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The European Commission’s decision on margin squeeze test once again confirmed by the European Court in Telefónica case

On 29 March 2012, the EU General Court (“GC”) vindicated the European Commission’s (the “Commission’s”) findings of liability under Article 102 of the Treaty for the functioning of the EU (“TFEU”) for abuse of a dominant position against Telefonica SA (“Telefonica”). The GC upheld the imposition of a €151m fine against the company. The GC’s ruling confirms, develops and further clarifies the circumstances in which margin squeeze practices constitute an abuse of dominant position under Article 102 TFEU.

Background facts

Telefonica inherited a legal monopoly upon liberalisation of the Spanish telecommunications sector in 1998, including the only fixed-line telecommunication network in the country. The telecommunications sector has developed considerably in the intervening years, particularly within the context of internet services and the development of combined telecommunication services (such as, for example, combining internet, telephone and television services).

The Commission investigated Telefonica’s conduct during the period 2001-2006. Telefonica constituted a ‘vertically integrated operator’ for the purposes of the Commission’s investigation into margin squeeze practices, as it was active at both the wholesale (upstream) and the retail (downstream) ends of the telecommunications supply chain. The Commission had found that Telefonica, a dominant company, had infringed Article 102 TFEU by charging unfair prices and, in particular, through margin squeeze practices in relation to broadband access in Spain.

Throughout the investigation, and in its subsequent appeal, Telefonica maintained that its practices were incapable of contravening Article 102 TEFU, because they neither charged abusively high (monopoly) prices to competing entities for wholesale broadband access, nor priced their products predatorily at the retail end. In the absence of either one of these anti-competitive practices (which Telefonica argued should be considered separately), it was argued, inter alia, that they had incurred no liability under Article 102 TFEU.

Margin squeeze and liability under Article 102 TFEU

Margin squeeze refers to the practice of vertically integrated operators that set their upstream and downstream prices to such a level where downstream competitors of the vertically integrated firm may not be in a position to earn a sufficient margin between the two to cover their costs and avoid sustaining losses. Eventually, those competitors may be forced to exit the market and/or their competitive position may be seriously affected.

The Commission and the GC both rejected Telefonica’s arguments in favour of upholding the previous decision in the Deutsche Telekom case, which dictates that it is the relationship between the two prices - the spread - that is the relevant source of liability, irrespective of whether or not either the wholesale or the retail price in isolation is anti-competitive. Thus, the decision in the Telefonica case is additionally significant for its vindication of Deutsche Telekom’s proposition that margin squeeze is assessable on the basis of the spread between the two prices and is in itself capable of constituting an abuse of dominant position under Article 102 TFEU.

The Commission, confirmed by the GC, used the same methodology to calculate the margin squeeze as it had done in Deutsche Telekom, namely the ‘equally efficient competitor’ test. Crucially, this test uses the dominant entity’s own costs as a benchmark, in order to establish whether or not it has unfairly constrained its rivals’ ability to compete in the market. Therefore, it was investigated whether the margin was such as to cover the costs of the dominant undertaking providing retail services and whether Telefonica would incur losses if it was charging the same upstream price charged to its competitors. The GC rejected Telefonica’s argument that the actual situation and costs of actual competitors should have been considered.

The Commission adopted the long run average incremental costs (“LRAIC”) measure in the calculation of the above analysis. LRAIC essentially means average variable costs, including fixed costs to be avoided in the long run and sunk costs for entrance into the market. This constitutes the usual cost measure used by the Commission in telecommunication cases. The Commission found that the use of both period-by-period and discounted cash flow profitability figures generated a negative result, thereby attesting to Telefonica’s imposition of a margin squeeze, as the dominant entity would not have been able to trade profitably with the same pricing constraints as it levied on its competitors. The GC, contrary to Telefonica’s appeal, confirmed that the Commission was correct in its market definition analysis and consequently did not err in law when it examined the existence of the abusive behaviour for each wholesale product separately. Moreover, there were no justifiable efficiencies for such abusive conduct in the form of a margin squeeze.

The GC confirmed that it was not necessary to argue that Telefonica was dominant at both wholesale and retail level to find an abuse in the form of a margin squeeze, despite the fact that the Commission had found the presence of dominance in both markets based on the facts of the case. The GC confirmed that the Commission was right to hold that Telefonica was dominant at the wholesale level and that this was sufficient.

It is, moreover, often argued that the margin squeeze practice resembles either a price predation downstream and/or a refusal to supply type of abusive behaviour upstream (or excessive pricing upstream). However, the Commission did not analyze the case as a refusal to supply, as confirmed by the GC and contrary to Telefonica’s arguments. The conditions for such types of abuse are more onerous, whereas the margin squeeze practice as such can be condemned pursuant to Article 102 TFEU in its own right. This practice involves the setting of the aforementioned margin at a level where downstream competitors would incur losses and it does not matter the exact level, namely whether it may be excessive upstream and/or predatory downstream. The GC confirmed that the Commission was right to hold that the spread between the two prices was unfair, contrary to Article 102 TFEU. However, the GC did note (albeit this was not argued by Telefonica) that the “indispensability” criterion of a refusal to supply case, namely the indispensability of the wholesale products, could be considered as an important element, at least in the context of the effects analysis of the margin squeeze.

Regulatory compliance is no defence to liability under Article 102 TFEU

In a further endorsement of the judgment in Deutsche Telekom, the GC also upheld the Commission’s ruling that Telefonica’s compliance with Spain’s domestic regulatory regime (which in any event the Commission determined was fair and did not erode the principles of competition law) within the e-communication sector was no defence to its abuse of dominance by way of margin squeeze pursuant to competition law.

Within the parameters of the regulatory framework, Telefonica’s prices were subject to a maximum cap. Thus, it could at any time have lowered its prices for access to the wholesale broadband market and there was no objective justification (save for improving its own profitability) for failing to do so. Further, the Commission held that Telefonica would easily have foreseen the negative impact that its pricing strategy would exert on the market in terms of the barriers to entry, foreclosure of competitors and detriment to consumers (who reportedly pay 20% over the average European price for internet access). Telefonica, according to the GC, was free in its pricing policy and was not, therefore, deemed constrained by the regulatory regime.

The GC highlighted the distinction between ‘ex ante’ assessment, (that is to say, the e-communication regulatory regime) and ‘ex post’ competitive assessment of abusive market practices that may contravene Article 102 TFEU. In this context, the fact that the national regulator may define differently the relevant market for the purposes of regulating the markets pursuant to the ex ante regulatory framework, does not provide a guarantee that the same market definition would apply pursuant to an ex post competitive assessment. This may have an impact on the level of fines imposed and the characterisation of the infringements pursuant to competition law, as it is clear from this case.

Conclusion

Aside from the further definitional contribution and confirmation this judgment makes to the EU jurisprudence concerning margin squeeze practices, the case imparts a clear message that former monopolies of this kind (and irrespective necessarily of the sector in which they operate), will be held to have a special responsibility towards the markets once they are liberalised. In addition, the judgment clarifies that ex ante regulation does not provide immunity from the application of ex post principles of EU competition law. Even in a regulated environment, dominant undertakings still enjoy freedom of choice and discretion, and have a special responsibility to be vigilant, understand and comply with EU competition laws.

For more information, please contact Konstantinos Adamantopoulos, Partner, on +32 2 643 3401 or konstantinos.adamantopoulos@hfw.com, or Eliza Petritsi, Partner, on +44 (0)20 7264 8772/+32 2 643 3402 or eliza.petritsi@hfw.com, or Anthony Woolich, Partner, on +44 (0)20 7264 8033 or anthony.woolich@hfw.com, or your usual HFW contact.

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