This article is written by Suryansh Verma, a 3rd-year student at Dr Ram Manohar Lohiya National Law University, Lucknow. In this article, he throws light on the Hub and Spoke Conspiracies that conspire between firms in the respective competitive markets in the form of cartels. He has also referred to case laws concerned with the same.
Table of Contents
Introduction
The Hub and Spoke model is a doctrine of the US Antitrust law in cases of Competition Law and Criminal Law. In antitrust law, it is a cartel in which a firm colludes amongst the upstream firms or the downstream firms through vertical restraints.
There are no definitions of the concept in European Law as well.
However, the US Court of Appeals for the First Circuit explained the basic concept behind this conspiracy. In such a conspiracy, there is a central mastermind which controls several spokes or co-conspirators. The co-conspirators usually participate in certain transactions with the individual or a group of individuals at the “Hub”. Such an agreement collectively furthers a single, illegal enterprise for achieving a specific object.
For example – There are three companies A, B, and C dealing in pharmaceuticals. B, in this case, will be used as the hub by A to implement a price increase. This will be done if C does the same. B will communicate to C, A’s intention to increase its prices. C will confirm this to B that it will be following A’s intention to increase the price. Finally, B will pass on C’s confirmation to A. B’s function is that of a hatch between the parties to the cartel.
Elements of the Hub and Spoke conspiracy
The Hub and Spoke Conspiracy is said to have four elements i.e. –
- The Hub, which is the dominant purchaser.
- The Spokes, which are the competitors in the market which enter into vertical agreements with the hub.
- The Rim, which connects the hubs and spokes resulting in horizontal agreements between the two.
- Vertical restraints which connect the hub and the spokes.
What does The Hub do?
The hub is the facilitator and enforcer of the collusion between the spokes. The hub is basically, an upstream supplier or a downstream customer that facilitates cartelization. Not all, but some of the cartel functions are centralized at the hub. A hub functions by the vertical or horizontal relationships with its spokes. The hub is the key player in coordinating the collusive scheme.
It is often the Hub that has an object to achieve by way of the hub and spoke collusion. The hub helps in achieving a mutual understanding between the Spokes.
A hub can reprimand the spokes if they do not comply with its policies. This, in turn, makes the enforcement of hub and spokes arrangement quite efficient. The hub performs its own monitoring of the collusion, collects reports from the spokes and worked accordingly with the non-compliant spokes. The hub also needs to convince each Spoke that the other Spokes are participating in the collusion.
How do the Spokes function?
The firms or the colluding competitors which are at the end of the rims are the Spokes. The Rim is the horizontal or the vertical agreement between the Hub and the Spokes. For a hub and spoke cartel, the existence of a Rim is of paramount importance. Without the rim, the cartel is just an arrangement of vertical relationships between the Spokes. The Spokes usually function via the Hubs. They convey their messages to the Hub which further conveys it to the other spokes in the collusion.
The requirement of Rim
In the hub and spoke cartels, the rim is very pertinent. Without, the rim, the hub and spoke cartel cannot exist. The alleged hub and spoke cartel, is just a set of vertical relationships which result in parallel conduct and do not establish a horizontal conspiracy.
For proving a hub and spoke conspiracy, there needs to be evidence that there is a rim which connects the spokes.
It has been held in various judgments of the US Supreme Court that rimless wheel theories do not establish the existence of an antitrust violation.
Cartels are facilitated through vertical relationships
Less use of horizontal coordination
Hub and Spoke cartels collude with either upstream firms or the downstream ones. Cartels make use of various mechanisms to collude such as using third parties to indulge in collusive activities. The hub enforces the cartel by using its vertical relationship with the spokes. This, in turn, reduces the need for horizontal coordination. The enforcement of these cartels is effective because the hub can reprimand the spokes in cases of non-compliance.
Ambiguity
Practices such as certain geographic restraints, exclusivity clauses or the Most Favoured Nation Clause divide the territory among competitors. Such arrangements may generate both, competitive or anti-competitive effects. The proof of a set of vertical relationships which give rise to parallel conduct cannot be conclusive proof of an antitrust violation.
This creates ambiguity in identifying such cartels. There needs to be proof that such an action will hinder the competitors from taking any independent action. There is rarely any proof of direct communication among the colluders.
The courts, however, take into account the set of vertical relationships that would have facilitated the horizontal relationships. The vertical relationships are very much ambiguous as there is no standard proof of existence. The courts take into account other necessary factors as well for proving the existence of a cartel. To know more about cartels Click Here.
Why the Hub and Spoke Cartels are Less Effective?
Collusion between competitors requires a mutual understanding between them and also direct contact between them. In a hub and spoke cartel, this mutual understanding is achieved by indirect communication through the Hub.
Comparing direct communication with indirect communication, hub and spoke cartels are less effective.
The first reason being the indirect communication between the competitors. The messages between the spokes lose information whilst going through the hub. Collusion requires each and every competitor to achieve the trust of other cartel members. This would, in turn, help them to take the cartel members in confidence and also that they will abide by the collusive outcome.
While making direct communication with the competitors, this trust can be gained not only by words but also by the facial expressions, body language, etc. In the hub and spoke cartels, indirect communication does away with all of these.
In addition to this, the hub may sometimes forget to convey the message said by a spoke or insert something else which the spoke did not say. Summing it all up, the messages conveyed by a hub are less informative which makes it difficult to coordinate on a collusive arrangement.
Secondly, the hub can intentionally contort the messages or control the communication between the spokes in any way. The hub cannot be presumed to be a neutral Third Party. The Hub might have a different objective when compared to the Spokes. Even though the Hub and Spokes all want collusion to exist, the desired collusion might differ between them. It is totally possible that even in direct communication some firms may try to mislead the others by convoluting the material facts.
Some illustrative cases
The article shall encompass the nine landmark cases on Hub and Spoke Cartels –
Interstate Circuit, Inc., et al v. the United States
The case is concerned with the propagation of movies. The market consisted of first-run theatres where the movies which were released were shown first. The market also consisted of second-run theatres where the movie was shown a little later at a lower price. There were two chains which dominated this whole arena. They were – the Interstate Circuit and the Texas Consolidated. The Interstate Circuit exercised a monopoly over forty-three theatres whereas the Texas Consolidated did on sixty-six theatres.
The first run theatres were showing a movie for a price of 40 cents, whereas the same movie was shown by the subsequent theatres showed two films sometimes at an extremely low price.
In 17 out of 18 subsequent-run theatres, the price of the ticket was even less than twenty-five cents. In the majority of those, the price was fifteen cents.
The tough competition forced Interstate to coordinate with the movie distributors in order to control the subsequent-run theatres. The manager of Interstate started to engage in communications with the branch managers of the eight distributors.
The plan was that the subsequent-run theatres should not charge less than twenty-five cents per ticket. The same was conveyed to the movie distributors. This arrangement would accrue benefit to Interstate. This plan would raise the price of the ticket and lower the quality of experience provided by the other theatres.
For this scheme, Interstate would need to inform each and every movie distributor about such a scheme. A letter was sent by the manager to the 8 distributors. This letter had the contents related to the scheme. After the letter, meetings were conducted between the manager and each of the distributors bilaterally.
The Supreme Court of the US considered this letter as instrumental in achieving the understanding between the distributors. The Court was of the view that even though there was a lack of direct communication between the movie distributors, there was a mutual understanding between them. All the distributors had given their adherence to the scheme.
The Court apparently found this conduct to be illegal as the arrangement went ahead of a vertical contract between one upstream firm and one downstream firm. The downstream firm achieved collusion by way of upstream firms. In this, the downstream firm i.e. Interstate was the Hub whereas the movie distributors were the Spokes. They were told that the other distributors were complying as well.
In re Toys “R” Us, 126 F.T.C. 415
In the 1900s, the dominant toy retailer in the U.S. market was Toys “R” Us (20% market share). There were certain upstream firms such as Mattel, Hasbro, Tyco and Little Tikes with 18%, 17%, 3.2% and 2.8% market shares respectively. Toys “R” Us was one of the most important customers of the upstream firms.
There existed warehouse clubs which sold at a lower rate as compared to Toys “R” Us(hereinafter referred to as TRU). The divisions of Walmart, K-mart, etc. These clubs sold lesser toys as compared to TRU. They also worked with the manufacturers to get some specially-packaged products which were sold at a higher price. However, the value of the unit was very less which created a huge margin of profit.
The clubs used to sell the toys at a price lower than that of TRU. TRU was no more the lower price seller. There was an alternative of cutting down on the prices of the toys but it would have ultimately led to stiff competition amongst the clubs. Moreover, it would also affect the profits of TRU.
The other way was by colluding with the toy manufacturers and limit the supply of toys to the clubs. The strategy adopted by TRU was pretty simple. It involved the exclusion of the rival firms by curbing down the variety of products being offered to them.
The toy manufacturers were sceptical about this arrangement. A toy manufacturer was willing to comply only if other manufacturers were willing to do so. Also, this collusive scheme would also be executable only when all the manufacturers were bought into it. Manufacturers such as Mattel, Hasbro and others wanted to know the reaction of their competitors with regards to the action of TRU.
All of them wanted to be assured that they are being treated the same as other competitors. TRU indulged into bilateral meetings with each of the toy manufacturers. TRU went to each of these manufacturers and communicated to them about the compliance by other manufacturers. TRU used the acceptance given by one toy manufacturer to bring others on board.
TRU did this for over a period of 12 months and surpassed many obstacles in the way. In this case, also, TRU was the Hub being the downstream supplier whereas the toy manufacturers were the Spokes. There was always apprehension on the part of the manufacturers of deviation by rival firms. TRU also used to monitor compliance by each and every manufacturer. The manufacturers who did not comply with TRU’s policies were punished for such non-compliance.
TRU had organized a horizontal agreement among the toy manufacturers. The executives at TRU were operating at the centre of the hub and spoke conspiracy. They were hurling commitments at the manufacturers as well.
This collusive strategy was actually effective in bringing down the sales of the clubs. The sale stats of Hasbro and Mattel to the clubs dropped from a whopping 32.5 million dollars in 1991 to 10.7 million dollars in 1993. This was a considerable drop that too within a period of 2 years.
TRU was successful in achieving the object of the Hub and Spoke conspiracy.
United States v. Parke, Davis & Company, 164 F. Supp. 827 (D.D.C. 1958)
This case is concerned with the manufacturing and selling of pharmaceutical products by Parke, Davis & Company to its retailers and drug wholesalers. Parke Davis used to have a suggested minimum retail price. In 1956, some of the drug shop chains in Washington D.C. began to price the drugs below the SMRP. There was one retailer, especially who was engaged in pricing the drugs below the SMRP at a very low cost.
Parke, Davis decided to refuse the drugs to the retailers who would price them below the SMRP. All the wholesalers and retailers were informed of this policy in July 1956. After this, Parke, Davis stopped the supply of five retailers who were still pricing the drugs below the SMRP. Parke decided to modify the policy by stating that if the retailer advertised a price below SMRP, then only the sales shall be cut off.
After some time, Drug Dart and the other retailers started to advertise lower prices of the drugs. Parke Davis did not refuse to sell to them because of an inquiry pending before the Antitrust Division of the U.S. on a complaint by Drug Dart.
The communications that Parke Davis had with the retailers and the wholesalers were bilateral, or with a single retailer or wholesaler. The Department of Justice held Parke Davis to be in violation of section 1 of the Sherman Act.
As the communications between Parke Davis and the wholesalers/retailers was always one on one, it was able to coordinate a plan through the hub and spoke arrangement. In such an arrangement, Parke Davis acted like the Hub whereas the wholesalers or retailers were the Spokes. The plan was to convince the retailers not to price the drugs below the SMRP.
Department of Justice’s complaint was dismissed by the District Court on the basis of evidence that there was none where Parke, Davis discussed its sales policies with any of the wholesalers or retailers.
The Supreme Court held the conduct of Parke, Davis to be in violation of sections 1 and 3 of the Sherman Act.
The United States v. Apple Inc.
Amazon used to dominate the e-book market back in 2007 by the introduction of Kindle. Amazon used to charge $9.99 for a typical $30 hardcover. Amazon had a 90% share in the e-book market. This is the famous e-book case wherein Apple was launching the iPad in January 2010. The goal of Apple was to stock the iBookstore.
This would help the iPad users in purchasing and downloading them by the time of the launch. For this, Apple had to work out an arrangement with the six big shots of the book publishing department – Hachette, HarperCollins, Penguin, Random House, Macmillan, and Simon & Schuster.
The CEOs of the Big Six used to discuss amongst themselves in meetings matters pertaining to the industry and also Amazon’s pricing policy and joint strategy for raising these prices. The publishing houses had to adopt a unified front to bring about a change in Amazon’s pricing policy.
The Big Six wanted to raise the price of the e-books from $9.99. The objective of Apple was to compete with Amazon and the publishers wanted to reduce the power of Amazon in the market. This made them allies. Amazon used to set the retail price of every e-book i.e. at $9.99 (known as the wholesale model). The director of Apple’s digital content stores, Eddy Cue was in negotiations with the Big Six.
He suggested another wholesale model but with higher prices of the e-books. Two of the big six companies suggested an agency model in which the retail prices would be decided by the publishing companies. And, the revenue would be shared by Apple and the companies. This model was accepted by Apple with some control over deciding the retail prices.
The retail prices suggested by Apple were $9.99, 12.99$ and $14.99. The price of the e-books was dependent on the price of the Hardcover of the same book. These prices would not benefit the publishers if Amazon continued with its price of $9.99.
Thus, Apple adopted a strategy where the publishers would compel Amazon to adopt the agency model. Furthermore, it added a clause to the contracts with publishers wherein if any publisher offered a lower price for the e-book to Amazon, it will do the same for the price at iBookstore. All of this would have done three things i.e.
- The high prices of e-books will increase the sale of hardcover where the margin of profit is more.
- Control over retail prices is going to be profitable for Apple. How? Once the e-book market is well established, Apple could raise the prices of the books.
- Apple will be able to enter the market more easily which would weaken Amazon’s position.
This plan of Apple was accepted by the publishers. As you’ve read in the previous case wherein Toys R Us made sure that every other toy manufacturer was complying with the collusive scheme, Apple also made sure that all the competitors i.e. the Big Six were on the same page.
The Department of Justice in the complaint against Apple said that this adoption of the Agency Model will raise the prices of e-books. It takes away the authority from the publishers to set the retail prices.
This, in turn, would result in higher prices of the e-books. The clause added to the contract also ensures that nobody could lower the prices of e-books except for Apple. Amazon was dominant in the e-book market. Both, Apple and the publishing houses wanted to decrease this dominance of Amazon in the market of e-books.
Eddy Cue was the Hub in this arrangement whereas the CEOs of the publishing houses were the Spokes. There was a direct communication between the hub and spokes.
Finally, after a series of negotiations, and collusions between Apple and the Big Six, Amazon finally adopted the Agency Model. This led to the rise in the retail prices of the e-books.
Apple was found guilty of violating section 1 of the Sherman Act by the District Court. Apple also lost when it preferred an appeal before the Court of the Second Circuit which supported the judgment of the District Court. The Supreme Court also denied the petition filed by Apple for Certiorari.
A horizontal price-fixing conspiracy was crafted by Apple in the instant case
The PepsiCo case
This case involved a high-profile hub and spoke conspiracy. Emphasis was laid down on the requirement of the existence of the rim to prove such cartel. In this case, what happened was that Coca Cola entered into vertical agreements with distributors which included loyalty clauses. These clauses forced the distributors to decide between Coca Cola and Pepsi Co. The legal validity of these clauses was challenged by Pepsi Co. wherein the judgment was given in favour of Coca Cola. The Courts of the Second and Fourth Circuit stressed the requirement of the rim.
Similarly, in the Dickson case wherein, certain distribution agreements were disputed. The district courts said that without the rim, an action cannot be taken against the plaintiffs. This contention was rejected by the Court of the Fourth Circuit that even rimless wheel theories can establish a violation of the antitrust conspiracies.
Conclusion
A hub and spoke cartel is like a wheel. The hub plays the most important role in executing such cartels. In the above-mentioned cases, it has been specified how the hub functions giving directions to the Spokes. And, also how the Spokes convey their messages to other spokes via the Hub. Such cartels are executed for achieving a certain objective. For example, Apple wanted to raise the retail prices of the e-books that is why it colluded with the publishers. Such cartels are easy to crack. Most of the cartels are caught within a minimum period of 3 months (in the Parke Davis Case).
This short duration shows the rapidity with which such cartels are caught. Such cartels involve the exchange of information in which the firm collects and distributes the information. This type of cartel is a method that firms use frequently to restrain competition in markets.
It is extremely difficult to achieve a mutual understanding by way of Hub and Spoke collusion because of indirect communication. However, once such an understanding is achieved, it becomes very easy to control the market.
