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DOJ and FTC Issue Commentary on Merger Guidelines

On March 27, 2006, the Federal Trade Commission (FTC) and the U.S. Department of Justice (DOJ) issued their joint “Commentary on the Horizontal Merger Guidelines.” The Horizontal Merger Guidelines were issued in 1992, with one minor revision in 1997. The agencies issued the Commentary in order to provide greater transparency concerning the manner in which they have implemented the Guidelines in particular investigations. There are no surprises in the Commentary, but it does provide a rich level of detail on issues that are only lightly addressed in the Guidelines. In addition, the Commentary explains how the Guidelines have been applied in the context of specific transactions.

The overall thrust of the Commentary is fully consistent with our experiences with the agencies over the last decade. The agencies have one overriding concern: will the merger allow the parties to exercise market power (i.e. raise prices). All of the factors addressed below are intended to help the agencies answer that central question. Assumptions and presumptions based on objective market factors such as market shares and concentration ratios play little role in the final outcome. In this advisory, we will highlight some of the more interesting points found in the Commentary.

Market Definition

The definition of the relevant product market and the relevant geographic market has always been the starting point of merger analysis. The Commentary acknowledges this point, but stresses that market analysis is closely linked to the agencies’ analysis of the competitive effects of the transaction.

The Commentary confirms that:

• Relevant product and geographic markets are determined solely from the perspective of the customer. The agencies attempt to ascertain how customers would respond to a hypothetical price increase on the product or service sold by the merging parties (i.e. would customers switch to substitute products or purchase from more distant suppliers in order to avoid paying the higher price).
• A transaction involving a single product or service may give rise to several relevant markets depending on how customers purchase that product or service. For example:

If certain customers would switch to substitute products, but other customers would not (and the parties can identify the customers who would not switch), the agencies will define a narrow market based on the customers who would not switch;

If some customers need only local or regional suppliers, but other customers require national suppliers, the agencies may define a market consisting of suppliers capable of servicing the customers who require national coverage.

• Although econometric data (like supermarket scanner data) may be helpful in defining markets (particularly for consumer goods) in most cases the key evidence comes from customers and from the parties’ own documents.

Competitive Effects

A. Unilateral Effects

The Guidelines identify two ways that a merger can create market power, unilaterally and in coordination with remaining competitors. Although the majority of cases brought by the agencies in recent years have involved the unilateral exercise of market power, the Guidelines contain only a few scant phrases on this subject. The Commentary contains much greater detail about how the agencies evaluate the potential for anticompetitive unilateral behavior.

The following situations are discussed in the Commentary:

• Merging parties will be able to exercise market power if they are the only two competitors in the market (i.e. a merger to monopoly);
• A merger can create a dominant firm that is able to raise prices even though fringe competitors remain in the market where the fringe firms lack the capacity to take significant sales away from the merged firm should it raise prices;
• A merger between firms who manufacture “next best substitute” products may allow the firms to exercise market power after the merger even though there are other competitors producing similar products who will remain in the market. This situation frequently involves consumer products where there is evidence that customers who like Brand A also like Brand B, but find Brands C, D and E less satisfactory. If a merger results in a single firm owning both Brand A and Brand B, it can raise prices on Brand A, knowing that, to the extent the price increase causes customers to stop buying Brand A, many will switch to Brand B;
• Anticompetitive effects may also arise in auction settings where, for example, there is evidence that Company A predicates its bids on the expected bids of Company B and vice versa even though there are other competitors in the market. This scenario typically occurs where the other firms are smaller, “fringe” firms.

B. Coordinated Effects

Historically, most mergers were challenged on the theory that it is easier for competitors to engage in tacit coordination when there are fewer firms in the market. This structural approach to merger analysis is an important element of the Guidelines, but, in practice, the agencies do not challenge mergers purely on the basis of market structure unless the transaction involves a merger of the only two competitors or, frequently, two of the three competitors in the market.

• However, a merger that results in the merging parties having a high market share is more likely to receive close scrutiny by the agencies even if it is ultimately permitted. The Commentary recognizes this important shift in emphasis from the time the Guidelines were originally adopted in 1992, noting that “market shares and concentration alone are not good predictors of enforcement challenges, except at high levels” (much higher than the levels described in the Guidelines). The Commentary also states: “when the evidence does not show that the merger will change the likelihood of coordination among the market participants . . . , the agencies regularly close merger investigations, including those involving markets that would have fewer than four firms.” The Commentary also makes clear that evidence that the firms in the market have previously colluded or have attempted to signal their intentions to one another (e.g. pre-announcement of price increases) will substantially increase the likelihood that the agencies will challenge a merger even though three or more competitors would remain in the market.

Entry

A merger cannot harm competition if new entry is easy, but the Commentary makes clear that merger parties must jump a number of hurdles to make a convincing entry argument. Along with traditional barriers such as the cost of building a manufacturing facility and access to intellectual property, the Commentary identifies a number of barriers that can sink an entry argument depending on the products in question:

• The need to develop brand awareness;
• The need to develop a distribution network;
• The need for a proven track record;
• The need to pass customer testing and quality control requirements.

Also, the merger parties must show that an entrant would be profitable at pre-merger prices (not at the higher prices to which the market might move after the merger). The Commentary also notes that evidence that customers have shown a willingness to deal with new entrants and that successful new entry has occurred will increase the chances for a successful entry argument.

Efficiencies

The Commentary confirms the limited significance of efficiencies in merger analysis: “Efficiencies are a significant factor in the agencies’ decisions not to challenge some mergers that otherwise are likely to have, at most, only slight anticompetitive effects.” In other words, if a transaction is likely to harm competition, an efficiencies argument will not save the day. The Commentary also confirms the difficulty that parties will face in establishing to the agencies’ satisfaction that a merger will generate meaningful efficiencies:

• Fixed cost savings (such as the elimination of overhead, management or administrative costs) are unlikely to matter to the agencies because these cost reductions typically result in improved profits rather than reduced prices;
• By contrast, efficiencies that reduce marginal production costs do matter;
• The agencies require substantial evidence that promised efficiencies will occur. Expect any efficiencies claim to be closely analyzed by a skeptical agency that will question the key assumptions relating to cost savings;
• The best proof that efficiencies will occur is evidence that similar efficiencies were achieved recently by similar actions.

Conclusion

The Commentary makes clear that the analysis of the competitive effects of a merger between competitors is highly fact specific (with a large dose of economics). The fact that the agencies no longer rely heavily on objective criteria like market shares and concentration levels makes it more difficult for businesses and their counsel to predict how the agencies will treat a particular transaction. However, that loss of clarity is more than offset by the opportunity to explain to the agencies why a particular transaction should be permitted to proceed notwithstanding high market shares. This puts a premium on the ability of the merger parties and their counsel to craft arguments, consistent with market realities, that explain why a transaction will not lead to the exercise of market power.

For More Information

Please contact Barry M. Block, Stephen J. Butler, Thomas J. Collin, Charles L. Freed, Robert F. Ware, or Thomas F. Zych or any member of our Antitrust, Competition & Distribution practice group for more information.

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