For businesses in financial difficulty a prompt sale to a competitor is often the best way forward, allowing the business to exit the market and recover some of its losses in the process. In such circumstances, the merger parties may need to rely upon the ‘failing firm’ argument to avoid falling foul of the Commerce Act.
Essentially the argument is that, absent the merger, the target firm and its assets will exit the market anyway and therefore the merger cannot be said to be the cause of a substantial lessening of competition.
In the year of financial downturn, the Commerce Commission issued guidelines outlining the types of information it is likely to require, and the methodology it will use, in assessing a ‘failing firm’ argument. The Guidelines will be useful in preparing clearance applications and in determining whether clearance needs to be sought at all (i.e. where a potential applicant has sufficient evidence that the firm is ‘failing’ then a clearance application may not be necessary).
The Commerce Commission Guidelines
The Guidelines state that the Commission will consider whether:
the business is likely to fail, and
there is an alternative third party purchaser whose acquisition of the firm’s assets would not lead to a substantial lessening of competition, and
the firm’s assets would otherwise exit the market.
The Commission will take into account whether there is a trend of negative cash flows, whether there is any prospect of restructuring or refinancing the business and whether reasonable efforts have been made to find a third party purchaser.
Given the likely urgent nature of a ‘failing firm’ situation the Guidelines recognise that a quick decision may be necessary. In this regard, the Guidelines state that “the Commission would be assisted in making its assessment quickly if relevant, complete and robust information is provided when a failing firm argument is made”.
The Guidelines set out a range of supporting evidence that will be helpful. Of particular importance will be any internal documents such as board minutes, budgets, forecasts and strategic plans relating to the future of the business, its continued viability and the possibility of any restructure or refinancing arrangement. Evidence of bona fide efforts to sell the business as a going concern or its assets on closure and any offers received will also be useful.
How far do you have to go to establish the ‘failing firm’ argument?
While the Guidelines provide further clarity as to the process and type of information the Commission is likely to require, there is still some uncertainty regarding exactly how far an applicant will need to go to establish the ‘failing firm’ argument.
A comparison of the two most recent Commerce Commission decisions involving the ‘failing firm’ argument (one successful, one not) provides a guide to what will be required from a successful applicant.
Decision One was an unsuccessful application by Southern Cross Health Trust to form a joint venture with Aorangi Hospital Limited in respect of its Palmerston North hospital. The applicant argued that one of the hospitals, most likely Southern Cross, would close and exit the market as it could not sustain current levels of economic loss.
However, the Commission commented on Southern Cross’s inability to provide any written material evidencing that the Board had addressed a closure scenario, saying:
“The Commission would have expected the closure option to have at least been discussed in confidential sessions of the Board, if closure was imminent.”
Also recent capital investments in the hospital, a variable history of profits and losses and the fact that there was no evidence that Southern Cross had fully investigated sale of the Palmerston North Hospital as an alternative to a joint venture or closure meant that the Commission was unable to conclude that Southern Cross’s Palmerston North Hospital was actually failing.
The Commission further noted that the lack of any attempt by Southern Cross to raise prices indicated that it did not appear to have exhausted all of the options available to increase its revenue.
Decision Two was the successful application by Fletcher Building Limited to acquire the Auckland and Whangarei masonry divisions of Stevenson Group Limited. The Commission found that:
“Stevenson was experiencing sustained and substantial losses in respect of its masonry business, despite efforts having been made to turn the business around. Stevenson’s Board of Directors made a formal decision to exit on 23 September 2008 (either by sale or closure).”
Stevenson was able to produce board minutes evidencing the decision to close its masonry business absent a sale to Fletchers. Stevenson had also taken a number of steps to commence the exit process including rationalising stock, meeting with employees and communicating its decision to customers.
Stevenson was also able to show that it had made bona fide attempts to sell the business, including a history of bids that were not successful (or would be unlikely to offer more than Stevenson would realise through closure) and that no bids had been received for the assets of the business. The Commission recognised that expressions of interest would not be enough to establish the existence of an alternative purchaser and that a firm offer would need to be established within the necessary timeframe.
These examples show that the critical elements which will need to be demonstrated to the Commission are:
that closure has been considered and is a real prospect given the firm’s financial predicament as evidenced in board papers or elsewhere, and
that the firm has attempted to find a third party purchaser.
Failing division arguments
To establish that a division of a firm is failing the Commission is likely to require additional information. This may include intra-corporate cost allocations, any contribution of the division to group overheads and any management fees charged to the division. The Commission notes that:
“Such cases require particular care because of the ability of the parent firm to allocate some costs, revenues and intra-company transactions between its subsidiaries, branches and divisions.”
In the Southern Cross case, the Commission noted that there may also be strategic reasons for continuing a particular division. The Commission considered that Southern Cross may be prepared to sustain some losses to maintain its nationwide presence and brand reputation (although it acknowledged that there would be a limit to this). The Commission concluded that:
“When assessed as a division of the Southern Cross Health Trust, and excluding network service charges, the operating revenues do not appear to be at a level that would indicate that its exit was necessarily inevitable.”
In the Stevenson decision, by contrast, the Commission acknowledged that in the current economic climate it was not feasible to continue to absorb the masonry division losses given that there was no strategic reason to continue operating.
Overseas regulators have also taken a stringent approach in assessing ‘failing firm’ arguments, requiring sufficient evidence of the requisite factual background before accepting that the argument applies.
In December 2008, the United Kingdom’s Office of Fair Trading issued a restatement of its position regarding failing firm arguments, noting its requirement for:
“...compelling evidence where merging parties present arguments on a counterfactual other than the prevailing conditions of competition (including ‘failing firm’ claims).”
Closer to home, the ACCC recently accepted a ‘failing firm’ argument in the context of a liquidation - finding that, on the evidence, it was satisfied that the business was in imminent danger of failure and that after a lengthy and unsuccessful sales process there was no alternative purchaser that would lead to a better outcome for competition.
How/when is the ‘failing firm’ argument likely to be useful?
The Guidelines, and the Commission decisions discussed above, indicate that failing firm applications will be closely scrutinised and will require compelling evidence (which may not always exist if events have unfolded quickly). Accordingly, they are only likely to succeed in relatively limited circumstances.
But the timing of the Guidelines suggests that the Commission expects the deployment of the failing firm argument to increase over the next 12 months as firms that are continuing to struggle due to the economic downturn look to exit the market.
Scenarios where it could be usefully deployed include:
where liquidators are conducting a short sale process in order to meet creditor demands (given that the firm is in liquidation, it should be easy to establish that it is failing), and
where, due to the global financial crisis, potential purchasers are unable to raise finance for acquisitions or face high financing costs. In such circumstances, existing competitors looking to generate efficiencies or increase capacity will probably be the most likely purchasers.
To succeed with a ‘failing firm’ argument, an applicant will need to show that the failing firm’s financial difficulties are fundamental rather than the result of a temporary lack of cash flow.
‘Flailing’ firm (as distinct from “failing” firm) arguments can be used to establish that the target firm will no longer be a significant competitor in the future and that historical market share figures are no longer relevant. The logic here is that although the business may continue to operate, it will no longer impose a competitive constraint. The ACCC in considering the purchase of Bank West by Commonwealth Bank of Australia acknowledged that:
“Given a counterfactual under which BankWest will continue to operate as an independent player but will no longer be the competitive force it once was, the ACCC considered the proposed acquisition was unlikely to substantially lessen competition… the ACCC found that it was unlikely that the acquisition of such a small competitor, no longer offering market leading prices, would substantially lessen competition.”
Accordingly, factors relevant in establishing a failing firm argument will be applicable, and useful, when undertaking a normal competitive assessment.
Overall the key will be determining the level of evidence that is available and, in the clearance application context, whether this is likely to be sufficient to meet the Commission’s requirements. If so, it is much more likely that an applicant will receive a quick decision. The Guidelines will assist in making this determination.