The chapter examines the recent rise in prominence of margin squeeze cases. In particular, focusing on when margin squeeze arises, important case law and issues that still remain unresolved in this area.
Paolo Palmigiano and Beatrice Roxburgh, British Telecommunications*
Recent years have seen a marked increase in cases of abuse of dominance under Article 82 of the EC Treaty (or the corresponding national rules) brought by the European Commission and the National Competition Authorities (NCAs). One issue that has featured prominently in these cases is the abuse of “margin squeeze”, principally in cases brought by NCAs acting in the telecommunications sector.
Despite an increase in related case law, many issues concerning the interpretation and scope of margin squeeze remain unclear. The case law has produced divergent outcomes on several key issues, to such an extent that, as the law currently stands, it remains unclear how a dominant company should manage the relationship between the prices it charges upstream to its wholesale customers, and the prices it charges in the downstream market where it competes with its wholesale customers. (The terms “wholesale” and “upstream” are used interchangeably in this chapter, as are the terms “downstream” and “retail”.) Pricing decisions by dominant firms have therefore become more difficult. The need for legal certainty has led to a lively debate recently on the scope of this abuse.
In the light of the increased prominence given to these issues and the general lack of certainty surrounding them, this chapter:
· Examines the basic factors required for margin squeeze abuse to arise.
· Provides a short overview of the principal decisions and case law on margin squeeze in the EU and the UK.
· Highlights a number of important issues that remain unresolved.
Basic principles of margin squeeze abuse
Generally, a margin squeeze can arise when a dominant firm which is vertically integrated supplies an essential input to its wholesale customers, which are also its competitors in a downstream market. If that input is essential for downstream competitors, the dominant firm can, in effect, “squeeze” its downstream competitors in the retail market by charging them an excessive upstream price, charging an unprofitable downstream price, or a combination of the two.
While there is considerable uncertainty about the precise legal test to establish the existence of margin squeeze abuse, the following indicators, taken from existing case law, provide basic guidance on the principal conditions required for a margin squeeze to occur:
· The dominant firm is vertically integrated. It is active in two different, but related, markets (at the wholesale and at the retail level). It supplies rivals on the downstream market with an input. The downstream rivals are both customers (at the wholesale level) and competitors (at the retail level) of the dominant firm.
· Input is essential to downstream competitors. If the downstream rivals have alternative sources of supply or there are substitutable inputs, or rely on alternative technologies, they will not be dependent on the input price charged by the dominant company. In this case it is unlikely that a margin squeeze would occur. This is confirmed by case law (see below, National Carbonising, British Sugar/Napier Brown, Industrie des Poudres Sphériques, Deutsche Telekom and Genzyme).
· Profitability. The adoption of the dominant firm’s upstream price, downstream price or the combination of both would not allow an equally efficient downstream rival to make a reasonable profit.
· Justification. There is no legitimate justification for the losses made downstream by the dominant firm (based on the wholesale input cost it charges to third parties). There are many legitimate reasons why a company may price below its own costs for a period of time, including:
o because of bad market conditions that are expected to improve;
o the company may be setting low prices as a temporary marketing device; or
o the company may have made a mistake and entered the market on too large a scale.
For a more reliable test to be developed, among the issues that would require further clarification in future case law are:
· The extent to which the company under investigation has the ability to control the downstream market price.
· The extent to which, if at all, evidence of actual or likely anti-competitive effects is a constituent part of the abuse.
· The relationship between the margin squeeze abuse and the abuse of predation.
See also below, Testing for a margin squeeze.
Case law on margin squeeze
The following section examines some of the most important case law provided by EC courts and UK courts and competition authorities in relation to margin squeeze.
National Carbonising (OJ 1976 L35/6). National Carbonising in 1976 is the earliest case and concerns a complaint that was eventually rejected by the European Commission. National Carbonising Company (NCC) bought all of its coal from the National Coal Board (NCB), whose subsidiary (NSF) produced coke in competition with NCC. NCC held a virtual monopoly in coal production and through NSF almost 90% of the downstream market. The Commission found that NSF was also the price leader (that is, a firm whose prices set a lead for other firms in the industry to follow) downstream and there was no possibility for NCC to increase its prices above NSF’s. As a result of successive increases in the cost of NCC’s raw material sourced from NCB, NCB’s costs of production rose by GB£10.39 per ton, whereas its subsidiary’s downstream price for the finished product was only GB£6.70. NCC was therefore unable to operate economically and sought interim relief. The Commission’s interim decision does not go into any details, but sets out the principle that a dominant company supplying a key input to rivals may “have an obligation to arrange its prices so as to allow a reasonably efficient manufacturer of the derivative a margin sufficient to enable it to survive in the long term”.
British Sugar/Napier Brown (OJ 1988 L284/41). In 1988 British Sugar plc (BS) was found dominant in the UK market for the sale of bulk sugar and the derived product (retail sugar). Napier Brown was a buyer and reseller of sugar in competition with BS. The Commission found that there was an insufficient margin for a sugar merchant as efficient as BS to survive, based on BS’s own costs which showed it operating at a loss. In this case the margin squeeze was simply one of a number of anti-competitive practices which were aimed at driving Napier Brown out of the market.
Industrie des Poudres Sphériques (Case T-5/97 , ECR II-3755). In 1996 the Commission rejected a complaint by Industrie des Poudres Sphériques (IPS) against Pechiney Electrometallurgie (PEM), the sole European Community producer of calcium metal, which also marketed its derivative, broken calcium metal. The complainant, IPS, was active in the derivative market and relied on supplies from PEM for the raw calcium metal. Because IPS had higher costs than PEM, it could not remain competitive in the downstream market. IPS applied to the Court of First Instance (CFI) for annulment of the Commission decision.
The CFI rejected the IPS appeal for a number of reasons and found no margin squeeze. In particular, because IPS had alternative sources of the relevant raw material from China, Russia and North America.
In addition, the CFI defined a price squeeze as arising where a vertically integrated dominant firm supplies an input to rivals at prices “at such level that those who purchase it do not have a sufficient profit margin on the processing to remain competitive on the market for the processed product”. The CFI suggested that this might occur in two ways:
· Where the prices for the upstream product were abusive.
· Where the prices for the derived product were predatory.
In practice the CFI held that this would happen if an “efficient competitor” could not compete on the basis of the dominant firm’s prices.
Deutsche Telekom (OJ 2003 L263/9). In 2003, the European Commission investigated Deutsche Telekom (DT). DT was dominant in the upstream and downstream markets and was found guilty of a margin squeeze in circumstances where it charged competitors more for “unbundled broadband access” at the wholesale level than it charged its subscribers for access at the retail level. The case is currently on appeal to the CFI.
In Deutsche Telekom, the Commission said that a margin squeeze would occur where “the spread between DT’s retail and wholesale prices is either negative or at least insufficient to cover DT’s own downstream costs”. DT would have been unable to offer its own retail services without incurring a loss if it had had to pay the wholesale access price. As a consequence the profit margins of competitors would be squeezed, even if they were just as efficient as DT. Interestingly, the Commission stated that “by proving the existence of a margin squeeze, the Commission has done enough to establish the existence of an abuse”, without having to consider the effects on the market.
However, it is debatable whether this case supports a theory of “per se abuses” under Article 82 of the EC Treaty. It was clear that DT’s prices would have resulted in market exclusion, because some of its retail prices were actually lower than the input price of the wholesale product supplied to competitors, who were therefore forced to price above DT to compete. Also, although the Commission said it did not need to consider market effects, in fact it looked at DT’s position in the market as well as its competitors’ position and concluded that DT’s conduct restricted competition. Despite first impressions, therefore, this case might not necessarily be inconsistent with the standard theory of competitive harm based on market exclusion.
Wanadoo Interactive (COMP/38.233 Wanadoo Interactive, Commission decision of 16 July 2003). In 2003, the Commission decided that France Telecom’s internet access subsidiary, Wanadoo, had charged predatory prices for its consumer broadband internet access services. This case could have been treated as one of margin squeeze but the Commission chose to address only predatory pricing in the retail market. The reason why this is a case of predation and not margin squeeze may be because either:
· Wanadoo at the time was not fully owned by France Telecom (during the period covered by the decision, France Telecom’s shareholding in Wanadoo fluctuated between 70% and 72.2%) and, therefore, there was not a clear case of vertical integration.
· The conditions for predation were clearly met, in particular:
o Wanadoo was dominant at the retail level;
o Wanadoo priced below its average variable costs for a period; and
o the Commission found internal company documents which evidenced an anti-competitive strategy.
Interestingly, to remedy the infringement, France Telecom’s wholesale prices were reduced (rather than an increase of Wanadoo’s retail prices). This case is currently on appeal. Its interest in margin squeeze cases lies primarily in the Commission’s analysis of the losses made by Wanadoo.
The UK’s national competition and regulatory authorities (the latter have competition law powers in their own right for the relevant sector) have been prolific on the subject of margin squeeze in recent years. The only actual finding of margin squeeze so far was made by the UK’s specialist competition law court, the Competition Appeal Tribunal (CAT), in 2003 in Genzyme (see below, Genzyme).
BSkyB (CA98/20/2002 dated 17 December 2002). In 2002, the UK’s NCA examined whether BSkyB had acted abusively when, on the basis of the wholesale prices charged to its distributors, BSkyB was assessed to have made losses in its downstream service of providing pay-TV sports and premium film channels. Losses continued for over a year while recovering the costs of investing in a new platform. Given BSkyB’s return to profitability, and the irreducible uncertainties in modeling losses and profitability, the NCA’s assessment was that the case against BSkyB was not proven.
British Telecom (Case CW/00613/04/03, 20 November 2003). In November 2003, The Office of Communications (Ofcom) decided that the margin between British Telecom’s (BT) residential broadband wholesale and retail prices was sufficient to allow an equally efficient operator to compete, by reference to BT’s own costs. In addition, BT’s declining broadband shares and lack of price leadership was consistent with there being no evidence of any material adverse effect on competition. Ofcom considered that there was no substantive difference between applying a test of predation at downstream level, or a test of margin squeeze.
Vodafone/O2/Orange/T-Mobile (Case CW/00615/05/03, 21 May 2004). In May 2004, Ofcom found that certain of the UK’s four mobile phone operators, each dominant in termination for its own calls, made an insufficient margin between the wholesale termination charge and mobile prices to retail business customers. However Ofcom decided that this did not materially restrict competition from the other mobile operators, or from mobile service providers, or in general, given high levels of competition, countervailing buyer power and low entry barriers.
Genzyme (Genzyme  CAT 4, 11 March 2004). The complainant was a company operating in the home care market. It had been appointed by Genzyme, a pharmaceutical company, to provide home care services for one of Genzyme’s drugs. Later the pharmaceutical company terminated the distribution agreement in order to provide home care services itself. The home care provider was no longer able to compete because it was charged the same price at which the UK’s national health service (NHS) was buying the drug, bundled with home care services, from Genzyme. As the complainant had to supply the additional home care services at its own expense, it would have made a loss on sales to the NHS.
The CAT upheld a finding of margin squeeze on the basis that both:
· The home care provider was entirely dependent on obtaining the drug from Genzyme.
· Genzyme’s pricing policy was likely to eliminate all competition in relation to home care for the drug.
Citing National Carbonising and Industries des Poudres Sphériques, the CAT described a price squeeze abuse as a further example of abusive leveraging, where “an undertaking that is dominant in an upstream market supplies an essential input to its competitors in a downstream market, on which the dominant company is also active, at a price which does not enable its competitors on the downstream market to remain competitive” (paragraph 7, Genzyme  CAT 4, 11 March 2004). However, this was not an orthodox case of margin squeeze in that it was not concerned with below cost pricing.
For a summary of the key features of these cases see box, EC margin squeeze cases.
There have also been cases of margin squeeze in several other jurisdictions, including Italy (Telecom Italia, A 351, provvedimento no. 13752 of 16 November 2004), France (France Telecom/ SFR Cegetel/ Bouygues, Decision no 04-D-48, 14 October 2004), Denmark (Song Networks A/S /TDC/SONOFON, 27 April 2004) and Sweden (TeliaSonera, dnr 1135/2005, 22 December 2004).
Unresolved issues in margin squeeze abuse cases
There are still important issues in the area of margin squeeze that remain unresolved. The following highlights some of the key areas that still need further development.
Legal basis of the margin squeeze abuse
A surprising feature of the decisional practice and case law is that the legal basis of a margin squeeze abuse remains unclear. It is not clear, for example, whether margin squeeze is a stand-alone abuse or merely an aspect of other established abuses, such as excessive pricing, cross-subsidisation or predation. This possibly reflects the fact that the law at EU level remains under-developed, with only a handful of cases in over 40 years of enforcement. Commentators remain divided: some believe that margin squeeze does not exist as a stand-alone abuse; others consider that it is a distinct violation. The pending appeal before the CFI in Deutsche Telekom may clarify the issue.
Testing for a margin squeeze
Testing for a margin squeeze involves an assessment of whether the dominant firm’s upstream prices allow downstream operators to make a profit. However, opinion remains divided on what test should be applied in order to assess whether a margin squeeze exists. Specifically, whether the relevant measure is either:
· The dominant company’s own costs.
· The costs of one or more downstream competitors.
The EC courts and the Commission have used the dominant company’s own costs in order to assess a margin squeeze (the “equally efficient operator” test), while certain national authorities have taken into account downstream competitors’ costs (the “reasonably efficient operator” test).
However, the “reasonably efficient operator” test is not an appropriate one for a margin squeeze under competition law. The first serious difficulty is legal certainty: a dominant company does not (and should not) know its competitors’ costs. It is, therefore, impossible for a dominant company to know in advance whether its prices are lawful or not. A more fundamental objection is that competition law should not, in general, protect less efficient firms, since the competitive process would (and should) ensure the exit of those firms.
The “equally efficient operator” test, based on the dominant firm’s costs is, therefore, more appropriate, since it protects firms who are at least as efficient.
Control of the upstream and downstream prices
Another much-debated issue is whether the vertically integrated firm should also have downstream dominance (in addition to upstream dominance). In practice, in nearly all cases in which a margin squeeze has been found, the company was also dominant downstream. However, certain commentators and NCAs argue that a margin squeeze can occur in the absence of dominance in the downstream market (that is, the vertically-integrated company which has upstream dominance can leverage this dominance to improve its position on the downstream market in a manner other than competition on the merits). However, this latter argument does raise a number of issues, for example:
· The question of proof (what evidence, if any, of actual or likely exclusion would be required)?
· Is it possible to be certain that a “squeeze” is caused by the wholesale price, given that the company under investigation has no control over the retail price in the market?
New and emerging markets
A significant feature of recent margin squeeze cases is that virtually all cases have arisen in the context of new and emerging markets (for example broadband internet access). Applying a margin squeeze test in these markets presents serious difficulties for competition authorities. Specifically, when new products or services are launched, companies usually have substantial upfront costs that will be recovered over time. It is therefore normal in such markets to have a period of below-cost pricing for reasons that have nothing to do with exclusionary behaviour. Therefore, competition authorities face the difficult task of trying to devise legal tests that distinguish between legitimate start-up losses and losses that represent an investment in an exclusionary strategy.
While the Commission and the NCAs accept in principle that there might be a legitimate justification for initial low prices by a dominant firm, they have struggled to formulate clear legal tests that can be applied ex ante when the dominant firm decides its pricing strategy. In practice, this problem is likely to be serious, since it involves an assessment of likely future profitability. This is highly speculative and open to error. Often, the only available evidence justifying future profits is the dominant firm’s business plan. Unless the plan is expressly based on exclusionary intent, or is based on implausible assumptions of future profits, there would be severe practical difficulties in inferring an abuse. Indeed, there is not even agreement on how future profits should be assessed in these cases. The principal cases (Wanadoo, BSkyB and British Telecom) have each adopted different approaches. All of this creates enormous difficulty for firms said to be dominant, as well as their legal advisers, when assessing key pricing decisions.
The need to show anti-competitive effects
A further uncertainty arising from the case law concerns whether there is a need to show actual or likely anti-competitive effects in a margin squeeze case, or whether the mere failure to pass the relevant price/cost test is a per se abuse. The Commission in Deutsche Telekom seemed to favour the latter approach, but still undertook some analysis of the likely effects and found that DT’s conduct restricted competition.
In France Telecom/SFR Cegetel/Bouygues, the French Competition Council applied Deutsche Telekom but still found that although Bouygues was dominant and was pricing below costs, it was only a small competitor and not in a position to distort competition downstream. In Telecom Italia, the Italian Antitrust Authority condemned Telecom Italia charges as part of a strategy to exclude competitors.
Other cases on abuse of dominance, however, suggest that a detailed effects inquiry is necessary (for example Wanadoo). This approach is more in line with the Commission’s increasing emphasis on an economics-based approach. Analysing actual or probable effects in a margin squeeze case also has a pragmatic appeal given the degree of uncertainty on many of the major elements of this abuse.
The future for margin squeeze
The issue of margin squeeze has assumed enormous practical importance for vertically integrated firms that supply downstream rivals with essential inputs. Despite the dramatic increase in margin squeeze decisions at EC and national level, a surprising number of central legal and economic issues remain to be resolved. Given the obvious importance of pricing decisions, these difficulties have created uncertainty for vertically integrated firms and their legal advisors. Put simply, many of the legal rules established in the decisional practice and case law are not easily capable of ex ante application at the time when the pricing decision is taken. This seems unacceptable and contrary to basic principles of legal certainty and the rule of law. In these circumstances, it is hoped that the appeals currently pending before the CFI in Deutsche Telekom and Wanadoo will clarify the law in a way that is useful.
EC margin squeeze cases
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*Paolo Palmigiano is the Head of Competition and Public Law, BT Retail and Beatrice Roxburgh is a Senior Competition Lawyer at British Telecommunications. This article represents the views of the authors alone and not of British Telecommunications.
– PLC Reference: 2-200-3736
– Article ID: a47390
– Law stated as at: 01 November 2004
– Publication date: 2005-02-01
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