The New Anti-Trust Law - What Does the Future Hold for China's Internet Giants?
Large internet companies such as Alibaba Group, Tencent, and JD, played a crucial role in driving the Chinese economy, especially during the past decade. However, as various sectors in China's economy began to mature, key incumbent players have emerged and consolidated their status through significant first-mover advantages and economies of scale, in addition to the exploitation of certain regulatory loopholes. The strong and relatively unchallenged positions of these incumbents prevented new players from entering or competing in the industry, which has resulted in a shift from innovation-driven profit-seeking business activities to a focus on predominantly price-driven profit maximization.
On November 10th, 2020, China's State Administration for Market Regulation published a draft named "Anti-Trust Guidelines for Platform Ecosystems", aimed at regulating large intenet companies with dominant platforms or ecosystems. These Guidelines are intended to reduce market distortions and promote greater competition in the markets, through the use of a dynamic and flexible regulatory framework with clearly identified factors that are particularly relevant to internet companies.
In this article, we walk through each component of the new Guidelines with applicable examples of high profile Chinese internet companies to illustrate.
Note: although Ant Group's IPO was suspended only a week before the Anti-Trust Guidelines were launched, the IPO was suspended because of the new online microlending regulations in China that came into effect immediately preceding the IPO (see here) rather than because of the Anti-Trust guidelines. However, Alibaba Group has recently been fined for anti-trust violations (article coming soon), which is most likely a signal from the Chinese government that the regulators will be more stringent with anti-trust monitoring, prevention and penalization in the future.
Click here to subscribe and stay tuned for future updates.
What is an Internet Platform?
Under the new Guidelines, an internet platform is defined as a business organization based on internet technology, where different entities that rely on each other interact with one another to generate mutual benefits under the specified rules created by the host.
For example, Meituan, the dominant food delivery services provider in China, qualifies as an internet platform since different entities including restaurant operators, riders and consumers, interact with one another to generate mutual benefits under the platform rules instigated by Meituan. Similarly, Taobao and China's popular travel booking website, Ctrip, also qualify as internet platforms.
How Are Markets Defined for Internet Platforms?
The Guidelines propose a set of specific factors relevant to internet companies that can be used to define the market(s) in which a company operates in. Interaction effects between different internet platforms (i.e. cross-platform effects) are also considered in market determination.
New Factors Relevant to Internet Companies
Since there is no such thing as a prototypical internet platform and each individual platform engages in a wide range of complex businesses with dynamically changing competitive landscapes, the traditional definition of what constitutes a market cannot be applied to internet platform companies. The new guidelines suggest that regulators should consider factors such as the platform's business function, business model, user demographics, and offline transactions in defining what constitutes a market.
Example - The Evolution of DiDi's Business Model and Growing Market Influence
DiDi is a Chinese app similar to Uber in the west and Grab in Southeast Asia where users can call private cars and taxis to get from place to place.
DiDi users can use the DiDi app to call a taxi and pay in cash to the taxi driver. In this case, the transaction is offline and does not count as a transaction via the DiDi platform. Even though it seems as if DiDi does not participate in the traditional taxi market, the company still has the potential to influence the market as consumers develop the habit of calling taxis through the DiDi app. Although DiDi did not charge a service fee at first for connecting drivers and riders, however after consumers became accustomed to using the DiDi app to hail their taxis, DiDi started piloting a small service fee for hailing taxies in select cities.
DiDi also gives out coupons to users which are only valid for DiDi cars rather than third-party taxis. Consequently, after building the consumer habit of calling private hires and taxis through the DiDi app, the company could easily influence consumers to shift from riding taxis to purely using private DiDi cars with online transactions on the DiDi platform.
Depending on the platform's functionalities and/or cross-platform effects, an internet platform may be viewed as operating in a single independent market or as operating in an ecosystem of multiple related markets. Cross-platform effects are also recommended for consideration when evaluating an internet platform's monopoly status.
Example - Alibaba Group/Ant Group Ecosystem
The integration between Alibaba Group's e-commerce platform and Ant Group's various financial platforms is a prime example of an internet company ecosystem. Shoppers who purchase items through Alibaba or partner merchants use Ant Group's Alipay digital payment platform to pay for their purchases, whilst Ant's other financial platforms (i.e. CreditTech, InvestmentTech, and InsureTech) rely on user data from Alibaba to generate appropriate financial product recommendations to users.
Read more about Ant Group here.
Example - WeChat Mini Programs Ecosystem
WeChat was designed to be a messaging app but has ultimately emerged to become China's go-to super-app. Many companies create platforms (called WeChat Mini Programs) that are compatible with the WeChat platform as a way to enter the market and gain access to a large customer base. WeChat users can access these third-party platforms on the WeChat app, with many kinds of businesses offering Mini Programs ranging from news and media to games and restaurant ordering services platforms.
Example - Tencent's Cross-Platform Influence in the E-Commerce Market
Tencent (which owns WeChat) does not directly operate an e-commerce business but still has significant influence over the e-commerce market. Since Tencent was a large shareholder of JD, the company banned the sharing of website links that can encourage WeChat users to shop from JD's competitors (e.g. Taobao or Pinduoduo) via the WeChat app. Afterwards when Tencent acquired a stake in Pinduoduo, the sharing of Pinduoduo links was subsequently allowed, although Taobao links are still banned.
How is an Internet Platform's Market Power Determined?
The Anti-Trust Guidelines propose a set of additional new factors that can be used as part of a dynamic approach in evaluating internet companies' market power.
New Factors Relevant to Internet Companies
Traditionally, revenue and transaction amount were the main factors used in determining companies' market power. However, since internet companies differ from traditional companies in terms of their business models and operating environment, the new guidelines propose an additional set of factors that are more relevant in determining the market share of internet companies. These factors include new user growth, number of clicks, average platform usage time, and user stickiness. For example, a growth stage internet platform might have low revenues due to discounts and free credits given to attract new users, although the platform can still be considered as monopolizing the market based on user growth and/or transaction volume.
A New Dynamic Approach to Assessing Market Power
The guidelines also emphasize the importance of adopting a dynamic view of market power rather than the traditional static view where companies' market power were evaluated purely based on their market shares at a given point in time. With a dynamic view, the key points of consideration are expanded to include ease of entry and barriers to market entry, with economies of scale and the acquisition cost of user data being two particularly important factors.
Generally, internet companies enjoy a first-mover advantage and economies of scale that can significantly hinder new competitors from entering the market. Under the traditional static approach to assessing market power, internet platforms that have a small market share would be considered as having little market power even if these incumbent platforms have a significant first-mover advantage or enjoy benefits from economies of scale that can deter new entrants from entering the industry, resulting in a monopoly in the long run. The goal of adopting a dynamic approach to assessing market power is to lower barriers to entry in order to promote competitive markets driven by long term innovation, rather than industries with powerful incumbents whose long run profits are driven by high prices as a result of their dominant market positions.
Additional factors that will be considered in determining an internet platform's market power include the platform's influence and ability to control downstream and upstream markets, any network effects, the ability to possess and process relevant data, switching costs for consumers, as well as the nature of investors who have a stake in the platform. For example, if many venture capital firms have already invested greatly in an internet platform, it would be difficult for new challengers entering the market to obtain funding. Moreover, if these investors are willing and able to keep injecting cash in order to drive out competitors, the internet platform can be considered in some sense to enjoy a de facto monopoly status.
New Definitions for Collusion and Market Manipulation
Traditional methods of collusion and market manipulation generally involve signed contracts and private meetings. However, with the advent of internet companies, colluded manipulation can take different forms, such as through the use of algorithms and big data. Under the new guidelines, these newer forms of collusive behaviour and market distortion will be taken into account.
For example, in the Topkins case (i.e. America's first e-commerce anti-trust prosecution in 2015), online poster sellers avoided undercutting each other's prices by implementing an automated re-pricing software that set the prices of their products to be in line with each other's on Amazon Marketplace. Even though there were no contracts signed between the parties involved and there were no manual decisions made with regards to product prices, collusion was still effectively achieved through the implementation of a common re-pricing algorithm.
Under the new guidelines in China, using the same third-party provider to build price-setting algorithms with identical input parameters as competing firms will also qualify as collusion.
Criteria for evaluating price discrimination have also been extended under the new guidelines to better suit the business characteristics of internet companies, with a particular focus on data-based pricing manipulation. This includes the (automatic) setting of different prices for different users depending on the user's attributes and past purchase history, as well as limiting the price range or transaction conditions for certain users.
Under the new guidelines, companies may set different prices for different users based on information that could potentially affect the transaction at hand, including transaction costs, related safety, user credibility, and the duration of the transaction. For example, housekeeping services can charge higher prices for larger homes that take a longer time to clean, whilst repair services can charge more for properties with more hazardous conditions.
However, price discrimination cannot be based on information that is unrelated to the transaction, such as confidential information, transaction history, user preference, or consumption behaviour. For example, prior to the publication of the new guidelines, it was not uncommon for travel booking websites to implement algorithm-based discriminatory pricing using past booking history, where users may be offered booking rates that are much higher than what is actually available simply because they were willing to pay higher rates for past bookings. Such price discrimination would be illegal under the new guidelines.
Competitor Exclusion Acts
In the past, a number of online merchants in China were forced by e-commerce companies to exclusively list their products on only one platform. For example, some merchants who sold their products on Taobao were not allowed to list the same products on competing platforms such as JD or Pinduoduo.
Under the new Guidelines, competitor exclusion acts will be scrutinized and examined by regulators even if the company issuing these acts are not determined to have a monopoly status in the market. Exclusion acts can be direct, such as limiting a participant's ability to participate in the markets (e.g. not listing a seller's products because they have listings on a competing platform), or indirect, such as unfairly reducing the volume of search traffic to a participant (e.g. listing a seller's products on the platform but unreasonably downranking their search results).
Regulators will examine factors including an internet platform's market status, the competitive landscape of the market, and barriers to entry in evaluating exclusion acts.
The Status of Variable Interest Entities (VIEs)
A variable interest entity (VIE) is a legal business structure where an investor has a controlling interest even though they do not have the majority of voting rights in the firm.
Historically, many Chinese companies that are listed abroad and rely on offshore funding have a VIE structure, where shareholders of the company listed abroad have the ultimate controlling interest even though the same company has a domestic entity within China where the majority of shareholders are Chinese. Since there are certain sectors where foreign firms face restrictions in China (including information technology), the VIE structure allows majority offshore-funded Chinese companies to be viewed as domestic companies and thereby operate in the Chinese markets without restrictions.
A Grey Area
Leading up to the launch of the Anti-Trust Guidelines, the legal status of VIEs was never clearly addressed by the law and was considered a grey area. In 2015, China's Ministry of Commerce listed VIE companies as a type of foreign company under the Foreign Investment Law, however the final version of the law that was published in 2019 did not specify whether VIE companies should be considered as domestic or foreign entities.
Exploiting the Regulatory Loophole
Companies planning mergers and acquisitions transactions in China are required to submit an application for approval to the government's anti-trust bureau. However, applications in which one or more of the parties involved are structured as VIE companies were typically ignored, because:
Chinese law never explicitly acknowledged or disacknowledged VIE companies as legal business entities in China.
To file for anti-trust approval in China, the parties involved in an M&A transaction need to confirm that they conform to market access regulations. However, Chinese law never addressed whether VIE companies would be entitled to the same market access as domestic Chinese companies or have restricted market access as is the case for foreign companies.
Consequently, applications involving VIE companies were usually neither approved nor disapproved by the anti-trust bureau since the bureau did not want to indirectly pass a judgment on the legal status of VIEs or their associated market access regulations.
Many internet companies structured as VIEs have interpreted and exploited the lack of clear approval or disapproval decision as a green light to go ahead with their M&A operations, resulting in an aggressive string of mergers as companies tried to further consolidate their market power before being called out for potential anti-trust violations in the future.
New Rules for VIEs
The new Guidelines explicitly state that companies with a VIE structure are governed under anti-trust laws and are required to report to the Anti-Monopoly Bureau of the State Administration for Market Regulation for approval before engaging in any M&A transactions.
Internet companies have played a crucial role in spurring China's economic growth, especially over the past decade. However, as the markets these internet companies operate in begin to mature, a number of companies have established themselves as key incumbent players with significant first-mover advantages and economies of scale that make it significantly more difficult for new players to enter the industry. Many internet companies have exploited these advantages and their unchallenged status, as well as regulatory loopholes such as those concerning VIE companies, to further consolidate their dominant market positions and shift their profit drivers from innovation to the undue charging of higher fees and prices.
The most important purpose of the new Anti-Trust Guidelines is to, as much as possible, reduce and eliminate these existing market distortions in order to promote fair competition that will be the driver for growth and innovation in the long run. The Guidelines provide a flexible, dynamic framework with specific factors relevant to internet companies for regulators to assess how internet platforms shape markets now and how they could potentially influence the markets in the future.
Our Insights: although the published Guidelines will most likely erode the first-mover advantage and strong incumbent status enjoyed by many internet companies, we believe that as a whole, if implemented effectively, the Guidelines will bring about more socially optimal outcomes through greater innovation and competitiveness as key long run driving forces of the Chinese economy.
Click here to subscribe and stay tuned for future updates.
More on Regulation
Investing in China