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Brief Counsel

The Commerce Commission – not as unpredictable as you might think

09 November 2015

​The Commerce Commission has blocked some 22 mergers since the current law came in effect in 2001.  We draw some trends from the Commission’s track record to date, then look in detail at three recent “no” decisions.

Pointers to the Commission’s decision-making

3:2 mergers are a hard sell 

The Commission will resist transactions which reduce the number of market participants from three to two (3:2).  Occasionally it will clear these deals1, but its starting point is that 3:2 mergers are “a priori likely to reduce levels of rivalry to the detriment of customers”. 

The Commission frets about tacit collusion particularly in markets characterised by price and cost transparency, homogenous products, stable or inelastic demand and barriers to entry.  Faced with those conditions firms can be tempted to share market power and co-ordinate behaviour and prices short of forming a cartel.2  The Commission is more likely to clear a 3:2 deal where the market at issue is technology driven.  Or where, say, regulation provides an ultimate constraint.3 

But the key lesson is that anyone seeking approval for a 3:2 merger will need excellent evidence of likely future constraints, and some useful advocacy close at hand.

The Commission isn’t bound by its previous determinations

The Commission’s clearance determinations (available here) can offer useful guidance on how the agency will examine a proposed consolidation in an industry it has looked at before.  But competition is a dynamic proposition and markets evolve over time.  So the Commission is not bound by its previous determinations, and will sometimes depart radically from a market definition it has applied in the past – as occurred in Connor Healthcare Ltd and Acurity Health Group [2014] NZCC.  There the Commission re-characterised the relevant market to highlight its theoretical concerns about the proposed 3:2 consolidation in the Wellington private hospital sector. Connor emphasises that clearance applicants cannot take previous Commission decisions for granted. 

Applicants carry the onus of proof; and good evidence is critical

Some clearance applications are long on conjecture and light on primary material from the market.  But that detail is vital.  It is, after all, the applicant which carries the onus of “satisfying” the Commerce Commission that its proposed merger will not substantially lessen competition in its market under s66(3)(a) of the Commerce Act. 

Countervailing power is not an all-singing, all-dancing constraint

“Countervailing power” is the idea that a firm is constrained by the risk that its buyers will punish any price hike or slip in service.  These arguments will seldom assist a clearance applicant where the merged entity will face limited, if any, immediate future rivalry as demand-side market power can only discipline a seller where the buyer can credibly threaten to switch to another provider.

That was not possible in two of the three recently blocked deals.

  • In Hamilton Radiology Ltd and Medimaging Ltd [2013] NZCC 7, post-merger, there would have been nowhere else to go for health insurers buying CT scans or MRI treatments in the Waikato. 
  • In Connor Healthcare Ltd and Acurity Health Group [2014] NZCC, the Commission was not convinced that Southern Cross Insurance could credibly threaten to move its work around in a market with two providers, not three. 

Merging parties usually overplay countervailing power.  Although firms often think, or at least like to say, that their buyers have them over a barrel, the truth can be quite different.  And buyers will usually tell the Commission’s investigators that they (the buyers) will be worse off in a market where they have one fewer source of supply. 

In the end, while countervailing power might be part of the story that clearance applicants tell the Commission, it will never be the whole story.  Countervailing power arguments were run and failed in all recently declined clearance applications. 

Any allegedly “failing firm” must be on death’s door

The applicants for clearance in two recently blocked deals, Hamilton Radiology Ltd (mentioned above) and Reckitt Benckiser Group Plc and Johnson and Johnson [2015] NZCC 12 both made half-hearted failing firm submissions.  Both failed.  In rare cases, a proposed consolidation will be competition neutral because the target firm is going out of business and is unattractive to a new entrant.  But the Commission will expect compelling evidence that the target is indeed on death’s door.  That evidence will include accounts, rescue attempts, restructuring proposals, exit plans and the like.  Conjecture alone from senior executives won’t cut it in Wellington.

Clearance may not be the best tactical option in marginal cases

The Commission can only grant clearance where it is “satisfied” that the transaction will not substantially lessen competition in any New Zealand market.  Where the Commission is in doubt over the merger’s likely effect, it cannot be “satisfied” and will decline clearance.  By contrast, the Commission carries the onus of proving damage to competition in any s47(1) enforcement action to the civil standard.  In those circumstances, some merging parties may think it worth ignoring the clearance option where they reckon that their merger is legal, but harbour concerns about whether they can rid the Commission of all doubt. 

Anyone contemplating this approach should have a draft clearance application in the bottom drawer in case the Commission takes an interest in the matter.  Parties cannot retrospectively seek clearance.  But a draft application will contain the data and competition analysis a merged entity will need to try and placate any Commerce Commission concerns about the transaction.   

The Commission can “call in” consummated mergers

Merging firms which decide not to seek clearance must be mindful that the Commission keeps an eye on the markets.  If the Commerce Commission spies a dubious transaction, or receives complaints about a merger, it will make a “please explain” call to the CEO of the merged entity.  That firm will need sturdy competition analysis close at hand.  With any luck, that analysis will meet the Commission’s concerns.  If not, the Commission could open an investigation into whether the merger breached s47(1) of the Commerce Act.  We’ve seen that happen recently. 

Three recent “no” decisions

Hamilton Radiology Ltd and Medimaging Ltd [2013] NZCC 7

This application involved the proposed consolidation of radiology service providers in the Waikato region. 

Radiologists are specialist doctors who interpret x-rays and ultra sound results.  Some of them can also analyse images produced by computed tomography (CT) and magnetic resonance imaging (MRI) to diagnose and treat disease.  X-ray and ultrasound are regarded as “low-tech” radiology.  They involve procedures which can be performed by all qualified radiologists, using standard equipment.  By contrast, CT and MRI scans require highly-trained specialists and multi-million dollar kit. 

In those circumstances the Commission saw separate markets for “low-tech” and “high-tech” radiology services.  It decided that the low-tech market was Hamilton-wide; while the high-tech market included the entire Waikato region as people would travel from small towns into Hamilton but not, it seems, to Auckland or Rotorua, for a CT or MRI scan.

The decision focused on two radiology groups:  Hamilton Radiology and Midland Radiology.  The Commission considered these groups to be “associated persons” under s47(2) of the Commerce Act as they had extensive cross-shareholdings and shared management.  In any event, the two outfits wanted to fold their existing operations into a new joint venture vehicle, Medimaging Radiology Limited.  The idea was that their new JV would then acquire the MRI and low-tech assets from another company, called Medimaging Limited.

The Commission held that “entry and expansion are likely to be straight forward in the Hamilton low-tech services market”.  It based that view on the facts that:

  • the two other participants were themselves relatively new entrants
  • capital equipment cost ($200,000-$300,000) was low relative to revenue, and
  • it wasn’t necessary to have a qualified radiologist on site at all times – scans could be read and reported remotely, presumably using locum resource where required. 

The Commission saw existing competition and the ACC’s countervailing power as significant constraints which meant that the JV “would not likely have the market power to unilaterally increase prices in the Hamilton low tech market”.  So no likely SLC, and hence no trouble with clearance on the low-tech front. 

But the high-tech market was a very different story.  In the factual – the future with the merger – the proposed JV was poised to be the only provider of MRI services in the Waikato.  To be sure, it is exceedingly hard to win clearance for a 2:1 merger.  In 2:1 cases, clearance applicants only really have “potential competition”, “countervailing market power”, and “failing firm” submissions to work with.  The Commission’s determination is heavily redacted, but it seems the applicants reached for all three. 

The applicants contended that entry conditions were manageable.  Now when it comes to possible new entry, the Commission must be satisfied that potential competition is, in fact, likely to emerge on a sufficient scale within a two year horizon.  The Commission was unconvinced by the applicants’ “optimism” that their JV would face future rivalry.  The Commission noted that entry involved:

  • high capital cost, with some sunk investment
  • access to DHB-funded work, which effectively required radiologists with consulting positions at the Waikato DHB
  • radiologists able to provide “high-tech” services in a world where radiologists are in short supply, and
  • strong relationships with specialists who refer patients for MRI scans.

The Commission saw those conditions telling against new entry any time soon. 

The Commission also made short work of the applicants’ contention that their JV would be constrained by the countervailing power of its customers:  the ACC, private insurance companies and privately funded patients.  The fundamental trouble with the countervailing power argument was that, in the factual, buyers could not discipline the proposed JV as they couldn’t credibly threaten to take their work elsewhere: there was nowhere else to go.  The Commission found no evidence that Southern Cross, by far the country’s biggest insurer, could either sponsor new entry or discipline the proposed merged entity by applying pressure in some other market. 

The applicants also apparently suggested that the proposed deal was competition neutral because the radiologist who owned the Medimaging assets was set to leave the market.  The Commission redacted its discussion on that point in its determination.  But the Commissioners disagreed.  That result underscores the need for compelling evidence that exit is inevitable for any “failing-firm”-style argument to carry weight on a clearance application.  On that score, see Decision 650:  Southern Cross Health Trust/Aorangi Hospital, which was a proposed 2:1 merger in the health sector that turned (against the applicants) on a failing firm argument.  The Commission did, however, give these two firms authorisation to merge some three years later in Decision 729. 

Connor Healthcare Ltd and Acurity Health Group [2014] NZCC4

This application (Connor) involved a proposed 3:2 consolidation of private hospitals in the Wellington region.  The deal would have combined Wakefield and Bowen Hospitals with Boulcott Hospital in Lower Hutt.  Those three hospitals would have competed with Southern Cross Hospitals’ significant Wellington private facility. 

The Commission’s previous decisions may have given the merging parties some confidence heading into the application.  In Decision 492, for example, the Commission cleared the acquisition of Bowen Hospital by the owners of Wakefield Hospital.  In doing so, the Commission summarised its analysis at paragraph [196] in this way:

“The Commission has made the following conclusions:

  • existing competition is sufficient to prevent the merged entity exercising unilateral market power

  • the potential for co-ordinated market power is low

  • barriers to entry are low and entry is likely if the merged entity attempted to exercise market power, and

  • the countervailing power of funders and insurance companies will provide an additional constraint on the behaviours of the merged entity.”

In Connor, the proposed deal would have reduced existing rivalry by taking Boulcott out of play.  But the three other factors remained equally in force.  In fact, countervailing power had probably increased via Southern Cross’ Affiliated Providers’ Scheme which sees the powerful insurer contract with hospitals for a bundled price which covers hospital, surgeon and anaesthetists’ fees. 

Furthermore, in Decision 492, the Commission defined the relevant market as being one for the provision of hospital facilities and related non-specialist services for elective secondary surgery for private patients.  That market definition was consistent with the Commission’s approach in other health-sector clearance and authorisation applications.  However, in Connor, the Commission adopted a completely new approach.  It chose to test the proposed acquisition against individual procedures in some 11 medical specialities broken down further by funding source:

  • patients funded by the ACC wider than the Wellington region
  • patients funded by a DHB in the Wellington region
  • patients funded by health insurance companies in the Wellington region, and
  • self-funded patients in the Wellington region.

The Commission felt these myriad narrow markets made sense because patients require, and seek funding for, particular operations:  heart surgery just won’t do it when you require a wisdom tooth extraction. 

By contrast, from a valid supply-side perspective, the applicants thought the Commission’s new analytical framework was sub-optimal.  The applicants believed that they were selling private hospital services and competing for surgeons who might wish to use their facilities to perform various procedures largely funded by Southern Cross and a couple of smaller private insurers. 

However, in the result, when the Commission dissected the market by surgical procedure, the applicants had a combined leading share in several of the 11 areas. 

That left the Commission and the applicant focussed on surgeon mobility.  Surgeons largely decide where a patient receives his or her operation.  They do that through their individual reputations, insurer and GP relationships.  The applicant observed that surgeons can and do switch between private hospitals for rational reasons, with many operating at two or more locations.  For its part, however, the Commission preferred anecdotal evidence that surgeons get comfortable at a particular hospital and are unwilling to work elsewhere for reasons of convenience and trust in equipment and support services. 

The Commission understandably emphasised that attracting surgeons was a crucial ingredient in entry/expansion analysis.  But it probably applied an incorrect economic framework.  While the individual surgeon does not pay the private hospital charge which is passed on to the patient, his or her service and the private hospital input are complements.  It follows that surgeons have a keen incentive to keep prices for the hospital input low because that in turn boosts demand for their services. 

A price increase by a hospital would reduce demand for the surgeon’s services performed at that hospital.  That will be particularly the case for self-funded patients where, in Connor, the Commission cited evidence of relative price sensitivity.  But the Commission overlooked economic reality.  Instead, at paragraph [278] of Connor, the Commission noted, for example, that Southern Cross Hospital “has faced difficulties in attracting surgeons”.  But again, that seems like it was the wrong approach.  The key question was whether surgeons would switch in response to the exercise of market power by the merged entity: that analysis is forward-looking rather than historical.  And in looking at whether surgeons would switch, the Commission ought to have considered the complementarity of hospital charges and surgical services.  But it didn’t.

At the heart of the Commission’s concerns in Conner was that 3:2 mergers are, in the Commission’s words, “a priori likely to reduce levels of rivalry to the detriment of customers”.  To that end, the Commission highlighted in Connor the Court of Appeal’s endorsement of that general proposition in Commerce Commission v Woolworths [2008] NZCA 276 at [187], [189], [200].

For balance, though, it is worth observing that clearance application analysis should be “horses for courses”.  Grocery markets, for instance, have an atomised demand side where individual buyers are poorly placed to constrain one or other supermarket behemoth.  By contrast, there are powerful buyers of hospital services in Wellington and throughout the country.  In Decision 729, for example, the Commission found that Southern Cross Insurance (SXI) and the ACC have sufficient countervailing power to protect themselves from hospital price rises.  By contrast, in the Connor determination, the Commission drew a line between ACC and SXI finding that the former had sufficient power to look after itself while the latter did not.  The Commission based that view on the fact that, inter alia, the ACC can shift patients outside Wellington to insulate itself against increasing hospital charges.  In Connor the evidence seems to have been that SXI has done the same:  paragraph [137].  The Commission downplayed that example by contending that SXI had not generally adopted the same approach in competitive private hospital markets.  But that static analysis rather missed the point: the issue was not whether SXI had done the same thing in Wellington or elsewhere; the issue is whether it could do the same thing should the proposed merged entity raise its prices.  However on this issue, as on other issues, the applicant found itself in the Commission’s “not satisfied” (or “not considered”) grey zone, thus failing to win clearance.  Connor quickly appealed to High Court but abandoned that appeal before the substantive hearing. 

To be sure, clearance is only available where the Commission is “satisfied” that there will be no SLC in any New Zealand markets.  The Commission is entitled to be doubtful and thus decline clearance.  Connor, though, must have been a line call.

Reckitt Benckiser Group Plc and Johnson and Johnson [2015] NZCC 12

In this matter the applicant, Reckitt Benckiser, sought clearance to buy the K-Y brand and product assets from its global rival, Johnson and Johnson.  By the time the application was declined in New Zealand it had been cleared everywhere except the United Kingdom, which subsequently approved the deal subject to a behavioural commitment designed to alleviate competition concerns.

K-Y is a well-known global brand of personal lubricant “used for intimacy enhancement and sexual activity”.  Reckitt Benckiser owns the Durex brand range of lubricants.  The only other market participants were: Ansell, which describes itself as “a global leader in protection solutions”; and two local manufactures, Geneva Marketing and FlowMotion, who make organic lubricants.  While all market shares are redacted, K-Y and Durex are by far the leading brands in New Zealand. 

The applicant contended that, in the counterfactual – the future without the merger – the K-Y brand would leave the market.  Now we saw that sort of contention in Hamilton Radiology Ltd and Medimaging Ltd [2013] NZCC 7, discussed above.  Where accepted, the submission emphasises that the proposed deal should be cleared on the basis that it is competition neutral.  As in Hamilton Radiology, the contention failed here too.  The Commission considered that there would be a “real chance” that K-Y brand would continue to be sold locally in the counterfactual, either by J&J or a third party.  And with that potential outcome being a “real likelihood”, it became one of the counterfactuals the proposed acquisition had to be tested against:  Woolworths & Ors v Commerce Commission (2008) NZBLC 102,128 (HC) at [122]. 

The Commission decided that the relevant markets were for the wholesale supply of personal lubricant to supermarkets and (separately) to pharmacies.  The applicant argued that supermarkets and pharmacies constrain each other.  The Commission wasn’t convinced, citing convenience as the main reason consumers visit one channel or the other.  The Commission noted for completeness, though, that whether it was one market or two, its analysis and the result would remain the same.

By the same token, the Commission was not convinced that entry or expansion was particularly likely either.  The Commission could not get past the significant equity in the K-Y and Durex trade marks and consumer loyalty to these brands.  In the Commission’s view, brand loyalty creates asymmetry between the leading incumbents and other suppliers seeking to enter or expand.  Put simply, intellectual property was a formidable barrier to entry. 

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Footnotes

1   It did so in, for example, Vector/Arc Innovations [2014] NZCC 36. 

2   The Court of Appeal overturned the High Court and validated the Commission’s long-standing concerns over 
 
     3:2 mergers in Commerce Commission v Woolworths (2008) 12 TCLR 194 (CA) at [200].

3   As it did in, for example, Sky City Entertainment Group and Otago Casinos Limited [2013] NZCC 11.

4   Disclosure: the author was partly involved in this matter, although not in the declined clearance application.  

 

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