Kyriakos Fountoukakos, Craig Pouncey

Herbert Smith LLP

Mergers in Times of Crisis: 'Business as Usual'?

Throughout the period since the credit crunch intensified in September 2008, the European Commission has said that competition rules continue to apply and that they are 'part of the solution, rather than the problem'.¹ An extraordinary amount of activity has taken place in the investigation and authorisation of state aid during this time, with attendant European Commission guidance specifically produced to address such measures,² but the impact on merger control has also been felt, not least in the overall drop of M&A activity taking place. However, Commissioner Neelie Kroes has insisted that 'it is business as usual in merger control - for all our sakes.'³

This article looks at whether the changed economic circumstances have nonetheless resulted in more flexibility in the application of the merger control rules in the EC, specifically looking at the substantive test that is applied to the assessment of mergers. We also investigate the scope for the economic climate to impact on aspects of the assessment such as the counterfactual, efficiencies and remedies. Finally, we look at the assessment of the economic entity to which a state-owned business belongs, something that may well need to be undertaken more frequently as a result of government interventions to deal with the financial crisis.

The substantive test for mergers

Under the EC Merger Regulation⁴ (ECMR), the European Commission (the Commission) applies a test that is purely based on competition in its assessment of mergers falling within its competence. The achievement of additional objectives such as financial stability, prevention of job losses or other aims that have received increased focus during the credit crunch are therefore not obviously relevant to the Commission's assessment.

Under article 2(3) of the ECMR, '[a] concentration which would significantly impede effective competition, in the common market or in a substantial part of it, in particular as a result of the creation or strengthening of a dominant position, shall be declared incompatible with the common market'. By contrast, a concentration that would not significantly impede effective competition must be cleared, under article 2(2).

While the Commission is required to place its competition appraisal of the concentration 'within the general framework of the achievement of the fundamental objectives referred to in Article 2 of the [EC Treaty] and Article 2 of the Treaty on European Union',⁵ this exhortation is found in the recitals to the ECMR and cannot override the clear meaning of articles 2(2) and 2(3) under which clearance or prohibition is based purely on the competition assessment.

Furthermore, while under article 2(1) of the ECMR the Commission must take certain factors into account when making its appraisal of whether the merger is compatible with the common market, such as the development of technical and economic progress, this factor is only to be taken into account 'provided it is to consumers' advantage and does not form an obstacle to competition'.

Thus the Commission is required to undertake its appraisal based on competition issues, and other concerns would not be able to 'trump' the assessment made on competition grounds.

Moreover, while the Commission is ultimately a political body, it has proved resilient to political lobbying in the past.⁶

By contrast, some member states operate merger control regimes that allow for a wider 'public interest' assessment to be made. For example, where mergers are assessed by the UK competition authorities (rather than the Commission),⁷ in the ordinary course of events that assessment is also made on competition grounds alone. However, there are residual powers for the government to intervene in mergers on certain public interest grounds, either those grounds that have been set out in the relevant legislation or any ground which the government considers should be specified (and which are then subsequently enacted).⁸

On this basis, in autumn 2008 the UK government introduced a new public interest ground ('the stability of the UK financial system') and cleared the acquisition of HBOS plc by Lloyds TSB after a Phase I review. Although the UK's Office of Fair Trading (OFT) found there to be significant prima facie competition concerns which would have justified an in-depth Phase II investigation, the government felt able to clear the transaction in any event, based on a balancing of that public interest against the competition grounds. This was done using the existing statutory regime, but proved highly controversial.

Such an outcome would not have been possible had the review taken place at EU level. This is due to the Commission's lack of discretion in taking into account non-competition concerns in making its assessment of the merger, discussed above, and the fact that member states' ability to intervene in mergers that are subject to Commission review is confined to taking restrictive measures based on legitimate interests that have been recognised as such by the Commission, under article 21 ECMR (such as public security and media plurality). It does not appear that article 21 can be used to clear a merger that would otherwise be subject to prohibition on competition grounds.⁹

Thus, while the impact of the credit crunch has resulted in member states resorting to little-used national powers when dealing with potentially anti-competitive mergers, no such option is available at EU level, and indeed Philip Lowe (director general for competition) said that 'we see no need to adjust our existing rules' with regard to substantive assessment of mergers.¹⁰ Instead, the credit crunch has had a more nuanced impact in affecting the parameters in which the competition test is applied.

Counterfactual: failing firm?

A restriction or prohibition can only be placed on a merger where the merger is likely to cause harm to competition. The merger outcome is therefore compared with the most likely counterfactual scenario (generally the prevailing competitive conditions).¹¹ One form in which the counterfactual can be used to merging parties' advantage is the use of the 'failing firm defence',¹² which has, however, historically been very strictly applied by the Commission. In view of the challenging economic climate faced by all types of companies between 2008 and 2009, many have posited that the failing firm defence would be successfully invoked more frequently. By mid-2009, this had not proved to be the case, and the Commission has made it clear that the standard would not be relaxed simply in light of the crisis.

By contrast, the UK has actively addressed the potential role that the financial crisis might play in the assessment of the counterfactual, in particular the failing firm defence, by restating its guidance on use of the defence.¹³ The restatement does not represent a relaxation of the principles but provides helpful guidance on how the particular economic circumstances might cause the conditions to be met. For example, the requirement that the target business inevitably exit the market might be a result of cash flow difficulties or an inability to raise finance in the current climate. Furthermore, the OFT expressed willingness to provide informal guidance on individual cases, which was welcomed.

The OFT applied the failing firm defence to clear the acquisition by HMV of 15 stores belonging to its direct competitor, the Zavvi entertainment retail chain, which had entered into administration in December 2008.¹⁴ The OFT appeared to apply a modern approach to its analysis of the counterfactual in its decision, applying the principles set out in its guidance on the use of the defence perhaps less sceptically than the Commission might have done. For example, the OFT considered in some detail whether the exit of the stores in question was inevitable in the absence of the merger, with no serious prospect of reorganisation,¹⁵ and whether there was a realistic alternative purchaser, but devoted much less explanation to why it considered that closure of the relevant stores would not be a more competitive outcome for consumers than the merger.

Efficiencies

The Commission can clear a merger that brings about efficiencies (for example in the production process) that counteract any adverse effects on competition. Under the Commission's horizontal merger guidelines, it will only take account of efficiencies that benefit consumers, and which are merger-specific and verifiable.¹⁶ In view of the particularly severe impact which the financial crisis has had on some industries, such as car manufacturing, it may be that the benefit of efficiencies will carry greater weight in the Commission's assessment of the effect on competition than it might at other times. However, efficiencies will be taken into account in the Commission's overall assessment of the merger¹⁷ and, as explained above, the Commission has to base its conclusion as to the compatibility of a merger with the common market on competition grounds alone.

Remedies

A merger that could otherwise cause a significant impediment to competition may be authorised by the Commission if it is modified by way of commitments from the parties involved in a manner that resolves the competition concerns and makes it compatible with the common market.

The Commission's stated preference is for structural commitments, not least because they do not require ongoing monitoring.¹⁸ However, structural commitments, such as divestiture of a business, may prove more difficult to implement in the changed financial climate. For example, there may be fewer ready and suitable buyers due to restricted access to finance. The Commission may therefore wish to avoid the potential uncertainties by ensuring that a suitable buyer is identified up front, and that a binding agreement is entered into for the sale during the Commission's review process or prior to completion. Alternatively, the Commission may seek to make increased use of its 'crown jewels' option, under which a divestiture commitment concerning the parties' preferred divestment option is backed up by a commitment to sell a business that would be capable of being implemented quickly and create a viable competitor, in case the first commitment cannot be fulfilled within the prescribed period.

In addition, it is crucial for the Commission that the divestment consists of a viable business, so that it can compete effectively with the merged entity. However, assessing the future viability of a business may be more difficult where the economic outlook is uncertain and where the current climate is already challenging.

For example, in crisis-hit industries such as airlines, traditional remedies such as slot divestitures may more frequently face the requirement that an entrant to take up the slots be vetted and approved prior to completion of the merger (as was done, for example, in the OFT's acceptance of slot divestitures in lieu of referral to the Competition Commission (CC) for in-depth review in the acquisition of VLM by Air France KLM in 2008). This is because concerns caused by the practical experience of competition authorities finding that divested slots are sometimes not taken up by competitors or new entrants may be reinforced by the increasing financial pressures on airlines in the economic downturn.

Where a condition is breached (for example through failure to divest within a foreseen time-frame), the consequences can potentially be severe: the compatibility decision is no longer applicable, the Commission is able in specific circumstances to order the unwinding of the merger and the party could be subject to fines. It seems more likely, however, that the Commission would grant extensions to the timetable or perhaps modify the commitments given than make full use of its powers in the event of a breach, though it appears that there will be no softening in the substantive assessment of whether remedies are adequate to address competition concerns. At a press conference in July 2009 dealing with restructuring obligations on banks which have received substantial state aid in the current crisis, Philip Lowe referred to the potential for delays in implementation of divestiture remedies in a merger control scenario, though noted that this could lead to customers and staff draining away, and even suggested that behavioural remedies might be appropriate if no other solution could be found (though it appears his comments related specifically to banks). It would nonetheless seem unwise for parties to rely on such flexibility with regard to implementation on the part of the Commission. For example, the Commission would be highly unlikely to take a lenient view in circumstances where it believed the parties concerned had not taken all due efforts to implement the commitments. The prospect of a poor sale price in the current market would moreover be unlikely to suffice for modification of the commitments.

In the UK, there has been explicit discussion of the potential issues but no stated change in policy. The CC held a round table in March 2009 to discuss the role of competition policy in the current crisis. As acknowledged in a background paper for the event prepared by CC economics staff, the merged parties in completed mergers 'could face significant losses' as a consequence of complications with divestment remedies if potential buyers face difficulties in raising finance.¹⁹ The basic principles and analysis for remedies did not need to change, but needed to be applied flexibly. For example, the CC had to acknowledge that it might not be able to find an acceptable buyer and so it needed to have 'fallback' behavioural remedies, as was the case in the Stagecoach/Citylink joint venture in 2006.²⁰

Timing issues and article 7 derogations

Another aspect of the merger review process that has been discussed in the economic downturn relates to the timing requirements of that process. Philip Lowe has made it clear that the Commission needs enough time to assess mergers²¹ and there has certainly been no indication that the official 25-day period of Phase I review would be shortened for 'rescue' mergers. However, there may be more flexibility at member state level. As noted by CC economics staff, there may be opportunities to speed up the merger process: the OFT has, for example, said that it may be possible to accelerate the referral of media mergers where the parties are in agreement with this approach, so that referral takes place within 10 days.²² However, early referral (so that the CC can proceed to undertake an in-depth investigation earlier) is not the same thing as allowing clearance (a decision not to refer) on an accelerated basis.

The counterweight to the Commission's strict timetable for review is that there are provisions in the ECMR by which the Commission may grant derogations from the normal standstill provisions.²³ Such derogations were granted in six cases in 2008 (twice as many as in the previous year), and three were granted in the first half of 2009.²⁴ However, the conditions for such derogations are strict, and obtaining a derogation is particularly problematic in situations where the merger raises prima facie competition concerns.

State participation in undertakings

There have been other consequences of the financial crisis. For example, some governments have taken stakes in certain financial institutions in order to ensure their liquidity and thereby the stability of the wider financial system. Where such a stake gives the government sole control of the bank, which would not be the case for 'silent' participations or preference shares, it will fall to be reviewed by the Commission if the undertakings concerned meet the turnover test.

Where state-controlled undertakings are concerned, account has to be taken of the turnover of all the undertakings controlled that make up 'an economic unit with an independent power of decision, irrespective of the way in which their capital is held or of the rules of administrative supervision applicable to them.'²⁵ The assessment of the undertakings making up a single economic unit is often intricate, and in the scenario of a nationalisation complexities can be added in the layers of government management and supervision that may apply. The appraisal made of which undertakings fall to be considered as part of the same group could clearly also affect the competition assessment made, depending on the extent to which a more widely drawn group would include subsidiaries active in the same area. The Commission had cause to consider these issues in the context of the nationalisation of Germany's Hypo Real Estate Holding, though was in the event able to leave open whether the Federal Ministry of Finance or even the higher levels of the federal government would constitute the appropriate economic unit, as the turnover thresholds were triggered even on a more narrowly drawn basis and substantive issues would apparently not have arisen on any scenario.²⁶

State aid measures will also have a wider impact. For example, merger activity in the financial sector is expected to result not least from the fact that the Commission is imposing stringent restructuring requirements on the banking recipients of large-scale state aid, as seen in, for example, its Commerzbank decision in May 2009²⁷ and the guidelines on restructuring obligations for banks, published on 23 July 2009.²⁸ Divestments may be required as part of a bank's return to viability after accepting state aid or as measures to compensate for the distortions to competition arising from receipt of such aid, or both. This could contribute to an increase in merger activity generally: while merger activity in the second half of 2008 and first half of 2009 was down, there were widespread expectations that it would pick up again in the near future.²⁹

***

The Commission does not have the flexibility to clear anti-competitive mergers at EU-level on the basis of interests such as financial stability or retaining employment levels, but it appears not to have faced in the financial crisis a situation where such flexibility was called for or appeared desirable. Even the tools with which the Commission has argued it would be able to address any problems using the existing ECMR framework, such as the failing firm defence, appear to have been infrequently invoked. At member state level, political interference has been possible in some regimes, with the UK's public interest intervention regime allowing clearance in the Lloyds/HBOS merger. Nonetheless, the UK competition authorities have maintained an emphasis on the importance of free and undistorted competition in helping to ensure quicker recovery from the recession. Like the Commission, the UK authorities consider the existing system to be sufficiently flexible, even for crisis-hit industries such as the local and regional press,³⁰ to take into account changing circumstances, including the current economic climate.

In March 2009 Neelie Kroes stated that 'we think the Merger regulation will be able to handle anything thrown at it in 2009'.³¹ Halfway through 2009, it seemed fair to conclude that the system remained fundamentally intact but it did not yet seem to have been unduly tested by 'credit-crisis phenomena'. For the most part it certainly seemed to be 'business as usual'.

Notes

*

The authors acknowledge the assistance of Ingrid Bukovics (associate, Herbert Smith LLP) in the production of this article.

1.

See, for example, 'How can the EU contribute to a more prosperous future?', speech by Neelie Kroes at Chatham House Conference, 26 June 2009.

2.

See the following Commission Communications: 'The application of State aid rules to measures taken in relation to financial institutions in the context of the current global financial crisis' (OJ C 270, 25/10/2008, p8), 'The recapitalisation of financial institutions in the current financial crisis: limitation of aid to the minimum necessary and safeguards against undue distortions of competition' (OJ C 10, 15/1/2009, p2), 'Treatment of Impaired assets in the Community Banking Sector' (OJ C 72, 26/3/2009, p1), 'The return to viability and the assessment of restructuring measures in the financial sector in the current crisis under the State aid rules' (released on 23 July 2009), and 'Temporary Community framework for State aid measures to support access to finance in the current financial and economic crisis' (OJ C 83, 7/4/2009, p1).

3.

'Competition, the crisis and the road to recovery', speech by Neelie Kroes at Economic Club of Toronto, 30 March 2009.

4.

Council Regulation 139/2004 of 20 January 2004 on the control of concentrations between undertakings.

5.

Recital 23, ECMR. The Treaty provisions referred to concern 'economic and social cohesion' among the member states and 'the harmonious, balanced and sustainable development of economic activities'.

6.

For example, it refused to bow to pressure to clear the Volvo/Scania or Schneider/Legrand mergers (Decision of 14 March 2000 in Case COMP/M.1672, OJ L 143, 29/5/2001, p74; Decision of 10 October 2001 in Case COMP/M.2283, OJ L 101, 6/4/2004, p1).

7.

The merger control regimes at EU and member state level are mutually exclusive, and which level applies is a function of the turnover of the parties involved (subject to certain provisions to refer the review to or from the Commission).

8.

This is the 'public interest intervention' regime found in ss 42-58A of the Enterprise Act 2002. Prior to the introduction of the financial stability ground, the specified public interest grounds related to national security and media. Moreover, in 2008 the UK government introduced legislation that permits the nationalisation of a failing bank or its transfer to a private party, and allows an order to be made to amend the law in order to achieve the objective of financial stability or the public interest where financial assistance has been provided for the purpose of financial stability, or both. An amendment to the law could be made, for example, by disapplying statutory provisions such as merger control legislation. These powers were not used in the Lloyds/HBOS merger. (See the Banking (Special Provisions) Act 2008, which introduced temporary powers that were replaced by the special resolution regime for dealing with distressed banks and building societies in the Banking Act 2009.)

9.

According to an interpretative statement by the Commission published in relation to the predecessor of the ECMR (Regulation 4064/89), which contained a clause which substantially the same wording as article 21(4), the clause 'reaffirms member-States' ability on [the grounds of legitimate interests] either to prohibit a concentration or to make it subject to additional conditions and requirements. It does not imply the attribution to them of any power to authorise concentrations which the Commission may have prohibited under this Regulation.' (Accompanying statements on individual articles of Regulation 4064/89 entered in the minutes of the EC Council, 19 December, 1989, [1990] 4 CMLR 314.)

10.

'Keeping markets working effectively: Europe's challenge in recessionary times', speech by Philip Lowe, Director General of DG Competition, 14 May 2009. On the question of whether the Commission's assessment should be extended to take into account wider considerations, Philip Lowe said in his speech that 'experience has shown that a legal instrument such as the EC Merger Regulation is most effective when it is directed to one single objective. I do not see how it would be possible to agree on the wider objectives that should be taken into account in our assessment. Nor indeed, do I see how it would be possible to agree on how these objectives should be implemented. The test would just be too complex.'

11.

Commission's Guidelines on the assessment of horizontal mergers under the Council Regulation on the control of concentrations between undertakings, OJ C 31, 5/2/2004, p5, (Horizontal guidelines) para 9.

12.

Horizontal guidelines, section VIII.

13.

Restatement of OFT's position regarding acquisitions of 'failing firms', December 2008, OFT 1047. This confirms that the failing firm defence will apply where the target business would inevitably exit the market absent the merger and there is no realistic and substantially less anti-competitive alternative.

14.

Anticipated acquisition by HMV of 15 Zavvi stores, OFT's decision on reference under section 22(1) given on 28 April 2009.

15.

The OFT was inter alia informed by the administrator that there was no prospect of obtaining finance for a bid for the whole business as a going concern for reasons including current market conditions, with for example an MBO not being possible due to the current lack of liquidity in the debt markets.

16.

Horizontal guidelines, section VII.

17.

Horizontal guidelines, para 77.

18.

Commission notice on remedies acceptable under Council Regulation (EC) No. 139/2004 and under Commission Regulation (EC) No. 802/2004, OJ C 267, 22/10/2008, p1, para 15.

19.

Background paper prepared by the CC economics staff on 'Competition Policy in Recession and Financial Crisis', para 54 (see also Report of Competition Commission Roundtable held at Victoria House, London, on 30 March 2009, para 41).

20.

Report of Competition Commission Roundtable held at Victoria House, London, on 30 March 2009, para 41.

21.

'Keeping markets working effectively: Europe's challenge in recessionary times', speech by Philip Lowe, Director General of Competition, 14 May 2009.

22.

Background paper prepared by the CC economics staff on 'Competition Policy in Recession and Financial Crisis', paragraph 53, citing the OFT's Discussion Paper for its Review of the local and regional media merger regime, March 2009 OFT 1069 (para 2.3).

23.

Under article 7(1) ECMR, where a transaction is notifiable to the Commission it must not be implemented prior to notification and clearance (though there are special rules for public takeover bids). Breach of the 'standstill obligation' can lead to fines of up to 10 per cent of group turnover. Derogations are available under article 7(3) ECMR.

24.

See http://ec.europa.eu/competition/mergers/statistics.pdf, accessed on 20 July 2009. Such a derogation may, for example, have been granted in the Fiat/Chrysler merger.

25.

Recital 22 to the ECMR.

26.

Commission Decision of 14 May 2009 in Case No COMP/M.5508 SoFFin/Hypo Real Estate.

27.

Commission Decision of 7 May 2009 in Case N 244/2009 - Commerzbank Germany.

28.

Commission Communication on the return to viability and the assessment of restructuring measures in the financial sector in the current crisis under the state aid rules, 23 July 2009.

29.

Philip Lowe said in May 2009 'It is […] likely that as the worst of the financial sector turbulence calms down, there will be further mergers. The same applies to other areas of the real economy where the effects of the economic downturn may result in some consolidation.' ('Keeping markets working effectively: Europe's challenge in recessionary times', speech by Philip Lowe, Director General of Competition, 14 May 2009).

30.

See, for example, Review of the local and regional media merger regime, OFT's Final Report, June 2009.

31.

'Many achievements, more to do' - Opening speech at IBA conference on 'Private and public enforcement of EU competition law - 5 years on', 12 March 2009.

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