Suppose a trade association, in response to a wave of mergers and consolidations in its industry, desires to narrow its focus and represent only a certain segment of the industry - only small, independent members of the industry, for instance, or only the large chains within the industry, or perhaps only those companies that receive no government subsidies. Similarly, suppose that same segment of an industry or profession decides to form a new association. In either event, the existing association will need to expel certain industry members from membership in the association, or the new association will need to bar certain industry members from joining the association at the outset. In either case, can the association do so without subjecting itself to antitrust liability or jeopardizing its tax exemption? In many cases, the answer is yes.
Under certain circumstances and if done for certain reasons, the federal antitrust and tax laws permit trade and professional associations to restrict, expel and otherwise limit their membership in a manner that effectively includes certain competitors but excludes others. However, associations contemplating such membership restrictions must tread very carefully - in both the formulation and execution of the restrictions - to avoid running afoul of the antitrust and tax laws. This article outlines the current legal landscape in this area and describes, from a practical perspective, how to prudently justify, structure, document, and execute desired membership restrictions.
Membership Restrictions and the Antitrust Laws.
The antitrust law in the area of association membership restrictions is governed principally by Section 1 of the federal Sherman Act, which prohibits "[unreasonable] contract[s], combination[s] . . . or conspirac[ies] in restraint of trade or commerce." Legal claims concerning exclusionary membership practices generally are brought under a "group boycott" theory, the theory being that the members of the association are "concertedly refusing to deal" with a competitor, and are thus illegally denying that competitor access to a competitively valuable association product or service, including association membership itself.
A successful claim under Section 1 of the Sherman Act requires proof of three elements: 1) a contract, combination or conspiracy; 2) a resultant unreasonable restraint of trade in the relevant market; and 3) an accompanying injury. Trade and professional associations are, by definition, combinations of competitors. Thus, generally most actions taken by associations satisfy the first element of the test. As a consequence, potential Section 1 violations by associations turn on the application of the second and third elements of the test.
Addressing the third element first, there must be proof of an impact on competition, not just an aggrieved competitor (unless the injury to competition is presumed, as discussed below). Nevertheless, plaintiffs are not burdened with establishing that the particular action actually produced higher prices or reduced output, but only that the action "is likely to affect substantially other participants and potential participants in the market and, in turn, to reduce competition." Despite the wide array of benefits trade and professional associations offer to their members, it is often difficult for plaintiffs to prove an adverse impact on competition in a given market as a consequence of the denial of membership in the industry association to certain competitors.
The second element of the test - a resultant unreasonable restraint of trade in the relevant market - is the focal point of most litigation and governmental enforcement action in the area of association membership restrictions. There are two standards for evaluating whether an alleged restraint of trade is unreasonable: the per se rule and the rule of reason. The nature of the restraint determines which rule will be applied. This determination is critical, as antitrust liability is much more likely to be found under the per se rule than under the rule of reason.
The general rule is that the rule of reason analysis guides the inquiry unless the challenged action falls into the category of "agreements or practices which because of their pernicious effect on competition and lack of any redeeming value are conclusively presumed to be unreasonable and therefore illegal without elaborate inquiry as to the precise harm they have caused or the business excuse for their use . . . This per se approach permits categorical judgments with respect to certain business practices that have proved to be predominantly anticompetitive. Courts can thereby avoid the 'significant costs' in 'business certainty and litigation efficiency' that a full-fledged rule-of-reason inquiry entails."
The fundamental inquiry under the rule of reason is whether the challenged action, on balance, promotes or suppresses competition. This determination can, and often does, involve an elaborate inquiry into the relevant market and the effect of the challenged action thereon to determine the effect of the action on competition in the market.
2. Per Se Analysis.
The decision to apply the per se rule turns on "whether the practice facially appears to be one that would always or almost always tend to restrict competition and decrease output . . . or instead one designed to 'increase economic efficiency and render markets more, rather than less, competitive' . . . 'Per se rules are invoked when surrounding circumstances make the likelihood of anticompetitive conduct so great as to render unjustified further examination of the challenged conduct."
The U.S. Supreme Court has long held that certain (but not all) group boycotts or concerted refusals to deal are "so likely to restrict competition without any offsetting efficiency gains that they should be condemned as per se violations of Section 1 of the Sherman Act." In the case of association membership restrictions, the question is whether the decision to exclude or expel members is properly viewed as a group boycott / concerted refusal to deal mandating per se invalidation, or whether such a decision should be evaluated under the rule of reason. As the U.S. Supreme Court stated in the landmark 1985 Northwest Stationers case: "Exactly what types of activity fall within the forbidden category is, however, far from certain . . . [In fact,] there is more confusion about the scope and operation of the per se rule against group boycotts than in reference to any other aspect of the per se doctrine . . . Cases to which [the U.S. Supreme Court] has applied the per se approach have generally involved joint efforts by a firm or firms to disadvantage competitors by 'either directly denying or persuading or coercing suppliers or customers to deny relationships the competitors need in the competitive struggle . . . In these cases, the boycott often cuts off access to a supply, facility, or market necessary to enable the boycotted firm to compete . . . and frequently the boycotting firms possessed a dominant position in the relevant market . . . In addition, the practices were generally not justified by plausible arguments that they were intended to enhance overall efficiency and make markets more competitive . . . Under such circumstances, the likelihood of anticompetitive effects [whereby competition is diminished] is clear and the possibility of countervailing procompetitive effects [whereby competition is enhanced] is remote."
As the U.S. Supreme Court stated in Northwest Stationers, "Wholesale purchasing cooperatives [as well as trade and professional associations generally] . . . are not a form of concerted activity characteristically likely to result in predominantly anticompetitive effects." Thus, the Court held that the application of the per se rule (including its presumption of economic impact on competition) is warranted only upon a threshold showing that "the cooperative possesses market power or exclusive access to an element essential to effect competition." "Absent such a showing with respect to a cooperative buying arrangement, courts should apply a rule-of-reason analysis." The Court went on to suggest that, even if one or both of these conditions is present, procompetitive efficiency justifications may remove the restraint from the per se category.
Thus, the Northwest Stationers decision establishes that anticompetitive effect can be presumed (and per se liability applied) only if the cooperative possesses market power or a facility essential to competition, and the challenged restraint lacks a legitimate and plausible business purpose or efficiency rationale. In other words, even a venture whose members possess market power or an essential facility may exclude a competitor for reasons ancillary to the venture's procompetitive purposes.
Lower courts have confirmed this. For example, in Carleton v. Vermont Dairy Herd Improvement Association, Inc., the U.S. District Court construed Northwest Stationers to mean:
…only that "market power or exclusive access" is a necessary precondition before expulsion from a cooperative should be deemed per se unreasonable. Neither market power nor exclusive access is a sufficient condition, however. The mere fact that membership in [defendant association] may provide exclusive access to essential facilities does not justify per se invalidation where other "surrounding circumstances" suggest, as here, that the challenged conduct should be weighed under the rule of reason. The rule of reason is therefore the correct method of proof in this case.
In another case also involving a membership restriction of an association monitoring dairy cattle, the U.S. District Court reached the same conclusion:[D]espite that plaintiffs have met Northwest Wholesale's threshold requirement, the court is constrained to conclude that meeting this requirement is an insufficient basis for applying the per se rule . . . To conclude that the [defendant association's] actions in enforcing its rules and regulations are automatically subject to a per se analysis would completely undermine the association's operations and would prevent the [association's] achieving its purpose - improving the breed of Holstein-Friesian dairy cattle - which ultimately has a positive impact on competition.
One area not addressed by the Northwest Stationers decision is whether per se treatment should apply to membership restrictions used to enforce an anticompetitive agreement among the association's members, if the members do not collectively possess market power or control an essential facility. However, it seems clear that absent market power or an essential facility, only those non-ancillary restrictions which are not used to enforce per se unlawful agreements are potentially benign and thus should be evaluated under the rule of reason. Importantly, refusals to deal intended to enforce an anticompetitive agreement (e.g., an agreement not to discount or to fix prices) will be subject to per se condemnation, even if the association lacks market power or a facility essential to competition, as they are effectively part of the underlying illegal conspiracy (e.g., part of the underlying per se unlawful price-fixing agreement).
In 1984, in a case in which a periodontist challenged a membership criterion of the American Dental Association and the American Academy of Periodontology, the United States Court of Appeals for the District of Columbia emphatically stated:
The D.C. Circuit thus recognized that membership restrictions of trade and professional associations, even when they operate to exclude certain competitors or would-be competitors of the association' members, generally do not warrant treatment as per se unlawful group boycotts. However, the juxtaposition of these seemingly diametrically opposed legal axioms - that is, that most association membership restrictions are lawful (despite their exclusionary effects), on the one hand, and that certain concerted group boycotts are per se unlawful, on the other hand - has assured an abundance of litigation in which individuals or firms excluded or expelled from trade and professional associations have sought redress in the courts.
3. Rule of Reason Analysis.
As stated above, the general rule in antitrust inquiries is that the rule of reason guides the inquiry unless the challenged action falls into the (limited) per se category. Due to Northwest Stationers' demands for more specific proof and a higher degree of economic impact under the per se rule, the rule of reason has become the primary mode of analysis for association membership restrictions. The fundamental inquiry under the rule of reason is whether the challenged action, on balance, promotes or suppresses competition. In other words, do the procompetitive benefits (whereby competition in the market is enhanced) outweigh the anticompetitive harm (whereby competition in the market is diminished), or vice-versa? This determination can, and often does, involve an elaborate inquiry into the relevant market and the effect of the challenged action thereon to determine the effect of the action on competition in the market.
It is axiomatic that proof of an impact on competition, and not just on an aggrieved competitor, is essential. Nevertheless, plaintiffs are not burdened with establishing that the particular action actually produced higher prices or reduced output, but only that the action "is likely to affect substantially other participants and potential participants in the market and, in turn, to reduce competition." Despite the wide array of benefits trade and professional associations offer to their members, it is often difficult for plaintiffs to prove an adverse impact on competition in a given market as a consequence of the denial of membership in the industry association to certain competitors.
The courts, federal enforcement agencies, and commentators have all observed that association membership restrictions are often procompetitive. Thus, most membership restrictions pass antitrust muster under the rule of reason, provided that certain parameters are observed. In short, limitations on membership should be narrowly drawn, nondiscriminatory, objective, and rationally related to some procompetitive purpose(s) of the association. Furthermore, the standards for membership should be fully articulated and uniformly applied.
The extent to which plausible efficiencies are valid depends upon the factual context of the restriction. The critical test is whether the challenged restraint is "substantially related to the efficiency-enhancing or procompetitive purposes that otherwise justify the [association's] practices." Where that nexus is lacking or attenuated, the restraint will be found unlawful under the rule of reason, provided that the requisite harm to competition is also established.
4. Quick Look Analysis.
The Sherman Act outlaws restraints on trade that injure competition. As discussed above, certain types of restraints have been determined by the courts to be so pernicious as to be illegal per se. In such event, there is no need to engage in economic analysis to determine if the restraint of trade is likely to injure competition in the relevant market. Rather, the adverse economic impact on competition will be presumed.
By contrast, as discussed above, restraints of trade that are not illegal per se must be reviewed under the rule of reason standard. Historically, application of the rule of reason requires that a complete economic analysis be made of the practices in question to determine whether the practices are, in fact, anticompetitive and whether the defendant has sufficient economic power to implement the illegal acts in a manner that will adversely affect consumers.
As stated by a recent commentator, "The Courts and the antirust agencies have recognized that in order to make a full rule of reason analysis, the record must include comprehensive economic evidence that defines the market, and then demonstrates the effect on the market of the restraints in question. The data developed by expert economists in presenting this type of evidence for the record takes substantial amounts of time and effort to prepare."
In order to simplify this process, a middle ground has been established in evaluating antirust cases - the "quick look" rule of reason analysis. Under the quick look analysis, the court or agency will evaluate a restraint of trade (such as a membership restriction) and determine that although the restraint is not a per se violation, the anticompetitive effects of the restraint are so obvious that a full-blown rule of reason analysis is not necessary. Under these circumstances, a truncated quick look economic analysis will suffice to demonstrate whether or not the restraint has an adverse effect on competition in the relevant market. If the "quick look" is inconclusive, then a full rule of reason analysis can follow. In its recent decision in the case of California Dental Association v. Federal Trade Commission, the U.S. Supreme Court stated that the quick look analysis may be applied when "an observer with even a rudimentary understanding of economic could conclude that the arrangements in question would have an anticompetitive effect on customers and markets."
In California Dental, the Supreme Court recognized that under the antitrust laws, there have been three traditional tests applied to evaluate anticompetitive practices - the per se test, the quick look rule of reason test, and the full rule of reason test. The Supreme Court concurred with the Ninth Circuit Court of Appeals that the association's practices in question - restrictions on dentists' advertising set forth in the association's Code of Ethics - were not a per se violation, and that there may not be a need for a full rule of reason analysis. However, the Court was troubled by the abbreviated quick look analysis performed by the Federal Trade Commission and the Court of Appeals. The Court said that in certain cases, such as this one, there needs to be more than a "quick look" but less than a full rule of reason review. The Court consequently remanded the case to the Court of Appeals to determine if sufficient evidence is on the record to make what a commentator recently termed a "hard stare" rule of reason economic analysis of the effects of the restraints.
While most association membership restrictions likely will continue to be evaluated under the full rule of reason test, in certain cases, particular membership restrictions may qualify for "quick look" or "hard stare" rule of reason review. Unfortunately, California Dental offers little assistance in determining when such review is appropriate.
Membership Restrictions and Federal Tax Exemption.
Most trade and professional associations are exempt from federal income tax under section 501(c)(6) of the Internal Revenue Code, which provides exemption for business leagues, boards of trade, chambers of commerce, and other similar entities. Organizations can qualify for exemption under this section of the Internal Revenue Code when they are organized and operated to advance the business interests of members of a particular industry or profession.
However, section 501(c)(6) has been construed by the Internal Revenue Service ("IRS") and the courts to permit exemption for associations representing only a certain segment of an industry or profession, including associations whose membership is limited to independent (e.g., non-chain or non-affiliated) members of the industry or profession. In general, if it can be reasonably demonstrated that a certain segment of an industry or profession (e.g., independent, non-affiliated companies) has characteristics and circumstances that make it structurally, competitively, economically, and otherwise unique from other segments of the industry or profession, then an association that represents and serves only that segment may be recognized as exempt, as the association is designed to advance the unique business interests of that segment alone.
However, in order to receive or maintain exemption, the association must draft or amend, as the case may be, its governing documents (e.g., Articles of Incorporation and Bylaws) to reflect its limited purposes and the fact that it represents only a certain segment of the industry or profession. Moreover, the association must make membership available to all companies or other persons within that segment on an objective and non-discriminatory basis. Conversely, the association also must exclude from membership (or at least from membership in the association's primary membership category) all companies that do not fall within this segment of the industry or profession on an objective and non-discriminatory basis; "grandfathering" of existing members and/or selective admission of companies from outside the segment must be avoided without exception. The new membership criteria must be unambiguously objective and objectively enforced - for tax reasons as well as the antitrust reasons discussed above.
Implementation of Membership Restrictions.
The implementation of membership restrictions generally is effected through amendments to the Articles of Incorporation and Bylaws of an association. Typically, amendments will be required to the sections concerning the association's purposes or objectives, as well as to those concerning the definitions, qualifications and criteria for association membership. As set forth by the provisions of such documents and as otherwise required by the nonprofit corporation statute of the state in which the association is incorporated, amendments thereto may require a vote of the Board of Directors, the membership, or both, often by a supermajority (e.g., two-thirds).
Amendments to Articles of Incorporation must be filed with the association's state of incorporation; amendments to Bylaws do not.
Importantly, it is critical that the preamble to any written Executive Committee and/or Board of Directors (and all committees thereof) resolutions adopting the amendments, as well as any membership ballots, resolutions and other communications to the membership regarding the same, set forth in sufficient detail the procompetitive rationale for the proposed membership restrictions. Such rationale also should be clearly stated orally at any association meetings at which this matter is being deliberated. As stated above, the intent of the association in restricting membership can be relevant to the antitrust analysis. For example, if the intent of the restriction was to punish industry price-cutters, the restriction might violate the antitrust laws, possibly as a per se group boycott and even possibly as a per se price-fixing conspiracy.
Regarding notification to the IRS, an organization's tax-exempt status will remain in effect so long as there are no "material changes in the organization's character, purposes, or methods of operation." A material change may or may not result in modification or revocation of the organization's tax-exempt status by the IRS. The burden of determining whether or not a change is "material" or "immaterial" falls on the organization. A material change must be communicated in writing to the IRS as soon as possible after the change is made or becomes effective; immaterial changes must be reflected in due on course on the organization's next annual information return (e.g., Form 990), with copies of the amendments to the organization's Articles of Incorporation and Bylaws attached thereto.
Trade and professional associations should be aware that despite their best efforts to properly plan and implement membership restrictions, actions that restrict association membership are by no means free of risk. The most careful preparation and execution of membership restrictions cannot prevent an aggrieved member (or would-be member) from suing the association, or from such a member (or would-be member) referring the matter to a federal or state antitrust enforcement agency for review.
This threat of litigation and government scrutiny is real and should be treated seriously and with great care. As a general rule, long-time association members expelled from membership are the most likely to seek redress of their grievances through the courts. No association should undertake the effectuation of such a membership restriction without being fully prepared to defend a private lawsuit or government investigation, with all of the financial, political, public relations, productivity, and other consequences that necessarily flow therefrom.
This having been said, such risk can be greatly minimized, and a favorable outcome more likely assured, by carefully and deliberately justifying, documenting, structuring, and executing membership restrictions, as described above. A well-conceived "paper trail" will go a long way toward ensuring that the association prevails in any such legal actions. Moreover, the association should ensure that it has sufficient liability insurance coverage in place to cover its potential legal defense costs - and any potential liability from an adverse judgment (if possible).
This article discussed the ability of trade and professional associations to restrict or bar would-be members, expel existing members, and otherwise limit their membership in a manner that effectively includes certain competitors but excludes others. As described above, the federal antitrust and tax laws permit such association membership restrictions, but only under certain circumstances and if done for certain reasons. This is a sensitive area of antitrust law and one ripe for private litigation and governmental enforcement. Great care must be taken to properly justify, structure, document, and execute association membership restrictions in a manner consistent with the federal antitrust and tax laws.
For more information, contact the author at jtenenbaum@TenenbaumLegal.com.