Intellectual Property Enforcement Guidelines - Consultation Draft (2nd)

Example 8: Agreement to Foreclose Complementary Products

There are five major record labels. The largest two, ROCKCO and POPCO, which together account for more than 65 percent of total sales and 70 percent of all major label artists, have formed a joint venture (DISCO) to develop, produce and market a new generation of digital playback devices. The DISCO technology provides a level of sound quality and other features far superior to those offered by existing technologies. DATCO has also developed a digital sound technology with similar high-fidelity qualities, but which is also portable and allows users to record. The costs of the two technologies are similar, but the technologies themselves are incompatible: music digitally encoded in DISCO format must be re-encoded for playback on DATCO's player. Under the terms of their joint venture agreement, ROCKCO and POPCO agree to not release, or license any other person to release, their copyrighted recordings in a digital format other than the DISCO format. Consistent with that agreement, ROCKCO and POPCO have declined DATCO's request for a licence to convert and release ROCKCO and POPCO recordings in the DATCO format. The other three record labels predict -- correctly -- that consumers will be reluctant to purchase the DATCO technology if they are unable to obtain music from either ROCKCO or POPCO in that format. The other record companies are willing to release their recordings in the DATCO format, but find that there is no market for it and are compelled, by popular demand, to license the DISCO technology in order to release their recordings in the DISCO format. As a result of the foregoing, DATCO's digital sound technology, which reviewers have generally viewed as superior to the DISCO technology, is being withdrawn and DISCO is substantially increasing both the price of the playback equipment that it sells and the royalties charged to the other record companies for the use of the DISCO technology to release recordings in the DISCO format.

Analysis

The Bureau would examine this case under the merger provision (section 92), the abuse-of-dominance provision (section 79) and/or section 32 of the Competition Act.

As a first step, the Bureau would consider whether the alleged anti-competitive conduct, namely the refusal of ROCKCO and POPCO to license the reproduction of their copyrighted recordings in the DATCO format, was a "mere exercise" of their IP rights or involved "something more." In this case, the Bureau would likely determine that the terms of the DISCO joint venture agreement and the refusal to license lessen competition and would seek to review that arrangement under either the merger provision or the abuse-of-dominance provision of the Competition Act.

If the Bureau elected to review the joint venture agreement under the merger provision on the basis that the joint venture was, for the purposes of the digital sound business, in substance a merger of the musical recording assets of ROCKCO and POPCO, the review would be carried out in accordance with the Merger Enforcement Guidelines. If, on the other hand, the Bureau elected to review the joint venture agreement under the abuse-of-dominance provision, on the basis that the joint venture agreement established and provided for the joint abuse of a dominant position, the review would be carried out in accordance with the framework and criteria for abuse of dominance outlined in the previous examples. In either case, the Bureau would have to establish the affected relevant market or markets, consider barriers to entry and evidence of market power or dominance, demonstrate a substantial prevention or lessening of competition and assess any business justification or efficiency rationale.

If the Bureau were to proceed under section 79, it would have to establish that the DISCO joint venture has substantial market power in either the market for digital sound technology or digital playback equipment. In addition, it would have to find that the DISCO joint venture had engaged in anti-competitive conduct that substantially lessens or prevents competition. The anti-competitive acts in this case would relate to the acquisition and foreclosure by the DISCO joint venture of access by its competitors to the music in the ROCKCO and POPCO music libraries. Foreclosure of access to these materials is apparently preventing alternative sound recording technologies from acquiring the critical mass of desirable music content required for them to achieve viability. It appears that this conduct may be substantially preventing or lessening competition and leading to the monopolization or the creation of dominance in the markets for digital sound technology and/or digital playback equipment sound reproduction. The foreclosure of other technologies creates market power for DISCO in these markets and is inefficient, as it reduces consumer choice, leads to increases in the royalties paid by the record companies to use this type of technology and increases the price of playback devices. The Bureau would likely seek an order requiring that ROCKCO and POPCO divest themselves of DISCO or that ROCKCO and POPCO license their works for release in alternative formats.

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Example 9: Refusal to License a Standard

ABACUS and two other firms were the first to market a spreadsheet for personal computers. Electronic spreadsheet software was one of the applications that established personal computers as a legitimate tool for business. In the first five years, ABACUS outsold its nearest competitor nearly two to one and its installed base (cumulative sales) grew to 50 percent. In the next two years, its annual market share grew to more than 75 percent and one of the other original firms left the market. At about the same time and after three years of programming, CALCULATOR introduced a spreadsheet product that had a number of innovative features not found in ABACUS. However, CALCULATOR soon ran into financial difficulties despite the innovative features and a lower price. CALCULATOR approached ABACUS for permission to copy the words and layout of its menu command hierarchy (permission was required since ABACUS has a valid IP right under IP law). With permission, CALCULATOR could have relaunched its product with an emulation mode and a key reader, which would have given CALCULATOR the ability to read ABACUS files and ensured compatibility between the two products. ABACUS refused to grant permission, asserting its IP right. In light of this, several other prominent software makers announced that they were discontinuing their spreadsheet development programs.

An important characteristic of spreadsheets that determines its benefits to a purchaser is network effects. Network effects exist if the value of a product increases with the number of others who purchase compatible spreadsheets. Network effects for spreadsheets arise since the greater the size of the network (the installed base of compatible spreadsheets), the greater the number of individuals with whom files can be shared, the greater the variety of complementary products -- utilities, software enhancements and macros, the more prevalent consulting and training services, and the greater the number of compatible data files.

Analysis

Given the circumstances surrounding this case, ABACUS' refusal to license its IP would constitute a "mere exercise" of its IP rights and would, therefore, be subject to review only under section 32 of the Competition Act.

To establish whether ABACUS' refusal created an undue restraint of trade or lessened competition, the Bureau would determine whether the refusal adversely affected competition in a relevant market that was different or larger than the subject matter of ABACUS' IP rights. In this case, competitive harm is alleged in the market for ABACUS-compatible spreadsheets.

Whether the market is ABACUS-compatible spreadsheets depends on the extent and importance of network effects and switching costs. If network effects are important, consumers that have never purchased a spreadsheet may still purchase the more expensive ABACUS product. Consumers who are already on the ABACUS network may be locked-in by the switching costs of joining a new spreadsheet network (for example, their sunk investments in training, files and complementary products) and the loss in network benefits. If network effects and switching costs are material, then existing consumers are likely to stay and new consumers to choose ABACUS even if it is priced above competitive levels.

If the relevant market is determined to be ABACUS-compatible spreadsheets, then ABACUS would be the only producer and thus have 100 per cent control of this market. If, in addition, entry barriers were found to be high, which is likely in an industry experiencing network effects, the Bureau would conclude that ABACUS is dominant. In determining whether the installed base of ABACUS contributes materially to entry barriers, the Bureau would consider the pace of innovation and the potential for a new technology to "leap-frog over" ABACUS despite its advantages (that is, its installed base and the switching costs). The Bureau would also determine whether there are other efficient avenues for creating compatibility that would not infringe on the IP rights of ABACUS.

If the relevant market is determined to be ABACUS-compatible spreadsheets then, given the facts in this case, the Bureau would likely conclude that the relevant market was larger than the subject matter of ABACUS' IP -- the words and layout of its menu command hierarchy, ABACUS is dominant in the relevant market, and the IP is an essential input for firms participating in the relevant market. On this basis, ABACUS' refusal satisfies the first step of the Bureau's two-step analysis to determine whether it would seek to have an application brought under section 32.

In the second step, the Bureau determines whether a special remedy invoked against ABACUS' IP right would adversely alter firms' incentives to invest in research and development in the economy.³⁸ In this case, the facts suggest that it is possible that ABACUS' ability to impose incompatibility may have a chilling effect on the development of more advanced spreadsheets. In addition, the choice by ABACUS of the words and layout of its menu hierarchy was likely arbitrary, and likely involved little innovative effort and had little value relative to other substitutes. In the absence of an installed base and switching costs, ABACUS' terms and menu hierarchy would be no better or worse than CALCULATOR's (or any other). It is only after consumers make sunk investments and adoption creates an installed base that ABACUS spreadsheets become the market or standard and that its choice of words and menu interface -- required for compatibility with the ABACUS network -- creates unintended and unwarranted market power, a situation that can be corrected through enforcement action under section 32. On this basis, the Bureau would likely conclude that a special remedy invoked under section 32 would not reduce incentives for other firms involved in research and development.

If the facts of the case suggest potential enforcement under section 32, the Bureau would seek a special remedy that would allow other spreadsheet firms to gain access to the words and layout of ABACUS' menu hierarchy.

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ANNEX 1: Providing Comments

Interested parties should submit their comments in electronic format (WordPerfect, Microsoft Word, Adobe PDF or ASCII TXT) to facilitate posting on the Bureau's Web site. Documents submitted should be sent with a note specifying the software, version number and operating system used. The Bureau will not post submissions labelled confidential.

Comments should be sent to Boulerice.Huguette@cb-bc.gc.ca no later than June 16, 2000.

You may also contact the Bureau's Information Centre to receive additional copies of these guidelines or more information on Competition Bureau activities.

Tel.: (819) 997-4282 (in the National Capital Region) or 1-800-348-5358 (toll free)

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NOTES

¹The Canadian Intellectual Property Office (CIPO) defines intellectual property and summarizes the role of IP rights as follows:

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"Ideas, designs, creativity... (that) help us (Canadians) work better, to make finer products and to compete more effectively in world trade. A brisk and orderly exchange of ideas is as important to our economy as the flow of money or goods and services. To promote this exchange, while protecting owners' rights, the Government of Canada considers certain kinds of creative endeavours ‘intellectual property.' You can receive legal recognition for these endeavours in much the same way as you receive title to a piece of land."

For more information, see the CIPO Web site http://strategis.ic.gc.ca/sc_mrksv/cipo/help/faq_ip-e.html.

²R. v. Nova Scotia Pharmaceutical Society et al., (1992) 2 S.C.R. 606), defines market power as "the ability to behave relatively independently of the market." DIR v. The NutraSweet Co., (1990) 32 C.P.R. (3d) 1(Comp. Trib.), defines it as the ability to maintain prices above competitive levels for a considerable period.

³With the exception of those for conspiracy and predatory pricing, these provisions do not require proof of market power or anti-competitive effects.

⁴The refusal-to-deal provision (section 75) does not require proof of substantial lessening or prevention of competition.

⁵ See Information Bulletin on Program of Compliance, Information Bulletin No. 3, June 1989 (Consumer and Corporate Affairs), for a detailed discussion of case resolution alternatives.

⁶See DIR v. Southam Inc. (1997), 71 C.P.R. (3d) 417 (S.C.C.), and (1995), 63 C.P.R. (3d) 67 (F.C.A.), aff'd (1992), 47 C.P.R. (3d) 240 (Comp. Trib.).

⁷See DIR v. D&B Companies of Canada Ltd. (1995), 64 C.P.R. (3d) 216 (Comp. Trib.) (hereafter referred to as Nielsen).

⁸ In order to enforce common law property rights, it must be possible to identify the property's owner and to clearly delineate the boundaries of the property. Both tasks can prove problematic in the case of IP. For other kinds of private property, possession can generally be seen as an indication of ownership. However, since many individuals can possess IP simultaneously, it may be difficult to establish the identity of the original creator and true owner of the IP. Furthermore, since IP is generally intangible, it is often difficult to clearly delineate the boundaries of the property. Without a legal delineation of these boundaries, IP owners may have difficulty showing that others have infringed on their property.

⁹For ease of discussion, and unless otherwise indicated, competitive harm is prospective. Note, however, that in many cases competitive harm may be occurring at the time the Bureau is conducting an investigation or may have occurred sometime in the past.

¹⁰Some of the transactions and conduct that could involve IP include merger, pooling of licences, setting standards for products, tied selling and exclusive dealing.

¹¹Licensing is a means by which owners trade IP, and it signals the willingness of IP holders to participate in the marketplace. This ability of owners to exchange and transfer IP can enhance the IP's value and increase the incentive for its creation and use. Licensing arrangements also promote the efficient use of IP by facilitating its integration with other components of production, such as manufacturing and distribution.

¹²Refer to sections 32, 61, 77, 79 and 86.

¹³Subsection 79(5) reads: "For the purpose of this section, an act engaged in pursuant only to the exercise of any right or enjoyment of any interest derived under the Copyright Act, Industrial Design Act, Integrated Circuit Topography Act, Patent Act, Trade-marks Act or any other Act of Parliament pertaining to intellectual or industrial property is not an anti-competitive act."

¹⁴ The remedies in section 32 are more extensive than those under the general provisions.

¹⁵This analysis would use the concept of a relevant market as discussed in section 5.1.

¹⁶DIR v. Tele-Direct (Publications) Inc. and Tele-Direct (Services) Inc. (1997), 73 C.P.R. (3d).

¹⁷DIR v. Warner Music Canada Ltd. (1997), 78 C.P.R. (3d) 321.

¹⁸In Tele-Direct the Competition Tribunal stated that, "The Tribunal is in agreement with the Director that there may be instances where a trade-mark may be misused. However in the Tribunal's view, something more than the mere exercise of statutory rights, even if exclusionary in effect, must be present before there can be a finding of misuse of a trade-mark."

¹⁹The Copyright Act provides that section 45 of the Competition Act not apply to any royalties or related terms and conditions arising under certain collective agreements filed with the Copyright Board.

²⁰The special remedies provided for under section 32 include declaring any agreement or licence relating to the challenged right void, ordering licensing of the right, revoking a patent, expunging or amending a trademark, or directing that such other acts be done or omitted as deemed necessary to prevent the challenged use.

²¹A network industry is an industry that exhibits network effects. These effects exist when the value or benefit derived from using a product increases with the number of other users. For example, fax machines exhibit network effects because the value of owning a fax machine clearly depends on the number of compatible fax machines in use.

²²This does not suggest that markets subject to network effects will inevitably be monopolized. Often, firms form alliances and make a new technology "open" to gain acceptance and build an installed base. These activities tend to be pro-competitive if firms that participate in the standard-setting process freely compete with each other in the market.

²³ The market definition exercise focuses primarily on demand substitution factors (i.e. possible consumer responses). The Bureau considers the potential constraining influence of firms that can participate in the market through a supply response (i.e. a possible production response) after it has defined the relevant market.

²⁴ This is generally the case with mergers.

²⁵ See sections 3.2 and 3.3 of the Competition Bureau's Merger Enforcement Guidelines.

²⁶ This is generally the case with alleged abuse of dominant position or a conspiracy.

²⁷Part 4 of the Merger Enforcement Guidelines provides a list of other factors the Bureau considers when it assesses market power. These include foreign competition, business failure and exit, the availability of acceptable substitutes, effective remaining competition, removal of a vigorous and effective competitor, and change and innovation.

²⁸The following factors are relevant to determining when a firm will divert sales within one year in response to a price increase: the cost of substituting production in the relevant market for current production (i.e. switching costs), the extent to which the firm is committed to producing other products or services, and the profitability of switching from current production.

²⁹If the actual participants in the market include firms that, within one year, represent potential sources of supply for the market, then market shares are usually calculated in terms of production capacities.

³⁰The Competition Tribunal stated in DIR. v. Laidlaw Waste Systems Ltd. (1992), 40 C.P.R. (3d) 289 (Comp. Trib) (hereafter Laidlaw), that market share calculations based on sales may overstate market power when the market is characterized by excess capacity.

³¹ The fact that anti-competitive conduct can create barriers to entry was recognized by the Competition Tribunal in Laidlaw.

³² Of course, the purpose of providing innovators with IP rights is to foster the development of new products. In this sense, IP rights may encourage firms to participate in environments in which technology changes very rapidly.

³³ Section 95 provides a specific exemption under the merger provisions to research and development joint ventures that satisfy certain criteria outlined in the provision.

³⁴ While there is no explicit recognition of efficiencies in the conspiracy provisions (section 45) of the Competition Act, there are 12 specific defences to agreements between competitors that may encompass efficiency-enhancing arrangements involving IP. Among these, the following may be more likely to apply to agreements involving IP: the exchange of statistics, the definition of product standards, the size and shapes of product packaging, cooperation in research and development, restrictions on advertising or promotion, measures to protect the environment, and export consortia or specialization agreements as defined in section 85(f).

³⁵ In Tele-Direct, the Competition Tribunal stated that, "(w)hat the Tribunal must decide is whether, once all relevant factors have been taken into account and weighed, the act in question is, on balance, ‘exclusionary, predatory or disciplinary'. Relevant factors include evidence of the effects of the act, of any business justification and of subjective intent which, while not necessary, may be informative in assessing the totality of the evidence. A ‘business justification' must be a ‘credible efficiency or pro-competitive' business justification for the act in issue. Further, the business justification must be weighed ‘in light of any anti-competitive effects to establish the overriding purpose' of the challenged act..."

³⁶ In Nielson, the Competition Tribunal held that even if there is some justification for the alleged anti-competitive conduct, this must be weighed against any anti-competitive effects.

³⁷ A manufacturer who wishes to use alternative memory products, in addition to MEMEX memory components, must pay twice, once for the alternative component and a second time for the per computer royalty payable to MEMEX.

³⁸ As outlined earlier, the Bureau would likely conclude that incentives to invest in research and development would not be adversely altered from invoking a special remedy if the cost to the innovator of creating the IP was insignificant or if the refusal to license the IP is stifling further innovation.