The Toys "R" Us Precedent: Reaching the Limits of the Colgate Doctrine
an interview with Richard Dagen of FTC Special Counsel to the Commissioner
Julie Wei | UC Davis School of Law

Posted Monday, May 1, 2006
6 U.C. Davis Bus. L.J. 22 (2006)

Richard Dagen is currently Special Counsel to the Director of the Bureau of Competition at the Federal Trade Commission (FTC). The Bureau of Competition is specifically charged with enforcing antitrust laws. Mr. Dagen has been with the FTC since 1990.

Mr. Dagen received his undergraduate degree at the University of Chicago, before getting a master's degree in Economics at Yale University. Mr. Dagen then attended Emory University Law School where he was the John M. Olin Fellow at the Law & Economics Center.

All representations made in this interview are the personal opinions of Richard Dagen. These views are in no way to be construed as representing the views of the FTC or any individual Commissioner.

Background

Starting in 1989 and continuing into the 1990s, Toys, "R" Us (TRU), the nation's largest toy retailer, attempted to quell growing competition from discount warehouse clubs like Costco by facilitating vertical agreements with top toy manufacturers. These vertical agreements placed restrictions on the toy manufacturers, limiting their ability to sell products to discount warehouse clubs. However, the only way to get the toy manufacturer industry to "agree" with TRU's plan was to broker similar horizontal agreements among the top toy manufacturers. The FTC found this activity to be in violation of antitrust laws.

In 1997, Administrative Judge James Timony upheld the FTC's finding. Judge Timony found that TRU had violated the Colgate doctrine, a fundamental antitrust principle,. Under the doctrine, a company is free to deal with whomever it wishes unilaterally as long as it does not act with the purpose of forming a monopoly.[1] The Commission upheld Judge Timony's finding that TRU violated the parameters of the Colgate doctrine by stepping beyond unilateral action and committing illegal concerted action. On appeal, the Court of Appeals for the Seventh Circuit affirmed the FTC findings.[2]

In this interview, Mr. Dagen discusses his role in the Toys "R" Us decision along with the perceptions and ramifications of the case today.

Q: What was biggest obstacle your office confronted in prosecuting in the Toys "R" Us case?

A: There were hundreds of boxes of documents to go through. However, I would not call that an obstacle. I would call that an opportunity. The opportunity is to go through them and try to figure out what happened. Since we are in a paper and e-mail world where people memorialize much of what they have done, we can try to recreate the chronology of events. For some people, that is one of the more tedious parts of a case. But for people who work on these cases, it tends to be very interesting, almost like a jigsaw puzzle. For example, you will get one fact from Mattel, another fact from Toys "R" Us, and another fact from Hasbro all relating to the same day of events. Then you try to figure out what really happened.

Q: I noticed the court used a lot of evidence from certain closed-door meetings between Toys "R" Us and many of its manufactures. In your opinion, why would they (TRU and the manufacturers) leave such paper trails? Why would they bother to document these things?

A: I think what happened within Toys "R" Us, is that they thought they were engaging in [permissible] unilateral conduct. They kept records because they had to report to their bosses on what was happening. They also needed to have records for the next time they spoke to that person. If there was ever a dispute they could point to documentation and say, "[y]ou promised me this." If a manufacturer goes to a retailer and says, "Here is our policy, if you discount, we are going to terminate you." Most people will put that in writing. Also, manufacturers might want a record of a trip by a salesman to a company, a so-called trip report. Companies all have trip reports, so they might have a trip report that says, "I delivered it to the person and I told them our policy and they are going to be terminated. I told them not to ask any questions about it if they do their policy right then. I told them we aren't reaching any agreement they could do whatever they wanted." To some degree, Toy "R" Us probably thought that that is what they were doing, exercising their Colgate rights. However, they crossed the line by actually coordinating agreements among and with the manufacturers.

The law in this area in regards to the Colgate doctrine is that a business can do things unilaterally.[3] And, if a business does things such as instituting a policy of terminating non-compliant retailers unilaterally, the courts allow them a very broad level of discretion. But, a business can go too far and get into monopolization. A retailer can refuse to deal with a manufacturer, but usually it works the other way around. Usually a manufacturer will refuse to deal with certain retailers. That is where the Colgate doctrine comes from. The doctrine applies when manufacturers essentially say, "I want a certain pricing structure maintained by retailers, and I don't want to deal with discounters because that is going to lower the price."

Historically, one saw this in stereo equipment long ago, where retailers were required to provide listening rooms and other amenities.[4] Manufacturers would want retailers to invest a lot of money and make the best possible ambience for people to see and view the product. The concept was that if prices went down due to discounting, high-end retailers couldn't afford to compete with their competitors and the services provided by the high-end retailers would disappear. If the services disappeared, then consumers would be worse off. This is an example of a free-rider argument.

Q: In the findings of the initial administrative decision, Judge Timony stated that if Toys "R" Us had issued a unilateral policy (under the Colgate doctrine), the court would have probably found that policy to be legitimate. Yet in his ruling, he focused a lot on the anti-competitive effects of Toys "R" Us' actions, as opposed to its "policies." If Toys "R" Us had issued a unilateral policy and the same effects happened, what action, if any, would have been taken against Toys "R" Us?

A: We call that the "but for" world. That is one of the arguments that Toys "R" Us made. That is, Toys "R" Us argued that even assuming that they did reach agreements with these people, Toys "R" Us could have done it unilaterally and the same thing would have happened. Well that is a good argument, but the problem with it is that we don't know that any of those things would have happened. To answer your question, if they just announced what their policy was and lived by it, it was unlikely that the Commission would have gone forward with the case. It is not certain but it is unlikely.

However, it is a fact that Toys "R" Us brokered these deals. That fact helped defeat a lot of their defenses. For example, we were able to use the agreement to show that the free rider arguments they made were not credible.[5] This case dealt a lot with free-rider issues, and up to that point, I think plaintiffs had not been very successful in rebutting the free-rider arguments in cases. We were able to say that there is not a cognizable free rider problem here because, first, Toys "R" Us gets paid for everything they do by the manufacturers, and second, in the end, it is the manufacturers that are concerned with free riding not the retailers. If there is a free rider problem, the manufacturers generally take care of it.[6] If the only reason the manufacturers stop selling to discount stores is because of pressure from Toys "R" Us and unrelated to efficiency considerations, then we really don't think there is a free rider argument.

Q: How do you respond to some critics who argue that Toys "R" Us did have a unilateral policy and had independent (and legal) vertical agreements with manufacturers as opposed to a horizontal agreement?

A: Ultimately I think since the vertical agreements were tied so closely to the horizontal agreement, it reduced the level of commentary in the case. At some point, people were thinking that we were just challenging a series of independent vertical agreements. Mattel has an agreement with Toys "R" Us, Hasbro has an agreement with Toys "R" Us, and Tyco has an agreement with Toys "R" Us. They all have agreements not to deal with or deal with on different terms with the warehouse clubs. The Commission also found a series of vertical restraints. But again, these vertical agreements were tied in large part to the horizontal agreement. Therefore, the Commission was able to say that the efficiency defenses really didn't exist. All we were left with were agreements that resulted in less competition and with no increase in benefits for consumers.

Q: What was the biggest criticism that you heard after the decision came down?

A: We didn't hear a lot of criticism; we heard questions when we were bringing the case forward. A lot of people thought that it made sense that there are restrictions on distribution. The argument was that Toys "R" Us was generating the buzz and that Costco and the clubs were free riding on that buzz because Toys "R" Us was bearing all the costs of advertising and marketing. After a hearing developed a full record, it turned out that Toys "R" Us was being compensated for these services Toys "R" Us spent a lot of money on advertising, but the manufacturers paid that cost. If you wanted to be carried by Toys "R" Us, you had to pay certain warehouse fees to compensate them. Toys "R" Us carried a broader line of toys than others, but Toys "R" Us got much higher prices for those toys, as a price cost margin because of the lesser competition. They sold fewer of these toys, they had lower turnover, but they received a higher margin.

Q: So there was more praise than criticism?

A: There were a lot of congratulations.

Q: Did the congratulations arise because of the magnitude of the case?

A: Yes, anytime we win a case in the private sector, it is cause for celebration. I don't know what percentage it is but roughly 90% of our cases settle. And when you wind up getting a case that doesn't settle, gets litigated, and goes all the way up to the Seventh Circuit, it is rare occurrence. Toys "R" Us ultimately chose litigation because they thought they would have a good hearing before Judge Posner and Judge Easterbrook on the Seventh Circuit. Toys "R" Us thought the Seventh Circuit would be their best forum on appeal. We were quite happy to go to the Seventh Circuit because we based a lot of our arguments on the writings of Judge Posner and Judge Easterbrook in terms of what they had said previously about free riding. We thought that was a good place for us. Judge Wood wound up writing the opinion for the Seventh Circuit, and she is a well-recognized antitrust expert. When we won, given how rare it is for us to be in appellate court, it was very satisfying.

Q: Do you know if this decision has substantially affected any other subsequent cases?

A: I don't know. I have seen it cited a couple of times. I think it has probably had the biggest impact in terms of counseling. Lawyers have re-doubled their efforts to make sure that when their clients pursue Colgate policies, that they steer clear of talking about what competitors were doing. "This is our policy here it is," and they leave it at that. That is where the trouble comes up a lot. A company has to be pretty careful with these policies.

Q: How would you advise a corporation, like Toys "R" Us facing the same business issues, today?

A: Well there are a couple of different issues. One is the antitrust issue. The other involves the business issue. I would hesitate to advise them on how to run their business. I do know they spent a lot of time at fairly high levels trying to figure out how to disadvantage their competitors instead of focusing on how to make themselves more efficient over time. Regardless of the outcome of our case, they were going to have to work on becoming a more efficient competitor. Strictly on an antitrust side, I would advise any company pursing a Colgate policy to be very clear on what their policy is, and not discuss what is going on with - again, it's usually in the manufacturer context - various other retailers.

Q: Some critics have said that these events took place in the early to the mid 1990's right after the more conservative era in FTC litigation. When Robert Pitofsky became Chairman of the FTC in 1995, there was a sharper focus on market exclusion. In your opinion, if these same events happened today, do you think anything would change with the way the case preceded?

A: In my personal view, I don't think that anything would be looked at differently now. When you've got a big company orchestrating a horizontal conspiracy, it will raise the same questions now that it raised then. The economics that were sound then would be sound now.

Q: In general, would you say that the actions taken by the FTC change much with the different directors in charge or the political landscape in Washington, D.C.?

A: That's a different question, you're asking about the specific case, and that's my answer about the specific case. Obviously different directors have different priorities in terms of what they think is important. Different Commissioners have different priorities, but in terms of this particular case again, given the same facts, I believe we would proceed the same way.



[1] United States v. Colgate & Co., 250 U.S. 300, 307-08 (1919)

[2] Toys "R" Us, Inc. v. Federal Trade Commission, 221 F.3d 928 (7th Cir. 2000)

[3] The term "unilaterally" refers to an independent business decision that does not involve a horizontal agreement between a business and its competitors. Unlike unilateral actions, horizontal agreements between manufacturers or retailers to deny a competitor a product, like toys in this case, will be found illegal under Colgate.

[4] See, e.g., United States v. Arnold, Schwinn & Co., 388 U.S. 365 (1967)

[5] The "free rider" problem refers to Toys "R" Us arguments that they spend a considerably amount of money on advertising and product placement. As a result of their efforts, restrictions on manufacturers from selling to discount stores is justified on the grounds that these discount stores are "free riding" on the marketing efforts of high-end retailers like Toys "R" Us.

[6] Manufacturers can "take care of it" by contractually insisting that retailers pay a percentage of marketing costs or use a certain type of product placements, etc. Manufacturers can also unilaterally refuse to sell to certain retailers not complying with restrictions tied to their products.