Australia: Product Bundling: The Implications Of The Recent Baxter Decision

The Full Federal Court has recently issued its decision in ACCC v Baxter Healthcare. This decision has significant implications for any firms that are considering bundling products. It is particularly relevant where a firm is bundling one product in relation to which it has a high market share with another product for which it faces greater competition.

IMPLICATIONS OF THE BAXTER DECISION

ACCC v Baxter Healthcare Pty Ltd is the first time that bundling has been found to be a misuse of market power under section 46 of the Trade Practices Act. The Full Federal Court's decision on 11 August 2008 illustrates the risks involved in implementing a bundling strategy. In particular, it shows that if you have market power in relation to one product, then you may need to be extremely careful when offering discounted pricing in return for an exclusive (or near exclusive) deal for that product and another product for which you face greater competition.

The Baxter decision also shows that section 46 is alive and well. The ACCC had expressed the view following previous unsuccessful section 46 cases that the section needs amendment and sets the bar too high. But Baxter shows that the current section still has some potential teeth and cannot be ignored.

UNFORTUNATELY BAXTER DOES NOT PROVIDE A CLEAR TEST FOR WHEN BUNDLING IS PROHIBITED

There is currently no clear test for determining when bundling will breach the Act. Bundling itself is not a breach. Instead, it is the pricing of the bundle that can constitute a breach. It will therefore turn on an assessment of the prices of the bundled products.

Economic tests have been developed and used overseas for assessing whether bundled prices are anti-competitive, but the Baxter judgments show that Australian judges tend to be sceptical of the usefulness of those tests. Both parties presented extensive evidence from economic experts, and Baxter's pricing was shown to breach the ACCC's economic tests. However, the judge at first instance decided that those models were not reliable and he did not base his decision on them. In the Full Federal Court, none of the judges even referred to the economic tests.

BUT IT DOES ENABLE US TO PROVIDE SOME GUIDELINES

As a result, the Baxter decision has not given us a brightline test. However, the various Baxter judgments enable us to develop several useful guidelines.

It's no defence that the buyer asked for bundled pricing

Baxter makes it clear that it is not a defence that the buyer expressly permitted or even asked for a bundled or exclusive offer. This point follows from the fact that it is not the making of a bundled offer itself that breaches section 46. Instead, it is the pricing of the bundle that is a breach. As a result, suppliers need to be careful when responding to tenders that request or allow bundled pricing. The need for caution is reinforced by the fact that an exclusive or near-exclusive offer could also constitute exclusive dealing that breaches section 47, as was the case in Baxter.

The ACCC's test for exclusionary bundling is a useful guide

In the original hearing, the ACCC set out a test for determining when bundling breaches section 46. Although that test was ultimately not relied on by the courts, it remains a useful indicator of the ACCC's approach and it can be a guide for assessing the risks that the pricing of a bundle may breach the Act. The ACCC's expert economist referred to bundling that breaches section 46 as 'exclusionary bundling'. If a firm has market power in product A but faces competition in product B, then 'it engages in exclusionary bundling when the incremental price for an AB bundle over A alone is less than the avoidable costs of B'.

The first step of this test is to impute a stand-alone price for the competitive product. This imputed price represents the price that competitors would have to offer in order to match the bundled price. This price is calculated by taking the bundled price for both products and deducting the unbundled price for the monopoly product. This imputed price is then compared with the cost of supplying the competitive product. If the imputed price for the competitive product is below the incremental cost of supplying that product, then a competitor could not match that price and the bundled pricing constitutes taking advantage of market power under section 46. The ACCC calculated the incremental cost of the competitive product by calculating the costs that Baxter would save if it ceased to provide that product, including a share of common costs.

Overseas regulators have endorsed tests that are similar to the ACCC's test in Baxter. For example, the European Commission's test for assessing whether bundling by a dominant firm breaches Article 82 of the EC Treaty is almost identical to the ACCC's test¹. The Commission assesses whether the bundling 'has a market distorting foreclosure effect' by asking whether 'the discount is so large that efficient competitors offering only some but not all of the components, cannot compete against the discounted bundle'. The Commission imputes a price for the competitive product in exactly the same way as under the ACCC's test in Baxter. It then considers that there is a foreclosure effect if that imputed price is less than the dominant firm's incremental cost of the competitive product.

The judges in Baxter appear to have applied a similar informal test

The judges in Baxter did not base their decisions on these economic tests. In the first instance, Justice Allsop reviewed the tests in detail but did not rely on them. His Honour had concerns about the robustness of the cost information and the treatment of uncertainty. In particular, Justice Allsop accepted Baxter's argument that in a tender situation, an accurate test should account for the uncertainty as to whether Baxter's tender would be successful and what would be the final prices and quantities, but that there are currently no models that can account for this uncertainty. On appeal, the Full Federal Court judges did not even refer to the economic tests.

However, the judges appear to have at least in part relied on a more 'gut feel' application of a similar informal test. Each of the judges appears to have asked himself whether the bundled price was so low compared with the unbundled prices that it was impossible for another supplier to make a competitive offer. Both the Federal Court and the Full Federal Court considered that Baxter's bundled prices contained such a large discount over the unbundled prices that there was no realistic prospect that a competitor could make an offer that the buyers could accept without paying substantially more than under Baxter's bundled offer.

In Baxter, this assessment was made easier by the very high bundled discount. Indeed, in relation to the offer in South Australia, Baxter's discount was so great it went beyond even giving the competitive product away for free and it actually cost significantly less to buy both products than to just buy the non-competitive product. In less clear cut cases, it may not be possible to apply this type of test without detailed economic modelling.

The beliefs of the supplier's personnel are important

Following on from the point above, internal documentation and evidence regarding the beliefs of the supplier's personnel that developed and approved the pricing will be important. If the evidence shows that they believed that the bundled price was so low compared with the unbundled price that it would be impossible for competitors to make an offer that had a realistic chance of success, then there is a high risk of a breach. Both courts in Baxter held that the evidence showed that senior management at Baxter knew that it would be impossible for competitors to match their prices and that the only way that a competitor could be successful would be if it had a significantly higher quality product. This evidence was a significant factor in the findings that Baxter had taken advantage of its market power and that it had acted with an anti-competitive purpose.

The purpose for offering the bundle and discount is also important

The supplier's purpose for making a bundled offer and including a discount in the bundled price will also be important. If the discount reflects cost savings and efficiencies from offering the two products together, then the risk of a breach is low. The ACCC's economists in Baxter conceded that bundling that breached the ACCC's tests would be justified where the bundled discount reflected cost savings from bundling. The ACCC's economists also conceded that low bundled prices would be rational in certain circumstances, such as when clearing stock, or if the firm failed to realise that prices were below cost, or where the cost of exit and re-entry is higher than the cost of staying in the market. A similar approach is taken by some overseas regulators. For example, the European Commission expressly recognises defences of 'objective justification' and efficiency².

However, if the purpose is to prevent competition in relation to the competitive product then there is a real risk of a breach. The line between seeking to win the business and seeking to prevent competition is a very fine one and the judges in the Full Federal Court disagreed on this issue. The majority considered that it is a breach if the purpose was to exclude the competition from putting in a realistic offer in that particular tender, and that the supplier did not need to have the purpose of forcing competitors to exit the market and not bid in future tenders.

The unbundled price should be a serious and realistic price

The unbundled price should be a serious and realistic price so that the customer has a genuine choice as to whether to accept the bundled offer. The judges in Baxter were clearly influenced by the fact that Baxter had no expectation that the unbundled price would be accepted and that Baxter's management did not consider it to be a serious offer. As an illustration, Baxter's bundled prices for the various tenders were 25 to 75% cheaper than its unbundled prices. The unbundled prices were also 50 to 80% higher than the prices currently paid by the relevant contracting parties. The judges saw this second point in particular as a clear indication that the unbundled pricing was not a serious offer that the buyers could conceivably accept.

Baxter also shows the risks of simply using your standard list price as the alternative to the bundled offer. In Baxter, the unbundled prices were taken from Baxter's 'basic hospital price list', but in practice those prices were only used for very small customers and were never paid by hospitals.

It is also no defence that the unbundled prices are not 'monopoly prices'. The Full Federal Court held that Baxter had taken advantage of its market power even though there was no evidence that its unbundled prices were totally unconstrained or were greatly in excess of its costs of production.

BAXTER ILLUSTRATES THAT THE CONDUCT OF FIRMS WITH MARKET POWER IS SUBJECT TO ADDITIONAL RESTRAINTS

These guidelines put firms with market power in a difficult position where competing aggressively can constitute a breach of the Act. That result may seem counterintuitive, given that the purpose of the Act is to promote competition. This conflict can only be reconciled by the fact that the Full Federal Court in Baxter acknowledged that different standards apply to firms with market power. For example, Justice Gyles stated that 'it has been recognised that the conduct of a firm with market power may be subject to restraints to which others without power are not'. Justice Mansfield also quoted with approval a comment made by Justice Scalia in the Supreme Court of the United States in Eastman Kodak:

Corporations with market power need to bear this point in mind. They should ensure that their staff understand that they need to take extra care as a result of that market power.

HOPEFULLY THE HIGH COURT CAN PROVIDE GREATER CLARITY

Baxter has applied to the High Court of Australia for special leave to appeal. It is therefore likely that we have not heard the final word on this issue. Hopefully, the High Court will use the opportunity to provide a clear test for assessing when bundling is simply an example of vigorous competition and when it crosses the line to become anticompetitive conduct.

Footnotes

1 European Commission, DG Competition discussion paper on the application of Article 82 of the Treaty to exclusionary abuses, December 2005, pages 57-58.

2 European Commission, DG Competition discussion paper on the application of Article 82 of the Treaty to exclusionary abuses, December 2005, page 60.

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