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All in the game – how the game theory framework helps design and understand leniency laws

ShreedharSasikumarMost game theory discussions start with an explanation of the “prisoners dilemma”. If only for the sake of originality (and since we will be coming back to the prisoner’s problems), let us start with a different ‘game’, the “driver’s dilemma”.

Imagine a world with no traffic rules. A driver can choose to drive on either the left or the right side of the road. Now, think of two drivers approaching a bend in the road from opposite directions. Since the road is curved, neither can see which side of the road the other is on. If both of them are on the same side of the road, they will crash into each other. If they are on opposite sides, they will pass each other with no incident. The following table shows the potential payoffs in this interaction.

Driver’s dilemma – No traffic rules

Driver's dilemma - No traffic rules

In a world with no rules, there is a 50 per cent chance that a driver will drive on the right and an equal chance that he or she will drive on the left. Since the individual driver cannot know the other driver’s choice, there is now a 50 per cent chance that they will both chose the same side and a 50 per cent chance that they won’t. And this means a 50 per cent chance of a crash each time they round a corner.

But if there were a law that fined drivers USD 500 for driving on the right, then all rational drivers would chose to drive on their left, thereby avoiding crashes.

Achieving beneficial outcomes for the group by aligning individual incentives

Game theory shows that a collection of individuals often act rationally and yet end up with outcomes that are bad both for the individual and for the group. In these situations, laws can be used to align individual incentives, for instance, let everyone agree on a side to drive on. This in turn leads to outcomes that are beneficial to the individual and to the society. Game theory frameworks can be used to identify areas where laws are necessary. Indeed, game theory justifies the very existence of laws in a free society!

Laws are designed to help individuals interact with each other productively to create successful societies and game theory is the study of how individual interactions add up to group outcomes. Game theory frameworks therefore, can be applied to a variety of legal questions.

For example in tort law, game theory can assist lawmakers and judges in setting punitive damages for defective products so as to incentivise manufacturers to establish the correct quality procedures. Game theory is also useful in intellectual property cases where regulators must balance the need to reward innovation (patent protection) against the necessity to make the innovation widely available (allowing generics). However, the most commonly discussed application of game theory in legal questions is the use of game theory in leniency policies, especially in the realm of antitrust enforcement.

Busting cartels and conspiracies using leniency

Broadly speaking, a leniency policy is an agreement that a member(s) of the conspiracy who assists law enforcement in proving a conspiracy will be given a reduced punishment, or perhaps no punishment at all.

When law enforcement investigates a crime, they usually suffer from an information asymmetry, that is, the conspirators know more than the enforcers about how the crime was committed. If the conspirators co-operate, then it becomes very difficult for law enforcement to obtain the proof they need to prove the conspiracy. By offering reduced punishments, leniency systems can give individual conspirators an incentive to ‘betray’ the conspiracy. This in turn provides enforcers with the necessary information to prove the conspiracy and punish the participants.

To illustrate how a leniency system can be an effective tool for law enforcement, let us use that canonical example of game theory, the “prisoner’s dilemma”.

First, consider a system without a leniency policy. Two criminal accomplices (A and B) have conspired in a serious crime that carries ten years in prison. The police however, have evidence of only a minor crime punishable by only two years in prison. The police need information from at least one of them to have proof of the serious crime. The table below describes each person’s payoffs in this scenario.

Prisoner’s dilemma – no leniency

PrisonersDilemma_NoLeniency1

In this scenario, both A and B will clearly stay silent. In any scenario other than both staying silent, they both get 10 years in prison. So without a leniency policy, neither will co-operate and law enforcement is unable to prove the major crime.

Now, what if the police were to offer some ‘leniency’ for cooperation. Both criminals will be offered a chance to confess. If one confesses while the other stays silent, the confessor will go free while the non-cooperator will get the maximum 10 years. However if both co-operate, both can get a reduced sentence of 6 years. The table below describes the payoffs in the revised scenario.

Prisoner’s dilemma – with leniency

PrisonersDilemma_WithLeniency1

In the revised scenario, if B is going to be silent, A is better off talking because A would go free. If B is going to talk, A is again better off talking since a six-year sentence is better than a 10-year sentence. So whatever B does, it is better for A to talk, so as a rational person, A will talk. However, if B is equally rational, he will talk as well. With both confessing, law enforcement can convict both for the serious crime.

This shows that leniency policies can be a powerful tool for law enforcement to break criminal conspiracies like cartels. For one, they provide the possibility of detecting conspiracies that might have gone undiscovered. Secondly information gleaned through the leniency system make it much more likely that the conspiracy can be proven and the participants sanctioned.

Perhaps more importantly, leniency policies act as a deterrent for conspiracies. If each conspirator knows that their partner has an incentive to betray them in the future, they are less likely to enter into the conspiracy to begin with. This is especially true when leniency is offered only to the first conspirator to come forward, creating a potential ‘race to betrayal’. Promoting confusion and mistrust in a conspiracy through leniency policies makes it less likely that a conspiracy can form or continue for long periods.

Leniency systems however, are no magic bullet. A leniency policy without a strong enforcement and investigative program for example, is toothless. Unless one or more conspirators fear imminent detection, they will have no incentive to come forward. Similarly, the level of punishment and leniency matter. If sanctions for conviction are minor, then it reduces the value of the leniency in coming forward.

Too much leniency however, means reducing the deterrent for forming conspiracies in the first place. At times, leniency policies can provide incentives for false testimony or even encourage the formation of cartels in certain situations. The specifics are important and game theory frameworks can be very useful in calibrating leniency policies. The dynamics of how game theory is used in setting the optimal policies for different situations is a fascinating discussion in itself. But to quote the famous Kipling, ‘that is another story for another time’.

Law enforcement uses leniency systems in a variety of contexts. The most common version is similar to the “prisoner’s dilemma” and a staple of most cop TV shows, where investigators urge a criminal ‘to roll’ on his accomplices. Whistleblower laws that reward employees for reporting malfeasance by their employers is another form of leniency policy. Perhaps the most discussed application of leniency policies is in investigating cartels of companies indulging in anti-competitive activities like price-rigging. Cartels are often very difficult to prove because much of the collusion between the firms is tacit and undocumented. This makes it crucial to have ‘inside info’ from one of the participants. A famous recent example was when Samsung was granted immunity by the European Commission for revealing a conspiracy with other firms like LG to collude on the prices of LCD screens. However, while it is a powerful tool, it must be used judiciously because there is much potential for abuse or for creating an environment where law enforcement seems inconsistent and arbitrary.

(Shree is a wandering economist who has changed his address fourteen times in the last fourteen years. He has few ideas except those opposite to who he is talking to.)

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Dealing with exploitative abuse: Does the Competition Commission have the power to fix prices?

JSaiDeepakpicMost students and practitioners of competition law are aware that Section 4 of the Competition Act, 2002 deals with the abuse of dominant position. Among other things, the direct or indirect imposition of unfair or discriminatory prices (including predatory prices) in the purchase or sale of goods or services by a dominant entity is deemed under Section 4(2)(a) of the Act as abuse by that entity of its position in the market.

Of the three kinds of pricing referred to in the provision, predatory price is the only one defined in the explanation to the provision. There is no express guidance on what constitutes “discriminatory price” and “unfair price”. Since the Act uses two distinct terms which are capable of being ascribed independent meanings, they must be recognised as two different forms of abuse by a dominant entity, which also have distinct consequences for the victim of the abusive conduct.

Discriminatory pricing results in what the literature broadly calls exclusionary abuse, whereas unfair pricing is understood to lead to exploitative abuse. Between the two, what constitutes “discriminatory pricing” is relatively easier to understand. The interpretation of “unfair price” poses the challenge of subjectivity and calls for safeguards to prevent the imputation of a meaning which was never intended by the legislature.

As stated earlier, the Act does not define “unfair price”. Section 2(z) of the Act states that words and expressions used but not defined in this Act and defined in the Companies Act, 1956 shall have the same meanings respectively assigned to them in the latter statute. Neither the Companies Act nor the Depositories Act, 1996 appears to define “unfair” or “unfair price”. The definitions of “unfair trade practice” in the Consumer Protection Act, 1986 or the erstwhile Monopolies and Restrictive Trade Practices Act, 1969 too do not seem to be of help in understanding the meaning of “unfair” from the perspective of pricing.

This requires us to look for interpretation of provisions in foreign legislations which are in pari materia with the Indian provision. Article 102 of the Treaty on Functioning of the European Union (TFEU) is similar in language to Section 4(2)(a) of the Competition Act. However, in the EU too, the body of case law on exploitative abuse is significantly small compared to judicial guidance on exclusionary abuse. The trend in the EU too perhaps may be attributed to the reluctance of the European Commission to deal with an inherently subjective enquiry such as exploitative abuse.

Dominant players have to adhere to a higher standard of conduct in pricing

Whatever little case law exists appears to interpret “unfair” as “excessive”. The frequently-cited case on unfair or excessive pricing in the EU is the decision of the European Court of Justice in United Brands Company v. Commission of the European Communities (C-27/76 [1978]), where the following test was laid down:

“The questions therefore to be determined are whether the differences between the costs actually incurred and the price actually charged is excessive, and, if the answer to this question is in the affirmative, whether a price has been imposed which is either unfair in itself or when compared to competing products.”

Of the two questions which need to be answered under the test, the first calls for the establishment of the absence of a correlation between the costs actually incurred and the price charged by the seller for a good or service. This would require the antitrust regulator to also assess the fairness of the profit margin earned by the seller. The larger policy implication is that dominant players could be expected to charge fairly, which obligation does not apply to entities which are not dominant. Simply put, since a dominant player, by definition, is one who can act independent of market forces, he is expected to adhere to higher standards of conduct given the potential for abuse and the consequences for consumers and market as a whole.

Can the regulator fix a price?

FreeCoursesHaving said this, the question that arises with respect to application of the United Brands test is this: is the regulator expected to merely establish the absence of a reasonable correlation between costs and selling price to arrive at a finding of unfair pricing? Or is it expected of the regulator to first arrive at what is fair before commenting on the unfairness of the price? It is one’s opinion that in either approach, the seller cannot be left in the dark as to what is truly fair in order for him to avoid being hauled up a second time for unfair pricing. In other words, although an enquiry on exploitative abuse requires the regulator to perform the role of a price regulator, it could be said that the regulator may also be called upon to set prices. That said, this is not merely an issue of policy, since a regulator who is the creature of a statute cannot exercise powers which have not been vested in him by the statute.

In the Indian context, this boils down to a simple question: whether the Competition Commission has the power to set or fix prices, and not just comment on its unfairness? To answer this, one must interpret Sections 27 and 28 of the Competition Act which spell out the powers of the Commission to deal with abuse of dominant position. Specifically, Section 27(d) empowers the Commission to direct that agreements which are in contravention of Section 4 “shall stand modified to the extent and in the manner as may be specified in the order by the Commission”. Section 27(g) is even broader since it permits the Commission to pass such orders or issue such directions it may deem fit.  Similarly, Section 28(2)(a) empowers the Commission to vest property rights, which implicitly includes creation of interest in favour of third parties by way of a license. The combined interpretation of these provisions makes it abundantly clear that the Commission has the necessary power to fix prices in a given case if the case so warrants.

For instance, in a situation where the agreement relates to a patent license between a patentee who is a dominant entity and another entity which is the licensee, the royalty tariff demanded by the dominant patentee could be accused of abuse under Section 4 for unfair or excessive pricing. In exercise of its power under Sections 27(d),(g) and 28(2)(a) based on the language of the provisions, it appears possible for the Commission to modify and spell out the prospective royalty tariff. Simply stated, apart from finding the extant royalty tariff unfair, the Commission has the express power to dictate the future tariff.

This conclusion typically raises objections relating to the ability and expertise of the Commission to set future commercial terms in highly specialised agreements where domain or sectoral expertise is called for to understand the commercial practicalities of the sector. But that objection is not one of statutory power, it is one of the Commission having the wherewithal or expertise to do justice to the nature of enquiry. Therefore, such an objection cannot be used to argue that the Commission lacks statutory authority to fix prices since it is the language of the Act that is decisive of the issue. In any event, this is not an insurmountable challenge since the Commission has the power to consult experts in the relevant domain before it fixes future tariff in specialised contexts.

In conclusion therefore, the Competition Commission has the power to enquire into exploitative abuse by a dominant entity and also has broad powers to fix prices, where warranted.

J. Sai Deepak, an engineer-turned-litigator, is a Senior Associate in the litigation team of Saikrishna & Associates. He is @jsaideepak on Twitter and the founder of “The Demanding Mistress” blawg. All opinions expressed here are academic and personal.

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The abuse of a dominant position acquired through a patent is a subject for competition law

JSaiDeepakpicTypically, patent litigation involves suits for infringement and counterclaims for patent invalidation. The conduct of parties to patent disputes however, has added another dimension — the effect of the patentee’s conduct on consumers and competition in the market.

Take for instance, the anti-trust proceedings initiated in 2012 by the European Commission against Motorola Mobility Inc. The main ground for the investigation was Motorola’s aggressive pursuit of injunctive relief against potential licensees to coerce them into paying unreasonable royalty for the use of Motorola’s Standard Essential Patents (“SEPs”) on video compression standards and standards for Wireless Local

AdvancedProfessionalCertificationinCorporateLawPractice_apcclpArea Network (WLAN) technologies. SEPs, a type of patents, claim inventions that are necessary to comply with the prevailing technology standards. Given the essential nature of the subject-matter claimed by these patents, their abuse or coercive use has serious and adverse implications for consumers and other players in the industry.

In light of these developments,we need to clearly understand the respective realms of the Patents Act, 1970 (“Patents Act”) and the Competition Act, 2002 (“Competition Act”). Although the Patents Act is typically associated with patent grant, validity, and enforcement, Section 140 of the Act lists the restrictive covenants that are forbidden in patent-related contracts such as licenses. The provision, among other things, expressly proscribes any contractual provision that prevents a challenge by a licensee to the validity of a licensed patent. Similarly, Section 84 of the Patents Act provides for a compulsory licensing mechanism to ensure that a patentee fulfils his obligations under the Act, one of which is to provide access to his patented technology at reasonably affordable rates.

Although both these provisions address certain “public” concerns, the Patents Act does not have the mandate, bandwidth, or the teeth to ensure that a patentee’s conduct does not have an adverse effect on other players and consumers. Instead, it is the Competition Act that has the express mandate to deal with and deter anti-competitive conduct and to promote balance in the market.

Section19(4)CompetitionAct2002_AbuseofominantPosition.jpgIn this regard, it would help to read Section 19(4) of the Competition Act. This particular provision spells out those factors which the Competition Commission of India (“CCI”) shall have regard to when enquiring if an enterprise enjoys a dominant position under Section 4 of the Competition Act. One of these factors is the monopoly or dominant position acquired as a result of any statute. This clearly includes a patent right, which is a statutory monopoly granted by and under the Patents Act. Simply put therefore, the CCI has the power under Section 4 of the Competition Act read with Section 19(4)(g) to look into allegations of abuse of dominance acquired as a result of a patent right. In other words, the manner of patent exploitation and enforcement, and its effect on the market are the primary preserve of the Competition Act, and not the Patents Act.

Specific and general legislation

Citing Sections 84 and 140 of the Patents Act, it could be argued that the Act — being the more “specific legislation” which governs patents and patentees compared to the Competition Act — must be treated as a self-sufficient code. This approach however, is flawed since, as stated earlier, addressing market inequities generated as a consequence of a patentee’s abuse of his rights is essentially a subject of scrutiny under the Competition Act, and not the Patents Act. This explains the reason for the presence of Section 62 of the Competition Act, which in effect states that the competition statute shall apply in addition to and not in derogation of, other legislations such as the Patents Act. Therefore, the specific-over-general rule does not apply to Competition Act insofar as the Patents Act is concerned. In fact, the Competition Act goes even a step further and provides in no uncertain terms in Section 60 that the Act shall prevail over any other law in force which is inconsistent with the Competition Act. This “overriding effect” ensures that the Competition Act’s applicability is never watered down or rendered futile because of a conflict with another provision in any other law.

Sections60and62_CompetitionAct2002.jpgAt this point, it may be important to clarify the position of the Competition Act under Sections 60 and 62 to understand the status of the legislation. While on the one hand Section 60 proclaims the overriding effect of the Competition Act over anything that is inconsistent with the Act, Section 62 states that the Act shall be in addition to, and not in derogation of other laws. What this means is that so long as there is no inconsistency between the Competition Act and other legislations such as the Patents Act, both statutes shall apply simultaneously to a situation to which both Acts apply. In the event an inconsistency, the Competition Act will prevail. Therefore, in case of a non-conflicting intersection, both statutes apply, and where there exists or arises a conflict, the Competition Act shall prevail. After all, market and consumer interests have to prevail over domain-specific issues.

J. Sai Deepak, an engineer-turned-litigator, is a Senior Associate in the litigation team of Saikrishna & Associates. He is the founder of “The Demanding Mistress” blawg. All opinions expressed here are academic and personal. 

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State aid to Spanish football clubs cannot be justified using the Market Economy Investor Principle

SudiptoSircar_mylaw.netRecently, the European Commission (“the Commission”) commenced an investigation into the funding of seven Spanish football clubs. The Commission Vice President in charge of competition policy, Joaquín Almunia said, “Professional football clubs should finance their running costs and investments with sound financial management rather than at the expense of the taxpayer. Member States and public authorities must comply with EU rules on state aid in this sector as in all economic sectors.” The Commission will investigate the tax privileges of four clubs including Real Madrid and Barcelona, assess a widely reported land transfer between the City of Madrid and Real Madrid, and examine guarantees given by the state-owned Valencia Institute of Finance for loans that were used to finance the three Valencia clubs while those clubs were seemingly undergoing financial difficulties.

Sport and competition law in the EU

Sport has a significant role in the European Union’s economy. According to the European Commission (“EC”), it represents 3.7 per cent of the EU’s GDP and employs fifteen million individuals. Football constitutes the major chunk. It should not come as a surprise therefore, that the Union of European Football Associations (“UEFA”) and the clubs affiliated with it are no strangers to competition law investigations.

A number of concerns have occupied these investigations and final judgements. The joint sale of sports media rights was at issue in the U.E.F.A. Champions League, the F.A. Premier League, and the Bundesliga decisions, while the joint acquisition of sports media rights came under scrutiny in Eurovision I  and Eurovision II. The European Court of Justice has confirmed that the commercial exploitation of sporting events is covered by E.U. competition rules (the MOTOE case), and in the Meca Medina Case, the Court finally held that the compatibility of sporting rules with EU competition law should be examined on a case-by-case basis.

State aid in EU competition law

The Treaty on the Functioning of the European Union (“TFEU”), under Articles 107 to 109, provides the Commission with the power to deal with aids provided by member states to their domestic industry or enterprises, which could distort competition in the internal market.

Article107TFEU_stateaid

The second and third clauses of Article 107 provide for the situations that the Commission shall and may respectively, consider as compatible with the internal market. Article 108 provides for the procedure for monitoring any state aid and the consequence for any state aid that is incompatible with the internal market. Council Regulation 659/1999 and Commission Regulation 794/2004 were framed under Article 109. Commission Directive 2006/111/EC on “the transparency of financial relations between Member States and public undertakings as well as on financial transparency within certain undertakings” is also relevant to this discussion.

Why is state aid a problem?

To understand why this investigation is in progress today, we must turn to a report on the financial health and status of professional football clubs, Club Licensing Benchmarking Report Financial Year 2008, published by the UEFA in 2008 during Michel Platini’s term as President.

Sports-LawAccording to the report, most professional football clubs were facing recurrent losses. It warned of a dire financial outlook for European clubs and blamed it on the constant increase in players’ salaries, which amount to more than sixty per cent of a club’s expenses. The most important leagues — for the sport and for the economy — were (ironically) the ones with the greatest aggregated debt. The report advocated “financial fair play”.

Many clubs were registered as companies and shareholder contributions and other sponsorship helped, but several clubs survived on public intervention. State aid appeared in several guises including direct subsidies, sponsorship under non-market conditions, non-collection of tax or social security debts, and aid for the construction of sports infrastructure. Some of the allegations made by the Commission in relation to the Spanish clubs, paint exactly such a picture.

Therefore, this is a much-delayed investigation and has probably been triggered by public sentiment following the financial crisis. In fact, the present investigation is not unprecedented. In March 2013, the Commission had opened an investigation into the public funding of five professional Dutch clubs, including PSV Eindhoven.

MEIP

Subject to a caveat that it is a prima facie opinion based on the facts already available in public domain, the Commission does seem to have a case. At the time of writing, the E.C. was negotiating confidentiality issues with the parties.

Salaries of players account for a large share of a Spanish football club's expenses.
Salaries of players account for a large share of a Spanish football club’s expenses.
(Photo above is from Jan SOLO’s photostream on Flickr. Image alone published under a CC BY-SA 2.0 license.)

Under E.U. competition law, one of the principles for the justification of state aid is the Market Economy Investor Principle (“MEIP”), according to which public interventions in favour of market actors that carry out economic activities can be considered free of state aid within the meaning of EU law when they are made on terms that a private operator would have accepted under market conditions. If the MEIP is not respected, the public interventions will constitute state aid within the meaning of Article 107, because they confer an economic advantage on the beneficiary that its competitors would not have. I find it very hard to justify the measures and subsidies in favour of these clubs under this principle. Strictly on economic terms, the clubs should have either downsized or closed down a long time ago. It is quite possible however, that the clubs and the Commission will choose to settle any penalties and work out a formula for the gradual withdrawal of state aid.

(Sudipto Sircar, an Advocate at the Delhi High Court is the founder of the Indian Competition and Anti – Trust Blog. You can reach him at sudiptosircar@outlook.com)

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Apar Gupta spoke about “network neutrality”

Click here to listen to Apar Gupta speak about whether network providers should be allowed to discriminate between the information flowing through their networks.
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