Trademarks Are Not Patents: The Second Circuit Rejects FTC Challenge to Trademark Settlements in 1-800 Contacts

U.S. Federal Trade Commission

In “big IP cases that count,” the U.S. Federal Trade Commission (FTC) has had a mixed record lately, going one-for-three – good in baseball but bad in government appellate litigation. (The biggest recent FTC loss that counts, the Supreme Court’s unanimous April 2021 AMG decision (see here), did not involve IP, but had major negative implications for the FTC’s future ability to obtain monetary relief in IP-related prosecutions).

In August 2020, as explained by Eileen McDermott, the Ninth Circuit vacated a district court “finding that Qualcomm had engaged in unlawful licensing practices, and reversed a permanent, worldwide injunction against several of Qualcomm’s core business practices.” (The full Ninth Circuit subsequently denied the FTC’s request for rehearing en banc, and the FTC threw in the towel in March 2021, electing not to seek Supreme Court review).

The FTC fared better in the Fifth Circuit’s April 2021 Impax decision on pharmaceutical patent settlements involving “reverse payments” from a brand name patentee to a potential generic market entrant. (Impax was the first Court of Appeals decision regarding FTC challenges to such settlements since the Supreme Court’s 2013 holding in Actavis, holding that such settlements are subject to antitrust scrutiny). The Impax court “affirmed the Commission’s conclusions that: (1) large, unjustified reverse payments [from patentee to generic producer] are anticompetitive regardless of the strength of the underlying patent litigation, and (2) reverse payment settlements are more anticompetitive than procompetitive if a less-restrictive alternative exists, and that a less-restrictive alternative can be an agreement without a payment that results in an earlier generic entry.” (See here for a discussion of Impax).

Most recently, on June 14, 2021, the Second Circuit rejected the FTC’s holding that 1-800 Contacts, Inc. (hereinafter “1-800”), the leading online seller of contacts lenses, violated the antitrust laws by entering into trademark infringement settlements with other online sellers. The settlements had restricted the terms under which the parties could “bid” on trademarked terms in online search engine auctions. This commentary focuses on the holding and implications of 1-800 Contacts.

The Second Circuit’s Decision

The Second Circuit’s per curiam opinion in 1-800 Contacts is short and decisive.

Facts

The facts as stated by the court are straightforward:

Between 2004 and 2013, Petitioner 1-800 Contacts, Inc. (“1-800”) entered into thirteen trademark settlement agreements and one sourcing and services agreement with competitors (the “Challenged Agreements”). As explained below, the Challenged Agreements contained provisions restricting specific terms on which the parties could “bid” when participating in auctions held by companies that operate search engines. By restricting bidding on terms in these auctions, the competitors agreed not to advertise their products when consumers used the search engines’ platforms to search the specific terms at issue. In August 2016, the Federal Trade Commission (“FTC” or the “Commission”) issued an administrative complaint against Petitioner, alleging that the Challenged Agreements and Petitioner’s enforcement of the agreements unreasonably restrain truthful, non-misleading advertising as well as price competition in search advertising auctions in violation of Section 5 of the FTC Act, 15 U.S.C. § 45. The claim was tried before an Administrative Law Judge (ALJ), who in 2017 issued an Initial Decision and Order finding that the agreements violate Section 5. Petitioner then appealed to the full Commission, which affirmed the ALJ’s conclusion in a three to one decision, with one Commissioner not participating. This timely petition for review followed the issuance of the Commission’s Final Order.

Legal Analysis

Upon review, the court vacated the FTC’s final order and remanded. It held:

[A]lthough trademark settlement agreements are not immune from antitrust scrutiny, the FTC (1) improperly considered the agreements to be “inherently suspect” and (2) incorrectly concluded that the challenged agreements are a violation of the FTC Act under the “rule of reason.”

Antitrust scrutiny applies to trademark settlements. Not surprisingly, the court summarily rejected 1-800 Contacts’ argument that trademark settlements are generally exempt from antitrust scrutiny. Citing the Supreme Court’s Actavis decision, the Second Circuit stated that “the mere fact that an agreement implicates intellectual property rights does not ‘immunize [an] agreement from antitrust attack.’”

Having found that antitrust scrutiny of 1-800’s settlements was appropriate, the Second Circuit then proceeded to reject the FTC’s findings that the 1-800 settlements were illegal under abbreviated antitrust “inherently suspect” (also called “quick look”) analysis and the full-blown antitrust “rule of reason.”

“Quick look” analysis is inapposite to this case. Citing Supreme Court precedent, the Second Circuit explained that a presumption of anticompetitive effect based on a “quick look” applies only “‘to business activities that are so plainly anticompetitive that courts need undertake only a cursory examination before imposing antitrust liability’ . . . . ‘[i]f an arrangement might plausibly be thought to have a net procompetitive effect, or possibly no effect at all on competition,’ more than a ‘quick look’ is required.” Applying these teachings to the case at hand, the Second Circuit rejected the quick look: “Crucially, the restraints at issue here could plausibly be thought to have a net procompetitive effect because they are derived from trademark settlement agreements.” More specifically, because trademarks by their nature are non-exclusionary, the Court stressed that “[a]greements to protect trademarks, then, should not immediately be assumed to be anticompetitive.” Moreover, “courts do not have sufficient experience with this type of conduct [trademark settlements] to permit the abbreviated analysis of the Challenged Agreements undertaken by the Commission.” In sum, the “quick look” was inapposite.

FTC also fails under the full-blown rule of reason. The Second Circuit was similarly unimpressed by the FTC’s argument in the alternative that the 1-800 settlements were illegal under the full-blown antitrust rule of reason.

The first step of the full rule of reason imposes an initial burden on plaintiff to show a prima facie anticompetitive effect. The FTC contended that it satisfied this burden in adducing direct evidence of increased contact lens prices and a reduction in the quantity of advertisements in the online market for contacts. But the court found the FTC’s price evidence to be merely “theoretical and anecdotal,” the FTC’s “conclusion that differences between 1-800 Contacts’ prices and those of its competitors constitute direct evidence of the Challenged Agreements’ anticompetitive effects is not supported by substantial evidence.”

Moreover, even if one accepted the FTC’s argument that “‘disrupted information flow’ is an anticompetitive effect and that a reduction in the quantity of advertisements is direct evidence of that effect,” the FTC would not prevail, according to the court. That conclusion followed from the fact that 1-800 “has shown a procompetitive justification [thus meeting its burden under the second step of the rule of reason] and the Commission fails to carry its burden at the third step” of the rule of reason. The procompetitive justification flowed from the fact that “‘trademark agreements are favored in the law as a means by which parties agree to market products in a way that reduces the likelihood of consumer confusion and avoids time-consuming litigation.’” Furthermore, under Second Circuit precedent, trademark settlement agreements are “presumed” to be procompetitive. Furthermore, although not all trademark agreements are procompetitive, there was “a lack of evidence here that the Challenged Agreements are the ‘product of anything other than hard-nosed trademark negotiations.’”

Because 1-800 had met its burden to show a procompetitive justification, the FTC could only prevail (under the third step of the rule of reason) by showing “that a less restrictive alternative exists that achieves the same legitimate competitive benefits.” A less restrictive alternative would not exist, however, if the restraint under scrutiny “is reasonably necessary to achieve the legitimate objectives proffered by the defendant.” The Second Circuit explained that what is “reasonably necessary” in the trademark settlement context “is likely to be determined by competitors during settlement negotiations[.] . . . A[bsent something that would negate the typically procompetitive nature of these agreements, ‘the parties’ determination of the scope of needed trademark protections is entitled to substantial weight.’” The court added that the government had “to show more than the mere possibility there could be crafted an alternative form of the trademark agreement. The alternative must be ‘substantially less restrictive.’ . . . The alternative must also achieve the same legitimate competitive benefits outlined by the [FTC].”

The FTC claimed as a less restrictive alternative that “the parties to the Challenged Agreements could have agreed to require clear disclosure in each search advertisement of the identity of the rival seller rather than prohibit all advertising on trademarked terms.” But the FTC did not explain, “for example, how the parties might enforce such a requirement moving forward or give any weight to how onerous such enforcement efforts would be for private parties.” What’s more, “[w]hile trademark agreements limit competitors from competing as effectively as they otherwise might, we owe significant deference to arm’s length use agreements negotiated by parties to those agreements.” In other words, “forcing companies to be less aggressive in enforcing their trademarks is antithetical to the procompetitive goals of trademark policy.” This led the court to conclude that, “without considering the downstream effects of requiring less aggressive enforcement, the government has failed to show that the proffered alternatives achieve the same legitimate procompetitive benefits as those advanced by Petitioner.”

The Broader Policy Implications: Trademarks Are Not Patents

The Second Circuit’s decision in 1-800 Contacts has significant policy implications for the FTC’s approach to IP settlements involving trademarks.

The FTC holds a fairly strong hand with respect to reverse payment patent settlements. Since the Supreme Court’s 2013 decision in Actavis, the FTC has sought to take a more aggressive posture toward patent settlements, seeking to extend the concept of “reverse payments” well beyond mere exchanges of cash flowing from the patent holder to the potential licensee. The high-profile FTC enforcement posture with regard to such settlements post-Actavis has borne fruit. Federal court holdings in private antitrust litigation have ruled that reverse payments extend beyond cash (see here). Moreover, the incidence of settlements with reverse payments appears to have fallen dramatically in recent years, according to a December 2020 FTC staff report. Furthermore, the FTC will undoubtedly cite the Fifth Circuit’s April 2021 Impax decision for the proposition that the possibility of settlements without reverse payments should be presumed to be a “less restrictive means” that should guarantee the Commission victories in litigated patent settlement cases. Of course, other Circuits have yet to be heard from. Also, in light of the Supreme Court’s AMG holding, the FTC (at least for now) will be stymied in extracting monetary payments from pharma defendants in reverse payment litigation. Nevertheless, the FTC overall holds fairly strong pharma settlement cards.

The FTC’s success in reverse payment patent litigation, however, is not readily translatable to settlements involving other sorts of IP. Patents by their very nature convey a right to exclude. When they are used to exclude competition in a manner that arguably goes beyond the scope of the patent property right (as may be the case when large reverse payments are present), full rule of reason antitrust scrutiny (not summary quick look evaluation) is warranted – as the Supreme Court made plain in Actavis.

Trademarks, in marked contrast, are a non-exclusionary property right, as the Second Circuit stressed in its 1-800 Contacts opinion. Trademarks strongly promote vigorous interbrand competition by enabling rival producers to (1) reduce confusion regarding source; and (2) bring to consumers’ attention distinct product-specific quality attributes. Thus, it is not surprising that litigation settlements protecting trademarks are favored by the law, as the 1-800 Contacts court recognized.

Accordingly, it was entirely predictable that the Second Circuit would give the back of its hand to the FTC’s effort to justify quick look condemnation of the 1-800 settlements – settlements which neither delayed entry nor precluded online comparative advertising.

Furthermore, the Second Circuit’s rejection of the FTC’s full rule of reason analysis  is not terribly surprising. The FTC’s finding of a potential anticompetitive effect was highly problematic, as Commissioner Phillips explained in his compelling dissent to the Commission’s 1-800 opinion. But even assuming, for the sake of argument, the existence of such a possible effect, the strong efficiency justifications for trademark settlements in general, and the 1-800 settlements in particular, constituted an effective rebuttal, as the Second Circuit explained.

Perhaps most interesting for students of antitrust theory is the Second Circuit’s rejection of the FTC’s proposed “less restrictive means” alternative. As a general matter, hypothesized less restrictive means are problematic, because they assume, against all experience, that bureaucratic actors are better able than market participants to derive “optimal” terms for doing business effectively (a manifestation of the “nirvana fallacy” and the “pretense of knowledge”). The Second Circuit did not make this particular point. Nevertheless, its comment that the FTC’s proposed “clear disclosure” alternative ignored the harm to competition from less aggressive trademark enforcement implicitly critiques the blinkered nature of less restrictive means analysis.

Ideally, “less restrictive means” alternatives should be ejected from the antitrust enforcer’s bag of tricks. As Professor Thomas Nachbar explains in a recent essay, this approach inappropriately complicates antitrust review and threatens to undermine innovation:

The boundaries of the less restrictive alternatives inquiry are not just vague, they are indescribable, and the test is likely to draw antitrust courts into increasingly strict review of restraints. Lessons drawn from other areas of law show that any real approach to “less” restrictive alternatives is likely to lead to a “least” restrictive alternatives test. Rigorous consideration of alternatives will chill innovation, with outsized effects on particular industries and restraints, particularly in two-sided platform markets and more generally in recently highly scrutinized “big tech” markets.          

But if the less restrictive means approach is not deep-sixed, specific means proffered by enforcers should at the very least be subjected to extremely close (and skeptical) scrutiny by reviewing courts. The Second Circuit’s critical evaluation of the FTC’s proposal in its 1-800 Contacts opinion provides a worthy model to emulate.

Concluding Comments

The Second Circuit reached the right result in 1-800 Contacts. Its crisp analysis ably exposed the shortcomings of the FTC’s finding of liability. The court’s opinion also evinced a good feel for the dynamic consumer welfare benefits associated with trademark-based competition. The court’s analysis perhaps reflects familiarity with Geoff Manne’s explanation that 1-800’s settlements were designed to avoid inefficient free-riding on the company’s investment in its valuable brand. More generally, antitrust attacks on trademarks that are not well-grounded in solid economics and empiricism threaten to diminish welfare-raising investments in product quality that are incentivized by the trademark system. Let us hope that the FTC and the Justice Department take note of this as they formulate their enforcement strategies going forward.

The views expressed herein represent the author’s personal policy view on the merits of the Second Circuit’s decision in 1-800 Contacts. As General Counsel, the author served as the FTC’s counsel for record in this case. The author believes that, as always, the career staff of the FTC’s Office of General Counsel did a superlative job in defending the Commission’s position before the appeals court in this matter, to the best of their ability.