29 November 2011

The NDRC Muscles Up: Increased Enforcement Activity by Chinese Pricing Regulator

Two major announcements by the National Development and Reform Commission ("NDRC") in recent weeks suggest that the anti-monopoly enforcement authority might be entering a new period of heightened activity in its fight against pricing abuses.

First, on 9 November, China Central Television's ("CCTV") News 30' program carried a report concerning an investigation being conducted by the NDRC into alleged abuses of dominance in the broadband access market by state-owned media giants China Telecom and China Unicom. Then, on 14 November, the NDRC announced that two Chinese pharmaceutical companies in Shandong Province had been fined more than RMB 7 million (approximately USD 1.1 million) for abuse of dominance in the market for high blood pressure medication. This represents by far the largest fine levied by the NDRC for anti-competitive pricing practices since the introduction of the Anti-monopoly Law ("AML") in 2008. This e-Bulletin provides a brief overview of these important developments in the field of competition law in China, as well as a brief assessment of the legal issues involved.

The NDRC's investigation into abuse of dominance by China Telecom and China Unicom

Background

News of the NDRC's investigation into state-owned telecom giants China Telecom and China Unicom first surfaced in a series of articles appearing in the Economy & Nation Weekly in mid-September. The origin of the recent controversy, however, can be traced to an interview given to CCTV's News 30' program by Li Qing, Deputy Director of the Price Supervision and Anti-monopoly Bureau of the NDRC, in an episode airing on 9 November. In the course of her interview, Deputy Director Li not only publicly acknowledged that the NDRC had been conducting an investigation into China Telecom and China Unicom since the first half of 2011, but also shared the preliminary findings of that investigation: with a combined share of more than two-thirds of the "broadband access" market in China, Deputy Director Li claimed that it was "clear" that China Telecom and China Unicom held a dominant position in the broadband access market. She also disclosed that, by charging higher prices for access to their broadband network to direct competitors than to non-competitors, China Telecom and China Unicom were guilty of price discrimination. They were therefore liable for fines calculated at between 1% and 10% of the income generated by the parties from their broadband access services in 2010, as provided for in the AML. Deputy Director Li stated that, with the companies' broadband businesses generating turnover in the tens of billions in 2010, the penalties to be imposed on China Telecom and China Unicom could potentially amount to billions of RMB.

SOEs definitely within the sights of the AML

The NDRC's investigation into two of the leading state-owned players in the telecommunications industry provides long-awaited confirmation that state-owned enterprises ("SOEs") fall within the reach of the AML's provisions on abuse of dominance. With many key sectors of the Chinese economy subject to state-owned control, the application of the AML to sectors characterised by strong government involvement has been a subject of considerable debate. This debate was fuelled by Article 7 of the AML, which deals with the issue in ambiguous terms, stating, on the one hand, that the state shall "supervise and regulate" the business and price-setting activities of SOEs, and, on the other hand, that SOEs have to "operate, in good faith, according to the law and in a self-disciplined manner". The announcement by the NDRC of its investigation makes clear that, whatever special treatment might be afforded to SOEs, Article 7 does not operate so as to immunise them from investigation by the antitrust authorities in China and from penalties for violations of the AML. MOFCOM has adopted a similar position in the merger control context, where it is now clear that SOEs are equally subject to the notification obligations applying to concentrations under the AML.

Key legal issues

(i) The test of "dominance"

In her interview with CCTV's News 30' program, Deputy Director Li stated that, by virtue of their combined share of more than two-thirds of the "broadband access" market, China Telecom and China Unicom hold a position of market dominance. Deputy Director Li implicitly referred to Article 19 of the AML, which provides that where two undertakings hold a combined market share of greater than two-thirds, those undertakings will be assumed to have a dominant position in that market.

What is not clear under Article 19, however, is the circumstances in which the market shares of two competitors should be combined for these purposes. The doctrine of joint dominance can be found in many international competition regimes, but generally only applies where the undertakings in question actively coordinate their market behaviour. By contrast, Article 19 of the AML appears to imply that two completely independent competitors can be found to hold joint dominance, notwithstanding the absence of any evidence that they are coordinating their market behaviour. This would appear to be confirmed by Deputy Director Li's statement that a combined market share of more than two-thirds is itself sufficient to ground a finding of joint dominance. Nevertheless, it is difficult to accept that two major companies should each be seen as dominant on the same market, and subject to the highly restrictive rules that apply to dominant companies, simply because the arithmetic combination of their market shares exceeds two-thirds of the market.

(ii) The relevant market

Any finding of dominance, be it joint dominance or sole dominance, is dependent upon the definition of the "relevant market" in respect of which the dominance is held. In her interview with CCTV, Deputy Director Li referred to the "broadband access" (宽带接入) market as the relevant market for the purposes of the NDRC's investigation. There is a question, however, as to which level of the Chinese broadband market is being targeted by the NDRC's investigation.

China Telecom and China Unicom are the sole commercial operators authorised by the Ministry of Industry and Information Technology to operate networks in China connected to the global internet (so-called "internet backbones" (骨干网)). Any internet service provider ("ISP") wishing to provide broadband services to customers on a commercial basis in China must therefore first enter into an agreement with either China Telecom or China Unicom to gain access to their "internet backbone" (akin to an "essential facility" in the broadband sector). Having secured access to the "internet backbone" of either China Telecom or China Unicom, ISPs are then in a position to provide broadband internet services to customers at the retail level. In addition to dealing with ISPs as customers in the provision of access to their respective "internet backbones", China Telecom and China Unicom also compete head-to-head with these ISPs "downstream" in the provision of retail broadband internet services to end-use customers.

Most commentary on the NDRC's investigation has assumed that Deputy Director Li's reference to the "broadband access" market means that the target of the NDRC's investigation is the upstream market for access to the "internet backbone". However, if that is the case, it is not clear how China Telecom and China Unicom could be said to hold a position of joint dominance in this market. That is because this level of the broadband market in China is split geographically between China Telecom (whose "internet backbone" covers most of the Southern provinces in China) and China Unicom (whose "internet backbone" covers most of the Northern provinces in China). It is therefore arguable that the market for access to "internet backbone" services is not one market with two competitors but rather two geographically defined markets operated by a single monopolist.

(iii) Alleged abuse of dominance

The final legal issue that has been the subject of much debate in the Chinese press is the specific means by which China Telecom and China Unicom are alleged to have abused their position of dominance in the "broadband access" market. China Telecom and China Unicom have been accused of price discrimination in the provision of access to their respective "internet backbones", providing relatively inexpensive access to their own large institutional clients, such as banks and large enterprises, whilst charging the maximum legally prescribed fee to other (competing) commercial ISPs. It is reported that, as a result of these alleged "discriminatory" pricing practices, smaller ISPs had started sub-leasing access to the "internet backbone" from China Telecom and China Unicom's large institutional customers and thereby avoiding the higher prices charged for direct access. However, in August 2010, China Telecom launched a widespread crackdown on these sub-leasing practices, effectively mandating that all ISPs enter into direct "internet backbone" access agreements with them. It has been speculated that the smaller ISPs harmed by China Telecom's crackdown in 2010 have been key players in the instigation of the present market investigation by the NDRC.

In her interview with CCTV, Deputy Director Li implicitly referred to the terms of Article 17(vii) of the AML, which prohibits undertakings holding a dominant position from applying differing treatment to two or more trading counter-parties "in the same position", whether in terms of pricing or other transaction conditions. In response to the NDRC's allegations, China Telecom has argued that the differing prices offered to ISPs are a consequence not of discriminatory price treatment but of objective differences in the transactional terms provided to different ISPs (in matters such as the geographic area covered by the agreement, the timing of the contract, the details of the product provided and the quality requirements of the counter-party).

In this sense, China Telecom has challenged the NDRC's assumption that the various ISPs operating in China are "in the same position" within the meaning of Article 17(vii) and has noted that it is up to the authority to prove that the operators have breached the AML, which will require concrete and sometimes highly technical evidence. No conclusion should be drawn before such evidence has been provided and the operators have had the opportunity to defend themselves.

(iv) Potential fines

The definition of the "relevant market" discussed above is arguably also important in determining the fines that might be imposed should the NDRC find China Telecom and China Unicom guilty of abusing their position of dominance on the "broadband access" market.

In her interview with CCTV, Deputy Director Li referred to the turnover generated by the telecommunications giants' "broadband business" in support of her claim that the parties could be subject to fines scaling tens of billions of RMB. However, in a fiery response to Deputy Director Li's claims in the CCTV report, China Telecom has argued that the turnover figures cited by Deputy Director Li encompass the entire revenue generated by the telecommunications companies from their broadband business, including both the upstream "internet backbone access" market and the downstream market for the provision of broadband services to end-use customers. China Telecom has argued that the proper basis for calculating the fines to which it might be exposed as part of the NDRC's investigation is not the RMB 50 billion generated from its combined (upstream and downstream) broadband businesses, but rather the less than RMB 200 million generated from its upstream "broadband access" business. On this basis, the maximum fine to be imposed on China Telecom would be far less than the tens of billions referred to in Deputy Director Li's interview.

The provisions of the AML are far from clear on this point. According to Article 47 of the AML, where undertakings are found to have abused their dominant position, the anti-monopoly enforcement authorities shall order the undertakings to "cease their unlawful conduct, confiscate any illegal gains from the unlawful conduct and impose a fine ranging from 1% to 10% of sales turnover in the previous financial year". This provision does not give any guidance as to how the authorities should calculate the fines and does not specify whether the reference to "sales turnover" in Article 47 means all sales turnover of the undertaking concerned in the previous year or only such sales turnover as can be attributed to the market in which it has been found guilty of abuse of dominance. If the NDRC ultimately issues fines against China Telecom and China Unicom, it will be interesting to see whether it publishes a written decision (expressly authorised under Article 44) and, if so, whether there is any explanation as to how the fines were calculated.

Alternatively, it might be that the NDRC concludes its investigation without the imposition of fines pursuant to Article 45 of the AML, which provides that the authority can suspend its investigation if the companies under investigation commit to "eliminate the effects of the conduct through the use of concrete measures". It is worth noting that a decision by the authority to suspend its investigation pursuant to Article 45 would not seem to require that the NDRC reach a conclusion regarding the alleged abuse of dominance. Article 16 of the NDRC Measures on Procedures for Administrative Anti-Price Monopoly Law Enforcement (the "NDRC's Procedural Measures", effective 1 February 2011) merely provides that if the authority decides to suspend its investigation following a commitment from the parties subject to the investigation, the NDRC shall issue a written decision setting forth, amongst other things, "the facts underlying the suspected violations by the target of the investigation." This seems to suggest that the NDRC will not make any final determination as to the parties' guilt in its written decision. By extension, even if this decision were published (a point which remains unclear under the NDRC's Procedural Measures), it is unlikely that third parties could use the decision as evidence against China Telecom and China Unicom in subsequent civil proceedings.

Pharmaceutical sector hit by NDRC's first major penalty for abuse of dominance

Just days after Deputy Director Li's public acknowledgement of the preliminary findings against China Telecom and China Unicom, on 14 November the NDRC issued the first major fine for abuse of dominance in the three years since the inception of the AML. With the combined total of the fines amounting to more than RMB 7 million (approximately USD 1.1 million), this case marks the first occasion on which the NDRC has sought to impose significant fines for price-related abuse of dominance under the AML.

Background

According to the public announcement issued on the NDRC website on 14 November, the offending companies were two distributors of the active ingredients used in the manufacture of Reserpine, an antihypertensive drug that is commonly used for the control of high blood pressure. With more than 10 million patients taking the drug nationwide, Reserpine has been listed as an "essential" medicine in the National Essential Drugs List.

In recent months, the Chinese market had witnessed a sharp increase in the price of Reserpine tablets. In response to these exponential price increases, the NDRC conducted an investigation into the market for the sale of Reserpine. The NDRC investigation found that there are only two companies authorized to manufacture the active ingredient used in Reserpine in China, promethazine hydrochloride; these two companies are Donggang Hongda Pharmaceutical Co., Ltd. ("Donggang Hongda") and Dandong Yichuang Yaoye Co., Ltd. ("Dandong Yichuang"). On 9 June 2011, these manufacturers had each entered into an exclusive distribution agreement with Shandong Weifang Shuntong Pharmaceuticals Co., Ltd. ("Shuntong") and Weifang Huaxin Pharmaceuticals & Trading Co., Ltd. ("Huaxin") under identical terms. Under the terms of these distribution agreements, the two manufacturers of promethazine hydrochloride on the Chinese market were prohibited from selling the product to third parties without first obtaining the consent of Shuntong and Huaxin.

Having secured exclusive distribution rights over the active ingredient promethazine hydrochloride from the two local manufacturers, Shuntong and Huaxin then sought to exploit their alleged dominant position in the distribution market for this product to reap greater benefits from the manufacturers of Reserpine active downstream. As a condition of their supply of promethazine hydrochloride, Shuntong and Huaxin apparently required downstream manufacturers to increase their own retail price of Reserpine by more than 400%. The proceeds of the required price increases were then to be shared between the manufacturers (Dongang Hongda and Dandong Yichuang) and their exclusive suppliers (Shuntong and Huaxin).

Key legal issues

Although not directly cited in the NDRC's announcement, Shuntong and Huaxin were said to have clearly abused their collective dominant position in the market for the supply of promethazine hydrochloride to unfairly increase prices, within the terms of Article 17(i) of the AML and Article 11 of the NDRC's Rules on Anti-monopolistic Pricing. The NDRC announced that, in accordance with Article 47 of the AML, Shuntong and Huaxin had been ordered to cease their prohibited conduct (the NDRC repealing the exclusive distribution agreement executed with the manufacturers of promethazine hydrochloride) and ordered them to pay fines, calculated on the basis of an unidentified proportion of the companies' turnover from the previous financial year as well as the illegal proceeds of their prohibited conduct.

There are a number of significant observations to be made regarding this case. First, the NDRC's approach in this case seems to confirm that the relevant markets in the pharmaceutical sector are national in scope, certainly at the distribution level but also at the manufacturer level (this has previously been the subject of debate, particularly in the context of merger filings before MOFCOM). Further, this case stresses the important role of distributors of pharmaceutical products in China, which often create a "bottleneck" situation, limiting supply from the manufacturer to the consumer. Finally, it is interesting to observe that the NDRC has preferred to tackle this wrongdoing based on the theory of abuse of collective dominance, which competition authorities in other jurisdictions are often reluctant to apply given the complexity of demonstrating the existence of a dominant position, especially where cartel or "concerted actions" can be proved.

It will be interesting to see whether the NDRC's decision leads to follow-on private actions in the courts. The NDRC decision in fact makes express mention of the fact that Shuntong and Huaxin's illegal conduct has affected many pharmaceutical companies. These companies might now seek redress from the courts for the losses they have suffered. In all private lawsuits initiated pursuant to the AML to date, the plaintiff has been unable to present sufficient evidence to convince the courts that the defendant company is in a position of market dominance and has in fact abused that position of dominance. However, given the fine and public notice issued by the NDRC in this case, this should not be a problem for any plaintiff initiating a private action against Shuntong and Huaxin, and possibly against the manufacturers of Reserpine. The legal arguments in these cases are thus likely to focus on the level of damages, evidence of those damages, the causal link between the damages and the wrongdoing, and the allocation of the damages amongst the wrongdoers.

Conclusion

The NDRC's recent activity in the field of anti-monopolistic pricing suggests that it has embarked on a new phase in its implementation of the AML. Having long been questioned on its ability or willingness to implement the pricing provisions of the AML, the NDRC now looks set to pursue abuse of dominance cases head-on, including cases involving domestic companies and SOEs. With the Chinese government increasingly focused on containing inflationary pressures in the national economy, the NDRC is likely to be particularly aggressive in respect of price increases affecting everyday household items and services. Only time will tell which company will be the next to fall within the NDRC's sights.

Thomas E Jones
City thomas.e.jones@allenovery.com
Victor Ho +86 106 535 4381
Managing Partner, Beijing victor.ho@allenovery.com
Richard Kim +86 21 3896 5015
Partner, Shanghai richard.kim@allenovery.com
Ji Zou +86 21 3896 5045
Managing Partner, Shanghai ji.zou@allenovery.com
Francois Renard +86 10 6535 4359
Counsel, Beijing francois.renard@allenovery.com
Annie Wang +86 10 6535 4321
Senior Associate, Beijing annie.wang@allenovery.com

Allen & Overy is an international legal practice with approximately 5,600 people, including some 580 partners, working in more than 40 offices worldwide. A current list of Allen & Overy offices is available at allenovery.com/global/global_coverage.

Allen & Overy means Allen & Overy LLP and/or its affiliated undertakings. Allen & Overy LLP is a limited liability partnership registered in England and Wales with registered number OC306763. Allen & Overy (Holdings) Limited is a limited company registered in England and Wales with registered number 07462870. Allen & Overy LLP and Allen & Overy (Holdings) Limited are authorised and regulated by the Solicitors Regulation Authority of England and Wales.

The term partner is used to refer to a member of Allen & Overy LLP or a director of Allen & Overy (Holdings) Limited or, in either case, an employee or consultant with equivalent standing and qualifications or an individual with equivalent status in one of Allen & Overy LLP’s affiliated undertakings. A list of the members of Allen & Overy LLP and of the non-members who are designated as partners, and a list of the directors of Allen & Overy (Holdings) Limited, is open to inspection at our registered office at One Bishops Square, London E1 6AD.

© Allen & Overy LLP 2022. This document is for general information purposes only and is not intended to provide legal or other professional advice.

allenovery.com