Case Comment: Federal District Judge Finds Section 1 Violation in Credit and Charge Card Network Case (United States v. American Express Co.)

On February 19, 2015, Federal District Judge Nicholas G. Garaufis of the Eastern District of New York handed down a victory for the Department of Justice, affirming the anticompetitive nature of American Express’s “anti-steering” contract provisions. The court employed a full rule of reason analysis in determining that these provisions, insisted on by American Express in its contracts with merchants, constitute unreasonable restraints of trade in violation of Section 1 of the Sherman Act by “sever[ing] the essential link between the price and sales of network services.” The decision constitutes an important extension of the application and scope of Section 1 to vertical agreements with horizontal effects.

In 2010, the DOJ, along with the attorneys general of eighteen states, filed suit against Visa, MasterCard, and American Express, alleging that anti-steering provisions in their merchant contracts reduced competition. Anti-steering provisions prevent merchants from steering customers to other cards—with lower merchant fees—through discounts, free shipping, or other perks. The DOJ alleged that these terms enabled the three payment networks to charge higher fees to merchants than they would have been able to charge in a competitive market. Visa and MasterCard entered consent decrees, agreeing to remove their anti-steering provisions from merchant contracts. American Express refused, choosing to litigate.

Under American Express’s anti-steering terms, which the company vigorously enforced, merchants were prohibited from indicating or implying in any way that they prefer consumers use any specific brand of credit card, from trying to dissuade customers from using the American Express Card, from offering benefits, such as discounts or free shipping to customers using non-American Express cards, from posting a sign that discloses the merchant’s actual cost of accepting each network’s cards or that compares the relative costs of acceptance across card brands—even if such information is accurate and truthful—and from a number of similar practices. American Express’s contracts do not, however, restrict merchants from steering customers to cash or check. Merchants found to be engaging in the prohibited practices were liable to be summarily cut off from the American Express network.

The parties disputed market definition, market power, anticompetitive effects, and efficiencies.

Market Definition
The judge defined the relevant market as “general purpose credit and charge card [“GPCC”] network services.” The parties agreed that the continental United States constituted the relevant geographic market. While the Defendant had argued that the market should include debit cards, which are often interchangeable from a customer’s point of view, Judge Garaufis was not swayed. Rather, he examined the market from a merchant’s perspective, reasoning that “there is no indication that merchants—the ‘relevant consumer’ for defining the relevant product market in this case—historically have been or would be inclined to switch to debit network services (i.e., drop acceptance of credit cards) in response to rising prices in the GPCC card network services market.” American Express disputed this reasoning, but the court noted that both internally and in negotiations with merchants American Express treats debit cards and charge cards as non-interchangeable.

With the market thus defined, the judge found that American Express accounted for 26.4% of the purchase dollar volume, behind Visa’s 45% market share and just ahead of the 23.3% claimed by MasterCard. He thus held the market to be highly concentrated, with high barriers to entry due to the two-sided nature of the market. Notably, the court considered the effect of new digital forms of payment such as PayPal, Square, and Google Wallet but found that because these services “piggy-back” on credit, charge, or debit cards rather than offering their own network, they are unable to discipline price increases of credit and charge cards. He therefore excluded them from the relevant market.

Market Power
The court held that the defendant had market power due to high market share, a very concentrated industry, high entry barriers in a two-sided market, and product loyalty of AmEx customers, which prevents most merchants from dropping AmEx when facing price increases. The judge ruled that American Express is likely to have market power even though he recognized that Visa and MasterCard each also has market power within the same market.

When given an all-or-nothing choice between acquiescing to American Express’s high network fees and not accepting American Express, most merchants are be forced to accept the high fees. “[T]he foregone profits associated with each transaction lost to a competitor because the merchant no longer accepts credit will significantly exceed the per transaction savings realized from successfully shifting a customer to a less expensive payment method.” The court found this was bolstered by AmEx’s “Corporate Card” program, noting that “approximately 70% of Corporate Card consumers are subject to some form of ‘mandation’ policy, by which employers require the employee-cardholders to use Amex cards for business expenses.” Any merchant wishing to avoid American Express’s high fees would have to forego profits from all these customers. The judge found that  “merchants’ ability to leave the network in response to . . . increases in the price of Amex’s network services—the only means by which merchants can exercise price discipline on American Express—is materially impeded by the readiness of Amex cardholders to shop elsewhere.” As a result, merchant attrition was held to be unlikely to reach levels necessary to render a SSNIP unprofitable.

Further, the court held that even if this evidence of market power had been unavailable, there was direct evidence of anticompetitive effects, which would have sufficed. “[B]etween 2005 and 2010, American Express repeatedly and profitably raised its discount rates to millions of merchants across the United States as part of its Value Recapture initiative without losing a single large merchant and losing relatively few small merchants as a result.” Despite AmEx already charging a premium over all its competitors, Judge Garaufis noted at least twenty separate price increases during that window, and that each increase raised both revenue and profits for the company. This evidence was likewise indicative of American Express’s market power.

Anticompetitive Effects
Despite the vertical nature of the merchant contracts, the court held that anti-steering provisions have anticompetitive effects in the horizontal market for credit card discount fees. “Steering is a lynchpin to inter-network competition on the basis of price. Without the ability to induce merchants to shift share in response to pricing differentials, a credit card network like Discover cannot increase sales or gain market share by offering merchants a more attractive price than its competitors.” If the merchant is unable to steer customers to a cheaper option, there is limited incentive for the card networks to lower fees to merchants—“[t]he result is an absence of price competition among American Express and its rival networks.” The judge appeared to find statements by American Express executives denigrating price competition to be especially revealing, quoting VP Jack Funda’s statements that “I don’t think anybody’s business strategy is to be cheaper than the next guy,” and “We should not compete on costs with Visa/MasterCard.”

Importantly, the court found that American Express’s NDPs, by forbidding any steering at all, allowed all four networks to charge higher prices than they would have been able to charge in a competitive market. “[B]y disrupting the price-setting mechanism ordinarily present in competitive markets, the NDPs reduce American Express’s incentive—as well as those of Visa, MasterCard, and Discover—to offer merchants lower discount rates and, as a result, they impede a significant avenue of horizontal interbrand competition in the network services market.” The judge was convinced that NDPs led to increased fees charged even to the three million merchants who do not accept American Express. Rival Discover investigated lower fees to this market segment, but ultimately concluded that if it were to charge lower fees to these often smaller merchants, much larger merchants, who also accepted American Express, would demand equal discounts. Thus, any increase in trade  from steering by smaller merchants would be offset by losses from discounts demanded by larger merchants, who were prohibited from steering customers towards Discover.

The court found that the harm is not limited to merchants, reasoning that “merchants facing increased credit card acceptance costs will pass most, if not all, of their additional costs along to their customers in the form of higher retail prices.” Thus non-cardholding consumers will pay more and be harmed even if American Express passed on all of its premium revenue to its own cardholders in the form of rewards. The court recognized that this dynamic entails an anticompetitive subsidy from all other consumers to the benefit of American Express cardholders.

Finally, the judge found that the policy harms innovation in the market for credit and charge card networks. The merchant restraints make it all but impossible for a firm to enter by offering a low-cost alternative or a substantially different business model. Any business model that tries to differentiate itself by charging less in return for greater volume will be frustrated, since consumers can neither independently access nor account for the cost of different forms of payment when deciding which to use.

In finding that the anti-steering provisions violated the Sherman Act, the court anticipated more robust competition going forward. “Providing merchants the freedom to participate in their customers’ payment decisions will . . . unlock an important avenue of competition among the credit card networks.” In the short term, “consumers would benefit from having options because ‘it is giving the cardholder more choice, more chance to decide . . . whether he or she wants to get the rewards for that given purchase . . . from the card issuer or whether he or she would rather get some sort of reward from the merchant.’” In the longer term, the court expects that merchants will pass along some amount of the savings associated with declining swipe fees to their customers in the form of lower retail prices.

American Express argued for two pro-competitive justifications for its NDPs. It claimed that the restraints were “reasonably necessary (1) to preserve American Express’s differentiated business model and thus the company’s ability to drive competition in the network services market, and (2) to prevent merchants from ‘free-riding’ on the network’s investments in its merchant and cardholder value propositions.” The court considered and rejected each.

American Express maintained that its restraints were necessary to prevent allegedly anticompetitive “spillover,” in which customers are dissuaded from using their American Express cards by some merchants, and as a result cease using American Express cards when shopping with other merchants as well. The company thus argued that the restraints were necessary to preserve its business model of signing high value, high volume customers. Without the anti-steering provisions, American Express believed Visa and MasterCard would eat into its market share, leading to an increasingly concentrated market overall. It therefore argued that protecting its product was necessary to protect competition.

The judge found that Defendant’s position was based on a flawed theory. He noted that American Express was, in essence, arguing that its current business model could not survive if exposed to the full spectrum of interbrand competition. To allow the company to avoid price competition on that reasoning amounts to “nothing less than a frontal assault on the basic policy of the Sherman Act.”

The judge also rejected American Express’s second defense, that the provision were reasonably necessary to avoid free-riding on the network’s customer data analytics services. The company contended that merchants would use proprietary analytic information for targeted marketing campaigns to draw in more customers, then steer them to using a lower-cost card.

The court rejected this free-rider defense by noting that American Express can, and often does, “price and sell these ancillary benefits separately from its core network services. Where, as here, ‘payment is possible, free-riding is not a problem because the “ride” is not free.’”

The judge ordered further briefing to help him determine an appropriate remedy.