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Pepper Hamilton, L.L.P.

Problems Continue with Government Contractors' Duties Under the Privacy Act
In the wake of heightened scrutiny regarding privacy issues, government contractors and their employees must understand and adhere to the requirements of the Privacy Act, 5 U.S.C. § 552a.

Problems with federal agency Privacy Act compliance were most recently addressed in a June 2003 report from the Government Accountability Office (GAO).1 While GAO did not specifically list the failures of a particular agency, it did report general findings. Of the 2,400 agency systems of records surveyed, GAO found, in part, that agencies:

lacked a process to review disclosures to determine whether data is being used outside the original purposes of the data collection;
did not assure that personal data on individuals is accurate, relevant, timely and complete for records released to non-federal organizations;
did not assess security safeguards for the data;
did not have the means to detect when persons without authorization read, disclosed or altered data;
could not account for disclosures of personal information; and
only one-third of the agencies surveyed, issued the Act’s required rules of conduct for employees as related to duties under the Privacy Act.
At the time GAO cited lack of Office of Management and Budget (OMB) guidance and lack of funding as reasons for these failures; however, these problems still exist. In 2005, GAO issued a second report that found that the Transportation Security Agency (TSA), which used personal information from commercial sources during secure flight testing, failed to provide appropriate disclosure about its collection, use and storage of personal information as required by the Privacy Act.2

Government Contractors

Like most federal agencies, federal government contractors have struggled with the Privacy Act.

5 U.S.C. § 552a(m)(1) says that when under contract to develop, design or operate a system of records on individuals to accomplish an agency function, the contractor and its employees are required to comply with the Privacy Act. The Federal Acquisition Regulations (FAR) 52.224-1 also subjects contractors to the Privacy Act’s regulations, and notes that violations may result in criminal penalties. The FAR also requires that certain clauses, including Privacy Act notifications (see FAR 52.224-2), be included in such contracts. FAR 52.224-2 also states that “when the contract is for the operation of a system of records on individuals to accomplish an agency function, the Contractor is considered to be an employee of the agency.”

Generally speaking, the Privacy Act has four core requirements:

limit the collection, use and dissemination of personally identifiable information about an individual
restrict the disclosure of information to third parties3
allow individuals who are the subject of the files the right to access and amend incorrect information in their files
require public notification of collections of information on individuals via forms, Web sites and record systems.
Contractors should contact an attorney to discuss additional requirements before submitting a proposal for a contract to develop, design or operate an agency function.

Good and Bad News

First – the bad news. The primary source of guidance on the Privacy Act for contractors comes from OMB Guidelines, 40 Fed. Reg. 28,975-76, (July 9, 1975), which GAO lambasted in its 2003 Report. However, many federal agencies have issued their own guidance and procedures. Also, even where a contractor is performing an agency’s function, it is the agency – and not the contractor – that would be subject to a Privacy Act civil lawsuit. This does not mean that contractor should take a laissez-faire approach when dealing with Privacy Act issues in contracts. While an agency might be civilly responsible for disclosures, a contractor’s failures could result in contract termination, or the government may seek other available contractual remedies.

ENDNOTES

1 GAO-03-304, Privacy Act: OMB leadership needed to improve agency compliance.

2 GAO-05-864R, Aviation Security: Transportation Security Administration did not fully disclose uses of personal information during secure flight program testing in intitial Privacy Notices, but has recently taken steps to more fully inform the public.

3 The Privacy Act does permit the disclosure agency, which maintains the record, to disclose to a contractor who serves the function of an agency employee.

07-19-2006

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Pepper Hamilton, L.L.P.

Reporting Requirements for Corporate Transactions Modified to Prepare for E-Filing
On May 30, 2006, the IRS issued T.D. 9264, creating more than 20 new temporary and proposed Regulations aimed at eliminating reporting burdens on corporations and shareholders engaging in certain transactions. By doing so, the IRS has decreased the detail of information required in certain reports and has also removed some of the hurdles presented to electronic filing of tax returns.1 Some of the changes simply clarify reporting requirements, however in other cases the reporting requirements are eliminated altogether. We have highlighted just a few of the changes in this article.

Section 355 Reporting Changes
If a company transfers a division of its business into a separate but wholly-owned subsidiary and distributes shares of the new company to its current shareholders, and the transaction receives non-recognition treatment under Section 355, Regulations require corporations and shareholders to report the transaction on their tax return.2 While the previous Regulations for corporate reporting prescribed only a “detailed statement setting forth such data as may be appropriate in order to show compliance,” the new Regulation sets out specific requirements for the report.3 While the previous Regulation required a report by every shareholder who received a distribution, the new Regulation restricts the reporting requirement to only “significant distributees” - those shareholders who held more than 5 percent of the shares of a publicly traded company or 1 percent of the shares of a non-publicly traded company.4

Section 368 Reporting Changes
When a company undergoes a reorganization described in Section 368, the parties to the transaction are required to submit a report with the tax return filed for the year in which the transaction occurred. The previous Regulations required very detailed reports from all the corporate parties, including a copy of the plan of reorganization, as well as detailed statements of the values of the assets and liabilities transferred.5 The new Regulation has pared down these requirements significantly, and now requires only the names and EINs of the corporate parties, the date of the reorganization, a statement of the FMV and basis of the property transferred, and the date and number of any private letter ruling issued in connection with the transaction. Under the previous Regulation, any shareholder receiving a distribution in connection with the reorganization was required to file a report. The new Regulation again requires only that “significant distributees” file reports.6

Section 382 Reporting Changes
New temporary Regulations have been issued requiring a report to be filed when a corporation with net operating loss carryovers undergoes an “ownership change” as described in Section 382. 7 The statement must include the date(s) of any ownership change and the amount of any attributes causing the corporation to be a loss corporation, including net operating losses or capital loss carryover. In addition to the basic statement, the loss corporation must also include (if taken) the elections to disregard the deemed exercise of an option8 or an election to close the loss corporation’s books.9

Pepper Perspective
All of these new Regulations were effective on May 30, 2006, and are currently applicable. Because of the sheer number of changes, taxpayers should carefully consider the new reporting requirements when engaging in a significant transaction to determine the timing and manner of complying with these new requirements.

07-19-2006

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Pepper Hamilton, L.L.P.

Soft Dollar Guidance Forthcoming
The SEC voted to publish an Interpretive Release regarding soft dollars that will clarify how money managers may use client commissions to pay for brokerage and research services under the “soft dollars safe harbor” in Section 28(e) of the Securities Exchange Act of 1934. Brokerage eligible for soft dollars and the availability of soft dollars for certain uses will be narrowed from past practices once the guidance takes effect.

Highlights of the Interpretive Release, which the SEC expects to publish shortly, include the following:

money managers may use client commissions to pay only for “eligible brokerage and research services”
eligible research services are limited to those eligible under Section 28(e) and include traditional research reports, market data and other items, but do not include computer hardware or mass-marketed publications
eligible brokerage is limited to those products and services that relate to the point in time at which the money manager communicates with the broker-dealer for the purpose of transmitting an order for execution, through the point at which funds or securities are delivered or credited to the advised account
to use the soft-dollar safe harbor, the money manager must use the eligible brokerage and research services in a manner that provides lawful and appropriate assistance
for mixed-use items (hard dollars and soft dollars), the money manager must make a reasonable allocation of client commissions in accord with the eligible and ineligible uses of the items, and maintain adequate records to support the allocation
money managers must make a good faith determination that the commissions they pay are reasonable in relation to the brokerage and research service they obtain
the safe harbor is available when the money manager does business with a broker-dealer that is involved in effecting the trades and providing the research. To be considered to be involved in effecting trades, the broker-dealer must do one of the following: execute, clear or settle the trade; or perform one of four functions relating to trade monitoring and record-keeping, and allocate the other functions to other broker-dealers.
the safe harbor is available to the money manager if the broker-dealer that is effecting the trades for the advised accounts is either legally obligated to pay for the research or pays the research preparer directly, and equally important, takes steps to see that the services are eligible under the safe harbor, such as monitoring compliance with the safe harbor.
The Interpretive Release also states that the SEC will be receiving and considering additional comments on client commission arrangements given the evolving developments in the industry, and that the SEC may supplement its guidance if appropriate. Although the Interpretive Release will be effective upon publication in the Federal Register, users and providers of soft dollars will be able to rely upon prior SEC guidance for six months following publication. We will continue to monitor these developments and notify you as soon as we know additional details. If you have questions regarding this matter, please contact Gregory J. Nowak at 215.981.4893 or nowakg@pepperlaw.com, or any member of the Investment Management team at Pepper Hamilton LLP.

Soft Dollar Treatment Eligibility

Eligible Items Non Eligible Items
Research (including market data)
Computers

Analytics
Overhead related expenditures

Advice
Mass-marketed or widely available publications
Reports
Travel expenses
Brokerage Services

07-19-2006

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Morrison & Foerster, LLP

California "Two-Party Consent Law" Applies to Recording of Calls Made from Other States
Companies often record or monitor conversations between their employees and customers for quality-control purposes. When both parties to the call are in a state that, like federal law, permits monitoring or recording with the consent of only one party to the conversation, the employee’s consent to monitoring is sufficient to prevent a successful legal challenge. When one party is in a state that permits monitoring only with the consent of both parties to the call, the company’s obligations are less certain.

In a decision entered Thursday, July 13, 2006, the California Supreme Court ruled that California’s two-party consent law governs a lawsuit arising from calls between a company’s location in Georgia (a one-party consent state) and clients located in California. The California decision confirms that states with restrictive eavesdropping laws will not hesitate to enforce those laws against interstate callers.

Kearney v. Salomon Smith Barney, Inc., S124739 (Sup. Ct. Cal. July 13, 2006) (“Kearney”), is a putative class action suit brought in the California Superior Court for San Francisco County. The plaintiffs alleged that Salomon Smith Barney, Inc. (“SSB”) recorded conversations between its employees in Georgia and the plaintiffs in California. According to the complaint, those recordings were made without the plaintiffs’ consent.

The Superior Court in San Francisco dismissed the complaint on the ground that the alleged calls were subject to — and lawful under — Georgia’s one-party consent law. The California Court of Appeals upheld that decision. The Supreme Court’s decision of July 13, however, found that the complaint was properly governed by California law and the lower court’s dismissal of the complaint was therefore in error.

The Supreme Court’s decision turned primarily upon the question of choice of law – in this case, whether California or Georgia law should be applied to a set of facts in which both states had a legitimate interest but as to which the two states’ laws were in conflict. Under California precedent, such conflicts are resolved by a “governmental interest” analysis, which consists of three steps. “First, the court determines whether the relevant law of each of the potentially affected jurisdictions with regard to the particular issue is the same or different. Second, if there is a difference, the court examines each jurisdiction’s interest in the application of its own law under the circumstances of the particular case to determine whether a true conflict exists. Third, if the court finds that there is a true conflict, it carefully evaluates and compares the nature and strength of the interest of each jurisdiction in the application of its own law ‘to determine which state’s interest would be more impaired if its policy were subordinated to the policy of the other state.’” Kearney, slip opinion at p. 13, quoting Bernhard v. Harrah’s Club, 16 Cal.3d 313, 320 (Sup. Ct. Cal. 1976). Once this analysis is complete, the court applies the law of the state that would suffer the greater adverse impact if its law was not applied. Id.

The court had little difficulty finding that the Georgia and California eavesdropping laws were in conflict, and that the conflict applied directly to the facts alleged in the complaint. Accordingly, the court proceeded to the third element of the “governmental interest” analysis, and found: (1) that California’s interest in protecting its residents’ privacy would be substantially impaired by failure to enforce its two-party consent law in this case; and (2) that the harm to Georgia from failure to enforce that state’s law would be substantially less. As to the second point, the court found, for example, that enforcing California’s law would affect only calls made from Georgia to California, and that even this limitation on Georgia callers could be mitigated by obtaining prior consent from California residents before their calls were recorded.

The California Supreme Court’s decision in Kearney does not find that SSB’s conduct was unlawful, but it does find that California law will decide that question if the case proceeds to trial. Regardless of the eventual result, Kearney reinforces some important principles about the application of state eavesdropping/wiretapping laws to interstate telephone calls.

1.Federal Law Does Not Preempt State Eavesdropping Laws

As the California Supreme Court made clear, federal law (which permits monitoring with the consent of one party) does not preempt more restrictive state eavesdropping laws, even when the monitored communications are interstate. Accordingly, companies that monitor interstate calls for quality control purposes must consult the applicable provisions of state, as well as federal, law.

2.The Laws of Both Originating and Terminating States Will Apply

Assuming that the complex Due Process elements of jurisdiction are otherwise present, either the originating or terminating state of an interstate call may have a claim to jurisdiction over an eavesdropping complaint. Specifically, the state in which the call is monitored or recorded may claim jurisdiction because the monitoring occurred there, and the state in which the plaintiff resides may take jurisdiction because the harm to the victim occurred there. In the Kearney case, for example, the plaintiffs might have chosen to bring their lawsuit in Georgia rather than California, leaving the choice of which state’s law to apply to be settled by a Georgia court. The laws of both the originating and terminating states must be taken into account before the decision to monitor or record a call between those states is made.

3.Obtain Required Consents

If both the originating and terminating states permit monitoring or recording with the consent of one party, ensure that your employee has consented to the monitoring and/or recording of all business-related uses of the company’s communication facilities. For this purpose, appropriate language in the company’s employee handbook or technology use policy should suffice. The presumption of employee consent will be strengthened, however, if the employee has acknowledged his or her agreement to the policy in writing.

If either end point of some of your company’s customer calls will be in a two-party consent state, your company should avoid monitoring/recording calls that originate or terminate in such states, or should precede the conversation with an announcement stating that the conversation may be recorded. The customer’s decision to continue with a call after hearing such an announcement constitutes prior consent to the subsequent monitoring or recording.

4.Special Problems of Outbound Calling

When a company places an outbound call to a customer, playing of a recording announcing that the call will be recorded may end the call before it starts. In order to avoid this result, companies placing outbound calls might choose not to monitor or record calls to or from two-party consent states. In the alternative, a company might review the laws of the two-party consent states for other exceptions that may permit monitoring or recording without customer consent.

Conclusion

The Kearney case underscores, but does not exhaust, the complexity of eavesdropping and wiretapping laws. Besides their one-party and two-party consent provisions, those laws may include other exemptions — such as rights to monitor for quality-control purposes or to protect the monitoring entity’s rights or property — that trump even the consent requirements. Careful review of the relevant state laws, therefore, might disclose protections as well as prohibitions for companies that wish to monitor calls for legitimate business reasons.

07-19-2006

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Morrison & Foerster, LLP

Consistency Determinations Under the California Endangered Species Act Streamline Permitting Process
Nearly every project in California must be evaluated to see if it will affect any species of fish, wildlife or plants protected under the Federal Endangered Species Act (FESA) and the California Endangered Species Act (CESA). It is not uncommon for a species to be listed under both laws, and, in such instances, both need to be satisfied. Applying to both federal and state agencies for permission to “take” protected species can be a tedious and time-consuming process, often fraught with duplication and inefficiencies.

Fortunately, CESA recognizes this problem. While a landowner may choose to apply for incidental take permits under both CESA and FESA, CESA allows for a streamlined permitting process to obtain state incidental take authorization if such take is already authorized under FESA. This process – known as a “consistency determination” – requires the California Department of Fish and Game (DFG) to review the federal authorization to determine whether it is “consistent” with CESA. Specifically, the law waives the state incidental take permit requirements so long as the applicant provides to DFG (1) written notification that the applicant holds a federal incidental take permit or incidental take statement (accompanying a biological opinion) and (2) a copy of the authorization. Under California Fish and Game Code section 2080.1, the applicant is allowed to commence activities immediately after submitting these documents. DFG is required to provide public notice of receipt of the documents and has 30 days to determine if they are consistent with CESA. If there is consistency, DFG cannot require a state permit, and the project may proceed under the federal authorization.

A consistency determination is not a permit, but instead a recognition of reliance on a federal authorization that satisfies the requirements of CESA. For this reason, DFG cannot add conditions to the federal incidental take permit or biological opinion to meet CESA requirements, but instead must accept it “as is” for the purposes of determining consistency. If additional conditions are necessary, no consistency determination can be issued. Consistency determinations are increasingly sought as developers and landowners look for ways to streamline the burdensome approval process for projects. Public agencies and local jurisdictions also rely on them for large-scale projects.

The valuable streamlining role of consistency determinations was solidified in a recent Sacramento County Superior Court decision of first impression, Center for Biological Diversity v. California Department of Fish & Game. At issue was DFG’s consistency determination for the marbled murrelet, a bird listed under CESA and FESA, based on the Pacific Lumber Company’s federal incidental take permit for the species. The Center claimed that DFG acted improperly in issuing the determination, arguing the determination was a project requiring review under the California Environmental Quality Act (CEQA).

The Court rejected the argument, concluding that a consistency determination is merely an agency determination of conformity with relevant statutes and regulations rather than a “discretionary” project triggering review under CEQA. This is supported by section 2080.1, which allows applicants to begin their project as soon as the documents are submitted to DFG. The law also provides a 30-day period for DFG to issue a consistency determination, which does not give the agency enough time for CEQA analysis. Moreover, construing a consistency determination to require CEQA review would undermine its streamlining purpose, which the Legislature expressly recognized in 1997 when it authorized consistency determinations to provide relief from the “duplicative permit process” of having to get permits under both CESA and FESA.

The Court rightly concluded that consistency determinations do not require CEQA review. Requiring CEQA review would greatly increase costs and delays for construction of important public projects at a time when state and local government budgets are tight, to say nothing of the costs and delays that would be imposed on private development projects. Consistency determinations remain a valuable tool for landowners and local jurisdictions for streamlining permitting and approval of projects.

07-19-2006

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Morrison & Foerster, LLP

EPA Reduces RCRA Reporting Requirements
The Environmental Protection Agency (EPA) recently published a new rule to reduce recordkeeping, reporting, and inspection requirements imposed on businesses, states, and members of the public regulated under federal hazardous waste laws. The new rule, which became effective May 4, 2006, is intended to reduce the paperwork burden imposed under the Resource Conservation and Recovery Act (RCRA). Industries affected by the new rule include manufacturing, transportation, waste treatment, utility and mineral processing operations. EPA estimates the new rule will lead to an annual hour savings of 22,000 to 37,500 hours, with an annual cost savings ranging from $2 million to $3 million.

Although paperwork reduction is one of the major aspects of the new rule, the new regulation will significantly alter the way many affected businesses conduct their operations. It also will make compliance with many RCRA requirements less onerous. However, recordkeeping, reporting and inspection requirements that may seem very simple often lead to significant non-compliance issues when not followed very carefully. To take full advantage of the benefits of the new rule, the requirements (as discussed below) must be thoroughly understood and followed.

Records Retention

RCRA requires that certain records for permitted facilities that treat, store or dispose of hazardous waste (TSD facilities) be retained for the life of the facility. The new rule reduces the length of time waste handlers must retain certain records onsite to three years, or five years in the case of hazardous waste incinerators, boilers, and industrial furnaces. The reduced retention time applies to waste analyses, certain monitoring, testing and analytical data, waste determinations, selected certifications and notifications. Facilities will still have to maintain records with the greatest potential to affect protection of human health and the environment for the life of the facility, such as those regarding the type and quantity of waste received, the location of hazardous waste and closure estimates. Facilities also will have to maintain records pertaining to groundwater monitoring and cleanup until closure of the facility.

Professional Engineer Certification

The new rule also changes the requirements regarding certification by a professional engineer of certain documents for generators of hazardous waste and TSD facilities. Previously, the regulations required that facilities retain engineers who are independent, qualified, registered, and professional. The new rule deletes the terms “independent” and “registered” and requires only that engineers be qualified to perform the task and professional (e.g., registered or licensed by the state and following a code of ethics, with the potential of losing that license for negligence). EPA has modified the certification requirements for permitted and interim status TSD facilities, including those for closure and post-closure, to reflect the revised engineer qualifications.

These changes mean that businesses may use their own in-house engineers to make any required certifications, provided the engineers are both qualified and professional. In-house engineers are generally more familiar with the operations at the facility and thus are in a better position to provide on-site review and make the necessary certifications than outside engineers.

Contingency Plan

RCRA currently requires owners and operators of hazardous waste TSD facilities to have a contingency plan covering their hazardous waste operations. Certain other statutes and regulations also require contingency plans with somewhat different requirements than those under RCRA. Under the new rule, facilities will have the option of developing one contingency plan per facility, provided that the plan follows the National Response Team’s Integrated Contingency Plan Guidance (known as One Plan). The One Plan was developed in 1996 by EPA in consultation with the Department of Transportation, Department of the Interior, and Department of Labor, each of which has requirements for contingency plans.

EPA anticipates that giving facilities this flexibility will eliminate confusion for facilities that must decide which contingency plan applies to a particular emergency. EPA also expects that using a single plan will enable first responders, such as firefighters, to comply with multiple regulatory requirements. Having one contingency plan also will ease the burden of coordinating with local emergency planning committees.

Emergency Response Training

Both EPA and the Department of Labor’s Occupational Safety and Health Administration (OSHA) have regulations governing worker activities and training at hazardous waste facilities. Once the new rule becomes effective, waste handlers will have the option of complying with requirements of either RCRA or OSHA regulations for training employees in emergency response procedures. (Facilities not subject to OSHA training requirements will still have to comply with the RCRA training requirements.)

Decreased Inspection Frequency

Existing rules require daily self-inspections of certain hazardous waste facilities. The new rule permits waste handlers to reduce required facility and equipment self-inspections for hazardous waste tank systems from daily to weekly, provided certain conditions are met. Tank owners and operators must either have leak detection equipment or use “established workplace practices” (such as an existing Environmental Management System) to ensure that leaks and spills are promptly identified and remediated. EPA recommends that a facility document which option it chooses in the facility’s operating record. If the facility chooses the workplace practices option, EPA also recommends that the specific practices be documented in the facility’s operating record.

Small-quantity waste generator tank system owners and operators also may reduce inspection frequency if tank systems have secondary containment with either leak detection equipment or established workplace practices that ensure prompt detection of releases. EPA also recommends that small-quantity generators document their choice of method in the facility as operating record.

Facilities that are members of the National Environmental Performance Track Program also are eligible for reduced inspections on a case-by-case basis for tank systems, container storage areas, and containment buildings. Such facilities must apply to EPA for a Class 1 permit modification with prior approval.

Records Retention and Decreased Document Submission Requirements

Under the new rule, waste handlers who previously both had to keep certain records onsite and submit them to EPA now only need to keep the records onsite. The new requirements will apply to, among other things, the submission of groundwater monitoring plans and assessment reports. It also applies to the submission of response action plans for surface impoundments, waste piles and landfills when the leakage rate in the leak detection system has been exceeded. Facilities now will only be required to keep these plans on site.

Another provision of the new rule eliminates a requirement that facilities submit a tank system certification of completion for major repairs. The new rule also requires recyclers to prepare and maintain notifications and certifications only with their initial shipments of waste. New documentation is required only when the waste, the treatment process, or the receiving facility changes. Information will be kept in the treating or recycling facility’s onsite files and must be available for inspection. EPA also is eliminating the requirement that a facility submit a land disposal restriction notification and certification. This information now need only be kept in the facility’s files.

Semi-Annual Reporting

Finally, EPA is changing the semi-annual reporting requirements for certain reports to an annual reporting requirement. This change will affect reports on the effectiveness and progress of a corrective action program. Previously, EPA required submission of these reports on a semi-annual basis. EPA has determined that there will be no impact to human health or the environment by having annual rather than semi-annual reporting for corrective action programs.

Implementation in Authorized States

States that operate a RCRA program in lieu of the federal program generally are not required to formally adopt federal regulations that are less stringent than previous federal regulations. For states with an approved RCRA program, such as California, the new rulemaking will not become effective until the state adopts the changes and seeks EPA authorization. It will be important that facilities ensure their particular state has adopted the new rules and is authorized by EPA before modifying any of their current recordkeeping, reporting, or inspection requirements.

07-19-2006

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Morrison & Foerster, LLP

European Court of First Instance Overturns the European Commission's SONY/BMG Clearance Decision
On July 13, 2006 the European Court of First Instance (hereinafter the “CFI”) for the first time reversed a decision of the European Commission (hereinafter the “Commission”) approving, under the EU Merger Regulation, the creation of a joint venture by Sony Corporation of America (hereinafter “Sony”) and Bertelsmann Music Group (hereinafter “BMG”).1

The CFI’s judgment should be seen as yet another episode in the crusade that it has conducted in the last four years to impose greater rigor in the Commission’s factual and legal analysis in merger cases.2 The CFI faulted the Commission on two of its technical findings relating to the absence of a collective dominant position in the recorded music market. This does not mean that there is a deep difference of view between the CFI and the Commission concerning this or any other market. The result of the judgment is that the Commission must conduct a new appraisal of the transaction under the Merger Regulation. While in theory the Commission could find it illegal and order it to be undone, this is highly unlikely.

Background

The merger notified to the European Commission on January 9, 2004 combined the companies’ respective worldwide recorded music businesses, including the discovery and development of artists and the marketing and sale of their disks. The Commission opened an in-depth second phase investigation of the proposed merger in February 2004. It initially took the view that there existed a collective dominant position in the recorded music market that would be strengthened by the merger, and issued a statement of objections on that basis. However, in the course of the proceeding, it changed its view and finally approved the merger, finding that there was no existing collective dominant position in the recorded music market, nor would one be created by the merger.

The Commission’s treatment of the issue of collective dominance

In its evaluation of the proposed merger, the Commission applied the test for collective dominance as set forth by the CFI in the Airtours case.3 The following factors are considered to be decisive in ascertaining whether or not there is a collective dominant position:

Transparency, i.e. the ability of each member of the dominant oligopoly to be aware of the conduct of the others in order to check whether or not they are adopting the same course of conduct on the market;
Possibility of retaliatory measures, i.e. existence of deterrent mechanisms in response to a possible deviation by members of the dominant oligopoly from the common policy;
Inability of the outsiders (e.g. non-participating suppliers, consumers) to undermine the collective dominance of the participants.
Applying this test, the Commission found that the first two elements were not present in the recorded music market.

As regards transparency, the Commission concluded that there was “insufficient transparency” on the market, in spite of the alignment of prices, because a certain category of discount (the campaign discount) was less transparent and presented a significant “fluctuation.” It also remarked that the heterogeneity of the products concerned (specifically in the content of albums) was counter-indicative of collective dominance and influenced market prices.

With reference to retaliatory measures, the Commission found that such measures had never been applied, and that therefore this element was not present.

The Commission made no finding regarding the possible countervailing power of competitors and consumers.

The CFI’s judgment

The CFI found that the Commission’s finding of lack of transparency was inadequately reasoned. It observed that “the few assertions relating to campaign discount […] are imprecise, unsupported and contradicted by other observations in the decision and cannot demonstrate the opacity of the market.” It noted that the Commission’s decision itself identified specific factors indicating transparency (namely the public nature of gross prices, the limited number of referenced prices and the limited number of albums to be monitored). The CFI found that the Commission had required a particularly high level of transparency “greater than that necessary to permit a collective dominant position.”

As regards retaliation, the CFI stated that in assessing the relevance of the historical absence of such measures, the Commission should also have considered whether there had ever been deviant conduct by the participants, and whether the facts indicated that retaliatory measures were available. Since the decision did not contain any analysis of these points, the Commission’s finding was inadequate.

Additionally, the CFI criticized the Commission for not having carried out a prospective analysis on the changes in market conditions that would result from the Sony/BMG merger.

Conclusion

The judgment at issue, rather than having a revolutionary impact on the music industry, is in line with the CFI’s constant criticism of the Commission’s working methods which lead to its merger decisions lacking in coherence and economic know-how.

The practical result for Sony BMG is that the parties will have to re-notify the transaction and the Commission will have to restart its analysis of the merger. An appeal against the CFI, limited to the points of law, may be brought by the Commission before the highest court (the Court of Justice of the European Communities) within two months from the notification of the judgment.

Footnotes
1 Case T-464/04, Independent Music Publishers and Labels Association (Impala) v. European Commission, judgment of 13 July 2006 available at: http://curia.europa.eu/jurisp/cgi-bin/form.pl?lang=EN&Submit=rechercher&numaff=T-464/04 .

2 See, for instance, Case T-5/02 ,Tetra LavalBV v European Commission; see Case T-310/01 Schneider SA/Legrand Electric SA.

3 Case T-342/99.

07-19-2006

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