Q&A: Vertical merger enforcement

August 2021  |  SPECIAL REPORT: COMPETITION & ANTITRUST

Financier Worldwide Magazine

August 2021 Issue

FW discusses vertical merger enforcement with David Cardwell at Baker Botts, Andy Parkinson at Compass Lexecon, Logan M. Breed at Hogan Lovells, and Farrell J. Malone at Latham & Watkins LLP.

FW: How would you describe recent vertical merger activity? What trends and developments are driving this area of the M&A market?

Breed: The M&A market has been very active, including transactions between companies at different levels of the value chain. In some sectors this is because vertical integration creates efficiencies that can help companies provide lower prices and compete more effectively, particularly during the coronavirus (COVID-19) pandemic. In other sectors, such as technology software, innovation in areas like artificial intelligence has led to a significant number of vertical deals as large platform providers scramble to keep up with new developments.

Malone: M&A activity generally and related antitrust regulatory work is as busy as ever. I do not perceive a particular uptick in vertical mergers, but rather an overall increase in deals, including complex strategic deals between companies active in many different segments of an industry. That, combined with an increased focus on antitrust enforcement, including vertical merger enforcement, has brought increased attention to vertical aspects of deals. So vertical aspects of deals have always been there; it is rather increased antitrust enforcement in general that has brought added attention to vertical aspects of deals.

Cardwell: Merger activity, in particular involving companies operating at different levels of the supply chain, is buoyant. This is not surprising as vertical mergers are very often motivated by cost-reducing and efficiency-enhancing considerations. As such, they are often a rational response to changes in the competitive landscape and a means for companies to compete more effectively. Many markets, in particular those that are affected by increased digitalisation, are currently undergoing transformational changes that redefine the need for inputs and distribution alternatives and that offer new business opportunities. Digitalisation has profound effects in financial services markets, mobile communications, energy, transportation and many other sectors. Vertical and conglomerate mergers are a key trend in this new environment as they combine companies active in adjacent and vertically-related markets.

FW: Could you provide an overview of how such mergers are generally treated for antitrust enforcement purposes?

Malone: Vertical integration can be and often is ‘efficient’ in the sense that it can reduce a supplier’s variable costs and incentivise it to reduce prices to consumers. If vertical integration lowers a supplier’s variable input costs, economics teaches us that the supplier will lower prices to consumers. That said, the antitrust enforcement agencies in the US, and many or most jurisdictions worldwide, will review vertical mergers under the same statutes and regulations that they review horizontal mergers between competitors. In the US, that means the assessment is whether the vertical merger may substantially lessen competition in any relevant market, which is effectively the standard under section 7 of the Clayton Act – the same statute used to assess mergers between horizontal competitors. Of course, the enforcement agencies may also challenge mergers under the Sherman Act or the Federal Trade Commission (FTC) Act, for the FTC.

Cardwell: Generally speaking, vertical mergers are treated like any other mergers: if the proposed merger or acquisition meets applicable notification thresholds then it must be notified to the relevant antitrust agencies for approval. While there are important differences between jurisdictions – with the European Commission (EC) procedure being heavily front-loaded and the US system more back end-loaded – competition agencies will generally ascertain whether the transaction likely results in a significant impediment of competition on any of the markets that are affected by the transaction. Often economic modelling and analyses are needed to bring these effects to light. In addition, the reviewing agency will actively solicit the views of competitors, customers and other potentially affected parties, which may complicate the review process.

Parkinson: Most vertical mergers do not raise competition concerns and can instead result in efficiencies. If a downstream company purchases its upstream supplier, instead of paying a wholesale price for the inputs, it can instead access those inputs at cost, which would enable it to offer lower prices to its own customers. In addition, vertical integration can align incentives within the merged firm to invest in new products. However, the upstream supplier will often also sell to competitors of the downstream company. Enforcement agencies may be concerned that post-merger, the merged entity might use its control of an important input to harm its downstream competitors, by charging higher prices to those competitors or by stopping supplying them altogether, and this could reduce competition in the downstream market. This is called input foreclosure. Less commonly, customer foreclosure might be a concern: post-merger, the downstream company might switch its purchases away from other suppliers to its own upstream division. If the downstream company is an important customer for other suppliers, the loss of sales suffered by other upstream suppliers might mean they become less effective competitors.

Breed: Historically, vertical mergers have been seen by the US antitrust agencies as less likely to raise material antitrust issues than horizontal mergers, and the agencies provided more deference to the possibility of pro-competitive efficiencies in vertical deals. More recently, however, US agencies have refocused their attention on vertical deals. Last year, agencies issued the first updated vertical merger guidelines since 1984, and the Department of Justice (DOJ) filed its first court challenge to a vertical transaction in a generation when it, unsuccessfully, attempted to block AT&T’s acquisition of Time Warner.

FW: Drilling down, could you outline the principal analytical techniques, practices and policies enforcement agencies are utilising to determine whether a vertical merger poses potential competitive harm in violation of antitrust laws?

Breed: US antitrust agencies issued new vertical merger guidelines in 2020 following the DOJ’s loss in the AT&T case. Notably, the new guidelines do not include any statement that vertical mergers are less likely to generate competitive harm than horizontal mergers. The primary theories of harm outlined in the guidelines are foreclosure and raising rivals’ costs. In a foreclosure case, a vertical merger may harm competition by increasing the merged firm’s incentive and ability to block rivals from related products, such as necessary inputs or distribution channels. In a raising rivals’ costs case, the issue is whether the merged firm would provide the necessary input or distribution channel to competitors, but only at higher prices or on other less favourable terms that could undermine competition. The guidelines concede that mergers “rarely warrant close scrutiny” when rivals can readily switch to alternative providers or supply themselves. The guidelines also state that, though levels of concentration may be relevant to assessing a deal’s competitive effects, the agencies will not rely exclusively on market shares or concentration statistics as screens for competitive harm in vertical cases.

Parkinson: Enforcement authorities examine whether the merged entity would have the ability to foreclose rivals, the incentive to do so and the effect of foreclosure on competition overall. The merged company may have an ability to engage in input foreclosure if it has an important position upstream, such that downstream rivals might not be able to easily switch to other suppliers. For example, if there are few alternative suppliers, the alternative suppliers face capacity constraints, or do not offer the same quality of product. Input foreclosure is more likely if the input is important to downstream rivals, either because it plays an important role in determining product quality or accounts for a substantial proportion of rivals’ costs. Engaging in input foreclosure can have costs as well as benefits for the merged company: it will lose sales upstream but may gain additional profits downstream. To understand whether the merged firm has an incentive to engage in input foreclosure, the agency will assess whether the benefits outweigh the costs, although this is often a complex area of economic analysis. Finally, if the merged company has the ability and incentive to engage in input foreclosure, the agency will assess whether that would harm competition. It may not do so, for example, if the merged company faces multiple rivals that are also vertically integrated.

Cardwell: Vertical mergers often bring about important static and dynamic efficiencies and, generally, competition agencies have embraced the notion that vertical mergers only exceptionally raise competitive concerns. Agencies tend to use a three-step analytical framework in assessing the competitive effects of such mergers: the ability to engage in anticompetitive conduct, the economic incentive to do so, and the actual effects of the anticipated conduct on the affected market. The evaluation of efficiencies is part of the analysis. The main anticompetitive effects that may theoretically occur in the context of vertical mergers are input and customer foreclosure – the former occurring if the merged firm would discontinue the supply of inputs to downstream rivals, the latter manifesting itself if the downstream division of the merged firm would no longer purchase inputs from the upstream firm’s rivals, thereby limiting competition on upstream markets.

Malone: In the US, in analysing a vertical merger or vertical aspects of a strategic deal, antitrust authorities will assess one primary type of harm – that is, whether the merged entity will have the ability and incentive to engage in ‘foreclosure’, which is essentially a question of whether the newly merged entity can use market power either upstream, in an input market, or downstream, in a finished goods market, to limit or eliminate its rivals’ ability to compete. There are two main types of foreclosure. First, input foreclosure, which is where a vertically integrated supplier with market power in the upstream input market – evidenced, for example, by a high market share in sales of the input – can either raise prices to its downstream rivals or stop selling to them altogether. Second, customer foreclosure, which is where a vertically integrated supplier with market power in the downstream market – so it is a significant buyer – can harm rivals upstream, simply by no longer purchasing their inputs, because, post-merger, the merged firm can source internally.

FW: Have you seen any recent updates to merger guidelines which will have an impact on vertical mergers going forward? To what extent do such guidelines reflect modern theoretical and empirical economic analysis?

Parkinson: The UK Competition and Markets Authority (CMA) issued new guidelines in 2021, replacing 2010 guidelines, with minimal changes to the analytical toolkit for assessing vertical mergers. However, the update may reflect a harder stance against some vertical mergers. The 2010 guidelines struck a relatively relaxed tone on vertical mergers, noting that most vertical mergers are benign and do not raise competition concerns. In contrast, the 2021 guidelines instead note that the UK authority has found competition concerns in several vertical mergers, and that commentators have warned of under-enforcement against vertical mergers. In addition, the 2021 guidelines are more sceptical of the efficiencies which can be generated by vertical mergers.

Malone: The DOJ and the FTC published vertical merger guidelines in 1984 – at the time, called ‘non-horizontal merger guidelines’. Those guidelines were updated, for the first time in almost 40 years, in June 2020. In December 2020, the FTC published a ‘Commentary on Vertical Merger Enforcement’, to provide additional context for the FTC’s vertical merger enforcement. It is really too early to tell how the updated guidelines will impact agency enforcement decisions in the long term. Importantly, including in the updated vertical merger guidelines, agencies now recognise the efficiency-enhancing aspects of vertical mergers.

Cardwell: Revised or new merger enforcement guidelines, including specific provisions on vertical mergers, have been issued recently in a number of important jurisdictions. In December 2020, the FTC issued new guidelines on vertical merger enforcement which encapsulated what some commentators characterised as a relatively light-touch approach to intervening in vertical mergers. A subsequent shift in the political makeup of the FTC, with president Biden’s nominee Lina Khan confirmed as FTC commissioner, suggests that vertical merger enforcement in the US may be more vigorous in the coming years, regardless of the tone of the vertical merger guidelines. In the UK, the CMA issued an updated version of its ‘Merger Assessment Guidelines’ in March 2021, including a revised section on non-horizontal merger assessment. Many of the changes to the guidelines are reflective of the CMA’s recent experience in its own merger investigations and case law outcomes, including significant losses.

FW: Could you highlight any recent cases which illustrate current antitrust enforcement efforts? What might we learn from their outcome?

Malone: In the US, there are many examples of the FTC and DOJ focusing on vertical aspects of mergers, and the agencies have both settled, through consent decree, and sought to challenge vertical mergers in court. The most significant recent DOJ enforcement action is the DOJ’s 2017 attempt to challenge AT&T’s acquisition of Time Warner. Another good example of enforcement resulting in consent decree is the FTC’s challenge to Staples’ acquisition of Essendant in 2019. The merger was pure vertical integration for Staples – a major Essendant customer. Staples’ competitors, however, also relied on Essendant, as an important input supplier, setting up a potential for input foreclosure, and setting up a scenario where Staples’ competitors would need to share sensitive ordering information with Essendent, which would be owned by Staples. After a lengthy review, the FTC ultimately cleared Staples’ vertical merger with Essendant, subject to behavioural commitments to limit the flow of competitively sensitive information to Staples.

Parkinson: In the UK, the CMA has assessed a number of vertical mergers in recent years. In Thermo Fisher and Roper, the authority assessed the acquisition of a supplier of peripherals for electron microscopes by a supplier of electron microscopes. The CMA found that, post-merger, Thermo Fisher would have the ability and incentive to engage in input foreclosure, stopping or degrading the supply of peripherals to rivals. Moreover, the CMA found that the long-term supply contracts in place would not sufficiently protect rivals. The transaction was ultimately abandoned. By contrast, the CMA unconditionally cleared the acquisition by BT – the UK’s largest fixed telecoms business – of EE, the UK’s largest mobile telecoms business. The merger raised multiple vertical issues, including BT’s supply of backhaul to mobile network operators. Despite a number of concerns expressed by other mobile network operators, the CMA concluded that, post-merger, BT would not have the ability and incentive to engage in input foreclosure. In contrast, the CMA found that some customers would be protected by their existing contracts. The differing outcomes in these cases illustrates that assessment of vertical mergers is heavily fact-specific and relies on detailed economic analysis.

Cardwell: Recent cases in the EU include the 2018 Essilor/Luxottica M&A, in which the EC engaged in an extensive investigation, but ultimately concluded that the merged entity would not be able to use Luxottica’s strong market position in certain brands of frames and sunglasses to foreclose competing suppliers of lenses from the market. While the Essilor/Luxottica merger was cleared without remedies, there are several recent vertical mergers at both EU and national level which have involved conditional clearances, several featuring behavioural remedies, including three cases in 2019: Telia/Bonnier in the EU, CTS Eventim/Barracuda in Austria, and LN-Gaiety/MCD in Ireland. These and other cases not only underline the substantial degree of scrutiny which vertical merger cases continue to attract in Europe, but also provide some reassurance that the EC and national authorities are open to behavioural remedies as a means to remedy vertical foreclosure concerns, even when they in general continue to prefer structural rather than behavioural remedies.

Breed: The most prominent vertical case in the past few years was the AT&T/Time Warner litigation. It was highly unusual for the DOJ to challenge a vertical transaction because, until the Trump administration, the typical solution for antitrust problems caused by a vertical deal was the imposition of ‘behavioural remedies’. These are remedies that, unlike the divestiture of a business unit or a fixed asset, require the buyer to commit to certain conduct, such as creating firewalls, compulsory licensing or non-discrimination principles. The most recent leader of the DOJ Antitrust Division, Makan Delrahim, stated that: “at times antitrust enforcers have experimented with allowing illegal mergers to proceed subject to certain behavioural commitments. That approach is fundamentally regulatory, imposing ongoing government oversight on what should preferably be a free market … Antitrust is law enforcement, it’s not regulation.” This position forced the DOJ to file a complaint to block the AT&T/Time Warner deal rather than implementing a behavioural remedy as it had done in prior similar deals, such as Comcast and NBCU. The DOJ’s loss in the case, combined with the change in presidential administration, may make it more likely that the DOJ will accept conduct remedies in some vertical cases in the future.

FW: To what extent have courts applied different legal standards to vertical mergers? What difficulties does this pose for those companies pursing vertical transactions?

Cardwell: The legal standards applied by various courts will obviously tend to be shaped by any local statutory provisions or guidelines on the substantive assessment of vertical mergers. In Europe at least, vertical mergers, and mergers more generally, do not often end up being litigated in court, meaning that there are only rare examples demonstrating the standards that will be applied by courts to vertical mergers. In the EU, the 2005 landmark judgment of the Court of Justice in Tetra Laval involved the Court overturning the EC’s prohibition of a conglomerate merger. That case confirmed that a high evidentiary burden rests on the EC to demonstrate that a non-horizontal merger raises serious concerns. The quality of evidence relied upon by the EC in non-horizontal mergers is particularly important given the need to predict future events over a long period of time. In effect, the judgment confirmed that the EC must prove each step of its analysis of non-horizontal mergers, including the ability to foreclose and the incentive to foreclose, in order to successfully establish a foreclosure theory.

Breed: The court in the AT&T/Time Warner litigation set a high bar for the government to win a vertical merger challenge. In vertical cases, there is no increase in concentration in any market – so the government cannot benefit from any presumption of anticompetitive effect. The DOJ failed to meet its burden of proof in the AT&T case, which could embolden future merging parties in vertical cases to test the DOJ’s willingness to litigate more vertical cases.

Parkinson: The CMA has been particularly active in challenging vertical mergers, with a number of transactions abandoned or prohibited in recent years. This includes transactions which were not challenged by other authorities, such as Thermo Fisher and Roper, both US-based companies. Companies should be aware of divergences in approach between authorities worldwide when assessing potential vertical mergers.

Malone: There is scant judicial precedent for vertical merger enforcement in the US. By far the highest-profile recent enforcement action against a vertical merger is the DOJ’s unsuccessful attempt to challenge AT&T’s acquisition of Time Warner. By most or all accounts, this was the first attempted ‘vertical merger’ challenge since 1979, when the FTC challenged, unsuccessfully, Freuhauf’s acquisition of Kelsey-Hayes Company. The AT&T/Time Warner merger was vertical because the companies did not compete: AT&T owned DirecTV, a distributor of TV content, and Time Warner owned and operated a number of television content networks, including multiple major cable TV channels of content. The DOJ’s challenge in the AT&T/Time Warner case revealed that the lack of judicial precedent in challenges to vertical mergers helps merging parties, not the DOJ, and that courts understand and will credit the efficiency-enhancing aspects of vertical mergers. Neither of these points deterred the DOJ. Nor will they deter the DOJ or the FTC from bringing vertical merger cases in the future.

FW: Against the current regulatory and political backdrop, what advice would you offer to companies considering a vertical merger in the current market?

Parkinson: An assessment of antitrust risk is always important. It is often useful to involve economic advisers at an early stage if the risk assessment is not clear cut. Economic analysis is particularly important and complex in vertical mergers and involving economic advisers will help in fully understanding the way in which the economists at the competition authorities will assess the vertical merger and therefore the associated risk to the transaction. Economic advisers can also help to start building the positive case for the transaction early in the process.

Breed: US antitrust agencies are focused on merger enforcement at the moment, and that includes vertical mergers that raise potential foreclosure concerns. In particular, if customers of either merging party are likely to complain, the odds of an extended review are shortened. Companies need to ensure that the documents they are creating about the transaction – which are sure to be reviewed by the antitrust agencies – accurately reflect the acquirer’s pro-competitive rationale for the deal and do not imply any incentive to undermine competition.

Malone: Merging parties should think carefully and heed antitrust counsel’s advice, which will invariably be that the antitrust enforcement agencies – especially the FTC but potentially also the DOJ – will be closely scrutinising mergers in general, including vertical aspects of mergers. It is less a focus on vertical enforcement in particular, and more a focus on merger enforcement more generally, including on vertical aspects of strategic deals.

Cardwell: In the current changing regulatory environment, companies considering vertical mergers may want to proceed with slightly more caution, particularly if the transaction involves innovation-intense, intellectual property-centric or digital markets, and especially when the transaction is likely to result in significant market power post-merger. While vertical mergers continue to be regarded as potentially pro-competitive, they are materially more likely to attract regulatory scrutiny. Overall, it makes good commercial sense to assess the potential effects of the transaction at an early stage of the process, to invest ample time in pre-notification discussions with key competition enforcement agencies, and to take a conservative approach with regard to obtaining regulatory approvals when drafting transaction agreements.

FW: What trends do you expect to see in antitrust policy and enforcement over the months ahead? How is this likely to shape vertical merger activity levels going forward?

Breed: Antitrust enforcement is likely to be vigorous for the foreseeable future, and vertical deals will continue to be scrutinised. The current US Congress has been discussing a number of new laws that would dramatically enhance the government’s antitrust enforcement powers. For example, new bills might make it much more difficult, or even impossible, for large technology platform companies to continue making significant vertical acquisitions. One proposed bill, the Platform Competition and Opportunity Act, would prohibit any significant online platform operator from acquiring any company that competes with it, or that could provide nascent competition to it, or that could enhance the platform’s market position, including by giving it access to more data.

Malone: We are at the very beginning of the Biden administration in the US and it will undoubtedly be an interesting next few years for antitrust enforcement. There is a growing tide for increased enforcement, new legislation and executive agency action, including executive orders specifically focused on antitrust enforcement. Lina Khan has just been appointed chairwoman of the FTC and has spoken publicly many times, including in her senate confirmation hearings, about the need to increase antitrust enforcement through whatever legal means possible, including by changing the laws. President Biden has not yet appointed someone to lead the antitrust division of the DOJ – the assistant attorney general for antitrust – but that appointment will be made in the coming weeks or months. And what affect will these appointments have on merger activity, and vertical merger activity in particular? My own personal view is not that much. There may be some proposed mergers that are deterred at the margins, but I very much believe in market forces, and parties to strategic deals will sign those deals. The biggest impact on merger activity will be the antitrust efforts covenants – parties to deals in 2021 and beyond need to leave sufficient time to obtain regulatory clearance, and to litigate the merits of their deals, even vertical deals, if necessary. For strategic deals with potential antitrust issues, this means routinely leaving 18 to 24 months for antitrust clearance.

Cardwell: Previously, competition agencies have tended to consider market power as the key factor in assessing whether a vertical merger could raise anticompetitive concerns, alongside an important presumption that such mergers would lead to efficiencies. That conventional analytical framework for identifying vertical foreclosure effects is still intact, but competition agencies have become more reluctant to rely on it alone and have recently shown signs of pursuing novel theories of harm. For example, in the Aurubis/Metallo merger in 2020, the EC pursued a novel buyer power consolidation theory of harm. More generally, vertical mergers in platform-based, digital industries, or in closely related sectors, are more frequently approached with scepticism and suspicion, particularly if they raise concerns from other market participants.

Parkinson: The trend appears to be toward closer examination of vertical mergers, and potentially increased enforcement. However, this may not necessarily reduce vertical merger activity levels, due to the attractiveness and potential benefits of vertical integration to many companies. Where one of the merging parties supplies an important input to rivals, the companies should prepare themselves for a potentially lengthy antitrust review.

David Cardwell is a partner in the antitrust and competition practice of Baker Botts’ Brussels office. His practice focuses on UK and EU competition law, including a particular concentration on EU and international merger control laws, and UK competition law, both mergers and behavioural matters. Mr Cardwell is recognised for his expertise in handling complex, cross-border merger reviews and has represented clients in significant mergers across many industry areas, including the energy, technology, pharmaceutical, media, automotive and heavy industry sectors. He can be contacted on +32 (2) 891 7330 or by email: david.cardwell@bakerbotts.com.

Andy Parkinson is a senior vice president with Compass Lexecon, based in London. He has 15 years of experience advising clients on the economics of competition law cases and has been recognised as a “Future Leader” in competition economics by Who’s Who Legal since 2018. He has particular experience in merger control before the UK and EU authorities and regularly advises on investigations and litigations arising from alleged infringements of competition law. He can be contacted on +44 (0)20 3932 9687 or by email: aparkinson@compasslexecon.com.

Logan Breed has handled many of the most cutting-edge antitrust reviews of mergers and acquisitions over the past 20 years, as well as numerous non-merger conduct investigations and antitrust litigation matters. He has particular experience with issues at the intersection of antitrust and intellectual property law. Mr Breed’s broad industry experience includes computer software and hardware, e-commerce, telecommunications, media and entertainment, consumer products and defence. He can be contacted on +1 (202) 637 6407 or by email: logan.breed@​hoganlovells.com.

Farrell Malone is a partner in the Washington, DC, office of Latham & Watkins and a member of the antitrust & competition practice. His practice focuses on the antitrust review of mergers and acquisitions, antitrust investigations and enforcement matters, and antitrust litigation in the US and abroad. He is recognised for his significant experience in handling large and complex global merger reviews before antitrust authorities in multiple jurisdictions worldwide, including Europe, Brazil, China and India. He can be contacted on +1 (202) 637 1024 or by email: farrell.malone@lw.com.

© Financier Worldwide

THE PANELLISTS

David Cardwell

Baker Botts LLP

Andy Parkinson

Compass Lexecon

Logan M. Breed

Hogan Lovells

Farrell J. Malone

Latham & Watkins LLP

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