Earlier this year, the two federal antitrust agencies—the Federal Trade Commission (FTC) and the Department of Justice (DOJ)—issued Draft Vertical Merger Guidelines (“Guidelines”). The Guidelines are intended to assist the business community in understanding how the agencies analyze vertical mergers, i.e., mergers between companies that operate at different levels in the supply chain, such as a manufacturer and a distributor. The Guidelines represent a significant shift away from the view that vertical mergers are typically efficiency-enhancing and rarely harmful to competition. Rather, the Guidelines apply the current economic framework for analyzing vertical mergers, recognizing that such mergers can result in anticompetitive harm from unilateral or coordinated conduct in a variety of ways.
The Guidelines come at a time when there has been an uptick in vertical merger enforcement at both federal agencies and by state attorneys general. The most prominent example was DOJ’s challenge to the AT&T/Time Warner merger in 2017. Time Warner was a leading creator and “packager” of video programming and AT&T was a significant distributor of video programming. The AT&T/Time Warner case was the first vertical merger case litigated by one of the federal agencies in almost 40 years. DOJ lost the case, which may have underscored the need to communicate more effectively to businesses, lawyers and judges how theories of vertical harm and economic thinking have evolved.
Additionally, businesses should be aware that mergers may not be primarily vertical but still have a vertical component that will get agency review. For example, in 2016, AMC Entertainment bought Carmike Cinemas. Both companies owned movie theaters, and that was their primary business. However, in addition to their movie theater businesses, AMC was a founding member of National CineMedia (NCM)—a pre-show services provider—while Carmike was one of the largest investors in NCM’s main competitor, Screenvision. The DOJ alleged that post-merger, the new AMC would reduce Carmike’s incentive to purchase from Screenvision, “resulting in less aggressive competition [between Screenvision and NCM] to gain exhibitors and advertisers at the expense of the other.”
The draft Guidelines are the first update to vertical merger guidance in more than three decades, and offer a window into current agency thinking. Moreover, comments from state attorneys general on the draft Guidelines suggest that states may serve as incubators for future vertical merger challenges.
Draft Guidelines Overview
First, and most broadly, the draft Guidelines make clear that vertical mergers and acquisitions are subject to the antitrust laws, just like horizontal mergers. The draft does not presume vertical mergers are beneficial, although it does indicate that the government is unlikely to challenge vertical mergers where the market shares are low (below 20% in the “relevant market” and 20% in the “related product”). The draft also explicitly recognizes that vertical mergers may create efficiencies, including streamlining production and better managing inventory, as well as eliminating “double marginalization” (two profit margins), but places the burden on the merging parties to prove these efficiencies. In short, the draft Guidelines recognize both benefits and harms can arise from vertical mergers. Unlike the view in the 1980s that vertical mergers were almost always benign, the draft indicates that agency and economic thinking has shifted toward greater scrutiny of these deals.
The draft identifies three ways vertical mergers may harm competition.<
Foreclosure. After a merger, a company may decide to refuse to supply a rival with a critical input, something the Guidelines label “foreclosure.” The draft gives the example of a wholesaler of orange juice that purchases an orange orchard. As a result of the merger, the company may decide to stop selling oranges from the orchard to rival wholesalers in the area. The merger could be regarded as anticompetitive if several conditions are met: rivals lose sales (because, for instance, they cannot find a comparable supply elsewhere); the merged firm gains a portion of those sales or otherwise reaps a benefit; and the strategy to cut off rivals is profitable because of the merger. The harm to competition arises because the foreclosure strategy weakens the competitors and reduces their ability to impose competitive constraints, such as constraints on pricing, allowing the merged firm to raise its prices.
Raising Rivals’ Costs. A closely related theory is that through a merger, the merged company may be able to raise the costs of its competitors or decrease the quality of their goods or services. In other words, for there to be competitive harm, there does not have to be complete “foreclosure” of a rival, i.e., totally blocking it from getting to market. From an economic standpoint, raising the costs of a rival may be sufficient to result in harm to competition.
Access to Competitively Sensitive Information. A separate theory is that a merged company may gain access to sensitive business information about its competitors through a vertical merger. For example, a manufacturer merges with a supplier of raw materials. The supplier may be in a position to obtain competitively sensitive information about other buyers, including those who compete against its merger partner. The draft identifies a number of ways this information access may be harmful to competition. Having access to competitively sensitive information can be used to preempt competitive moves and soften competition by rivals, and it could also be used to help competitors collude.
Missing from the draft Guidelines is any discussion about remedies, an important topic for lawyers and clients. In the past 25 years, vertical mergers found to be problematic have been permitted to go forward, subject often to “conduct” remedies such as a firewall or non-discrimination provisions. However, the AT&T case, and various statements by DOJ officials, suggests a resistance to such behavioral remedies. It may well be that there is some dispute between the FTC and DOJ on the appropriateness of “conduct” as opposed to “structural” remedies, and until this gets resolved, it makes sense to pass on the question of remedies.
State Attorneys General Comments to the Draft Vertical Merger Guidelines
On February 26, a bipartisan group of 26 state attorneys general submitted comments on the draft Guidelines, expressing support for updating them to acknowledge the competitive harm that can result from vertical mergers. However, the comments make several recommendations on amending the draft Guidelines, suggesting that state attorneys general may emerge as aggressive vertical merger challengers.
First, the states recommend amending the draft Guidelines to include additional theories of harm, including the suppression of nascent or potential competition, the necessity of two-tier entry, regulatory evasion, and treatment of bargaining leverage. The elimination of nascent competition refers to using a merger to take out an entity that could have been a potential new competitor to the acquirer. The states use the Ticketmaster/Live Nation merger as an example, where Live Nation was well-positioned to enter the ticket sales market, but was removed as a potential competitive threat to Ticketmaster, the dominant player in that space, through the merger. A vertical merger could also result in significant barriers to entry in a particular market through requiring that any new entrant be viable in two segments of the supply chain rather than just one.
Regulatory evasion can occur in a vertical merger where a company uses the acquired product or service to offset regulatory constraints in its other product or service. For example, hospitals could use acquisitions of outpatient clinics to increase charges in those settings, thus offsetting the requirement that hospitals keep inpatient pricing, which must be disclosed to consumers, at more competitive rates. Finally, the states point out that vertically integrated entities could use increased bargaining power to force pricing below competitive levels such that competitors are eventually driven out of the market and prices to consumers increase. This was the argument in the AT&T/Time Warner merger, and in light of the result of that challenge, the states recommend additional guidance on how the agencies will assess bargaining leverage in future vertical mergers.
Second, the states propose eliminating the 20% or below market share “safe harbor” as described above. They reason that the 20% figure does not take into account the overall concentration of a market, i.e., a market may still have relatively few participants such that one of them merging with a critical supplier could result in anticompetitive effects. Additionally, the states argue that imposing a safe harbor fails to account for cumulative anticompetitive effects from a series of smaller vertical integrations.
Finally, the states advocate for more specific guidance on how to account for claimed efficiencies in a vertical merger analysis. They recommend that the Guidelines clarify the merging parties’ burden in establishing efficiencies (that they be reasonably verifiable, merger-specific, and sufficient to offset potential anticompetitive effects), that the efficiencies must occur in the challenged markets, and that the efficiencies must be passed on to consumers in some fashion.<
The states’ comments, as well as recent enforcement actions in vertical mergers in Colorado and California, demonstrate that state attorneys general will be applying a heightened level of scrutiny to vertical integration in their respective jurisdictions. Additionally, Colorado recently passed legislation amending its state antitrust law so the attorney general may challenge a merger even if the federal antitrust authorities decline to take any action against a proposed merger.
Companies considering vertical mergers or acquisitions should be mindful of increased state engagement on these transactions, as well as of the specific guidance from the federal antitrust authorities on how they will analyze these deals going forward. Merging parties can no longer assume that vertical integration will receive minimal scrutiny from antitrust enforcers, and should have experienced antitrust counsel review the transaction as part of their due diligence process.