating double marginalization.18 Finally, agent’s (costly) economic endeavors. The classic example direct selling provides closer contact with customers involves a complex consumer durable good whose sale and customer information, improving supply chain requires a knowledgeable salesperson to inform and efficiency by giving the manufacturer a better picture persuade a consumer of the product’s merits. Suppose of market demand.19 Manufacturers that choose a dual that, upon receiving the requisite information from the distribution strategy are able to realize these benefits full-service retailer, the shopper leaves the store without while simultaneously enjoying the benefits of third-party making a purchase, travels to a discount operation that distribution in other market segments. This efficient stocks the product the consumer now knows she wants,

13 A. A. Tsay and N. Agrawal, Modeling Conflict and Coordination in Multi-Channel Distribution Systems: A Review, in Handbook of Quantitative Supply Chain Analysis: Modeling in the E-Business Era 558 (2004).

14 Jain, supra note 5 at 340.

15 Kevin Lane Keller, Brand equity management in a multichannel, multimedia retail environment. 24:2 J. Interactive Marketing 58-70 (2010).

16 Tsay, supra note 13 at 559.

17 Steve Tobak, How to Sell Like Apple, CBS News Moneywatch (May 13, 2010), available at http://www.cbsnews.com/news/how-to-sell-like-apple/. 18 Jean Tirole, The Theory of , MIT Press (1988), pp. 174-175.

19 Tsay, supra note 13 at 558.

20 A minimum resale price maintenance agreement between a manufacturer and a retailer sets a minimum price that a retailer may charge for the manufacturer’s products. See Dennis W. Carlton and Jeffrey M. Perloff, Modern Industrial Oorganization 423 (4th ed 2004).

March 2016 10 Distribution and Franchising Committee: ABA Section of Antitrust Law

and buys it for a lower price. The lower price is possible retailers supply non-contractible retail service that because the buyer and ultimate seller can free-ride on increases the demand for the manufacturer’s product. (i.e., appropriate the benefits of) the full-service retailer’s Where incomplete information and monitoring costs costly investment in pre-sale service. make writing and enforcing a complete and explicit performance contract with a retailer impractical, In markets in which free-riding is common, sellers may manufacturers may instead use RPM to elicit reduce the level of services they provide because they performance by retailers who are eager to retain the do not receive adequate compensation in the form of a protected retail margin it affords.23 sufficient retail margin. Consumers in turn may reduce their participation in such markets because they do not The problem of free-riding can be a particular concern receive adequate pre- or post-sale services. The upshot is in cases where there is dual distribution. The fact a reduction of output, consumer welfare, and interbrand that the retailer and the manufacturer have different competition. In the extreme, the market for a desirable incentives, business models, and cost structures can good (i.e., a good whose value exceeds its opportunity increase the likelihood of conflict between the retailer cost) can simply dissolve because of free-riding. and manufacturer and increase the incentives to free-ride. Therefore, to have an effective dual distribution system, RPM corrects the free-rider problem by requiring a manufacturer can use RPM to reduce conflicts and retailers of a manufacturer’s products to charge a eliminate free-riding. minimum price that provides a profit margin sufficient to justify investment in pre-sale service, thereby thwarting A. Manufacturers Selling Directly to Consumers discounters that seek to free-ride on other retailers.21 Have Incentives Consistent with Interbrand The effect of the policy is to enhance intrabrand service Competition competition, limit intrabrand price competition, and increase interbrand competition. Manufacturers who sell directly to consumers do not have the same incentive to free-ride as non-affiliated The use of RPM is not confined to markets for retailers. This is because the manufacturer internalizes information-intensive consumer goods vulnerable the impact of its actions on the brand as a whole. While to free-riding. Manufacturers also implement RPM any individual third-party retailer has an incentive to pricing policies for goods that do not require detailed reduce its provision of service and reduce its price to information or extensive product demonstration undercut other retailers of the manufacturer’s products, at the point of sale, or significant post-sale service the manufacturer will not engage in such behavior itself commitments. Economics offers two theories to explain because it recognizes that this behavior is inconsistent this phenomenon. Under the “quality certification” with the long-term competitiveness of its brand. This view of RPM, retailers may use protected margins to is one reason why some manufacturers, particularly invest in greater services (e.g., longer hours of operation, those who are concerned with the provision of service nicer store furnishings, additional sales force training) or the consistency of their brand image, may choose to that signal or certify the quality of their merchandise control the online sales of their products: whereas third- and increase demand for the manufacturer’s product.22 party Internet retailers have an incentive to free ride on A second view explains RPM as a contract enforcement the services provided by bricks-and-mortar stores, the mechanism that a manufacturer adopts to assure that manufacturer does not.

21 Lester G. Tesler, Why should manufacturers want fair trade? 3 J. Law and Econ. 86-105 (1960).

22 See Howard P.Marvel and Stephen McCafferty, Resale price maintenance and quality certification, 15 RAND J. Econ. 346-359 (1984).

23 See Benjamin Klein and Kevin M. Murphy, Vertical restraints as contract enforcement mechanisms, 31 J. Law and Econ. 265-297 (1988); Benjamin Klein, Competitive Resale Price Maintenance in the Absence of Free Riding, 76 Antitrust L.J. 431-481 (2009).

March 2016 11 Distribution and Franchising Committee: ABA Section of Antitrust Law

This distinction between the incentives of the and education. Since the manufacturer is concerned manufacturer (in its role as a direct-to-consumer seller) with the long-term profitability and strength of its brand, and third-party retailers is perhaps best illustrated it prices its online sales at a level that internalizes the through examples. As the following examples show, impact of online sales on service. In doing so, it may, RPM policies can be useful to manufacturers with for example, choose to sell online only at MSRP. By different retail strategies. However, in both examples, supporting the provision of service and education, this an RPM policy allows the manufacturer to implement arrangement may strengthen the competitiveness of a dual distribution strategy that increases interbrand the cosmetic manufacturer’s brand and thereby enhance competition. inter-brand competition.

B. Example: Dual Distribution Online and C. Example: Multi-Channel Distribution through Through Specialty Stores Online and Retail Direct Channels and Multiple Third-Party Retail Channels As a first example, consider a manufacturer of high-end cosmetics that sells products both through beauticians As a second example, consider a manufacturer of (specialty bricks-and-mortar stores) and through its own computers and electronics that sells its products to website. This manufacturer sells (offline) only through consumers directly both online and in manufacturer- beauticians because it wants to make sure that customers operated retail stores, and indirectly through a variety of are provided with the service and education needed to third-party retailers, including big-box electronics stores properly use the manufacturer’s products. and small businesses that focus on repair and sales of the manufacturer’s products. Much like the cosmetics Suppose the manufacturer sells its products to beautician manufacturer described above, this manufacturer chooses retailers at prices substantially below the manufacturer’s to sell through vendors that it believes will adequately suggested retail price (MSRP). The gap between the convey its brand and educate consumers about its wholesale price and MSRP is meant to cover the costs products. that retailers will incur in providing service related to the manufacturer’s products. However, in this situation, As part of its retail strategy, this manufacturer also each individual retailer has an incentive to set up an introduces an RPM policy to eliminate the possibility of online storefront and sell the manufacturer’s products at discounted online sales by third parties. This policy is discounted prices below MSRP, because the retailer does meant to prevent third parties from free-riding on the not incur the costs of service and education in sales to brand-building activity conducted by the manufacturer. online customers. To protect against this type of free Since the manufacturer has a strong incentive to ensure riding, the manufacturer may put in place an RPM policy a positive customer experience that will generate repeat to keep retailers from selling online at deep discounts. purchases, and since it benefits from customer purchases regardless of channel, the manufacturer has chosen At first blush, the need to prohibit retailers from selling to invest substantial capital in the development of its at deep discounts online (and therefore not providing website, with professionally-produced videos explaining in-store service) may seem inconsistent with the its products and beautifully-designed interfaces that manufacturer itself selling its products online. But the generate a premium shopping experience. A third-party key difference is that the manufacturer, when it sells online seller does not share the manufacturer’s incentive online, does not have the same incentive to free ride on to create a premium online shopping experience, the service and education provided by the bricks-and- because it cannot completely internalize the return mortar retailers. When pricing its own online sales, the from that investment. Instead, it has an incentive to manufacturer weighs the direct profits from online sales minimize its costs associated with the online sale of against the broader impact of those sales on the ability the manufacturer’s brand and free-ride on the positive of the bricks-and-mortar beauticians to provide service

March 2016 12 Distribution and Franchising Committee: ABA Section of Antitrust Law

brand image and national marketing conducted by the differentiated goods and services to different customer manufacturer. By setting a minimum resale price, the segments efficiently and permit them to delegate manufacturer removes the ability of third party online tasks such as order processing and customer support retailers to free ride on the manufacturer’s brand building that may be difficult for them to complete in a cost activities by undercutting the manufacturer on price. effective manner. However, retailer free-riding and The RPM policy also incentivizes third party online difficulty in obtaining non-contractible retail services sellers to compete, both with each other and with the can compromise these benefits and undermine dual manufacturer, on the quality of the online shopping and multi-channel distribution. RPM policies can experience, which benefits consumer welfare. The RPM support dual and multi-channel distribution and increase policy therefore helps the manufacturer eliminate online interbrand competition. Thus, when analyzing RPM customer experiences that would damage its brand, thus under the rule of reason, the presence of dual and improving its ability to compete in the long term against multi-channel distribution — and its attendant benefits other consumer electronics manufacturers. to consumers and competition — should be taken into account. III. Conclusion

Dual and multi-channel distribution strategies, when working as intended, allow manufacturers to deliver

March 2016 13

©Copyright 2016 American Bar Association. All rights reserved. The contents of this publication may not be reproduced, in whole or in part, without written permission of the ABA. All requests for reprints should be sent to www.americanbar.org/utility/reprint