Recent California Decision Counsels Caution in Aftermarket Restrictions

May 19, 2010

A recent decision from the Northern District of California has signaled that a plaintiff may state a viable claim in some limited circumstances for aftermarket monopolization and attempted monopolization based on a single-brand market definition. In Datel Holdings Ltd. v. Microsoft Corp., Case No. 3:09-cv-05535-EDL, N.D. Cal., April 23, 2010, the court held that Datel’s complaint (the “Complaint”), in which it alleged a single-brand aftermarket for Xbox 360 accessories and add-ons, could survive a motion to dismiss based on ambiguous language in Microsoft’s warranty, software license and terms of use, which purportedly restricted consumers from using unauthorized third-party accessories with its Xbox 360 gaming console.

Datel Holdings is a developer of video game enhancement products, including accessories such as the MAX memory card for Microsoft’s Xbox 360 video game system. Microsoft is the only other manufacturer of memory cards for the Xbox 360. In 2009, Datel’s two-gigabyte memory card retailed for approximately the same price as Microsoft’s smaller 512-megabyte memory card. About six months after Datel released its memory card, according to the Complaint, Microsoft issued a notice to its Xbox 360 customers that a software update for the gaming console would be released the following week, which would render unauthorized memory cards inoperable with the Xbox 360. The notice also suggested that users move information from unauthorized memory cards to authorized ones.

According to the Complaint, Microsoft initially informed Datel that disabling third-party memory cards was an unintentional effect of the software update. Later, Datel claimed, Microsoft suggested that use of unauthorized memory cards with the Xbox service promoted cheating, and could cause compatibility and safety issues. Datel alleged that these reasons were pretextual and that disabling third-party memory cards was actually an attempt to exclude competition in the aftermarket for Xbox 360 accessories and force users to buy Microsoft’s memory cards at a supracompetitive price.

Datel defined the relevant market as “the aftermarket for accessories and add-ons specific to the Xbox brand.” Order at 4. Microsoft argued that Datel’s claims should be dismissed because an antitrust plaintiff cannot base its claims on a single-brand product market. Datel countered that, under Eastman Kodak Co. v. Image Tech. Servs., Inc., 504 U.S. 451 (1992), a single-brand product market can exist where, as here, customers were not aware of, or did not agree to, aftermarket restrictions at the time they purchased products in the primary market.

Distinguishing the case from those following the reasoning of Queen City Pizza v. Domino’s Pizza, Inc., 124 F.3d 430 (3d Cir. 1997), where the challenged aftermarket restraint was disclosed and contractually agreed to by the consumers at the time of purchase in the primary market, the court held that because of arguably ambiguous language in Microsoft’s warranty and software license that accompanied the Xbox 360 gaming console, as well as the Xbox Live terms of use, Datel’s single-brand market definition was sufficient to state a claim. Unlike Queen City Pizza, the court could not say that Xbox 360 customers knowingly and voluntarily agreed to be restricted to consumption of Microsoft’s products in the aftermarket.

Given the absence of a clearly binding contractual agreement, the court also examined the four factors outlined in Newcal Indus., Inc. v. IKON Office Solution, 513 F.3d 1038 (9th Cir. 2008) to determine whether the Xbox 360 customers’ purchase of the gaming console in the primary market was the functional equivalent of a contractual agreement to be restrained in the aftermarket (as in Queen City Pizza), or instead that Datel could base its claims on a single-brand aftermarket (as in Eastman Kodak and the court’s reading of Newcal): (1) the existence of two separate but related markets where the aftermarket is wholly derivative from and dependent on the primary market; (2) the allegations of anticompetitive behavior relate only to the aftermarket; (3) the source of the defendant’s market power, which allegedly flowed from the defendant’s relationship with its consumers; and (4) market imperfections which prevented consumers from realizing that their choice in the primary market would constrain their freedom in the aftermarket. See Newcal, 513 F.3d at 1049-50.

Finding three of the four factors met, the court denied Microsoft’s motion to dismiss. First, the derivative and dependent nature of the aftermarket for Xbox 360 accessories and add-ons was such that Microsoft could leverage its power in the primary market to gain market power in the aftermarket. Second, the Complaint alleged that the relationship between Microsoft and its customers, as opposed to any contractual provision, gave Microsoft special access to its customers. Finally, Microsoft’s representations and market imperfections (e.g., the existence of a USB port on the gaming console) allegedly led customers to mistakenly believe they would not be restricted to Microsoft products in the aftermarket despite their purchase of a Microsoft product in the primary market. Order at 18.

Although only a district court opinion, Datel provides practical guidance for technology companies that both manufacture products sold in a primary market and participate in the aftermarket provision of goods or services for that product. Where customers enter into a contract that affects choice in the aftermarket simply by virtue of their purchase in the primary market, clear contractual language should be used such that any restrained freedom in the aftermarket is agreed to knowingly. If no actual contract exists, companies should be careful to disclose any potential aftermarket restrictions to consumers such that the selection of a particular brand in the primary market is the functional equivalent of a contractual commitment to consume that brand in the aftermarket. Finally, changes in policy that affect competition in a wholly derivative aftermarket, as in Datel, should be made with care because they carry the risk that a plaintiff could state a viable antitrust claim based on a narrow relevant product market limited to the defendant’s single brand. While such claims, as the Ninth Circuit recognized in Newcal, might well be disposed of at summary judgment, a defendant may be forced to engage in costly discovery before that opportunity arises.

This article was originally published by Bingham McCutchen LLP.