Companies seeking rescue M&A will need speed and pragmatism from U.S. antitrust agencies under the failing firm defense
The Covid-19 pandemic continues to cause unprecedented harm to the global economy, leading many companies to face collapse across a wide range of sectors, and increasing opportunities for distressed M&A by stronger rivals. Current U.S. merger policy provides a “failing company” defense (and variations thereof) for acquisitions that would otherwise raise competition concerns. The policy acknowledges that weakened firms pose less of a competitive threat and that it is preferable to preserve productive assets in the market than might result from inefficient liquidations. But the defense is highly technical, takes a long time to prove up, and is met with skepticism by the agencies, who recently have reaffirmed their view that emergency exceptions to the antitrust laws are not needed. In light of the accelerating economic impact of the pandemic, the U.S. agencies will need to use the existing principles quickly and flexibly to insure that productive assets will remain in the market to efficiently serve those sectors that will rebound.
The Failing Firm Defense, and its Variants
A brief review of how U.S. antitrust agencies look at the failing firm defense (and its variations, the failing division and weakened firm defenses) highlights just how difficult it is to successfully assert.
The Failing Firm Defense
The 2010 Horizontal Merger Guidelines of the United States Department of Justice and the Federal Trade Commission (“2010 Merger Guidelines”) outline the U.S. antitrust agencies’ analytical approach to merger reviews and explicitly recognize the failing firm defense. Under those Guidelines, a transaction “is not likely to enhance market power if imminent failure... of one of the merging firms would cause the assets of that firm to exit the relevant market.” To succeed in asserting the failing firm defense, the parties must show that the failing firm will exit the relevant market absent the acquisition and establish that:
- “the allegedly failing firm would be unable to meet its financial obligations in the near future”;
- “it would not be able to reorganize successfully under Chapter 11 of the Bankruptcy Act”; and
- “it has made unsuccessful good-faith efforts to elicit reasonable alternative offers that would keep its tangible and intangible assets in the relevant market and pose a less severe danger to competition than does the proposed merger.”
Parties can fail to satisfy the above requirements, for example, by not yet being insolvent, even if they are on a trajectory to exit the market. Indeed, the drastic impact of the pandemic may provide a very short period of time and a brief track record to demonstrate to regulators that insolvency is imminent and reorganization is not viable. Particularly challenging is establishing that the failing firm was unable to locate an alternative buyer that would be less detrimental to competition. It is generally understood that this would require conducting a robust auction satisfactory to the U.S. antitrust agencies. In the current environment, failing firms may not have the luxury of time or resources to establish all prongs of the test.
Failing Division Defense
The 2010 Merger Guidelines also recognize the “failing division” defense (also known as the failing business defense). For the U.S. antitrust agencies to recognize this defense, the parties must convince them that the failing division will exit the relevant market absent the transaction by showing that:
- “applying cost allocation rules that reflect true economic costs, the division has a persistently negative cash flow on an operating basis, and such negative cash flow is not economically justified for the firm by benefits such as added sales in complementary markets or enhanced customer goodwill”; and
- “the owner of the failing division has made unsuccessful good-faith efforts to elicit reasonable alternative offers that would keep its tangible and intangible assets in the relevant market and pose a less severe danger to competition than does the proposed acquisition.”
The failing division defense does not require an inability to reorganize under Chapter 11 but otherwise shares the basic principles (and key challenges) of the failing firm defense. Merger analysis often involves a battle of the economists. The failing division defense requires a battle of the accountants - e.g. regarding how costs should be allocated and how much a parent company should be expected to put into a division to prevent it from failing.
The Weakened, “Flailing” Firm Defense
It is clear from the above that the criteria for the failing firm and failing division defenses are met only in truly exceptional circumstances. When otherwise failing to meet the high standards of the failing firm or failing division defenses, the U.S. agencies have in the past viewed a firm’s weakened financial position as a mitigating factor in its analysis under the so-called “weakened firm” or “flailing firm” defense. The weakened firm defense is not explicitly recognized by the 2010 Merger Guidelines, and it is not technically a defense. Rather, it is a factor that is weighed as part of the standard competitive effects analysis, taking account of the fact that a company in financial distress may be a less effective competitor.
A fast-moving crisis will need fast-moving assessments
The speed with which Covid-19 has impacted the U.S. economy and individual businesses is unprecedented. Any application of the failing firm defense must take account of that dynamic and context. Existing standards do not need to be modified or watered down. However, the fast-moving crisis may mean that traditional evidence – a track record of financial performance or a highly structured auction process – may not be available. The agencies should be open to assessing the types of evidence that will be practically available to parties in the midst of quickly-changing economic conditions. The agencies have recognized the exigencies of the circumstances by promising to assess proposed collaborations between competitors quickly under the revised business review policies. They should equally adept in assessing proposed M&A transactions that will preserve assets for the future economy.
The need for the U.S. agencies to move quickly is not a new concept. In the wake of the 2008-2009 financial crisis, an OECD working group acknowledged that global failing firm defense standards were strict, but called on agencies to update lengthy review processes. It concluded that “competition authorities recognize that [failing firm defense] investigations may be too lengthy, which is problematic given the position of firms in distress may rapidly deteriorate, which in turn may cause inefficient liquidation. This may justify procedural changes to ensure a speedier review of mergers involving a failing firm.” The financial crisis created a shock liquidity. Likewise, the Covid-19 pandemic is generating massive and sudden shifts in demand that will require rapid responses by many stakeholders, among them the antitrust agencies.