Strategic Alliances — Appendix 1: Illustrative Scenarios

Strategic Alliances Scenarios
(I) Conspiracy Example
(II) Information Sharing Example
(III) Cooperative Measures To Meet Environmental Regulations Example
(IV) Export Consortium Example
(V) Specialization Agreement Example
(VI) Merger Example
(VII) International Alliance Example
(VIII) Abuse Of Dominance Example
(IX) Industry-Wide Agreement Example

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The possibilities for different kinds of strategic alliances are virtually without limit. Strategic alliances can be found in most, if not all, industries and include firms of all sizes and descriptions. The motivations for entering into alliances also vary considerably, including research, efficiency, learning, market access, or anticompetitive ends. Finally, strategic alliances may be constructed in various corporate forms.

To assist business people in determining the status of various types of strategic alliances under the Act, nine illustrative scenarios are presented below, relating to conspiracy, information sharing, cooperative measures to meet environmental regulations, export consortia, specialization agreements, mergers, international alliances, abuse of dominance, and industry-wide alliances. These scenarios are presented in summary form and of necessity do not include an exhaustive factual background nor a lengthy discussion of the issues raised. They are meant only to highlight the likely analytical approach taken in each situation. While the principles and issues identified in these scenarios have general application to all industries and to the many forms which strategic alliances may take, parties may wish to approach the Bureau for more specific guidance in respect of a particular alliance.

Strategic Alliances Scenarios

(I) Conspiracy Example

All of the members at one trade level of an industry want to take joint action to rectify or "clean up" two principal concerns: discount levels have become "too high" and credit terms have become "too long". Because each of these "problems" represents a form of competitive inducement to the customers of the industry, no single firm is willing to discontinue the current practice unilaterally due to the risk of lost business. Hence, they argue that joint action is required, perhaps through an alliance of interests established by their trade association. It is agreed by the three largest members of the industry association that they will participate in an alliance to better align their long-term interests, particularly their marketing strategies. As part of this strategy, the parties agree to discount levels and credit terms. A couple of smaller firms engaged in importing remain outside of the agreement although neither is viewed as a significant rival by the alliance partners.

Discussion

Whether the firms' proposals will cause the Director to initiate an inquiry will depend upon whether the likely effect of the alliance is an undue prevention or lessening of competition. As noted earlier, the "undueness" concept essentially involves a measurement of the market power held by the parties to the agreement combined with behaviour injurious to competition. In this example, the alliance of interests to be established involves the largest and most significant members of the industry. There are few firms outside of the alliance, and they are not viewed as providing significant enough competition to disrupt the participating firms' efforts to align their marketing strategies. If it is also the case that new firms would find it difficult to profitably enter this industry on a timely basis then new entry is unlikely to discourage the implementation of the agreement. In such circumstances, the Director is likely to find that the parties to the alliance possess market power.

As a result, the proposed course of action would likely cause the Director to initiate an inquiry under the conspiracy provisions. Notwithstanding the fact that the firms do not want to fix the nominal prices of the products which they sell in competition with each other, they are agreeing with respect to factors (i.e., discount levels and credit terms) which do have a bearing on the ultimate transaction prices to be paid and costs to be borne by their customers, with ensuing downstream price consequences. Hence, it is the Director's view that the behaviour of the firms would likely be injurious to competition.

(II) Information Sharing Example

A manufacturer of consumer appliances finds that it must become more efficient if it is to maintain its market position relative to its rivals in a increasingly competitive market. Impressive efficiency gains in warehousing and distribution have been realized by some firms outside of the appliance industry, which are being widely benchmarked by their own and other industries. (note 28) Following the example of others, the manufacturer seeks out a clothing retailer as a benchmark for distribution. The two firms enter into a contract pursuant to which the retailing company agrees to share confidential cost information with the manufacturer for a fee and subject to various non-disclosure provisions. The two firms also agree to work together to improve future warehousing and distribution techniques.

Encouraged by the benchmarking of the clothing retailer, the manufacturer seeks a wider strategic alliance with one of its competitors. Each firm would benchmark the other with respect to administration, warehousing and distribution.

The key lesson learned by the participants involved in the second benchmarking exercise is that neither firm can individually afford an information technology system but each needs to utilize such a system in order to remain competitive with the largest firms in the industry who are able to afford the system on their own. The two competitors enter into a further alliance whereby they jointly buy the information technology and share it as a common facility, but do not share competitively sensitive information through it. The sharing of information on their administration, warehousing and distribution costs ends with the acquisition of the information technology.

Discussion

In the first alliance involving benchmarking between the appliance manufacturer and the clothing retailer, there are no competition issues, given that the two firms do not compete with each other in their relevant markets. As the benchmarking exercise is shifted towards a horizontal competitor of the appliance manufacturer, however, there is a potential risk of exposure under the conspiracy provisions of the Act. The level of risk will depend upon the degree of collective market power held by the two manufacturers and upon what kind of information is shared, who shares it and the particular process whereby the information is compiled and disseminated.

In this example, it is unlikely that the participants in the second benchmarking exercise possess market power. While the benchmarking exercise includes two horizontal firms, it does not include the largest firms in the industry. Furthermore, the larger firms operating in the industry are able to afford the new technology and hence would appear to have a cost advantage over the benchmarking participants. This cost advantage presumably allows the larger firms to price in a more aggressive fashion compared to the benchmarking firms.

Under a different set of assumptions, the example could be constructed to give the parties to the second benchmarking exercise market power. In such a case, the benchmarking exercise could give rise to reduced uncertainty about the competitive reaction of rivals. Under these circumstances, a competition issue could arise even in cases where the information to be shared does not relate to future pricing, output, or marketing strategies. As the above example of sharing information technology is constructed, the parties jointly purchase information technology which is shared as a common facility without competitively sensitive information being exchanged. Hence, their behaviour is unlikely to be found to be injurious to competition.

(III) Cooperative Measures To Meet Environmental Regulations Example

An industry faces strong pressures from its customers, the general public and the federal government to reduce the level of emissions in manufacturing. Each manufacturer is willing to comply with environmental targets but only if its competitors also comply. Concerned that laggards would enjoy a competitive cost advantage, no firm is willing to take the lead in spending the necessary funds to reduce its level of emissions. To remove this concern, the industry association signs a memorandum of understanding with the federal government pursuant to which its members will work together to voluntarily achieve target reductions of certain emissions.

The four largest firms, accounting for 80% of Canadian output, also agree to enter into a research alliance to develop new technologies for reducing emissions and to find substitutes to existing products which present an environmental hazard.

Discussion

Voluntary agreements by industry to comply with environmental standards set by government are an alternative to command-and-control type regulations. They are part of an international trend towards market-oriented policies and decreasing reliance on industry-specific government regulation. Voluntary environmental agreements may refer only to emissions and the unwanted by-products of production, or they may refer to the final products that are sold on the market themselves (e.g., the reduction or complete elimination of products that contain certain harmful substances).

This example falls within the defences to the conspiracy provisions outlined in the Act; namely, measures to protect the environment. (note 29) As a result, it will cause the Director to initiate an inquiry under the conspiracy provisions only if the exception to the defence applies. If the environmental agreement relates only to emissions and unwanted by-products of production, it is not likely to prevent or lessen competition unduly in respect of either prices, quantity or quality of production, markets or customers, channels or methods of distribution or restrict entry or expansion and as a result the defence will hold. Likewise, if the research alliance is not likely to result in any of the adverse effects contained in the exceptions above, it too will fall within the defence.

Alternatively, if the environmental goal requires a reduction or limitation upon final product output, as opposed to emissions, an issue could arise under the Act if the participants to the voluntary agreement collectively possess market power. Targets for reduced industry output or an agreement on levels of output could well amount to a market sharing agreement, behaviour which is captured under the exceptions in subsection 45(4). Where market power is present, such agreements would likely lead to an undue lessening or prevention of competition.

With all firms within the industry party to the voluntary agreement, it is likely that collectively they hold market power although this will depend upon barriers to entry. Having found that market power exists, information sharing in the course of discussions relating to the voluntary agreement that results in an agreement that adversely impacts on prices, market shares, quantity or quality of output, or industry capacity would likely cause the Director to initiate an inquiry under section 45.

In principle, there is less potential for anticompetitive actions to be taken if all of the affected groups -- including key customers and suppliers -- are adequately represented in the process. Both industry and government participants could obtain comfort if a voluntary environmental agreement incorporates a disclaimer to send a clear message that the government is not condoning or promoting any type of activity that would violate the Act or any other Canadian statute. (note 30)

In the case of the research alliance, a determination of whether the parties to the alliance hold market power will depend upon the degree of import competition and barriers to entry. If it is found that market power exists and that the information exchange extends beyond cooperation in research and development such that either prices, market shares, output or industry capacity are negatively affected, it is likely that the Director would initiate an inquiry under section 45.

(IV) Export Consortium Example

Canadian producers of certain resource processing equipment sell their output exclusively within the domestic market. They realize that there are opportunities in foreign markets but each firm lacks the knowledge of how to penetrate those markets. Individual firms also face strong pressure to minimize costs, making any individual firm reluctant to invest the time, money and managerial attention required to establish a position in export markets.

The Canadian producers form an export consortium, which would purchase the expertise that is necessary to penetrate foreign markets, coordinate and combine the output from different firms into large shipment units, negotiate favorable shipping rates for the combined shipments, and negotiate on behalf of the industry with foreign buyers. The firms involved would possess market power if they acted in concert in the domestic market owing to existing trade restrictions, but not necessarily in any of the foreign markets they seek to enter.

Discussion

The Act provides a defence to the conspiracy provisions where the agreement in question relates only to the export of products from Canada. In this example, the alliance falls within the defence and hence the Director would not initiate an inquiry in respect of the alliance. It is only in the event that participation in the consortium is used as a cover to unduly lessen or prevent competition in the domestic market that the conspiracy provisions may be violated. Alternatively, the defence may be lost if the consortium acts to reduce the real value of exports of the product from Canada. This could be the effect if potential exporters were denied membership in the consortium or denied supply of the product in order to preclude them from participating in the export market.

(V) Specialization Agreement Example

Two Canadian firms account for the entire domestic production of a type of manufacturing equipment. Each domestic firm has several manufacturing plants spread across the country to serve regional markets, and sells its products through sales agents who visit manufacturing plants. While imports have traditionally been minimal, the threat of more significant import competition has increased following a reduction of tariffs. This has forced the two firms to consider further rationalization of their plants in order to achieve available economies of scale. They decide to enter into a specialization agreement in which each firm will concentrate on producing only certain of the products while discontinuing production of certain others. All of the products currently being produced would continue to be produced by one firm or the other.

Under the agreement, each firm would continue to market a full line of products by virtue of an exclusive supply arrangement between themselves. Transaction prices between the firms would be determined over time by a cost-based formula set out in their agreement, but final prices to customers are to be set by each firm independently. The firms claim that entering into this specialization agreement will enable them to realize certain purchasing and production economies, and result also in transportation savings. Since they are currently direct competitors in the production and sale of the relevant products, they want to know if their negotiations to enter into a specialization agreement would cause the Director to oppose the registration of the agreement by the Competition Tribunal.

Discussion

The registration of a specialization agreement by the parties with the Competition Tribunal provides an exemption from the conspiracy and exclusive dealing provisions of the Act where the efficiency gains expected to result from the agreement outweigh any lessening or prevention of competition. In this example, the parties to the agreement account for all domestic output. A final conclusion on market power, and hence the likelihood of a lessening or prevention of competition, will depend on the degree of import competition and barriers to entry. The efficiency gains flowing from the agreement may be defined as, inter alia, economies of scale, better integrated production facilities, plant specialization, lower transportation costs, and improved services and distribution operations. Reduction in general overhead expenses may also result. If the agreement is likely to lead to any lessening or prevention of competition, these cost savings must be large enough to offset the adverse effects on competition. In assessing the extent to which competition is lessened, the continued independence of the parties in pricing or marketing their products would be an important consideration. Furthermore, the relevant efficiency gains included in the trade-off analysis are those which would not likely be attained if the specialization agreement was not implemented.

The specialization agreement exemption relates only to the registered agreement, and does not cover other activities which may go beyond the registered agreement. In addition, entering into a specialization agreement without first attempting to have it registered before the Tribunal would leave the parties open to a possible inquiry under the conspiracy provisions for which the efficiency aspects of their agreement would not be a defence. Section 45 does not contain any provision for assessing the merit or value of efficiency gains which may offset negative effects on competition. The sole issue reviewed by the Director under the conspiracy provisions would be the extent to which the agreement lessened or prevented competition unduly.

(VI) Merger Example

Two horizontal competitors produce high technology equipment. A large, foreign multinational (Firm A) acquires a 14.9% equity share in a Canadian firm (Firm B) and will place one person on the six person board of directors of Firm B. Firm B supplies Firm A with a component of the equipment they produce whose source of supply has been rapidly diminishing in recent years. The alliance involves: a long-term supply contract for this component between the two firms; Firm A will collaborate with Firm B in certain research, development and manufacturing activities related to the equipment but the two firms will operate independently with respect to manufacturing, distribution and sales activities; Firm A will act as an "industry advisor" to Firm B and as such will have access to confidential proprietary information on Firm B and will play a significant role in expanding, altering, and diversifying product development and technology and the marketing and distribution of Firm B's products.

Discussion

Under section 91, a merger is defined to be the acquisition of control over, or significant interest in, a business or part thereof. While there is not an acquisition of de jure control in this case, the Director is likely to find that the transaction constitutes the acquisition of a "significant interest" by Firm A in Firm B. In this case, the collective effect of the various arrangements entered into is to place Firm A in a position to materially influence the competitive behaviour of Firm B by virtue of its equity holding; participation on the acquired firm's board of directors; multiple roles of financier, supplier and competitor; long-term supply agreement; advisory role; access to commercially confidential information; and the likelihood that the arrangement significantly changes the economic behaviour of Firm B or ends vigorous, effective competition between the partners. In order to determine whether the transaction is likely to give rise to a substantial lessening or prevention of competition it will require a full analysis following the Merger Enforcement Guidelines.

In general, a merger will be found to likely prevent or lessen competition substantially when the parties to the merger would be in a position to exercise a materially greater degree of market power in a substantial part of the relevant market for two years or more. In order to make this assessment, information in respect of market share or industry concentration must be augmented with an analysis of foreign competition, the availability of substitutes, whether one of the parties is failing, barriers to entry, the effectiveness of remaining competition, and any other relevant factor. Finally, even in the event that a merger is found to prevent or lessen competition substantially, the merger will not be prohibited when there are gains in efficiency sufficient to offset the anticompetitive effects and these efficiencies would not be attainable if an order against the merger were made by the Competition Tribunal.

(VII) International Alliance Example

A small Canadian company specializes in pharmaceutical research. The firm has patents on four promising compounds, but finds that in order to generate profits from the patents, it requires certain complementary resources, including: clinical research capability in terms of experienced personnel and the funds to finance it; production facilities capable of producing large volumes after the drug has been approved by the government; management of the government approval process which requires experienced personnel and significant financial resources; and marketing and sales capability. The company enters into a strategic alliance with a major multinational pharmaceutical manufacturer in order to acquire these resources for one of its most promising compounds. The agreement covers the obligations of each partner with respect to development and distribution of the new drugs, the manufacturer's "right of first negotiation" on new drugs that are developed from the compound, world-wide marketing rights, the sharing of confidential information, and the sharing of development costs and revenues. In order to minimize its dependence upon the manufacturer, the research firm makes similar agreements with different manufacturers for each of its other three compounds.

Discussion

It is possible to view this example as a strategic alliance which combines the core competence of each partner. The core competence of the small research firm is its ability to develop new compounds. The manufacturer's core competence (at least with respect to this particular compound) lies in the financial resources and knowledge required to shepherd new compounds through the regulatory approval process, manufacturing, marketing and distribution. The two firms may in fact be competitors in research but when the smaller company has produced a marketable compound, it is advantageous for both to combine their respective core competencies.

There are numerous firms participating in the market for drug research, production and sale world-wide. Small research companies may select their alliance partners from among a number of large, multinational pharmaceutical manufacturers and distributors, as illustrated in the example above. The opportunities to make alliances of this sort encourages smaller firms to enter into the research field in competition with the large multinationals. Given these factors, an alliance of this type would not likely maintain, create or enhance market power and as such would not raise an issue under the Act.

(VIII) Abuse Of Dominance Example

There is only one supplier of a chemical which is an essential ingredient in producing a new model of a consumer product. The chemical is used in many applications and is produced under patent, which will not expire for another ten years. The new consumer product enjoys a substantial price premium over the old models because of its unique features making it far more convenient to use. Two consumer product manufacturers begin producing the new model, which quickly wins a 70% market share. The larger of these manufacturers, holding a 50% market share enters into a strategic alliance with the chemical supplier to replace existing production facilities for the chemical with a new plant. Pursuant to the alliance, the manufacturer offers financing for the new chemical plant and the supplier agrees to sell the chemical exclusively to the consumer product manufacturer. The manufacturer's competitor is then excluded from producing the new model because the alliance agreement has tied up the supply of the chemical. There are no other producers of a substitute for the chemical apparent on the horizon.

In response to repeated requests of the smaller manufacturer, the larger manufacturer agrees to supply the chemical to its competitor on a spot basis. While the smaller manufacturer gains access to the chemical, it finds its supply is sporadic and as a result it is unable to maintain its production levels at a cost-efficient level. In addition, the smaller manufacturer complains that the price which it is charged for the chemical greatly exceeds the price which the chemical supplier had previously charged, alleging that the larger manufacturer is attempting to squeeze its competitor's margins to reduce its ability to effectively compete and possibly force its exit. Even when the smaller manufacturer receives supply from the larger manufacturer, it finds that delivery is erratic, quality is not necessarily of the standard agreed to, and it is required to meet what it believes are unreasonable credit and payment terms. In response to its complaints, the larger manufacturer threatens to cut off supply entirely and to reinitiate an old-standing legal action against the smaller manufacturer in an unrelated area.

Discussion

In this example, the source of market power lies in the control of the chemical. By excluding competitors from reliable and independent access to an essential resource, the alliance may raise an issue under the abuse of dominance provisions of the Act. Among the nine anticompetitive act examples outlined in section 78 is the pre-emption of scarce facilities or resources required by a competitor for the operation of a business, with the object of withholding the facilities or resources from a market.

A number of factors make it likely that this agreement would cause the Director to initiate an inquiry under the abuse provisions. By pre-empting an essential input, the larger manufacturer effectively excludes its smaller competitor from producing, in a cost-effective manner, a model which has won 70% of the market for a product and thereby effectively controls the market for the new model of consumer product. The rapid gain in market share of the new model despite being sold at a substantial price premium indicates that the old models are not particularly close substitutes. Control in this case is achieved by an anticompetitive act, namely the pre-emption of an essential input through the strategic alliance with the chemical supplier.

Having gained this control, the manufacturer proceeds to engage in a number of anticompetitive acts which appear to be designed to exclude or discipline its smaller rival. These acts include the original exclusive supply agreement for the chemical and squeezing of its rival's margins through a number of actions designed to raise the rival's costs, including higher prices for the chemical, spot supply, erratic delivery schedules, poorer chemical quality, and unfavourable credit and payment terms. The threatened legal action might also be found to constitute an anticompetitive act if it is frivolous or otherwise without merit. Such control and the subsequent anticompetitive acts appear likely to lead to a substantial lessening of competition for the consumer product. As the example is constructed, there does not appear to be any efficiency enhancing aspect of the exclusive supply arrangement between the parties to the alliance or the other actions taken by the manufacturer against its smaller rival.

(IX) Industry-Wide Agreement Example

Canadian manufacturers of a wide range of branded products find themselves exposed to strong import competition as a result of falling barriers to trade and reduced transportation costs. They find that they are competitive with foreign producers on manufacturing costs, having recently modernized plants and rationalized capacity, but that their distribution system is highly uncompetitive. Foreign manufacturers have achieved distribution economies by selling through alternative retail formats such as warehouse stores and mass merchandisers, which enjoy economies of scale, low-cost location, and who have electronically linked their retail check-out scanners to the foreign manufacturers' factory floors.

The Canadian manufacturers wish to continue selling to the traditional retail chains because they are viewed as giving better support to the value of brand names than do alternative retail formats. However, they do not believe that distribution efficiencies could be achieved quickly enough to prevent a drastic loss of market share to foreign manufacturers on the basis of each individual retailer working one-on-one with each of its suppliers to establish electronic links and implement new logistics systems. As a result, the manufacturers seek an industry-wide commitment, involving both vertical and horizontal alliances, which would significantly accelerate improvements to the distribution process. Once the new system is in place, it will function purely as a vertical alliance between traditional retail chains, brokers and manufacturers.

Discussion

Although this example looks quite different from the cooperative measures to meet environmental regulations example and the information sharing example, above, the same principles regarding horizontal agreements and information sharing among firms which collectively possess market power apply. In this example, the horizontal feature of the alliance involves a significant amount of communication and cooperation between the domestic manufacturers. This will only cause the Director to initiate an inquiry under section 45 if the parties to the exchange possess market power. An important factor to consider in making this determination is the presence of strong import competition. If competition from the foreign-based manufacturers limits the domestic firms' ability to collectively raise price or lower output, quality, service, promotional activity or innovation then the Director is unlikely to initiate a formal inquiry.

If the parties are found to collectively possess market power, the Director's examination will turn to whether the contemplated arrangements are likely to constitute behaviour injurious to competition. The potential always exists when competitors meet around the same table, even for the purpose of implementing an essentially vertical arrangement, that discussions regarding competitive factors, such as pricing policy and the details of trade promotions will take place or that information exchanges may unduly lessen or prevent competition. If the arrangements entered into relate primarily to achieving cost-savings efficiencies along the vertical chain, they are unlikely to constitute injurious behaviour and hence unlikely to cause the Director to initiate a formal inquiry. The risk of a formal inquiry is increased, however, should the arrangements contemplate coordination among the horizontal manufacturers in respect of pricing, output, service or promotional activity.

This scenario is an example of competition, not only between individual firms, but between vertical systems. Such rivalry can be highly beneficial, resulting in lower costs, lower prices, a better selection of products and better service to consumers. Nonetheless, given the potential for widespread effects across the industry, particularly when the alliance entails agreements between all domestic horizontal competitors, firms contemplating such an arrangement may wish to approach the Bureau under its Program of Advisory Opinions. In responding to a request under the Program of Advisory Opinions, the Bureau would provide advice to assist the firms in achieving their aims without coming into conflict with the Act.

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Notes

28. Benchmarking refers to comparisons made with other firms in order to highlight best practices and promote their adoption. (back to text)

29. The research alliance could fall under either the defence related to measures to protect the environment or cooperation in research and development. (back to text)

30. Government involvement would preclude conviction under the Act only when such conduct is specifically authorized and effectively regulated pursuant to valid legislation. (back to text)