SPIEGEL & MCDIARMID. Conscious Parallelism: Can it turn a corner?

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1 SPIEGEL & MCDIARMID 1333 New Hampshire Avenue, NW Washington, DC Phone: Fax: Reprinted with Permission from the Winter/Spring/Summer 2001 issue of Infrastructure, the Journal of the American Bar Association's Section of Public Utility, Communications and Transportation Law, Vol. 40, Nos Conscious Parallelism: Can it turn a corner? By Robert A. Jablon Jablon is a partner at Spiegel & McDiarmid in Washington. He specializes in energy and antitrust matters and his is robert.jablon@spiegelmcd.com. Siobhan McInerney-Lankford, who has a law degree from Harvard University and a B.C.L. from Oxford University where she is a Ph. D. candidate in E.U. law and Stephanie Dorn, who is a law student at the University of Michigan, assisted on this article. Some wholesale electricity and natural gas markets resemble commodities markets of the 19th century s Gilded Age. Legendary entrepreneurs, or as they became to be known, Robber Barons 1 like Jay Gould, Jim Fiske, and Daniel Drew figured out how to corner markets, making hefty profits in the process. 2 Surely, they would envy their modern day counterparts, who have reaped billions of dollars from wholesale electricity sales in constrained markets, while asserting that price caps will deprive them of necessary incentives. Some wholesale electricity prices have become a public issue. The California Electricity Oversight Board has estimated that 2001 electricity costs may reach $70 billion in 2001 compared with $6 billion in 1998 and $7.4 billion in Claims to the contrary notwithstanding, these are not examples of properly functioning markets adjusting to shortage, but are examples of bold profiteering by those who possess monopoly power over an essential commodity. It is theorized that in working second price auction (or market clearing price commodity auctions), sellers bid approximations of their marginal costs of production. Otherwise, they risk losing sales. Although one might not be surprised by sellers bidding 10 percent or 20 percent or even 30 percent above cost, one would not expect bids to be 10 times or even far more above that level. In most markets if commodities were offered for sale at multiples of their customary price for example, if a bunch of bananas that might sell for $2 were offered for $20 or $200 sufficiently few would buy so that the price would fall. However, in wholesale power markets electricity that has had a customary price of $20 to $100 per MWh has sold at $1,000 or even at up to $10,000. The way electricity is sold is changing and with deregulation the applicable laws are evolving, particularly

2 with respect to sellers obligations to deal. However, utilities must generally supply customers electricity demand. Electricity is an essential product. Therefore, wholesale electricity customers will generally not refuse to buy because prices are too high where such refusals will cause blackouts or brownouts. When wholesale prices are at multiples of cost, demand remains high. This phenomenon is undoubtedly influenced by the fact that retail electricity users do not immediately feel the pinch of high wholesale prices. However, regardless of why reductions in demand do not discipline price, wholesale electricity markets are not working properly in at least some places. Moreover, even if high prices during times of peak usage can be said to be justified by the market, in California wholesale prices have been at multiples of cost during off-peak periods. The conclusion is inescapable that sellers have monopoly power. Antitrust law provides the basic tools for dealing with market structure and conduct. The doctrine of Conscious Parallelism suggests that antitrust law and policy has a role with respect to recent happenings in wholesale electricity (and natural gas) markets. If wholesale electricity sellers were to get together in the proverbial back room to set the prices, they would clearly be guilty of price-fixing under Section One of the Sherman Antitrust Act, which makes illegal those contracts, combinations and conspiracies in restraint of trade. 15 U.S.C. 1 (1994). Similarly, they would be guilty if they agreed on a formula to jointly set prices. But what if sellers can anticipate electricity demand? What if they can estimate the supply that will be available to serve a market by monitoring plant and power import availability? What if individual sellers determine that within a broad range of anticipated demand, cutting prices does not pay, even though they may lose individual sales? And what if sellers see competitors likewise maintaining their prices? If the sellers never directly agree to maintain prices, but just do it, would their conduct be illegal under Section One? Obviously, such conduct has occurred. Some sellers have bid well above their costs (including reasonable returns) with an awareness that others will follow suit. Although they may lose some sales, such suppliers can sell at monopoly prices, offsetting lost sales by selling at high prices at other times or even by selling at high prices at the same time, but from different plants or under different contracts. 4 Where there are electricity price caps at $1,500 per MWh or where there are no caps at all and where power costs are less than $100, it does not take many sales to offset lost opportunities. 5 Conscious parallelism is where rival firms act similarly or interdependently. Their pricing, production and other decisions are made with an awareness of each other s conduct, but competitors do not have express agreements to set prices. It has been described as the process, not in itself unlawful, by which firms in a concentrated market might in effect share monopoly power, setting their prices at a profit-maximizing supracompetitive level by recognizing their shared economic interests and their interdependence with respect to price and output decisions. 6 Competitors parallel conduct does not, by itself, violate the Sherman Antitrust Act. Theatre Enterprises, Inc. v. Paramount Film Distributing Corp., 346 U.S. 537 (1954). However, if there are sufficient plus factors to show concerted action, a violation may be found. 7 Courts and commentators disagree over what evidence or plus factors will demonstrate a violation. Conscious parallelism may be considered either as sellers entering into a tacit contract in restraint of trade or as a combination or conspiracy in restraint of trade. Either way, the doctrine provides a powerful tool to control runaway electricity, natural gas and other similarly structured commodity prices. Conscious parallelism can be as damaging to competition as sellers entering into explicit price fixing or other anticompetitive agreements. There is the absence of an express agreement, although there may be tacit

3 collusion. In conscious parallelism cases, courts may concentrate more on the effects of parallel conduct in economic markets than on the elements of an agreement that is alleged to restrain trade. 8 However, some courts have been reluctant to find that consciously parallel conduct constitutes an independent antitrust offense as opposed to evidence of a tacit or hidden agreement or conspiracy. Interstate Circuit Inc. v. United States, 306 U.S. 208 (1939), is an important early case. Individual members of a group of motion picture distributors, at the behest of two large exhibitors, imposed identical restrictions on subsequent showings of the films that they distributed. Despite the absence of proof of any formal agreement between the distributors, evidence of the knowledge of the proposal having been made to all distributors and indication that the imposition of the restrictions could operate only if adhered to by all sufficed for the Supreme Court to infer tacit agreement between distributors. However, the Court later limited the use of conscious parallelism to infer conspiracy in Theatre Enterprises, 346 U.S. at Affirming judgment for defendants, the Supreme Court held that while business behavior is admissible circumstantial evidence from which the fact finder may infer agreement, 9 proof of parallel business behavior does not conclusively establish agreement. The Court concluded: Circumstantial evidence of consciously parallel behavior may have made heavy inroads into the traditional judicial attitude toward conspiracy; but conscious parallelism has not yet read conspiracy out of the Sherman Act entirely. 10 Perhaps because the facts in Theatre Enterprises strongly suggested that the defendants had acted independently and because it has language ambiguities, lower courts and commentators have interpreted the case somewhat differently. 11 It has long been recognized that, for Sherman Act Section One purposes, parties can have a contract without signing a formal document and even without their having explicit communications. Where sellers always follow a price leader or bid uniformly at a particular price, there may be no written document, but there may nonetheless be an agreement. In American Tobacco Co. v. United States, 328 U.S. 781 (1946), a practice of dealing among the major cigarette companies to buy tobacco needed by their low-priced competitors was condemned. It is not the form of the combination or the particular means used but the result to be achieved that the statute condemns.no formal agreement is necessary to constitute an unlawful conspiracy.where the circumstances are such as to warrant a jury in finding that the conspirators had a unity of purpose or a common design and understanding or a meeting of minds in an unlawful arrangement, the conclusion that a conspiracy is established is justified. 12 Similarly, in United States v. Container Corp. of America, 393 U.S. 333 (1969), the exchange of price information was held to violate Section One, even though there was no agreement to fix prices. 13 There are difficulties with the application of the doctrine of conscious parallelism. At its extreme, the doctrine would cover conduct that virtually any market participant would engage

4 in. It may thus make illegal at least some common business behavior. For example, sellers often charge high prices when the opportunity arises. Absent a Section One violation, antitrust courts generally allow those possessing a monopoly to maintain high prices. 14 It is often thought that high prices encourage the entry and expansion of competitors into the market. 15 And nearly all market participants take into account competitors likely conduct when they set prices. 16 Professor Donald F. Turner, a leading critic of the doctrine of conscious parallelism, argues that because condemned behavior mimics normal business conduct, effective remedies for violations cannot be fashioned. If one enters a price fixing contract, a court can declare that contract to have been illegal. But can it enjoin sellers from charging high prices? Or can it bar competitors from paying attention to each others prices? 17 Clamp-All Corp. v. Cast Iron Soil Pipe Institute, 851 F.2d 478, 484 (1 st Cir. 1988) (Breyer, J.). Faced with the reality that many markets are not functioning because of conscious parallelism, but that that conduct mimics legally permitted conduct, courts have recognized conscious parallelism as giving rise to an antitrust offense. However, they tend to do so only when plus factors that differentiate defendants conduct from normal business practices are shown. That is, in addition to alleging a plausible conspiracy, a plaintiff also must demonstrate the existence of certain plus factors, for only when these additional factors are present does the evidence tend to exclude the possibility that the defendants acted independently. Petruzzi s IGA Supermarkets, Inc. v. Darling-Delaware Co., 998 F.2d 1224, 1232 (3 rd Cir. 1993). Plus factors may include evidence demonstrating that the defendants: (1) acted contrary to their economic interests absent parallel pricing and (2) were motivated to enter into a price-fixing conspiracy. Blomkest Fertilizer Inc. v. Potash Corp. of Saskatchewan, 203 F.3d 1028, 1032 (8 th Cir. 2000); Jacob Blinder & Sons Inc. v Gerber Products Co. (In Re Baby Food Antitrust Litigation), 166 F.3d 112, 122 (3 rd Cir. 1999); Petruzzi s IGA Supermarkets, 998 F.2d at 1243; In re Medical X-Ray Film Antitrust Litigation, 946 F. Supp. at Motive to conspire, opportunity to conspire, high level of interfirm communications, irrational acts or acts contrary to a defendant's economic interest but rational if the alleged agreement existed and departure from normal business practices have been recognized as plus factors. Merck-Medco Managed Care, LLC v. Rite Aid Corp., 201 F.3d 436, full text available at 1999 U.S. App. LEXIS (4 th Cir. 1999). Parallel price conduct combined with the dissemination of price and supply data has been held sufficient for a jury to infer conspiracy. In re Coordinated Pretrial Proceedings in Petroleum Products Antitrust Litigation, 906 F.2d 432 (9 th Cir. 1990). Where there is competition, defendants could not be expected to maintain high prices when demand falls (such as, in electricity markets at off-peak periods) without losing sales. They can do so only where they know competitors will not cut the price so that there is effectively no competition. The probative value of plus factors may be somewhat exaggerated in that it would almost always pay market participants to contract to price in parallel. Where there is conscious parallelism, almost by definition, market actors charge prices that could not be maintained in more competitive markets. However, even so, the problem remains that through parallel actions market participants can control prices and make markets noncompetitive. Faced with this reality of the incentives towards tacit collusion, Professor now Judge

5 Posner has advocated that courts identify[] those markets in which conditions are propitious for the emergence of collusion 18 and, if they are, that courts examine whether such collusion exists. 19 Countering Professor Turner (supra note 13), Judge Posner says that problems of proof in conscious parallelism cases are no different than in other price-fixing cases: If the economic evidence introduced in a case warrants an inference of collusive pricing, there is neither legal nor practical justification for requiring evidence that will support the further inference that the collusion was explicit rather than tacit. Certainly from an economic standpoint it is a detail whether the collusive pricing scheme was organized and implemented in such a way as to generate evidence of actual communications. 20 Posner maintains that the harms from conscious parallelism are such as to require an analysis of the economic facts in particular cases to distinguish legality from illegality. It must be emphasized that tacit collusion is not an unconscious state.moreover, it is unlikely that there are many cases of purely tacit collusion. What is being proposed here is not so much the alteration of the substantive contours of the law as a change in evidentiary requirements to permit illegal price fixing to be found in circumstances where, although explicit collusion cannot be proved, an actual meeting of the minds on a noncompetitive price can be inferred. In most of these cases there will be explicit although well-concealed collusion that can surely be deterred by threat of punishment. 21 Most conscious parallelism market analysis takes place in the context of oligopoly, where the exercise of market control is more feasible and more common than they are in more competitive markets. Moreover, if the doctrine were applied to electricity and natural gas markets, as this article suggests, most likely analysts and courts would consider models and case law that were developed for less vital products where buyers are not compelled to buy. In electricity and other markets where demand cannot be expected to provide an effective corrective to market abuse, it is suggested that there should be an added plus factor and an added reason to insist on strict application of the antitrust laws. This added plus factor is whether buyers must (or have strong pressures to) buy the product. In this situation, it cannot be presumed that market forces will correct for conscious parallelism. Even where the wholesale purchaser does not have a strict legal obligation to serve wholesale or retail customers, if conditions show that buyers will not substantially cut demand with price changes, one ought not allow competitors to follow consciously parallel pricing or supply behavior. Admittedly, the lack of a clear line between the normal conduct of sellers in competitive markets and the illegal conduct in constrained markets that gives rise to claims of conscious parallelism is troubling. Nonetheless, the permissibility of businesses to price as they wish interdependently with others in ways that maintain prices far above cost when such businesses could not do so if they were really acting alone has the potential and has had the actuality of making a mockery of competitive markets, of transferring billions of dollars from the public to a handful who have market control and of broadly injuring the public well-being. It was to correct such evils that the antitrust laws were passed. To borrow from Justice Holmes, The law is the witness and external deposit of our moral life. 22 The life of the law has not been logic: it has been experience. 23 Although we might prefer the illusion of certainty, 24 the body of law contains many examples where competing

6 principles must be balanced and where conduct will be praised or condemned, depending on its factual context. It is hardly foreign to antitrust law that conduct may be legal if done by those without market power, but illegal if done by those who possess it. 25 In an antitrust context where the exercise of market power by competitors who act concertedly creates both great market distortions and unconscionable wealth transfers, it is not too much to ask that courts examine the circumstances of private behavior and that market participants themselves constrain that behavior that constitutes market abuse. After all, we are dealing with businesses clothed with a public interest, who have no inherent right to collect rates far above their costs. 26 This is the result that working markets are designed to prevent. 27 There are relatively few conscious parallelism cases. Renewed thought in this area is required. The antitrust laws concern making markets work. If antitrust law cannot define workable, competitive market structure and conduct, the only choice will be to rely on political and regulatory control. Experience shows that the latter provides less than perfect tools. Notes: 1 Matthew Josephson, The Robber Barons (Harvest 1962). 2 See William Cronon, Nature s Metropolis: Chicago and the Great West (W. W. Norton 1991). 3 Request for Rehearing of the California Electricity Oversight Board of the April 26, 2001 Order, San Diego Gas & Electric Co., 95 F.E.R.C. 61,115 (2001), FERC Docket No. EL (May 29, 2001). See Robert McDiarmid, Lisa Dowden & Daniel Davidson, A Modest Proposal: Revoke the Nobel Prize? Recognize the Limitations of Theory? Or grant a License to Steal?, 14 Electricity Journal 11 (Jan./Feb. 2001). 4 In markets where all sales are at a market clearing price, a seller can use hockey stick offers to sell. Under this approach one can set most sell offers at cost guaranteeing a buy-sell match, but set one or more sell offers at the cap or at high prices. By such bidding conduct, sellers hope to reduce their individual risk, but increase the market clearing price. 5 Revenues from high-priced sales reflect profits disproportionately. 6 In re Medical X-Ray Film Antitrust Litigation, 946 F. Supp. 209, 217 (E.D. N.Y. 1996) (quoting Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., 509 U.S. 209, 227 (1993)). 7 See cases cited infra pp See Richard Posner, Antitrust Law: An Economic Perspective (University of Chicago 1976). 9 The court cites (346 U.S. at ) Interstate Circuit Inc. v. United States, 306 U.S. 208 (1939); United States v. Masonite Corp., 316 U.S. 265 (1942); United States v. Bausch & Lomb

7 difficulties of differentiating legal from illegal conduct and finding adequate remedies lead him to eschew making conscious parallelism a separate antitrust offense. 18 Posner, supra note 9, 55. Judge Posner cites 12 factors: (1) market concentrated on the selling side; (2) no fringe of small sellers; (3) inelastic demand at competitive price; (4) entry takes a long time; (5) many customers; (6) standard product; (7) principal firms sell at the same level in the chain of distribution; (8) price competition more important than other forms of competition; (9) high ratio of fixed to variable costs; (10) demand static or declining over time; (11) sealed bidding; and (12) the industry s antitrust record. Id. at Id. at 55. Evidence deemed relevant to demonstrate collusive behavior includes (1) fixed relative market shares; (2) price discrimination; (3) exchanges of price information; (4) regional price variations; (5) identical bids; (6) price, output, and capacity changes at the formation of the cartel; (7) industry-wide resale price maintenance; (8) declining market shares of leaders; (9) amplitude and fluctuation of price changes; (10) demand elasticity at market prices; (11) level and pattern of profits; and (12) basing-point pricing. Id. at Id. at Id. at 74, Oliver Wendell Holmes, The Path of Law, 10 Harv. L. Rev. 457, 459 (1879). 23 Oliver Wendell Holmes, The Common Law 1 (Little, Brown & Co. 1881). 24 See Holmes, supra note 23, Compare United States v. Colgate & Co., 250 U.S. 300 (1919) with United States v. Terminal Railroad Ass'n of St. Louis, 224 U.S. 383 (1912) and Otter Tail Power Co. v. United States, 410 U.S. 366 (1973). 26 Munn v. Illinois, 94 U.S. 113, 126 (1877). 27 In cases where courts find abuse, antitrust law teaches that remedies can and must be fashioned in light of particular situations. Borrowing from economic and legal theory, commentators have suggested that electricity market participants in working, short-term deregulated electricity markets were expected to bid their costs. See, e.g., McDiarmid et al., supra note 4 (commenting on William Vickrey, Counterspeculation, Auctions, and Competitive Sealed Tenders, published in the Journal of Finance, Vol. XVI, No. 1, March 1961).

8 Optical Co., 321 U.S. 707 (1944); American Tobacco Co. v. United States, 328 U.S. 781 (1946); United States v. Paramount Pictures Inc., 334 U.S. 131 (1948). 10 Theatre Enterprises, 346 U.S. at 541 (footnote omitted). 11 Compare, e.g., In re Medical X-Ray Film Antitrust Litigation, 946 F. Supp. 209, (E.D. N.Y. 1996); Brokers Assistant Inc. v. Williams Real Estate Co, Inc., 646 F. Supp. 1110, (S.D. N.Y. 1986) with Blomkest Fertilizer v. Potash Corporation of Saskatchewan, 203 F. 3d 1028, (8 th Cir. 2000). 12 American Tobacco Co., 328 U.S. at (emphasis added). 13 However, claims under conscious parallelism are subject to antitrust defenses that would otherwise be available. Thus, a plaintiff who alleges predatory conduct is unlikely to succeed where it cannot point to acts that appear to a court to have been designed to monopolize or restrain trade. Matsushita Electric Industrial Co. v Zenith Radio Corp., 475 U.S. 574 (1986); Monsanto Co. v Spray-Rite Service Corp., 465 U.S. 752 (1984). Likewise, a plaintiff must overcome defenses such as that conduct is sanctioned by state law or is within the jurisdiction of regulatory bodies. Parker v. Brown, 317 U.S. 341 (1943) (private anticompetitive conduct that implements state law may not be covered by antitrust laws); Square D Co. v. Niagara Frontier Tariff Bureau, Inc., 476 U.S. 409 (1986) (rates that are filed with regulatory agencies are generally immune from antitrust challenges under filed rate doctrine). But see California Retail Liquor Dealers Ass'n v. Midcal Aluminum, Inc., 445 U.S. 97 (1980); FTC v. Ticor Ins. Co., 504 U.S. 621 (1992) (private conduct is not immune from antitrust attack under state action doctrine unless state policy is clearly articulated and the state actively supervises the challenged conduct); Carnation Co. v. Pacific Westbound Conference, 383 U.S. 213, amended, 383 US. 932 (1966) (implementation of nonapproved rate agreements are subject to antitrust laws); Florida Municipal Power Agency v. Florida Power & Light Co., 64 F.3d 614 (11 th Cir. 1995) (filed rate doctrine does not immunize rates not on file with agency). Where regulatory agencies, such as the Federal Energy Regulatory Commission, relying on deregulated markets, permit the implementation of privately set rates, application of antitrust laws appears appropriate. 14 See Chicago Professional Sports Ltd. Partnership v. National Basketball Ass n, 95 F.3d 593, 597 (7 th Cir. 1996) ( high price is not itself a violation of the Sherman Act ). 15 Areeda & Hovenkamp, Antitrust Law 720a (1996). See Advo Inc. v. Philadelphia Newspapers Inc., 51 F.3d 1191, 1202 (3 rd Cir. 1995); Kartell v. Blue Shield of Massachusetts Inc., 749 F.2d 922, 927 (1 st Cir. 1984). 16 Areeda, Hovenkamp & Solow, Antitrust Law 404 (1995); Frederic Scherer & David Ross, Industrial Market Structure and Economic Performance (3d ed. 1990). 17 Donald F Turner, The Definition of Agreement Under the Sherman Act: Conscious Parallelism and Refusals to Deal, 75 Harv. L. Rev. 655 (1962). Turner recognizes that conscious parallelism has many of the elements and effects of price-fixing agreements. But the