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New government merger rules may stimulate growth and acquisition.

More corporate takeovers occurred in the first six months of 1992 than in any similar period since 1988. Early indications from the second half of 1992 suggest that new government merger rules may increase this trend by facilitating substantial, new acquisition opportunities. On April 2, 1992, the Department of Justice and the Federal Trade Commission jointly issued new guidelines for evaluating the legality of mergers and acquisitions under U.S. antitrust laws. The most significant aspect of these guidelines is a requirement that, before challenging a merger or acquisition, the government must demonstrate that the transaction will have an adverse "competitive effect." This new "competitive effects" requirement promises to provide substantial growth opportunities in industries whose acquisitions previously were inhibited by market concentration levels.

The Department of Justice (DOJ) issued its first merger guidelines in 1968. Those guidelines utilized a rigid structural format that focused on market shares and industry concentration. Under this approach, the legality of a specific merger was determined almost exclusively by the degree to which it would increase the surviving firm's market share and the level of concentration in the industry. When a merger created a firm with a large market share or significantly increased market concentration, the merger generally brought a government challenge. As a result, defining the relevant markets in which the merging firms competed constituted the primary focus of the firms' defense.

In the early 1980s, the focus of merger analysis changed in the form of the Federal Trade Commission's (FTC) 1982 Statement Concerning Horizontal Mergers and the DOJ's 1984 Merger Guidelines. Although market shares and concentration retained significance, the potential for new market entry or expansion became the focal point of merger analysis. Under this new framework, presumptions resulting from large market shares and high concentration levels could be overcome when entry or expansion was possible. Consequently, successful merger defense often turned on the ability to identify firms that would likely enter the market and potentially decrease concentration by initiating production or expanding geographic coverage.

Revisions to Prior Guidelines

The 1992 Horizontal Merger Guidelines issued jointly by the FTC and DOJ are divided into five sections that address important aspects of merger analysis. Four of the sections address, with certain changes, issues contained in the 1982 and 1984 guidelines.

Much of the previous guidelines' treatment of market definition and concentration, including frameworks for defining product and geographic markets as well as the identification of various "safe-harbor" concentration levels, has been retained in the 1992 guidelines. New, however, is an apparent intent to find narrower product and geographic markets. This intent is demonstrated most vividly in the discussion of "price discrimination" which provides that a relevant market could be limited to a particular location or buyer where the seller can profitably impose a discriminatory price increase on that buyer or on buyers in that location.

The entry defense also has been retained; however, the utility of this defense has been significantly diminished because merging firms now must show that any entry will be "timely, likely and sufficient" to defeat anticompetitive behavior. Parties must continue to demonstrate that entry would occur within two years. In addition, a sophisticated economic analysis will be required to prove that entry would be profitable at premerger prices. The costs required to reach the minimum viable scale in the industry must be compared to the likely sales opportunities, at premerger prices, to determine whether entry would be profitable.

The 1992 guidelines confirm that the government win consider efficiencies in evaluating the effect of the merger. But, such efficiencies must be specifically identified and must be unattainable without the merger.

Like earlier guidelines, the 1992 guidelines recognize a "failing firm" defense, but the availability of this defense has been curtailed. A firm must now demonstrate that it is unable to meet its financial obligations; that Chapter 11 reorganization is not a viable alternative; that it has made an unsuccessful good-faith effort to seek an alternative buyer; and that, without the merger, the firm's assets would exit the market.

New "Competitive Effects" Test

The most dramatic change in the 1992 guidelines is the new "competitive effects" requirement set forth in the second section. This section articulates three theories that the government can utilize to determine whether a merger or acquisition in a concentrated market should be opposed. Each of these three theories requires the government to demonstrate that the transaction will result a particular anticompetitive effect. The first theory seeks to determine whether the merger will facilitate collusion among the remaining firms in the market. The other two theories seek to determine whether the merged firm will be capable of raising prices unilaterally. Regardless of which theory is utilized, it will no longer be sufficient for the government merely to show that a merger will increase concentration and raise entry barriers.

The first "competitive effects" theory examines whether the merger would facilitate collusion or "coordinated interaction" among the remaining firms in the market. Here, the government will analyze the industry structure, as well as the incentives of the remaining firms, to determine whether the merger will lead to anticompetitive collusive conduct. Industry factors that will increase the likelihood of collusion include non-differentiated, commodity-like products, publicly available price lists and prior evidence of price-fixing in the industry. Industry factors that indicate that collusion will be less likely are the existence of differentiation among products, negotiated pricing and extensive non-price competition. If the merger is likely to facilitate explicit or implicit collusion, the government will then determine whether the participants could detect and punish violations of any collusive agreement. When coordination, detection and punishment are anticipated, the government likely will oppose the merger.

A second "competitive effects" theory that the government can use applies where the relevant products are differentiated and the surviving firm will have at least a 35 percent market share. In that case, the government will analyze whether the merged firm could raise prices unilaterally. Under this analysis, the government will determine how close the products of the merging firms are as substitutes and whether other remaining firms can reposition their products. In determining whether the merging firms' products are close substitutes, the government will examine the parties' marketing plans and other internal documents, consumer surveys and other market research and econometric studies. In examining the likelihood that another firm could reposition its product line, the new guidelines require that the repositioning be likely to occur within two years and be sufficient to defeat any anticompetitive conduct by the merged firm. If the products are not close substitutes or if other producers can easily reposition their products to compete with the merged firm's products, then the merger should pass scrutiny under the second test.

The third theory that the government can use to analyze a merger's "competitive effects" applies where the relevant products are homogenous and the surviving firm will have at least a 35 percent market share. In this case, the government will again seek to determine whether the merged firm could raise prices unilaterally. The government will calculate whether the profits realized over the merged firm's expanded sales base would be sufficient to offset sales lost by any price increase. Even if a price increase were profitable, the government would not challenge the merger under this third "competitive effects" test if other competitors have excess capacity or could rapidly increase capacity to foil any price increase.

It is primarily this new obligation to show anticompetitive effects that will enable firms in concentrated industries to grow through mergers or acquisitions, where high market shares previously inhibited such expansion under the prior guidelines. Although almost every industry will benefit from the changes contained in the 1992 guidelines, certain industries may find specific changes particularly helpful.

Consumer Products Industries

Manufacturers of heterogeneous consumer products - such as small appliances, consumer electronics and over-the-counter medications - will realize new growth opportunities under the 1992 guidelines. The previous guidelines inhibited firms in highly concentrated consumer product industries from acquiring competitors because of high market shares and concentration levels. Under the new guidelines, mergers should no longer be prevented solely because of market share or concentration concerns.

Specifically, enhanced opportunities exist for mergers in consumer products industries for firms whose products are not each other's closest substitutes. The new guidelines instruct the government to consider the differences between the merging firms' products in determining whether a transaction between consumer products manufacturers will have anticompetitive effects. The government will compare such factors as price, positioning and consumer appeal to determine which existing products are the closest substitutes for the products of each merging firm. For example, expensive, top-of-the-line stereo systems targeted at upscale purchasers would not be deemed the closest substitute for inexpensive AM/FM radios sold in discount stores. When the firms' products are not each other's closest substitutes, the new guidelines assume that a unilaterally imposed price increase will not likely occur.

Even if the merged firms' products are close substitutes, however, the potential merger may not be doomed under the new guidelines. The merging firms may overcome the presumption that anticompetitive effects will result by demonstrating that other existing firms are likely to reposition their products to become close substitutes for the new firm's products. For example, in a merger of two top-of-the-line stereo manufacturers, if another stereo manufacturer could easily add features such as a CD player or an equalizer to its product to more closely resemble the top-of-the-line model, then the merged firm would likely be deemed incapable of unilaterally raising prices. When anticompetitive effects are unlikely under either analysis, the government would be unlikely to challenge the transaction.

Retail Stores

Like consumer products manufacturers, increased merger opportunities will be available among retail sales firms such as department stores and grocery stores. Under the previous guidelines, a retail store owner with a large market share often experienced difficulty in acquiring competing retail operations within the same geographic market. The potential acquirer was typically forced to rely, often unsuccessfully, on product market or entry arguments.

Under the "competitive effects" test, a firm may realize new opportunities for growth when its potential target is not its closest competitor. For example, a department store that sells upscale or high-price merchandise may increase its customer base by acquiring discount stores or suburban stores targeted at middle-income consumers. Similarly, a firm that focuses on warehouse sales may diversify its holdings by acquiring boutiques or stores that provide customers individualized service or other amenities.

Such acquisitions will be possible because the target firm's patrons are less likely to turn to the acquirer's existing stores as an alternative. As a result, combining such firms under the same ownership will not be deemed likely to yield a unilaterally imposed price increase. This, in turn, will enable retail sales firms to realize substantial growth by diversifying their holdings across various segments of the industry.

Defense Contractors

The 1992 guidelines should also provide new merger opportunities for defense firms and other government contractors. With the prospect of a scaled-down defense budget and a new emphasis on domestic spending, analysts predict that it will become increasingly difficult to sustain the current number of defense-related contractors. In response, these contractors may now resort to increased consolidation through acquisition to retain their competitiveness and profitability. Two facets of the 1992 guidelines may now make previously unavailable transactions more likely.

First, the new guidelines' emphasis on narrower product markets may now allow a defense contractor to acquire a firm that manufactures similar or complementary products or utilities technologies that do not directly compete with those of the acquirer, such as land-based versus carrier-based aircraft. Under broader product market definitions, such firms may well have been considered competitors in the same market and a merger prohibited because of high market shares. Utilizing the narrower product market analysis under the new guidelines, these same firms might not be considered competitors in the same market, and their merger would pass scrutiny.

Even if the merging parties are considered in the same market, the ability of the Department of Defense or another contracting agency to enter into long-term contracts will facilitate growth opportunities. Under the new guidelines, the ability of a customer to enter into long-term supply contracts is one factor that will inhibit collusion after the merger. This ability is deemed to inhibit collusion by giving each firm in the market a compelling incentive to compete for the large, long-term contracts to avoid losing the contracts to a competitor. As a result, defense/government contractors interested in acquisition will possess a new argument that the acquisition of rivals should be permitted.

Health Care

Hospitals considering expansion or the creation of health care networks will also find opportunity in the new guidelines. As discussed above, the new guidelines provide evidence of an intent to define narrower geographic markets that may be limited to a single city or even part of a city. Under this approach, a hospital or hospital chain may now argue that a potential competitor located nearby should be excluded from the relevant geographic market. Hospitals in neighboring cities or in distant areas of the same city would not be deemed competitors with the acquiring hospital; therefore, a merger would not result in increased concentration in any relevant market.

The existence of strong managed care programs, such as HMOs and PPOs, may also provide opportunities for mergers even between direct competitors in highly concentrated markets. Managed care programs with large numbers of subscribers generally can prevent collusive price increases by offering long term exclusive contracts to any of the remaining competing hospitals. This will impede the creation or enforcement of any collusive agreement. As a result, the opportunity for mergers in markets with strong managed care programs will increase.

The new guidelines also indicate an increased acceptance of efficiency arguments in which such efficiencies are unlikely to be achieved without the merger. Hospital mergers are often driven by a firm's need to reduce costs associated with over-capacity or unnecessary duplication of services. The new guidelines confirm that when such efficiencies are demonstrable they may justify an otherwise objectionable transaction. This will be especially true for efficiencies that result from the consolidation of core clinical services, a result that likely would be impossible without the merger.

Mining and Natural Resources

For firms in mining and natural resources fields, the new guidelines may be beneficial in several respects. First, as in the case of hospital mergers, the new guidelines' intent to define narrower geographic markets may assist firms in acquiring similar firms that do not compete in the same geographic regions. Competition among firms engaged in mining or other natural resource industries is often limited by practical factors such as shipping costs and geographic impediments to transportation including mountain ranges and rivers. When firms can demonstrate that these factors inhibit or prevent direct competition, under the new guidelines the firms would not be considered competitors within the same geographic market, and there would be no increase in concentration. Consequently, firms will experience new opportunities to acquire other firms in these industries that are geographically remote to the acquirer.

Second, even competing firms with high market shares may be able to merge when the remaining competitors possess substantial excess capacity. Mining and natural resource industries typically involve the production of homogenous products such as coal, iron ore or timber, with other firms producing suitable substitutes for the merging firms' products. When these other firms possess substantial excess capacity or reserves that can be readily tapped, the merging firms may show that the remaining firms could easily expand their sales and thus defeat any unjustified price increase.

Durable Goods

The 1992 guidelines may also provide new merger opportunities for manufacturers of durable goods such as farm equipment, large appliances, heavy machinery and business jets. The new guidelines reaffirm that resellers of used goods should, under certain circumstances, be considered competitors of new equipment manufacturers. More importantly, the new guidelines may increase the strength of arguments that potential entrants will restrain a merger's possible anticompetitive effects.

Under the previous guidelines, a firm would be considered an entrant capable of defeating an anticompetitive price increase if it could enter the market within two years. Entry into the production of durable goods, such as farm equipment, typically would be difficult to accomplish because of the complexity and cost of developing and manufacturing such products. Consequently, two years would generally represent an insufficient time to enable entry.

The new guidelines, however, explicitly acknowledge that consumers can, and often do, prolong a product's life either through routine maintenance or major repairs. This ability to prolong the product's life will allow a consumer to delay a current purchase in anticipation of a new product expected on the market. This would also apply to a new entrant's anticipated product offering. Recognizing this, the 1992 guidelines extend the period for entry into durable goods manufacturing beyond two years. As a result, producers of durable goods now may argue that the potential for entry will diminish the likelihood of anticompetitive effects resulting from a merger among competitors.

Looking Ahead

Throughout most of the 1980s and early '90s, the government regulated mergers based primarily on market shares and the ability of other firms to enter the market. The 1992 merger guidelines, however, impose new requirements on government prosecutors who attempt to block mergers. Under their new guidelines, the government must now demonstrate how a merger - even one in a highly concentrated industry - will result in one of three potential anticompetitive effects.

This new requirement will prevent government reliance on market shares and entry barriers alone. As a result, it promises to provide opportunities for substantial growth and expansion across a wide variety of industries. Because most experts agree that the new guidelines are intellectually and analytically sound, these opportunities are likely to be continued by the new Clinton administration. What could change, however, is the weight given to the new competitive effects test or a redefining of the burden of demonstrating the likelihood of any anticompetitive effects. Corporate directors and executives should act now to take advantage of the new guidelines and their current application.

RAYMOND A. JACOBSEN, a graduate of Georgetown law School, is a partner in the law firm of Howrey & Simon, the largest antitrust firm in the United States. Focusing on antitrust and commercial litigation, the firm specializes in mergers and acquisitions. Its clients comprise many national corporations, including PepsiCo, Martin Marietta Corporation, Mobile Oil Corporation and Cyprus Minerals Company, as well as regional institutions, including number of major hospital groups.

SCOTT S. MEGREGIAN, a graduate of Harvard Law School, is an associate with Howrey & Simon and has written numerous articles in the area of mergers and acquisitions.
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Title Annotation:1992 Horizontal Merger Guidelines
Author:Jacobsen, Raymond A.; Megregian, Scott S.
Publication:Business Forum
Date:Jan 1, 1993
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