by Elana Varon

Orbitz Under a Legal Cloud

Jan 15, 200111 mins
BPM Systems

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Decide whether Orbitz is headed for antitrust trouble

Understand how online sites are changing the economics of the travel industry

Learn how online exchanges can stay on the right side of the Justice Department

It’s late July in Washington, D.C., and an oppressive blanket of fog and humidity is settling over the Capitol building. Inside a grand, turn-of-the-last-century office building across the street, the air-conditioning is at full blast, but Jeffrey Katz, chairman, president and CEO of the online travel website Orbitz, looks uncomfortable as he takes the heat for the airline industry’s years of antitrust shenanigans.

Facing the Senate Commerce, Science and Transportation Committee and flanked by rivals and critics, Katz is defending his company against accusations that it is a cartel whose owners—five major domestic air-lines—will use it to control ticket prices and put the squeeze on competitors. Chicago-based Orbitz hasn’t made its first sale, but already it’s the subject of two federal antitrust inquiries: one by the U.S. Department of Justice, which enforces competition laws, and another by the U.S. Department of Transportation, which regulates airlines’ marketing practices.

Now, Sen. John McCain, R-Ariz., the committee chairman, wants to know why the airlines, with a history of price-fixing and other fare manipulations through their computer reservation systems, won’t try the same tactics on the Internet. “Can you appreciate the skepticism that exists here?” asks McCain. “Completely,” replies Katz, who once ran Sabre, the reservation system built by American Airlines in 1964. Katz explains that the airlines’ contracts with Orbitz rule out collusion. “As chairman of this board I can tell you: Not on my watch. We understand the law and intend to comply with the spirit and the letter.”

Katz’s Washington audience appreciates his pledge, but that doesn’t mean they’ll let him and his company off their radar screen. With Orbitz, there is a lot at stake for the airlines, the federal government and airline passengers. Beyond the airline industry, what happens with Orbitz could very well touch companies in all corners of the new economy. As organizations band together in electronic marketplaces, they’re collaborating much more closely than they have in the past. These new relationships are supposed to benefit both buyers and sellers by reducing transaction costs and prices. But when exchange members are direct rivals, as in the case of Orbitz, it’s not clear whether such cooperation might lead instead to collusion that will quash competition and cheat consumers.

As one of the first online exchanges to undergo antitrust scrutiny, Orbitz will help set standards for how such marketplaces operate and whether or not they deliver on their economic promise. “There’s an analog [to Orbitz] in almost every industry,” says Dan Rybeck, managing director of business research consultancy ASI Associates in Minneapolis. Exchanges have already been formed by the automobile industry, electronics manufacturers and chemical companies, among others. “Anywhere you see pure-play dotcoms set themselves up as online intermediaries, you’re finding a push [back] by industry leaders,” Rybeck continues. “The basic business issue [is] who controls the e-marketplace”—in Orbitz’s case, for airline tickets.

The make or break question for companies exploring these new ways of doing business is whether online collaboration—either on virtual catalogs that let customers find products easily or on transaction standards that make doing business more efficient—crosses the line into illegality. Here, online exchanges like Orbitz are clearing new legal ground. Early rulings by the government, like the pending Justice Department opinion about Orbitz and one issued in September by the Federal Trade Commission giving cautious approval to Covisint, an automakers’ exchange (see “Legal Questions,” Page 128), offer flight plans to other online marketplaces on how to stay out of court.

At the most, the federal agencies are applying the principle of free and open competition as stringently to the online realm as they always have to old-line businesses. “[Orbitz] ought to be out there competing with Travelocity and Expedia,” the two largest online travel sites, says Albert Foer, president of the American Antitrust Institute (AAI) in Washington, D.C. “If it plays fair and doesn’t have any particular advantages because it is [owned by] the airlines, and it runs an innovative consumer-friendly system, that’s good.”

Foer and other antitrust experts say Orbitz faces several key legal tests similar to those any exchange will confront, including:

The company must show that the airlines won’t be able to use the site as an exclusive channel for selling their lowest-priced tickets, discriminating against competing travel agencies.

It has to ensure the airlines won’t be able to use an integrated transaction database that they jointly own as a tool to fix prices—either by collectively raising them or cutting them so deeply that they drive competing airlines out of business.

Orbitz must guarantee that if it does dominate ticket sales, it won’t restrict membership.

An Online Opportunity

Orbitz enters a burgeoning online travel market. Though many consumers prefer the personal touch provided by brick-and-mortar travel agents, online travel sales are expected to more than double from the current level of $11 billion to $28.8 billion by 2005, according to New York City-based Jupiter Research. While the airlines do 58 percent of their online business through their own websites, according to the Washington, D.C.-based Travel Industry Association of America, most of their remaining Internet sales are handled by Travelocity and Expedia.

Booking through these or any other online agents costs airlines more because they have to pay commissions and fees to an intermediary—a computer reservation system (CRS)—that relays the booking data to the airlines’ internal reservation systems. Four CRSs process 80 percent of all airline ticket sales, at a cost to carriers of up to $16 per round-trip ticket. (Some carriers, such as Southwest, choose not to list fares in these systems.)

By launching their own online travel agency, Orbitz backers, which include founders American Airlines, Continental Airlines, Delta Air Lines, Northwest Airlines and United Air Lines, and 23 associate members, hope to loosen, and perhaps eventually cut, their ties to the CRSs. To attract customers, Orbitz has made deals with its members that guarantee they will post their lowest published fares on the site, including the Internet-only specials they now mainly offer on their own websites. Central to Orbitz’s business model is a new search engine that the company’s Chief Technology Officer, Alex Zoghlin, says will do a better job of searching for low fares than the CRSs.

Orbitz’s initial strike against CRSs is a promise that member airlines will get discounts on booking fees when they sell tickets on the site (although Orbitz will include fares from any carrier in its database). Under a deal with Atlanta-based Worldspan, a CRS that is 74 percent owned by two Orbitz founders, Delta and Northwest, Orbitz will rebate its members a third of their booking fees from its sales. But Zoghlin says that eventually Orbitz wants to link its systems directly to the airlines and get rid of booking fees altogether. “We have an overt goal that we are going to drive travel distribution costs to their lowest point,” he says. Airlines would likely still be paying Orbitz the same commission they pay other online travel agencies, which get less than brick-and-mortar agents.

New Economy, Same Rules

With such contractual incentives to make sales through Orbitz, member airlines could be tempted to drive fares there by not distributing them elsewhere. One clause in Orbitz members’ contract says they’re not obliged to give the site exclusive deals, but another says they can fulfill their commitments to promoting the venture by doing just that. That’s a red flag for AAI’s Foer, who thinks providing fare specials through the site could inhibit competition from other online travel sites.

Terrell Jones, president and CEO of in Fort Worth, Texas, says suppliers regularly offer fare specials through his site, just as “sometimes you’ll see a sale at one grocery store and sometimes in another.” It’s fair for the airlines to spread deals among travel agents, he adds, but “if you’ve got one guy who always gets the best deals and it’s the guy who happens to be owned by the producers, I don’t think that fosters competition.” More generally, an exchange could end up being a source for the best prices simply because it lowers suppliers’ distribution costs. It would run afoul of the law, however, if participants were using the exchange to somehow control prices, says Bill Baer, head of the antitrust practice with the Washington, D.C., law firm Arnold & Porter.

Kenneth Mead, inspector general with the U.S. Department of Transportation, has been studying the impact of the Internet on the travel industry. He wouldn’t be interviewed for this story, but in answers to written questions from McCain after July’s hearing, he said that Orbitz’s low fare guarantees aren’t anticompetitive “at face value.” Nevertheless, he said, the government or the airlines themselves might want to negotiate an agreement that ensures the airlines will offer the same low fares through any travel agency that provides the same financial incentives as Orbitz.

Meanwhile, the Dallas-based South-west Airlines, which has no plans to join Orbitz, is questioning whether the five exchange owners—who collectively capture 80 percent of domestic ticket sales—could undercut smaller competitors by using transaction data collected by the site to share information about routes and pricing. Zoghlin counters that Orbitz’s contracts with its members prohibit the company from sharing booking data. “We’re barred from it,” he says, and the airlines won’t have any access to Orbitz’s database. “We have only a push mechanism.”

Finally, critics are speculating that if Orbitz becomes successful it would monopolize the marketplace, forcing carriers to join just to reach their customers. That’s still a big if, considering that the site won’t go live to registered beta users until February 2001 and won’t offer a complete package of services, including hotel and rental car bookings, until April. But in such a case, Orbitz could potentially start charging participants high fees, from which site owners would profit. Such a practice would effectively exclude low-priced rivals by raising their costs and could eventually lead to price increases for consumers, says William Kovacic, a law professor at George Washington University in Washington, D.C.

One way Orbitz could address this concern would be to dilute its ownership, says Mead, so that company decision makers would have to think more broadly about what’s in shareholders’ best interests. And in fact, Orbitz has hired Morgan Stanley Dean Witter & Co. to secure additional private investors. Katz says he expects this round of funding to be complete by the end of the first quarter of 2001, with an initial public offering to follow about 18 months later. If these plans go through, then the airlines collectively would control less than half of company stock by the end of 2002; the rest would be owned by public shareholders and other private investors, including other travel suppliers.

Zoghlin, meanwhile, dismisses the monopoly issue outright. Orbitz’s competitors, he says, aren’t likely to disappear. Microsoft owns 70 percent of Expedia, and Sabre, a large CRS company, controls Travelocity. “Microsoft isn’t going to fold up its tent and go home,” Zoghlin offers. “It’s not just mere coincidence that Sabre is cutting employees and buying GetThere [a small online travel site, which] owns the only other independent fare engine on the planet.”

For now, at least, Zoghlin has a point. Suzi Levine, marketing director with Bellevue, Wash.-based Expedia, says her company’s new search engine, which was expected to be rolled out this month, provides the same consumer benefits that Orbitz claims for its technology. “We feel very confident in our leading position,” Levine says. “We have individual relationships with many airlines,” that, presumably, won’t stop selling through the site as long as customers keep coming.

Jennifer Rose, a Justice Department press assistant, won’t provide any details about the status of the Orbitz inquiry, except to say it is ongoing. And Orbitz spokeswoman Stacey Spencer says the company has been told the review is “low on the totem pole” and probably won’t be completed before the site’s official launch in June. Meanwhile, companies that are making plans to start, or join, an online exchange will want to watch carefully as the case unfolds. “The explosion of these exchanges has created a great deal of concern” about the future of competition, concludes Foer. “The airlines are pretty far along, and it’s natural everyone is going to focus on them.”