August 15, 2009

By Bill H. ZHANG

On July 7, 2009, the China’s Anti-Monopoly Commission under the State Council (“AMC”) published a Guideline on Definition of Relevant Market (“Guideline”)[i] on its official website to guide the Anti-monopoly Enforcement Agencies (“AMEA”) to effectively define the “relevant market” in the monopolistic activities by business operators during their antitrust enforcement. The Guideline has clearly identified the definition of relevant market, the functions of the definition of relevant market, the basis and general methods for defining relevant market, and particularly, set forth the Hypothetical Monopolist Test for defining the relevant market. These rules and principles newly established by this Guideline will have a significant impact on the mergers and acquisitions of Chinese entities by foreign investors. Foreign investors intending to merge with and acquire Chinese entities, or enter into operating agreement in the nature of monopoly with their Chinese business partners shall closely watch and acquaint themselves with this Guideline so as to timely adjust their strategies for mergers and acquisitions in China. This article tries to address the basic rules specified by this Guideline for reference by foreign investors when merging and acquiring entities in China.

Introduction

It is reported that, from August 1, 2008 to the end of June, 2009, the China’s Ministry of Commerce (“MOFCOM”) has received, for review, 58 declarations by business operators in terms of their concentrations, and already reviewed 46 declarations. Among them, MOFCOM has unconditionally approved 43 concentrations, conditionally approved two, but disapproved one concentration by the US-based Coca-Cola Company and the China-based Huiyuan Juice Group[ii]. An important issue MOFCOM reviewed the concentrations is the market shares of the business operators to the concentration in the relevant market and the degree of the market concentration within such relevant market. Obviously, the relevant market issue has played a decisive role in mergers and acquisitions which trigger for anti-trust review.

Any competitive activities, including those activities which have or might have the effect of eliminating or restricting competition, occurs within the scope of a particular market. To define the relevant market is to specify the market scope within which the business operators compete with each other. The antitrust enforcement, such as prohibiting business operators from entering into monopolistic agreements or abusing their dominant market positions, and controlling concentrations by business operator which have or might have the effect of eliminating or restricting competition, will might involve the definition of relevant market. Therefore, scientifically and reasonably defining the relevant market plays an important role in identifying competitors and potential competitors, determining the market share and the degree of market concentration of a business operator, determining the market position of a business operator, analyzing the impact of the activities of a business operator on market competition, and further evaluating whether a business operator acts in violation of laws, and determining the legal liabilities which the business operator must assume if it has violated the law.

Under the Anti-monopoly Law of the People’s Republic of China (“AML”)[iii], when determining the market position of a business operator, AMEA will have to consider the market share of business operators in the relevant market, the competition within the relevant market, the difficulties of other business operators to enter into the relevant market[iv]. Further, when reviewing the concentration by business operators, AMEA will also have to review the market share of the business operator to a concentration within the relevant market and his capabilities to control the relevant market, as well as the market concentration within the relevant market[v]. Since the definition of relevant market plays such decisive role in antitrust enforcement, article 12 of AML has tried to define the relevant market. However, its wording is too general, abstract and vague to understand. Thus the practicability of such definition is not very strong for AMEA to enforce. Under such occasion, AMC has timely issued this Guideline.

Definition of Relevant Market and Its Classification

Under the Guideline, the relevant market refers to the product scope and geographic scope within which business operators compete with each for specific products or services during a particular period of time. In antitrust enforcement practice, it is usually necessary to define the relevant product market and relevant geographic market.

1.        Relevant Product Market

Under the Guideline, the “relevant product market” is a market composed of a group or category of products which is considered by buyers to be relatively closely substitutable according to the features, use and price of the products. These products are intensively competitive with each other. In the antitrust enforcement, they may be used as the product scope within which business operators compete with each other.

2.        Relevant Geographic Market

According to the Guideline, the “relevant geographic market” is the geographic area within which buyers acquire the products that are relatively closely substitutable. These areas are intensively competitive with each other. In antitrust enforcement, these areas may also be used as the geographic scope within which business operators compete with each other.

3.        Other Factors to Be Considered

The Guideline further provides that timeliness shall also be considered in defining the relevant market, when a product’s production cycle, lifetime, seasonability, fashion, or a valid term for intellectual property protection has become an essential characteristic of the product. For the same, it may also be necessary to define the relevant technology market, and consider those factors such as intellectual property rights and innovation, when the antitrust enforcement is related to technology trade or license agreements involving intellectual property rights.

Basis for Defining Relevant Market

In the practice of antitrust enforcement, the scope of the relevant market depends on the extent to which a product (or geographic area) can be substituted. What directly and effectively restricts business operators’ activities in market competition is the existence of products in the market considered by buyers to be considerably substitutable, or the existence of geographic areas in which buyers consider these products to be available. Therefore, it shall mainly conduct demand substitution analysis from the buyer’s perspective when defining a relevant market. When supply substitution has a restrictive effect on the business operators’ actions similar to that of demand substitution, supply substitution may also be considered in defining the relevant market.

1.        Demand Substitution

Demand substitution is to determine the degree of substitutability among different products from buyers’ perspective according to the functions and uses which buyers require, as well as the quality, price acceptance and availability. Principally, from buyers’ perspective, the greater the substitutability and the more intense the competition among products, the more likely it is that the products fall into the same relevant market.

2.        Supply Substitution

Supply substitution is to determine the degree of substitutability among different products from business operators’ perspective according to the investment by other business operators in renovating their production facilities, the risks they will have to assume, and the time in which they enter the target market. In principle, the less investment other business operators will have to make in renovating production facilities, the less risk they will have to assume, as well as the more quickly the closely substitutable products can be supplied, then the higher the degree of supply substitution is. Therefore, when defining relevant market, particularly, in identifying relevant market participants, supply substitution shall be taken into consideration.

General Methods for Defining Relevant Market

When defining the relevant market, demand substitution analysis may be used according to the product characteristics, intended use and price, and supply substitution analysis may be employed too when necessary. When business operators’ market scopes are unclear or hard to determine, it may further use the “hypothetical monopolist test”, which will be addressed below, to define the relevant market. However, according to the Guideline, no matter which method is used to define the relevant market, the basic attributes of the products which meet the demand of consumers shall always be essential to the analysis, and form the basis for correcting significant deviations in defining a relevant market.

1.        Main Factors to be Considered in Defining Relevant Product Market

A.       From Demand Substitution Perspective

While defining the relevant product market from the demand substitution perspective, according to the Guideline, the factors which shall be considered include but are not limited to the following:

(1)   evidence showing that buyers switch to or consider switching to other products due to changes in product price or other competitive factors;

(2)   the product’s overall characteristics and use, such as shape, nature, quality, and technical features. Although some differences may be apparent in the products’ characteristics, buyers may regard them as closely substitutable products if they have identical or similar uses;

(3)   the price difference among products. Generally, closely substitutable products are similarly priced, and these products’ prices often change in the same direction. When analyzing the price of the products, those factors which trigger for price changes other than competition shall be eliminated;

(4)   the product’s distribution channels. Products which are distributed through different channels might target to different buyers, and therefore lack competition among them, so it is not very likely that they become relevant products; and

(5)   other important factors, such as the degree of the buyers’ preference for or reliance on the product; barriers, risks, and costs which might prevent many buyers from switching to certain closely substitutable products; and the lack or existence of differential pricing, etc.

B.        From Supply Substitution Perspective

When defining the relevant product market from the supply perspective, under the Guideline, generally, those factors, such as any evidence of other business operators’ reacting to the changes of product price; other business operators’ production process and techniques, the degree of difficulties involved in switching to another line of products, the time thereof required, the extra costs and risks related to such switching; the competitiveness and the distribution channels of the product after the switch, shall be considered.

2.        Main Factors to be Considered in Defining Relevant Geographic Market

A.       From Demand Substitution Perspective

While defining the relevant geographic market from the demand substitution perspective, according to the Guideline, the factors which shall be considered include but are not limited to the following:

(1)   evidence showing that buyers switch or consider switching to other geographic areas for purchasing a product due to the changes in product price or other competitive factors;

(2)   the product’s transportation cost and transportation characteristics. In terms of product price, the higher the transportation cost, the smaller the scope of the relevant geographic market is. The product’s transportation characteristics will also determine the sales region;

(3)   the actual regions where the majority of buyers select their products, and the product distribution locations of the major business operators;

(4)   regional trade barriers, such as tariffs, local administrative regulations, environmental protection issues, and technical factors. For example, when a tariff is relatively high compared to the product price, it is very likely that the relevant geographic market is a regional market; and

(5)   other important factors, such as preference of buyers in a specific geographic region, the amount of products transported into and out of geographic region, etc.

B.        From Supply Substitution Perspective

When defining a relevant geographic market from the supply perspective, according to the Guideline, generally, those factors, such as any evidence of other business operators’ reacting to the changes of product price; the promptness and feasibility of business operators in other areas to supply or distribute the relevant product, for instance, the costs associated with switching orders to business operators in other geographic areas, shall be considered.

Hypothetical Monopolist Test

The Guideline has introduced a hypothetical monopolist test (“HMT”) to assist AMEA in defining the relevant product market and relevant geographic market.

1.        Defining “Relevant Product Market” by Referring to HMT

Under HMT, it is assumed that the business operator is a monopolist (“Hypothetical Monopolist”) aiming for profit maximization. The relevant product market is determined by examining whether the Hypothetical Monopolist is able to continuously (generally, one year) increase the price of its products (“Target Product”) on a small scale (generally, 5-10%) when the sales conditions of other products remain the same. The price increase of the Target Product will cause buyers to switch to other closely substitutable products, which consequently will cause the Hypothetical Monopolist’s sales to decrease. If the Hypothetical Monopolist is still able to make profits despite of the sales decrease which occurs after the price increase, then the Target Product constitutes the relevant product market. If the price increase causes buyers to switch to other closely substitutable products, and the Hypothetical Monopolist is unable to make profits after its price increase, then the substitute products shall be included in the relevant product market to form a product group with the Target Product. If the Hypothetical Monopolist is still be able to make profits after increase of the price of the product group, then the product group constitutes the relevant product market.

2.        Defining “Relevant Geographic Market” by Referring to HMT

According to the Guideline, the relevant geographic market may be determined through a similar method as that to determine the relevant product market. Specifically, under HMT, the relevant geographic market is determined by examining whether it is profitable for a Hypothetical Monopolist to continuously (generally, one year) increase the price of the relevant products within its geographic area where it carries out business activities (“Target Area”) on a small scale (generally, 5-10%) when the sales conditions in other geographic areas remain the same. If the answer is yes, then the Target Area constitutes a relevant geographic market.

3.        Price Adjustment under HMT

In principle, the benchmark price derived in HMT shall be the current market price resulting from sufficient competition. However, in the event of the abuse of dominant market positions, concerted actions, and concentration transactions carried out by business operators that have the effect of concerted actions, the current market price will obviously deviate from the competitive price, and using the current price as the benchmark price will lead to an unreasonable definition of the relevant market. Under such occasion, according to the Guideline, the current market price shall be adjusted, which is generally increased by 5-10%, so as to bring it closer to the competitive price.

Conclusion

When foreign investors merge with and acquire Chinese enterprises through concentration which trigger for anti-trust review by AMEA, the definition of relevant market is often involved. Before the issuance of this Guideline, the determination of the market shares of the entities to a proposed concentration within the relevant market is often unpredictable. Also AMEA does not have a unified criterion to scientifically and reasonably define the relevant market during their anti-trust enforcement. Such practice has frustrated many foreign investors from merging and acquiring Chinese entities. This Guideline will present foreign investors a clear picture on how to define the relevant market. Having taken this Guideline in mind, foreign investors may correctly calculate their market shares in the relevant market, and then further decide whether their acquisition in China will have to subject to antitrust approval. Most importantly, this will get the calculation of relevant market shares of the business operators to a concentration become more transparent and predictable. Therefore, foreign investors intending to acquire business operation by merging Chinese entities shall keep this Guideline in mind and acquaint themselves with the specific methods specified by this Guideline to define the relevant market so as to timely adjust their mergers and acquisitions strategies in China.

About The Author

Bill H. Zhang is the managing partner of China Sunbow & Associates with rich experience in cross-border transactions involving China, particularly on corporate and commercial matters, such as mergers and acquisitions, direct investment in China, joint venture, antitrust analysis and filing during the cross-border mergers and acquisitions involving China, international trade, corporate governance and compliance, restructuring and reorganization, labor and employment, and dispute resolutions, as well as on intellectual property transactions such as patent and trademark prosecution, enforcement, dispute resolution, infringement analysis, due diligence, technology license and transfer. He has advised many multi-national companies on merging and acquiring Chinese enterprises, making investment, resolving commercial disputes in China and represented them to register, prosecute and enforce various trademarks, patents and copyrights in China. He has also counseled many foreign invested enterprises on their daily operations in China.

For more information about this article and the author, please contact:

Bill H. Zhang, Esq.

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About China Sunbow & Associates

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