MERGER ANALYSIS UNDER THE U.S. ANTITRUST LAWS

Transcription

1 MERGER ANALYSIS UNDER THE U.S. ANTITRUST LAWS William Blumenthal * King & Spalding Washington, D.C. This outline summarizes the basic principles of merger analysis under the federal antitrust laws. It is organized as follows: Part I summarizes the text and purpose of Section 7 of the Clayton Act, the principal provision governing mergers, and it briefly identifies other relevant antitrust provisions. Part II addresses standards governing market definition in merger matters. Part III identifies issues in identifying market participants and measuring the extent of their participation. Part IV addresses the standards governing the assessment of the competitive effects of horizontal mergers. Part V addresses entry considerations, and Part VI addresses efficiency considerations. Part VII addresses issues presented by transactions involving failing firms. Part VIII addresses the standards governing the assessment of the competitive effects of vertical mergers. Finally, Part IX reviews the requirements for filing premerger notification under the Hart-Scott-Rodino Antitrust Improvements Act of A. Section 7 of the Clayton Act I. STATUTORY FOUNDATIONS OF U.S. MERGER LAW The principal federal statutory provision governing mergers is Section 7 of the Clayton Act, 15 U.S.C. 18, which provides: No person engaged in commerce or in any activity affecting commerce shall acquire, directly or indirectly, the whole or any part of the stock or other share capital and no person subject to the jurisdiction of the Federal Trade Commission shall acquire the whole or any part of the assets of another person engaged also in commerce or in any activity affecting commerce, where in any line of commerce or in any activity affecting commerce in any section of the country, the effect of such acquisition may be substantially to lessen competition, or tend to create a monopoly. The text of Section 7 is constitutional in scope. Nearly all substantive merger law is derived from this single sentence. For example, the extensive body of law governing market definition derives from the statute s references to line of commerce and section of the country. * The author is grateful to Peter M. Todaro and Kathryn E. Walsh, also of the Washington office of King & Spalding, for providing assistance in compiling and updating this outline from the author s prior materials.

2 B. Other Statutes Although most merger enforcement actions are based on Section 7 of the Clayton Act, mergers may also be challenged under Section 1 or Section 2 of the Sherman Act, 15 U.S.C. 1-2, or Section 5 of the Federal Trade Commission Act, 15 U.S.C Section 1 of the Sherman Act declares, Every contract, combination in the form of trust or other, or conspiracy, in restraint of trade or commerce[,]... to be illegal. 15 U.S.C. 1; see, e.g., United States v. First Nat l Bank & Trust Co. of Lexington, 376 U.S. 665, (1964); United States v. Rockford Memorial Corp., 898 F.2d 1278, (7th Cir. 1990). 2. Section 2 of the Sherman Act makes it illegal to monopolize, or attempt to monopolize, or combine or conspire... to monopolize U.S.C. 2; see, e.g., United States v. Grinnell Corp., 384 U.S. 563, (1966). 3. Section 5 of the Federal Trade Commission Act prohibits [u]nfair methods of competition... and unfair or deceptive acts or practices U.S.C. 45; see, e.g., In re American Medical Int l, 104 F.T.C. 1, 110 (1984). C. Agency Guidelines 1. The 1992 Merger Guidelines issued by the U.S. Department of Justice and the Federal Trade Commission are the most recent comprehensive statement outlining the agencies analysis of horizontal mergers. 2. The Department s 1984 Merger Guidelines are the agencies most recent comprehensive statement on evaluating vertical mergers, but they should be read in the context of the 1992 Guidelines. U.S. Department of Justice and Federal Trade Commission Statement Accompanying Release of Revised Merger Guidelines (Apr. 2, 1992), reprinted in 2 ABA ANTITRUST SECTION, ANTITRUST LAW DEVELOPMENTS 1368 (3d ed. 1992). D. Purpose of Section 7 1. Commentators offer differing views on the purpose of Section 7 and of the antitrust laws more generally. See ABA ANTITRUST SECTION, MONOGRAPH NO. 12, HORIZONTAL MERGERS: LAW AND POLICY 6-26 (1986) [hereinafter ABA MERGER MONOGRAPH]. The views fall along a spectrum. One pole is represented by the view that the sole purpose of the antitrust laws is to maximize economic efficiency. Id. at 7 (collecting authority at n.27). The opposite pole is represented by the view that the antitrust laws are based upon both economic and sociopolitical values. See id. at 7-9 (collecting authority). An intermediate position reflects the view that the antitrust laws are based upon economic values, but that those values include factors beyond efficiency, most notably distributional factors such as the prevention of wealth transfers from consumers to producers. See id. at 8-2 -

3 n.30. Resolution of the purpose of the statute is crucial, because [o]nly when the issue of goals has been settled is it possible to frame a coherent body of substantive rules. R. BORK, THE ANTITRUST PARADOX 50 (1978). 2. The 1992 Guidelines provide: The unifying theme of the Guidelines is that mergers should not be permitted to create or enhance market power or to facilitate its exercise.... [T]he result of the exercise of market power is a transfer of wealth from buyers to sellers or a misallocation of resources GUIDELINES At the time of the 1992 Guidelines release, some individuals within the enforcement agencies appeared to disagree over the purpose of Section 7 as reflected in the preceding paragraph. a. The FTC staff wrote: The 1992 Guidelines clarify that mergers may be condemned either because they lead to a misallocation of resources (efficiencies) or a transfer of wealth from buyers to sellers (welfare of consumers). FTC Bureau of Competition Pocket Guide, reprinted in FTC: WATCH No. 364, at 2 (Apr. 6, 1992) [hereinafter FTC Pocket Guide]. b. The Guidelines provision, however, is open to another interpretation: mergers may be condemned only because of adverse effects on economic efficiency, which effects result in resource misallocation and typically (but not invariably) coincide with wealth transfers. Under this view, wealth transfers would not provide an independent basis for challenge. This interpretation was offered by at least some persons within the Antitrust Division. 4. The difference of interpretation will not matter with respect to many transactions, since adverse efficiency effects are usually accompanied by wealth transfers. The difference may matter, however, with respect to markets characterized by very low demand elasticity; and it will matter fundamentally to the interpretation of certain other provisions of the Guidelines -- most notably, whether efficiency gains from a merger must be passed on to consumers, see infra part VI.B. E. Motivation of Private Conduct 1. Section 7 is a predictive statute, see, e.g, United States v. General Dynamics Corp., 415 U.S. 486, 501 (1974) ( companies that have controlled sufficiently large shares of a concentrated market are barred from merger by 7, not because of their past acts, but because their past performances imply an ability to continue to dominate ), and guidelines or legal rules intended to implement Section 7 necessarily must attempt to predict the effect of a transaction upon future economic performance. Such prediction requires a vision of how markets work -- an economic model, whether explicit or implicit. Such a vision/model, in turn, requires certain assumptions about how people behave

4 2. The 1992 Guidelines provide: Throughout the Guidelines, the analysis is focused on whether consumers or producers likely would take certain actions, that is, whether the action is in the actor s economic interest GUIDELINES The Guidelines approach is consistent with the common assumption in economic theory that persons and businesses are rational and profit-maximizing. That assumption has increasingly come under attack or has been relaxed, however, in much of modern economic theory. The theory over the past decade has made great strides in explaining what has been evident to practitioners for a long time -- that corporate clients often act in a manner that appears irrational or inconsistent with profit maximization. a. Thus, the so called principal-agent literature explains that in hierarchies such as corporations, managers will act in their personal interests rather than the enterprises interests unless appropriate incentive structures are devised -- often a difficult task. As a result, corporations may act in a manner that is irrational or nonmaximizing from the corporation s perspective. See, e.g, J. Stiglitz, Principal and Agent, in ALLOCATION, INFORMATION, AND MARKETS (1989) (collecting authority); B. Holmstrom & J. Tirole, The Theory of the Firm, in 1 HANDBOOK OF INDUSTRIAL ORGANIZATION (1989) (same). b. Because information is costly to obtain and process, persons may act in a manner that is boundedly rational -- that is, they intend to be rational, but are limited in the effort. See, e.g., D. KREPS, GAME THEORY AND ECONOMIC MODELING ch. 6 (1990). Cognitive biases affect judgment. See M. NEALE & M. BAZERMAN, COGNITION AND RATIONALITY IN NEGOTIATION (1991). c. Game theory, upon which the Guidelines competitive effects section is largely based, see infra part IV, increasingly is making efforts to model irrationality. See, e.g., D. KREPS, A COURSE IN MICROECONOMIC THEORY (1990); see also R. THALER, QUASI RATIONAL ECONOMICS (1991). 4. As a theoretical matter, then, notwithstanding the Guidelines underlying assumption, market behavior may not be based on whether the action is in the actor s economic interest, 1992 GUIDELINES 0.1. As an evidentiary matter, predicting whether consumers or producers likely would take certain actions, id., is extremely difficult without the benefit of behavioral assumptions and therefore is open to substantial dispute. II. MARKET DEFINITION Because Section 7 is violated only by transactions that may substantially lessen competition in any line of commerce... in any section of the country, a merger must be examined in terms of its likely effect within a relevant market having both a product and a geographic dimension. See Brown Shoe Co. v. United States, 370 U.S. 294, 324 (1962). The Supreme Court has held that [d]etermination of the relevant market is a necessary predicate to a finding of a violation of - 4 -

5 the Clayton Act because... [s]ubstantiality can be determined only in terms of the market affected. United States v. E.I. du Pont de Nemours & Co., 353 U.S. 586, 593 (1957). A. Demand Substitution 1. Demand substitution is the substitution by consumers of one product for another product. Courts have long recognized demand substitution as the leading basis for product market definition. See Brown Shoe Co. v. United States, 370 U.S. 294, 325 (1962) ( the outer boundaries of a product market are determined by the reasonable interchangeability of use or the cross-elasticity of demand between the product itself and substitutes for it ); United States v. E.I. du Pont de Nemours & Co. (Cellophane), 351 U.S. 377, (1956) (products that are reasonably interchangeable by consumers for the same purposes are in the same market.). 2. There are differing visions as to how demand substitution should be taken into account operationally. See ABA MERGER MONOGRAPH, supra part I.D.1, at a. Most commonly, demand substitution is measured by the cross-elasticity of demand which compares the change in the quantity demanded of one product given a price change of another product. If a change in the price of one product causes a large change in the demand of another product, the two products have a high crosselasticity of demand and are treated as being in a single market. See id. at b. The geographic component of market definition is often defined by looking at the historical insularity of a given geographic area for a specific group of products. Under the Elzinga-Hogarty Test, a market is measured by determining both the inflows of products (where products consumed within the area are produced) and the outflows of products (where products produced within the area are consumed). A market is properly defined when little of the specified group of products flows in or out of the specified geographic area. See id. at Although questioned by many, this approach remains common in hospital merger cases. See, e.g., FTC v. Freeman Hospital, 69 F.3d 260 (8th Cir. 1995). c. A market can also be defined as a group of products and corresponding geographic area within which prices tend toward equality. Close price relationships are evidence that products or geographic markets are in the same market. See ABA MERGER MONOGRAPH, supra part I.D.1, at d. Finally, markets can be defined by looking at the ability of a hypothetical monopolist to exert market power (e.g., raise prices profitably). If a price increase across a specified group of products would be unprofitable because enough consumers would switch to other products outside the group, then the specified group does not constitute a market. If, on the other hand, the price increase across a specified group would be profitable for the hypothetical monopolist, then the group constitutes a market. See id. at The 1992 Guidelines approach of looking at - 5 -

6 the effect of a small but significant and nontransitory increase in price relies on this method. B. Supply Substitution 1. Although there is no question that demand substitution is a fundamental consideration in market definition, there is substantial debate as to whether supply substitution should also be considered in market definition. a. Authority is split into three camps: (i) define the relevant market by reference to both supply-side and demand-side criteria; (ii) define the relevant market solely by reference to demand-side criteria, but consider supply substitution in identifying market participants and measuring the market; and (iii) define and measure the relevant market solely by reference to demand substitution. See ABA MERGER MONOGRAPH, supra part I.D.1, at The 1992 Guidelines adopted approach (ii). b. The three approaches can lead to substantial differences in measured market concentration. Consider this example: Widgets and gizmos are used for entirely unrelated purposes, but can sometimes be produced in the same facilities, depending on the supplier s particular production process. Firm R, which produces widgets in a dedicated facility, proposes to merge with Firm S, which produces widgets and gizmos in a common facility. Firms P and Q also produce widgets in dedicated facilities. Firm T also produces widgets and gizmos in a common facility. Firms U and V currently produce only widgets, but could immediately shift to the production of gizmos in common facilities. Firms W, X, and Y produce only gizmos in dedicated facilities. In assessing the effect of the merger of Firms R and S on widgets, what is the relevant product? Under approach (i), the product would probably be both widgets and gizmos because of the common production facilities and all firms would be in the market. Under approach (ii), the product would be widgets only, and Firms P-V would be in the market. Under approach (iii), the product would be widgets only, and Firms P-T would be in the market. 2. The 1992 Guidelines provide: Market definition focuses solely on demand substitution factors -- i.e., possible consumer responses. Supply substitution factors -- i.e., possible production responses -- are considered elsewhere in the Guidelines in the identification of firms that participate in the relevant market and the analysis of entry GUIDELINES Courts have recognized supply substitution as a factor in market definition. See, e.g., Brown Shoe, 370 U.S. at 325 n.42 ( cross-elasticity of production facilities may also be an important factor in defining a product market ); Carter Hawley Hale Stores, Inc. v. Limited, Inc., 587 F. Supp 246, 253 (C.D. Cal. 1984), aff d, 760 F.2d 945 (9th Cir. 1985) (garment manufacturer can easily switch production to different quality and sizes of clothing)

7 C. Threshold Levels: Magnitude of Price Increase 1. Market definition requires an analysis of substitution possibilities. The scope of substitution possibilities, in turn, depends on relative price levels: at a high enough price even poor substitutes look good to the consumer, R. POSNER, ANTITRUST LAW: AN ECONOMIC PERSPECTIVE 128 (1976). Under the 1992 Guidelines framework, market definition is performed by considering substitution in response to a hypothetical price increase. The magnitude of the price increase will materially affect the extent to which substitution occurs. See generally ABA MERGER MONOGRAPH, supra part I.D.1, at The 1992 Guidelines provide: In attempting to determine objectively the effect of a small but significant and nontransitory increase in price, the Agency, in most contexts, will use a price increase of five percent.... However, what constitutes a small but significant and nontransitory increase in price will depend on the nature of the industry, and the Agency at times may use a price increase that is larger or smaller than five percent GUIDELINES 1.11; see also id (for geographic market definition, what constitutes a small but significant and nontransitory increase in price... will be determined in the same way as for product market definition). 3. The Guidelines allow for deviation from five percent, but do not provide any standard by which to determine when a different percentage is appropriate or what it should be. Under the Guidelines, the decisionmaker has substantial discretion, the exercise of which may materially affect the contours of the market. At a low percentage increase, few products will be substitutes. At a high percentage increase, many products will be. 4. In United States v. Engelhard, 970 F. Supp (M.D. Ga.), aff d, 126 F.3d 1302 (11 th Cir. 1997), the court rejected the government s use of five to ten percent as a price increase threshold because the did not provide an accurate picture of the relevant product market for attapulgite clay. Some customers had stated that they would not switch clays if their suppliers raised prices by five percent, since the clay was a low percentage of their overall product cost and switching clays involved potentially significant qualification costs. 970 F. Supp. at The court denied the government s motion for injunctive relief. D. Threshold Levels: Uniformity of Price Increase 1. An issue to which little thought has previously been given in the cases and commentary was raised (perhaps inadvertently) by one sentence in the 1992 Guidelines -- whether the percentage price increase, once selected, is to be applied uniformly across all products in the market, or whether it is to be simply the average of a set of price increases that will be applied at varying levels to different products in the market. Suppose, for example, that the small but significant and nontransitory increase to be used in evaluating a particular transaction in the widget market is five percent. Under the market definition exercise, do we hypothesize that the price of all widgets will increase five percent? Or do we hypothesize that widget producers will apply varying percentages, some more and some - 7 -

8 less than five percent, such that the producers maximize profits and the price increase across the market averages five percent? 2. The 1992 Guidelines provide: [T]he hypothetical monopolist will be assumed to pursue maximum profits in deciding whether to raise the prices of any or all of the additional products under its control GUIDELINES 1.11; see also id (similar standard with respect to geographic locations). 3. This provision was addressed by Commissioner Azcuenaga in her statement dissenting from the issuance of the Guidelines: The test used to identify the relevant market seems changed in a way that may be difficult to implement and may make market definition less predictable. The 1984 Guidelines hypothesized a uniform price increase to identify the market. Under the new Guidelines, the price increase is not necessarily uniform. Instead, the hypothetical monopolist, to pursue maximum profits, may increase prices for some products and for some locales more than for others.... Requiring a determination of the pricing policy of the hypothetical monopolist raises the level of complexity in market analysis. With even a moderate number of products and locales, the analysis may prove to be a daunting task. Various assumptions about factors influencing the monopolist s decision may lead to different pricing policies and, thus, different definitions of relevant markets. While the approach may be appropriate in theory, it is unclear how we might choose among the myriad of plausible price choices that the hypothetical profit-maximizing monopolist might make. The relatively crude test of the 1984 Guidelines has the saving grace of simplicity, feasibility and predictability. Dissenting Statement of Commissioner Mary L. Azcuenaga, On the Issuance of the Horizontal Merger Guidelines, at 3 (Apr. 2, 1992). 4. If the Guidelines mean what Commissioner Azcuenaga says they mean, her analysis has merit. In order to define a market, one would have to determine the optimal pricing policy of market participants acting in a coordinated manner, taking into account the differing degrees of substitutability of each product in the market for all alternatives inside and outside the market. To be sure, aircraft engineers use supercomputers to analyze equally sophisticated problems in the design of airfoils, but rules of law do not normally have a level of complexity comparable to fluid dynamics. As a practical matter, this provision of the Guidelines will not be applied literally. E. Threshold Levels: Duration of Price Increase 1. The scope of the market depends not only on the magnitude of the hypothesized price increase, but also on the duration for which the increase is assumed to be in effect. In general, purchasers can turn to a broader range of substitutes as they have more time to do so. See generally ABA MERGER MONOGRAPH, supra part I.D.1, at The 1982 Guidelines and the 1984 Guidelines used one year as the period for assessing the extent of - 8 -

9 substitution for market definition purposes. (They used other time frames for other purposes, such as entry or measurement of production substitution.) 2. The 1992 Guidelines provide: [T]he Agency, in most contexts, will use a price increase... lasting for the foreseeable future GUIDELINES The Guidelines provide no indication of what constitutes the foreseeable future. One interpretation would be in perpetuity, which would lead to markets broader than under the former one year standard; this does not appear to be the interpretation that the agencies intended. Other interpretations, which agency staffs have suggested in private conversations, would be for one product cycle or until the next purchase decision. F. Threshold Levels: Base Price (I) 1. Selection of the base price from which the hypothetical price increase is taken is conceptually important in defining markets. The base price may be the prevailing price, the competitive price (used to avoid the so-called Cellophane trap where the prevailing price reflects market power), or something else. See generally ABA MERGER MONOGRAPH, supra part I.D.1, at The 1992 Guidelines address the Cellophane trap directly changing the earlier approach of the 1982 Guidelines and 1984 Guidelines which indicated that prevailing price would be used (at least as between prevailing price and a lower competitive price). 2. The 1992 Guidelines provide: [T]he Agency will use prevailing prices of the products of the merging firms and possible substitutes for such products, unless premerger circumstances are strongly suggestive of coordinated interaction, in which case the Agency will use a price more reflective of the competitive price GUIDELINES 1.11 (footnote omitted); see also id (for geographic market definition, base price will be determined in the same way as for product market definition). 3. The Guidelines are asymmetrical in that they do not appear to recognize other circumstances in which prevailing price is below competitive price. In particular, in declining industries that are undergoing a shakeout, prevailing prices will often fall below long-term competitive price (that is, the price that will prevail when the industry reaches equilibrium). The Guidelines, of course, do not specify the meaning of competitive price, and the agencies are likely to take the position that the term refers to the short-term competitive price. In an appropriate failing company or declining industry case, however, counsel may wish to invoke the Guidelines to support the proposition that the market should be defined by reference to post-shakeout price and should therefore be broadened. (The Guidelines provision discussed infra part II.G may also provide a basis for such an argument.) - 9 -

10 G. Threshold Levels: Base Price (II) 1. For reasons already stated, the price selected for assessing the degree of substitution materially affects the resulting market definition. That price, in turn, depends on two components: the base price from which the hypothetical price increase is taken, and the magnitude of the price increase. We have already discussed the magnitude of the price increase, see supra part II.C, and we have discussed one basis for selecting a base price that differs from prevailing price, namely coordinated basis for selecting a base price that differs from prevailing price: since Section 7 is forward-looking, see supra part I.E.1, the market definition exercise arguably should be performed by reference to the price that will prevail in the future in the absence of the transaction under investigation. This concept was reflected in the 1982 and 1984 Guidelines and was carried over in revised form to the 1992 Guidelines. 2. The 1992 Guidelines provide: [T]he agency may use likely future prices, absent the merger, when changes in the prevailing prices can be predicted with reasonable reliability. Changes in price may be predicted on the basis of, for example, changes in regulation which affect price either directly or indirectly by affecting costs or demand GUIDELINES 1.11; see also id (for geographic market definition, base price will be determined in the same way as for product market definition). H. Price Discrimination as a Basis for Market Definition 1. The 1982 Guidelines identified price discrimination as a basis for market definition where certain conditions were satisfied. The practice was continued in the 1984 Guidelines and the 1992 Guidelines. 2. The 1992 Guidelines provide: The Agency will consider additional relevant product markets consisting of a particular use or uses by groups of buyers of the product for which a hypothetical monopolist would profitably and separately impose at least a small but significant and nontransitory increase in price GUIDELINES 1.12; see also id (similar standard with respect to geographic markets). 3. In light of its history, this provision is now standard in merger analysis. The significance of the provision depends largely on its application, which remains highly discretionary. Even though the language of the 1992 Guidelines on price discrimination was substantially similar to the 1982 Guidelines and 1984 Guidelines, the FTC staff, at least, discerned a shift: The 1992 Guidelines embrace a greater acceptance of product markets based on price discrimination. (Where price discrimination is possible, markets can be as small as sales to a single buyer.) FTC Pocket Guide, supra part I.D.3.a, at The price discrimination provisions in the Guidelines are often viewed as creating an analogue to the submarkets found in older cases. See ABA Merger Monograph, supra part I.D.1, at 128 (discussion relationship to criteria identified in Brown Shoe Co. v. United States, 370 U.S. 294, 325 (1962))

11 a. One objective of the 1982 Guidelines was to drive a stake through the heart of the Brown Shoe approach to submarkets. See Panel Discussion: The New Merger Guidelines, 51 ANTITRUST L.J. 317, 321 (1982) (remarks of William F. Baxter, Assistant Att y Gen., that the submarket concept has been terribly abused and the sooner we see the end to that kind of chatter the better ). b. Explicit adoption of submarkets, sometimes by reference to the Brown Shoe criteria without regard to the principles described in the Guidelines, has begun to reappear in recent cases. See FTC v. Cardinal Health, Inc., 12 F. Supp. 2d 34, (D.D.C. 1998) (finding distinct submarket of wholesale prescription drug distribution to customers that did not self-warehouse drugs and could not use other methods of distribution as reasonable substitutes for defendants services); FTC v. Staples, 970 F. Supp. 1066, (D.D.C. 1997) (finding submarket for the sale of consumable office supplies through office supply superstores, despite high degree of functional interchangeability between consumable office supplies sold by office superstores and other retailers of office supplies, because certain customers did not go elsewhere for supplies). For a detailed discussion of the market definition methodologiesw in these cases, see William Blumenthal & David A. Cohen, Channels of Distribution as Merger Markets : Interpreting Staples and Cardinal, ANTITRUST REP. (MB), Nov. 1998, at 2. III. MARKET PARTICIPATION AND MEASUREMENT Once the market has been defined, market participants must be identified and market shares must be assigned before HHI concentration levels can be calculated. Under the 1992 Guidelines, this is not a mechanical exercise, but rather is highly judgmental. A. Firms that Currently Produce or Sell 1. The identification and measurement of market participants normally begin with suppliers that currently sell in the merchant market (that is, between firms that lack corporate affiliation). The 1982 Guidelines and 1984 Guidelines stated that the evaluation of a merger will focus primarily, on firms that currently produce and sell the relevant product GUIDELINES II.B (emphasis added); 1984 GUIDELINES 2.2 (emphasis added). Other firms would be included based on probable supply responses. 2. The 1992 Guidelines provide: The Agency s identification of firms that participate in the relevant market begins with all firms that currently produce or sell in the relevant market GUIDELINES 1.31 (emphasis added). a. The Guidelines include, at least initially, both participants in the merchant market and vertically integrated firms. The inclusion of vertically integrated firms in

12 B. Captive Use the relevant market is, however, limited by the captive use provisions of the Guidelines. See infra part III.B. b. The provision is clear in indicating that current suppliers are only the beginning of the analysis of market participation, rather than the primary focus. The substantive significance of this shift appears to be slight, though. Captive use is treated as part of the beginning, 1992 GUIDELINES 1.31, and the treatment of the only other classes expressly recognized in the Guidelines -- durable products and production substitution, see id. 1.31, is not markedly more inviting than in the 1982 Guidelines and 1984 Guidelines. 1. Authority is mixed on whether production for captive use should be considered when identifying market participants and measuring market shares. The 1982 Guidelines and 1984 Guidelines provided that producers for captive use would be included in the market if they would respond to a small but significant and nontransitory price increase by beginning to sell the relevant product in the merchant market or by increasing production of both the relevant product and the downstream product in which the relevant product is embodied. See 1982 GUIDELINES II.B.3; 1984 GUIDELINES The 1992 Guidelines provide that market participants include[] vertically integrated firms to the extent that such inclusion accurately reflects their competitive significance in the relevant market prior to the merger GUIDELINES The Guidelines provision is cryptic, and its significance is not yet clear. From interpretations issued shortly after the release of the Guidelines, however, the enforcement agencies appear to disagree on the treatment of vertically integrated firms. a. The Antitrust Division evidently includes vertically integrated firms even if production is solely for captive use. See J. Rill, Assistant Att y Gen., 60 Minutes with the Honorable James F. Rill, Before the ABA 40th Annual Antitrust Spring Meeting, at 8 (Apr. 3, 1992) [hereinafter Rill Speech] ( the Guidelines now include all current producers or sellers of the relevant product, even if the firm is vertically integrated and produces only for its own internal consumption ); C. James, Deputy Assistant Att y Gen., Remarks before the Manufacturer s Alliance on Productivity and Innovation, at 12 (Apr. 10, 1992) [hereinafter James Speech] ( [i]nternal production by vertically integrated firms is given full credit in market measurement under the new Guidelines ). b. At least as of 1992, the FTC evidently included vertically integrated firms only to the extent specified in the 1984 Guidelines. See K. Arquit, Director, FTC Bureau of Competition, Further Thoughts on the 1992 U.S. Government Horizontal Merger Guidelines, before the State Bar of Texas, at 7-8 (Apr. 24, 1992) [hereinafter Arquit Speech] (little or no substantive change from 1984 Guidelines intended, so standard is

13 whether, and to what extent, captive producers are likely to exert a competitive impact on the relevant market, either by selling the relevant product or by increasing production of both the relevant product and downstream products ). The agency s current practice is not clear. 4. The practical difficulty of measuring the market participation of vertically integrated firms depends largely on which of the preview interpretations is adopted. If inclusion of vertically integrated firms depends on a matter-specific assessment of their competitive impact, market measurement is highly judgmental -- how will they respond to a price increase? -- and provides substantial room for argument. If production by vertically integrated firms is counted fully, market measurement is eased considerably. (There will still be some difficulties, though -- the merger parties often lack data estimating vertically integrated competitors production for captive use.) C. Durable Products 1. In United States v. Aluminum Co. of America, 146 F.2d 416 (2d Cir. 1945), the court excluded scrap aluminum from the relevant aluminum market. Since then, authority has been split on the treatment of recycled or durable products when measuring markets. See ABA MERGER MONOGRAPH, supra part I.D.1, at Rejecting the Alcoa methodology, the 1982 Guidelines and 1984 Guidelines include in the market firms that recycle or recondition products that represent good substitutes for new products GUIDELINES II.B.2; 1984 GUIDELINES The 1992 Guidelines provide: To the extent that the analysis [in the product market definition provisions] under Section 1.1 indicates that used, reconditioned or recycled goods are included in the relevant market, market participants will include firms that produce or sell such goods and that likely would offer those goods in competition with other relevant products GUIDELINES D. Supply Substitution 1. As discussed supra part II.B, authority is split as to the appropriate treatment of supply substitution. Under the 1984 Guidelines, the standard governing the treatment of supply substitution was essentially this: If a firm has existing productive and distributive facilities that could easily and economically be used to produce and sell the relevant product within one year in response to a small but significant and nontransitory increase in price, the Department will include that firm in the market GUIDELINES 2.21; see also 1982 GUIDELINES II.B.1 (same standard, except that period for shifting was six months). While retaining this concept, the 1992 Guidelines elaborate upon the elements of the standard and expand it to include supply responses through rapid construction or acquisition of new facilities

14 2. In particular, the 1992 Guidelines provide: a. If a firm has existing assets that likely would be shifted or extended into production and sale of the relevant product within one year, and without incurring significant sunk costs of entry and exit, in response to a small but significant and nontransitory increase in price for only the relevant product, the Agency will treat that firm as a market participant GUIDELINES b. If new firms, or existing firms without closely related products or productive assets, likely would enter into production or sale in the relevant market within one year without the expenditure of significant sunk costs of entry and exit, the Agency will treat those firms as market participants. Id c. [Defining one of the important terms in these standards:] Sunk costs are the acquisition costs of tangible and intangible assets that cannot be recovered through the redeployment of these assets outside the relevant market, i.e., costs uniquely incurred to supply the relevant product and geographic market. Id The provisions of the 1984 Guidelines relating to supply substitution and to the related issue of entry, see 1992 GUIDELINES 1.32; infra part V, resulted in substantial differences in judgment between agency staffs and counsel for merger parties. While the 1992 Guidelines specify the agencies standard in greater detail, differences in judgment are likely still to occur with some regularity. a. The 1984 Guidelines asked whether supply substitution could occur; the 1992 Guidelines ask whether supply substitution would occur. Whether the appropriate legal standard is could or would remains open to dispute. A would standard imposes greater burdens on the merger parties. It is also highly sensitive to the manner in which facts are gathered -- for example, if agency staff seek to determine whether supply substitution would occur by calling possible market participants, the order and phrasing of questions can affect the answers received. This raises a further issue: insofar as a would standard is deemed appropriate, is the determination of whether firms would shift to be made through a subjective test (what do they say?) or an objective test (what would you do if you were they?)? b. The sunk cost analysis is new to the private bar, and its practicalities have yet to be explored. After further experience, it may not prove to be so difficult as initially feared by many practitioners. And if it is difficult to apply, its practical significance may be limited -- if sunk costs are low, supply responses are treated under this section of the Guidelines; and if sunk costs are high, supply responses are treated under the Guidelines entry provisions, see 1992 GUIDELINES 3; infra part V. (What is high in the world of sunk costs? See Rill Speech, supra part III.B.3.a, at 11 ( sunk costs in excess of five percent of total annual costs will be regarded as significant ).) Therefore, supply responses are credited, but sunk costs are material as to the specific

15 manner in which credit is given. Selection of the specific manner will matter in some cases. More generally, though, counsel might consider these rules of thumb: i. If large supply responses are likely to occur, the transaction is likely to be deemed lawful by virtue of either the supply response provisions or the entry provisions of the Guidelines. ii. If very limited supply responses are likely to occur, neither the supply response provisions nor the entry provisions are likely to be of much assistance, so move on to another issue. iii. If some intermediate level of supply response is likely to occur and the issue may be dispositive, invest the resources to learn the theory of sunk costs, as well as the facts pertinent to the cost structure of the industry under review. c. If firms are to be included in the market based upon the Guidelines supply response provisions, they must be assigned market shares for purposes of market measurement. The determination of their market share is highly judgmental, and agency staff and counsel for the merger parties may have different views. E. Selection of Statistical Proxy 1. In some instances the analysis of a transaction will depend on the statistical proxy used to measure the market -- capacity, revenues, unit sales, reserves, or something else (such as branches and deposits in banking, for example.) Where market shares fluctuate, the time period over which activity is measured can also be important. Considering the potential importance of the issue, surprisingly little authority addresses the methodology of measurement. See ABA MERGER MONOGRAPH, supra part I.D.1, at 153 n.749 (making similar observation and summarizing available authority). 2. The 1992 Guidelines provide: market shares can be expressed either in dollar terms through measurement of sales, shipments, or production, or in physical terms through measurement of sales, shipments, production, capacity, or reserves. Market shares will be calculated using the best indicator of firms future competitive significance. Dollar sales or shipments generally will be used if firms are distinguished primarily by differentiation of their products. Unit sales generally will be used if firms are distinguished primarily on the basis of their relative advantages in serving different buyers or groups of buyers. Physical capacity or reserves generally will be used if it is these measures that most effectively distinguish firms. Typically, annual data are used, but where individual sales are large and infrequent so that annual data may be unrepresentative, the Agency may measure market shares over a longer period of time

16 1992 GUIDELINES 1.41 (footnote omitted). 3. When market shares differ materially depending on the proxy or time frame selected, counsel should learn why. The explanation will often be significant in understanding the workings of the market and therefore the competitive effects of the transaction, cf. infra part IV (discussing Guidelines provisions on competitive effects). The explanation may also provide a basis for arguing that the transaction should be evaluated by reference to a particular proxy resulting in relatively low concentration levels. 4. Certain technology and consumer products industries are characterized by generational competition, in which firms compete to develop the product that will have substantial share until the next product cycle. Market shares in such industries often vary sharply from year to year, depending on which particular firm is offering the hot product for that generation. In evaluating transactions involving such industries, counsel should consider a footnote in the Guidelines: Where all firms have, on a forward-looking basis, an equal likelihood of securing sales, the Agency will assign firms equal shares GUIDELINES 1.41 n.15; see also ABA MERGER MONOGRAPH, supra part I.D.1, at (discussing bidding models ). (The footnote applies to other industries as well, such as certain professional services.) Adjustments to market shares in light of generational competition may also be appropriate under the Guidelines provisions for Changing Market Conditions, see infra part III.H. F. Adjustments for Committed Capacity 1. Limited authority suggests that production undertaken pursuant to a supply contract might appropriately be attributed in some circumstances to a purchaser/reseller, rather than to the producer. ABA MERGER MONOGRAPH, supra part I.D.1, at 136 (collecting cases). The line of authority traces to United States v. General Dynamics Corp., 415 U.S. 486 (1974), in which a merger in the coal industry was held lawful because the acquired firm, the reserves of which were either depleted or committed under long-term contract, was in a position to offer for sale neither its past production nor the bulk of the coal it is presently capable of producing, id. at The 1992 Guidelines provide: In measuring a firm s market share, the Agency wil1 not include its sales or capacity to the extent that the firm s capacity is committed or so profitably employed outside the relevant market that it would not be available to respond to an increase in price in the market GUIDELINES The Guidelines provision presents at least two issues: a. For how long a period must the capacity be committed before the provision may be invoked? The standard is not clear. Presumably we would not slash the measured share by half because the firm was sold out for the next six months. But what if the firm is committed for a year? For five years? Does the Guidelines time frame for

17 assessing entry (two years), see 1992 GUIDELINES 3.2, provide a beeline? And does it matter whether the firm is committed to a single purchaser or to multiple purchasers? b. While the Guidelines provide for reduction in the producer s share based on committed capacity, they do not address whether that capacity is simply dropped from the market or, instead, whether the share may be attributed to the purchaser. Where a purchaser has a long-term call on output, attribution may be appropriate in certain circumstances. See ABA MERGER MONOGRAPH, supra part I.D.1, at G. Adjustments for Foreign Firms 1. [T]here is a broad recognition that some accommodations in the treatment of foreign competitors must be made to reflect jurisdictional, economic, and other considerations.... Id. at 141. The particular accommodations have been the subject of wide debate. Id. at Many of the revisions from the 1982 Guidelines to the 1984 Guidelines related to foreign firms, which were treated by the 1984 Guidelines in three different sections, see 1984 GUIDELINES 2.34, 2.4, Those three sections were combined and revised in a single section in the 1992 Guidelines. 2. The 1992 Guidelines provide that market shares will be assigned to foreign competitors in the same way in which they are assigned to domestic competitors[,] but that adjustments will be made in certain circumstances to reflect exchange rate fluctuations, quotas and other trade restraints, and foreign coordination GUIDELINES The adjustments specified in the 1992 Guidelines require judgments, as to which counsel for the merger parties may disagree with agency staff. In view of the divergent authority on the treatment of foreign competition, see supra part III.G.1, counsel might also ask whether standards other than those reflected in the Guidelines should be applied; such an argument is unlikely to be favorably received at the enforcement agencies, but might have persuasive value before a court. H. Adjustments for Changing Market Conditions 1. Because Section 7 is a forward-looking statute, see supra part I.E.1, historical market share data have significance only to the extent that they have predictive value. When market conditions are changing such that historical data lack predictive value, those data must be disregarded or adjusted, or their interpretation must be modified. The 1984 Guidelines provided that the government s interpretation of market concentration and market share data take account of reasonably predictable effects of changing market conditions. See 1984 GUIDELINES 3.21; see also W. Baxter, The Definition and Measurement of Market Power in Industries Characterized by Rapidly Developing and Changing Technology, 53 ANTITRUST L.J. 717 (1984). The provision was carried over into the 1992 Guidelines

18 2. The 1992 Guidelines provide: [R]ecent or ongoing changes in the market may indicate that the current market share of a particular firm either understates or overstates the firm s future competitive significance.... The Agency will consider reasonably predictable effects of recent or ongoing changes in market conditions in interpreting market concentration and market share data GUIDELINES The Guidelines approach involves interpretation of market concentration and market share data, rather than adjustment of the data for purposes of the market concentration calculation. (This compares with the treatment of committed capacity and foreign firms, see supra parts III.F-G, as to which the Guidelines adjust the data.) The distinction is of limited significance, but the adjustment approach pressures the advocate of adjustment (whether the agency staff or counsel for the parties) to specify numbers with an arithmetic precision that can be sidestepped under the reinterpretation approach. 4. Of greater significance is the substantial discretion afforded by this provision of the Guidelines. Unless invoked sparingly, the provision is an imitation to blue-sky conjectures as to the future of the market. Counsel should note that the provision allows for data to be reinterpreted downward or upwards. In at least one matter in which the author was involved, agency staff contended that the transaction should be enjoined because the acquiring firm was well poised to have a great future, so that its meager market share therefore understated its competitive significance. I. Adjustments for Financial Weakness 1. Authority is split as to whether market share data may be adjusted to account for financial weakness of a merging firm when the elements of the failing company doctrine, see infra part VII, are not satisfied. See generally ABA MERGER MONOGRAPH, supra part I.D.1, at Over the years the enforcement agencies have taken inconsistent positions. In Pillsbury Co., 93 F.T.C. 966, (1979), the Commission rejected financial weakness as a decision factor except as a tiebreaker. In the 1982 FTC Statement on Horizontal Mergers, at III.A.2, however, the Commission wrote that evidence of individual firm performance can be of use in evaluating the probable effects of a merger. The 1982 Guidelines took no position on the issue, but the 1984 Guidelines provided that a firm s market share may overstate its significance if the firm faces financial difficulties that clearly reflect an underlying weakness, see 1984 GUIDELINES The 1992 Guidelines do not include an express discussion of financial condition as a factor affecting the significance of market shares and concentration. 3. The significance of the deletion of the discussion of financial condition from the Guidelines is not clear, and the enforcement agencies have expressed differing views. a. Discussing the change, the then-chairman of the FTC said that the provision of the 1984 Guidelines had been misapplied in efforts to create a flailing firm defense. See Remarks of J. Steiger before the ABA 40th Annual Antitrust Spring Meeting, at

19 (Apr. 3, 1992); see also Arquit Speech, supra part III.B.3.b, at (elimination of provision from 1984 Guidelines should dispel any notion... that a firm s financial weakness, standing alone and short of imminent failure, is likely to be a changing market condition ). b. The Antitrust Division, however, indicated that the changing market conditions provision of the 1992 Guidelines, see supra part III.H, should be read to include the deleted provision on financial condition. See James Speech, supra part III.B.3.a, at 12. J. Adjustments for Other Factors 1. The scope of other factors that might merit adjustment or reinterpretation of market share and concentration data is open to dispute. At least one scholarly article has advocated routine adjustment of data, see L. Kaplow, The Accuracy of Traditional Market Power Analysis and a Direct Adjustment Alternative, 95 HARV. L. REV (1982). In several cases of the late 1970s, the FTC discounted market shares to reflect the conclusion that the merging firms, while in the same market, were not head-to-head competitors. See Heublein, Inc., 96 F.T.C. 385, (1980); SKF Industries, 94 F.T.C. 6 (1979); Coca- Cola Bottling Co., 93 F.T.C. 110 (1979). The 1984 Guidelines identified changing market conditions, financial condition, and foreign firms as examples of situations that might warrant the conclusion that market share data understate or overstate the future competitive significance of market participants GUIDELINES The 1992 Guidelines also treat changing market conditions, see supra part III.H, as illustrative. More generally, the Guidelines provide: in some situations, market share and market concentration data may either understate or overstate the likely future competitive significance of a firm or firms in the market or the impact of a merger GUIDELINES In addition to changing market conditions, the degree of difference between the products and locations in the market and substitutes outside the market, id , is identified as an example of a situation that might warrant reinterpretation. 3. In general, however, counsel should be reluctant to argue for adjustment or reinterpretation of data based on considerations not expressly treated in the Guidelines. If the facts that would support such an argument have merit, they ordinarily can be weaved into an alternative argument based upon some consideration treated expressly in the Guidelines. Often that consideration will be the Guidelines competitive effects section, a catch-all to which we turn next. K. Herfindahl-Hirschman Index 1. After the market participants and shares have been determined, the HHI is used to calculate market concentration. The market share of each participant is squared and the results are summed to produce the HHI level. Thus, a market with only one participant (a

20 true monopoly) will have an HHI level of 10,000 while a market with ten equal participants will have an HHI level of 1, Under the 1992 Guidelines, a market with post-merger HHI of less than 1,000 is considered unconcentrated and requires no analysis of competitive effects GUIDELINES Markets with post-merger HHI levels between 1,000 and 1,800 are considered moderately concentrated and an increase of 100 or more raises significant competitive concerns, requiring further investigation. A market with an HHI level of 1,800 or greater is considered highly concentrated and increases of 50 or more require further investigation. Increases in HHI levels of 100 or more for highly concentrated markets are presumed to create or enhance market power. IV. COMPETITIVE EFFECTS OF HORIZONTAL MERGERS If a transaction falls within HHI-based safe harbors set forth in the Guidelines General Standards, see 1992 GUIDELINES 1.51, it ordinarily will be cleared without further analysis, id. Otherwise, the enforcement agencies undertake to assess the transaction s competitive effects before determining whether a challenge is warranted, see id. 2. The requirements of a competitive effects analysis, at least in its current form, is new to the Guidelines. Its inclusion poses numerous issues, several of which are addressed here. A. Coordinated Interaction 1. Mergers may facilitate tacit collusion in certain circumstances. Courts and enforcement officials have known that for a long time, and the 1982 Guidelines and 1984 Guidelines were based largely on that premise. From the perspective of framing guidelines or legal rules, the practical problem has been to identify the circumstances in which facilitation of tacit collusion is a valid concern. For many years courts tried to identify the circumstances through a summary statistic -- concentration. See, e.g., United States v. Philadelphia National Bank, 374 U.S. 321, 363 (1963). The analysis now extends to considerably more factors. 2. The 1992 Guidelines provide a general framework for thinking about coordinated interaction, and they identify many factors that warrant consideration. Market conditions that are considered conducive to reaching terms of coordination include: homogeneous products, standardized pricing, standardized marketing practices, and the availability of key market information GUIDELINES Conditions that are conducive to detecting or punishing deviations from the terms of coordination include: regular availability of information on actual prices and output level of competitors, small and frequent individual transactions which reduce the incentive to cheat on the terms of coordination and allow other firms to monitor cheaters, and the absence of maverick firms which have a greater economic incentive to cheat GUIDELINES