The management of subcontractors is often crucial for brands in various industry sectors such as automotive, where the control of their supply chain is a main value driver for the business. One of the most widely used tools to control supply chain partners is the use of contractual exclusivity restrictions of subcontractors. The China Anti-Monopoly Guideline for the Automotive Industry resembles the position of the EU antitrust authority, with its exemption of exclusivity restrictions on subcontractors under certain circumstances. While it has been increasingly important to control sub-contractors’ competitive behaviour, especially those who are developing new technologies and trying to move up the value chain, companies in China need to assess more carefully whether these restrictions are legally permitted, considering that in a recent case the Supreme Court of China has upheld a different opinion.

The dispute in the aforesaid case arose from the patent infringement settlement between a subcontractor entity and its customer, who is also the patent holder.  The subcontractor sued for the invalidation of the settlement agreement under which the customer has restricted the subcontractor’s freedom to set its resale price and choose its trading parties, in the name of patent enforcement. The Supreme Court overturned the ruling of the court of first instance and saw the horizontal hardcore restrictions violated. This provided the ground to invalidate the contract. 

To prevent their subcontracting agreements from being invalidated, companies could evaluate their arrangements with subcontractors from the following aspects:

1) Whether the subcontractor is a potential competitor or a genuine subcontractor in the same relevant market.

In a genuine subcontracting relationship, the customer and subcontractor should be in different upstream and downstream markets to complement each other and increase efficiency. However, in practice subcontractors and their customers  are often able to provide substitute products and compete with each other. Such possibility raises questions as to whether the anti-competitive restraints, e.g. exclusive supply clauses in subcontracting agreements, could be deemed horizontal restraints that are subject to more hardcore restrictions than vertical restraints. 

If the anti-competitive restraints are imposed on a genuine subcontractor where the customers will provide essential IP, know-how, documents or equipment for the production, the subcontractors will usually not be deemed as independent suppliers. The China Anti-Monopoly Guideline for the Automotive Industry provides that the prohibition of vertical restraints normally should not apply, which is similar to the EU rules in this regard.

2) Whether the customer has a dominant market position

The exclusive supply will be deemed as abuse of dominant market position if the customer holds a dominance in the relevant upstream market. Defining the relevant market will be the precondition to establish such abuse. For example, the China Anti-Monopoly Guideline for the Automotive Industry provides that the car manufacturer customer may not hold a dominant position in the new vehicle sales market, but each car manufacturer brand may be in a dominant position in its aftermarket considering the lock-in effect of the brand and the product compatibility. Therefore, the car manufacturer should carefully evaluate its dominant market position before imposing the exclusive supply obligations on its supplier without legitimate concern or pro-competitive effect, unless it is a genuine subcontracting relationship where the antitrust risk of exclusive supply is relatively low.

3) Whether the restrictions on the subcontractor serve to enforce IP rights or to divide the market.

The customer under a subcontracting relationship is often the IP owner of the technology required to manufacture the product. Such IP ownership and proprietary right can also entitle the customer to set the scope of the IP use right. However, there is a fine line between an IP enforcement right under patent or trademark laws on one hand and illegal restrictions as the abuse of IP rights on the other. Evidence from the conversations of the parties eventually reveals the ultimate purpose of restricting competition in the form of IP enforcement in the downstream market in the court case mentioned above.   

The Supreme Court emphasized that while the enforcement of the IP right should be respected, it  should also be strictly limited to the scope of registered patent protection, to reflect its genuine purpose. The scope of IP rights enforcement should only cover the products with technical features of the registered patent. The sales price, volume, category, and territory of the subcontractors should be based on the patent right granted in China. If any restraints are beyond the statutory protection of the patent right, the court may suspect there is no substantial relevance between the IP protection and restraints imposed on the subcontractors. 

The legal standard applied by the Supreme Court can serve as an alert for companies to reassess the relationship between subcontractors and their customers. If both operators potentially compete in the same relevant market, there is a substantial monopoly law risk. Careful consideration should be used before deciding to indeed agree on fixing resale prices or dividing the market, both hardcore restraints under the law. Meanwhile, the exchange of sensitive information on resale prices, customers, sale strategies etc should be limited to the least necessary extent for the subcontracting purposes.  If the subcontractor undertakes other roles such as those of an agency or joint developer, the relevant market should be redefined and assessed separately, as well as the applicable vertical restraints. 

If you need more information or further guidance in this area, please contact Sven-Michael Werner or Serena Du.   

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