We thank the International Trade Administration (ITA), the National Institute of Standards and Technology (NIST) and the U.S. Patent and Trademark Office (USPTO) for this opportunity to comment on its call for evidence concerning a new framework for standard-essential patents.[1] The International Center for Law and Economics (ICLE) is a nonprofit, nonpartisan research center whose work promotes the use of law & economics methodologies to inform public-policy debates. We believe that intellectually rigorous, data-driven analysis will lead to efficient policy solutions that promote consumer welfare and global economic growth. ICLE’s scholars have written extensively on competition, intellectual property, and consumer-protection policy.

In this comment, we express concerns about global regulatory developments in the standard-essential patent (SEP) industry. The European Union is in the process of considering legislation that would fundamentally alter the landscape of global standards setting, making it more difficult for inventors to enforce their intellectual-property rights.[2] Not only will this legislation have profound ramifications for companies located all over the globe but—as the USPTO’s call for comments recognizes—the EU risks kicking off a global race to the bottom in regulating SEPs that will ultimately harm innovation and slow the diffusion of groundbreaking technologies.

We are concerned that a tit-for-tat response intended to counteract bad policies in the EU (and among other allied nations) is doomed to do more harm than good. Erecting what amount to protectionist barriers—even if in response to similar regulations abroad—would diminish U.S. interests, as well as those of our partners. Instead, the agencies should be seeking opportunities to influence the policy decisions made in foreign jurisdictions, in the hope that those entities will pursue better policies.

For obvious reasons, the way intellectual-property disputes are resolved has tremendous ramifications for firms that operate in standard-reliant industries. Not only do many of the firms in this space derive a large share of their revenue from patents but, perhaps more importantly, the prospect of litigation dictates how firms structure the transfer of intellectual-property assets. In simple terms, ineffectual judicial remedies for IP infringements and uncertainty concerning the resolution of IP disputes discourage firms from concluding license agreements in the first place.

The key role that IP plays in these industries should impel policymakers to proceed with caution. By virtually all available metrics, the current system works. The development of innovative technologies through standards development organizations (SDOs) has led to the emergence of some of the most groundbreaking technologies that consumers use today;[3] and recent empirical evidence suggests that many of the alleged ills that have been associated with the overenforcement of intellectual-property rights simply fail to materialize in industries that rely on standard-essential patents.[4]

At the same time, “there is no empirical evidence of structural and systematic problems of holdup and royalty stacking affecting standard-essential patent (“SEP”) licensing.”[5] Indeed, “[t]he notion that implementers in such innovation–driven industries are being suffocated by an insurmountable patent royalty stack has turned out to be nothing more than horror fiction.”[6] Yet, without a sound basis, the anti-injunctions approach increasingly espoused by policymakers unnecessarily “adds a layer of additional legal complexity and alters bargaining processes, unduly favoring implementers.”[7]

Licensing negotiations involving complex technologies are legally intricate. It is simply not helpful for a regulatory body to impose a particular vision of licensing negotiations if the goal is more innovation and greater ultimate returns to consumers. Instead, where possible, policy should prefer allowing parties to negotiate at arm’s length and to resolve disputes through courts. In addition to maintaining the sometimes-necessary remedy of injunctive relief against bad-faith implementers, this approach allows courts to explore when injunctive relief is appropriate on a case-by-case basis. Thus, over the course of examining actual cases, courts can refine the standards that determine when an injunctive remedy is inappropriate. Indeed, the very exercise of designing ex ante rules and guidelines to inform F/RAND licensing is antagonistic to optimal policymaking, as judges are far better situated and equipped to make the necessary marginal adjustments to the system.

Against this backdrop, our comments highlight several factors that should counsel preserving the rules that currently govern SEP-licensing agreements:

To start, the SEP space is far more complex than many recognize. Critics often assume that collaborative standards development creates significant scope for opportunistic behavior—notably, patent holdup. The tremendous growth of SEP-reliant industries and market participants’ strong preference for this form of technological development, however, suggest these problems are nowhere near as widespread as many believe.

Second, it is important not to overlook the important benefits conferred by existing IP protections. This includes the advantages inherent in pursuing injunctions rather than damages awards.

Third, weakening the protections afforded to SEP holders would also erode the West’s technological leadership over economies that are heavily reliant on manufacturing, and whose policymakers routinely undermine foreign firms’ intellectual-property rights. In short, while IP promotes innovation, weakened patent protection has second-order effects that are often overlooked, such as ceding advantages to China’s manufacturing sector and thereby exacerbating U.S.-China tensions.

Fourth, while mandated transparency in SEP negotiations may appear beneficial, the reality is more complex, as disclosure requirements can have mixed effects. Further, transparency mandates would likely require government interventions, such as essentiality checks, which can be very costly.

Finally, collective SEP rate-setting raises antitrust issues that stem from firms’ need to share sensitive data in order to determine a standard’s value. Vertically integrated SEP holders setting collective royalties on the inputs they manufacture could enable price-fixing and collusion. Safeguards like third-party mediation in patent pools may be needed so that joint SEP rate negotiation does not violate antitrust rules barring competitors from fixing prices.

I.        Regulatory Developments in Foreign Jurisdictions

In their call for comments, the agencies essentially ask whether regulatory developments in foreign jurisdictions threaten U.S. technological leadership in industries that rely on standard-essential patents and, if so, how the United States should respond:

Do the intellectual property rights policies of foreign jurisdictions threaten any of U.S. leadership in international standard setting, U.S. participation in international standard setting, and/or the growth of U.S. SMEs that rely on the ability to readily license standard essential patents?

If responding affirmatively to question 1, what can the Department of Commerce do to mitigate the effects of any adverse foreign policies relating to intellectual property rights and standards? Please clearly identify any such adverse foreign policies with specificity.[8]

Recent regulatory developments in the European Union loom large over the agencies’ two questions. On April 27, the European Commission published its Proposal for a Regulation on Standard Essential Patents (“SEP Regulation”). The SEP Regulation’s proclaimed aims are to ensure that end users—including small businesses and EU consumers—benefit from products based on the latest standardized technologies; make the EU attractive for standards innovation; and encourage both SEP holders and implementers to innovate in the EU, make and sell products in the EU, and be competitive in non-EU markets.[9]

While we share the agencies’ concern, responding to this foreign legislation (and other international responses that are likely to arise) by enacting similar policies would only exacerbate the situation and further erode U.S. technological leadership. In fact, several of the EU legislation’s shortcomings that would be rendered more destructive if the United States responded in kind.

As ICLE-affiliated scholars have explained in comments on the draft European legislation,[10]  the available evidence does not support a finding of market failure in SEP-licensing markets that would justify intrusive regulatory oversight. Instead, the Commission’s own evidence points to the low incidence of SEP litigation and no systemic negative effects on SEP owners and implementers. The mobile-telecommunication market, which is claimed to have the most SEP litigation and licensing inefficiencies, has over the years seen rapid growth, expansion, declining consumer prices, and new market entry.

Some market imperfections are necessary-but-not-sufficient conditions for regulatory intervention. Regulation might not be necessary or proportionate if its aims could be achieved with less costly instruments.

The EU’s proposed SEP Regulation appears to pursue the value-redistributive function of imposing costs on only one group (SEP owners), while accruing all benefits to non-EU (or US)-based standard implementers. It is difficult to find justification for such value redistribution from the evidence presented on the functioning of SEP licensing markets.

The proposed EU SEP Regulation applies to all standards licensed on FRAND terms. It is unclear how many standards would be caught and why all standards licensed on FRAND terms are presumed to be inefficient, requiring regulatory intervention. One early study identified 148 standards licensed on FRAND terms in a 2010 laptop. No evidence was presented that licensing inefficiencies of these standards caused harms in laptop markets.

The EU legislation would require evaluators and conciliators that need to be qualified and experienced experts in relevant fields. There are unlikely to be enough evaluators to conduct essentiality checks reliably on such a massive scale.

To make matters worse, the proposed SEP Regulation raises competition concerns, as it requires SEP owners to agree on global aggregate royalty rates. No safeguards are provided against the exchange of sensitive commercial information and possible cartelization.

There is also a risk that legislation seeking to make the standardization space more transparent, by mandating aggregate royalty-rate notifications and nonbinding expert opinions on global aggregate royalty rates, may lead to even more confusion for implementers.

Finally, the EU’s proposed SEP Regulation would have extraterritorial effects. Indeed, while the SEP Register and system of “essentiality checks” created by the regulation would apply only for patents in force in EU Member States, its system of nonbinding opinions on aggregate royalties and FRAND determination would apply worldwide, covering portfolios in other countries. Other countries—including the United States—may follow suit and introduce their own regulations on SEPs. Such regulations may be used as a strategic and protectionist tool to devaluate the royalties of innovative SEP owners. The proliferation of regulatory regimes would make SEP licensing even more costly, with unknown effects on the viability of the current system of collaborative and open standardization.

Considering the above, it would appear unwise for the United States to mimic the EU’s draft SEP regulation. In its current form, the regulation is likely to harm both U.S. and European innovators. In turn, this threatens the west’s technological leadership on a global stage and will serve the interests of jurisdictions whose economies rely heavily on implementing standard-essential technologies and that generally have weaker IP protection than either the United States or the EU.

Instead, the agencies should look for opportunities to work with their foreign counterparts to improve the proposed EU legislation (and other similar measures in other jurisdictions). Neither EU nor U.S. interests will be well-served by these sorts of regulatory endeavors, least of all if both areas enact ill-advised SEP policies. Sound policy should be focused on ensuring that the successful SEP ecosystem continues to perform as impressively as it has to date. Enacting defensive measures against the EU legislation will create a tit-for-tat dynamic that will double the obstacles faced by innovators in both the EU and the United States, allowing foreign rivals to take advantage of the situation.

II.      Regulatory Restraint

In their call for comments, the agencies ask what private entities can do to boost America’s participation in international standard-setting efforts:

What more can other entities do, such as standards development organizations, industry or consumer associations, academia, or U.S. businesses to help improve American leadership, participation in international standard setting, and/or increased participation of small to medium-sized enterprises that rely on the ability to readily license standard essential patents?[11]

While this is a good way to look at the issue (today’s standardization practices were born of spontaneous market interactions, rather than government fiat, which leaves private entities with a clearly significant role to play in this space), one should not overestimate the extent to which governments can identify inefficiencies that may afflict standard-reliant industries and nudge private parties to resolve them—e.g., by asking SDOs to curb the use of injunctions or encourage collective royalty-setting agreements.

It’s tempting for lawmakers to look at the complex SEP licensing process as a Gordian Knot to be solved through regulatory fiat. But pursuing Alexander’s solution, though expedient, would similarly leave the SEP licensing ecosystem in tatters.

Consider smartphones: Tens of thousands of patents are essential to making smartphone technology work.^[12] Some critics posit that this makes it extremely difficult to market smartphones effectively, but no evidence supports this claim, and the proliferation of smartphones suggests otherwise.[13] It is worth considering that cellphone technology marks the culmination of research efforts spanning the entire globe. The coordinated efforts of these numerous firms are not the result of government coercion, but the free play of competitive forces.

Coordination on such a vast scale is no simple task. And yet, of the vast array of options available to them, an increasing number of firms have settled on one particular paradigm to solve these coordination problems: the development of new technologies and open standards within SDOs. These organizations and their members are responsible not only for wireless cellular technologies (e.g., 3G, 4G, 5G) but also for such high-profile technologies as Wi-Fi, USB, and Blu-ray, among many others.[14]

Throughout history, economic actors have sought to reap the benefits of specialization and interoperability. This has led to the emergence of various standardization practices, ranging from de facto standards and competition for the market, to complex standard-setting procedures within SDOs.

Ultimately, because interoperability standards rely on firms being able to coordinate their behavior, standardization necessarily implies a degree of incentive compatibility. That is, parties will coordinate their behavior only if they expect that doing so will be mutually beneficial. “This mutuality of considerations has been at the heart of the voluntary FRAND bargain from the outset, given that any risks of holdup or misappropriation of information are bilateral—that is, such risks work in both directions.”[15] This implies that SDOs must design balanced internal rules that bring both patent holders and implementers to the table through mutually agreeable interoperability standards, and guarantee that they will continue to work together into the future as new technologies emerge.[16]

Establishment of SDO interoperability standards typically follows a process by which interested parties come together and identify technological problems that they might be able to solve cooperatively.^[17] SDO members include a wide range of stakeholders, including (among others): companies that manufacture products implementing the technology, companies that market services that use the standards, companies that operate networks that practice the standards, technology firms that create technologies that are included in the standards, academic institutions, and government agencies.[18]

The SDO provides information to interested parties about the standard-setting project and a forum for collaboration.[19] Members attend standard-setting meetings, vote on standardization decisions, and make technological contributions. Participation in standard setting can be subject to a substantial fee and always entails considerable time. There are policies and procedures (“bylaws”) that govern the process of adoption and standard development. Participation in SDOs is voluntary and is subject to acceptance of the terms and conditions set out in the bylaws. These aim to allow the most appropriate technology to become standardized, based on several factors. This is a democratic and consensus-based process designed to ensure that no single participant can manipulate it. Many SDOs also allow for post-adoption appeals by dissenting members. This ultimately leads to a series of technical specifications upon which implementers can build products.

Throughout this process, a critical challenge for SDOs is to ensure that their internal regulations remain “incentive compatible.” To optimize their technological output and ensure the success of their standards, SDOs must attract the right mix of both implementers and innovators. “Most succinctly, the ‘right membership’ comprises a significant portion of each class of stakeholder whose active support is needed to achieve broad adoption.”[20] They thus need to design internal procedures that strike a balance between the sometimes-diverging interests of these stakeholders.

This is no simple task. Although there are numerous ways in which these rules may favor a particular group of participants, allocating the profits of standardization is perhaps the most salient. To a first approximation, SEP holders will tend to favor internal rules that allow them to charge prices that are close to the monopoly benchmark (though not the double-marginalization one). Conversely, implementers will generally prefer policies that limit SEP holders’ returns (so long as this does not dry up the supply of inventions). However, these first-order incentives may not always hold true in the real world. Practical considerations may, for instance, urge SEP holders to accept a pricing structure that is not “profit maximizing” in the short run, but which may incentivize further cooperation or the adoption of an underlying technology.^[21]

The above has important consequences for patent and antitrust policy in SEP-reliant industries. As we have explained, collaborative standard development gives rise to complex incentives, as well as a web of heterogeneous and deliberately incomplete contracts (i.e., where the parties choose not to specify some aspects of their agreement).[22] Given this diversity, uniform and centralized policies that needlessly constrain the range of negotiation—such as a federal-enforcement presumption against injunctions—would likely lead to fewer agreements and inefficient outcomes in numerous cases, especially compared to case-by-case adjudication of F/RAND commitments under the common law of contract.[23]

In short, “standards organizations and market participants are better than regulators at balancing the interests of patent holders and implementers.”[24] Interfering with the emergent norms of the standard-development industry thus risks undermining innovators’ expectations of a reasonable return on their investments:

Each of the innovative companies that agrees to be an SSO participant does so with the understanding of the investments they have made in research, development, and participation, as well as the risks that their innovations may not be selected for incorporation in the standard. They bear these investments and risk with the further understanding that they will receive adequate and fair remuneration as part of the FRAND commitment they have made to the SSO.

Unfortunately, the actions of the courts and the proposals by commentators are greatly undermining the value and benefits of SSO participation that are expected….[25]

III.    The Importance of Injunctions

The agencies’ call for comments appears concerned that current standardization practices may be hindering U.S. innovation and the creation of startups in the SEP space:

Are current fair, reasonable, and non-discriminatory (FRAND) licensing practices adequate to sustain U.S. innovation and global competitiveness? Are there other international models which would better serve U.S. innovation in the future?

Are there specific U.S. intellectual property laws or policies that inhibit participation in standards development?

Are there specific U.S. intellectual property laws or policies that inhibit growth of SMEs that rely on licensing and implementing standards? [26]

While they are not mentioned explicitly in the agencies’ call for comments, the role of injunctions sought against implementers by SEP holders looms large over the above questions. The use of injunctions is arguably one of the most contentious—and widely misunderstood—topics in SEP policy debates. While often portrayed as a means for inventors to extract unreasonable royalties from helpless implementors injunctions are, in fact, a critical legal tool that encourages all parties in the standardization space to come to the negotiation table. In fact, even the EU’s draft regulation on SEPs—which in many other respects reduces the protections afforded to inventors—implicitly recognizes the crucial role that injunctions play, by ensuring that the various proposed SEP transparency and arbitration procedures do not undermine parties’ ability to obtain an injunction:

The obligation to initiate FRAND determination should not be detrimental to the effective protection of the parties’ rights. In that respect, the party that commits to comply with the outcome of the FRAND determination while the other party fails to do so should be entitled to initiate proceedings before the competent national court pending the FRAND determination. In addition, either party should be able to request a provisional injunction of a financial nature before the competent court.[27]

A.   The Fundamental Value of Injunctions

Historically, one of the most important features of property rights in general, and patents in particular, is that they provide owners with the power to exclude unauthorized use by third parties and thus enable them to negotiate over the terms on which instances of use or sale will be authorized.^[28] While the ability to exclude is important in creating the incentive to innovate, it is equally—and perhaps more—important in facilitating the licensing of inventions.^[29]

There are many reasons that someone may invent a new product or process. But if they are to be optimally encouraged to distribute that product and thus generate the associated social welfare, it is crucial that they retain the ability to engage supply chains to commercialize the invention fully.^[30] “[T]he patent system encourages and enables not just invention but also innovation by providing the basic, enforceable property rights that facilitate (theoretically) efficient organizations of economic resources and the negotiations necessary to coordinate production among them.”[31] If a patent holder believes that the path to commercialization and remuneration is hindered by infringers, she will have less incentive to invest fully in the commercialization process (or in the innovation in the first place).

Removing the injunction option… not only changes the bargaining range (and makes infringement a valid business option), but, by extension, it lowers the expected returns of investing in the creation and commercialization of patents, in the first place…. With a no-injunction presumption…, as long as the expected cost of litigation is less than the expected gain from infringing without paying any royalties, potential licensees will always have an incentive to pursue this strategy. The net result is a shift in bargaining power so that, even when license agreements are struck, royalty rates are lower than they would otherwise be, as well as an increased likelihood of infringement.[32]

Because infringement affects both the initial incentive to innovate as well as the complex process of commercialization, courts have historically granted injunctions against those who have used a patent without proper authorization.

B.   Damages Alone Are Often Insufficient

Injunctions are almost certainly the most powerful means to enforce property rights and remedy breaches. Nonetheless, courts may sometimes award damages, either in addition to or as an alternative to awarding an injunction.^[33] It is often difficult to establish the appropriate size of an award of damages, however, when intangible property—such as invention and innovation, in the case of patents—is the core property being protected.

In this respect, a key feature of patents is that they possess uncertain value ex ante. The value of a particular invention or discovery cannot be known until it is either integrated into the end-product that will be distributed to consumers, or actually used by consumers.[34] This massive upfront uncertainty creates the need for technology designers to carefully structure their investments such that the risk/reward ratio remains sufficiently low. This, in turn, means ensuring that their inventions’ commercialization can reasonably be expected to generate sufficient profits.

Commercializing highly complex innovations, such as pharmaceuticals and advanced technologies, requires a large degree of risk taking and capital investment, as well as massive foregone opportunities. As such, it will often be difficult, or even impossible, to adequately calculate appropriate monetary damages for the unauthorized use of a patent, even if the patent’s ex post value is knowable. Put differently, the inability to bargain effectively for royalties post-standardization may “deter investment… and ultimately harm consumers.”[35]

While it is necessary to establish damages for violations after the fact, it will nearly always be appropriate to award injunctions to deter ongoing violations. This would further allow the property owner to do their own value calculations, based on their investments, sunk costs, and—critically—lost opportunities that were foregone in order to realize the particular invention. “[A] property rule is superior to a liability rule when ‘the court lacks information about both damages and benefits.’ Without accurate information, the damages may be set below the actual level of harm, encouraging the ‘injurer’ (or infringer) to engage in an excessive level of activity—in our case, increased infringement.”[36]

C.   Injunctions Encourage Efficient Licensing Negotiations

In addition to the concerns outlined in the previous section, it is worth noting that curbs on injunctions pertaining to SEPs would make inventors bear the risk of opportunistic behavior, thus enabling  firms to opt out of commercial negotiations and wait for potential litigation. In turn, this would tilt the bargaining scale in their favor in subsequent royalty negotiations undertaken in the shadow of prior court proceedings.[37]

The U.S. Supreme Court’s 2006 decision in eBay v. MercExchange offers a case in point. The court rejected the “general rule” that a prevailing patentee is entitled to an injunction.[38] In the aftermath of the decision, courts refused to grant injunctions in considerably more cases.[39]

Nearly two decades later, however, questions remain regarding eBay’s effect on patent licensing, negotiation, and litigation.[40] In particular, it is likely that eBay systematically distorted the relative bargaining positions in SEP licensing in favor of implementers, at the expense of patent holders. One post-eBay assessment argues that limiting injunctions to prevent holdup results in more “false positives”—where patent holders with no designs of patent holdup are nonetheless denied injunctive relief—than it does deterrence of actual holdups.[41] The result is a reduction in the cost of willful infringement and “under-compensation” for innovation.[42]

One of the important features of injunctions that critics miss is that they are not solely a tool for simple exclusion from property, but a tool that promotes efficient bargaining.[43] If a property holder ultimately has the right to exclude infringers, there is relatively more weight placed on the importance of initial bargaining for licenses. “It is the very threat of the injunction right—and its associated high transaction costs—that brings the parties to the negotiating table and motivates them to draw upon the full scope of their knowledge and creativity in forming contractual and institutional solutions to the perceived holdup problem.”[44]

Post-eBay, “efficient infringement” becomes a viable choice for firms seeking to maximize profits. Thus, implementing firms seeking to pay as little as possible for use of an invention have incentive to disregard the bargaining process with a patent holder altogether. The relative decline in the importance of injunctions narrows the bargaining range. The narrower range of prices that an implementing firm will offer means that, even where it does bargain, agreement will be less likely. Where rightsholders can be reasonably expected to enforce their patent rights, by contrast, the bargaining range is expanded and agreement is more likely, because the initial cost of negotiating for a license is relatively less than always (or usually) opting for “efficient infringement”; that is, infringement becomes less efficient.

The ultimate tension is not between seeking damages or an injunction, but between whether a firm opts to negotiate or to litigate, while facing the risk of some combination of damages and injunction on the back end.

This reality is particularly important in the context of SDOs, where implementers and innovators are in a constant dance both to maximize their own profits as well as to facilitate the product of an incomplete, joint agreement that binds each party. “The seminal example of intentional contractual incompleteness is the F/RAND commitment common in many [SDO’s] IPR policies.”[45] Permitting one party, through weakened legal doctrine, to circumvent or artificially constrain the bargaining process inappropriately imbalances the careful commercial relationships that should otherwise exist.

In the SEP context, furthermore, it is rarely mentioned that “an implementer’s decision to reject a certifiably F/RAND license and continue to infringe is contrary to the spirit of the F/RAND framework as well.”^[46]

Moreover, it is not typically the case that a negotiation process would end with an injunction and a refusal to license, as critics sometimes allege. Rather, the threat of an injunction is important in hastening an infringing implementer to the table and ensuring that protracted litigation to determine the appropriate royalty (which is how such disputes do actually end) is costly not only to the patentee, but also to the infringer. As James Ratliff and Daniel Rubinfeld explain:

[T]he existence of that threat does not lead to holdup as feared by those who propose that a RAND pledge implies (or should embody) a waiver of seeking injunctive relief. If RAND terms are reached by negotiation, the negotiation is not conducted in the shadow of an injunctive threat but rather in the shadow of knowledge that the court will impose a set of terms if the parties do not reach agreement themselves. The crucial element of this model that substantially diminishes the likelihood that the injunctive threat will have real bite against an implementer willing to license on RAND terms is the assumption that an SEP owner maintains its obligation to offer a RAND license even if its initial offer is challenged by the implementer and, further, even if the court agrees with the SEP owner that its initial offer was indeed RAND. Thus any implementer that is willing to license on court-certified RAND terms can avoid an injunction by accepting those RAND terms without eschewing any of its challenges to the RAND-ness of the SEP owner’s earlier offers.[47]

Ultimately, this means that an implementer that accepts nominally F/RAND terms need not be an actual “willing licensee,” but instead can gain that designation as a matter of law without ever accepting a royalty rate within the true bargaining range that includes the licensor’s valid injunction threat. “[B]y stripping the SEP holder’s right to injunctive relief, [a no-injunction rule] may enable a potential licensee to delay good faith negotiation of a F/RAND license and the patent holder could be forced to accept less than fair market value for the use of the patent…. Undermining this bargaining outcome using antitrust rules runs a significant risk of doing more harm than good.”[48]

For the purposes of this proceeding, the lesson is clear: U.S. policy needs to return to a neutral position in which both parties in a F/RAND negotiation are encouraged to reach mutually agreeable terms in arm’s length licensing transactions. The effects of eBay and its progeny have distorted that bargaining process. Here, the agencies have an important role to play in pressing the need for this change.

IV.    Increased Transparency Is No Free Lunch

The agencies’ call for comments asks whether increased transparency requirements in the SEP space could make SEP licensing more efficient:

What can the Department of Commerce do to mitigate emergence or facilitate the resolution of FRAND licensing disputes? Can requiring further transparency concerning patent ownership make standard essential patent (SEP) licensing more efficient? What are other impediments to reaching a FRAND license that the Department of Commerce could address through policy or regulation?[49]

But while fostering transparency may appear to be a win-win proposition for all parties in the standardization space, the reality is far more complex. In many instances, inventors are already required to disclose their standard essential patents—and these requirements have ambiguous effects.[50] Given this, demands for further transparency would almost certainly entail some form of government intervention, such as the creation of SEP registers and government-run essentiality checks, which seek to verify whether the patents that firms declare as standard-essential are truly so.

Unfortunately, these attempts to make SEP-reliant industries more transparent are anything but costless. The EU’s draft SEP regulation offers a case in point. The regulation would create a system of government-run essentiality checks and nonbinding royalty arbitrations that seek to make the process easier for implementers. But as ICLE scholars have written, this scheme will prove extremely difficult and costly to operate in practice.[51] Much the same would be true of attempts to introduce similar measures in the United States.

The proposed EU regulation would rely on qualified experts to work as evaluators and conciliators. Evaluators will need specialized knowledge of the particular technological area in which they will conduct essentiality checks. The European Commission estimates that there are about 1,500 experts (650 patent attorneys and 800 patent examiners) qualified to do essentiality checks in the EU.[52]

The sheer magnitude of the task, however, will require many more evaluators and it is very doubtful that the optimal number of potential qualified experts are even available to join this process. For certain, special arrangements would need to be made with patent offices to grant patent examiners leave to conduct essentiality checks. Each year, evaluators would need to test a random sample of up to 100 SEPs if requested by each SEP owner or an implementer per standard. Thus, the amount of work may exponentially increase depending on how many standards are caught by the regulation.

If 148 FRAND-licensed standards per laptop are to serve as a rough proxy, then we might expect more than 100-200 standards to be checked for essentiality every year. In addition, if SEP owners and implementers regularly use the possibility of testing up to 100 SEPs per standard and per SEP owner, the sheer magnitude of work may exceed the capacity of patent attorneys. Patent attorneys may find it challenging to regularly engage in such high volumes of essentiality checks while also serving other clients. And why should they do it at all unless the rate of pay is at least what they could earn in a patent law firm? To be blunt, the work would not be as much fun as acting for real clients, so the pay would probably have to be even higher to attract applicants.

Consequently, it is very unlikely that the capability even exists to annually perform a large number of essentiality checks of registered SEPs. If the requirements to become an evaluator were relaxed to address this workload, this would cast doubt on the reliability of the whole system. There is no point in building a battleship unless you are sure you can get a competent crew.

Additionally, the patent attorneys most likely to be familiar with these technologies may well also find themselves with conflicts of interest. They will probably have worked for some SEP owners or implementers. Elaborate rules to avoid such conflicts would need to be implemented to prevent patent attorneys who were, or still are, engaged with certain clients from becoming evaluators of those clients’ registered SEPs. The conflicts problem would, of course, apply not just to individual attorneys but to their entire firms.

Conciliators would also need to be experts in the field. They might come from the ranks of retired judges, seasoned former company officials, or experienced lawyers. Conflict-of-interest provisions would also be needed to ensure their independence and impartiality in mandatory FRAND determinations.  But the job would, again, have to be sufficiently attractive, both in remuneration and in work content and culture. The Commission has made no investigation as to whether a sufficiently large pool of credible individuals could be found to make the system work.

Of course, there are well-established voluntary systems of conciliators and mediators, some of which are used now to help resolve FRAND disputes. But the proposal adds the idea of compulsory mediation or conciliation. There is scant evidence that either system works in other commercial disputes around the world, and it is unclear why it should be assumed to work here.

In short, it is doubtful that a government-operated scheme of essentiality checks and SEP-royalty arbitrations could reach satisfactory outcomes, as the expertise to do so is lacking and attracting potentially thousands of professionals from the private sector would be too costly. The result is that any government scheme along these lines is unlikely to have the necessary staffing to conduct its mission to the requisite standard. It would thus risk doing more harm than good.

V.      SEP Rights and China’s ‘Cyber Great Power’ Ambitions

In their call for comments, the agencies express a desire to protect the United States’ leading position in the field of standard development and implementation:

Are there steps that the Department of Commerce can take regarding intellectual property rights policy that will help advance U.S. leadership in standards development and implementation for critical and emerging technologies?[53]

The agencies essentially ask what active steps they could take to preserve the United States’ leading position. This, however, ignores the arguably more important question: What steps should the United States avoid taking? As we explain below, U.S. agencies should be particularly careful not to weaken intellectual-property protection in ways that may, ultimately, favor firms in other jurisdictions, such as China.

Observers often regard intellectual property as merely protecting original creations and inventions, thus boosting investments. But while IP certainly does this, it is important to look beyond this narrow framing. Indeed, by protecting these creations, intellectual-property protection—particularly that of patents—produces beneficial second-order effects in several important policy areas.

Consequently, weakening patent protection could have detrimental ramifications that are routinely overlooked by policymakers. This includes giving a leg up to jurisdictions that are heavily geared toward manufacturing, rather than  R&D, and specifically to  China (with knock-on effects for ongoing political tensions between these two superpowers).

As the USPTO has observed:

Innovation and creative endeavors are indispensable elements that drive economic growth and sustain the competitive edge of the U.S. economy. The last century recorded unprecedented improvements in the health, economic well-being, and overall quality of life for the entire U.S. population. As the world leader in innovation, U.S. companies have relied on intellectual property (IP) as one of the leading tools with which such advances were promoted and realized.[54]

The United States is a world leader in the production and commercialization of IP, and naturally seeks to retain that comparative advantage.[55] IP and its legal protections will become increasingly important if the United States is to maintain its prominence, especially when dealing with international jurisdictions, like China, that don’t offer similar levels of legal protection.[56] By making it harder for patent holders to obtain injunctions, licensees and implementers gain the advantage in the short term, because they are able to use patented technology without having to engage in negotiations to pay the full market price. In the case of many SEPs—particularly those in the telecommunications sector—a great many patent holders are U.S.-based, while the lion’s share of implementers are Chinese. Potential anti-injunction policies may thus amount to a subsidy to Chinese infringers of western technology.

At the same time, China routinely undermines western intellectual-property protections through its industrial policy. The government’s stated goal is to promote “fair and reasonable” international rules, but it is clear that China stretches its power over intellectual property around the world by granting “anti-suit injunctions” on behalf of Chinese smartphone makers, designed to curtail enforcement of foreign companies’ patent rights.[57]

In several recent cases, Chinese courts have claimed jurisdiction over F/RAND issues.[58] In Oppo v. Sharp, the Supreme People’s Court of China determined that Chinese courts can set the global terms of what is a fair and reasonable price for a license,[59] even if that award would be considerably lower than in other jurisdictions. This decision follows Huawei v. Conversant, in which a Chinese court for the first time claimed the ability to issue an anti-suit injunction against the Chinese company.[60]

All of this is part of the Chinese government’s larger approach to industrial policy, which seeks to expand Chinese power in international trade negotiations and in global standards bodies.[61] As one Chinese Communist Party official put it: “Standards are the commanding heights, the right to speak, and the right to control. Therefore, the one who obtains the standards gains the world.”[62] Chinese President Xi Jinping frequently (but only domestically) references China’s “cyber great power” ambitions: “We must accelerate the promotion of China’s international discourse power and rule-making power in cyberspace and make unremitting efforts towards the goal of building a cyber great power.”[63] Chinese leaders are intentionally pursuing a two-track strategy of taking over standards bodies and focusing on building platforms to create path dependencies that cause others to rely on Chinese technology.[64] As a Hinrich Foundation Report notes:

Trade and technical standards are inherently interrelated. They are mutually reinforcing. But Beijing treats standard setting, and standards organizations, as competitive domains. This approach risks distorting global trade. Beijing does not support a neutral architecture where iterative negotiating strives for technical interoperability. Instead, Beijing promotes an architecture that bolsters and cements Chinese competitiveness. Due to China’s size and centralization, the consequences of this approach will reverberate across the international system. Given the nature of emerging technology and standards, the consequences will endure.[65]

Insufficient protections for intellectual property will hasten China’s objective of dominating collaborative standard development in the medium- to long-term.[66] U.S. entrepreneurs are able to engage in the types of research and development that drive innovation because they can monetize those innovations. Reducing the returns for patents that eventually become standards will lead to less investment in those technologies. It will also harm the competitive position of American companies that refrain from collaborating because the benefits don’t outweigh the costs, including “missing the opportunity to steer a standard in the manner most compatible with a company’s product offerings, falling behind competitors, or failing to head off broad adoption of a second standard….”[67]

Simultaneously, this will engender a switch to greater reliance on proprietary, closed standards rather than collaborative, open standards. Proprietary standards (and competition among those standards) are sometimes the most efficient outcome: for instance, when the costs of interoperability outweigh the benefits. The same cannot be said, however, for government policies that effectively coerce firms into adopting proprietary standards by raising the relative costs of the collaborative standard-development process. In other words, there are social costs when firms are artificially prevented from taking part in collaborative standard setting and forced instead to opt for proprietary standards.

Yet this is precisely what will happen to U.S. firms if IP rights are not sufficiently enforceable. Indeed, as explained above, collaborative standardization is an important driver of growth.[68] It is crucial that governments do not needlessly undermine these benefits by preventing American firms from competing effectively in these international markets.

These harmful consequences are magnified in the context of the global technology landscape, and in light of China’s strategic effort to shape international technology standards.[69] With U.S. firms systematically deterred from participating in the development of open technology standards, Chinese companies, directed by their government authorities, will gain significant control of the technologies that will underpin tomorrow’s digital goods and services. The consequences are potentially catastrophic:

The effect of [China’s] approach goes far beyond competitive commercial advantage. The export of Chinese surveillance and censorship technology provides authoritarian governments with new tools of repression. Governments that seek to control their citizens’ access to the internet are supportive of Beijing’s “cyber sovereignty” paradigm, which can lead to a balkanized internet riddled with incompatibilities that impede international commerce and slow technological innovation. And when cyber sovereignty is paired with Beijing’s push to redefine human rights as the “collective” rights of society as defined by the state, authoritarian governments gain a shield of impunity for violations of universal norms.[70]

With Chinese authorities joining standardization bodies and increasingly claiming jurisdiction over F/RAND disputes, there should be careful reevaluation of the ways weakened IP protection would further hamper the U.S. position as  a leader in intellectual property and innovation.

To return to the framing question, yes, there are steps the agencies could take to secure and promote U.S. leadership in intellectual-property-intensive industries. The first step, as noted throughout this comment, is to refrain from promoting policies that unnecessarily imbalance the negotiation process between innovators and implementers. The second step is twofold. First, work with trustworthy partners, like the EU, to make sure that U.S. Allies’ IP policies are in alignment with and are geared  toward promoting neutral standards that allow tech industries to thrive. The second part is to advocate for trade policies that dissuade countries like China from using their domestic courts and regulatory agencies as protectionist entities designed simply to advance China’s national interests.

VI.    Competition Concerns with Aggregate Royalties

In the call for comments, the agencies ask:

Do policy solutions that would require SEP holders to agree collectively on rates or have parties rely on joint negotiation to reach FRAND license agreements with SEP holders create legal risks? Are there other concerns with these solutions?[71]

A host of competition concerns are implicated in this question, in that it requires SEP owners to negotiate and ultimately agree on aggregate royalty rates for standards.  This may require SEP owners to exchange sensitive commercial information relevant to establishing the value that devices derive from using the standardized technology. Competition-sensitive data could include projected revenues on a per-unit basis following the incorporation of connectivity in the end products, the number of end products sold on the market, actual and forecast sales, and price projections.[72] The competitive dangers inherent in this process are more serious for those vertically integrated SEP owners, who simultaneously hold SEPs and manufacture standard-implementing products. They would effectively agree to set the costs (royalties) for their inputs and exchange data about their downstream sales.

Jointly negotiated rates could therefore potentially run afoul of antitrust laws that prohibit companies from engaging in price-fixing and collusion. Requirements to jointly negotiate aggregate royalty rates should thus be accompanied by safeguards and guidance that ensure such negotiations comply with antitrust law. An example would be royalty-rate negotiations in patent pools, where pool administrators take a mediatory role, collecting and protecting confidential information from pool members.[73]

It is also unclear whether these joint royalty negotiations would be of much use to either inventors or implementers. For example, the EU has proposed introducing an aggregate notification regulation along these lines. The regulation appears to allow multiple groups of SEP owners to jointly notify their views concerning the appropriate royalties for a given technology. This could add even more confusion for standard implementers. For example, some SEP owners could announce an aggregate rate of $10 per product, another 5% of the end-product price, while a third group would prefer a lower $1 per-product rate.

Moreover, it is unclear how joint aggregate royalty-rate notifications would change the existing practice of unilateral announcement of licensing terms. Many SEP owners already publicly announce their royalty programs in advance. To be on the safe side, SEP owners may simply notify their maximum preference, knowing that negotiations would lead to different prices depending on the unique details of various licensees. As a result, aggregate royalty rates may not produce meaningful data points.

Nonbinding expert opinions on global aggregate royalty rates could also add to the confusion. Implementers would likely initiate the process, which would then proceed in parallel with SEP owners’ joint notifications of aggregate rates. All these differing and possibly conflicting estimates might lead to even greater uncertainty. Moreover, if those providing nonbinding opinions are not universally regarded as “experts,” the parties are unlikely to respect such opinions.

Aggregate royalty notifications and nonbinding opinions might be used in the top-down method for FRAND-royalty determinations. A top-down method provides that the SEP owner should receive a proportional share of a standard’s total aggregate royalty. It requires establishing a cumulative royalty for a standard and then calculating the share of the total royalty for an individual SEP owner. This may be the reason for having aggregate royalty-rate notifications and opinions. At the same time, essentiality checks would still be needed to filter out which patents are truly essential, and to assess each individual SEP owner’s share.

We caution strongly against relying too heavily on the top-down approach for FRAND-royalty determinations. It is not used in commercial-licensing negotiations, and courts have frequently rejected its application. Industry practice is to use comparable licensing agreements. The top-down approach was applied in Unwired Planet v Huawei only as a cross-check for the rates derived from comparable agreements.[74] TCL v Ericsson relied on this method, but was vacated on appeal.[75] The most recent Interdigital v Lenovo judgment considered and rejected its use, finding “no value in Interdigital’s Top-Down cross-check in any of its guises.”[76] Moreover, the top-down approach, as currently applied, relies solely on patent counting. It fails to consider that not every patent is of equal value, nor that some patents may be invalid or not infringed by a specific device.

In short, there are important legal and practical obstacles to the joint negotiation of aggregate royalty rates. Legal mandates to conduct such negotiations would thus be of dubious added value to players in standard-reliant industries.

 

 

 

 

[1] U.S. Patent and Trademark Office, Joint ITA-NIST-USPTO Collaboration Initiative Regarding Standards, Federal Register (Sep. 27, 2023), https://www.federalregister.gov/documents/2023/09/27/2023-20919/joint-ita-nist-uspto-collaboration-initiative-regarding-standards; U.S. Patent and Trademark Office, Joint ITA–NIST–USPTO Collaboration Initiative Regarding Standards; Notice of Public Listening Session and Request for Comments, Federal Register (Sep. 11, 2023), available at https://www.govinfo.gov/content/pkg/FR-2023-09-11/pdf/2023-19667.pdf (“Call for Comments”).

[2] European Commission, Explanatory Memorandum for Proposal for a Regulation of the European Parliament and of the Council on Standard Essential Patents and Amending Regulation (EU) 2017/1001, COM (2023) 232 Final (“Explanatory Memorandum”).

[3] See, e.g., Dirk Auer & Julian Morris, Governing the Patent Commons, 38 Cardozo Arts & Ent. L.J. 294 (2020).

[4] See, e.g., Alexander Galetovic, Stephen Haber & Ross Levine, An Empirical Examination of Patent Holdup, 11 J. Competition L. & Econ. 549 (2015). This is in keeping with general observations about the dynamic nature of intellectual property protections. See, e.g., Ronald A. Cass & Keith N. Hylton, Laws of Creation: Property Rights in the World of Ideas 42-44 (2013).

[5] Oscar Borgogno & Giuseppe Colangelo, Disentangling the FRAND Conundrum, DEEP-IN Research Paper (Dec. 5, 2019) at 5, available at https://ssrn.com/abstract=3498995.

[6] Richard A. Epstein & Kayvan B. Noroozi, Why Incentives for “Patent Holdout” Threaten to Dismantle FRAND, and Why It Matters, 32 Berkeley Tech. L.J. 1381, 1411 (2017).

[7] Borgogno & Colangelo, supra note 5, at 5.

[8] Call for Comments, supra note 1, Questions 1 and 2.

[9] Proposal for a Regulation of the European Parliament and of the Council on Standard Essential Patents and Amending Regulation (EU) 2017/1001, COM (2023) 232 Final (“Draft SEP Regulation”).

 

[10] Robin Jacob & Igor Nikolic, ICLE Comments Regarding the Draft Regulation on Standard Essential Patents (Jul. 28, 2023), available at https://laweconcenter.org/wp-content/uploads/2023/07/ICLE-Comments-to-the-SEP-Regulation.pdf.

[11] Call for Comments, supra note 1, Question 3.

[12] See, e.g., Jorge Padilla, John Davies, & Aleksandra Boutin, Economic Impact of Technology Standards: The Past and the Road Ahead (2017), available at https://www.compasslexecon.com/wp-content/uploads/2018/04/CL_Economic_Impact_of_Technology_Standards_Report_FINAL.pdf (Section 3 has an in-depth discussion of the adoption of standards and the benefits to the growth of mobile technology); iRunway, Patent & Landscape Analysis of 4G-LTE Technology 9-12 (2012), https://www.i-runway.com/images/pdf/iRunway%20-%20Patent%20&%20Landscape%20Analysis%20of%204G-LTE.pdf.

[13] See, e.g., Galetovic, et al., supra note 4; Keith Mallinson, Don’t Fix What Isn’t Broken: The Extraordinary Record of Innovation and Success in the Cellular Industry under Existing Licensing Practices, 23 Geo. Mason L. Rev. 967 (2016); Damien Geradin, Anne Layne-Farrar, & Jorge Padilla, The Complements Problem within Standard Setting: Assessing the Evidence on Royalty Stacking, 14 B.U. J. Sci. & Tech. L.144 (2008).

[14] Auer & Morris, supra note 3, at 5.

[15] Epstein & Noroozi, supra note 6, at 1394.

[16] See, e.g., Daniel F. Spulber, Standard Setting Organisations and Standard Essential Patents: Voting and Markets, 129 Econ. J. 1477, 1502-03 (2018) (“The interaction between inventors and adopters helps explain the variation of decision rules among SSOs, ranging from majority rule to consensus requirements…. Technology standards will be efficient when SSO decision making reflects the countervailing effects of voting power and market power.”).

[17] See Kirti Gupta, How SSOs Work: Unpacking the Mobile Industry’s 3GPP Standards, in The Cambridge Handbook of Technical Standardization Law: Competition, Antitrust, and Patents (Jorge L. Contreras ed., 2017).

[18] See Kristen Jakobsen Osenga, Ignorance Over Innovation: Why Misunderstanding Standard Setting Organizations Will Hinder Technological Progress, 56 U. Louisville L. Rev. 159, 178 (2018); Andrew Updegrove, Value Propositions, Roles and Strategies: Participating in a SSO, in The Essential Guide to Standards, https://www.consortiuminfo.org/guide (last visited Jan. 23, 2022).

[19] Adapted from Auer & Morris, supra note 3, at 18-19.

[20] Andrew Updegrove, Business Considerations: Forming and Managing a SSO, in The Essential Guide to Standards, https://www.consortiuminfo.org/guide/forming-managing-a-sso/business-considerations (last visited Nov. 6, 2023).

[21] See, e.g., Jonathan M. Barnett, The Host’s Dilemma: Strategic Forfeiture in Platform Markets for Informational Goods, 124 Harv. L. Rev. 1861, 1883 (2010) (showing that firms routinely forfeit their intellectual assets in order to boost the growth of the platform they operate).

[22] See Joanna Tsai & Joshua D. Wright, Standard Setting, Intellectual Property Rights, and the Role of Antitrust in Regulating Incomplete Contracts, 80 Antitrust L.J. 157, 159 (2015) (“SSOs [standard-setting organizations] and their IPR policies appear to be responsive to changes in perceived patent holdup risks and other factors. We find the SSOs’ responses to these changes are varied, and that contractual incompleteness and ambiguity persist across SSOs and over time, despite many revisions and improvements to IPR policies. We interpret the evidence as consistent with a competitive contracting process and with the view that contractual incompleteness is an intended and efficient feature of SSO contracts.”) (emphasis added).

[23] See, e.g., Daniel F. Spulber, Licensing Standard Essential Patents with FRAND Commitments: Preparing for 5G Mobile Telecommunications, 18 Co. Tech. L.J. 79, 147 (2020) (“Adjudication of SEP disputes guided by common law principles and comparable licenses complements SSO FRAND commitments and market negotiation of SEP licenses. Adjudication based on common law and comparable licenses provides general rules for the resolution of SEP disputes that does not restrict SSO IP policies and or interfere with consensus decision making by SSOs. Such adjudication also does not interfere with efficient market negotiation of SEP licenses.”).

[24] Id. at 148.

[25] Osenga, supra note 19, at 213-14.

[26] Call for Comments, supra note 1, Questions 4, 5, 6.

[27] Draft SEP Regulation, preamble at (35).

[28] Richard A. Epstein, The Clear View of The Cathedral: The Dominance of Property Rules, 106 Yale L.J. 2091, 2091 (1996) (“Property rights are, in this sense, made absolute because the ownership of some asset confers sole and exclusive power on a given individual to determine whether to retain or part with an asset on whatever terms he sees fit.”)

[29] See generally Edmund W. Kitch, The Nature and Function of the Patent System, 20 J.L. & Econ. 265 (1977); F. Scott Kieff, Property Rights and Property Rules for Commercializing Inventions, 85 Minn. L. Rev. 697 (2001).

[30] See, e.g., Barnett, supra note 22, at 856 (“Strong patents provide firms with opportunities to disaggregate supply chains through contract-based relationships, which in turn give rise to trading markets in intellectual resources, whereas weak patents foreclose those options.”).

[31] Dirk Auer, Geoffrey A. Manne, Julian Morris, & Kristian Stout, The Deterioration of Appropriate Remedies in Patent Disputes, 21 Federalist Soc’y Rev. 158, 160 (2020).

[32] Id. at 163.

[33] See, e.g., Doris Johnson Hines & J. Preston Long, The Continuing (R)evolution of Injunctive Relief in the District Courts and the International Trade Commission, IP Litigator (Jan./Feb. 2013) (citing Tracy Lee Sloan, The 1988 Trade Act and Intellectual Property Cases Before the International Trade Commission, 30 Santa Clara L. Rev. 293, 302 (1990) (“Out of 221 intellectual property cases between 1974 and 1987, the ITC found that only five failed to establish sufficient injury… for injunctive-type relief.”)), available at https://www.finnegan.com/en/insights/articles/the-continuing-r-evolution-of-injunctive-relief-in-the-district.html.

[34] And even then, the specific contribution of a particular patent to ultimate consumer value will remain uncertain. See Robert P. Merges, Of Property Rules, Coase, and Intellectual Property, 94 Colum. L. Rev. 2655, 2659 (1994) (“The problems with [clearly defining harms/benefits] in the IPR field result from the abstract quality of the benefits conferred by prior works and the cumulative, interdependent nature of works covered by IPRs. Valuation, then, is at least as great a problem as detection.”)

[35] See Richard Epstein, F. Scott Kieff, & Daniel Spulber, The FTC, IP, and SSOs: Government Hold-Up Replacing Private Coordination, 8 J. Competition L. & Econ. 1 (2012) at 21, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1907450 (“The simple reality is that before a standard is set, it just is not clear whether a patent might become more or less valuable. Some upward pressure on value may be created later to the extent that the patent is important to a standard that is important to the market. In addition, some downward pressure may be caused by a later RAND commitment or some other factor, such as repeat play. The FTC seems to want to give manufacturers all of the benefits of both of these dynamic effects by in effect giving the manufacturer the free option of picking different focal points for elements of the damages calculations. The patentee is forced to surrender all of the benefit of the upward pressure while the manufacturer is allowed to get all of the benefit of the downward pressure.”).

[36] Merges, supra note 38, at 2666-67 (quoting A. Mitchell Polinsky, Resolving Nuisance Disputes: The Simple Economics of Injunctive and Damage Remedies, 32 Stan. L. Rev. 1075, 1092 (1980)).

[37] See Auer, et al., supra note 35, at 163 (“It also establishes this lower royalty rate as the ‘customary’ rate, which ensures that subsequent royalty negotiations, particularly in the standard-setting context, are artificially constrained.”).

[38] eBay Inc. v. MercExchange, LLC, 547 U.S. 388 (2006).

[39] See Benjamin Petersen, Injunctive Relief in the Post-eBay World, 23 Berkeley Tech. L.J. 193, 196 (2008), (“In the two years after the Supreme Court’s ruling in eBay, there were thirty-three district court decisions that interpreted eBay when determining whether to grant injunctive relief to a patent holder. Of these decisions, twenty-four have granted permanent injunctions and ten have denied injunctions.”). See also Bernard H. Chao, After eBay, Inc. v. MercExchange: The Changing Landscape for Patent Remedies, 9 Minn. J.L. Sci. & Tech. 543, 572 (2008) (“For the first time, courts are not granting permanent injunctions to many successful patent plaintiffs.”); Robin M. Davis, Failed Attempts to Dwarf the Patent Trolls: Permanent Injunctions in Patent Infringement Cases Under the Proposed Patent Reform Act of 2005 and eBay v. MercExchange, 17 Cornell J.L. & Pub. Pol’y 431, 444 (2008) (“However, the first few district courts deciding patent cases following that decision granted injunctions to patent owners in the majority of cases, at a rate of approximately two-to-one.”).

[40] See generally Epstein & Noroozi, supra note 6, at 1406-08.

[41] Vincenzo Denicolò, Damien Geradin, Anne Layne-Farrar & A. Jorge Padilla, Revisiting Injunctive Relief: Interpreting eBay in High-Tech Industries with Non-Practicing Patent Holders, 4 J. Comp. L. & Econ. 571 (2008).

[42] Id. at 608. See also Vincenzo Denicolò, Do Patents Over-Compensate Innovators?, 22 Econ. Pol’y 681 (2007) (noting that, with respect to patents in general, “a preponderance of what evidence is currently available points against the over-reward hypothesis”).

[43] See, e.g., Mark Schankerman & Suzanne Scotchmer, Damages and Injunctions in Protecting Intellectual Property, 32 RAND J. Econ. 201 (2001).

[44] Epstein & Noroozi, supra note 6, at 1408.

[45] Tsai & Wright, supra note 23, at 163.

^[46] James Ratliff & Daniel L. Rubinfeld, The Use and Threat of Injunctions in the RAND Context, 9 J. Competition L. & Econ. 14 (2013).

^[47] Ratliff & Rubinfeld, supra note 50, at 7 (emphasis added).

[48] Tsai & Wright, supra note 23, at 182.

[49] Call for Comments, supra note 1, Question 9.

[50] See, e.g., Rudi Bekkers, Christian Catalini, Arianna Martinelli, Cesare Righi, and Timothy Simcoe. Disclosure Rules and Declared Essential Patents, 52 Research Policy, 104618, 3 (2023) (“Thus, allowing blanket disclosure can be efficient if the main purpose of a disclosure policy is to reassure prospective implementers that a license will be available. On the other hand, blanket disclosure shifts search costs from the patent holder (who presumably has a comparative advantage at finding its own essential patents) onto other interested parties, such as prospective licensees who wish to evaluate the scope and value of a firm’s dSEPs; other SSO participants seeking to make explicit cost-benefit comparisons of alternative technologies before committing to a standard; and regulators or courts that might use information about relevant dSEPs to determine reasonable royalties.”).

[51] See Jacob & Nikolic, supra note 10.

[52] See European Commission, Impact Assessment Report Accompanying the Document Proposal for a Regulation of the European Parliament and of the Council on Standard Essential Patents and Amending Regulation (EU) 2017/1001, SWD(2023) 124 final (“Impact Assessment”), at 101.

[53] Call for Comments, supra note 1, Question 10.

[54] See, e.g., U.S. Patent Office, Intellectual Property and the U.S. Economy: 2016 Update (2016), available at https://www.uspto.gov/sites/default/files/documents/IPandtheUSEconomySept2016.pdf.

[55] Shayerah Ilias Akhtar, Liana Wong & Ian F. Fergusson, Intellectual Property Rights and International Trade, at 6 (Congressional Research Service, May 12, 2020), available at https://crsreports.congress.gov/product/pdf/RL/RL34292 (“Intellectual property generally is viewed as a long-standing strategic driver of U.S. productivity, economic growth, employment, higher wages, and exports. It also is considered a key source of U.S. comparative advantage, such as in innovation and high-technology products. Nearly every industry depends on it for its businesses. Industries that rely on patent protection include the aerospace, automotive, computer, consumer electronics, pharmaceutical, and semiconductor industries.”).

[56] See, e.g., Martina F. Ferracane & Hosuk Lee-Makiyama, China’s Technology Protectionism and Its Non-negotiable Rationales, ECIPE (Jun. 2017), available at https://ecipe.org/publications/chinas-technology-protectionism. Consider that, even for actual citizens of the People’s Republic of China, individual rights are legally subordinate to “the interests of the state.” Const. of the People’s Rep. of China, Art. 51, available athttp://www.npc.gov.cn/englishnpc/constitution2019/201911/1f65146fb6104dd3a2793875d19b5b29.shtml. One has to imagine that the level of legal protections afforded foreign firms is no better, and surely must be subordinate to the objectives of China’s industrial policy, including the goal of leapfrogging the United States in IP production. See, e.g., Karen M. Sutter, “Made in China 2025” Industrial Policies: Issues for Congress (Congressional Research Service, Aug. 11, 2020), available at https://sgp.fas.org/crs/row/IF10964.pdf.

[57] See China Is Becoming More Assertive in International Legal Disputes, The Economist (Sep. 18, 2021), https://www.economist.com/china/2021/09/18/china-is-becoming-more-assertive-in-international-legal-disputes (“In the past year Chinese courts have issued sweeping orders on behalf of Chinese smartphone-makers that seek to prevent lawsuits against them in other countries over the use of foreign companies’ intellectual property… so that they (rather than foreign courts) can decide how much Chinese firms should pay in royalties to the holders of patents that their products use.”).

[58] See Matthew Laight, Shifting landscape in SEP FRAND litigation – 2021 will see hard fought disputes in China and India, digital business (Dec. 9, 2020), https://digitalbusiness.law/2020/12/shifting-landscape-in-sep-frand-litigation-2021-will-see-hard-fought-disputes-in-china-and-india.

[59] See RPX Corporation, China: Chinese Courts Can Set Global SEP License Terms, Rules Supreme People’s Court, Mondaq (Oct. 21, 2021), https://www.mondaq.com/china/patent/1120114/chinese-courts-can-set-global-sep-license-terms-rules-supreme-people39s-court.

[60] Id.

[61] See Rush Doshi, Emily De La Bruye?re, Nathan Picarsic, & John Ferguson, China as a “Cyber Great Power”: Beijing’s Two Voices in Telecommunications, Brookings Institute Foreign Policy Paper (Apr. 2021) at 16, available at https://www.brookings.edu/wp-content/uploads/2021/04/FP_20210405_china_cyber_power.pdf. (“In March 2018, Beijing launched the China Standards 2035 project, led by the Chinese Academy of Engineering. After a two-year research phase, that project evolved into the National Standardization Development Strategy Research in January 2020. The ‘Main Points of Standardization Work in 2020’ issued by China’s National Standardization Committee in March 2020 outlined intentions to ‘strengthen the interaction between the standardization strategy and major national strategies.’”).

[62] Quoted in id.

[63] Id. “The phrase ‘cyber great power’ is a key concept guiding Chinese strategy in telecommunications as well as IT more broadly. It appears in the title of almost every major speech by President Xi Jinping on China’s telecommunications and network strategy aimed at a domestic audience since 2014. But the phrase is rarely found in messaging aimed at external foreign audiences, appearing only once in six years of remarks by Foreign Ministry spokespersons. This suggests that Beijing intentionally dilutes discussions of its ambitions in order not to alarm foreign audiences.” Id. at 3 (emphasis added).

[64] See Danny Russel & Blake Berger, Is China Stacking the Technology Deck by Setting International Standards?, The Diplomat (Dec. 2, 2021), https://thediplomat.com/2021/12/is-china-stacking-the-technology-deck-by-setting-international-standards.

[65] Emily de la Bruyere, China’s Quest to Shape the World Through Standards Setting, Hinrich Foundation (Jul. 2021), at 11 (emphasis added), available at https://www.hinrichfoundation.com/research/article/tech/china-quest-to-shape-the-world-through-standards-setting.

[66] Although China is currently under-represented in most SDOs, that is already rapidly changing. See Justus Baron & Olia Kanevskaia, Global Competition for Leadership Positions in Standards Development Organizations, Working Paper (Mar. 31, 2021), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3818143. As Baron and Kanevskaia note, “[t]he surge in the number of leadership positions held by Huawei… [have] raised concerns that… Huawei [may] gain an undue competitive advantage over Western commercial and strategic interests.” Id. at 2.

[67] Updegrove, supra note 19.

[68] See id. at 30-36 (surveying the economic benefits from standardization). See also Soon-Yong Choi & Andrew B. Whinston, Benefits and Requirements for Interoperability in the Electronic Marketplace, 2 Tech. in Soc’y 33, 33 (2000) (“Economic benefits of interoperability result in lowered production or transaction costs typically utilizing standardized parts or automated processes. In the networked economy, the need for interoperability extends into an entire commercial processes, market organizations and products.”).

[69] Anna Gross, Madhumita Murgia & Yuan Yang, Chinese Tech Groups Shaping UN Facial Recognition Standards, Financial Times (Dec. 1, 2019), https://www.ft.com/content/c3555a3c-0d3e-11ea-b2d6-9bf4d1957a67 (“‘The drive to shape international standards… reflects longstanding concerns that Chinese representatives were not at the table to help set the rules of the game for the global Internet,’ the authors of the New America report wrote. ‘The Chinese government wants to make sure that this does not happen in other ICT spheres, now that China has become a technology power with a sizeable market and leading technology companies, including in AI.’”).

[70] Russel & Berger, supra note 67.

[71] Request for Comments, supra note 1,  Question 11.

[72] Igor Nikolic, Licensing Negotiations Groups for SEPs: Collusive Technology Buyers Arrangements? Their Pitfalls and Reasonable Alternatives, Les Nouvelles 350 (2021).

[73] Hector Axel Contreras & Julia Brito, Patent Pools: A Practical Perspective – Part II, Les Nouvelles 39 (2022).

[74] Unwired Planet v Huawei [2017] EWHC 711 (Pat).

[75] TCL v Ericsson, Case No. 8:14-cv-003410JVS-DFM (C.D. Cal. 2018); TCL v Ericsson, 943 F.3d 1360 (Fed. Cir. 2019)

[76] Interdigital v Lenovo [2023] EWHC 539 (Pat) 733.

INTEREST OF AMICI CURIAE^[1]

The International Center for Law & Economics (“ICLE”) is a nonprofit, non-partisan global research and policy center aimed at building the intellectual foundations for sensible, economically grounded policy.  ICLE promotes the use of law and economics methodologies to inform public policy debates and has longstanding expertise in antitrust law.  ICLE has an interest in ensuring that antitrust promotes the public interest by remaining grounded in sensible legal rules informed by sound economic analysis.

Amici also include fifteen scholars of antitrust, law, and economics at leading universities and research institutions across the United States.  Their names, titles, and academic affiliations are listed in Appendix A.  All have longstanding expertise in antitrust law and economics.

Amici respectfully submit that this brief will aid the Court in reviewing the order of dismissal by explaining that the district court properly held, on the pleadings, that the restraint at issue is ancillary and thus that per se treatment is inappropriate.  The restraint furthers Saks’s procompetitive goal of creating a strong and stable luxury brand through collaboration with the Brand Defendants.  Treating such a restraint as per se unlawful, as Plaintiffs ask this Court to do, would stifle the type of legitimate cooperation that facilitates output and would ultimately harm consumers.  Amici also explain why Plaintiffs and several of their amici, including the United States, make foundational errors of law and economics in arguing that ancillarity is an affirmative defense that may not be resolved on the pleadings.

INTRODUCTION AND SUMMARY OF ARGUMENT

Saks and the Brand Defendants are well-known luxury retail brands.  As luxury retailers, their business models depend on developing and maintaining a distinct, exclusive brand to differentiate their products from the lower-priced goods sold by mass-market retailers.  A primary way in which they define and protect their brands is by cultivating a premium shopping experience for customers that promotes “an atmosphere of exclusivity and opulence surrounding . . . luxury products.”  Compl. ¶ 33.  To that end, Saks and the Brand Defendants have for years collaborated through “store-within-a-store” arrangements: Saks allows the Brand Defendants to set up boutiques and concessions within Saks’s stores, which in turn helps all involved grow their customer base, augment their luxury brand status, and sell more products.  This “store-within-a-store” model not only expands customer product choice within a single retail establishment, resulting in a better shopping experience, but also creates additional jobs at Brand Defendants’ concessions in Saks’s stores.

Plaintiffs allege that the Brand Defendants agree, as part of their respective partnerships with Saks, not to hire Saks’s own luxury retail employees without the approval of a Saks manager or until six months after the employee leaves Saks.  Plaintiffs argue that these alleged no-hire provisions violate Section 1 of the Sherman Act.  The district court disagreed, concluding that the per se rule could not apply because the no-hire provisions were “ancillary” to a broader procompetitive collaboration between Saks and each of the Brand Defendants, and that Plaintiffs failed to plead a plausible claim under the rule of reason.  That decision is correct and should be affirmed.

First, the alleged no-hire agreements are ancillary to the arrangements between Saks and the Brand Defendants.  Saks invests heavily in its employees.  But without the no-hire provision, Saks would stand to lose those investments as the Brand Defendants could take advantage of their co-location within Saks’s stores to hire away Saks’s best workers, thereby free-riding on Saks’s training.  The alleged no-hire provisions eliminate that powerful economic disincentive and thereby facilitate brand-enhancing, procompetitive store-within-a-store arrangements.  That is all that is required for the agreements to be “ancillary.”  Plaintiffs’ (and their amici’s) insistence on a rigid two-prong test for ancillarity is not only at odds with economic logic but also out of step with this Circuit’s precedent—and, in any event, would not change the result here.

Second, the district court properly resolved ancillarity on the pleadings.  Ancillarity is a threshold inquiry decided at the earliest possible stage of a Section 1 case to determine whether the alleged facts justify departing from the default rule of reason standard.  That is precisely what the district court did here: based on Plaintiffs’ own allegations—including those regarding “a continual risk that the Brand Defendants would use their concessions in Saks stores to recruit employees” (Op. 32)—the district court ruled that the alleged restraints were ancillary and thus incompatible with per se condemnation.  Contrary to Plaintiffs’ argument, the district court did not improperly resolve any factual inferences.  The court considered the Complaint in its entirety and determined that Plaintiffs did not state a plausible per se claim, just as it was supposed to do before requiring the enormous expense that would result should this kind of “potentially massive factual controversy . . . proceed.”  Bell Atl. Corp. v. Twombly, 550 U.S. 544, 558 (2007).

ARGUMENT

I.              The Alleged Restraints Are Ancillary To Procompetitive Collaboration

The per se rule is reserved for the most pernicious and anticompetitive restraints.  Before condemning a restraint as per se unlawful, therefore, courts must “have amassed considerable experience with the type of restraint at issue” and be able to “predict with confidence that it would be invalidated in all or almost all instances.”  NCAA v. Alston, 141 S. Ct. 2141, 2156 (2021).  Reserving per se condemnation for that small category of restraints ensures that the antitrust laws do not inadvertently chill procompetitive conduct.  Ancillary restraints do not fit the per se mold because they have a “reasonable procompetitive justification, related to the efficiency-enhancing purposes of [a] joint venture.”  MLB Props., Inc. v. Salvino, Inc., 542 F.3d 290, 339 (2d Cir. 2008) (Sotomayor, J., concurring in the judgment).

Here, any purported no-hire agreements form a key plank of the broader leasing, concession, and distribution arrangements between Saks and the Brand Defendants.  Op. 30-32.  It is beyond dispute that these agreements are procompetitive.  They not only enhance Saks’s and the Brand Defendants’ ability to vigorously compete against other retailers and luxury brands (i.e., increasing output in markets for luxury products) but also create jobs (i.e., increase output in labor markets).  That places the restraint far beyond the per se rule, MLB, 542 F.3d at 339 (Sotomayor, J., concurring in the judgment); only the rule of reason can be used to determine whether the restraint “stimulat[es] competition that [is] in the consumer’s best interest” or has “anticompetitive effect[s] that are harmful to the consumer.”  Leegin Creative Leather Prods., Inc. v. PSKS, Inc., 551 U.S. 877, 886 (2007).[2]

                  A.            The Alleged No-Hire Agreements Are Facially Procompetitive

A restraint is ancillary where it “could have a procompetitive impact related to the efficiency-enhancing purposes” of a cooperative venture.  MLB, 542 F.3d at 340 (Sotomayor, J., concurring in the judgment); see Polk Bros., Inc. v. Forest City Enters., Inc., 776 F.2d 185, 188-89 (7th Cir. 1985) (restraint is ancillary if it “may contribute to the success of a cooperative venture that promises greater productivity and output”).  Where a restraint is deemed “ancillary to the legitimate and competitive purposes” of a venture, the restraint is presumptively “valid” and must be assessed under the rule of reason.  Texaco Inc. v. Dagher, 547 U.S. 1, 7 (2006).  There is a clear procompetitive rationale for the collaboration arrangement between Saks and the Brand Defendants: the arrangement allows customers to expand their choice in one-stop shopping, and the retailers to offer a wider range of high-end luxury goods.  And it creates a halo effect across the store-within-a-store through proximity and availability of multiple luxury brands.  All of this in turn promotes and enhances the luxury status of Saks and the Brand Defendants alike.  The alleged no-hire restraints enable and are ancillary to that larger endeavor.

As Plaintiffs allege, Defendants each derive much of their respective brand value from their ability to project a “luxury brand[] aura[],” which both entices customers and creates demand for Defendants’ goods “over other, lower-priced goods.”  Compl. ¶¶ 23, 26, 28.  For this reason, Defendants “go[] to great lengths to market” and otherwise “maintain[] their luxury brands’ auras.”  Id. ¶¶ 23, 26.  They “accomplish this feat,” in part, by ensuring that their brick-and-mortar stores provide a “luxury shopping experience[].”  Id. ¶ 27.  Defendants do that with sophisticated “décor and design” and premium “customer service” from skilled employees “who reflect their respective brand images and cultures.”  Id. ¶¶ 27-29.

Store-within-a-store arrangements further enhance the luxury brand shopping experience for both consumers and retailers.  In these arrangements, Saks allows the Brand Defendants to set up mini-stores or concessions within Saks’s large stores.  These arrangements, similar to those used by “[a]lmost all department store chains,” Kinshuk Jerath & Z. John Zhang, Store Within a Store, 47 J. Mktg. Rsch. 748, 748 (2010), are mutually beneficial and procompetitive.  The presence of the popular luxury brands helps draw brand-loyal customers into Saks, thus increasing foot traffic and broadening Saks’s customer reach—directly boosting sales output.  Compl. ¶ 28; see Jerath & Zhang, supra, at 756-57 (“The introduction of new products through stores within a store can bring new consumers to the store who want to purchase the focal product and also purchase other products.”).  The Brand Defendants benefit from access to Saks’s considerable customer base, Compl. ¶ 28, and their presence also makes possible cross-brand marketing opportunities.  Consumers benefit as well: they have access to a wider array of products, and have it all at hand in a single store.  And they have the benefit of workers highly trained with respect to the luxury goods they sell.  Id. ¶¶ 27-29, 32-34.

But there is a significant practical impediment to allowing stores-within-stores: employee raiding.  Saks invests heavily in its luxury retail employees, providing them with the “extensive training on service, selling, and product-knowledge” required to ensure that they are “knowledgeable about the particular products” for sale “as well as current trends.”  Compl. ¶¶ 32, 34.  Permitting the Brand Defendants to operate inside of Saks stores without restriction would put that investment in immediate danger.  The Brand Defendants would have every incentive to free-ride off of Saks’s investment, observing and hiring Saks’s highly trained luxury retail employees, thereby “tak[ing] advantage of the efforts [Saks] has expended in soliciting, interviewing, and training skilled labor” and “simultaneously inflicting a cost on [Saks] by removing an employee on whom [Saks] may depend.”  Id. ¶ 62.  This risk—and the mistrust it can create—disincentivizes the formation and maintenance of store-within-a-store agreements.

No-hire restraints solve this problem.  By imposing a narrow, time-limited, waivable restriction on the Brand Defendants’ ability to hire Saks employees, Compl. ¶ 92, the alleged no-hire agreements remove a roadblock from the “cooperation underlying the restraint,” which “has the potential to create the efficient production that consumers value,” Premier Elec. Constr. Co. v. Nat’l Elec. Contractors Ass’n, Inc., 814 F.2d 358, 370 (7th Cir. 1987).  In particular, the alleged no-hire restrictions help prevent free-riding by Brand Defendants on Saks’s training.  The agreement encourages Saks to invest in employee development, including by providing specific training on Brand Defendants’ products, and that investment enhances Saks’s ability to sell products from and compete against Brand Defendants’ stand-alone brick and mortar and online stores.  See, e.g., Gregory J. Werden, The Ancillary Restraints Doctrine After Dagher, 8 Sedona Conf. J. 17, 21 (2007).  “[W]ith the restraint,” Saks may “collaborate” with the Brand Defendants “for the benefit of its [customers] without ‘cutting [its] own throat.’”  Aya Healthcare Servs., Inc. v. AMN Healthcare, Inc., 9 F.4th 1102, 1110-11 (9th Cir. 2021) (quoting Polk Bros., 776 F.2d at 189).  As a result, the alleged no-hire restraints are “at least potentially reasonably ancillary to joint, efficiency-creating economic activities.”  Phillips v. Vandygriff, 711 F.2d 1217, 1229 (5th Cir. 1983); cf. Eichorn v. AT&T Corp., 248 F.3d 131, 146-47 (3d Cir. 2001) (“As an ancillary covenant not to compete, the no-hire agreement was reasonable in its restrictions on the plaintiffs’ ability to seek employment elsewhere.”).

The contrary conclusion—that the alleged no-hire restraints are not ancillary—risks stifling competition across the retail economy.  No-hire agreements are merely one of the many ancillary contractual restraints commonly used in store-within-a-store partnerships (exemplified by, for instance, the well-known collaborations between Target and Starbucks or Best Buy and Samsung) to preserve brand integrity, guard against misuse of store space, and safeguard investments in specialized training.  By solving for risks such as employee raiding or damage to property, these restrictions instill confidence in both parties, facilitating the creation of these cooperative ventures in the first place.  Categorizing the alleged no-hire provisions here as per se unlawful could chill a whole spectrum of reasonable ancillary restraints, undermining the careful balance that store-within-a-store arrangements aim to maintain and inhibiting market innovation.  That would be bad for potential employees, who would lose the opportunity to work at stores-within-stores, as well as for consumers, who would lose the convenient access to goods in-store concessions provide.

                   B.            The Rigid Two-Prong Test Advanced By Plaintiffs And Their Amici Is Not The Law, And The Alleged Restraints Here Satisfy It In Any Event

Plaintiffs and their amici resist ancillarity by, in part, insisting upon application of a strict and formalistic test not found in the law of this Circuit or any other.  In their view, an ancillary restraint must be both (1) “subordinate and collateral to a separate legitimate transaction” and (2) “reasonably necessary to achiev[e] that transaction’s procompetitive purpose.”  AOB 34-35.  This rigid two-step test is not the law in this Circuit.  But even if it were, Plaintiffs and amici misconstrue the second prong, improperly transforming it into a strict necessity standard that no circuit has adopted.  Consistent with their evident procompetitive potential, the alleged restraints here amply satisfy the actual test.

Although some courts have moved toward a delineated two-prong standard, this Court has not.  This Court’s leading opinion on ancillarity is then-Judge Sotomayor’s influential concurrence in MLB, in which she observed that a restraint is ancillary where it is “reasonably necessary to achieve any of the efficiency-enhancing benefits of a joint venture.”  542 F.3d at 338 (Sotomayor, J., concurring in the judgment).  She noted no other requirements, invoking Judge Easterbrook’s similar formulation in Polk Bros. that a restraint is ancillary where it “may contribute to the success of a cooperative venture that promises greater productivity and output.”  Id.; Polk Bros., 776 F.2d at 189; see Rothery Storage & Van Co. v. Atlas Van Lines, Inc., 792 F.2d 210, 229 (D.C. Cir. 1986) (restraint is ancillary when it “appears capable of enhancing the group’s efficiency”).  That approach in turn traces all the way to then-Judge Taft’s seminal United States v. Addyston Pipe & Steel Co. decision, which assessed ancillarity using this same flexible formulation.  See 85 F. 271, 281 (6th Cir. 1898).

Even if the two-prong test advanced by Plaintiffs and their amici did apply, however, they misconstrue the second prong by paying only lip service to a “reasonably necessary” standard and in reality asking this Court to impose a “strictly necessary” test.  Instead of asking whether the restraint “promoted enterprise and productivity”—which is all that is required for a restraint to be “reasonably necessary,” Aya, 9 F.4th at 1110-11—Plaintiffs would require Defendants to show that the “restraint [is] necessary to achieve the business relationship,” AOB 36, such that in its absence, “Saks would terminate or . . . alter its purported collaborative relationships,” NY Br. 29.

No court of appeals has embraced this strict-necessity standard.  In Medical Center at Elizabeth Place, LLC v. Atrium Health System, for instance, the Sixth Circuit considered and rejected it, holding that requiring a defendant to show that a restraint “is necessary” is “too high a standard to determine what qualifies as ‘reasonable.’”  922 F.3d 713, 725 (6th Cir. 2019); see also id. at 726 (observing Judge Sotomayor’s MLB concurrence “categorically rejected” a strict necessity test).  Rather, an ancillary restraint “need not be essential, but rather only reasonably ancillary to the legitimate cooperative aspects of the venture” because “there exists a plausible procompetitive rationale for the restraint.”  Id. (quotation marks omitted).  The Ninth Circuit similarly rejected the United States’ attempt to advance this standard, and instead held in Aya that a no-hire restraint was “properly characterized as ancillary” where it “promoted enterprise and productivity at the time it was adopted.”  9 F.4th at 1111.  And the United States and a different set of plaintiffs recently argued for a strict-necessity test in the Seventh Circuit.  See Br. for the U.S. and the FTC as Amici Curiae Supporting Neither Party at 26, Deslandes v. McDonald’s USA, LLC, Nos. 22-2333 & 22-2334 (7th Cir. Nov. 9, 2022) (arguing no-hire agreement was not ancillary because it “was not necessary to encourage franchisees to sign” franchising agreements).  The panel declined to adopt it, adhering instead to the Polk Bros. test.  See Deslandes v. McDonald’s USA, LLC, 81 F.4th 699, 703 (7th Cir. 2023).

All of these decisions make sense.  The per se rule applies only when a challenged restraint is obviously and clearly anticompetitive, and a restraint that is plausibly part of a procompetitive venture should be judged by “the facts peculiar to the business to which the restraint is applied.”  Bd. of Trade of Chi. v. United States, 246 U.S. 231, 238 (1918).  A contrary decision would discourage competition; strict necessity is not only an unrealistic requirement, as businesses make these decisions ex ante, but also would require them to constantly recalibrate their policies.  The result would be that firms forego potentially procompetitive collaborations, chilling innovative policies and business models.  See Werden, supra, at 23-24 (comprehensive analysis by DOJ economist rejecting strict-necessity test).

Nor is there any legal or logical basis for Plaintiffs’ made-up “tailor[ing]” prong—that a “restraint must be ‘tailored’ to a legitimate objective to qualify as ancillary.”  AOB 35.  Courts routinely reject any “reasonabl[e] tailor[ing]” requirement, because that phrase would not “carr[y] a materially different meaning than ‘reasonably necessary’” and because a restraint “need not satisfy a less-restrictive-means test.”  Aya, 9 F.4th at 1111 & n.5.  A tailoring analysis can be part of the rule-of-reason framework employed after a restraint is deemed ancillary, but it has no role in the ancillarity inquiry itself, which evaluates whether a restraint “should be reviewed under the rule of reason” in the first place.  MLB, 542 F.3d at 341 (Sotomayor, J., concurring in the judgment).  The flaw in Plaintiffs’ argument is underscored by the only case they cite to support their purported tailoring requirement, which did not even involve ancillarity, but instead analyzed whether there was a less restrictive alternative under the rule of reason.  See NCAA v. Bd. of Regents of Univ. of Okla., 468 U.S. 85, 117 (1984); see also Aya, 9 F.4th at 1111 (“[T]he less restrictive alternative analysis falls within the rule-of-reason analysis, not the ancillary restraint consideration.”).

Properly interpreted to require only “reasonable necessity,” the two-prong test is satisfied here on the face of the Complaint.  The alleged restraint is “subordinate and collateral” to a broader venture in which Saks permits the Brand Defendants to “sell their goods and apparel” with Saks’s stores.  Compl. ¶ 21.  Although the United States argues that the Complaint “contains no allegations of any connection . . . between the alleged conspiracy and those business relationships,” U.S. Br. 15-16, that is not correct: the Brand Defendants operate “concessions at Saks stores,” Compl. ¶ 21, and Saks employees receive brand-specific training, id. ¶ 160.  As the district court held, Op. 34 n.22, the alleged restraint prevented the Brand Defendants from hiring Saks employees who sold the Brand Defendants’ merchandise, thereby protecting Saks’s training investments, see Compl. ¶¶ 156-61, 187-91, increasing the attractiveness of the broader collaboration, and promoting mutual trust between the parties, see Rothery Storage, 792 F.2d at 224 (restraint that “serves to make the main transaction more effective in accomplishing its purpose” is “subordinate and collateral”).

Plaintiff Susan Giordano’s allegations about her own experience demonstrate that this alleged restraint is ancillary.  Giordano was a Saks employee at Saks’s Loro Piana boutique for “18 months,” during which time she became “familiar[] with Loro Piana’s . . . merchandise.”  Compl. ¶¶ 157, 160.  Giordano sought employment at a standalone Loro Piana boutique, explaining that she “would surely be an asset” because of her familiarity with Loro Piana’s product gained from Saks’s training.  Id. ¶¶ 156-61.  But the no-hire restraint allegedly prevented Loro Piana from hiring Giordano, id. ¶ 161, “ensur[ing] that [Saks] [did] not lose its personnel during the collaboration” with Brand Defendants, Aya, 9 F.4th at 1110.  Courts have found just these sorts of no-hire agreements to facilitate “procompetitive collaboration” to be “reasonably necessary.”  Id.; cf. Bogan v. Hodgkins, 166 F.3d 509, 515 (2d Cir. 1999) (rejecting per se treatment for no-hire agreements).

The United States’ arguments to the contrary are unavailing.  It argues that the alleged no-hire agreements go beyond solicitation at the concessions themselves, barring the Brand Defendants from hiring even Saks employees who independently apply or approach the Brand Defendants for a job.  U.S. Br. 19.  But the no-hire agreements’ purpose, to protect against risks that employees would leave for a collaborating brand located inside their own store, applies equally regardless of whether an employee is solicited by or independently approaches a competitor.  In both instances, Saks invested in brand-specific employee training, see Compl. ¶¶ 32, 34, 156, that the no-hire agreement protects from the unique exposure of a store-within-a-store.

The United States also suggests that the restraint is not reasonably necessary because it applies to “any brand [or designer company] carried by Saks” rather than just brands that maintain concession stands.  U.S. Br. 16, 19.  But a restraint “need not satisfy a less-restrictive-means test,” Aya, 9 F.4th at 1111; regardless, Saks employees receive detailed training on all luxury brands sold in the stores, even those that do not maintain concession stands, see Compl. ¶ 34.  The alleged no-hire agreement notably does not extend to the many luxury brands whose goods are not “carried by Saks,” id. ¶ 175, leaving Saks employees free to take their talents to those competing employers or to other retailers of luxury goods.  And the United States’ suggestion that the duration of the agreement is too long, U.S. Br. 19, ignores that employees receive continuous training to remain “knowledgeable about the particular products [sold] . . . as well as current trends,” Compl. ¶ 34 (emphasis added).  If employees could leave their employment with Saks and immediately join the competitor, then the alleged restraint would have no effect at all, and Saks would lose the incentive to invest in ongoing specialized training regarding competitor brands.

II.            The District Court Properly Decided Ancillarity On The Pleadings

Nothing in the antitrust laws prohibits a district court from resolving ancillarity on the pleadings, and the court’s decision to do so here was procedurally proper and analytically sound.  Determining whether a challenged restraint is “naked” or “ancillary” is a threshold inquiry for a Section 1 claim because “[t]his all-important classification largely determines the course of subsequent legal evaluation of [the] restraint.”  Phillip E. Areeda & Herbert Hovenkamp, Antitrust Law: An Analysis of Antitrust Principles and Their Application, ¶ 1904 (5th ed., 2023 Cum. Supp.).  Put another way, resolving ancillarity at the outset of the case dictates the mode of analysis employed by the court: naked restraints are subject to per se treatment, while ancillary restraints are analyzed under the rule of reason.

This does not mean that ancillarity must be resolved at the pleadings—depending on the circumstances, it may be resolved after the pleadings but before summary judgment, at summary judgment, or even at trial.  See In re HIV Antitrust Litig., 2023 WL 3088218, at *23 (N.D. Cal. Feb. 17, 2023) (summary judgment); N. Jackson Pharmacy, Inc. v. Caremark RX, Inc., 385 F. Supp. 2d 740, 743 (N.D. Ill. 2005) (pre-summary judgment Rule 16 motion).  Rather, ancillarity is a threshold issue that sets the stage for the analysis that follows, and deciding it at the pleadings stage permits defendants to defeat meritless claims before undergoing costly discovery.

The district court properly resolved the question on a motion to dismiss here because Plaintiffs’ own allegations made clear that the alleged no-hire agreements were ancillary.  Plaintiffs and their amici make two arguments: first, that ancillarity cannot be resolved on the pleadings, and second, that the district court improperly resolved facts in Defendants’ favor.  Neither argument persuades.

                  A.            Ancillarity Is A Threshold Inquiry, Not An Affirmative Defense

Courts analyzing Section 1 claims must first determine the proper framework to apply: the per se rule or the rule of reason (or, in some cases, an abbreviated “quick look” analysis).  See Leegin, 551 U.S. at 886-87.  To make that determination, “[a] court must distinguish between ‘naked’ restraints, those in which the restriction on competition is unaccompanied by new production or products, and ‘ancillary’ restraints, those that are part of a larger endeavor whose success they promote.”  MLB, 542 F.3d at 339 (Sotomayor, J., concurring in the judgment) (quoting Polk Bros., 776 F.2d at 188).  “This all-important classification largely determines the course of subsequent legal evaluation of any restraint.”  Areeda & Hovenkamp, supra, ¶ 1904; see Thomas B. Nachbar, Less Restrictive Alternatives and the Ancillary Restraints Doctrine, 45 Seattle U. L. Rev. 587, 634 (2022) (“In order to do any real work, the ancillary restraints doctrine has to precede the rule of reason.”); Herbert Hovenkamp, The Rule of Reason, 70 Fla. L. Rev. 81, 140 (2018) (“The ancillary restraints doctrine is not a comprehensive method for applying the rule of reason, but rather an early stage decision about which mode of analysis should be applied.”).  Thus, ancillarity is a gating inquiry.  By determining at the outset of the case whether a challenged restraint is naked or ancillary, the court ensures it applies the proper analytical framework.

Because this determination guides how the parties conduct discovery and try the case, it is important to decide ancillarity at the earliest possible stage.  This avoids “expensive pretrial discovery” on the wrong questions and issues.  And it avoids discovery altogether in cases that do not state a claim and should never proceed past the pleadings.  Limestone Dev. Corp. v. Vill. of Lemont, 520 F.3d 797, 803 (7th Cir. 2008) (noting importance of carefully evaluating antitrust claims at pleading stage “lest a defendant be forced to conduct expensive pretrial discovery in order to demonstrate the groundlessness of the plaintiff’s claim” (citing Bell Atl. Corp. v. Twombly, 550 U.S. 544, 558-59 (2007))).

Treating ancillarity as a gating inquiry also is consistent with the Supreme Court’s admonition that per se treatment must be confined to a narrow class of cases.  As the Court has explained, “the per se rule is appropriate only after courts have had considerable experience with the type of restraint at issue and only if courts can predict with confidence that it would be invalidated” under the rule of reason.  Leegin, 551 U.S. at 886-87; Dagher, 547 U.S. at 5 (“Per se liability is reserved for only those agreements that are so plainly anticompetitive that no elaborate study of the industry is needed to establish their illegality.” (quotation marks omitted)).  That predictive confidence must be rooted in the “demonstrable economic effect” of the restraint at issue, not a plaintiff’s suspicion that the restraint is harmful.  Leegin, 551 U.S. at 887.  This is a high bar.  Only when a restraint is “so obviously lacking in any redeeming pro-competitive values” may courts apply the per se rule.  Cap. Imaging Assocs., P.C. v. Mohawk Valley Med. Assocs., Inc., 996 F.2d 537, 542 (2d Cir. 1993).

Because per se analysis is warranted only when justified by “demonstrable economic effect,” resolving the issue of ancillarity on the pleadings ensures that plaintiffs cannot invoke per se treatment on mere say-so.  The ancillarity inquiry, by definition, considers the relationship of the challenged restraint to the parties’ business collaboration—that is, the inquiry explores the likely “economic effect” of the restraint within the context of commercial realities.  That is precisely what the Supreme Court requires before expanding the per se rule into new frontiers.  Broad. Music, Inc. v. Columbia Broad. Sys., Inc., 441 U.S. 1, 19 n.33 (1979) (“[T]he per se rule is not employed until after considerable experience with the type of challenged restraint.”); Bogan, 166 F.3d at 514 (“The Supreme Court is slow to . . . extend per se analysis to restraints imposed in the context of business relationships where the economic impact of certain practices is not immediately obvious.” (quotation marks omitted)).

If ancillarity could be resolved only after the pleadings stage, as Plaintiffs and their amici urge, then a Section 1 plaintiff could survive dismissal simply by invoking the per se rule without regard for the restraint’s “economic effect” or the courts’ ability to “predict with confidence that [the restraint] would be invalidated.”  Leegin, 551 U.S. at 886-87.  A simple example underscores the absurdity of that rule: ever since they were recognized in Addyston Pipe as axiomatic ancillary restraints, no-hire provisions are commonly included in agreements for the sale of a business.  The approach proposed would require litigation through discovery to decide if such a provision were ancillary.

Moreover, neither the federal courts nor the academy have amassed sufficient experience with this subject to allow default per se treatment.  Indeed, the only study that attempted to analyze the relevant economic considerations in a systematic way concluded that eliminating no-hire provisions “causes minimal reductions in job concentration and no increase in wages.”  Daniel S. Levy et al., No-Poaching Clauses, Job Concentration and Wages: A Natural Experiment Generated by a State Attorney General, Advanced Analytical Consulting Group, Inc., at 1 (Jan. 23, 2020).  That inconclusive literature falls far short of justifying a rule that would effectively extend per se treatment to all no-hire agreements.

If anything, the economic incentives weigh strongly in favor of deciding ancillarity at the earliest possible stage allowed by the record.  This is because a rule prohibiting courts from deciding ancillarity at the pleadings stage would be a free pass to discovery (and the “potentially enormous expense” associated with it), which would “push cost-conscious defendants to settle even anemic [Section 1] cases.”  Twombly, 550 U.S. at 559.  That pressure, in turn, would distort normal business incentives—faced with the prospect of huge discovery costs from meritless claims, rational businesses would understandably refrain from entering into legitimate, procompetitive collaborations.  Plaintiffs and their amici offer no good reason for adopting a rule that would undercut the very efficiency-enhancing purposes antitrust law is meant to advance.  See Morrison v. Murray Biscuit Co., 797 F.2d 1430, 1437 (7th Cir. 1986) (“The purpose of antitrust law, at least as articulated in the modern cases, is to protect the competitive process as a means of promoting economic efficiency.”); see also MLB, 542 F.3d at 339 (Sotomayor, J., concurring in the judgment) (restraints do not receive per se treatment when they have a “reasonable procompetitive justification, related to the efficiency-enhancing purposes of [a] joint venture”).

The United States asserts that ancillarity is only a “defense” to per se illegality, rather than a threshold inquiry to determine whether a case calls for departing from the rule of reason.  U.S. Br. 12-13.  None of the United States’ cases, however, limit the ancillarity restraints doctrine in this way.  The lone Second Circuit case the United States cites was a criminal matter where the standard applied to motions to dismiss is far more lenient and deferential to the United States than that mandated for civil cases in Twombly.  In such cases, courts treat the government’s characterization of conduct as within the four corners of a recognized per se theory as sufficient for indictment purposes.  See United States v. Aiyer, 33 F.4th 97, 116 (2d Cir. 2022) (indictments need only “contain[] the elements of the offense charged” and enable defendant to enter plea).  Moreover, in that case, the defendant had not even challenged on appeal the district court’s conclusion that the indictment at issue adequately alleged a per se antitrust violation.  See id. at 116-23.  The panel never characterized ancillarity as a “defense.”  See id.

The same goes for Blackburn and Board of Regents.  Although the courts in those cases ultimately concluded the restraints at issue were not ancillary, neither case held that ancillarity was only a defense.  Blackburn v. Sweeney, 53 F.3d 825, 828-29 (7th Cir. 1995); Bd. of Regents of Univ. of Okla. v. NCAA, 707 F.2d 1147, 1153-56 (10th Cir. 1983).  Freeman is similarly off base.  While the court there offhandedly referred to the defendant’s overall argument against the antitrust claim as a “defense,” it did so after the ancillarity discussion.  Freeman v. San Diego Ass’n of Realtors, 322 F.3d 1133, 1151-52 (9th Cir. 2003).  The court did not use the term with specific reference to ancillarity, and in any event its use of “defense” was not meant in the same way that Plaintiffs and their amici use it—that is, as an issue that cannot be resolved at the outset of the case.  AOB 39; U.S. Br. 12-13, 15.  In short, none of the government’s cases hold that ancillarity is strictly a defense or is otherwise immune from resolution on the pleadings.

The Seventh Circuit’s recent decision in Deslandes doesn’t advance the government’s cause either.  Although the court in Deslandes summarily stated that “the classification of a restraint as ancillary is a defense,” 81 F.4th at 705, plaintiffs can plead themselves out of court, Hadid v. City of New York, 730 F. App’x 68, 71 (2d Cir. 2018), which is what Plaintiffs have done here.  Nor should it be followed: the Seventh Circuit cited no case law and offered no analysis to support its bald assertion.  Deslandes, 81 F.4th at 705.  And, as explained, any suggestion that ancillarity can be treated only as a defense would undo the clear demarcation between the rule of reason and per se treatment.  If courts can’t evaluate ancillarity at the outset, restraints that should be presumptively analyzed under the rule of reason would instead be presumptively treated as per se illegal.  That result is plainly inconsistent with the Supreme Court’s antitrust precedents.

In a related argument, Plaintiffs contend that ancillarity cannot be decided on the pleadings, but instead “requires discovery.”  AOB 39.  But that also is wrong.  “In considering a motion to dismiss, the court is not required to don blinders and to ignore commercial reality.”  Car Carriers, Inc. v. Ford Motor Co., 745 F.2d 1101, 1110 (7th Cir. 1984), abrogated on other grounds by Schmees v. HC1.COM, Inc., 77 F.4th 483 (7th Cir. 2023).  Consistent with this principle, courts routinely resolve ancillarity on the pleadings where it is clear from the complaint that the restraint may be procompetitive.  For example, in Helmerich & Payne International Drilling Co. v. Schlumberger Technology Corp., the court dismissed a restraint of trade claim at the pleading stage where “the pleadings in [the] case [made] clear” that the challenged non-solicitation provision was “ancillary” to “a larger business transaction between two independent parties.”  2017 WL 6597512, at *4 (N.D. Okla. Dec. 26, 2017).  Similarly, the court in Gerlinger v. Amazon.Com, Inc. determined that a purported price-fixing arrangement between Borders and Amazon was “ancillary” to the companies’ broader website hosting agreement, in part because the “context in which the agreement was entered into” confirmed its procompetitive potential.  311 F. Supp. 2d 838, 848-49 (N.D. Cal. 2004).  The court reached this conclusion on a motion for judgment on the pleadings.  Id.  Other courts have similarly decided ancillarity on the pleadings alone.  See Kelsey K. v. NFL Enters. LLC, 2017 WL 3115169, at *4 (N.D. Cal. July 21, 2017) (motion to amend), aff’d, 757 F. App’x 524, 526 (9th Cir. 2018); Hanger v. Berkley Grp., Inc., 2015 WL 3439255, at *5 (W.D. Va. May 28, 2015) (motion to dismiss); Caudill v. Lancaster Bingo Co., 2005 WL 2738930, at *3-6 (S.D. Ohio Oct. 4, 2005) (motion for judgment on the pleadings).  Contrary to Plaintiffs’ argument, the district court’s pleading-stage ancillarity ruling was entirely proper.

                   B.            The District Court Did Not Reach Past Plaintiffs’ Allegations

Ancillarity can support dismissal when it is “apparent from the allegations in the complaint,” as even the United States acknowledges.  U.S. Br. 15.  Here, the district court’s ancillarity ruling was amply supported by Plaintiffs’ own allegations.  Plaintiffs allege that Saks and the Brand Defendants collaborate in the sale of luxury goods by partnering to sell the Brand Defendants’ goods both directly at Saks stores and through concessions within them.  Compl. ¶¶ 21, 28; see supra, at 4-10.  By cooperating in this way, Saks and the Brand Defendants can leverage each other’s employees and brands to create a distinct “shopping experience for customers”—that is, the “atmosphere of exclusivity and opulence surrounding . . . luxury products,” Compl. ¶ 33, needed to promote “demand for[] luxury goods over other, lower-priced goods,” id. ¶ 23.  The upshot is a procompetitive collaboration that, in the words of Polk Bros., “promises greater productivity and output.”  776 F.2d at 189.

The district court also properly relied on the Complaint to conclude that “absent the no-hire agreement, there would be a continual risk that the Brand Defendants would use their concessions in Saks stores to recruit [Saks] employees.”  Op. 32 (citing Compl. ¶¶ 56-57, 83).  Minimizing the risk of such “free rid[ing]” is a common, efficiency-enhancing feature of ancillary restraints.  Rothery Storage, 792 F.2d at 229 (restraints were ancillary where they “preserve[d] the efficiencies of the [collaboration] by eliminating the problem of the free ride”); Polk Bros., 776 F.2d at 190 (agreement was ancillary to a joint sales venture where it limited the potential that one retailer would free ride on the sales efforts of another).  That includes procompetitive restraints on employee movement.  Aya, 9 F.4th at 1110 (restraint was ancillary to business collaboration where it guarded against risk of one party “proactively raiding . . . employees” of another party).

Notably, the risk of free riding wasn’t hypothetical: as the district court pointed out, the Complaint specifically alleges that Plaintiff Giordano sought to leverage the experience she acquired while working at the Loro Piana boutique as a Saks employee to seek employment with Loro Piana.  Op. 34 n.22.  The district court also highlighted Plaintiffs’ allegations that without the no-hire agreements, Brand Defendants such as Louis Vuitton could “take advantage” of Saks’s hiring efforts by recruiting Saks employees away from Saks after that company had already invested time and money to recruit and train its personnel.  Op. 32; Compl. ¶¶ 62-63; see Compl. ¶ 53 (alleging that “a Defendant would save on training costs and receive the immediate benefit of a well-trained, motivated salesperson” by hiring “from one of its rivals”).  This poaching, according to Plaintiffs, would “inflict[] a cost on [Saks] by removing an employee on whom [Saks] may depend.”  Compl. ¶ 62.  Thus, Plaintiffs’ own allegations demonstrate the alleged no-hire agreement is ancillary.  By addressing the free-rider problem, the agreement eliminates an externality “that may otherwise distort the incentives of [the Brand Defendants] and limit the potential efficiency gains of [the collaboration].”  MLB, 542 F.3d at 340 (Sotomayor, J., concurring in the judgment).  Nothing more was required to resolve ancillarity on the pleadings.

Plaintiffs and their amici argue the district court erred by drawing factual inferences in favor of Saks, rather than Plaintiffs.  AOB 37-40; N.Y. Br. 26-27.  According to Plaintiffs, ancillarity was a “contested factual issue” that could be resolved in Saks’s favor only by improperly rejecting Plaintiffs’ allegations.  AOB 37-38.  Plaintiffs’ argument is misplaced.

“Determining whether a complaint states a plausible claim for relief [is] a context-specific task that requires the reviewing court to draw on its judicial experience and common sense.”  Jessani v. Monini N. Am., Inc., 744 F. App’x 18, 19 (2d Cir. 2018) (quoting Ashcroft v. Iqbal, 556 U.S. 662, 679 (2009)).  As part of that exercise, courts consider “a host of considerations: the full factual picture presented by the complaint, the particular cause of action and its elements, and the existence of alternative explanations so obvious that they render plaintiff’s inferences unreasonable.”  Fink v. Time Warner Cable, 714 F.3d 739, 741 (2d Cir. 2013); see Boca Raton Firefighters & Police Pension Fund v. Bahash, 506 F. App’x 32, 35 (2d Cir. 2012).

That is precisely what the district court did here.  It considered the “full factual picture presented by the complaint”—including the nature of the Defendants’ business relationship and the role of the no-hire agreement in the context of that relationship—to conclude that the alleged no-hire agreement was ancillary to a procompetitive collaboration.  Fink, 714 F.3d at 741 (emphasis added); Op. 28-34.  And in doing so, the court properly demonstrated that Plaintiffs’ own allegations precluded per se treatment.  See Weisbuch v. Cnty. of Los Angeles, 119 F.3d 778, 783 n.1 (9th Cir. 1997) (“Whether [a] case can be dismissed on the pleadings depends on what the pleadings say.”).  Plaintiffs can’t avoid the consequences of their allegations by truncating the court’s properly holistic review of the pleadings—indeed, “[i]f the pleadings establish facts compelling a decision one way, that is as good as if depositions and other expensively obtained evidence on summary judgment establishes the identical facts.”  Id.

The district court’s ancillarity ruling was sound.

CONCLUSION

For the foregoing reasons, this Court should affirm.

[1] All parties have consented to the filing of this brief.  Pursuant to Federal Rule of Appellate Procedure 29(a)(4)(E), counsel for ICLE represents that no counsel for any of the parties authored any portion of this brief and that no entity, other than amici curiae or their counsel, monetarily contributed to the preparation or submission of this brief.

[2] The alleged no-hire agreements also do not fit the per se mold because they are part of a dual-distribution relation in which the Brand Defendants sell their products to end consumers through “their own standalone boutiques” as well as through distributors, “including Saks.”  Compl. ¶ 21; see Beyer Farms, Inc. v. Elmhurst Dairy, Inc., 35 F. App’x 29, 29-30 (2d Cir. 2002) (holding that a restraint was “subject to scrutiny under the ‘rule of reason’” because the complaint alleged a “dual-distributorship relationship”); Elecs. Commc’ns Corp. v. Toshiba Am. Consumer Prods., Inc., 129 F.3d 240, 243 (2d Cir. 1997) (similar).

Introduction

We thank you for the opportunity to comment on this important notice of inquiry (NOI)[1] on artificial intelligence (AI) and copyright. We appreciate the U.S. Copyright Office undertaking a comprehensive review of the policy and copyright-law issues raised by recent advances in generative AI systems. This NOI covers key areas that require attention, from legal questions regarding infringement and fair use, to questions about how policy choices could shape opportunities for creators and AI producers to engage in licensing.

At this early date, AI systems have already generated some incredible visual art and impressive written texts, as well as a good deal of controversy. Some artists have banded together as part of an anti-AI campaign;^[2] lawsuits have been filed;^[3] and policy experts have attempted to think through the various legal questions raised by these machine-learning systems.

The debates over the role of AI in creative industries have particular salience for intellectual-property rights. Copyright is notoriously difficult to protect online, and the emergence of AI may exacerbate that difficulty. AI systems also potentially pose an additional wrinkle: it is at least arguable that the outputs they produce can themselves be considered unique creations. There are, of course, other open questions whose answers are relevant here, not the least being whether it is fair to assert that only a human can be “creative” (at least, so far).[4]

But leaving these questions aside, we can say that at least some AI systems produce unique outputs and are not merely routinely duplicating other pieces of work in a digital equivalent of collage. That is, at some level, the machines are engaged in a rudimentary sort of “learning” about how humans arrange creative inputs when generating images, music, or written works. The machines appear to be able to reconstruct this process and produce new sets of words, sounds, or lines and colors that conform to the patterns found in human art, in at least a simulacrum of “creativity.”

But that conclusion isn’t the end of the story. Even if some of these AI outputs are unique and noninfringing, the way that AI systems learn—by ingesting massive quantities of existing creative work—raises a number of thorny copyright-law issues. Indeed, some argue that these systems inherently infringe copyright during the learning phase and that, as discussed below, such processes may not survive a “fair use” analysis.

But nor is that assertion the end of the analysis. Rather, it raises the question of whether applying existing doctrine in this novel technological context yields the best results for society. Moreover, it heightens the need for a comprehensive analytical framework to help parse these questions.

A.            The Law & Economics of Copyright and AI

Nearly all would agree that it is crucial that law and public policy strike the appropriate balance between protecting creators’ existing rights and enabling society to enjoy the potentially significant benefits that could arise from the development of AI systems. Indeed, the subject is often cast as a dramatic conflict between creative professionals struggling to make ends meet and innovative firms working to provide cutting-edge AI technology. For the moment, however, it is likely more important to determine the right questions to ask and the proper analytical framework to employ than it is to identify any precise balancing point.

What is important to remember is that copyright policy is foremost economic in nature and “can be explained as a means for promoting efficient allocation of resources.”[5] That is to say, the reason that property rights in creative expression exist is to guarantee the continued production of such works.[6] The fundamental tradeoff in copyright policy is between the costs of limiting access to creative works, and the value obtained by encouraging production of such works.[7] The same applies in the context of AI: identifying the key tradeoffs and weighing the costs and benefits of restricting access to protected works by the producers (and users) of AI systems.[8]

This entails examining the costs and benefits of relatively stronger or weaker forms copyright protection in terms of their effects on both incentives and access, and as they relate to both copyright holders and AI-system developers. It also requires considering where the transaction costs should be allocated for negotiating access to both copyright and, as discussed infra,[9] the use of name/image/likeness, as well as how those allocations are likely to shape outcomes.

At root, these questions center on how to think about the property rights that limit access to protected works and, possibly even more importantly, how to assign new property rights governing the ability to control the use of a name/image/likeness. As we know from the work of the late Nobel laureate Ronald Coase, the actual demarcation of rights affects parties’ abilities to negotiate superior solutions.^[10] The development of nuisance law provides a good example of the problem at hand. When a legal regime provides either strict liability or no-liability rules around pollution, parties have little incentive to minimize harmful conduct:

The factory that has the absolute right to pollute will, if transaction costs are prohibitive, have no incentives to stop (or reduce) pollution even if the cost of stopping would be much less than the cost of pollution to the homeowners. Conversely, homeowners who have an absolute right to be free from pollution will, if transaction costs are prohibitive, have no incentive to take steps of their own to reduce the effects of pollution even if the cost to them of doing so (perhaps by moving away) is less than the cost to the factory of not polluting or of polluting less.^[11]

As Coase observed, this class of problem is best regarded as reciprocal in nature, and the allocation of rights matters in obtaining an efficient outcome. This is necessarily so because, when fully considered, B’s ability to restrain A from the pollution-generating activity can itself be conceived of as another kind of harm that B can impose on A. Therefore, the problem requires a balancing of the relative harms generated by both A and B in exercising conflicting claims in a particular context.

When thinking about how to minimize harms—whether from pollution or other activity that generates social costs (which is to say, nearly every activity)—the aim is to decide whether “the gain from preventing the harm is greater than the loss which would be suffered elsewhere as a result of stopping the action which produces the harm.”^[12] Theoretically, in a world without transaction costs, even assignments of no-liability or strict-liability rules could be bargained around. But we do not live in such a world.^[13] Thus, “[i]n a world in which there are costs of rearranging the rights established by the legal system [common law and statutory assignments of liability] are, in effect, making a decision on the economic problem and determining how resources are to be employed.”^[14]

While pollution rules, unlicensed uses of intellectual property, and a host of other activities subject to legal sanction are not typically framed as resource-allocation decisions, it is undeniable that they do have this character. This is true even where legislation attempts to correct deficiencies in the system. We experience a form of blindness when we focus on correcting what may be rightly perceived as problems in a liability regime. Such analysis tends to concentrate attention on particular deficiencies of the system and to nourish the belief that any measure that removes the deficiency is necessarily desirable. It diverts attention from other changes inevitably associated with the corrective measure—changes that may well produce more harm than the original deficiency.^[15]

All of this is to say that one solution to the costs generated by the need for AI systems to process a massive corpus of expensive, copyright-protected material is neither to undermine property rights, nor to make AI impossible, but to think about how new property rights could make the system work. It may be that some entirely different form or allocation of property right would facilitate bargaining between rightsholders and AI creators, optimizing resource allocation in a way the existing doctrinal regime may not be able to.

A number of other questions flow from this insight into the allocative nature of copyright. How would the incentives for human creators change under different copyright rules for AI systems, or in the face of additional rights? And how would access to copyrighted works for AI training change with different rules, and what effects would that access have on AI innovation?

Above all, our goal today should be to properly frame the AI and copyright debate by identifying tradeoffs, quantifying effects (where possible), and asking what rules best serve the overall objectives of the copyright system and the social goal of encouraging AI innovation. The best chance of striking the right balance will come from a rigorous framing of the questions and from the use of economic analysis to try to answer them.

B.            Copyright Law and AI: Moving Forward

As the Copyright Office undertakes this inquiry, it is important to recognize that, regardless of how the immediate legal questions around AI and copyright are resolved, the growing capabilities and adoption of generative AI systems will likely necessitate some changes in the long term.

The complex questions surrounding the intersection of AI and copyright law admit reasonable arguments on both sides. But AI is here to stay, regardless, and if copyright law is applied in an unduly restrictive manner that substantially hinders socially beneficial AI innovation, it could provoke a broader public-policy backlash that does more to harm copyright’s ability to protect creative works than it does to stanch AI’s ability to undermine it. Copyright law risks being perceived as an obstruction to technological progress if it is used preemptively to kill AI in the cradle. Such an outcome could galvanize calls for recalibrating copyright’s scope and protections in the name of the public interest.

This illustrates the precarious balancing act that copyright law faces in the wake of rapidly evolving technologies like AI. Aggressive copyright restrictions that curtail AI development could instigate a public-policy counter-reaction before Congress and the courts that ultimately undermines copyright’s objectives. The judicious course is to adapt copyright law cautiously to enable AI’s responsible evolution, while resolutely preserving the incentives for human creativity.

In the remainder of this analysis, we offer our perspective on the likely outcomes of the AI-copyright issues raised in this NOI, given the current state of the law. These assessments reflect our perspective formed through the rigorous application of established copyright principles and precedent to the novel technological context of generative AI systems. Reasonable arguments rooted in existing doctrine could be made to support different conclusions. We submit these comments not as definitive predictions or normative preferences, but rather as informed appraisals of how courts may analyze AI under present copyright law, absent legislative intervention.

We appreciate the Copyright Office starting this process to modernize copyright law for the AI age. This inquiry is an important first step, but openness to further evolution will be key to promoting progress in both AI and the arts. We believe an open, evidence-based discussion of these issues will lead to balanced solutions that uphold copyright’s constitutionally mandated purpose, while allowing responsible AI innovation for the public benefit.

II.            The Training of AI Systems and the Applicability of Fair Use

In the NOI, the Copyright Offices asks: “[u]nder what circumstances would the unauthorized use of copyrighted works to train AI models constitute fair use?”^[16]

To answer this question, it would be useful to first briefly walk through a high-level example of how AI systems work, in order to address the most relevant points of contact between AI systems and copyright law.

A.            A Brief Technical Description of AI Training

AI-generated content is not a single “thing,” but a collection of differing processes, each with different implications for the law. For the purposes of this discussion, we will discuss image generation using “generated adversarial networks” (GANs) and diffusion models. Although different systems and different types of content generation will vary, the basic concepts discussed below are nonetheless useful at a general level.^[17]

A GAN is a type of machine-learning model that consists of two parts: a generator and a discriminator.^[18] The generator is trained to create new images that look like they come from a particular dataset, while the discriminator is trained to distinguish the generated images from real images in its original dataset.^[19] The two parts are trained together in an adversarial manner, with the generator trying to produce images that can fool the discriminator and the discriminator trying to correctly identify the generated images.^[20]

A diffusion model, by contrast, analyzes the distribution of information in an image, as noise is progressively added to it.^[21] This kind of algorithm analyzes characteristics of sample images, like the distribution of colors or lines, in order to understand what counts as an accurate representation of a subject (i.e., what makes a picture of a cat look like a cat, and not like a dog).^[22]

For example, in the generation phase, diffusion-based systems start with randomly generated noise, and work backward in “denoising” steps to essentially “see” shapes:

The sampled noise is predicted so that if we subtract it from the image, we get an image that’s closer to the images the model was trained on (not the exact images themselves, but the distribution – the world of pixel arrangements where the sky is usually blue and above the ground, people have two eyes, cats look a certain way – pointy ears and clearly unimpressed).^[23]

While it is possible that some implementations might be designed in a way that saves copies of the training images,^[24] for at least some systems, once the network is trained using these techniques, it will not need to rely on saved copies of input work in order to produce outputs. The models that are produced during training are, in essence, instructions to a different piece of software about how to start with a prompt from a user, a palette of pure noise, and progressively “discover” signal in that image until some new image emerges.

B.            Fair Use

The creator of some of the most popular AI tools, OpenAI, is not shy about their use of protected works in the training phase of the algorithms. In comments to the U.S. Patent and Trademark Office (PTO), OpenAI noted that:

Modern AI systems require large amounts of data. For certain tasks, that data is derived from existing publicly accessible “corpora”… of data that include copyrighted works. By analyzing large corpora (which necessarily involves first making copies of the data to be analyzed), AI systems can learn patterns inherent in human-generated data and then use those patterns to synthesize similar data which yield increasingly compelling novel media in modalities as diverse as text, image, and audio. (emphasis added).^[25]

Thus, at the training stage, the most popular forms of AI systems require making copies of existing works. And where that material is either not in the public domain or is not licensed, an infringement can occur. Thus, the copy must not be infringing (say, because it is transient), or some affirmative defense is needed to excuse the infringement. Toward this end, OpenAI believes that this use should qualify as fair use,^[26] as do most or all the other major producers of generative AI systems.^[27]

But as OpenAI has framed the fair-use analysis, it is not clear that these uses should qualify. There are two major questions in this respect: will the data used to train these systems count as “copies” under the Copyright Act, and, if so, is the use of these “copies” sufficiently “transformative” to qualify for the fair-use defense?

1.              Are AI systems being trained with ‘copies’ of protected works?

Section 106 of the Copyright Act grants the owner of a copyright the exclusive right “to reproduce… copyrighted work in copies” and to authorize others to do so.^[28] If an AI system makes a copy of a file to a computer during training, this would likely constitute a prima facie violation of the copyright owner’s exclusive right of reproduction under Section 106. This is fairly straightforward.

But what if the “copy” is “transient” and/or only partial pieces of content are used in the training? For example, what if a training program merely streamed small bits of a protected work into temporary memory as part of its training, and retained no permanent copy?

As the Copyright Office has previously observed, even temporary reproductions of a work in a computer’s memory can constitute “copies” under the Copyright Act.^[29] Critically, this includes even temporary reproductions made as part of a packet-switching network transmission, where a particular file is broken into individual packets, because the packets can be reassembled into substantial portions or even entire works.^[30] On the topic of network-based transmission, the Copyright Office further observed that:

Digital networks permit a single disk copy of a work to meet the demands of many users by creating multiple RAM copies. These copies need exist only long enough to be perceived (e.g., displayed on the screen or played through speakers), reproduced or otherwise communicated (e.g., to a computer’s processing unit) in order for their economic value to be realized. If the network is sufficiently reliable, users have no need to retain copies of the material. Commercial exploitation in a network environment can be said to be based on selling a right to perceive temporary reproductions of works.^[31]

This is a critical insight that translates well to the context of AI training. The “transience” of the copy matters with respect to the receiver’s ability to perceive the work in a way that yields commercial value. Under this reasoning, the relevant locus of analysis is on the AI system’s ability to “perceive” a work for the purposes of being trained to “understand” the work. In this sense, you could theoretically find the existence of even more temporary copies than that necessary for human perception to implicate the reproduction right.

Even where courts have been skeptical of extending the definition of “copy” to “fleeting” copies in computer memory, this underlying logic is revealed. In Cartoon Network LP, LLLP v. CSC Holdings, Inc., 536 F.3d 121 (2008), the 2nd U.S. Circuit Court of Appeals had to determine whether buffered media sent to a DVR device was too “transient” to count as a “copy”:

No bit of data remains in any buffer for more than a fleeting 1.2 seconds. And unlike the data in cases like MAI Systems, which remained embodied in the computer’s RAM memory until the user turned the computer off, each bit of data here is rapidly and automatically overwritten as soon as it is processed. While our inquiry is necessarily fact-specific, and other factors not present here may alter the duration analysis significantly, these facts strongly suggest that the works in this case are embodied in the buffer for only a “transitory” period, thus failing the duration requirement.^[32]

In Cartoon Network, the court acknowledged both that the duration analysis was fact-bound, and also that the “fleeting” nature of the reproduction was important. “Fleeting” is a relative term, based on the receiver’s capacities. A ball flying through the air may look “fleeting” to a human observer, but may appear to go much more cognizable to a creature with faster reaction time, such as a house fly. So, too, with copies of a work in a computer’s memory and the ability to “perceive” what is fixed in a buffer: what may be much too quick for a human to perceive may very well be within an AI system’s perceptual capabilities.

Therefore, however the training copies are held, there is a strong possibility that a court will find them to be “copies” for the purposes of the reproduction right—even with respect to partial copies that exist for very small amounts of time.

2.              The purpose and character of using protected works to train AI systems

Fair use provides for an affirmative defense against infringement when the use is, among other things, “for purposes such as criticism, comment, news reporting, teaching…, scholarship, or research.”^[33] When deciding whether a fair-use defense is applicable, a court must balance a number of factors:

1. the purpose and character of the use, including whether such use is of a commercial nature or is for nonprofit educational purposes;
2. the nature of the copyrighted work;
3. the amount and substantiality of the portion used in relation to the copyrighted work as a whole; and
4. the effect of the use upon the potential market for or value of the copyrighted work.^[34]

The fair-use defense that AI creators have advanced is rooted in the first factor: the nature and character of the use. Although a full analysis of all the factors is ultimately necessary, analysis of the first factor is sufficiently complicated to warrant full attention here. In particular, the complex issue at hand is whether uses of protected works to train AI systems are sufficiently “transformative” or not.^[35]

Whether the use of a copyrighted work to train an AI is “transformative” is certainly a novel question, but it is one that will likely be answered in light of an observation the U.S. Supreme Court made in Campbell v. Acuff Rose Music:

[W]hen a commercial use amounts to mere duplication of the entirety of an original, it clearly “supersede[s] the objects,”… of the original and serves as a market replacement for it, making it likely that cognizable market harm to the original will occur… But when, on the contrary, the second use is transformative, market substitution is at least less certain, and market harm may not be so readily inferred.^[36]

Moreover, “[t]he word ‘transformative’ cannot be taken too literally as a sufficient key to understanding the elements of fair use. It is rather a suggestive symbol for a complex thought, and does not mean that any and all changes made to an author’s original text will necessarily support a finding of fair use.”[37] A key question, then, is whether training AI systems on copyrighted works amounts to a mere “duplication of the entirety of an original” or is sufficiently “transformative” to support a fair-use defense. As noted above, OpenAI believes that its use is transformative. According to its comments:

Training of AI systems is clearly highly transformative. Works in training corpora were meant primarily for human consumption for their standalone entertainment value. The “object of the original creation,” in other words, is direct human consumption of the author’s ?expression.? Intermediate copying of works in training AI systems is, by contrast, “non-expressive” the copying helps computer programs learn the patterns inherent in human-generated media. The aim of this process—creation of a useful generative AI system—is quite different than the original object of human consumption. The output is different too: nobody looking to read a specific webpage contained in the corpus used to train an AI system can do so by studying the AI system or its outputs. The new purpose and expression are thus both highly transformative.^[38]

This framing, however, works against OpenAI’s interests. As noted above, and reinforced in the immediately preceding quote, generative AI systems are made of at least two distinct pieces. The first is a piece of software that ingests existing works and creates a file that can serve as instructions to the second piece of software. The second piece of software takes the output of the first and can produce independent results. Thus, there is a clear discontinuity in the process whereby the ultimate work created by the system is disconnected from the creative inputs used to train the software.

Therefore, the protected works are arguably ingested into the first part of the system “for their standalone entertainment value.” That is to say, the goal of copying and showing a protected work to an AI system is for the analog of “direct human consumption of the author’s expression” in order for the system to learn about that expression.

The software is learning what counts as “standalone entertainment value” and therefore the works must be used in those terms. Surely, a computer is not sitting on a couch and surfing for its pleasure. But it is solely for the very “standalone entertainment value” that the first piece of software is being shown copyrighted material. By contrast, parody or “remixing” uses incorporate a work into some secondary expression that directly transforms the input. The way these systems work is to learn what makes a piece entertaining and then to discard that piece altogether. Moreover, this use for the art qua art most certainly interferes with the existing market, insofar as this use is in lieu of reaching a licensing agreement with rightsholders.

A good analogy is art students and art textbooks. Art students view protected works in an art textbook in order to learn how to reproduce the styles contained therein. The students would not be forgiven for pirating the textbooks merely because they intend to go on to make new paintings. They would still be liable for copyright infringement if they used unlicensed protected works as part of their education.

The 2nd U.S. Circuit Court of Appeals dealt with a case that operates similarly to this dynamic. In American Geophysical Union v. Texaco, 60 F.3d 913 (2d Cir. 1994), the 2nd Circuit considered whether Texaco’s photocopying of scientific articles produced by the plaintiffs qualified for a fair-use defense. Texaco employed between 400 and 500 research scientists and, as part of supporting their work, maintained subscriptions to a number of scientific journals.^[39]

It was common practice for Texaco’s scientists to photocopy entire articles and save them in a file.^[40] The plaintiffs sued for copyright infringement.^[41] Texaco asserted that photocopying by its scientists for the purposes of furthering scientific research—that is to train the scientists on the content of the journal articles—should count as a fair use. The argument was, at least in part, that this was sufficiently “transformative,” because the scientists were using that knowledge to invent new products.^[42] The 2nd Circuit disagreed:

The “transformative use” concept is pertinent to a court’s investigation under the first factor because it assesses the value generated by the secondary use and the means by which such value is generated. To the extent that the secondary use involves merely an untransformed duplication, the value generated by the secondary use is little or nothing more than the value that inheres in the original. Rather than making some contribution of new intellectual value and thereby fostering the advancement of the arts and sciences, an untransformed copy is likely to be used simply for the same intrinsic purpose as the original, thereby providing limited justification for a finding of fair use….^[43]

The 2nd Circuit thus observed that copies of the scientific articles were made solely to consume the material itself. AI developers often make an argument analogous to that made by Texaco: that training AI systems surely advances scientific research, and therefore fosters the “advancement of the arts and sciences.” But in American Geophysical Union, the initial copying of copyrighted content, even where it was ultimately used for the “advancement of the arts and sciences,” was not held to be sufficiently “transformative.”^[44] The case thus stands for the proposition that one cannot merely identify a social goal down that would be advanced at some future date in order to permit an exception to copyright protection. As the court put it:

[T]he dominant purpose of the use is a systematic institutional policy of multiplying the available number of copies of pertinent copyrighted articles by circulating the journals among employed scientists for them to make copies, thereby serving the same purpose for which additional subscriptions are normally sold, or… for which photocopying licenses may be obtained.[45]

The use itself must be transformative and different, and copying is not transformative merely because it may be used as an input into a later transformative use. By the same token, therefore, it seems likely that where an AI system ingests (copies) copyrighted works, that use is similarly not transformative, despite its ultimate use as an input in the creation of other original works.

Comparing the American Geophysical Union analysis with the search-engine “snippets” and “thumbnails” cases provides a useful comparison relevant to the AI analysis. In Kelly v. Arriba Soft Corp., 336 F.3d 811 (9^th Cir. 2002), the 9^th U.S. Circuit Court of Appeals ruled that a search engine’s creation of thumbnail images from original copies was a transformative fair use.[46] Arriba’s search-engine crawler made full-sized copies of Kelly’s images and stored them temporarily on Arriba’s server to generate thumbnail versions. After the thumbnails were created, the full-sized originals were deleted. The thumbnails were used to facilitate Arriba’s image-based search engine. In reaching its fair-use conclusion, the 9^th Circuit opined that:

Arriba’s use of Kelly’s images promotes the goals of the Copyright Act and the fair use exception. The thumbnails do not stifle artistic creativity because they are not used for illustrative or artistic purposes and therefore do not supplant the need for the originals.[47]

Further, although “Arriba made exact replications of Kelly’s images, the thumbnails were much smaller, lower-resolution images that served an entirely different function than Kelly’s original images.”[48]

The court found it important that the search engine did not use the protected works for their intended “aesthetic experience,” but rather for the purpose of constructing a search index.[49] Indeed, the entire point of a search engine is not to “supersede” the original, but in many or most cases to provider users an efficient means to find that original online.[50]

The court discussed, but only briefly, the benefit to the public of Arriba’s transformative use,[51] noting that “[Arriba’s thumbnails] benefit the public by enhancing information-gathering techniques on the internet.”[52] Five years later, in Perfect 10 Inc. v. Amazon.com Inc., 487 F.3d 701 (2007), the 9^th Circuit expanded on this question somewhat.[53] There, in holding that the novelty of the use was of crucial importance to the analysis,[54] the court also stressed that the value of that use was a function of its newness:

[A] search engine provides social benefit by incorporating an original work into a new work, namely, an electronic reference tool. Indeed, a search engine may be more transformative than a parody [the use at issue in Campbell] because a search engine provides an entirely new use for the original work, while a parody typically has the same entertainment purpose as the original work.[55]

Indeed, even in light of the commercial nature of Google’s use of copyrighted content in its search engine, its significant public benefit carried the day: “We conclude that the significantly transformative nature of Google’s search engine, particularly in light of its public benefit, outweighs Google’s superseding and commercial uses of the thumbnails in this case.”[56] And, of particular relevance to these questions in the context of AI, the court in Perfect 10 went on to “note the importance of analyzing fair use flexibly in light of new circumstances.”[57]

Ultimately, the Perfect 10 decision tracked Kelly fairly closely on the rest of the “transformativeness” analysis in finding fair use, because “[a]lthough an image may have been created originally to serve an entertainment, aesthetic, or informative function, a search engine transforms the image into a pointer directing a user to a source of information.”[58]

The core throughline in this line of cases is the question of whether a piece of content is being used for its expressive content, weighed against the backdrop of whether the use is for some new (and, thus, presumptively valuable) purpose. In Perfect 10 and Kelly, the transformative use was the creation of a search index.

“Snippets” fair-use cases track a similar line of reasoning. For example, in Authors Guild v. Google Inc., 804 F.3d 202 (2d Cir. 2015), the 2nd Circuit ruled that Google’s use of “snippets” of copyrighted books in its Library Project and Google Books website was a “transformative” fair use.[59] Holding that the “snippet view” of books digitized as part of the Google Books project did not constitute an effectively competing substitute to the original works, the circuit court noted that copying for the purpose of “criticism” or—as in that case—copying for the purpose of “provision of information about” the protected work, “tends most clearly to satisfy Campbell’s notion of the ‘transformative’ purpose.”[60]

Importantly, the court emphasized the importance of the public-benefit aspect of transformative uses: “[T]ransformative uses tend to favor a fair use finding because a transformative use is one that communicates something new and different from the original or expands its utility, thus serving copyright’s overall objective of contributing to public knowledge.”[61]

Underscoring the idea that the “transformativeness” analysis weighs whether a use is merely for expressive content against the novelty/utility of the intended use, the court observed:

Google’s division of the page into tiny snippets is designed to show the searcher just enough context surrounding the searched term to help her evaluate whether the book falls within the scope of her interest (without revealing so much as to threaten the author’s copyright interests). Snippet view thus adds importantly to the highly transformative purpose of identifying books of interest to the searcher.[62]

Thus, the absence of use of the work’s expressive content, coupled with a fairly circumscribed (but highly novel) use was critical to the outcome.

The entwined questions of transformative use and the public benefit it confers are significantly more complicated in the AI context, however. Unlike the incidental copying involved in search-engine indexing or thumbnails, training generative AI systems directly leverages copyrighted works for their expressive value. In the Google Books and Kelly cases, the defendant systems extracted limited portions of works or down-sampled images solely to identify and catalog their location for search purposes. The copies enabled indexing and access, and they expanded public knowledge through a means unrelated to the works’ protected aesthetics.

But in training AI models on copyrighted data, the systems necessarily parse the intrinsic creative expression of those works. The AI engages with the protected aesthetic elements themselves, not just superficial markers (like title, length, location on the internet, etc.), in order to internalize stylistic and compositional principles. This appropriates the heart of the works’ copyright protection for expressive ends, unlike the more tenuous connections in search systems.

The AI is thus “learning” directly from the protected expression in a manner akin to a human student studying an art textbook, or like the scientists learning from the journals in American Geophysical Union. The subsequent AI generations are built from mastery of the copyrighted training materials’ creative expression. Thus, while search-engine copies only incidentally interact with protected expression to enable unrelated innovation, AI training is predicated on excavating the protected expression itself to fuel iterative creation. These meaningfully different purposes have significant fair-use implications.

This functional difference is, as noted, central to the analysis of a use’s “purpose and character.” Indeed, “even making an exact copy of a work may be transformative so long as the copy serves a different function than the original work.”[63] But the benefit to the public from the new use is important, as well, particularly with respect to the possible legislative response that a restrictive interpretation of existing doctrine may engender.

If existing fair-use principles prohibit the copying required for AI, absent costly item-by-item negotiation and licensing, the transaction costs could become prohibitive, thwarting the development of technologies that promise great public value.[64] Copyright law has faced similar dilemmas before, where the transaction costs of obtaining permission for socially beneficial uses could frustrate those uses entirely.[65] In such cases, we have developed mechanisms like compulsory licensing to facilitate the necessary copying, while still attempting to compensate rightsholders. An unduly narrow fair-use finding for AI training could spur calls for similar interventions in service of enabling AI progress.

In other words, regardless of the veracity of the above conclusion that AI’s use of copyrighted works may not, in fact, serve a different function than the original, courts and legislators may be reluctant to allow copyright doctrine to serve as an absolute bar against self-evidently valuable activity like AI development. Our aim should be to interpret or recalibrate copyright law to permit such progress while upholding critical incentives for creators.

C.            Opt-In vs. Opt-Out Use of Protected Works

The question at the heart of the prior discussion—and, indeed, at the heart of the economic analysis of copyright—is whether the transaction costs that accompany requiring express ex ante permission for the use of protected works are so high that they impedes socially beneficial conduct whose value would outweigh the social cost of allowing permissionless and/or uncompensated use.[66] The NOI alludes to this question when it asks: “Should copyright owners have to affirmatively consent (opt in) to the use of their works for training materials, or should they be provided with the means to object (opt out)?”^[67]

This is a complex problem. Given the foregoing thoughts on fair use, it seems quite possible that, at present, the law requires creators of AI systems to seek licenses for protected content, or else must resort to public-domain works for training. Given the volume of copyrighted works that AI developers currently use to train these systems, such requirements may be broadly infeasible.

On one hand, requiring affirmative opt-in consent from copyright holders imposes significant transaction costs on AI-system developers to identify and negotiate licenses for the vast amounts of training data required. This could hamper innovation in socially beneficial AI systems. On the other hand, an opt-out approach shifts more of the transaction-cost burden to copyright holders, who must monitor and object to unwanted uses of their works. This raises concerns about uncompensated use.

Ultimately, the question is where the burden should lie: with AI-system developers to obtain express consent, or with copyright holders to monitor and object to uses? Requiring some form of consent may be necessary to respect copyright interests. Yet an opt-out approach may strike the right balance, by shifting some of the burden back to AI developers while avoiding the infeasibly high transaction costs of mandatory opt-in consent. The optimal approach likely involves nuanced policymaking to balance these competing considerations. Moreover, as we discuss infra, the realistic outcome is most likely going to require rethinking the allocation of property rights in ways that provide for large-scale licensing. Ideally, this could be done through collective negotiation, but perhaps at a de minimis rate, while allowing creators to bargain for remuneration on the basis of other rights, like a right of publicity or other rights attached to the output of AI systems, rather than the inputs.[68]

1.              Creator consent

Relatedly, the Copyright Office asks: “If copyright owners’ consent is required to train generative AI models, how can or should licenses be obtained?”^[69]

Licensing markets exist, and it is entirely possible that major AI developers and large groups of rightsholders can come to mutually beneficial terms that permit a sufficiently large body of protected works to be made available as training data. Something like a licensing agency for creators who choose to make their works available could arise, similar to the services that exist to provide licensed music and footage for video creators.^[70] It is also possible for some to form collective-licensing organizations to negotiate blanket permissions covering many works.

It’s important to remember that our current thinking is constrained by our past experience. All we know today are AI models trained on vast amounts of unlicensed works. It is entirely possible that, if firms were required to seek licenses, unexpected business models would emerge to satisfy both sides of the equation.

For example, an AI firm could develop its own version of YouTube’s ContentID, which would allow creators to control when their work is used in AI training. For some well-known artists, this could be negotiated with an upfront licensing fee. On the user side, any artist who has opted in could then be selected as a “style” for the AI to emulate—triggering a royalty payment to the artist when a user generates an image or song in that style. Creators could also have the option of removing their influence from the system if they so desire.

Undoubtedly, there are other ways to structure the relationship between creators and AI systems  that would facilitate creators’ monetization of the use of their work in AI systems, including legal and commercial structures that create opportunities for both creators and AI firms to succeed.

III.          Generative AI Outputs: Protection of Outputs and Outputs that Infringe

The Copyright Office asks: “Under copyright law, are there circumstances when a human using a generative AI system should be considered the ‘author’ of material produced by the system?”^[71]

Generally speaking, we see no reason why copyright law should be altered to afford protection to purely automatic creations generated by AI systems. That said, when a human makes a nontrivial contribution to generative AI output—such as editing, reframing, or embedding the AI-generated component within a larger work—the resulting work should qualify for copyright protection.

Copyright law centers on the concept of original human authorship.^[72] The U.S. Constitution expressly limits copyright to “authors.”^[73] As of this writing, however, generative AI’s capacities do not rise to the level of true independent authorship. AI systems remain tools that require human direction and judgment.[74] As such, when a person provides the initial prompt or framing, makes choices regarding the iterative development of the AI output, and decides that the result is satisfactory for inclusion in a final work, they are fundamentally engaging in creative decision making that constitutes authorship under copyright law.

As Joshua Gans has observed of recent Copyright Review Board decisions:

Trying to draw some line between AI and humans with the current technology opens up a massive can of worms. There is literally no piece of digital work these days that does not have some AI element to it, and some of these mix and blur the lines in terms of what is creative and what is not. Here are some examples:

A music artist uses AI to denoise a track or to add an instrument or beat to a track or to just get a composition started.

A photographer uses Photoshop or takes pictures with an iPhone that already uses AI to focus the image and to sort a burst of images into one that is appropriate.

A writer uses AI to prompt for some dialogue when stuck at some point or to suggest a frame for writing a story.[75]

Attempting to separate out an “AI portion” from the final work, as the Copyright Review Board proposed, fundamentally misunderstands the integrated nature of the human-AI collaborative process. The AI system cannot function without human input, and its output remains raw material requiring human creativity to incorporate meaningfully into a finished product.

Therefore, when a generative AI system is used as part of a process guided by human creative choices, the final work should be protected by copyright, just as a work created using any other artistic tool or collaborator would be. Attenuating copyrightability due to the use of AI would undermine basic copyright principles and fail to recognize the essentially human nature of the creative process.

A.            AI Outputs and Infringement

The NOI asks: “Is the substantial similarity test adequate to address claims of infringement based on outputs from a generative AI system, or is some other standard appropriate or necessary?” (Question 23)

The outputs of AI systems may or may not violate IP laws, but there is nothing inherent in the processes described above that dictates that they must. As noted, the most common AI systems do not save copies of existing works, but merely “instructions” (more or less) on how to create new work that conforms to patterns found by examining existing work. If we assume that a system isn’t violating copyright at the input stage, it’s entirely possible that it can produce completely new pieces of art that have never before existed and do not violate copyright.

They can, however, be made to violate copyrights. For example, these systems can be instructed to generate art, not just in the style of a particular artist, but art that very closely resembles existing pieces. In this sense, it would be making a copy that theoretically infringes. The fact of an AI’s involvement would not change the analysis: just as with a human-created work, if it is substantially similar to a copyrighted work, it may be found infringing.

There is, however, a common bug in AI systems that leads to outputs that are more likely to violate copyright in this way. Known as “overfitting,” the training leg of these AI systems can be presented with samples that contain too many instances of a particular image.^[76] This leads to a dataset that contains too much information about the specific image, such that—when the AI generates a new image—it is constrained to producing something very close to the original. Similarly, there is evidence that some AI systems are “memorizing” parts of protected books.^[77] This could lead to AI systems repeating copyright-protected written works.

1.              The substantial-similarity test

The substantial-similarity test remains functionally the same when evaluating works generated using AI. To find “substantial similarity,” courts require evidence of copying, as well as an expression that is substantially similar to a protected work.^[78] “It is now an axiom of copyright law that actionable copying can be inferred from the defendant’s access to the copyrighted work and substantial similarity between the copyrighted work and the alleged infringement.”^[79] In many or most cases, it will arguably be the case that AI systems have access to quite a wide array of protected works that are posted online. Thus, there may not be a particularly high hurdle to determine that an AI system actually copied a protected work.

There is, however, one potential problem for the first prong of this analysis. Models produced during a system’s training process do not (usually) contain the original work, but are the “ideas” that the AI systems generated during training. Thus, where the provenance of works contained in a training corpus is difficult to source, it may not be so straightforward to make inferences about whether a model “saw” a particular work. This is because the “ideas” that the AI “learns” from its training corpus are unprotected under U.S. copyright law, as it is permissible to mimic unprotected elements of a copyrighted work (such as ideas).^[80]

Imagine a generative AI system trained on horror fiction. It would be possible for this system to produce a new short story that is similar to one written by Stephen King, but the latent data in the model almost certainly would not violate any copyrights that King holds in his work. The model would contain “ideas” about horror stories, including those learned from an array of authors who were themselves influences on Stephen King, and potentially some of King’s own stories. What the AI system “learns” in this case is the relationship between words and other linguistic particularities that are commonly contained in horror fiction. That is, it has “ideas” about what goes into a horror story, not (theoretically) the text of the horror story itself.

Thus, when demonstrating indirect proof of copying in the case of a Stephen King story, it may pose a difficulty that an AI system has ingested all of H.P. Lovecraft’s work—an author who had a major influence on King. The “ideas” in the model and the output it subsequently produces may, in fact, produce something similar to a Stephen King work, but it may have been constructed largely or entirely on material from Lovecraft and other public-domain horror writers. The problem becomes only more complicated when you realize that this system could also have been trained on public-domain fan fiction written in the style of Stephen King. Thus, for the purposes of the first prong of this analysis, courts may place greater burden on plaintiffs in copyright actions against model producers to demonstrate more than merely that a work was merely available online.

Assuming that plaintiffs are able to satisfy the first prong, once an AI system “expresses” those ideas, that expression could violate copyright law under the second prong of the substantial-similarity test. The second prong inquires whether the final work appropriated the protected original expression.^[81] Any similarities in unprotectable ideas, facts, or common tropes are disregarded.^[82] So, in both traditional and AI contexts, the substantial-similarity test ultimately focuses on the protected components of creative expression, not surface similarity.

The key determination is whether the original work’s protected expression itself has been impermissibly copied, no matter the process that generated the copy. AI is properly viewed as simply another potential tool that could be used in certain acts of copying. It does not require revisiting settled principles of copyright law.

B.            Direct and Secondary Liability

The NOI asks: “If AI-generated material is found to infringe a copyrighted work, who should be directly or secondarily liable—the developer of a generative AI model, the developer of the system incorporating that model, end users of the system, or other parties?”[83]

Applying traditional copyright-infringement frameworks to AI-generated works poses unique challenges in determining direct versus secondary liability. In some cases, the AI system itself may create infringing content without any direct human causation.

1.              Direct liability

If the end user prompts an AI system in a way that intentionally targets copyrighted source material, they may meet the threshold for direct infringement by causing the AI to reproduce protected expression.^[84] Though many AI prompts contain only unprotected ideas, users may sometimes input copyrightable material as the basis for the AI output. For example, a user could upload a copyrighted image and request the AI to make a new drawing based on the sample. In such cases, the user is intentionally targeting copyrighted works and directly “causing” the AI system to reproduce output that is similar. If sufficiently similar, that output could infringe on the protected input. This would be a question of first impression, but it is a plausible reading of available cases.

For example, in CoStar Grp. Inc. v. LoopNet Inc., 373 F.3d 544 (4th Cir. 2004), the 4^th U.S. Circuit Court of Appeals had to consider whether an internet service provider (ISP) could be directly liable when third parties reposted copyrighted material owned by the plaintiff. In determining that merely owning the “machine” through which copies were made or transmitted was not enough to “cause” a direct infringement, the court held that:

[T]o establish direct liability under §§ 501 and 106 of the Act, something more must be shown than mere ownership of a machine used by others to make illegal copies. There must be actual infringing conduct with a nexus sufficiently close and causal to the illegal copying that one could conclude that the machine owner himself trespassed on the exclusive domain of the copyright owner. The Netcom court described this nexus as requiring some aspect of volition or causation… Indeed, counsel for both parties agreed at oral argument that a copy machine owner who makes the machine available to the public to use for copying is not, without more, strictly liable under § 106 for illegal copying by a customer. The ISP in this case is an analogue to the owner of a traditional copying machine whose customers pay a fixed amount per copy and operate the machine themselves to make copies. When a customer duplicates an infringing work, the owner of the copy machine is not considered a direct infringer. Similarly, an ISP who owns an electronic facility that responds automatically to users’ input is not a direct infringer.^[85]

Implied in the 4^th Circuit’s analogy is that, while the owner of a copying machine might not be a direct infringer, a user employing such a machine could be a direct infringer. It’s an imperfect analogy, but a user of an AI system prompting it to create a “substantially similar” reproduction of a protected work could very well be a direct infringer under this framing. Nevertheless, the analogy is inexact, because the user feeds an original into a copying machine in order to make a more-or-less perfect copy of the original, whereas an AI system generates something new but similar. The basic mechanism of using a machine to try to reproduce a protected work, however, remains essentially the same. Whether there is an infringement would be a question of “substantial similarity.”

2.              Secondary liability

As in the case of direct liability, the nature of generative AI makes the secondary-liability determination slightly more complicated, as well. That is, paradoxically, the basis for secondary liability could theoretically arise even where there was no direct infringement.[86]

The first piece of this analysis is relatively easier. If a user is directly liable for infringing a protected work, as noted above, the developer and provider of a generative AI system may face secondary copyright liability. If the AI developer or distributor knows the system can produce infringing outputs, and provides tools or material support that allows users to infringe, it may be liable for contributory infringement.^[87] Critically, merely designing a system that is capable of infringing is not enough to find contributory liability.^[88]

An AI producer or distributor may also have vicarious liability, insofar as it has the right and ability to supervise users’ activity and a direct financial interest in that activity.^[89] AI producers have already demonstrated their ability to control users’ behavior to thwart unwanted uses of the service.^[90] Thus, if there is a direct infringement by a user, a plausible claim for vicarious liability could be made so long as there is sufficient connection between the user’s behavior and the producer’s financial interests.

The question becomes more complicated when a user did not direct the AI system to infringe. When the AI generates infringing content without user direction, it’s not immediately clear who would be liable for the infringement.^[91] Consider the case where, unprompted by either the user or the AI producer, an AI system creates an output that would infringe under the substantial-similarity test. Assuming that the model has not been directed by the producer to “memorize” the works it ingests, the model itself consists of statistical information about the relationship between different kinds of data. The infringer, in a literal sense, is the AI system itself, as it is the creator of the offending output. Technically, this may be a case of vicarious liability, even without an independent human agent causing the direct infringement.

We know that copyright protection can only be granted to humans. As the Copyright Review Board recently found in a case deciding whether AI-generated outputs can be copyrighted:

The Copyright Act protects, and the Office registers, “original works of authorship fixed in any tangible medium of expression.” 17 U.S.C. § 102(a). Courts have interpreted the statutory phrase “works of authorship” to require human creation of the work.^[92]

But can an AI system directly violate copyright? In his Aereo dissent, Justice Clarence Thomas asserted that it was a longstanding feature of copyright law that violation of the performance right required volitional behavior.^[93] But the majority disagreed with him, holding that, by running a fully automated system of antennas intended to allow users to view video at home, the system gave rise to direct copyright liability.^[94] Thus, implied in the majority’s opinion is the idea that direct copyright infringement does not require “volitional” conduct.

It is therefore plausible that a non-sentient, fully automated AI system could infringe copyright, even if, ultimately, there is no way to recover against the nonhuman agent. That does, however, provide an opportunity for claims of vicarious liability against the AI producer or distributor— at least, where the producer has the power to control the AI system’s behavior and that behavior appears to align with the producer’s financial interests.

3.              Protecting the ‘style’ of human creators

The NOI asks: “Are there or should there be protections against an AI system generating outputs that imitate the artistic style of a human creator (such as an AI system producing visual works ‘in the style of’ a specific artist)?”[95]

At the federal level, one candidate for protection against AI imitating some aspects of a creator’s works can currently be found in trademark law. Trademark law, governed by the Lanham Act, protects names, symbols, and other source identifiers that distinguish goods and services in commerce.^[96] Unfortunately, a photograph or likeness, on its own, typically does not qualify for trademark protection, unless it is consistently used on specific goods.^[97] Even where there is a likeness (or similar “mark”) used consistently as part of branding a distinct product, many trademark-infringement claims would be difficult to establish in this context, because trademark law does little to protect many aspects of a creator’s work.

Moreover, the Supreme Court has been wary about creating a sort of “mutant copyright” in cases that invoke the Lanham Act as a means to enforce a sort of “right of attribution,” which would potentially give creators the ability to control the use of their name in broader contexts.^[98] In this context, the Court has held that the relevant parts of the Lanham Act were not designed to “protect originality or creativity,”^[99] but are focused solely on “actions like trademark infringement that deceive consumers and impair a producer’s goodwill.”^[100]

In many ways, there is a parallel here to the trademark cases involving keyword bidding in online ads. At a high level, search engines and other digital-advertising services do not generally infringe trademark when they allow businesses to purchase ads triggered by a user’s search for competitor trademarks (i.e., rivals’ business names).^[101] But in some contexts, this can be infringing—e.g., where the use of trademarked terms in combination with advertising text can mislead consumers about the origin of a good or service.^[102]

Thus, the harm, when it arises, would not be in a user asking an AI system to generate something “in the style of” a known creator, but when that user subsequently seeks to release a new AI-generated work and falsely claims it originated from the creator, or leaves the matter ambiguous and misleading to consumers.

Alternative remedies for creators could be found in the “right of publicity” laws in various states. A state-level right of publicity “is not merely a legal right of the ‘celebrity,’ but is a right inherent to everyone to control the commercial use of identity and persona and recover in court damages and the commercial value of an unpermitted taking.”^[103] Such rights are recognized under state common law and statutes, which vary considerably in scope across jurisdictions—frequently as part of other privacy statutes.^[104] For example, some states only protect an individual’s name, likeness, or voice, while others also cover distinctive appearances, gestures, and mannerisms.^[105] The protections afforded for right-of-publicity claims vary significantly based on the state where the unauthorized use occurs or the individual is domiciled.^[106] This creates challenges for the application of uniform nationwide protection of creators’ interests in the various aspects that such laws protect.

In recent hearings before the U.S. Senate Judiciary Subcommittee on Intellectual Property, several witnesses advocated creating a federal version of the right of publicity.^[107] The Copyright Office has also previously opined that it may be desirable for Congress to enact some form of a “right of publicity” law.^[108] If Congress chose to enact a federal “right of privacy” statute, several key issues would need to be addressed regarding the scope of protection, effect on state laws, constitutional authority, and First Amendment limitations.

Congress would have to delineate the contours of the federal right of publicity, including the aspects of identity covered and the types of uses prohibited. A broad right of privacy could protect names, images, likenesses, voices, gestures, distinctive appearances, and biographical information from any unauthorized commercial use. Or Congress could take a narrower approach focused only on particular identity attributes, like name and likeness. Congress would also need to determine whether a federal right-of-publicity statute preempts state right-of-publicity laws or sets a floor that would allow state protections to exceed the federal standards.

4.              Bargaining for the use of likenesses

A federal right of publicity could present an interesting way out of the current dispute between rightsholders and AI producers. Most of the foregoing comment attempts to pull apart different pieces of potential infringement actions, but such actions are only necessary, obviously, if a mutually beneficial agreement cannot be struck between creators and AI producers. The main issue at hand is that, given the vast amount of content necessary to train an AI system, it could be financially impractical for even the largest AI firms to license all the necessary content. Even if the comments above are correct, and fair use is not available, it could very well be the case that AI producers will not license very much content, possibly relying on public-domain material, and choosing to license only a very small selection.

Something like a “right of publicity,” or an equivalent agreement between creators and AI producers, could provide alternative licensing and monetization strategies that encourage cooperation between the parties. If creators had the opportunity to opt into the use of their likeness (or the relevant equivalent for the sort of AI system in question), the creators could generate revenue when the AI system actually uses the results of processing their content. Thus, the producers would not need to license content that contributes an unknown and possibly de minimis value to their systems, and would only need to pay for individual instances of use.

Indeed, in this respect, we are already beginning to see some experimentation with business models. The licensing of celebrity likenesses for Meta’s new AI chatbots highlights an emerging opportunity for creators to monetize their brand through contractual agreements that grant usage rights to tech companies that commercialize conversational AI.[109] As this technology matures, there will be more opportunities for collaborations between AI producers—who are eager to leverage reputable and recognizable personalities—and celebrities or influencers seeking new income streams.

As noted, much of the opportunity for creators and AI producers to reach these agreements will depend on how rights are assigned.[110] It may be the case that a “right of publicity” is not necessary to make this sort of bargaining happen, as creators could—at least theoretically—pursue litigation on a state-by-state basis. This disparate-litigation strategy could deter many creators, however, and it could also be the case that a single federal standard outlining a minimal property right in “publicity” could help to facilitate bargaining.

Conclusion

The advent of generative AI systems presents complex new public-policy challenges centered on the intersection of technology and copyright law. As the Copyright Office’s inquiry recognizes, there are open questions around the legal status of AI-training data, the attribution of AI outputs, and infringement liability, which all require thoughtful analysis.

Ultimately, maintaining incentives for human creativity, while also allowing AI systems to flourish, will require compromise and cooperation between stakeholders. Rather than an outright ban on the unauthorized use of copyrighted works for training data, a licensing market that enables access to a large corpora could emerge. Rightsholders may need to accept changes to how they typically license content. In exchange, AI producers will have to consider how they can share the benefit of their use of protected works with creators.

Copyright law retains flexibility to adapt to new technologies, as past reforms reacting to photography, sound recordings, software, and the internet all demonstrate. With careful balancing of interests, appropriate limitations, and respect for constitutional bounds, copyright can continue to promote the progress of science and the useful arts even in the age of artificial intelligence. This inquiry marks a constructive starting point, although ongoing reassessment will likely be needed as generative AI capabilities continue to advance rapidly.

[1] Artificial Intelligence and Copyright, Notice of Inquiry and Request for Comments, U.S. Copyright Office, Library of Congress (Aug. 30, 2023) [hereinafter “NOI”].

^[2] Tim Sweeney (@TimSweeneyEpic), Twitter (Jan. 15, 2023, 3:35 AM), https://twitter.com/timsweeneyepic/status/1614541807064608768?s=46&t=0MH_nl5w4PJJl46J2ZT0Dw.

^[3] Pulitzer Prize Winner and Other Authors Accuse OpenAI of Misusing Their Writing, Competition Policy International (Sep. 11, 2023), https://www.pymnts.com/cpi_posts/pulitzer-prize-winner-and-other-authors-accuse-openai-of-misusing-their-writing; Getty Images Statement, Getty Images (Jan. 17, 2023), https://newsroom.gettyimages.com/en/getty-images/getty-images-statement.

[4] See, e.g., Anton Oleinik, What Are Neural Networks Not Good At? On Artificial Creativity, 6 Big Data & Society (2019), available at https://journals.sagepub.com/doi/full/10.1177/2053951719839433#bibr75-2053951719839433.

[5] William M. Landes & Richard A. Posner, An Economic Analysis of Copyright Law, 18 J. Legal Stud. 325 (1989).

[6] Id. at 332.

[7] Id. at 326.

[8] Id.

[9] See infra, notes 102-103 and accompanying text.

^[10] See generally R.H. Coase, The Problem of Social Cost, 3 J. L. & Econ. 1, 2 (1960).

^[11] Richard Posner, Economic Analysis of Law (Aspen 5^th ed 1998) 65, 79.

^[12] Coase, supra note 9, at 27.

^[13] Id.

^[14] Id. at 27.

^[15] Id. at 42-43.

^[16] U.S. Copyright Office, Library of Congress, supra note 1, at 14.

^[17] For more detailed discussion of GANs and Stable Diffusion see Ian Spektor, From DALL E to Stable Diffusion: How Do Text-to-image Generation Models Work?, Tryo Labs Blog (Aug. 31, 2022), https://tryolabs.com/blog/2022/08/31/from-dalle-to-stable-diffusion.

^[18] Id.

^[19] Id.

^[20] Id.

^[21] Id.

^[22] Id.

^[23] Jay Alammar, The Illustrated Stable Diffusion, Blog (Oct. 4, 2022), https://jalammar.github.io/illustrated-stable-diffusion.

^[24] Indeed, there is evidence that some models may be trained in a way that they “memorize” their training set, to at least some extent. See, e.g., Kent K. Chang, Mackenzie Cramer, Sandeep Soni, & David Bamman, Speak, Memory: An Archaeology of Books Known to ChatGPT/GPT-4, arXiv Preprint (Oct. 20, 2023), https://arxiv.org/abs/2305.00118; OpenAI LP, Comment Regarding Request for Comments on Intellectual Property Protection for Artificial Intelligence Innovation, Before the USPTO, Dep’t of Com. (2019), available at https://www.uspto.gov/sites/default/files/documents/OpenAI_RFC-84-FR-58141.pdf.

^[25] OpenAI, LP, Comment Regarding Request for Comments on Intellectual Property Protection for Artificial Intelligence, id. (emphasis added).

^[26] 17 U.S.C. § 107.

^[27] See, e.g., Blake Brittain, Meta Tells Court AI Software Does Not Violate Author Copyrights, Reuters (Sep. 19, 2023), https://www.reuters.com/legal/litigation/meta-tells-court-ai-software-does-not-violate-author-copyrights-2023-09-19; Avram Piltch, Google Wants AI Scraping to be ‘Fair Use.’ Will That Fly in Court?, Tom’s Hardware (Aug. 11, 2023), https://www.tomshardware.com/news/google-ai-scraping-as-fair-use.

^[28] 17 U.S.C. § 106.

^[29] Register of Copyrights, DMCA Section 104 Report (U.S. Copyright Office, Aug. 2001), at 108-22, available at https://www.copyright.gov/reports/studies/dmca/sec-104-report-vol-1.pdf.

^[30] Id. at 122-23.

^[31] Id. at 112 (emphasis added).

[32] Id. at 129–30.

[33] 17 U.S.C. § 107.

[34] Id.; see also Campbell v. Acuff-Rose Music Inc., 510 U.S. 569 (1994).

[35] Critically, a fair use analysis is a multi-factor test, and even within the first factor, it’s not a mandatory requirement that a use be “transformative.” It is entirely possible that a court balancing all of the factors could indeed find that training AI systems is fair use, even if it does not hold that such uses are “transformative.”

[36] Campbell, supra note 22, at 591.

[37] Authors Guild v. Google, Inc., 804 F.3d 202, 214 (2d Cir. 2015).

[38] OpenAI submission, supra note 13, at 5.

[39] Id. at 915.

[40] Id.

[41] Id.

^[42] Id. at 933-34.

^[43] Id. at 923. (emphasis added)

^[44] Id.

[45] Id. at 924.

[46] Kelly v. Arriba Soft Corp., 336 F.3d 811 (9th Cir. 2002).

[47] Id.

[48] Id. at 818.

[49] Id.

[50] Id. at 819 (“Arriba’s use of the images serves a different function than Kelly’s use—improving access to information on the internet versus artistic expression.”).

[51] The “public benefit” aspect of copyright law is reflected in the fair-use provision, 17 U.S.C. § 107. In Campbell v. Acuff-Rose Music, Inc., 510 U.S. 569, 579 (1994), the Supreme Court highlighted the “social benefit” that a use may provide, depending on the first of the statute’s four fair-use factors, the “the purpose and character of the use.”

[52] Supra note 46, at 820.

[53] Perfect 10 Inc. v. Amazon.com Inc., 487 F.3d 701 (9^th Cir., 2007)

[54] Id. at 721 (“Although an image may have been created originally to serve an entertainment, aesthetic, or informative function, a search engine transforms the image into a pointer directing a user to a source of information.”).

[55] Id. at 721.

[56] Id. at 723 (emphasis added).

[57] Id. (emphasis added).

[58] Id.

[59] Supra note 37, at 218.

[60] Id. at 215-16.

[61] Id. at 214. See also id. (“The more the appropriator is using the copied material for new, transformative purposes, the more it serves copyright’s goal of enriching public knowledge and the less likely it is that the appropriation will serve as a substitute for the original or its plausible derivatives, shrinking the protected market opportunities of the copyrighted work.”).

[62] Id. at 218.

[63] Perfect 10, 487 F.3d at 721-22 (citing Kelly, 336 F.3d at 818-19). See also Campbell, 510 U.S. at 579 (“The central purpose of this investigation is to see, in Justice Story’s words, whether the new work merely ‘supersede[s] the objects’ of the original creation, or instead adds something new, with a further purpose or different character….”) (citations omitted).

[64] See supra, notes 9-14 and accompanying text.

[65] See, e.g., the development of the compulsory “mechanical royalty,” now embodied in 17 U.S.C. § 115, that was adopted in the early 20^th century as a way to make it possible for the manufacturers of player pianos to distribute sheet music playable by their instruments.

[66] See supra notes 9-14 and accompanying text.

^[67] U.S. Copyright Office, Library of Congress, supra note 1, at 15.

[68] See infra, notes at 102-103 and accompanying text.

^[69] U.S. Copyright Office, Library of Congress, supra note 1, at 15.

^[70] See, e.g., Copyright Free Music, Premium Beat By Shutterstock, https://www.premiumbeat.com/royalty-free/licensed-music; Royalty-free stock footage at your fingertips, Adobe Stock, https://stock.adobe.com/video.

^[71] U.S. Copyright Office, Library of Congress, supra note 1, at 19.

^[72] Id.

^[73] U.S. Const. art. I, § 8, cl. 8.

[74] See Ajay Agrawal, Joshua S. Gans, & Avi Goldfarb, Exploring the Impact of Artificial Intelligence: Prediction Versus Judgment, 47 Info. Econ. & Pol’y 1, 1 (2019) (“We term this process of understanding payoffs, ‘judgment’. At the moment, it is uniquely human as no machine can form those payoffs.”).

^[75] Joshua Gans, Can AI works get copyright protection? (Redux), Joshua Gans’ Newsletter (Sept. 7, 2023), https://joshuagans.substack.com/p/can-ai-works-get-copyright-protection.

^[76] See Nicholas Carlini, et al., Extracting Training Data from Diffusion Models, Cornell Univ. (Jan. 30, 2023), available at https://arxiv.org/abs/2301.13188.

^[77] See Chang, Cramer, Soni, & Bamman, supra note 24; see also Matthew Sag, Copyright Safety for Generative AI, Working Paper (May 4, 2023), available at https://ssrn.com/abstract=4438593.; Andrés Guadamuz, A Scanner Darkly: Copyright Liability and Exceptions in Artificial Intelligence Inputs and Outputs, 25-27 (Mar. 1, 2023), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4371204.

^[78] Laureyssens v. Idea Grp. Inc., 964 F.2d 131, 140 (2d Cir. 1992), as amended (June 24, 1992).

^[79] Id. at 139.

^[80] Harney v. Sony Pictures Television Inc., 704 F.3d 173, 178 (1st Cir. 2013). This assumes, for argument’s sake, that a given model is not “memorizing,” as noted above.

^[81] Id. at 178-79.

^[82] Id.

[83] U.S. Copyright Office, Library of Congress, supra note 1, at 25.

^[84] Notably, the state of mind of the user would be irrelevant from the point of view of whether an infringement occurs. All that is required is that a plaintiff owns a valid copyright, and that the defendant infringed it. 17 U.S.C. 106. There are cases where the state of mind of the defendant will matter, however. For one, willful or recklessly indifferent infringement by a plaintiff will open the door for higher statutory damages. See, e.g., Island Software & Computer Serv., Inc. v. Microsoft Corp., 413 F.3d 257, 263 (2d Cir. 2005). For another, a case of criminal copyright infringement will require that a defendant have acted “willfully.” 17 U.S.C. § 506(a)(1) (2023), 18 U.S.C. § 2319 (2023).

^[85] Id. at 550.

[86] Legally speaking, it would be incoherent to suggest that there can be secondary liability without primary liability. The way that AI systems work, however, could prompt Congress to modify the law in order to account for the identified situation.

^[87] See, e.g., Metro-Goldwyn-Mayer Studios Inc. v. Grokster Ltd., 380 F.3d 1154, 1160 (9th Cir. 2004), vacated and remanded, 545 U.S. 913, 125 S. Ct. 2764, 162 L. Ed. 2d 781 (2005).

^[88] See BMG Rts. Mgmt. (US) LLC v. Cox Commc’ns Inc., 881 F.3d 293, 306 (4th Cir. 2018); Sony Corp. of Am. v. Universal City Studios Inc., 464 U.S. 417, 442 (1984).

^[89] A&M Recs. Inc. v. Napster Inc., 239 F.3d 1004, 1022 (9th Cir. 2001), as amended (Apr. 3, 2001), aff’d sub nom. A&M Recs. Inc. v. Napster Inc., 284 F.3d 1091 (9th Cir. 2002), and aff’d sub nom. A&M Recs. Inc. v. Napster Inc., 284 F.3d 1091 (9th Cir. 2002).

^[90] See, e.g., Content Filtering, Microsoft Ignite, available at https://learn.microsoft.com/en-us/azure/ai-services/openai/concepts/content-filter (last visited Oct. 27, 2023).

^[91] Note that, if an AI producer can demonstrate that they used no protected works in the training phase, there may in fact be no liability for infringement at all. If a protected work is never made available to the AI system, even an output very similar to that protected work might not be “substantially similar” in a legal sense.

^[92] Copyright Review Board, Second Request for Reconsideration for Refusal to Register Théâtre D’opéra Spatial (SR # 1-11743923581; Correspondence ID: 1-5T5320R), U.S. Copyright Office (Sep. 5, 2023), available at https://fingfx.thomsonreuters.com/gfx/legaldocs/byprrqkqxpe/AI%20COPYRIGHT%20REGISTRATION%20decision.pdf.

^[93] Am. Broad. Companies Inc. v. Aereo Inc., 573 U.S. 431, 453 (2014). (Thomas J, dissenting).

^[94] Id. at 451.

[95] U.S. Copyright Office, Library of Congress, supra note 1, at 21.

^[96] See 5 U.S.C. § 1051 et seq. at § 1127.

^[97] See, e.g., ETW Corp. v. Jireh Pub. Inc., 332 F.3d 915, 923 (6th Cir. 2003).

^[98] Dastar Corp. v. Twentieth Century Fox Film Corp., 539 U.S. 23, 34 (2003).

^[99] Id. at 37.

^[100] Id. at 32.

^[101] See, e.g., Multi Time Mach. Inc. v. Amazon.com Inc., 804 F.3d 930, 938 (9^th Cir. 2015); EarthCam Inc. v. OxBlue Corp., 49 F. Supp. 3d 1210, 1241 (N.D. Ga. 2014); Coll. Network Inc. v. Moore Educ. Publishers Inc., 378 F. App’x 403, 414 (5th Cir. 2010).

^[102] Digby Adler Grp. LLC v. Image Rent a Car Inc., 79 F. Supp. 3d 1095, 1102 (N.D. Cal. 2015).

^[103] J. Thomas McCarthy, The Rights of Publicity and Privacy § 1:3. Introduction—Definition and History of the Right of Publicity—Simple Definition of the Right of Publicity, 1 Rights of Publicity and Privacy § 1:3 (2d ed).

^[104] See id. at § 6:3.

^[105] Compare Ind. Code § 32-36-1-7 (covering name, voice, signature, photograph, image, likeness, distinctive appearance, gesture, or mannerism), with Ky. Rev. Stat. Ann. § 391.170 (limited to name and likeness for “public figures”).

^[106] See Restatement (Third) of Unfair Competition § 46 (1995).

^[107] See, e.g., Jeff Harleston, Artificial Intelligence and Intellectual Property – Part II: Copyright, U.S. Senate Comm. on the Judiciary Subcomm. on Intellectual Property (Jul.12, 2023), available at https://www.judiciary.senate.gov/imo/media/doc/2023-07-12_pm_-_testimony_-_harleston1.pdf; Karla Ortiz, “AI and Copyright”, U.S. Senate Comm. on the Judiciary Subcomm. on Intellectual Property (Jul. 7, 2023), available at https://www.judiciary.senate.gov/imo/media/doc/2023-07-12_pm_-_testimony_-_ortiz.pdf; Matthew Sag, “Artificial Intelligence and Intellectual Property – Part II: Copyright and Artificial Intelligence”, U.S. Senate Comm. on the Judiciary Subcomm. on Intellectual Property (Jul. 12, 2023), available at https://www.judiciary.senate.gov/imo/media/doc/2023-07-12_pm_-_testimony_-_sag.pdf.

^[108] Authors, Attribution, and Integrity: Examining Moral Rights in the United States, U.S. Copyright Office (Apr. 2019) at 117-119, https://www.copyright.gov/policy/moralrights/full-report.pdf.

[109] Benj Edwards, Meta Launches Consumer AI Chatbots with Celebrity Avatars in its Social Apps, ArsTechnica (Sep. 28, 2023), https://arstechnica.com/information-technology/2023/09/meta-launches-consumer-ai-chatbots-with-celebrity-avatars-in-its-social-apps; Max Chafkin, Meta’s New AI Buddies Aren’t Great Conversationalists, Bloomberg (Oct. 17, 2023), https://www.bloomberg.com/news/newsletters/2023-10-17/meta-s-celebrity-ai-chatbots-on-facebook-instagram-are-surreal.

[110] See supra, notes 8-14 and accompanying text.

Amicus respectfully submits this brief in support of Petitioner Apple Inc.[1]

INTEREST OF AMICUS CURIAE

The International Center for Law & Economics (“ICLE”) is a nonprofit, non-partisan global research and policy center aimed at building the intellectual foundations for sensible, economically grounded policy. ICLE promotes the use of law and economics methodologies and economic learning to inform policy debates and has longstanding expertise evaluating antitrust law and policy.

ICLE has an interest in ensuring that antitrust law promotes the public interest by remaining grounded in sensible rules informed by sound economic analysis. That includes fostering consistency between antitrust law and other laws that proscribe unfair methods of competition, such as California’s Unfair Competition Law, and advising against far-reaching injunctions that could deteriorate the quality of mobile ecosystems, thereby harming the interests of consumers and app developers.

INTRODUCTION AND SUMMARY OF ARGUMENT

This Court has admonished that “injunctive relief should be no more burdensome to the defendant than necessary to provide complete relief to the plaintiffs.” Califano v. Yamasaki, 442 U.S. 682, 702 (1979); see also Application for a Stay at 5, Murthy v. Missouri, No. 23-411 (Sept. 14, 2023) (review granted on government’s stay motion arguing “the injunction sweeps far beyond what is necessary to address any cognizable harm to respondents”). The nationwide injunction issued in this case, which applies to millions of non-party app developers, cannot be reconciled with that principle.

The lower court’s use of a nationwide injunction to address narrow alleged injuries has severe consequences that are best understood through the lens of law and economics principles. The district court recognized that Apple’s walled-garden ecosystem yields procompetitive consumer benefits, including greater privacy and data security, and that such benefits are cognizable under federal antitrust law. Pet. App. 261a-270a. Yet the district court’s nationwide injunction undercuts precisely those benefits. Apple’s practice of vetting unsafe payment systems and malware on its App Store depends on its ability to prevent third parties from “steering” consumers towards purchase mechanisms other than Apple’s secure in-app purchasing (“IAP”) system. In addition, the anti-steering policy prevents free-riding and protects Apple’s incentive to invest in its platform to improve the curation of apps, privacy, safety, and security.

These harms to Apple’s platform are not offset by benefits to consumers, or even to developers taken as a whole. All the injunction does is alter the allocation of app store fees between developers, because even if Apple’s ability to collect a commission through its IAP is limited, Apple would still have the right to collect a commission in other ways for the use of its proprietary software and technology. It could do so by readjusting whom it charges for access to the App Store, and how much it charges.

For instance, rather than charge a commission to developers on paid downloads of apps and on in-app purchases of digital goods and services, as it does now, Apple could instead charge all developers a fee for accessing the App Store. While this might ostensibly benefit big developers who rely heavily on in-app purchases and paid downloads to monetize their apps, it is not at all clear that the net effects would be positive. One thing does seem clear, however: The current model, in which small, free apps pay few fees, would likely cease to be tenable under a nationwide federal injunction.

Put differently, despite not violating federal antitrust law, the district court’s sweeping remedy risks harming the vast majority of app developers, who have not requested the injunction and are now operating on the iOS for free. And it may ultimately harm tens of millions of consumers using Apple’s App Store and iOS.

ARGUMENT

I.              The Injunction Is Unnecessarily Broad and Would Affect Millions of Developers, Not Just Epic

The district court imposed an injunction that affects Apple’s anti-steering provisions across the board, and thus redefines Apple’s relationship with many developers—not just Epic. As it stands, the injunction is overly broad and at odds with established jurisprudence. Gill v. Witford, 138 S. Ct. 1916, 1933-34 (2018); Califano, 442 U.S. at 702. And it reduces consumer welfare by precluding more beneficial conduct than the harmful behavior it deters.

There are about thirty million registered app developers of native iOS apps. Pet. App. 10a. There are about two million apps  available in the United States storefront for the App Store, and most of them were created by third-party developers. See Apple Inc. v. Pepper, 139 S. Ct. 1514, 1519 (2019). All the developers have signed Apple’s guidelines regarding the exclusive use of Apple’s IAP and the related anti-steering provisions. By contrast, the trial evidence established that a little over 100 developers use Epic’s Epic Store. See Pet. App. 115a (citing Trial Tr. 1220:18-20). Yet, the anti-steering injunction would affect all App Store developers. The plaintiff is not even among these developers, because Epic was jettisoned from the App Store in 2020 for introducing an in-app payment system that bypassed Apple’s IAP. Epic has only one subsidiary that is active on the App Store. See Pet. App. 12a; D.Ct. ECF No. 825-8.

It is thus unclear why the district court found it necessary to issue an injunction covering all developers who are licensed to make iOS apps for the App Store’s U.S. storefront, not just Epic’s subsidiary and the approximately 100 developers who use the Epic Store.

Two considerations are especially pertinent. First, Califano precludes the Ninth Circuit’s erroneous assertion that an injunction need only be “tied to Epic’s injuries.” Pet. App. 82a; Califano, 442 U.S. at 702. Indeed, as the government argued in a recently granted petition that raises similar issues, an overbroad injunction cannot be justified on the theory that the non-parties are simply incidental beneficiaries of the injunction for the prevailing parties. Application for a Stay, supra, at 34-36; see Order Granting Review & Order Granting Stay, Murthy v. Missouri, No. 23-411 (Oct. 20, 2023). Instead, “[i]njunctive relief may ‘be no more burdensome to the defendant than necessary to provide complete relief to the plaintiffs.’” Id. at 34-35 (quoting Califano, 442 U.S. at 702).

Second, Apple already settled a class-action lawsuit with developers regarding developer-consumer communications. As part of the Cameron v. Apple Inc. settlement, Apple deleted a prohibition on targeted communication between developers and consumers outside of the app, meaning that developers are now free to communicate outside the apps about external purchasing options (or anything else). See Order: Granting Motion for Final Approval of Class Action Settlement; Granting in Part and Denying in Part Mot. for Attorney’s Fees, Costs, and Service Award; and Judgment at 13, Cameron v. Apple Inc., No. 19-cv-03074 (N.D. Cal. June 10, 2022), ECF No. 491. That settlement, spurred by a properly certified Rule 23 class action representing around 6,700 app developers, did not, however, require Apple to modify or remove the anti-steering provision at issue here (links and buttons within apps). See Declaration of Steve W. Berman in Support of Developer Plaintiffs’ Motion for Preliminary Approval of Settlement with Defendant Apple Inc. at 7-41, Cameron v. Apple Inc., No. 19-cv-3074 (Aug. 26, 2021), ECF No. 396-1.

It is jarring that the courts would now issue a much broader injunction in a case involving a single plaintiff. This could cause serious harm to nonparties who had no opportunity to argue for more limited relief. Zayn Siddique, Nationwide Injunctions, 117 Colum. L. Rev. 2095, 2125 (2017). And it also raises the question whether such a blanket remedy is even necessary given that Cameron v. Apple strikes a balance between Apple’s ability to safeguard its investments and maintain the safety and security of its ecosystem, and app developers’ ability to steer users to alternative payment systems. That agreement was found acceptable by Apple and some 6,700 app developers. Why should it be overridden by an injunction in a case involving a single plaintiff, when app developers have already had the opportunity to join a properly certified class action before, and have either chosen not to do so or have agreed to a different settlement? Further, if a single plaintiff’s allegations of harm can undercut a court-approved, negotiated settlement involving a much larger number of plaintiffs, that diminishes the incentives of parties to fashion and negotiate reasonable settlements in the first instance.

A broad injunction may well be warranted when it is difficult to separate the parties affected by the enjoined conduct from those that are not. But this is not the case here. The identity of the parties that have supposedly been harmed is clear—they are, at most, Epic’s subsidiary and the approximately 100 developers that use the Epic Store. Even if the district court’s conclusions regarding harm to Epic’s subsidiary and other developers with apps on the Epic Store were correct, it would be easy—and necessary—to carve a much narrower remedy than the one the district court imposed. See Barr v. Am. Ass’n of Pol. Consultants, Inc., 140 S. Ct. 2335, 2354-55 (2020).

Overly broad injunctions represent a Constitutional threat, as several members of this Court have warned. See, e.g., United States v. Texas, 143 S. Ct. 1964, 1980 (2023) (Gorusch, J., concurring); Trump v. Hawaii, 138 S. Ct. 2392, 2425 (2018) (Thomas, J., concurring); see also Lewis v. Casey, 518 U.S. 343, 360 (1996). “[G]ranting a remedy beyond what [is] necessary to provide relief to [the plaintiff is] improper.” Lewis, 518 U.S. at 360. In addition to such constitutional implications, overly broad injunctions also raise problems from a law and economics perspective such as hindering and even destroying beneficial conduct. If an injunction is not properly tailored, the beneficial conduct which it precludes may be greater than the harmful conduct which it prevents, resulting in a loss to both total social welfare and consumer welfare.

II.           Platforms Have Legitimate Business Reasons for Anti-Steering Provisions

By casting an overly wide net, the district court’s injunction throws the proverbial baby out with the bathwater. Anti-steering provisions are commonly used by digital platforms and other businesses because they serve a series of legitimate aims, such as allowing for the recoupment of investments. They also result in tangible procompetitive benefits, such as increased privacy, security, and market-wide output. These rules can be procompetitive, as this Court has recognized. Ohio v. Am. Express Co., 138 S. Ct. 2274, 2289 (2018) [hereinafter Amex].

Absent intervention by this Court, Apple will have to comply with a nationwide injunction that risks diminishing these benefits. If the decision is not corrected, the precedent could have a harmful ripple effect, subjecting other platforms to overly broad injunctions against anti-steering provisions, even though those anti-steering provisions may help sustain and improve the overall quality of those platforms.

A.            The framework for assessing competitive effects in a two-sided market requires a broad examination of the market as a whole

The district court properly found that Apple’s procompetitive justifications for the anti-steering provisions in its IAP system outweighed any anticompetitive effects of those provisions. In fact, Epic failed to make even a prima facie case under the requisite rule-of-reason analysis, as Epic failed to show that Apple’s app distribution and IAP system caused the significant, market-wide competitive harm that the Supreme Court deemed necessary to a showing of anticompetitive harm in Amex.

In Amex, the Court recognized the importance of platform economics and network effects to understanding the market and competitive effects at issue. Two-sided platforms intermediate between two groups, offering a different product or service to each. 138 S. Ct. at 2280 (citing e.g., David Evans & Richard Schmalensee, Markets with Two-Sided Platforms, 1 Issues in Competition L. & Pol’y 667 (2008); David Evans & Michael Noel, Defining Antitrust Markets When Firms Operate Two-Sided Platforms, 2005 Colum. Bus. L. Rev. 667 (2005)).

The Court noted that two-sided platforms are characterized by indirect network effects, where the value of the platform to each group depends on the scale of, or number of members in, the other. Id. at 2280-81. Specifically, the Court observed that “two-sided transaction platforms exhibit more pronounced indirect network effects and interconnected pricing and demand.” Id. at 2286 (emphasis added) (citing Benjamin Klein et al., Competition in Two-Sided Markets: The Antitrust Economics of Payment Card Interchange Fees, 73 Antitrust L.J. 571, 583 (2006)). Hence, “[e]valuating both sides of a two-sided transaction platform is . . . necessary to accurately assess competition.” Id. at 2287.

B.            Anti-steering provisions can be procompetitive

At issue in Amex were various anti-steering provisions American Express had placed in its contracts with merchants. The plaintiffs had alleged that the anti-steering provisions violated Section 1 of the Sherman Act. 138 S. Ct. at 2283. But in Amex, the Court recognized that “there is nothing inherently anticompetitive about . . . antisteering provisions.” Id. at 2289. Those vertical provisions can, among other things, prevent merchants from free-riding, thereby increasing the availability of “‘tangible or intangible services or promotional efforts’ that enhance competition and consumer welfare.” Id. at 2290 (quoting Leegin Creative Leather Prods., Inc. v. PSKS, Inc., 551 U.S. 877, 890-91 (2007)).

As in Amex, understanding the competitive effects of conduct between the platform and parties on either side of the platform—for example, vertical agreements between the IAP and app developers—requires examining effects on the system as a whole. And just as in Amex, there are legitimate, procompetitive reasons for anti-steering provisions.

First, as discussed above, anti-steering provisions help prevent free-riding. Simply put, “free-riding” occurs when someone uses a valuable resource without paying for it. Free-riding—even the potential for free-riding—tends to undermine incentives to provide the resource in the first place, as well as incentives to improve it in later development. It presents an especially serious challenge to the provision of goods or services where it is difficult to exclude those who have not paid, as with city parks or policing. Everyone, even those who would be willing to pay if they had to, has an incentive to avoid fees. Thus, where free-riding is possible, desirable goods and services tend to be underfunded, reducing their provision (or, in antitrust terms, output), or, in the alternative, are provided dependent on government subsidy. The most common solution to free-rider problems is to create ways to exclude those who are unwilling to pay.

In this case, Apple owns a valuable resource that it has created and steadily improved—the iPhone and iOS ecosystem, including the App Store. Apple currently charges commissions between 15% and 30% for digital goods sold through the App Store, including for certain in-app purchases. Epic would like to access that ecosystem without paying. But while Epic may benefit from its long-term strategy to reduce the fees it pays to Apple, consumers might not. If reductions in revenue from the iOS ecosystem mean that Apple has less incentive to invest in it, Epic’s gain may come at the consumer’s expense.

The district court correctly rejected Epic’s main claim, as Epic failed to establish cognizable harm under the antitrust laws. That foreclosed Epic’s ability to directly circumvent the App Store and pay a lower commission, or none at all. In granting a nationwide injunction against Apple’s anti-steering provisions, the district court facilitated precisely the type of free-riding that failed to gain traction under federal antitrust law. Doing so will greatly exacerbate any free-rider problem Epic itself might have caused Apple, to the likely detriment of many developers and most consumers.

The situation is further complicated by the fact that the district court’s injunction is vaguely written and is thus likely to be interpreted quite differently by different parties. Ultimately, if it allows app developers to link users outside of the in-app payments flow, and bypass Apple’s IAP fees, it will further enable free-riding and undermine Apple’s incentives to invest in iOS, iPhones, and iPads. And the injunction could undermine the incentive for Apple’s competitors to develop whatever products might someday displace the current ones through competition.

Second, as a two-sided market, the App Store is valuable only because it is used by both consumers and developers, and Apple has to balance both sides of the market. The risk of developers leaving the iOS ecosystem creates a built-in ceiling on the prices Apple can charge, as users will be less inclined to pay for Apple products if valuable apps are not there. The commission-fee business model gives Apple and other platforms significant incentives to develop new distribution mediums (like smart TVs, for example) and to improve existing ones. Such development expands the audience that software can reach.

Apple’s “closed” distribution model also allows the company to curate the App Store’s apps and payment options. For example, Apple’s guidelines exclude apps that pose data security threats, threaten to impose physical harm on users, or undermine child-safety filters. These rules increase trust between users and previously unknown developers, because users do not have to fear their apps contain malware. They also reduce user fears about payment fraud. Rivals could free-ride on Apple’s curation by mimicking its decisions and undercutting it on price. Doing so does not enhance competition on the merits: It eviscerates it by eroding Apple’s incentives to enforce such rules.

Apple’s closed business model also enables it to maintain a high standard of performance on iOS devices by excluding apps and payment systems that might slow devices or crash frequently. Users may not know when device performance is affected by a given app or purchase mechanism, so an open system would mean the potential for apps that crash the entire device. Apple’s closed model ensures that unscrupulous developers cannot impose negative externalities on the entire ecosystem.

By increasing the total value of the platform, these benefits also increase the number of market-wide transactions. In a two-sided market, it is output—not prices—that tells us what is happening on the market as a whole, and it is therefore output that should be used as the relevant parameter to determine whether conduct is procompetitive or anticompetitive. “What is material is whether Apple’s overall pricing structure reduces output by deterring app developers from participating in the market or users from purchasing apps (or iOS devices at all) because of the amount of the app developer commission.” Geoffrey A. Manne & Kristian Stout, The Evolution of Antitrust Doctrine After Ohio v. Amex and the Apple v. Pepper Decision That Should Have Been, 98 Neb. L. Rev. 425, 457 (2019). Notably, the district court found that it could not ascertain whether Apple’s alleged restrictions had “a negative or a positive impact on game transaction volume.” Pet. App. 253a; see also id. (“no evidence that a substantial number of developers actually forego making games because of Apple’s commission.”); id. at 319a (finding Epic failed to show reduction in output and that “[t]he record contains substantial evidence that output has increased.”).

Ultimately, however, the benefits of anti-steering provisions are obvious only if one adopts the correct, holistic vision of app stores as a two-sided market; conversely, they appear less relevant if one applies “one-sided logic in two-sided markets.” Julian Wright, One-sided Logic in Two-sided Markets, 3 Review of Network Econ. 44, 45-51 (2004). In this sense, in a two-sided market, anti-steering provisions can reduce transaction friction and bolster security and safety, thereby improving the platform’s overall quality and, ultimately, attracting more users. See Amex, 138 S. Ct. at 2889 (sustaining similar anti-circumvention rules as procompetitive for these reasons). Developers may get a smaller share of revenues, but it is a smaller slice of a much larger pie. Thus, while the ability to circumvent Apple’s commission fee can, on the surface, appear to benefit some developers, in the longer term most developers and consumers will be worse off.

Apple’s anti-steering provisions increase safety and curation, and an injunction against them can reduce the overall value of Apple’s platform. That would in turn discourage developers and users from using the iOS ecosystem, and would prompt a downward spiral in quality and choice for both sides of the market—which would depreciate the value of the platform even further.

C.            Open and closed platforms are not inherently good or bad: They represent alternative business models with potential advantages and disadvantages

Any comparison between “open” and “closed” platforms should account for the fact that there are tradeoffs between the two; it should not simply assume that “open” equals “good” while “closed” equals “bad.” Such analysis also must consider tradeoffs among consumers, and among developers, in addition to tradeoffs between developers and consumers. More vigilant users might be better served by an “open” platform because they find it easier to avoid harmful content; less vigilant ones may want more active assistance in screening for malware, spyware, or software that simply isn’t optimized for the user’s device.

There are similar tradeoffs on the developer side: Apple’s model lowers the cost to join the App store, which especially benefits smaller developers and those whose apps fall outside the popular gaming sector. In short, the IAP fee cross-subsidizes the delivery of services to the approximately 80% of apps on the App Store that are free to consumers and pay no IAP fees.

Centralized app distribution and Apple’s “walled garden” model (including IAP) increase interbrand competition because they are at the core of what differentiates Apple from Android, the other major competing platform. 1-ER-148–49. They play into Apple’s historical business model, which focuses on being user-friendly, reliable, safe, private, and secure. 1?ER-86; see also 1-ER-107 (recognizing that the safety and security of Apple’s closed system is a “competitive differentiator for its devices and operating system”). Even Epic recognized that Apple would lose its competitive advantage if it were to compromise its safety and security features. 1-ER-48 n.250 (noting Epic’s expert, Susan Athey, testified that “privacy and security are competitive differentiators for Apple”).

For Apple and its users, the touchstone of a good platform is not “openness,” but carefully curated selection and security, understood broadly as encompassing the removal of objectionable content, protection of privacy, and protection from “social engineering,” and the like. 1-ER-148–49. By contrast, Android’s bet is on the open platform model, which sacrifices some degree of security for the greater variety and customization associated with more open distribution. These are legitimate differences in product design and business philosophy. See Andrei Hagiu, Proprietary vs. Open Two-Sided Platforms and Social Efficiency 2-3 (AEI-Brookings Joint Ctr. for Regul. Stud., Working Paper No. 06-12, 2006) [hereinafter Proprietary vs. Open Platforms] (explaining that there is a “fundamental welfare tradeoff between two-sided proprietary . . . platforms and two-sided open platforms, which allow ‘free entry’ on both sides of the market” and thus “it is by no means obvious which type of platform will create higher product variety, consumer adoption and total social welfare”) (emphasis omitted); Jonathan M. Barnett, The Host’s Dilemma: Strategic Forfeiture in Platform Mkts. for Informational Goods, 124 Harv. L. Rev. 1861, 1927 (2011) (“Open systems may yield no net social gain over closed systems, can impose a net social loss under certain circumstances, and . . . can impose a net social gain under yet other circumstances.”).

Because consumers and developers could reasonably prefer either ecosystem, it is not clear that loosening Apple’s control over the App Store would necessarily lead to more app transactions market wide. Indeed, in a two-sided market context, a proprietary platform like Apple’s “may in fact induce more developer entry (i.e. product variety), user adoption and higher total social welfare than an open platform.” Proprietary vs. Open Platforms, at 15-16. In other words, preventing certain apps from accessing the App Store, and preventing certain transactions from taking place on it, may ultimately have increased the number of apps and transactions on Apple’s platform, because doing so made it attractive to a wider set of consumers and developers.

Yet the injunction brings Apple’s iOS closer to an “open” system, effectively rendering Apple’s platform more similar to Android’s. The district court found that Apple did not have a monopoly, yet under the guise of fostering competition on Apple’s platform the injunction eliminates competition where it matters most—at the interbrand, systems level between Apple and Android. See Michael L. Katz & Carl Shapiro, Systems Competition and Network Effects, 8 J. Econ. Persps. 93, 110 (1994), (“[T]he primary cost of standardization is a loss of variety: consumers have fewer differentiated products to pick from, especially if standardization prevents the development of promising but unique and incompatible new systems”). By limiting intrabrand competition, in other words, Apple ultimately promotes interbrand competition. 1-ER-148–49. Again, Amex provides useful insight here, because the Court noted that the business model had “spurred robust interbrand competition,” while increasing both the quality and quantity of transactions. Amex, 138 S. Ct. at 2290.

D.            Anti-steering provisions are a legitimate way of recouping a platform’s investments

Anti-steering provisions are a legitimate way for a platform to recoup its investments. Epic has argued that Apple could simply lift restrictions on the use of third-party IAP processors (e.g., Visa and MasterCard), but still be appropriately compensated for the use of its intellectual property, ensure that iPhone users’ IAP are sufficiently secure, and guarantee quality. 1-ER-153; Epic 9th Cir. Br. 44-47. But exactly how Apple could achieve these ends without increasing its costs is a question Epic has not even tried to answer. See, e.g., 1-ER-151–52 (noting that Epic’s requests for relief “leave unclear whether Apple can collect licensing royalties and, if so, how it would do so”); 1-ER-153 & n.617 (noting it would “be more difficult” and more costly for Apple to collect commission without the IAP system). Nor did Epic, the Epic amici, or the district court properly address the effect of the proposed less restrictive alternatives on consumers rather than competing developers. See 1-ER-148 n.605 (noting it is “unclear the extent or degree to which developers would pass on any savings to consumers”).

Consistent with Epic’s proposed approach, Apple could allow independent payment processors to compete, and charge an all-in fee of 30% when Apple’s IAP is chosen. To recoup the costs of developing and running its App Store, Apple could then charge app developers a reduced, mandatory per-transaction fee (on top of developers’ “competitive” payment to a third-party IAP provider) when Apple’s IAP is not used. Indeed, where a similar remedy has been imposed already, Apple has taken similar steps. In the Netherlands, for example, where Apple is required by the Authority for Consumers and Markets to uncouple distribution and payments for dating apps, Apple has adopted a policy under which any apps that want to use a non-Apple payment provider must still “pay Apple a commission on transactions” that is 3% less than normal (so 27% for most transactions), a slightly “reduced rate that excludes value related to payment processing and related activities.” Apple, Distributing Dating Apps in the Netherlands, (last visited Oct. 26, 2023).

III.         A State Law Should Not Undermine the Fundamental Goals of Federal Antitrust Policy

When assessing the effects of Apple’s anti-steering provisions, the courts should not ignore Federal antitrust law and, especially, the effects on competition and consumers. In other words, the fact that anti-steering provisions are procompetitive should be a relevant factor in whether a federal court grants nationwide injunctive relief. To interpret California’s Unfair Competition Law (“UCL”) as the district court has done—in a way that is at loggerheads with federal antitrust law but yet permits a nationwide injunction—is to undermine the fundamental goal of antitrust policy, and to do so on a national level. As the Court has observed, “The heart of our national economic policy long has been faith in the value of competition.” Nat’l Soc’y of Prof. Eng’rs v. United States, 435 U.S. 679, 695 (1978) (quoting Standard Oil Co. v. FTC, 340 U.S. 231, 248 (1951)).

The district court recognized Apple’s security arguments as a key procompetitive factor that determines Apple’s success and increases output across the platform, ultimately benefitting both consumers and developers. Yet the court issued an unnecessarily broad injunction against Apple’s anti-steering provisions that risks chilling procompetitive conduct by deterring investment in efficiency-enhancing business practices, such as Apple’s “walled-garden” iOS (see sections II.B and II.D on the procompetitive benefits of anti-steering provisions). See also Verizon Commc’ns, Inc. v. Law Offices of Curtis V. Trinko, LLP, 540 U.S. 398, 414 (2004) (“[F]alse condemnations ‘are especially costly, because they chill the very conduct the antitrust laws are designed to protect.’”) (quoting Matsushita Elec. Indus. Co. v. Zenith Radio Corp., 475 U.S. 574, 594 (1986)).

Even more egregiously, perhaps: It risks undermining federal antitrust law by enjoining conduct under state unfair competition law that is recognized as benign—and even beneficial—under federal antitrust law. If the district court’s remedy is left to stand, state laws will be stretched beyond their territorial remit and used to contradict federal antitrust laws nationally, thus eviscerating federal antitrust policy from the bottom-up. This is not a hypothetical threat, either: California has already expressed its intent to use the UCL to “seek nationwide injunctions” on the same theory as the ruling below. Michael Acton, Epic Games-Apple US Appeals Court Ruling Shows Power of California’s Competition Law, Blizzard Says, MLex (May 10, 2023).

The district court erred in finding Apple’s anti-steering provision “unfair” despite a concurrent finding that there is no incipient antitrust violation. And a nationwide injunction based on that finding lifts what could have been a relatively contained mistake to the national level, and thereby magnifies it.

This is misguided from an antitrust perspective because it undermines some of the procompetitive benefits that anti-steering provisions in closed two-sided platforms can give to consumers and app developers. A national injunction that subverts Apple’s ability to charge a commission for the use of its software and technology through paid apps and in-app payments might also alter the current balance between the two sides of the App Store, to the detriment of smaller developers of free apps. In this zero-sum game, the gain of a handful of developers who rely on paid downloads of apps and frequent in-app purchases by users will come at the expense of the majority who do not.

CONCLUSION

For the foregoing reasons, this Court should grant Apple’s petition for a writ of certiorari.

[1] Amicus notified counsel for the parties of its intent to file this brief more than ten days before the deadline. No counsel in this matter for any party authored this brief in whole or in part, and no person other than amicus or its counsel have made any monetary contribution intended to fund the preparation or submission of this brief.

ICLE President Geoff Manne joined the Tech Policy Podcast to discuss the Federal Trade Commission’s lawsuit against Amazon. Audio of the full episode is embedded below.

STATEMENT OF AMICI INTEREST

Amici are law professors, economists, or other academics with expertise in competition law and economic regulation. Amici do not work for Tesla, nor have they been compensated in any way for their participation in this brief.[1]

SUMMARY OF ARGUMENT

Amici appear in support of Tesla on two issues with a common thread.[2] The district court’s opinion erred in insulating the actions of the Louisiana legislature and the Louisiana Motor Vehicle Commission (“LMVC”) from antitrust and constitutional review under a flawed framework for scrutinizing state regulations that suppress competition and favor economic special interests.

First, Amici submit that the district court erred in holding that commissioners of the LMVC were protected by Noerr-Pennington immunity when they “agreed with [the Louisiana Automobile Dealers Association (“LADA”)] to use the regulatory power of the Commission to investigate Tesla.” Op. at 27. Although public officials may enjoy Noerr-Pennington immunity when they act in a purely private capacity, a public official who is also a market participant and agrees with others to utilize public power in a manner designed to suppress competition in order to further his own economic interests should not be immunized from antitrust scrutiny. The Noerr-Pennington doctrine protects the rights of citizens to petition the government for redress of grievance. It does not protect governmental officials who conspire to use governmental power to favor their own economic interests. The district court’s approach would create a loophole in the antitrust laws permitting actors wielding state power to avoid responsibility for abuses of official power.

Second, Amici dispute the district court’s finding that Louisiana’s direct sales ban had a rational basis in consumer protection. As Amici explain below, direct sales bans in automotive retailing were historically focused on the exclusive goal of protecting dealers in franchise relationships with manufacturers. Thus, in the cases in which this Court upheld such statutes against constitutional challenge—Ford Motor Co. v. Texas Dep’t of Transp., 264 F.3d 493 (5th Cir. 2001); Int’l Truck & Engine Corp. v. Bray, 372 F.3d 717 (5th Cir. 2004)—the ostensible rational basis of the legislation was the protection of dealers against the superior bargaining power of their franchising manufacturers. But that logic can have no bearing on the application of Louisiana’s 2017, anti-Tesla direct sales prohibition, for the simple reason that Tesla (and other new electric vehicle manufacturers) do not use franchised dealers at all, but sell directly to the consuming public. In such circumstances, dealers are not being protected as franchisees, they are protected from economic competition by companies using a different business model—exactly what this Court held does not count as a rational basis in St. Joseph Abbey v. Castille, 712 F.3d 215 (5th Cir. 2013). Further, efforts to justify direct sales bans as consumer protection rather than dealer protection have no support in economic theory or evidence. Such arguments are mere pretexts for the economic protectionism that this Court has held does not survive equal protection scrutiny

[1] Amici join this brief solely in their individual capacities and express only their individual views. Institutional affiliations are listed for identification purposes only.

[2] Amici take no position on other arguments raised by Tesla’s appeal.

 

Executive Summary

In October 2022, the Kroger Co. and Albertsons Cos. Inc. announced their intent to merge in a deal valued at $24.6 billion.[1] Given the Federal Trade Commission’s (FTC) increasingly aggressive enforcement stance against mergers and acquisitions, as well as Chair Lina Khan’s previous writings on food retail specifically,[2] the agency appears poised to try to block the transaction—even with divestitures.[3] The FTC and U.S. Justice Department’s (DOJ) recently unveiled draft revisions to the agencies’ merger guidelines further suggest that they plan to challenge more mergers—and to do so more aggressively than under past administrations.[4]

But attempting to block this transaction would go against the analytical framework the FTC has historically used to evaluate similar transactions, as well as the agency’s historical precedent of accepting divestures as a remedy to address localized problems where they arise. Such breaks with the past sometimes happen; our understanding of the law and economics evolves. But in the case at hand, these breaks from tradition would reflect a failure to consider relevant and significant changes in how consumers shop for food and groceries in today’s world.

The FTC has a long history of assessing retail mergers in a manner significantly at odds with the aggressive approach it is currently signaling. Only one supermarket merger has been challenged in court since American Store’s acquisition of Lucky Stores in 1988: the Whole Foods/Wild Oats merger in 2007.[5] Over the last 35 years, the FTC has allowed every other supermarket merger and most retail-store transactions to proceed with divestitures. Within the last two years alone, these have included Tractor Supply/Orschlein and 7-Eleven/Speedway.[6] The FTC’s historic approach recognizes the reality that competitive concerns regarding supermarket mergers can be readily and adequately remedied by divestitures in geographic markets of concern; indeed, even Whole Foods/Wild Oats was ultimately resolved with a divestiture agreement following a fractured circuit court decision.[7]

The retail food and grocery landscape has changed dramatically since American/Lucky and Whole Foods/Wild Oats. But the ways in which the market has changed point toward its becoming more competitive, further undermining a possible FTC case. With the growth of wholesale clubs, delivery services, e-commerce, and other retail formats, the industry is no longer dominated by traditional supermarkets. In addition, these changing dynamics have made geographic distance, traffic patterns, and population density decreasingly relevant in a consumer’s choice of where they purchase food and groceries. Today, Kroger is only the fourth-largest food and grocery retailer in the United States, behind Walmart, Amazon, and Costco. If the merger goes through, the combined firm will move into third place in market share but would still account for just 9% of nationwide sales.[8]

The upshot is that the food and grocery industry is arguably as competitive as it has ever been. Unfortunately, recent developments suggest the FTC may well ignore or dismiss the economic realities of this rapid transformation of the food and grocery industry, substituting instead the outdated approach to market definition and industry concentration signaled by the draft guidelines.[9]

In light of these developments in the food-retail market and the FTC’s likely break from precedent, this paper highlights important areas where both the commission and commentators’ stances appear to run headlong into legal precedent that mandates an evidence-based approach to merger review, even as the best available evidence points to a dynamic and competitive grocery industry. The correct understanding of the law and the industry appears entirely at odds with a challenge to the proposed merger.

A.     The FTC’s Merger-Enforcement Policy Is on a Collision Course with the Law

The Kroger/Albertsons merger proceeds against a backdrop of tough merger-enforcement rhetoric and actions from the FTC. Recent developments include the publication of aggressive revised merger guidelines, a string of cases brought to block seemingly benign mergers, process revisions that burden even unproblematic mergers, and FTC leadership’s contentious and expansive interpretation of the merger laws. The FTC’s ambition to remake U.S. merger law is likely to falter before the courts, but not before imposing a substantial tax on all corporate transactions—and, ultimately, on consumers.

The retail food and grocery market has changed substantially since the last time a supermarket merger was challenged in court. If the merger goes to trial, the court will need to address issues that have not been litigated in decades, if ever. Depending how the court rules, the market definition for future supermarket mergers may be substantially revised. Moreover, if the FTC attempts to litigate allegations of labor-market or input-market monopsony, the agency runs the risk of a humiliating loss that could stymie future attempts to expand the role of monopsony in competition enforcement and policy. The FTC thus would do well to even-handedly assess the Kroger Albertsons merger, remaining open to new evidence and sensible remedies. This is especially true given the agency’s losing streak in court—culminating with its unsuccessful challenges of the Meta/Within and Microsoft/Activision Blizzard deals.[10]

B.     The Product Market Is Broader Than Local Supermarkets

Because of recent changes in market dynamics, it no longer makes sense to limit the relevant market to supermarkets alone. Rather, consumer behavior in the face of omnipresent wholesale clubs, e-commerce, and local delivery platforms significantly constrains supermarkets’ pricing decisions.

Recent FTC consent orders involving supermarket mergers have limited the relevant product market to local brick-and-mortar supermarkets and food and grocery sales at nearby hypermarkets (e.g., Walmart supercenters), while excluding wholesale-club stores (e.g., Costco), e-commerce (e.g., Amazon), and further-flung stores accessible through online-delivery platforms (e.g., Instacart). This is based on an assertion that the relevant market includes only those retail formats in which a consumer can purchase nearly all of a household’s weekly food and grocery needs from a single stop, at a single retailer, in the shopper’s neighborhood. This is, however, no longer how most of today’s consumers shop. Instead, shoppers purchase different bundles of groceries from multiple sources, often simultaneously.[11] This pattern has substantial implications for supermarkets’ competitive environment, and underscores why the FTC should not rely on outdated market definitions.

Past FTC consent orders have defined the relevant geographic markets to be areas that range from a two- to ten-mile radius around each of the merging parties’ supermarkets.[12] The radius depends on such factors as population density, traffic patterns, and the unique characteristics of each market. It would, however, be reasonable to expand the relevant geographic market when club stores are present, as these have a larger catchment area than supermarkets. Finally, the rapid growth of e-commerce and delivery services make distance, traffic patterns, and population density decreasingly relevant in a consumer’s choice of where they purchase food and groceries. As with product-market definitions, this is a crucial empirical issue that should be evaluated in the FTC’s merger review and any litigation.

C.     Labor Monopsony Concerns Are Unlikely to Hold Up in Court

More than in any previous retail merger, opponents of the Kroger/Albertsons deal have raised the specter of potential monopsony power in labor markets. But these concerns reflect a manifestly unrealistic conception of labor-market competition. Fundamentally, the market for labor in the retail sector is extremely competitive, and workers have a wide range of alternative employment options—both in and out of the retail sector. At the same time, both Kroger and Albertsons are highly unionized, providing a counterbalance to any potential exercise of monopsony power by the merged firm.

D.    The Alleged ‘Waterbed Effect’ Is Not Borne Out by Evidence

Some critics of the merger have speculated that the merged company would be able to exercise monopsony power against its food and grocery suppliers (i.e., wholesalers and small manufacturers), often invoking an economic concept called the “waterbed effect.” The intuition is that the largest buyers may use their monopsony power to negotiate lower input prices from suppliers, leading the suppliers to make up the lost revenue by raising prices for their smaller, weaker buyers.

But these arguments are far from compelling. It is very difficult, for example, to hypothesize any relevant market for purchasing a good where the merged firm would have market power. Critics also often fail to consider the ability of many producers—both small and large—to sell directly to consumers, as demonstrated by the rise of online shopping, with its low entry barriers entry and low-cost structure.

Much of the discussion of the waterbed effect focuses on harm to competing retailers, rather than consumers. But this is not the harm that U.S. antitrust law seeks to prevent. It is thus not surprising that at least one U.S. court has rejected waterbed-effect claims on grounds that there was no harm to consumers.

E.     Divestitures Historically Have Proven an Appropriate and Adequate Remedy

Historically, the FTC has allowed most grocery-store transactions to proceed with divestitures, such as Ahold/Delhaize (81 stores divested), Albertsons/Safeway (168 stores), and Price Chopper/Tops (12 stores). The extent of the remedies sought depends on the extent of post-merger competition in the relevant local markets, as well as the likelihood of significant entry by additional competitors into the relevant markets. The benefit of selling off stores is that you can allow the vast majority of stores—where there is no worry about anticompetitive effect—to merge, while targeting the areas that have the highest concern.

Despite a long history of divestitures serving as an appropriate and adequate remedy in supermarket mergers, some point to the Albertsons/Safeway merger divestitures to Haggen as evidence that divestitures are no longer an appropriate remedy. But several factors idiosyncratic to Haggen and its acquisition strategy led to the failure of that divestiture, and it does not properly stand for the claim that all supermarket divestitures are doomed.

In September 2023, Kroger and Albertsons announced a $1.9 billion divestiture proposal to sell 413 stores, eight distribution centers, two offices, and five private-label brands to C&S Wholesale Grocers LLC.[13] If consummated, the deal would cover operations spanning 17 states and the District of Columbia, and C&S has committed to maintain collective-bargaining agreements with labor.[14] As antitrust enforcers review whether these proposed divestitures are adequate, they should learn from the Haggen experience, rather than view it as justification to reject reasonable divestiture options that have worked for other mergers.

I.  Introduction

In October 2022, the Kroger Co. and Albertsons Cos. announced their intent to merge the two companies in a deal valued at $24.6 billion.[15] Kroger is the fourth-largest food and grocery retailer in the United States—behind Walmart, Amazon, and Costco—while Albertsons is fifth.[16] Both chains trail market-leading Walmart  by a considerable margin. Kroger operates 2,726 stores under the Kroger, Harris Teeter, and Smith’s banners, while Albertsons operates 2,278 stores under the Safeway, Albertsons, and Von’s grocery banners.[17] By contrast, Walmart and Sam’s Club combined store count is greater than 5,300, and the company’s grocery revenue is more than twice that of Kroger and Albertsons combined.[18]

While the proposed Kroger/Albertsons merger is a large transaction in terms of dollar valuation and the combined firm would move into third place in market share, it would still account for just 9% of nationwide sales.[19] In some localities, the market share would be much larger, however, raising questions regarding whether the merger would increase Kroger/Albertson’s monopoly power in those retail markets and convey monopsony power in wholesale markets and local labor markets. To address such questions, Kroger and Albertsons have announced a $1.9 billion divestiture proposal that would include the sale of 413 stores and eight distribution centers across 17 states to C&S Wholesale Grocers LLC.[20]

But given the Federal Trade Commission’s (FTC) recent disposition toward proposed mergers and Chair Lina Khan’s previous writings about food retail, it is widely expected that the FTC will not be satisfied with any remedy offers from the companies—including offers to divest stores—and will instead attempt to block the merger.[21] California Attorney General Rob Bonta has also signaled that he is likely to challenge the deal.[22] In anticipation, Kroger’s chief executive officer announced that both companies are “committed to litigate” if the enforcers act to block the merger.^[23]

What can we expect of such a court battle? The precedent is slightly complicated. While several retail mergers have been challenged in court, including Staples/Office Depot in 2015[24] and Whole Foods/Wild Oats in 2007,[25] no supermarket mergers have been litigated since the State of California’s 1988 challenge to American Store’s acquisition of Lucky Stores.[26] Both the supermarket business and antitrust analysis have changed dramatically over the intervening 35 years. In this paper, we describe some of the changes that have occurred within food retail over the past 35 years, and how they should be addressed by the merging parties, the FTC, and—if litigated—by the courts.

As with most merger analysis, many of the most important questions hinge on a proper definition of the relevant market. The most obvious changes we have observed in food retail in recent decades, including the rise of wholesale club stores and e-commerce, are directly relevant to the question of market definition. The most recent FTC consent orders involving supermarket mergers defined the relevant product market to include “traditional” brick-and-mortar supermarkets, as well as food and grocery sales at hypermarkets (e.g., Walmart supercenters), while excluding wholesale club stores (e.g., Costco) and e-commerce (e.g., Amazon and home-delivery services).[27] This is based on the longstanding assertion that the relevant market includes only those retail formats in which a consumer can purchase all or nearly all of their household’s weekly food and grocery needs during a single stop at a single retailer.

Any attempt by the FTC to maintain this outdated market definition will likely be challenged in court. Research has shown that consumer behavior has changed over time, in that the typical consumer no longer makes once-a-week shopping trips to a single food and grocery retailer.[28] Instead, the typical consumer makes multiple weekly trips and multi-homes across several different retailers and retail formats. This change alone blurs the line between traditional supermarkets and other retail formats. The extent to which wholesale clubs, e-commerce, and delivery services should be included in the relevant market is a key empirical issue that surely will—and should—be evaluated in the FTC’s merger review and any ensuing litigation.

Geographic market is also an issue. The most recent FTC consent orders have defined the relevant geographic markets to be areas that range from a two- to ten-mile radius surrounding each of the merging parties’ supermarkets.[29] The radius depends on such factors as population density, traffic patterns, and the unique characteristics of each market. That, too, needs revision. Based on academic research, industry surveys, and reports from companies that find club stores compete with supermarkets and have larger catchment areas, we conclude that it would be reasonable to expand the relevant geographic market when club stores are present. In addition, the rapid growth of e-commerce and delivery services make distance, traffic patterns, and population density decreasingly relevant in a consumer’s choice of where they purchase food and groceries. As with product-market definition, this is a crucial empirical issue that should be evaluated in the FTC’s merger review and any ensuing litigation.

More than in any previous retail merger, opponents of the Kroger/Albertsons merger have raised the specter of potential monopsony power in labor markets. We argue that these concerns are likely overblown and will be nearly impossible to demonstrate if the merger were to be litigated. Fundamentally, the market for labor in the retail sector is highly competitive, with workers having a wide range of alternative employment if a particular employer attempted to exploit any claimed monopsony power. In addition, both Kroger and Albertsons are highly unionized. Through their collective-bargaining agreements, unions exercise monopoly power in labor negotiations that likely counterbalances any attempted exercise of monopsony power by the merged firm.

Lastly, some critics of the merger have speculated that the merged company may have and exercise monopsony power among its food and grocery suppliers (e.g., wholesalers and small manufacturers). In particular, critics invoke a concept colloquially called the “waterbed effect,” where pushing input prices down for some retailers ends up raising the price for other retailers. Why prices are “pushed” down is not always clear in popular discussions, nor is it clear that it qualifies as an antitrust harm in any way. Being the easiest trading partner would also result in lower prices.

We conclude this may be the weakest argument raised in opposition to the merger. The United Kingdom has evaluated “waterbed effect” allegations in at least two supermarket mergers and found no evidence indicating any anticipated effects from the mergers on input prices that would harm consumers.[30] More importantly, much of the discussion of waterbed effects focuses on harm to competing retailers, rather than to consumers. At least one U.S. court has rejected waterbed-effect claims on the grounds that (1) the plaintiffs did not demonstrate any harm to consumers, and (2) firms can substitute to other suppliers, thereby mitigating any anticipated waterbed effect.[31]

Given the size of a merged Kroger and Albertsons, it would be easy, but naïve, to conclude that the merger should be blocked.[32] The retail food and grocery market has changed substantially since the last time a supermarket merger was challenged in court. If the merger goes to trial, the court will address issues that have not been litigated in decades, if ever. Depending how the court rules, the market definition for future supermarket mergers may be substantially revised. Moreover, if the FTC attempts to litigate allegations of labor-market or input-market monopsony, the agency runs the risk of a humiliating loss that could stymie future attempts to expand the role of monopsony in competition enforcement and policy.

II.     The Agencies Are Trying to Rewrite Merger-Review Standards

The recently published FTC-DOJ draft merger guidelines are a particularly notable backdrop for the Kroger/Albertsons merger, leading many commentators to expect the FTC to take a hardline stance on the deal.[33] Merger case law, however, has not changed much in recent years. Given the merging parties’ apparent willingness to litigate the case, if necessary, the likelihood of a protracted legal battle appears to be high. As we explain below, at least at first sight, any case against the merger would be largely built on sand, and the commission’s chances of succeeding in court appear slim.

The Clayton Act of 1914 grants the U.S. government authority to review and challenge mergers that may substantially lessen competition. The FTC and DOJ are the two antitrust agencies that share responsibility to enforce this law. Traditionally, the FTC investigates retail mergers, while the DOJ oversees other sectors, such as telecommunications, banking, and transportation.

Before the FTC and DOJ officials appointed by the current administration came into office, the settled practice was for the antitrust agencies to follow the 2010 Horizontal Merger Guidelines, which outline the analytical framework and evidence they use to evaluate mergers. The 2010 guidelines describe four major steps of merger analysis:

1. The first step is to define the relevant product and geographic markets affected by the merger. The goal is to identify the set of products and regions that are close substitutes to the merging parties’ products and regions.
2. The second step is to assess the merger’s competitive effects, or how the merger may harm competition in the defined markets.
3. The third step is to examine the role of market entry as a potential counterbalance to the merger’s competitive effects. For entry to be sufficient to deter or undo the anticompetitive effects of a merger, it must be timely, likely, and sufficient in scale and scope.
4. The fourth and final step is to evaluate the efficiencies the merger would generate, or how the merger may benefit consumers by reducing costs and improving quality.

The antitrust agencies weigh all these factors to determine whether a merger is likely to harm competition and consumers. If they find that a merger raises significant competitive concerns, they may seek to block it or require remedies such as divestitures or behavioral commitments from the merging parties.

Several factors, however, suggest that authorities are unlikely to follow this measured approach when reviewing the Kroger/Albertsons merger. Primarily, the FTC and DOJ have recently issued draft revised merger guidelines. The 2023 guidelines have not yet been adopted, although the public comment period is closed. Compared to the previous iteration, which guided recent consent decrees, the new guidelines contain more stringent structural presumptions—that is, a presumption that a merger that merely increases concentration (as all horizontal mergers do) by a certain amount violates the law, rather than deferring to more nuanced economic analysis connecting specific market attributes to a likelihood of actual consumer harm.[34] These new, more stringent structural presumptions are not justified by new economic learnings about the economic effects of concentration. As now-FTC Bureau of Economics Director Aviv Nevo and colleagues wrote in 2022 (just before he joined the commission):

If the agencies were to substantially change the presumption thresholds, they would also need to persuade courts that the new thresholds were at the right level. Is the evidence there to do so? The existing body of research on this question is, today, thin and mostly based on individual case studies in a handful of industries. Our reading of the literature is that it is not clear and persuasive enough, at this point in time, to support a substantially different threshold that will be applied across the board to all industries and market conditions.[35]

Although elements of Nevo and coauthors’ proposed framework are present in the new proposed guidelines, the guidelines also incorporate new language that reflects a persistent thumb on the scale, systematically undermining merging parties’ ability to justify their merger. For example, while a presumption of harm is triggered at a certain level of concentration (an HHI of 1800), in markets where there has previously been consolidation (over an unspecified timeframe), an impermissible “trend [toward concentration] can be established by… a steadily increasing HHI [that] exceeds 1,000 and rises toward 1,800.”[36] Traditionally, an HHI under 1500 would be considered “unconcentrated” and presumed to raise no competitive concerns.[37]

While the FTC will likely point to the renewed focus on concentration measures as capturing the Clayton Act’s focus on lessening competition and the tendency to create a monopoly, the draft guidelines make clear that commission now views concentration as problematic in itself, regardless of whether it lessens competition. For example, the draft guidelines state “efficiencies are not cognizable if they will accelerate a trend toward concentration.”[38] Such a statement effectively negates any efficiency defense available to all but the very smallest firms. Efficiencies will almost always increase concentration—especially if those efficiencies come from economies of scale. If a merger creates efficiencies, the merged firm can lower costs, cut prices, and attract more customers. Attracting more customers with better products and prices will likely increase competition.

The economic evidence is quite strong that efficiency increases concentration.[39] If no efficiency defense is possible, any horizontal merger could accelerate a trend toward concentration (if it had been previously becoming more concentrated). Spinning in these circles is why the notion of a “trend” toward concentration raising particular concern hasn’t been reflected in guidelines since 1968,[40] and reached its apotheosis in Von’s Grocery in 1966[41]—one of the most thoroughly reviled merger cases in U.S. history.[42]

Before updating the merger guidelines, the FTC had already started to tighten its merger-enforcement policy. Among other actions, the agency brought high-profile cases against the Illumina/GRAIL, Meta/Within, and Microsoft/Activision Blizzard deals.[43] So far, all three challenges have resulted in defeat for the FTC in adjudication. Taken together, these cases suggest the agency is willing to push the law beyond its limits in an attempt to limit corporate consolidation, whatever the actual competitive effect. The courts have thus far shown themselves unwilling to buy the agencies more speculative claims of harm. In contrast, the DOJ recently was able to block Penguin-Random House from merging with Simon & Schuster.[44] On the surface, this may seem like a novel case similar to those the FTC has been pursuing; it involved monopsony power against authors. But in this case, the parties agreed that, if there was harm to the authors, there would be fewer books, thereby harming consumers.[45] Fighting over harms to consumers (not concentration) is textbook antitrust litigation.[46]

Finally, the FTC’s leadership has been particularly bearish about the potential consumer benefits of corporate mergers and acquisitions. This inclination is reflected in Chair Khan’s assertion that the Clayton Act embodies a “broad mandate aimed at prohibiting mergers even when they do not constitute monopolization and even when their tendency to lessen competition is not certain.”[47] One way to prohibit mergers is to make them more costly without even going to court. This is what will happen under the agencies’ proposed changes to the premerger notification rules (“Hart-Scott-Rodino Act”).[48] Despite no evidence presented of anticompetitive mergers slipping through the cracks due to the current reporting being too lax, the revised guidelines would greatly increase the cost of merging, thereby reducing the number of mergers.

Even the FTC estimates a massive increase in compliance costs of approximately $350 million, to more than $470 million per year. But that estimate is likely a serious underestimate, as it is based on, among other things, an unscientific “estimate” of the time involved and a dated assumption about the average hourly costs imposed on filers’ senior executives and firms’ counsel.

A survey that the U.S. Chamber of Commerce conducted of 70 antitrust practitioners about the proposed HSR revisions found that the new rules would increase compliance costs by $1.66 billion, almost five times the FTC’s $350 million estimate.”[49] While this general approach to blocking more mergers will not be directly applicable in any particular case, it highlights the FTC’s willingness to not follow “the old rules.”

All of these factors—in concert with the merging parties’ claim that they are prepared to go to court if the FTC decides to block the transaction outright[50]—suggest that there is a particularly high likelihood that the Kroger/Albertsons merger will be challenged and litigated, rather than approved, or challenged and settled.

For the reasons outlined in the following sections, however, the FTC is unlikely to prevail in court. The market overlaps between the merging parties are few and can be resolved by relatively straightforward divestiture remedies, as already proposed by the parties—which, even if disfavored by the agency, are routinely accepted by courts. Likewise, the FTC’s likely market definition and potential theories of harm pertaining to labor monopsony and purchasing power more generally appear speculative at best. The upshot is that the FTC’s desire to bring tougher merger enforcement appears to be on a collision course with the law as it is currently enforced by U.S. courts.

III.   The Relevant Market Is Broader Than Hyper-Local Supermarkets

The retail food and grocery landscape has changed dramatically since the last litigated supermarket merger. Consumer-shopping behavior has shifted toward more frequent shopping trips across a wide variety of formats, which include warehouse clubs (e.g., Costco); e-commerce (e.g., Amazon); online-delivery platforms (e.g., Instacart); limited-assortment stores (e.g., Trader Joe’s and Aldi); natural and organic markets (e.g., Whole Foods); and ethnic-specialty stores (e.g., H Mart); in addition to traditional supermarkets. Because of these enormous changes, the market definition assumed in previous FTC consent orders likely will be—and should be—challenged, given the empirical evidence.

A.     Recent Trends in Retailing Have Upended the ‘Traditional’ Grocery Market Definition

The FTC is likely to find the relevant product market to be supermarkets, which the agency has previously defined as retail stores that enable consumers to purchase all of their weekly food and grocery requirements during a single shopping visit. This product-market definition has remained mostly unchanged for at least a quarter of a century. In both the Albertsons/Safeway merger and the Ahold/Delhaize merger, consent orders between the FTC and the merging parties defined the relevant market to be “the retail sale of food and other grocery products in supermarkets.”[51] The orders defined supermarkets as “full-line grocery stores” that provide “one-stop shopping” that enables consumers “to shop in a single store for all of their food and grocery needs.”[52]

On the one hand, the consent orders’ product-market definitions included supermarkets located within hypermarkets, such as Walmart supercenters. Hypermarkets sell both products that are not typically sold in traditional supermarkets, as well as a sufficient range of food and grocery products such that consumers can “purchase all of their weekly grocery requirements in a single shopping visit.”[53]

On the other hand, the consent orders excluded club stores—such as Costco, Sam’s Club, and BJ’s Wholesale Club—as well as “hard discounters, limited assortment stores, natural and organic markets, [and] ethnic specialty stores.”[54] The orders claim that these stores are excluded from the relevant product market because “they offer a more limited range of products and services than supermarkets and because they appeal to a distinct customer type.”[55] In addition, the orders indicate that “supermarkets do not view them as providing as significant or close competition as traditional supermarkets.”[56] Prior consent orders omitted any discussion of whether online retailers or delivery services should be included or excluded from the relevant market. This product-market definition has remained mostly unchanged—and mostly unchallenged—since the Ahold/Giant merger a quarter-century ago.[57]

Figure 1 shows that retail sales by supermarkets, warehouse clubs, supercenters, and other grocery stores have been relatively stable at 5-6% of U.S. gross domestic product (GDP).[58] Figure 2 shows that supermarkets’ share of retail sales dropped sharply from the early 1990s through the mid-2000s, with that share shifting to warehouse clubs and supercenters. These figures are consistent with the conclusion that warehouse clubs and supercenters successfully compete against traditional grocery stores. Indeed, it would be reasonable to conclude that the rise of warehouse clubs and supercenters at the expense of traditional supermarkets is one of the most significant long-run trends in retail.

The retail food and grocery industry has changed dramatically. In particular, a great deal of attention has been paid to consolidation in the industry. Lina Khan & Sandeep Vaheesan, for example, note that “[t]he share of groceries sold by the four biggest food retailers more than doubled between 1997 and 2009, from seventeen percent in 1994 to twenty-eight percent in 1999 and thirty-four percent in 2004.”[59]

Below, we note that the average consumer shops for food and groceries more than once a week and shops at more than one retail format in a given week. Competition in groceries is not just between supermarkets. While Khan & Vaheesan recognize that supermarkets started to compete with warehouse clubs and supercenters, they fail to update their market definition to reflect that competition.[60] Over the period of increasing concentration within groceries, warehouse clubs and supercenters were steadily eroding supermarkets’ share of retail sales.

Figure 2 shows that, in 1994, supermarkets accounted for 81% of retail sales, which fell to 61% by 2004.[61] Over the same period warehouse clubs and supercenters grew from 14% of retail sales to 35%. In 2021, supermarkets accounted for 56% of retail sales and warehouse clubs and supercenters accounted for 42%. Since the Ahold/Giant merger in 1998, warehouse clubs and supercenters have doubled their share of retail sales, while supermarkets’ share has dropped by more than 25%.[62] Put simply, the four largest supermarket retailers were occupying a larger share of a shrinking segment.

Based on these observations, the product-market definition that the FTC has employed in its consent orders over the past more than two decades is likely to be—and should be—challenged to include warehouse clubs, in addition to accounting for online retail and delivery.

B.     The Once-a-Week Shopper Is No Longer the Norm

In the past, the FTC has specified that, for a firm to be in the relevant market of “supermarkets,” it must be able to “enable[e] consumers to purchase substantially all of their weekly food and grocery shopping requirements in a single shopping visit.”[63] This definition suffers from several deficiencies.

The first deficiency is that this hypothetical consumer behavior is at odds with how many or most consumers behave today.

• Surveys conducted by the Food Marketing Institute and The Hartman Group report the average shopper makes 1.6 weekly trips to buy groceries.[64]
• Earlier research by FMI and Hartman find, in addition, other household members take another 0.6 trips, implying that the total number of trips per household each week is about 2.2, or approximately one trip every three days.[65]
• Surveys conducted by Drive Research show the average household makes an average of 8.1 grocery shopping trips a month, or around two trips a week F(Table 1).[66]

There is no evidence that consumers view retailers that provide one-stop shopping for an entire week’s food and grocery needs as distinct from other retailers who provide food and groceries. In fact, evidence suggests that many consumers “multi-home” across several different retail categories.

• Survey data published by Drive Research indicate that many households spread their shopping across grocery stores, mass merchants, warehouse clubs, independent grocery stores, natural and specialty grocery stores, dollar stores, and online retailers (Table 1).[67]
• Acosta, a sales and marketing consulting firm, reports that 76% of consumers shop at more than one retailer a week and about one third “retail hop” among three or more retailers a week for groceries and staples.[68]
• Research from the University of Florida found that, in 2017, an average consumer visited 3.2 to 4.3 different formats of food outlets a month, depending on income level.[69]
• Survey results from PYMNTS, a data-analysis firm, demonstrate a significant shift in consumer spending away from traditional supermarkets. For example, in 2020, approximately 98% of consumers who bought at least one common household product each week—“center aisle” products, such as paper towels, cleaning supplies, and canned goods—made the purchase at a grocery store. In 2023, more than a third of consumers (37%) say they purchase none of these products from a traditional grocery store, with online purchases accounting for much of the shift.[70]

Thus, while one-stop weekly food and grocery shopping at single retailers was once typical, the evidence indicates such a phenomenon is much less common today.

C.     Supermarkets Compete with Warehouse Clubs

The FTC’s earlier consent orders provide four reasons to exclude warehouse clubs from the relevant market that includes supermarkets:

1. They offer a “more limited range of products and services” than supermarkets;
2. They “appeal to a distinct customer type” from supermarket customers;
3. Shoppers do not view warehouse clubs as “adequate substitutes for supermarkets;” and
4. Supermarkets do not view warehouse clubs as “significant or close competition,” relative to other supermarkets.[71]

In contrast to these conclusions, there is widespread recognition today that warehouse clubs impose significant competitive pressure on supermarkets.[72]

• The National Academies of Sciences concludes that, over time, the entry and growth of warehouse clubs, superstores, and online retail has “blurred” the distinctions among retail formats.[73] More importantly for merger-review analysis, the National Academies concludes that the retail sector is “highly competitive,” in part because of the entry and growth of warehouse clubs, superstores, and online retail.[74]
• Based on their empirical analysis, Paul Ellickson and coauthors conclude that warehouse clubs are “relevant substitutes” for supermarkets, even when the club stores are outside the geographic area typically used by the FTC in merger reviews.3[75]
• Prior to her appointment as FTC chair, Lina Khan and her coauthor concluded that competition from warehouse clubs “fueled” grocery mergers in the late 1990s.[76]

The FTC’s consent orders note that warehouse clubs offer a “more limited range of products and services” than supermarkets. The orders identify products sold at supermarket as “including, but not limited to, fresh meat, dairy products, frozen foods, beverages, bakery goods, dry groceries, detergents, and health and beauty products.”[77]

The annual reports for Costco, Walmart (which include Sam’s Club), and BJ’s, however, indicate that each company offers the same range of products the FTC consent orders identify as being offered by supermarkets.[78] Indeed, the reports indicate that supermarkets do consider wholesale clubs to be competitors and vice versa. BJ’s annual report goes to great lengths to explain its efforts to compete with supermarkets by offering similar manufacturer-branded products at lower prices.[79] The role of warehouse clubs cannot be assumed or asserted away. Indeed, any identification of the relevant market for retail food and grocery sales should begin with a presumption that warehouse clubs provide competitive pressure, since that is what the economics research finds.

It is true that warehouse stores typically carry fewer stock-keeping units (“SKUs”) than supermarkets. Costco’s annual report indicates the company carries fewer than 4,000 SKUs in its warehouse stores and offers 10,000 to 11,000 SKUs for online purchases.[80] BJ’s annual report says that the company carries “approximately 7,000 core active stock keeping units.”[81] In contrast, the BJ’s report notes, “supermarkets normally carry an average of 40,000 SKUs, and supercenters may stock 100,000 SKUs or more.” But these differences in SKU counts do not in themselves demonstrate fundamental differences in product offerings between the two store formats.[82]

The main difference between the two formats is that warehouse clubs tend to offer a smaller range of sizes and packaging and a smaller variety of brands. For example, Costco notes that many of the products it stocks “are offered for sale in case, carton, or multiple-pack quantities only.”[83] Another difference can be observed in the variety of brands offered. For example, Costco has invested in developing its Costco Wholesale and Kirkland Signature private labels.[84] In contrast, CFRA Research analyst Arun Sundaram observes that Sam’s Club “typically offers a bigger national-brand product selection than its club cohorts.”[85] Such differences are insufficient to exclude wholesale clubs from the relevant market. If warehouse clubs offer similar products, see themselves as competing with supermarkets, and customers view them as substitutes, warehouse clubs must be in the same market.

D.    E-Commerce Has Changed the Food Landscape

In the years since the Ahold/Giant merger in 1998, online shopping and home delivery have grown from niche services serving only 10,000 households nationwide to a landscape where approximately one-in-eight consumers purchase groceries “exclusively” or “mostly” online.[86] This shift has increased competition and innovation in the supermarket industry, as traditional supermarkets have adapted to changing consumer preferences and behaviors by offering more delivery and pickup options, expanding their online assortments, and enhancing their digital capabilities.[87] Some have invested in their own e-commerce platforms and many have partnered with such third-party providers as Instacart, Shipt, and Peapod.[88]

One might surmise that e-commerce simply replaced in-person shopping, but with the same stores competing. This is not what has been observed. E-commerce has also increased competition by bringing in new companies with which traditional stores need to compete (e.g., Amazon) and by increasing the options available to consumers through services like Instacart, which allow for direct price and product comparisons among many stores. Each of these innovations has blurred the lines between brick-and-mortar food and grocery retailers and e-commerce, as well as the lines between supermarkets and other retail formats.

In 2023, more than a third of consumers (37%) say they purchase no center-aisle products (products such as paper towels, cleaning supplies, and canned goods) from a traditional grocery store, with online purchases accounting for much of the shift.[89] The fluidity between supermarkets, grocery stores, and online purchases makes the distinction nearly meaningless.

If a consumer uses Instacart to purchase and deliver groceries from Safeway, is that a supermarket purchase or e-commerce? What if the same consumer uses Instacart to purchase and deliver the same goods from Costco or Target? Does the consumer care which retailer the food and groceries came from when competition is just a click away? Indeed, the National Academies of Sciences concludes it is “often impossible” to distinguish between brick-and-mortar retail sales and e-commerce.[90]

E-commerce and club stores also matter for defining the geographic market. Past FTC consent orders have defined the relevant geographic markets to be areas that range from a two- to ten-mile radius around each of the merging parties’ supermarkets. We conclude that, because club stores have a larger catchment area than supermarkets, it would be reasonable to expand the relevant geographic market in localities where club stores are present.

Combined, the rapid growth of e-commerce and delivery services make distance, traffic patterns, and population density decreasingly relevant in a consumer’s choice of where they purchase food and groceries. Dimitropoulos and coauthors note (1) the presence of warehouse clubs expands the relevant geographic market, (2) online-delivery options expand the geographic market “far away,” and (3) online food and grocery purchases can be delivered from fulfillment centers, as well as from traditional stores.[91]

Because of these observations, the product market-definition that has been employed in the FTC’s consent orders over the past more than two decades is likely to be—and should be—challenged and should be revised to include warehouse clubs and to account for online retail and delivery.

IV.   The Merger Is Unlikely to Increase Labor Monopsony Power

In recent years, there has been an increasing emphasis in antitrust discussions on labor markets and potential harms to workers. The recent draft merger guidelines added an explicit section on mergers that “May Substantially Lessen Competition for Workers or Other Sellers.”[92] Even before the guidelines’ publication, some observers predicted that the FTC was set to push a case on labor competition.[93] While, in theory, antitrust harms can occur in labor markets, just as in product markets, proving that harm is more difficult.

An important fact about the proposed Kroger/Albertsons merger is that both companies have many unionized workers. Around two-thirds of Kroger employees[94] and a majority of Albertsons employees[95] are part of the United Food and Commercial Workers International Union (UFCW), which represents 1.3 million members. Even if the merger would increase labor monopsony power in the absence of unions, the FTC will have to acknowledge the reality of the unions’ own bargaining power.

Delegates of the UFCW unanimously voted to oppose the merger[96] Rather than monopsony power or lower wages, however, the union’s stated reason for their opposition was lack of transparency.[97] While lack of transparency may be problematic for the UFCW members, it does not constitute an antitrust harm. Kroger, for its part, has contended that the merger will benefit employees, citing a commitment to invest an additional $1 billion toward increased wages and expanded benefits, starting from the day the deal closes.[98] Albertsons claims that no store closures or frontline associate layoffs will result from the transaction and that the merger will “secure the long-term future of union jobs by establishing a more competitive alternative to large, non-union retailers.”[99]?As with most announced goals, however, there is no enforcement mechanism for this commitment at present, although one could be litigated.

Rather than relying on proclamations from any of the parties, we need economic analysis of the relevant labor markets, asking the types of questions raised above regarding the output markets. A policy report from Economic Policy Institute estimates that “workers stand to lose over $300 million annually” from the merger,[100] but the report arrives at that estimate by using an estimate of the correlation between concentration (HHI) in labor markets and wages. While academic research may benefit from such an estimate, it is unhelpful in merger analysis. As a long list of prominent antitrust economists recently wrote, “regressions of price on HHI should not be used in merger review… [A] regression of price on the HHI does not recover a causal effect that could inform the likely competitive effects of a merger.”[101]

While HHI regressions are of little practical help in this context, according to standard economic theory, it is possible that the average worker would be harmed for traditional labor-monopsony reasons. It is, however, more difficult to identify anticompetitive labor-market harms than to identify analogous product-market harms. For the product market, if the merger simply enhanced monopoly power without producing efficiency gains, the quantity sold would decrease, either because the merging parties raise prices or because quality declines. A merger that creates monopsony power will necessarily reduce the prices and quantity purchased of inputs like labor and materials. A strong union could counteract a firm’s monopsony power to some extent, by collectively advocating for higher wages, fewer layoffs, and other worker benefits. Indeed, obtaining and exerting labor market power is a union’s raison d’être.

Of course, the presence of a unionized workforce does not render monopsony impossible; unions’ ability to offset the effects of a monopsony or monopoly may also be limited, and monopsony power could increase under a merger, even with unions. Still, the existence of union bargaining power makes any monopsony case more difficult and is an important factor to consider in evaluating a merger’s likely labor-market effects—particularly in this case, given the high rates of union membership at both companies.

Moreover, the FTC needs to be careful with any labor case. For labor markets, a decline in the number of workers employed (which harms the workers) may not be anticompetitive. The reduction in input purchases may be because of efficiency gains.[102] For example, if two merging hospitals integrate their information-technology resources, therefore requiring fewer overlapping workers, the merged firm will employ fewer IT workers. This may even reduce the wages of specialized IT workers, even if the newly merged hospital does not exercise any market power to suppress wages.

The same applies for any inputs from an efficiency-enhancing merger: inputs may decrease. But using fewer inputs is not an antitrust harm. The key point is that monopsony needs to be treated differently than monopoly. The antitrust agencies cannot simply look at the quantity of inputs purchased in the monopsony case as the flip side of the quantity sold in the monopoly case, because the efficiency-enhancing merger can look like the monopsony merger in terms of the level of inputs purchased.

Another difficulty with pursuing a labor monopsony case is that the usual antitrust tools, such as merger simulation, cannot be easily applied to the labor market. Unlike the DOJ’s recent success in blocking Penguin-Random House from merging with Simon & Schuster on grounds that the merger would hurt authors with advances above $250,000,[103] the labor market for most employees of Kroger and Albertsons is much larger than those two companies, or even the largest definition of grocery stores. Indeed, it cannot be narrowed down to a handful of companies.

Any labor case would require showing that the merger would harm workers by reducing their bargaining power. For most workers involved, there are still many potential employers competing. One relevant piece of evidence for this is that press releases Kroger issued during the COVID-19 pandemic highlighted that the company was hiring workers from a wide variety of firms and industries—from hospitality (Marriott International) to restaurants (Waffle House) to food distribution (Sysco).[104] While we are not aware of publicly available data that would more comprehensively illustrated worker flows among different companies, such flows of retail workers into and out of roughly adjacent labor markets makes intuitive sense. As economist Kevin Murphy has explained:

If you look at where people go when they leave a firm or where people come from when they go to the firm, often very diffuse. People go many, many different places. If you look at employer data and you ask where do people go when they leave, often you’ll find no more than 5 percent of them go to any one firm, that they go all over the place. And some go in the same industry. Some go in other industries. Some change occupations. Some don’t. You look at plant closings, where people go. Again, not so often a big concentration of where they go to. If you look at data on where people are hired from, you see much the same patterns. That’s kind of a much more diffuse nature.[105]

If, as is likely, an overwhelming majority of Kroger’s workers’ next best option (what they would do if a store closed) was not an Albertsons store, but something completely outside of the market for grocery-store labor (or even outside the retail-food industry more broadly), the merger would not take away those workers’ next best option. If true, the merger cannot be said to increase labor monopsony power to the extent necessary to justify blocking a merger.

V.     ‘Waterbed Effects’ Are Highly Speculative

One potential antitrust harm that has been discussed frequently in recent years is the so-called “waterbed effect,” in which “a large and powerful firm improves its own terms of supply by exercising its bargaining power, [but] the terms of its competitors can deteriorate sufficiently so as ultimately to increase average retail prices and, thereby, reduce total consumer surplus.”[106] The waterbed effect is not unique to mergers, but can apply any time there is differential buyer-market power. The firm with more market power gets a better deal from suppliers and its competitors are ostensibly harmed because they cannot get the same deal. Long before the proposed merger, but still in the context of retail, people were speculating about a waterbed effect regarding Walmart.[107]

In the context of the Kroger/Albertsons merger, critics have again raised the possibility of a waterbed effect. Michael Needler Jr.—the president and chief executive of Fresh Encounter, a chain of 98 grocery stores based in Findlay, Ohio—raised the possibility in a U.S. Senate hearing on the merger.[108] He was also quoted by The New York Times as saying:

When the large power buyers demand full orders, on time and at the lowest cost, it effectively causes the water-bed effect. They push down, and the consumer packaged goods companies have no option but to supply them at their demands, leaving rural stores with higher costs and less availability to products.[109]

In a letter to the FTC, the American Antitrust Institute raised several concerns about the merger, arguing that:

The waterbed effect is likely to worsen with Kroger-Albertsons enhanced buyer power post-merger, with adverse effects on the ability of independent grocers to compete in a tighter oligopoly of large grocery chains.[110]

The implied argument in this version of the waterbed effect goes as follows: A merged Kroger and Albertsons would have additional market power over some of its suppliers. It could then exercise that market power to extract discounts from those suppliers, which would be unavailable to its competitors. The merged firm could then pass those cost savings on to consumers in the form of lower retail prices, thereby increasing Kroger/Albertsons’ sales. Some of these sales would come at the expense of smaller competitors, who could no longer compete on price. And because of these reduced sales, they would purchase less from their suppliers, further eroding their bargaining power with suppliers. Ultimately, consumers of the smaller retailers may face higher retail prices. Thus, under this theory, consumers of the merged firm would pay lower retail prices, while consumers of the smaller retailers would pay more.

Even if all of that were true, however, what remains unknown (and unaddressed under this argument) is whether consumers as a whole would be better or worse off. That, of course, is precisely the result that would be required to establish harm under antitrust law.

Roman Inderst & Tommaso Valletti are credited with the first formal theoretical model of a waterbed effect and how it could potentially harm consumers as a whole (as opposed to merely certain competitors or the subset of consumers who continue to buy from them).[111] In order to establish consumer harm under their model, three key assumptions must be met:

1. Retailers buy their inputs from a supplier who can price discriminate among retailers;
2. Retailers can access an alternative source of supply, but must incur a fixed switching cost, which is the same across all retailers; and
3. Retailers compete on price.

Because a larger retailer can spread the fixed switching costs across more units, its per-unit costs will be lower. This provides the larger retailer with a better bargaining position with its suppliers to extract lower input prices. If the large retailer reduces its prices to consumers, the reduced sales to smaller competing retailers results in those competitors having higher per-unit switching costs, thus reducing their ability to change suppliers, reducing their bargaining power with the initial supplier, and increasing the price they pay to the supplier for inputs.

While the model shows how the effect is possible and that it could harm consumers, it does not imply that the waterbed effect necessarily harms consumers. In fact, the same waterbed effect would also occur if a merger generated efficiency gains (as the authors point out), but with considerably different welfare and antitrust implications. Setting aside mergers, in Inderst & Valletti’s model, if one firm discovers a cheaper importer, for example, it would give that firm more buyer power, because it presents a more credible threat of leaving for a competitor. Recognizing that the firm has a better “outside option,” the wholesaler offers better terms. This, too, generates a waterbed effect, but it is clearly pro-competitive, as it would help consumers. Unless we are willing to declare finding another source of supply to be anticompetitive, we should be hesitant about jumping to the conclusion that the waterbed effect is anticompetitive.

Inderst & Valletti’s model also demonstrates that, with relatively low supplier-switching costs, the supplier has little scope to price discriminate among retailers. As a result, “any further growth of the large buyer… will reduce all retail prices.”[112] This is true even in the presence of a waterbed effect. Thus, for a waterbed effect to result in higher average retail prices for consumers, the large retailer’s buying advantage must be “sufficiently larger in size,” and smaller retailers must face much high switching costs, with those switching costs serving as the reason why the supplier can effectively price discriminate across the retailers.[113] For many products, this simply won’t be the case.

A competition authority that pursued a waterbed theory to block a merger must first demonstrate that a waterbed effect exists. Because each product sold in a food and grocery retailer may have its own idiosyncratic manufacturing, wholesale, and distribution characteristics, this evaluation likely must be conducted on a product-by-product basis. Then, for each market, the authority must evaluate the suppliers’ abilities to price discriminate (which could raise additional antitrust issues). Last, the authority must evaluate competing firms’ anticipated price response to any identified waterbed effect. While Inderst & Valletti provide a seemingly straightforward theoretical approach to evaluating allegations of a waterbed effect, applying their model to the real world of food and grocery mergers would likely amount to a costly and time-consuming wild goose chase.

That is likely why finding empirical demonstration of a waterbed effect has been so elusive. Indeed, we are not aware of any empirical literature indicating the existence of a waterbed effect in retail markets, let alone any evidence of consumer harms from such an effect.[114] Indeed, UK competition authorities have been unconvinced of any waterbed effects in the food and grocery mergers in which the issue has been raised. In 2006, the UK Office of Fair Trading concluded:

[T]here are theoretical questions that would need to be resolved before concluding that the price differentials observed are evidence of a waterbed effect. For example, it is not clear how suppliers would be able to charge significantly above cost to smaller retailers without rivals undercutting them in the market; similarly, it is not clear why suppliers would price persistently below cost to the large supermarkets.[115]

In the United States, only one district court has issued an opinion on the waterbed effect. In DeHoog, consumers sued to block AB InBev’s acquisition of SABMiller.[116] The consumers alleged that the merged firm would be a “powerful buyer” that “demands lower prices or other concessions from its suppliers, causing the supplier to, in turn, increase prices to smaller buyers.” The district court rejected the consumers’ waterbed claim because (1) the alleged harm was to competing brewers, not to consumers, and (2) competing brewers could switch to different hops, thereby avoiding any waterbed effect.

DeHoog highlights the high hurdles an antitrust authority or private plaintiff would need to clear in order to successfully allege a waterbed effect. Challengers must demonstrate that switching costs are insurmountably high and that a waterbed effect exists. They must demonstrate then that the waterbed effect harms consumers, rather than competitors.

Demonstrating a waterbed effect in the Kroger/Albertsons merger may be especially challenging. Although the notion has been invoked by several critics of the merger, we are not aware of any specific product or product category in which a potential waterbed effect has been alleged.[117] If the FTC chooses to pursue the waterbed-effect theory, it must identify the relevant products that would be subject to the effect and demonstrate the anticipated consumer harm associated with it. If the agency relies on the waterbed effect in an effort to block the Kroger/Albertsons merger, then it would be reasonable to conclude that its “traditional” claims of horizontal market power are especially weak.

VI.   Remedies Can Resolve Any Remaining Competitive Concerns

While the above sections argue that the FTC will (and should) have a hard time making a case that the Kroger/Albertsons merger is overall anticompetitive, there may be some specific geographic markets where concerns remain. In the face of such concerns, the FTC historically has allowed most supermarket transactions to proceed with divestitures, such as Ahold/Delhaize (81 stores divested), Albertsons/Safeway (168 stores), and Price Chopper/Tops (12 stores).[118] The extent of the remedies sought depends on the extent of post-merger competition in the relevant markets, as well as the likelihood of entry by additional competitors.[119] Dimitropoulos and coauthors have noted that most divestitures required by consent orders in recent supermarket mergers have occurred in geographic markets with fewer than five remaining competitors.[120]

There is good reason (and a long history of examples in previous grocery-merger settlements) to think that targeted divestitures in certain markets—as have been proposed from the start of this process by the merging parties[121]—should be sufficient to address any geographic-market-specific concerns that may arise.

One reason that divestiture—instead of outright blocking—should be appropriate in this case is that the vast majority of Kroger and Albertsons stores are in geographic markets where the other is not located (Figure 3). As such, there is no antitrust concerns from a product-market perspective. The merger does not affect competition in the South (where Kroger is focused) or in the Northeast (where Albertsons is focused). In these regions, the merger generates all of the efficiencies without the possible downside of a loss to competition.

In some other geographic locations, however, the companies do currently compete, and antitrust concerns could therefore arise. This is where divestiture comes in. By most measures, there appear to be some 1,400 overlapping stores; resolving this overlap entails divestiture of no more than 700, or 14% of the two companies’ more than 5,000 stores.[122] By the same token, only a limited number of geographic markets have Kroger and Albertsons stores in close proximity, suggesting that targeted divestitures could address those concerns, while allowing the merger to proceed unimpeded in the great majority of markets.[123]

Previous remedies sought by the FTC in merger cases have generally been successful in achieving their goals. The FTC’s most recent merger-remedies study, covering 89 orders from 2006-2012, provides additional support for the feasibility of divestitures as an effective remedy.[124] The study found that the vast majority of divestitures succeeded in maintaining competition in the affected markets. All remedies involving divestiture of an ongoing business were successful. Divestitures of more limited “selected assets” also largely succeeded, although at a lower rate. Overall, the FTC concluded that more than 80% of the orders examined achieved the goal of maintaining or restoring competition post-merger.[125]

Nonetheless, despite a long history of divestitures serving as an appropriate and adequate remedy in food-retail mergers, some advocates for stronger antitrust are extremely skeptical of divestiture remedies. As authors from the American Economic Liberties Project and the Open Markets Institute put it in one recent article:

It should not fall on our overburdened antitrust enforcers to pore over the individual assets changing hands in service of coming up with a carve-out that somehow brings a merger into technical compliance with an arbitrary Reaganite standard devised by bad-faith ideologues.[126]

Such concerns are leveled at the grocery industry, in particular, with critics consistently pointing to the Albertsons/Safeway merger divestitures to Haggen as evidence that, in this industry (if not elsewhere), divestiture is no longer an appropriate merger remedy.[127] But these arguments ring hollow. Several factors idiosyncratic to Haggen and its acquisition strategy led to that divestiture’s failure.

A.     Distinguishing the 2014 Haggen Divestiture

In 2014, the parent company of Albertsons announced plans to purchase rival food and grocery chain Safeway for $9.4 billion.[128] Prior to the merger, Albertsons was the fifth-largest grocer in the United States and operated approximately 1,075 supermarkets in 29 U.S. states. At the time, Safeway was the second-largest and operated more than 1,300 stores nationwide.[129] During its merger review, the FTC identified 130 local markets in Western and Midwestern states where it alleged the merger would be anticompetitive.[130] In response, Albertsons and Safeway agreed to divest 168 supermarkets in those geographic markets.[131] Haggen Holdings LLC was the largest buyer of the divested stores, acquiring 146 Albertsons and Safeway stores in Arizona, California, Nevada, Oregon, and Washington.

Following the acquisition, Haggen almost immediately encountered numerous problems at the converted stores. Consumers complained of high prices, and sales plummeted at some stores. The company struggled and began selling some of its stores. Less than a year after the FTC announced the divestiture agreement, Haggen filed for bankruptcy. Following the bankruptcy, Albertsons bought back 33 of the stores it had divested in its merger with Safeway.

In retrospect, Haggen may not have been an appropriate buyer for the divested stores. Before acquiring the divested stores, Haggen was a small regional chain with only 18 stores, mostly in Washington State. The acquisition represented a tenfold increase in the number of stores the company would operate. While Haggen was once an independent, family-owned firm, at the time of the acquisition, the company was owned by a private investment firm that used a sale-leaseback scheme to finance the purchase. Christopher Wetzel notes that Haggen failed to invest sufficiently in the marketing necessary to create brand awareness in regions where Haggen had not previously operated.[132] Such issues would need to be avoided in any future divestitures, and experience shows they can be.

Around the same time that it filed for bankruptcy, Haggen also filed a lawsuit against Albertsons in federal district court, arguing that Albertsons engaged in “coordinated and systematic efforts to eliminate competition and Haggen as a viable competitor.”[133] Haggen claimed that Albertsons made false representations to both Haggen and the FTC about its commitment to providing a smooth transition that would allow Haggen to be a viable competitor. Among other allegations, Haggen claimed that Albertsons overstocked the divested stores with perishable meat and produce, provided inaccurate and misleading price information that led to inflated prices, and failed to perform maintenance on stores and equipment.

None of these claims were demonstrated, as the matter settled months after the complaint was filed. Even so, FTC consent orders typically provide asset-maintenance agreements to address the kinds of issues raised by Haggen. David Balto reports that, after the 1995 Schnucks/National merger, the FTC sued Schnucks, alleging that it had violated a provision of the asset-maintenance agreement in the consent order.[134] The suit resulted in a settlement in which Schnucks paid a $3 million civil penalty and was required to divest two additional properties. These two properties were stores that had been closed by Schnucks, but that presumably could be reopened by a new buyer.

The problems with the Haggen divestiture need not be repeated. In particular, there are many companies of various sizes that have the capabilities and desire to expand. In recent merger-consent orders, divested stores have been acquired by both retail supermarkets and wholesalers with retail outlets, including Publix, Supervalu, Big Y, Weis, Associated Wholesale Grocers, Associated Food Stores, and C&S Wholesale Grocers.[135] Several of these companies have successfully expanded—in some cases outside of their “home” territories. For example, Publix is a Florida-based chain that operates nearly 1,350 stores in seven southeastern states.[136] Publix expanded to North Carolina in 2014, Virginia in 2017, and has announced plans to expand into Kentucky this year.[137] Weis Markets is a Pennsylvania-based chain that operates more than 200 stores in seven northeastern states.[138] Last year, the company announced plans to spend more than $150 million on projects, including new retail locations and upgrades to existing facilities.[139] And Rochester, New York-based Wegmans has successfully entered Delaware, Virginia, and the District of Columbia in recent years.[140]

While the relevant product and geographic markets for supermarket mergers has shifted enormously over the past few decades, divestitures remain an appropriate and adequate remedy for any competitive concerns. The FTC has knowledge and experience with divestiture remedies and should have a good understanding of what works. In particular—and, perhaps, unlike in the Haggen example—firms acquiring divested assets should have an adequate cushion of capital, experience with the market conditions in which the stores are located, and the operational and marketing expertise to transition customers through the change.

B.     Proposed C&S Divestiture

As noted, Kroger and Albertsons have contemplated divestitures from the beginning, even including a provision in their merger agreement preemptively agreeing to divest up to 650 stores.[141] More recently, however, the companies have made their divestiture plans more concrete. In September 2023, the companies presented a proposal (both publicly and to the FTC) proposing to divest 413 stores, eight distribution centers, and three store brands to C&S Wholesale Grocers for $1.9 billion.[142] The agreement also allows C&S to purchase up to 237 additional stores if needed to resolve antitrust concerns. C&S also has committed to maintain any existing collective-bargaining agreements with labor unions.[143]

The specific characteristics of the proposed buyer of the divested stores suggests that it is unlikely to fall prey to the limitations that scuttled the Haggen divestiture. Unlike Haggen, the purchasing party here has experience operating more than 160 supermarkets under brands like Grand Union. This existing operation of stores makes C&S better positioned as a buyer than Haggen was when it attempted to rapidly expand from 18 to 168 stores.[144]

While C&S is primarily a wholesaler, its Grand Union retail operations and the transition support offered under the divestiture agreement should position it to successfully operate the divested stores. In that way, the divestiture does not just spin off or increase the size of a horizontal competitor. Rather, the plan jumpstarts greater vertical integration by C&S, whose wholesale operations include the production of private-label products.

Indeed, by enabling C&S to take better advantage of the benefits of vertical integration, the divestiture appears to ensure that C&S will emerge with a structure more in line with the rest of the food-retail market. Over the past decade, many retailers (including Kroger and Albertsons) have shifted toward “bringing private label production in-house.”[145] This move by firms (even without any market power) likely reflects competitive advantages gained from vertical integration.

The targeted nature of the divestiture would allow the merger to proceed in the majority of geographic markets where there are no competitive concerns between Kroger and Albertsons. Divesting stores only where localized overlaps in specific regions exist enables the realization of efficiencies and benefits in the many remaining markets. The FTC will still need to closely scrutinize the buyer and the proposed divestiture package. But the announced plan demonstrates that the merging parties are taking seriously the need for divestitures.

Of course, as with any complex business transaction, there is always some possibility that aspects of a divestiture may not fully go according to plan. The recent piece by Maureen Tkacik & Claire Kelloway throws out many of these possibilities.[146] It’s possible that C&S turns out to not want to run grocery stores but only wants to resell the properties. It’s possible that C&S will be unable to afford the leases. Regulators and merging parties alike operate under inherent uncertainty when predicting competitive outcomes. Antitrust analysis does not deal with certainties, but rather with probabilistic assessments of likely competitive effects.

The relevant question is whether the divestiture is likely to effectively maintain competition in the markets of concern, not whether it can be guaranteed to perfectly do so in all scenarios. When we take more episodes than Haggen’s into account, despite the uncertainty, the FTC’s experience shows that targeted divestitures with an experienced buyer are likely to adequately protect consumers post-merger. The possibility that some unforeseen complication may arise does not negate the high probability that competition will be preserved. Antitrust regulation requires reasonable predictive judgments, acknowledging that business transactions inherently carry risks.

With the FTC’s knowledge of the industry and of its own past successes and failures, divestitures remain an appropriate and adequate remedy for this merger. The parties appear committed to working cooperatively with regulators to craft divestitures that fully resolve competitive concerns. Rather than blocking the deal outright, the FTC can allow the merger to proceed, conditioned on acceptable divestitures that protect consumers, while permitting efficiency gains across the majority of stores.

 

[1] Press Release, Kroger and Albertsons Companies Announce Definitive Merger Agreement, Kroger (Oct. 14, 2022), https://ir.kroger.com/CorporateProfile/press-releases/press-release/2022/Kroger-and-Albertsons-Companies-Announce-Definitive-Merger-Agreement/default.aspx.

[2] In an article written with Sandeep Vaheesan before she became chair of the FTC, Lina Khan expressed disdain for grocery-industry consolidation and deep skepticism of even the best divestiture packages. See Lina Khan & Sandeep Vaheesan, Market Power and Inequality: The Antitrust Counterrevolution and Its Discontents, 11 Harv. L. & Pol’y Rev. 235, 254 (2017) (“Retail consolidation has enabled firms to squeeze their suppliers… and led to worse outcomes for consumers.”) & 289 (“Even if divestitures could be perfectly tailored and if they preserved competition in narrow markets in every instance, they would fail to advance the citizen interest standard.”).

[3] See, e.g., David Dayen, Proposed Kroger-Albertsons Merger Would Create a Grocery Giant, The American Prospect (Oct. 17, 2022), https://prospect.org/power/proposed-kroger-albertsons-merger-would-create-grocery-giant; Richard Smoley, Kroger, Albertsons, and Lina Khan, Blue Book Services (May 2, 2023), https://www.producebluebook.com/2023/05/02/kroger-albertsons-and-lina-khan.

[4] U.S. Dep’t of Justice & Fed. Trade Comm’n, Draft Merger Guidelines (Jul. 19, 2023), available at https://www.justice.gov/d9/2023-07/2023-draft-merger-guidelines_0.pdf. See also Gus Hurwitz & Geoffrey Manne, Antitrust Regulation by Intimidation, Wall St. J. (Jul. 24, 2023), https://www.wsj.com/articles/antitrust-regulation-by-intimidation-khan-kanter-case-law-courts-merger-27f610d9.

[5] Prior to Whole Foods/Wild Oats, the last litigated supermarket merger was the State of California’s 1988 challenge to American Store’s acquisition of Lucky Stores. Several retail mergers have been challenged in court, however, such as Staples/Office Depot in 2015. See Press Release, FTC Challenges Proposed Merger of Staples, Inc. and Office Depot, Inc., Federal Trade Commission (Dec. 7, 2015), https://www.ftc.gov/news-events/news/press-releases/2015/12/ftc-challenges-proposed-merger-staples-inc-office-depot-inc.

[6] This includes approving Albertsons/Safeway (2015), Ahold/Delhaize (2016), and Price Chopper/Tops (2022). See Analysis of Agreement Containing Consent Order to Aid Public Comment, In the Matter of Cerberus Institutional Partners V, L.P., AB Acquisition, LLC, and Safeway Inc. (File No. 141 0108) (Jan. 27, 2015) available at https://www.ftc.gov/system/files/documents/cases/150127cereberusfrn.pdf; Analysis of Agreement Containing Consent Order to Aid Public Comment, In the Matter of Koninklijke Ahold N.V. and Delhaize Group NV/SA (File No. 151-0175) (Jul. 22, 2016), available at https://www.ftc.gov/system/files/documents/cases/160722koninklijkeanalysis.pdf; Analysis of Agreement Containing Consent Order to Aid Public Comment, In the Matter of The Golub Corporation and Tops Markets Corporation (File No. 211-0002, Docket No. C-4753) (Nov. 8, 2021), available at https://www.ftc.gov/system/files/documents/cases/2110002pricechoppertopsaapc.pdf.

[7] Decision and Order, In the Matter of Whole Foods Market, Inc., (Docket No. 9324) (May 28, 2009), available at https://www.ftc.gov/sites/default/files/documents/cases/2009/05/090529wfdo.pdf; FTC v. Whole Foods Market, 548 F.3d 1028 (D.C. Cir. 2008).

[8] Number based on authors’ calculations, using data from 90^th Annual Report, Progressive Grocer (May 2023), https://progressivegrocer.com/crossroads-progressive-grocers-90th-annual-report.

[9] See Draft Merger Guidelines, supra note 4.

[10] FTC v. Meta Platforms Inc., U.S. Dist. LEXIS 29832 (2023); FTC v. Microsoft Corporation et al., No. 23-cv-02880-JSC (N.D. Cal. Jul. 10, 2023), available at https://s3.documentcloud.org/documents/23870711/ftc-v-microsoft-preliminary-injunction-opinion.pdf.

[11] See, e.g., George Kuhn, Grocery Shopping Consumer Segmentation, Drive Research (2002), available at https://www.driveresearch.com/media/4725/final-2022-grocery-segmentation-report.pdf.

[12] See, e.g., In the Matter of Cerberus Institutional Partners, supra note 6, at 3.

[13] Press Release, Kroger and Albertsons Companies Announce Comprehensive Divestiture Plan with C&S Wholesale Grocers, LLC in Connection with Proposed Merger, The Kroger Co. (Sep. 8, 2023), https://www.prnewswire.com/news-releases/kroger-and-albertsons-companies-announce-comprehensive-divestiture-plan-with-cs-wholesale-grocers-llc-in-connection-with-proposed-merger-301921933.html.

[14] Id.

[15] See Press Release, supra note 1.

[16] Progressive Grocer, supra note 8.

[17] Who Are the Top 10 Grocers in the United States?, Foodindustry.com (last visited Oct. 10, 2023), https://www.foodindustry.com/articles/top-10-grocers-in-the-united-states-2019.

[18] Id.

[19] Number based on authors’ calculations, using data from Progressive Grocer Staff, 90^th Annual Report, Progressive Grocer (May 2023), https://progressivegrocer.com/crossroads-progressive-grocers-90th-annual-report.

[20] Kroger, supra note 13.

[21] See Khan & Vaheesan, supra note 2.

[22] See Leah Nylen & Jeannette Neumann, California Preparing Lawsuit to Block Merger of Kroger, Jewel Parent, Bloomberg (Oct. 12, 2023), https://www.chicagobusiness.com/retail/california-preparing-lawsuit-block-kroger-albertsons-deal.

[23] Alexander Coolidge, Report: Kroger CEO Is “Committed to Litigate” If FTC Regulators Fight Albertsons Merger, Cincinnati Enquirer (May 11, 2023), https://www.cincinnati.com/story/money/2023/05/11/kroger-commited-to-litigate-if-ftc-blocks-albertsons-deal/70206692007.

[24] Press Release, FTC Challenges Proposed Merger of Staples, Inc. and Office Depot, Inc., Federal Trade Commission (Dec. 7, 2015), https://www.ftc.gov/news-events/news/press-releases/2015/12/ftc-challenges-proposed-merger-staples-inc-office-depot-inc.

[25] Jesse Greenspan, FTC To Challenge Whole Foods, Wild Oats Merger, Law360 (Jun. 5, 2007), https://www.law360.com/texas/articles/26191/ftc-to-challenge-whole-foods-wild-oats-merger.

[26] State of Cal. v. American Stores Co., 872 F.2d 837 (9^th Cir. 1989) (granting preliminary injunction).

[27] See, e.g., In the Matter of Cerberus Institutional Partners, supra note 6, at 2-3.

[28] See, e.g., Food Marketing Institute & The Hartman Group, Consumers’ Weekly Grocery Shopping Trips in the United States from 2006 to 2022 (Average Weekly Trips per Household), Statista (May 2022), available at https://www.statista.com/statistics/251728/weekly-number-of-us-grocery-shopping-trips-per-household.

[29] See, e.g., In the Matter of Cerberus Institutional Partners, supra note 6, at 3.

[30] Safeway Merger Report, UK Competition Commission (2003), available at https://webarchive.nationalarchives.gov.uk/ukgwa/20120119163858/http:/www.competition-commission.org.uk/inquiries/completed/2003/safeway/index.htm (“Overall, therefore, there is little evidence of an immediate or short-term ‘waterbed’ effect. … [O]ur surveys produced insufficient evidence on this point for us to conclude that any waterbed effect would be exacerbated by any of the mergers.”); Anticipated Merger between J Sainsbury PLC and ASDA Group Ltd: Summary of Final Report, UK Competition & Markets Authority (Apr. 25, 2019), available at https://assets.publishing.service.gov.uk/media/5cc1434ee5274a467a8dd482/Executive_summary.pdf (“Overall, it seems unlikely that many retailers will raise their prices in response to the Merger; and even if some individual retailers do, the overall effect on UK households is unlikely to be negative. On that basis, our finding is that the Merger is unlikely to lead to customer harm through a waterbed effect.”).

[31] DeHoog v. Anheuser-Busch InBev, SA/NV, No. 1:15-CV-02250-CL, 2016 U.S. Dist. LEXIS 137759, at *13-16 (D. Or. July 22, 2016).

[32] Leading to truculent statements like that of California Attorney General Rob Bonta that “[r]ight now, there’s not a lot of reason not to sue [to block the merger].” See Nylen & Neumann, supra note 19.

[33] See, e.g., Dayen, supra note 3; Smoley, id.

[34] For instance, the Herfindahl–Hirschman Index (HHI) at which mergers are deemed problematic has been lowered from 2500 (and a post-merger increase of 200) to 1800 (and a post-merger increase of 100). Likewise, combined market shares of more than 30% are generally deemed problematic under the new guidelines (if a merger also increase the market’s HHI by 100 or more). The revised guidelines also focus more heavily on monopsony and labor-market issues. See Draft Merger Guidelines, supra note 4, at 6-7.

[35] John Asker et al, Comments on the January 2022 DOJ and FTC RFI on Merger Enforcement, available at https://www.regulations.gov/comment/FTC-2022-0003-1847 at 15-16 (emphasis added).

[36] Draft Merger Guidelines, supra note 4, at 21.

[37] See U.S. Dep’t of Justice & Fed. Trade Comm’n, 2010 Horizontal Merger Guidelines (Aug. 19, 2010) at §5.3, available at https://www.justice.gov/atr/horizontal-merger-guidelines-08192010#5c.

[38] Draft Merger Guidelines, supra note 4, at 26.

[39] Chad Syverson, Macroeconomics and Market Power: Context, Implications, and Open Questions 33 J. Econ. Persp. 23, 27 (2019).

[40] See U.S. Dep’t of Justice, Merger Guidelines (1968) at 6-7, available at https://www.justice.gov/archives/atr/1968-merger-guidelines.

[41] United States v. Von’s Grocery Co., 384 U.S. 270 (1966).

[42] See, e.g., Robert H. Bork, The Goals of Antitrust Policy, 57 Am. Econ. Rev. Papers & Proceedings 242 (1967) (“In the Von’s Grocery case a majority of the Supreme Court was willing to outlaw a merger which did not conceivably threaten consumers in order to help preserve small groceries in the Los Angeles area against the superior efficiency of the chains.”).

[43] Supra note 10; FTC v. Illumina, Inc., U.S. Dist. LEXIS 75172 (2021).

[44] United States v. Bertelsmann SE & Co. KGaA, No. CV 21-2886-FYP, 2022 WL 16949715 (D.D.C. Nov. 15, 2022).

[45] Id. (“The defendants do not dispute that if advances are significantly decreased, some authors will not be able to write, resulting in fewer books being published, less variety in the marketplace of ideas, and an inevitable loss of intellectual and creative output.”)

[46] Brian Albrecht, Business as Usual for Antitrust, City Journal (Nov 22, 2022), available at https://www.city-journal.org/article/business-as-usual-for-antitrust.

[47] Lina M. Khan, Rohit Chopra, & Kelly Slaughter, Comm’rs, Fed. Trade Comm’n, Statement on the Withdrawal of the Vertical Merger Guidelines (Sep. 15, 2021) at 3, available at https://www.ftc.gov/system/files/documents/public_statements/1596396/statement_of_chair_lina_m_khan_commissioner_rohit_chopra_and_commissioner_rebecca_kelly_slaughter_on.pdf.

[48] Premerger Notification Rules, 88 Fed. Reg. 42178 (RIN 3084-AB46), proposed Jun. 29, 2023 (to be codified at 16 C.F.R. Parts 801 and 803).

[49] Antitrust Experts Reject FTC/DOJ Changes to Merger Process, U.S. Chamber of Commerce (Sep. 19, 2023), https://www.uschamber.com/finance/antitrust/antitrust-experts-reject-ftc-doj-changes-to-merger-process. The surveyed group was made up seasoned antitrust veterans from across a variety of backgrounds: 80% had been involved in more than 50 mergers and 59% in more than 100.

[50] Supra note 23.

[51] Analysis of Agreement Containing Consent Order to Aid Public Comment, In the Matter of Cerberus Institutional Partners V, L.P., AB Acquisition, LLC, and Safeway Inc. (File No. 141 0108) (Jan. 27, 2015) available at https://www.ftc.gov/system/files/documents/cases/150127cereberusfrn.pdf. Analysis of Agreement Containing Consent Order to Aid Public Comment, In the Matter of Koninklijke Ahold N.V. and Delhaize Group NV/SA (Jul. 22, 2016) (File No. 151-0175) available at https://www.ftc.gov/system/files/documents/cases/160722koninklijkeanalysis.pdf.

[52] In the Matter of Cerberus Institutional Partners, supra note 6, at 2.

[53] In this paper, the terms “hypermarket” and “supercenter” are used synonymously. See Richard Volpe, Annemarie Kuhns, & Ted Jaenicke, Store Formats and Patterns in Household Grocery Purchases, Economic Research Service Economic Information Bulletin No. 167 (Mar. 2017), https://www.ers.usda.gov/webdocs/publications/82929/eib-167.pdf?v=0 (supercenters are also known as hypermarkets or superstores).

[54] In the Matter of Cerberus Institutional Partners, supra note 6, at 3.

[55] Id.

[56] Id.

[57] See In the Matter of Koninklijke Ahold, supra note 6.

[58] Data obtained from: U.S. Census Bureau, Report on Retail Sales and Trends: Annual Retail Trade Survey: 2021, https://www.census.gov/data/tables/2021/econ/arts/annual-report.html.

[59] Khan & Vaheesan, supra note 2, at 255.

[60] Id. (“Grocers sought to bulk up in order to compete with the scale of warehouse clubs and large discount stores, fueling further mergers and leading many local grocers to close….”).

[61] U.S. Census Bureau, supra note 58.

[62] Id.

[63] In the Matter of Cerberus Institutional Partners, supra note 6, at 2.

[64] Food Marketing Institute & The Hartman Group, Consumers’ Weekly Grocery Shopping Trips in the United States from 2006 to 2022 (Average Weekly Trips per Household), Statista (May 2022), available at https://www.statista.com/statistics/251728/weekly-number-of-us-grocery-shopping-trips-per-household.

[65] Michael Browne, Grocery Shopping Has a Hold on Consumers, Study Finds, Supermarket News (Jun. 27, 2018), https://www.supermarketnews.com/issues-trends/grocery-shopping-has-hold-consumers-study-finds.

[66] Kuhn, supra note 11.

[67] Id.

[68] Trip Drivers: Top Influencers Driving Shopper Traffic, Acosta (2017), available at https://acostastorage.blob.core.windows.net/uploads/prod/newsroom/publication_phetw_0rzq.pdf.

[69] Lijun Angelia Chen & Lisa House, US Food Shopper Trends in 2017, Univ. of Fla, IFAS Extension Pub. No. FE1126 (Dec. 7, 2022), https://edis.ifas.ufl.edu/publication/FE1126.

[70] Karen Webster, Consumer Shopping Data Shows Troubling Signs for Grocery Stores’ Future, PYMNTS (Feb. 6, 2023), https://www.pymnts.com/news/retail/2023/consumer-shopping-data-shows-troubling-signs-for-grocery-stores-future.

[71] See, e.g., In the Matter of Cerberus Institutional Partners, supra note 6, at 3.

[72] See Paul B. Ellickson, Paul L.E. Grieco, & Oleksii Khvastunov, Measuring Competition in Spatial Retail, 51 RAND J. Econ. 189 (2020) (“[C]lub stores are able to draw revenue from a significantly larger geographic area than traditional grocers. Hence, club stores are relevant substitutes for grocery stores, even if they are located even several miles away, a fact that could easily be overlooked in an analysis in which stores are simply clustered by geographic market.”).

[73] National Academies of Sciences, Engineering, and Medicine, A Satellite Account to Measure the Retail Transformation: Organizational, Conceptual, and Data Foundations (2021), available at https://www.bls.gov/evaluation/a-satellite-account-to-measure-the-retail-transformation.pdf (“[T]he restructuring that started first with the warehouse clubs and superstores and then moved on to e-commerce has begun to blur the lines between the retail industry and several other sectors….”).

[74] Id. at 25 (“[C]hanges experienced by retail over the past few decades suggest that the sector is highly competitive and is undergoing substantial change and reorganization. As discussed earlier, the changes described involve warehouse clubs and superstores … e-commerce … digital goods, imports, and large firms….”).

[75] Ellickson et al., supra note 72, (“Due to their size and attractiveness for larger purchases, club stores represent strong competitors to grocery stores even, when they are a significant distance away.”).

[76] Khan & Vaheesan, supra note 2, at 255 (“Grocers sought to bulk up in order to compete with the scale of warehouse clubs and large discount stores, fueling further mergers and leading many local grocers to close….”).

[77] See, e.g., In the Matter of Cerberus Institutional Partners, supra note 6, at 2.

[78] Costco Wholesale Corporation, Annual Report (Form 10-K) (Aug. 28, 2022), https://www.sec.gov/ix?doc=/Archives/edgar/data/0000909832/000090983222000021/cost-20220828.htm; BJ’s Wholesale Club Holdings, Inc., Annual Report (Form 10-K) (Mar. 16, 2023), https://www.sec.gov/ix?doc=/Archives/edgar/data/1531152/000153115223000026/bj-20230128.htm; Walmart Inc., Annual Report (Form 10-K) (Mar. 27, 2023), https://www.sec.gov/ix?doc=/Archives/edgar/data/104169/000010416923000020/wmt-20230131.htm.

[79] BJ’s Wholesale Club Holdings, Inc, id.

[80] Costco Wholesale Corporation, id.

[81] BJ’s Wholesale Club Holdings, Inc, id.

[82] Id.

[83] Costco Wholesale Corporation, id.

[84] Id.

[85] Russell Redman, Report: Club Stores Absorbing Grocery Market Share from Supermarkets, Winsight Grocery Business (Apr. 20, 2023), https://www.winsightgrocerybusiness.com/retailers/report-club-stores-absorbing-grocery-market-share-supermarkets.

[86] Hean Tat Keh & Elain Shieh, Online Grocery Retailing: Success Factors and Potential Pitfalls, 44 Bus. Horizons 73 (Jul.-Aug., 2001); Appinio & Spryker, Share of Consumers Purchasing Groceries Online in the United States in 2022, by Channel, Statista (Sep. 2002).

[87] Navigating the Market Headwinds: The State of Grocery Retail 2022, McKinsey & Co. (May 2022), available at https://www.mckinsey.com/~/media/mckinsey/industries/retail/how%20we%20help%20clients/the%20state%20of%20grocery%20retail%202022%20north%20america/mck_state%20of%20grocery%20na_fullreport_v9.pdf.

[88] Id.; Dimitri Dimitropoulos, Renée M. Duplantis, & Loren K. Smith, Trends in Consumer Shopping Behavior and Their Implications for Retail Grocery Merger Reviews, CPI Antitrust Chron. (Dec. 2021), available at https://www.brattle.com/wp-content/uploads/2022/01/Trends-in-Consumer-Shopping-Behavior-and-their-Implications-for-Retail-Grocery-Merger-Review.pdf.

[89] See Webster, supra note 70.

[90] National Academies of Sciences, Engineering, and Medicine, supra note 73 (“As e-commerce has grown in recent years, it has become increasingly difficult to separate out the e-commerce portion of the industry. Most e-commerce could be identified within the nonstore retailer category as of 2013, but e-commerce is becoming so pervasive that it is now not only difficult to clearly identify individual firms as predominantly e-commerce firms, but also often impossible to clearly classify individual retail sales as either e-commerce or not.” citations omitted).

[91] Dimitropoulos, et al., supra note 88 (“Of course, adjustments to geographic market definition likely would need to be factored into the analysis, as club stores tend to have larger catchment areas than traditional grocery stores, and online delivery can reach as far away as can be travelled by truck from a central fulfilment center.”)

[92] Draft Merger Guidelines, supra note 4, at 25-7.

[93] Maeve Sheehey & Dan Papscun, Kroger-Albertsons Merger Tests FTC’s Focus on Labor Competition, Bloomberg Law (Dec. 2, 2022) https://news.bloomberglaw.com/antitrust/kroger-albertsons-merger-tests-ftcs-focus-on-labor-competition.

[94] Kroger Union, UFCW (last accessed Jul. 26, 2023), https://www.ufcw.org/actions/campaign/kroger-union.

[95] Albertsons and Safeway Union, UFCW (last accessed Jul. 26, 2023), https://www.ufcw.org/actions/campaign/albertsons-and-safeway-union.

[96] Press Release, America’s Largest Union of Essential Grocery Workers Announces Opposition to Kroger and Albertsons Merger, UFCW (May 5, 2023), https://www.ufcw.org/press-releases/americas-largest-union-of-essential-grocery-workers-announces-opposition-to-kroger-and-albertsons-merger.

[97] Id. (“Given the lack of transparency and the impact a merger between two of the largest supermarket companies could have on essential workers – and the communities and customers they serve – the UFCW stands united in its opposition to the proposed Kroger and Albertsons merger”).

[98] Press Release, Kroger and Albertsons Companies Announce Definitive Merger Agreement, Kroger (Oct. 14, 2022), https://ir.kroger.com/CorporateProfile/press-releases/press-release/2022/Kroger-and-Albertsons-Companies-Announce-Definitive-Merger-Agreement/default.aspx.

[99] Bill Wilson, Teamsters Union Says ‘No’ to Kroger, Albertsons Merger, Supermarket News (Jun. 13, 2023),  https://www.supermarketnews.com/retail-financial/teamsters-union-says-no-kroger-albertsons-merger.

[100] Ben Zipperer, Kroger-Albertsons Merger Will Harm Grocery Store Worker Wages, Economic Policy Institute (May 1, 2023), https://www.epi.org/publication/kroger-albertsons-merger.

[101] Nathan Miller et al., On the Misuse of Regressions of Price on the HHI in Merger Review, 10 J. Antitrust Enforcement 248 (2022).

[102] See Geoffrey A. Manne, Dirk Auer, Brian C. Albrecht, Eric Fruits & Lazar Radi?, Comments of the International Center for Law and Economics on the DOJ-FTC Request for Information on Merger Enforcement (2022), at 29, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4090844.

[103] See United States v. Bertelsmann SE & Co. KGaA, 1:21-CV-02886, 2022 WL 16949715 (D.D.C. Nov. 15, 2022).

[104] Press Release, The Kroger Family of Companies Provides New Career Opportunities to 100,000 Workers, Kroger (May 14, 2020), https://ir.kroger.com/CorporateProfile/press-releases/press-release/2020/The-Kroger-Family-of-Companies-Provides-New-Career-Opportunities-to-100000-Workers/default.aspx. While the exact job-to-job switches are unknown, at least during the pandemic we know that some workers at non-grocery employers viewed at least some grocery-industry jobs as substitutes.

[105] Transcript of Proceedings at the Public Workshop Held by the Antitrust Division of the United States Department of Justice, U.S. Justice Department (Sep. 23, 2019), available at https://www.justice.gov/atr/page/file/1209071/download.

[106] Roman Inderst & Tommaso M. Valletti, Buyer Power and the ‘Waterbed Effect’ 59 J. Ind. Econ. 1, 2 (2011).

[107] Albert Foer, Mr. Magoo Visits Wal-Mart: Finding the Right Lens for Antitrust, American Antitrust Institute Working Paper No. 06-07, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1103609.

[108] Michael Needler Jr., Senate Hearing on Kroger and Albertsons Grocery Store Chains, at 1:43:00, available at https://www.c-span.org/video/?524439-1/senate-hearing-kroger-albertsons-grocery-store-chains.

[109] Julie Creswell, Kroger-Albertsons Merger Faces Long Road Before Approval, New York Times (Jan. 23, 2023), https://www.nytimes.com/2023/01/23/business/kroger-albertsons-merger.html.

[110] Diana Moss, The American Antitrust Institute to the Honorable Lina M. Khan, American Antitrust Institute (Feb. 7, 2023), available at https://www.antitrustinstitute.org/wp-content/uploads/2023/02/Kroger-Albertsons_Ltr-to-FTC_2.7.23.pdf.

[111] Inderst & Valletti, supra note 106. For a short history of the development of the waterbed model, see Eric Fruits, Sloshing Around with the “Waterbed Effect,” Truth on the Market (Sep. 5, 2023), https://truthonthemarket.com/2023/09/05/sloshing-around-with-the-waterbed-effect.

[112] Inderst & Valletti, supra note 106, at 9.

[113] Id. at 10.

[114] There has been some investigation of the waterbed effect in two-sided markets in telecommunications, but these markets are very different from retail food and grocery. See Christos Genakos & Tommaso Valletti, Testing the “Waterbed” Effect in Mobile Telephony, 9 J. Eur. Econ. Assoc. 1114 (Dec. 2011) (evaluating the effect of cutting mobile-termination fees on mobile-subscription prices).

[115] UK Competition & Markets Authority, supra note 30.

[116] DeHoog v. Anheuser-Busch InBev, supra note 31.

[117] See, e.g., Albert Foer, Mr. Magoo Visits Wal-Mart: Finding the Right Lens for Antitrust, American Antitrust Institute Working Paper No. 06-07 (Nov. 30, 2006), available at https://ssrn.com/abstract=1103609 (alleging a Walmart waterbed effect without identifying any product or product category with the relevant characteristics that would make it subject to the effect).

[118] See In the Matter of Cerberus Institutional Partners, supra note 6; In the Matter of Koninklijke Ahold, id., In the Matter of the Golub Corporation, id.

[119] See Dimitropoulos, et al., supra note 88.

[120] See id.

[121] See, e.g., Abigail Summerville and Anirban Sen, Analysis: Kroger, Albertsons Spin-Off Is Extra Ammunition in Regulatory Battle, Reuters (Oct. 17, 2022), https://www.reuters.com/business/retail-consumer/kroger-albertsons-spin-off-is-extra-ammunition-regulatory-battle-2022-10-17 (“Kroger Co and Albertsons Cos Inc are willing to divest up to 650 supermarket stores to secure regulatory clearance for their $24.6 billion deal….”); Dan Papscun, Kroger-Albertsons Divestiture Bid Aims to Head Off Challenge, Bloomberg Law (Oct. 14, 2022) https://news.bloomberglaw.com/antitrust/kroger-albertsons-divestiture-plan-is-bid-to-deflect-regulators (“The FTC must factor the divestiture proposal in its deal analysis, now that the companies themselves have built it into their own proposal, said Steven Cernak, a Bona Law partner. The companies’ divestiture proposal makes the tie-up ‘a tougher deal for the FTC to challenge,’ Cernak said.”).

[122] See Kroger/Albertsons: Companies Have Overlap of More Than 1,400 Stores; Khan Highly Critical of Failed Supermarket Divestitures, The Capitol Forum (Nov. 2, 2022), https://thecapitolforum.com/kroger-albertsons-companies-have-overlap-of-more-than-1400-stores-khan-highly-critical-of-failed-supermarket-divestitures.

[123] Id.

[124] The FTC’s Merger Remedies 2006-2012: A Report of the Bureaus of Competition and Economics, Fed. Trade Comm’n (Jan. 2017), available at https://www.ftc.gov/system/files/documents/reports/ftcs-merger-remedies-2006-2012-report-bureaus-competition-economics/p143100_ftc_merger_remedies_2006-2012.pdf.

[125] Id. at 2.

[126] Maureen Tkacik & Claire Kelloway, The No Spin-Off Zone, The American Prospect (Oct. 11, 2023), https://prospect.org/power/2023-10-11-no-spin-off-zone-kroger-albertsons-merger/.

[127] See, e.g., Dayen, supra note 3 (“As the Haggen affair makes clear, the whole idea of using conditions to allow high-level mergers and competition simultaneously has been a failure.”). See also Tkacik & Kelloway, id. (“The Kroger-Albertsons merger shows us why regulators need to permanently divest the concept of, well, divesting.”).

[128] Scott Neuman, Grocery Chains Safeway and Albertson’s Announce Merger Deal, The Two Way (Mar. 6, 2014), https://www.npr.org/sections/thetwo-way/2014/03/06/286935900/grocery-chains-safeway-and-albertsons-announce-merger-deal.

[129] See In the Matter of Cerberus Institutional Partners, supra note 6, at 2.

[130] See id., at 3-5.

[131] See id., at 5.

[132] Christopher A. Wetzel, Strict(er) Scrutiny: The Impact of Failed Divestitures on U.S. Merger Remedies, 64 Antitrust Bull. 341 (2019).

[133] Jon Talton, Haggen: What Went Wrong?, Seattle Times (Mar. 15, 2016), https://www.seattletimes.com/business/economy/haggen-what-went-wrong.

[134] David A. Balto, Supermarket Merger Enforcement, 20 J. Pub. Pol’y & Marketing 38 (Spr. 2001).

[135] See In the Matter of Cerberus Institutional Partners, supra note 6; In the Matter of Koninklijke Ahold, id., In the Matter of the Golub Corporation, id.

[136] See Facts and Figures, Publix (last visited Oct. 10, 2023), https://corporate.publix.com/about-publix/company-overview/facts-figures.

[137] See Caroline A., The History of Publix: Entering New States, The Publix Checkout (Jan. 4, 2018), https://blog.publix.com/publix/the-history-of-publix-entering-new-states; Press Release, Publix Breaks Ground on First Kentucky Store and Announces Third Location, Publix (Jun. 23, 2022), https://corporate.publix.com/newsroom/news-stories/publix-breaks-ground-on-first-kentucky-store-and-announces-third-location.

[138] Weis Markets, LinkedIn https://www.linkedin.com/company/weis-markets/about, (last accessed Jul. 26, 2023).

[139] Sam Silverstein, Weis Markets Unveils $150M Expansion and Upgrade Plan, Grocery Dive (May 2, 2022), https://www.grocerydive.com/news/weis-markets-unveils-150m-expansion-and-upgrade-plan/623015.

[140] Russell Redman, Wegmans lines up its next new store locations, Winsight Grocery Business (Dec. 1, 2022) https://www.winsightgrocerybusiness.com/retailers/wegmans-lines-its-next-new-store-locations.

[141] See, e.g., Summerville & Sen, supra note 121.

[142] See Catherine Douglas Moran & Petyon Giora, Mapping Kroger and Albertson’s Store Divestiture Deal with C&S, Grocery Dive (Sept. 12, 2023), https://www.grocerydive.com/news/mapping-kroger-and-albertsons-store-divestiture-deal-with-cs/693186.

[143] Kroger, supra note 13.

[144] Grocery Dive Staff, The Friday Checkout: C&S Would Catapult to Major Retailer Status with Kroger-Albertsons Deal, Grocery Dive (Sept. 8, 2023), available at https://www.grocerydive.com/news/cs-wholesale-grocers-major-grocer-kroger-albertsons-merger-deal/693127.

[145] Catherine Douglas Moran, Why More Grocers Are Bringing Private Label Production In-House, Grocery Dive (June 13, 2023), available at https://www.grocerydive.com/news/grocers-private-label-production-in-house-sales-manufacturing/651986.

[146] Tkacik & Kelloway, supra note 119

tl;dr

Background: The Federal Trade Commission (FTC) and 17 states this month filed a major antitrust complaint against Amazon. The much-anticipated suit comes more than two years after Lina Khan became FTC chair and more than six years since her student note criticizing Amazon’s practices. The complaint describes a broad scheme in which Amazon (1) used various practices to prevent sellers from offering prices at Amazon’s rivals below the level at Amazon (anti-discounting), and (2) conditioned a product’s eligibility for Amazon Prime on whether the seller used Fulfillment by Amazon (FBA). This conduct allegedly violates Section 5 of the FTC Act as an unfair method of competition, Section 2 of the Sherman Act as maintenance of monopoly, and various state laws.

But… It will be difficult for the FTC and the states to prove Amazon’s monopoly power and to discredit the procompetitive justifications for the challenged conduct. Retail competition is robust and the proposed narrow markets are ripe for criticism. Moreover, the challenged conduct is core to Amazon’s offer of important consumer benefits, such as fast and reliable shipping. Whatever remedy the FTC ultimately pursues, it risks undermining the benefits Amazon has created for consumers and sellers alike.

KEY TAKEAWAYS

SEEMINGLY TRADITIONAL THEORIES OF HARM

The complaint relies on two overarching theories of anticompetitive conduct: anti-discounting and conditioning Prime eligibility on a seller using FBA.

The first is reminiscent of a challenge to “most-favored nation” (MFN) provisions, in which a defendant demands terms that are equivalent to or better than those given to its rivals. However, MFNs are agreements typically challenged under Section 1 of the Sherman Act; the FTC doesn’t explicitly claim that Amazon’s unilateral policy constitutes an MFN.

The second theory appears similar to a tying claim. But the FTC doesn’t allege an actual tie between the sale of two distinct products, perhaps because sellers cannot buy the Prime badge; they must qualify for it by meeting the two-day shipping requirement (which FBA ensures).

NARROW RELEVANT MARKETS

Both of the relevant markets put forward in the FTC’s complaint fail to reflect real-world competition.

Amazon allegedly possesses monopoly power in the “online superstore market.” According to the FTC, online “superstores” provide a unique breadth and depth of products and unique services that brick-and-mortar stores and smaller online retailers don’t. Thus the commission alleges that these rivals cannot constrain Amazon’s market power over consumers. 

This alleged market is so narrowly drawn that it appears to include just Amazon, eBay, and the online stores offered by Walmart and Target. This excludes single-brand online retailers, product-category-specific online retailers, and all brick-and-mortar stores. It beggars belief that these rivals don’t exert competitive constraints on Amazon. After all, no consumers shop exclusively online, and price-comparison services like Google Shopping facilitate shopping across all online outlets. This will almost certainly prove to be a sticking point when the case goes to trial.

The FTC also defines a relevant market for “online marketplace services”—i.e., the services needed to sell products online (including access to shoppers, online interface, pricing capabilities, customer reviews). This excludes traditional wholesalers and e-commerce platforms like Shopify that offer software allowing sellers to create their own online stores.

As with the first market, it’s hard to imagine these claims will be borne out by the evidence. Most retail sales still occur offline and manufacturers and brands readily access these outlets. And the recent success of new marketplaces like Shein and Temu—which entered the U.S. market during the FTC’s investigation of Amazon—further undermines both the alleged market and Amazon’s market power.

OVERLOOKING THE BENEFITS OF AMAZON’S CONDUCT

While both unlawful MFNs and unlawful tying would be legitimate theories of harm, both are also vertical restrictions reviewed under the rule of reason, which requires weighing the anticompetitive and procompetitive effects.

The economics literature shows that MFNs can promote efficiency by protecting investments that couldn’t have been recouped without the protections offered by an MFN, such as Amazon’s substantial investment in the infrastructure to deliver products within two days. These provisions can benefit consumers by cutting their search costs and offering retailers incentives to improve the quality of their search and display capabilities.

Economic theory also suggests that it can be cheaper to offer some products together, rather than selling them separately; in some cases, it may be necessary to sell the products together in order to offer the products at all. If Amazon’s FBA services are critical for it to dependably deliver on Prime’s promise of two-day-shipping, then the alleged tying may be procompetitive. 

RESTORING ‘FAIR COMPETITION’

While the FTC’s complaint doesn’t explicitly ask for Amazon to be broken up, it does ask for the court to provide “equitable relief, including but not limited to structural relief, necessary to restore fair competition.” 

It’s anyone’s guess what this means. “Fair competition” isn’t part of U.S. antitrust case law or mainstream economic terminology.

This seemingly innocuous wording may be used to impose the FTC’s idiosyncratic—and nostalgic—vision of online retail on Amazon. Worse, it may be a euphemism for breaking up the company.

 

Dear Chairman Sanders, Ranking Member Cassidy, Chairman Smith, and Ranking Member Neal:

As former judges, former government officials, and scholars who are experts in patent law, healthcare policy, or both, we write to express our concerns about lobbying efforts for the government to impose price controls on patented drugs. Some activists and academics have written to Congress and to agency officials arguing that existing laws are “tools” for the government to impose price controls on patented drugs to lower drug prices.[1] Their arguments mischaracterize these statutes by inaccurately claiming that Congress has endorsed the imposition of price controls on patented drugs. It has not.

Drug pricing presents a multi-dimensional policy issue because the U.S. healthcare system comprises a complex, intermingled system of federal and state laws and regulations, as well as a myriad of equally complex and intermingled set of public and private institutions. Yet, activists and others inaccurately reduce the causes of drug prices to a single issue: patents. They argue that the federal government can “lower drug prices by breaking patent barriers,”[2] and they claim that two statutes can be used to achieve this policy goal: the Bayh-Dole Act and 28 U.S.C. § 1498.

Neither the Bayh-Dole Act nor § 1498 are price-control statutes, and thus they do not authorize the federal government to impose price controls on patents. This is clear by their plain legal text, as well as by their consistent interpretation by courts and agencies. The Bayh-Dole Act promotes the commercialization of patented inventions that may result from government funding of research, and § 1498 secures patent-owners in obtaining compensation for unauthorized uses of their property rights by the government. Neither law says anything about drug prices. If the government used either law to impose price controls on patented drugs, this would conflict with the clear purpose of these statutes. It would also represent an unprecedented and fundamental change in U.S. patent law. From 1790 through the twentieth century, Congress rejected bills that would impose compulsory licensing on patents.[3] The calls to use the Bayh-Dole Act or § 1498 for similar purposes fundamentally are at odds with these statutes and threaten to undermine the U.S. patent system’s historic success as a driver of U.S. global leadership in biopharmaceutical innovation.

This letter explains why neither the Bayh-Dole Act nor § 1498 can be used to break patents to impose price controls on drugs. First, it sets forth the proven success of the patent system as a driver of innovation in healthcare, which is the framework to evaluate the argument to “lower drug prices by breaking patent barriers.”[4] This argument threatens to undermine the legal system that has saved lives and improved everyone’s quality of life. It then describes the Bayh-Dole Act and § 1498, explaining how neither authorizes price controls on patented drugs. The policy argument seeking to impose price controls on drugs contradicts the clear text and purpose of these statutes.

Read the full letter here.

[1] See Letter to Senator Elizabeth Warren from Amy Kapczynski, Aaron S. Kesselheim, et al., at 1 (Apr. 20, 2022), https://tinyurl.com/yt62wt4t. Professor Kapczynski and Professor Kesselheim are the co-authors of this letter, which is based on their articles, and thus this letter is identified as the “Kapczynski-Kesselheim Letter.”

[2] Id. at 8

[3] See, e.g., Bruce W. Bugbee, Genesis of American Patent and Copyright Law 143-44 (1967) (discussing the rejection of a Senate proposal for a compulsory licensing requirement in the bill that eventually became the Patent Act of 1790); Kali Murray, Constitutional Patent Law: Principles and Institutions, 93 Nebraska Law Review 901, 935-37 (2015) (discussing 1912 bill that imposed compulsory licensing on patent owners who are not manufacturing a patented invention, which received twenty-seven days of hearings, but was not enacted into law).

[4] Kapczynski-Kesselheim Letter, supra note 1, at 8.