China: Vertical Antitrust Issues In Distribution Agreements

Last Updated: 15 October 2013
Article by Vincent Chiu

Background

Resale price maintenance and territorial restraints terms are common in distribution agreements between producers (or suppliers) and their distributors. Recently, many of our clients have enquired whether distribution agreements containing such territorial or resale price restraints are considered vertical monopoly agreements and how companies can achieve business objectives of restricting the resale price and sales territory of distributors within the law. Mr. Qiu cites relevant statutes and practices and gives a brief analysis on the above issues to provide useful suggestions for companies facing such problems.

I. Nature of distribution agreements

In general, a distribution agreement is a legal agreement between a producer (supplier) and a distributor of goods and the distributor sells the goods provided by the producer or supplier in his own name. Such an agreement falls into the category of vertical agreements concluded between business operators and their trading parties,as set out in Article 14 of the Anti-Monopoly Law of China (AML).

II. Does a distribution agreement with terms "restricting the minimum resale price and sales territory" violate the AML?

To answer this question, first we should be clear what vertical monopoly agreements are. A vertical monopoly agreement is an agreement, express or implied, made by and between two or more parties which are not in direct competition but in a buyer-seller relationship and operate at different levels of the supply chain in the same industry. The agreement is believed to have a restrictive or exclusive effect on competition. Vertical monopoly agreements may be classified into two categories: vertical price agreements and vertical non-price agreements, based on the characteristics of specific agreements.

Article 14 of the AML and Article 8 of the Anti-Price Monopoly Provisions set out two categories of vertical price agreements, including "price-fixing" and "resale price maintenance", and they provide that "business operators and their trading parties are not allowed to reach price monopoly agreements that: (1) fix the resale price of goods; or (2) restrict the minimum price of goods for resale to a third party". The preceding articles also contain miscellaneous provisions stating that other vertical price agreements shall be determined by the antitrust enforcement agencies and the price departments of the State Council.

Article 17(1) of the AML sets out two categories of vertical non-price agreements, including" designated trading" and "tied sale or attaching unjustified conditions". In theory and practice, vertical non-price monopoly also includes territorial or client restraints, exclusive distribution, exclusive deals, quantity-forcing agreements and any other conducts restricting the operation of upstream or downstream businesses.

Based on the above analysis, a distribution agreement containing the "minimum resale price maintenance" terms may be considered a vertical price monopoly agreement; however, "prohibiting cross-regional sales of products" is not expressly classified into the category of vertical monopoly (agreement)1, even Article 13(3) of the AML states that the "sales market segmentation" is a monopoly agreement, but only competing undertakings are prohibited from reaching such agreements (a type of horizontal agreements). Article 15 of the AML sets out some exemptions of resale price restraints such that if undertakings can prove their agreements have been reached under certain special circumstances, such agreements may fall outside the category of monopoly agreements.2

It can be ascertain from the above that only monopolies that harm competition are subject to the AML. To establish if the practice of restricting the minimum resale prices should be prohibited, we must analyze if the price restraints harm competition. According to the preceding provisions, price restraints with anti-competition effects fall within the scope of vertical monopoly agreements as prohibited by the AML. It should be noted that if a company is accused of antitrust behavior because of using the minimum resale price terms in a distribution agreement, the company should prove that such terms meet the criteria of exemptions, as provided in Article 15 of the AML, and that the agreement containing such terms enables consumers to share the benefits created by the agreement and does not impose severe restrictions on competition in the relevant market. Given that the AML and Anti-Price Monopoly Provisions do explain the proofs further, thus the scope and definitions of "severe restriction" and "consumers" are not clear. Manufactures (suppliers) of goods should carefully draft the price terms and conditions in their distribution agreements to avoid the establishment of price monopoly conducts which will be punished by antitrust authorities.

III. If the resale price restraint provisions are suspected of violating the AML rules, how to flexibly draft the terms of an agreement that legally achieve the business objectives of certain distributors' malignant competition?

According to the above analysis, we can see that the risk that "minimum resale price restraints" are considered vertical monopoly (agreement) is high and once antitrust authorities conduct an investigation, the investigated party assumes a heavier burden of proof. Therefore, we suggest that companies should avoid directly restricting the minimum price for selling products to the third party in their distribution agreements. Whenever possible, they should try to use the "suggested retail price or recommended resale price", and it is better not to connect such suggested or recommended price with the refusal to deal or price discount. These business arrangements do not eliminate price competition among sellers; therefore, they are in compliance with the AML rules.

In addition, if the distribution agreement is essentially a sales agency agreement, the agreement with the preceding terms and conditions may not be subject to the AML. In general, in determining whether a distribution agreement is an agency agreement, a crucial factor is whether the agent undertakes risks in assets and business when engaging in the commissioned business activities. In other words, if the agent does not undertake any business risks in the commissioned activities, the agency agreement can be deemed as a true agency agreement which is not regulated by the AML. Further, if a distribution agreement is concluded between a patent company and its affiliates, such agreement is also not regulated by the AML.

IV. Establishment of "a business operator with dominant market position"

Some clients asked if a supplier, who is the sole agent for some branded products, would be considered as having "dominant market position" for having distribution rights for several brands.

We think that market dominance in the AML means an undertaking has a degree of dominance or control in a certain market, that is, the capacity to control the quality, price and sales of products in a relevant product and geographic market. The abuse of a dominant position in a market is one of the monopoly conducts regulated by the AML. To establish the abuse of a dominant market position, we first should define market dominance.

Defining the relevant market is the premise for determining whether an undertaking has a dominant position in a market. Article 12(2) of the AML provides that, "the relevant market mentioned herein refers to the product and geographic market in which specific goods or services of business operators compete with each other during a certain period of time (hereinafter collectively "goods"). Therefore we can see that the relevant market has two components: the product market and the geographic market. In the preceding context, we only need to consider the relevant product market, which contains all those substitute products that constitute a particular market. International experience shows that the scope of a market is determined according to two factors: demand-side substitution and supply-side substitution3. The demand-side substitution is used by the European Union and the United States as the basic standard to define the product market. If two products are regarded as substitutable by the consumer by reason of the products' prices, quality and their intended use, these two products fall within the scope of one market. A case decided by a US court involved cellophane, which differs from flexible packaging materials and they are fungible in use. The court ruled that the relevant product market should contain the above two materials with different characteristics. From this perspective, for consumers, it could not eliminate other brands that can substitute brands to which the supplier has exclusive distribution right, thus, a company having the exclusive distribution rights to some brands should not be considered as having dominant position in a relevant or particular market.

V. If a business operator is not dominant in a market; will the use of resale price or territorial restraints in a distribution agreement be not considered as severely restricting competition in the relevant market and not violating Article 14 of the AML?

This issue's essence is to analyze the statutory exemptions of horizontal and vertical monopoly agreements as set out in Article 15 of the AML. It should be first noted that the provisions providing exemptions merely require that operators shall prove that the agreement between them will not severely restrict competition in the relevant market but that the term, "severely restrict competition in the relevant market" is not defined. Considering that there are countless variable factors in the market, it is incorrect to simply conclude that an operator who is not in a dominant position will not" severely restrict competition in the relevant market". As a matter of fact, for a vertical agreement point of view, we believe that the rationale behind the prohibition of monopoly agreements is as follows:

First, if a business operator and its trading parties reach agreements "fixing the resale price of goods" or "restricting the minimum price of goods for resale to a third party" and "any other monopoly agreements as determined by the antitrust enforcement agencies of the State Council", the above agreements can be considered vertical monopoly agreements, as prohibited by Article 14 of the AML, and the "business operator" is not required to enjoy dominant position.  

Second, if the business operator can prove that the agreements they reached meet the exemptions criteria as provided in Article 15 and can also prove that such agreements enable consumers to share the benefits created by the agreement and do not impose severe restrictions on competition in the relevant market. The inverse is not established.

VI. The legal liability of a distribution agreement in violation of the AML

Above, we discussed how a distribution agreement avoids violating the AML. A company should also be clear about legal liabilities for violating the AML and be well prepared.

(1)     Civil liability

The AML does not specify civil liabilities for a distribution agreement which violates the law. Article 11 of the draft of the AML provided that the monopoly agreement as prohibited in this chapter is considered to be invalid from the outset, but the final version of the AML removed this article. Therefore, it is not clear whether the distribution agreement considered the monopoly agreement under the AML is valid or not, and further explanations need to be given by antitrust enforcement agencies or the Supreme People's Court.

(2) Administrative liability

According to Article 46 of the AML, where a business operator's distribution agreement violates the AML, it shall assume administrative liability and (i) be ordered to cease violations, (ii) surrender the illegal gains and, (iii) receive a fine of 1% up to 10% of the sales revenue in the previous year. Where the distribution agreement has not been performed, a fine of less than Rmb500,000 shall be imposed.

It should be noted that, if the business operator voluntarily reports the conclusion of the monopolistic distribution agreement and presents vital evidence to antitrust enforcement agencies, it may be subject to a mitigated punishment or exempt from punishments, as the case may be.

(3) Criminal liability

Under the AML, if an undertaking's distribution agreement is in violation of the AML, the undertaking or its responsible persons (such as the chairman of the board or other senior managers) bear no criminal liability.

Footnotes

1 We also need to take into account Article 14 (3) of the AML which provides that other vertical price agreements shall be determined by the antitrust enforcement agencies and the price departments of the State Council.

2 Article 15 of the AML provides that an agreement reached by and between business operators shall be exempted from application of Articles 13 and 14 if it can be proven to be in any of the following circumstances:

(1) for the purpose of improving technologies, researching and developing new products;

(2) for the purpose of upgrading product quality, reducing costs, improving efficiency, unifying product specifications or standards, or carrying out professional labor division;

(3) for the purpose of enhancing operational efficiency and reinforcing the competitiveness of small and medium-sized business operators;

(4) for the purpose of achieving public interests such as conserving energy, protecting the environment and relieving the victims of a disaster and so on;

(5) for the purpose of mitigating serious decreases in sales volume or obviously excessive production during economic recessions;

(6) for the purpose of safeguarding the justifiable interests in foreign trade or foreign economic cooperation; or

(7) any other circumstance as stipulated by laws or the State Council.

Where a monopoly agreement is in any of the circumstances stipulated in Items (1)- (5) and is exempt from Articles 13 and 14 of this Law, the business operators must additionally prove that the agreement enables consumers to share the interests derived from the agreement, and will not severely restrict the competition in relevant market.

3 The theoretical basis of supply-side substitution is elasticity of supply, which considers the "potential competition" in the market. For instance, if the price of the product concerned is high enough, it is likely to cause other potential producers to switch production so that the market supply is increased and the price for the product is restrained. The situation described in this article should not be measured on the basis of this standard.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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