Prior to the pandemic, the failing firm defence was considered a somewhat theoretical, perhaps even mythical, economic concept, which was occasionally put forward as a last-ditch attempt to gain merger clearance.
Across the UK and Europe, the number of successful clearances using this defence was in single digits, with the Aegean/Olympic II case in 2013 being the last time that the three criteria were successfully met before the European Commission. However, COVID-19 brought about the expectation that this defence might become more prevalent.
Having initially expressed "serious competition concerns" around Amazon’s proposed acquisition of a stake in Deliveroo in 2019, the change in circumstances caused by the pandemic compelled the CMA to provisionally approve the deal in April 2020, relying – in part – on the finding that Deliveroo would have been likely to exit the market without Amazon’s injection of funds.
The CMA revisited this analysis in August 2020, and it was apparent that the food delivery market had recovered rapidly from the initial disruption; consequently, the competition authority decided that the failing firm defence was no longer relevant. The transaction was ultimately cleared with the view it would not substantially lessen competition, but the success of the Amazon/Deliveroo failing firm defence was only temporary.
It was expected that this defence would become more prevalent as the pandemic continued. Indeed, financial difficulties were expected to be the preferred defence when seeking clearance of mergers by the CMA, and pre-empting this, the CMA provided further guidance on how it will deal with the failing firm defence in the context of the pandemic. However, the unprecedented level of government support to businesses, including Coronavirus Business Interruption Loans (CBILs), Coronavirus Job Retention Scheme (CJRS) and grants lessened the financial impact on businesses and made the defence less plausible.
The defence was not used successfully until March 2022 when it was a key component of the CMA’s Phase 1 unconditional clearance of Freshways Group’s acquisition of the Medina group. Here, the parties successful demonstrated that: (i) the firm in difficulty, Medina, would have imminently exited the market, and had exhausted all other options to remain viable absent the merger; and (ii) there were limited ‘alternative purchasers’ of Medina who would run the business as competitively as Freshways.
As government support is withdrawn, businesses are required to pay back elements of coronavirus support and as we move into a period of high inflation and likely recession, we'll see many of them come under increasing financial pressure. As they try to survive, they may well look to government for further assistance.
However, the new Subsidy Control Act (2022) limits the support that can be given to firms in financial distress – see sections 19-26 – and, in any case, the number of competing demands on already stretched government finance makes receiving government support increasingly unlikely. Merger and acquisition may well be one way in which businesses look to survive these turbulent times.
Typically, an acquisition by a competitor can be tough, and competition authorities across the globe are taking increasingly strict stances on horizontal (and non-horizontal) mergers as industries become more and more consolidated. Horizontal mergers can raise concerns of unilateral effects, whereby competition between merging firms may be eliminated as a result of the transaction, with the merged entity potential holding significant market power as a combined business. This can lead to an increase in prices, and a reduction in consumer welfare.
More recently, new theories of harm have begun to emerge in merger control, with so-called ‘dynamic competition’ concerns becoming more commonplace – this is where competition authorities consider that innovation might be reduced as a result of a transaction, leading to a reduction in future consumer choice. Even vertical transactions are attracting more scrutiny, which have historically been considered as competitively-benign, with greater focus being placed on potential foreclosure of competitors. However, the failing firm defence introduces a new dimension and may allow mergers to proceed which would otherwise have been blocked due to competition concerns.
The failing firm defence is a three-limb test. The merging entities need to persuade the CMA, or other competition authorities, on all three counts that:
1 the target firm will exit the market absent the merger
2 there are no alternative transactions that would result in less harmful effects on competition
3 allowing the firm to exit is more harmful to consumers than the contemplated (or completed) merger.
These are difficult questions to answer since they require the consideration of a merger counterfactual against a counterfactual of the firm exiting the market, in the context of uncertain economic conditions.
Claims of financial distress that would lead to a firm's inevitable exit need to be supported by strong evidence – for example, internal documents, board minutes, financial statements, business plans, withdrawal of credit, tightening of credit conditions, etc. The CMA will want assurance that the firm has explored other options to remain in operation. For example, has it:
Furthermore, the UK government introduced changes to insolvency law aimed at providing firms in financial distress with additional time to explore options for rescue. The CMA will also want to know if this time was fully utilised.
The CMA will also likely want to see expert opinions substantiating the likely failure and exit of the firm in question and the inability to turn it around. For example, this could include third-party opinions (legal and financial) on insolvency, to determine whether the firm would have exited without the transaction. This can also include evidence submitted by monitoring trustees (if in place), as was the case in the Medina/Freshways successful failing firm defence.
Indeed, the competition authority is unlikely to presume that a firm will fail on the basis of the difficulties posed by a recession alone. The burden of proof lies on the ‘failing’ firm.
The CMA will want assurance that a less anti-competitive transaction is not possible. For example, is there a smaller competitor who may be in a position to acquire the failing firm? Or, could the piecemeal acquisition of the firm’s assets by other market participants bring a better outcome (for example, a failing airline’s aircrafts, airport slots, etc.).
The possibility of alternative transactions that may have a lesser impact on competition could be determined quantitatively by an examination of market shares for the relevant product and geographic markets. The argument could be expanded through surveys, the estimation of diversion ratios, and a comparison of the Gross Upward Pricing Pressure Indices (GUPPIs) between prospective acquirers.
In the current market environment, many firms are cash-stripped and more risk-averse, potentially leaving fewer alternative buyers for a failing firm (or its assets). In addition, access to finance is increasingly restricted. While the current market conditions are conducive to arguing that there are fewer plausible alternatives to a given merger, there is more uncertainty going forward. It's harder to assess the likelihood of alternative buyers emerging in the future (should the firm’s exit not be imminent) as the current inflation rates and impending recession are driven, at least in part, by global factors, which are difficult to forecast.
In its Amazon/Deliveroo provisional findings, the CMA attempts to show that broad-brush arguments about the impact of coronavirus on financial markets are unlikely to pass this second test. The competition authority argues that its conclusion that an exit of Deliveroo would be the most likely outcome absent the Amazon transaction rests on “the particular structure of Deliveroo’s business and its need for external funding, the effects of coronavirus, and the particular point in Deliveroo’s funding cycle that coronavirus occurred."
The final test in a failing firm defence is the one that's most complicated by the pandemic and the forecast recession. Competition authorities will have to contend with the fact that current market conditions are drastically different from pre-pandemic circumstances and it's not clear how particular sectors will recover from, and what the impact of any recession will be on the recovery profile.
There's a high likelihood that coronavirus will have lead to structural changes in consumer behaviour and market structure in the long term. For example, there's evidence that workers are continuing to work from home, to use leisure and entertainment facilities closer to where they live rather than near to work and to vacation in the UK (albeit with European travel now on the rise).
While the long-term repercussions of exit are complicated by the potential for strategic response from competitors, the short-term transitory impacts on price quality, range, and service can be more readily quantified. Analysis of the level of harm caused by exit can include increases in local and national market concentration, increases in travel time for bricks and mortar activities and decreases in geographic coverage for service provision in markets where such considerations are relevant.
A key part of merger control is the use of surveys to estimate diversion ratios and ultimately the GUPPI. These surveys ask consumers to consider what they would do in hypothetical scenarios, one of these scenarios could be the exit of the firm which could be informative as to the impact of exit relative to merger.
It's possible that a firm's dissolution can be more detrimental to competition than if the transaction were to go ahead, for example, if the demand from the failing firm spilled over to another, already-dominant one in the market. In this case, the merger may improve competitiveness – these tools are useful to demonstrating this impact.
As any 'rescue mergers' will have permanent effects on the competitive landscape, it's necessary to consider the medium- to long-term view, as well as the ability of the market to scale capacity in response to demand changes, including through entry and exit.
For example, consider two airlines operating from a single airport (airport A) with one airline at risk of failure. While a failing airline may cause harm in the short term – as travellers unexpectedly have to cancel trips, be repatriated or to rebook at higher prices reflecting a lessening of competition, it may be possible for another airline to scale up its capacity even if it were at a different airport (airport B).
In which case, the CMA would need to consider whether a scale up of capacity at Airport A would be considered a reasonable substitute for the lost routes at Airport B and how the consumer harm and benefits from “competition” from Airport A (and the constraints it places on the remaining airline at Airport A) compare to those from a merger of the two airlines at Airport A.
Balancing harm and benefit across both scenarios not only requires understanding customer behaviour and preferences, companies' response mechanisms, and how a recession impacts the industry and how it may be expected to recover from coronavirus, or a recession. If it's judged that demand levels will be permanently depressed, it's possible that companies might not be able to operate above minimum efficient scale, and a merger will not lead to detrimental effects.
If, however, demand is likely to recover at a future point, prohibiting the merger might be the preferred course of action if the failing firm's physical assets can easily transfer to potential new competitors at a later point in time.
The CMA underscored the importance of the ability of the market to quickly alter levels of productive capacity in its assessment of the Deliveroo/Amazon transaction: a key line of analysis concerned the substantial time it would take for Amazon (or other potential competitors) to establish a point-to-point delivery network, equivalent to Deliveroo. This feature of the online delivery market makes it more likely that competition will be restricted for a significant period of time following an exit of Deliveroo and a recovery of demand levels.
In some cases the firm may already have failed and, instead of merging in the traditional sense, the corporate may be seeking to acquire the assets from an insolvent business. In this case: (i) does merger control still apply in this context; and (ii) can the failing firm defence be utilised?
With regards to the deal being the subject of merger control, the acquisition of assets from an insolvent business may still be subject to competition clearance, as demonstrated in the 2016 Supreme Court judgement in the Eurotunnel-SeaFrance merger enquiry. Eurotunnel acquired the assets of SeaFrance in 2012, two years after it had entered into administration and almost half a year after it had entered into liquidation. The Competition Commission (now the CMA) found that the transaction would lead to a substantial lessening of competition between the Channel Tunnel and cross-Channel ferry services, and therefore imposed remedies on the transaction.
The decision was appealed by Eurotunnel, who argued that it had not acquired an ‘enterprise’ as a going concern but only the ‘assets,’ which it had used to create a business.
The Supreme Court ultimately ruled that UK merger control is not restricted to the acquisition of businesses as a going concern, and a business ‘enterprise’ would exist as long as the business “if the capacity to perform [the relevant] activities as part of the same business subsists”. The court set out two tests to determining ‘economic continuity’ ie, whether the transaction constitutes the acquisition of an enterprise (as opposed to simply assets):
In the event that these two tests are met, then the acquisition of already-insolvent firms may attract merger control scrutiny.
In relation to the failing firm defence, clearly the first test is already passed as the firm has become insolvent. However, the second test (alternative transaction) and third test (cost-versus benefit) would need to be satisfied for the defence to hold.
This high evidential bar means that the ‘failing firm’ defence has historically been a difficult argument to present by merging parties. Coronavirus increased merging parties' reliance on this argument – to both reduce the scope of remedies imposed and also lessen the degree to which enforcement orders restrict business-as-usual activities – and this trend may continue as we face a deepening economic crisis.
While a recession might make it easier to show financial distress and a lack of alternative financing, a potential recession coming so soon after the pandemic adds an additional layer of complexity when it comes to assessing impacts on competition and consumer welfare of different counterfactual scenarios in the medium and longer term.
Successfully running a failing defence argument requires expert analysis from restructuring, transaction and economic experts to demonstrate that the firm cannot be turned around absent the merger, to test the market for alternative transactions, and undertake a cost-benefit assessment.
You can receive independent diligence on business plans, alternative financial and operational arrangements, undertake market testing exercises, and robust counterfactuals using quantitative economic techniques from our experienced advisors.