Article Financier Worldwide

The Economic Downturn And The Failing Firm Defence

With the global recession continuing, the pressure on competition authorities to adapt their policies to reflect changing market conditions is increasing. The failing firm defence becomes all the more relevant in this context. In assessing whether a transaction gives rise to a substantial lessening of competition ('SLC'), authorities will employ a hypothetical comparison of the future likely state of competition if the transaction proceeds (i.e., the factual) against the likely state of competition if it does not (i.e., the counterfactual). In a failing firm case, the argument of the parties will be that the factual and the counterfactual will be the same, and there will be no SLC. Failing firm defences are based on the premise that a business will exit the market in the absence of the merger and, as a result, any SLC identified should not be attributable to the merger. The current Chairman of the UK Competition Commission, Peter Freeman, recently observed that "competition is not a luxury policy relevant only to times of expansion and growth". Firms seeking to push through transactions on the basis of current market conditions and any rescue argument, in the UK, or for that matter in most other jurisdictions, need to remember that fundamentally, a failing firm defence remains a difficult one to make.

In December 2008, the Office of Fair Trading (OFT) restated its guidelines on failing firms, seemingly in anticipation of a flurry of reliance on the defence during the economic downturn. In summary, the OFT must be provided with "sufficient compelling evidence" that: (i) the firm is in such a "parlous financial situation" that the firm and its assets would inevitably exit the market in the near future; (ii) there is no serious prospect of reorganising the business (taking into account that businesses in receivership often survive and recover); and (iii) there are no other realistic purchasers whose acquisition of the firm would produce a less-anticompetitive outcome. While the OFT explains that it will take into account prevailing economic and market conditions when assessing the evidence, for example, with respect to cash flow difficulties and the realistic availability of alternative purchasers as a result of difficulties in raising investment finance, this does not mean that the OFT has given a green light to easy reliance on the failing firm defence

The OFT has indeed emphasised that it will not relax its requirement for the production of "sufficient compelling evidence" that all the relevant criteria of the failing firm defence are met, regardless of market conditions. The OFT's Chairman, Philip Collins, has stated that competition authorities should resist any calls for a more relaxed view of competition enforcement and the adoption of a more liberal interpretation of the relevant exemption criteria. In a rare event – in fact, only the fifth time in its history that the OFT has cleared a transaction on this basis and the first time since the OFT issued its restatement in December 2009 – the OFT cleared in March 2009 the proposed acquisition of 15 former Zavvi stores by HMV plc, having investigated the merger on its own initiative. The OFT decided that a reference to the Competition Commission was not necessary (an obligation incumbent on the OFT where any potential SLC is identified) since the criteria for the failing firm defence were met. The OFT had received compelling evidence that, without the merger, the stores would inevitably have exited the entertainment retail market, and that there was no less anti-competitive alternative transaction, since there was no other realistic entertainment retail purchaser for the stores.

In January 2009, the Competition Commission approved the completed acquisition of the Millway Stilton and specialty cheese business of Dairy Crest Group (Millway) by the Stilton producer Long Clawson Dairy (Long Clawson) on the basis of a failing firm defence. Upon investigation with third parties, the Competition Commission concluded that Millway was indeed failing – as claimed by Long Clawson – it had been operating at a loss for many years and was dependent on the support of its parent company. It had also lost significant customers due to problems with the quality and consistency of its product. The Competition Commission considered that Dairy Crest had invested significantly in an attempt to resolve Millway's production problems but had been unable to make the business profitable, and that Millway was not viable. Compared with the sale of the business to Long Clawson, the Competition Commission would not find a less anti-competitive alternative for Millway or its assets. Furthermore, if Long Clawson had not purchased Millway, Dairy Crest would have closed the business following production of stilton for Christmas 2008 and its assets would have exited the market. Although the Competition Commission found, against this counterfactual, that there would be some loss of competition in the acquisition of Millway's customers, such customers could switch away from Long Clawson if they so wished. The loss of competition was not substantial compared with the situation absent the merger.

The Competition Commission is currently reviewing the completed acquisition by Stagecoach Group plc of Preston Bus Ltd, upon reference by the OFT in May 2009. On 7 July 2009, the Competition Commission published an issues statement setting out the main issues with the acquisition. The Competition Commission explained that it will consider whether, in the absence of the merger, Preston Bus would have remained an independent and viable business, whether it would have been acquired by a different purchaser, and whether it would have exited the market and, if so, what would have happened to its assets. Preston Bus was in financial difficulties prior to its sale; however, while it was possible that it may have entered administration save for the acquisition, the relevant criteria for a valid failing firm defence were found by the OFT to be lacking. The OFT considered that, while it was possible that the Preston Bus may have failed and gone into administration had it not been sold, there could have been a more competitive alternative to the merger.

Given interest expressed by other bidders, it could not be ruled out that Preston Bus' assets could have been used by a new entrant to the market to compete with Stagecoach. The Competition Commission is due to report on its provisional findings in August.

In Europe, the failing firm defence was developed in the mid-90s in two cases: Kali+Salz / MdK / Treuhand and BASF / Pantochim / Eurodiol. The relevant criteria, as contained in the European Commission's Guidelines on the assessment of horizontal mergers, are similar to the OFT criteria, namely that (i) the acquired undertaking would in the near future be forced out of the market because of financial difficulties of not acquired; (ii) there is no less anti-competitive alternative purchase than the notified merger; and (iii) in the absence of the merger, the assets of the failing firm would inevitably exit the market. The OECD recently published a substantial report, 'Competition and Financial Markets 2009', regarding competition issues raised by the current financial crisis (the 'OECD Report'). The OECD Report notes that the crisis will result in an increase in merger activity and the number of failing firm defences advanced. In its contribution to the OECD Report, the European Commission notes that as yet, there has been no case brought before it where the failing firm defence has been raised as a result of the financial crisis, largely because governments have so far intervened under State aid rules to rescue banks and subsidise industries. The European Commission comments that the EC Merger Regulation allows for account to be had of rapidly evolving market conditions and the failing firm defence. In addition, the European Commission goes on to explain that even where the three failing firm criteria are not met, an analysis of what would be the development of the market absent the merger could still lead to the conclusion that a lessening of competition in the market is not a causal effect of the merger. The European Commission therefore considers that "there has been no case for setting aside existing policy".

The OECD considers that competition authorities need to create greater predictability through reliance on a similar set of standards for failing firm defences, and warns that divestiture remedies may become more difficult because there are fewer potential purchasers of assets to be divested. This may mean that behavioural remedies play a greater role than has traditionally been the preference of competition authorities. In the OECD Report, the European Commission indicates that, while existing merger policy remains unaltered, it may accommodate rapidly evolving market conditions by granting a derogation from the stand-still obligation pending the merger review. This will allow for full or partial completion of a transaction prior to obtaining clearance and appropriately reflects the need for urgency in rescue deals.

In the UK, the most important merger clearance to date during credit-crunch times has clearly been that of Lloyds TSB / HBOS. In this case, despite competition concerns raised by the OFT, the UK Secretary of State intervened to force the merger through. Under UK merger law, the UK Government is empowered to intervene in matters of national security and the media. The Government extended these categories to include "maintaining the stability of the UK financial system", in legislation which took effect on 24 October 2008. Effectively, this enables the Government to brush aside competition concerns where it deems it necessary.

Given the recent financial support stimulus package offered by the UK Government and the repeated emphasis by both UK's competition authorities and the European Commission on maintaining and strengthening existing competition policy, it is unlikely that failing firm defences will become the norm even in this economic downturn. Philip Lowe, the current Director General for DG Competition at the European Commission, explained in May this year that, in his view "the best way out of the current crisis is a robust and rigorous competition policy". The competition authorities will, however, need to take a more flexible approach when applying their procedural requirements; although clearly, without loosening evidential burdens. In particular, in rescue situations, time is of the essence, therefore competition authorities must be able to respond quicker than as required under 'normal' merger scenarios. Furthermore, competition authorities will need to adapt their approach to remedy proposals; especially, as concerns divestiture requirements and their respective timelines, in order to have due regard to the realities of the current economic crisis.

This article was published on financierworldwide.com in August 2009. All rights reserved.