New draft merger Guidelines raise questions

After a long gestation the ACCC last week released its new draft merger Guidelines for public comment by 28 March 2008, following which the Guidelines will be finalised and formally issued.

The Guidelines do not have the force of law but clearly reflect current ACCC thinking and can largely be regarded as guiding the competition analysis of mergers and acquisitions in Australia for the next decade.

The Commission's draft represents a deliberate step to move the Guidelines closer to merger Guidelines that apply in the United States and under the authority of the European Commission.

There are a number of significant changes from the 1999 Guidelines which businesses and their advisers will need to carefully consider in merger planning and execution.

The new Guidelines traverse in some detail a process to define markets; discuss what types of mergers may cause issues - horizontal, vertical or "conglomerate" - and canvass all the merger factors in section 50 as well as the treatment of efficiencies and divestiture remedies.

We discuss some of these features below.

Widening the range of mergers that should be notified to the ACCC

First, the Commission wants to see a much wider range of transactions notified to it.

The old "safe harbours" outlining deals which fell below the ACCC radar have been scrapped without comment.

There are few short cuts with the new Guidelines- a more thorough assessment of the potential concerns will be required for every deal, before these Guidelines would give it a tick.

The Commission has scrapped the old "CR4" test (ie. would the merger lead to four firms or less with a combined market share above 75%?) and it is no longer safe to rely on market concentration thresholds alone as a basis not to notify.

The draft adopts the US approach of the Herfindahl-Hirschman Index ("HHI"), which is calculated by summing the squares of the market shares of each supplier in a market.

If the merged firm would operate in at least one market where the HHI is greater than 2000, the Commission encourages merger parties to notify it well in advance of completing a merger.

A market may have a HHI score exceeding 2000 in a number of ways - for example if the market shares of the top three or four firms, post-merger, met any of the following criteria: -

• Firm A - 45%, Firm B - 20%, Firm C - 10%
• Firm A - 30%, Firm B - 30%, Firm C - 20%
• Firm A - 30%, Firm B - 25%, Firm C - 25%
• Firm A - 22%, Firm B - 20%, Firm C - 20%, Firm D - 20%, Firm E - 18%

Under the draft, it will not matter what size or share is held by the target entity for the merger to be notifiable under this test. The test focuses on the post-merger market shares of the firms in the market and might be triggered, even if an acquisition was made of a very small competitor eg. with a share below 5%.

No presumptions to assist business

The Commission has opted to omit any presumptions as to whether a deal may breach section 50. There are some presumptions in some jurisdictions that competition concerns are unlikely where:

• the post-merger HHI is below 1000; or
• the post-merger HHI falls between 1000 and 1800-2000 and the change (or "delta") is below a range of 100 and 250; or
• the post-merger HHI is about 1800-2000 and the delta is below 50-150.

These presumptions are noted in the International Competition Network survey of merger Guidelines but plainly hold no attraction for this Commission. No explanation is offered for this omission.

Other criteria requiring a deal to be notified to the ACCC

Other new criteria for a merger to be "expected to be notified" are rather vague and may be difficult to apply.

They include:

• If a "substantial number" of customers (how many is not stated) consider the products of the two merger parties to be "particularly close substitutes" such that the merger parties represent their first and second choices.

Comment: A difficulty with this criterion is that the number of customers who hold this view might be quite small and yet vocal. What if 10% or less of customers held this view?

Secondly, how would the merger parties be aware of this perception?

Thirdly, it is a common mistake in merger assessment to reply on opinions of customers as to whether they say two firms are particularly close substitutes. The true economic test is whether in fact customers have acted or would act to substitute between those two firms, rather than merely saying so.

Another source of information that the ACCC has said it will rely on is documents of the acquirer and target. While it may be easier to infer close competition between some companies than others (eg. because they both subscribe to certain industry reports) it would be risky to conclude that a company having more data about another company meant that they regarded one another as close competitors.

• "That the target firm has achieved a recent rapid increase in market share, has driven innovation or has tended to charge lower prices"

These criteria are clearly relevant but rather vaguely described in the draft and thus may be very difficult to apply in practice.

Over what period of time and by how much of an increase is a "recent rapid increase in market share" to be tested? What is meant by "driven innovation"?

The fact that a target has "charged lower prices" than its competitors can be ambiguous.

It might suggest that the target is a keen competitor. Alternatively it might only mean that the target operates on a different cost model, has a lower price positioning point in the market, chooses to focus on the lower price end of the market or has a weaker brand position. Many of these criteria will be difficult to measure if the parties have to consider whether or not they should approach the ACCC.

Method of ACCC approach

Curiously, the draft Guidelines suggest that if merger parties believe their merger proposal will meet any of these thresholds they are encouraged to approach the ACCC on a "confidential and informal basis".

As those with experience know, it is very rare that approaching the ACC on a "confidential and informal" basis will result in any feedback of any value to be obtained. The Commission invariably will press for public market inquiries if the transaction poses a competition issue of any significance

Assessment of merger proposal under the draft Guidelines

The new Guidelines include the general principles that:

• The starting point for an analysis is whether a merged firm might be able to profitability increase prices by around 5% to 10% for a sustained period of time;
• Mergers generally will be assessed across three broad criteria:
  • horizontal mergers are those between competitors who directly compete in the same market;
  • vertical mergers being those involved in combining firms that operate at different stages of the single vertical supply chart - upstream and downstream. The typical issue is whether a firm which vertically integrates can foreclose rivals from some important input so as to reduce competition;
  • conglomerate mergers involve firms that interact across several separate markets where the firms do not directly compete but supply "complementary products" where the merger might create "an increased ability to engage in bundling or other types of foreclosure" over the controlled portfolio of related products desired by particular consumers.

In our experience, true conglomerate mergers raising competition issues of substance in Australia are very rare. Yet curiously this topic is given an extended treatment in the draft.

Market definition

Under the draft the process of market definition will focus on identifying the key substitutes between firms that are close competitors.

The draft notes that if only some customers view a product to be highly substitutable, where others do not, the Commission may choose to define a market around only those customers who see their products are substitutes and a separate market to those who do not. This is a novel approach in terms of the approaches which the Federal Court and the Australian Competition Tribunal have used in defining markets.

Unilateral and co-ordinated effects

As with the US and EC Guidelines, merger effects are divided for analysis into unilateral (or single firm) effects ie. the "dominant firm" concern.

Alternatively mergers may be challenged where they increase the risk of oligopoly or co-ordinated effects between a relatively small number of firms.

Given Australia's small economy the second issue is commonly encountered and given very close attention by the Commission.

A merger may assist co-ordination to occur by reducing the number of firms or weakening competition between the firms in the market.

Entry barriers

The Commission's view is that a market will involve entry barriers if entry is not likely to occur within one to two years in response to any exercise in market power by the merged firm. Furthermore entry must be of sufficient scale with a sufficient range of products to provide an effective competitive restraint.

Imports

In contrast to the previous policy which tended to allow domestic firm mergers where imports held at least 10% of the relative market, the Commission now attaches a number of further conditions around the presence of imports in order to answer concerns over a domestic merger. These include that imports are:

• independent of domestic parties
• face no barriers in rapidly increasing their share
• a "strong substitute in all respects" for the domestic products
• the import parity price is close to domestic prices.

This is consistent with the practice which the ACCC has been using to consider imports at least since the OneSteel/Smorgon merger.

Close similarity between the merger parties' products and operations is a concern

A new emphasis in the draft Guidelines is whether the merger parties are particularly close competitors or substitutes for each other such as if they are each others "closest competitor" - if so, then unless third parties are likely to move into a merged firm space the ACCC may well raise concerns.

Countervailing power of strong customers is discussed as a possible antidote to competition concerns raised by a merger of two suppliers - but the Commission will require evidence that buyers can exercise this power in a meaningful way by bypassing the merged firm. Furthermore, if only large buyers hold this ability and small buyers are unable to bypass a supplier then countervailing power is unlikely to prevent a substantial lessening in competition.

Acquiring so-called "maverick" firms

The Commission confirms that it will be particularly concerned about the removal of a maverick firm which drives competition in the market by reason of it being an innovator which is less predictable in its behaviour or which undermines attempts by other firms to co-ordinate the exercise of market power.

Efficiencies

The Commission notes the potential for improved efficiency is a common motivation for firms to merge but maintains its view that increased efficiencies will not be considered relevant to a competition assessment unless there is "clear and compelling evidence that the efficiencies directly affect the level of competition in the market". Otherwise the parties will need to approach the Tribunal for authorisation.

Remedies and divestiture undertakings

Finally, the Commission confirms recent public statements that it has hardened its attitude on merger remedies.

To be generally satisfactory the following criteria are spelt out:

• Assets must be sold to a viable, effective and long term competitor.
• There should be no continuing supply or other transitional arrangements between the merged firm and the purchaser of the divested business.
• The purchaser will have to be approved by the Commission in its discretion.
• The ACCC prefers divestiture to occur on or before completion date of the merger "particularly the case if there are risks in identifying a suitable purchaser or asset deterioration risks".
• There will be circumstances where if the remedy cannot be implemented on or before completion of the main transaction "no remedy will be acceptable to the ACCC".
• There will need to be an ACCC approved sales agent to be engaged to divest the business if the firms fails to comply with its core obligations; and
• There will be auditing provisions and information requirements.

Accepting so-called behavioural undertakings (concerning how firms will behave or conduct their business post-merger) as a remedy will still required exceptional circumstances.

The hardline attitude of this Commission on undertakings has become well known. Frequently the Commission's requirements for an acceptable framework for divestment are completely reworked by the Commission staff on each new deal, with even more dizzying and exotic requirements added from the previous undertaking.

Overseas comparison of remedies

Curiously the position in the US which has two regulators is quite different. The US Federal Trade Commission has a preference that the divestiture parties find a buyer up front whereas the US Department of Justice ("DOJ") in its 2004 Policy Guide to Merger Remedies has no such requirement and reportedly has never required a buyer in advance. Its guide is silent on the issue.

On the other hand, the US DOJ does recognise - but does not always require - what it calls a "fix it first" remedy which involves essentially a proposal by the acquiring parties to restructure their deal in some way to address all the competition concerns, in return for which the DOJ will forego issuing any challenge to the merger. A "fix it first" remedy allows the assets to be sold to be tailored to a specific proposed purchaser.

The position in the UK is similar to that adopted by the US DOJ. The 2003 Merger Procedural Guidelines issued by the Office of Fair Trading (the first phase review body in the UK) provide that where a merger has already been completed, the merged entity may submit an interim hold-separate undertaking to the Competition Commission (the second phase review body) to avoid the Commission taking pre-emptive action.

Such undertakings are common practice in the UK and normally require the merged company not to take further steps to integrate the businesses until the outcome of the Competition Commission investigation has been made public.

Conclusion

Merger planning will need to take into account these Guidelines. In nearly all cases, the Commission will interpret and apply them virtually free of supervision or review.

Very few matters go to the Federal Court or the Tribunal and when they do those bodies tend not to focus on the Commission's Guidelines but go to the substantive competition questions.

For these reasons business will need to learn to adjust to life under these Guidelines.

While there is an opportunity for comment and adjustment, and hopefully clarification of some of the issues raised in this Alert, it is unclear how much further the Commission may move from this draft before the Guidelines are formally adopted.