With an influx of distressed companies as a result of the COVID-19 pandemic, the “failing firm” defense has been attracting increased attention as a way to let an otherwise anticompetitive merger to proceed. The failing firm defense is based on the theory that an anticompetitive merger is better than allowing the failing firm’s assets to exit the market altogether. Julie Elmer, antitrust expert at the global law firm Freshfields, discusses the elements and the high bar for proving the defense, a related defense called the “flailing firm” defense, and what companies should keep in mind as they prepare to employ either the failing or flailing firm defense.
Julie Elmer is a partner in the antitrust and litigation practices at Freshfields.
More from Julie Elmer
Ohio v. American Express, a Shift in Antitrust (a TOL Brief)
Can the Failing Firm Defense Save a Deal in the COVID Era? (a Freshfields practice alert, October 12, 2020)
Interview with Antitrust Lawyer – Julie Elmer
Joel Cohen (Host): Given the unprecedented number of bankruptcies we're currently seeing in the United States, interest in the M&A world has spiked in something referred to as the failing firm defense. Here with me to discuss is Julie Elmer of the law firm Freshfields. Julie, welcome to TalksOnLaw.
Julie Elmer (JE): Hi Joel. It's nice to be here.
Host: I wish you could be here in person, but zoom seems to be the the way to do it.
JE: It's the way to do it these days.
What is the failing firm defense?
Host: So what exactly is the failed firm defense?
JE: This is an argument that would allow a merger or an acquisition that might otherwise be deemed anticompetitive to occur. So it's something that's used when maybe firms that are competitors of each other, where ordinarily the US antitrust agencies might be very skeptical of allowing a merger, it might be an argument for allowing that merger to go through. And the rationale behind this argument is that it would be better to allow a potentially anti-competitive merger rather than allow a firm's assets to exit the market altogether. That's because you would have a drop in output and one less competitor and that's bad for consumers.
Host: So, it's an argument for efficiency, if a company that's otherwise going to be gone anyway, if you can let it be snapped up, the new company can use those assets and lead to less waste.
JE: Well, it can keep those assets in the market. You don't want to have a reduction in output or an increase in prices. Lower output, higher prices those are two examples of anti-competitive effects and that's what the antitrust laws are designed to try to prevent. This is a defense to a merger enforcement action so the federal antitrust agencies are charged with not only investigating alleged violations of the Sherman act, such as price fixing or monopolization, they are also responsible for reviewing mergers under the Hart-Scott-Rodino Act. These are mergers of a certain size and they determine whether or not a merger is likely to harm competition or not. If it's not, they clear it and they clear most mergers, but there are some instances where the Federal Trade Commission or the Department of Justice might sue in a federal court to block a merger from taking place. So this would be an argument that merging firms could make to try to prevent that injunction from occurring. And allowing the merger to go through it's also an argument that they can make to the agencies to try to persuade the agencies to allow the merger and not sue in the first place.
Legal Test for the Failing Firm Defense
Host: Let's imagine that there's an an otherwise anti-competitive merger on the table, but one side wants to make this failing firm defense, what do they have to show? What's the legal test?
JE: It's actually a very tough test to meet because they have to show three things. They have to show that:
(1) the target firm, that's the firm that would be purchased, faces the grave probability of imminent failure;
(2) they also have to show that that target firm cannot reorganize under chapter 11 of the U.S. Bankruptcy Code; and
(3) they have to show that the target firm has tried to find an alternative purchaser who would buy the target firm's assets for an amount equal or higher than liquidation value and be less harmful to competition.
And so all three of those elements must be demonstrated in order to prove the failing firm defense.
Host: what's the hardest part of the failing firm defense test? It seems like multiple prongs could be difficult.
JE: Yes, multiple problems could be difficult. The one that seems to hang up firms the most is the third prong, the good faith search for an alternative purchaser. And one of the reasons is because it's a difficult test to meet because the firm has to be able to show that it was unable to find anybody who would have less of an impact on competition than their current suitor, who tends to be a strategic buyer, probably a competitor. They must show that they were unable to find anybody else that was willing to pay liquidation value or higher for their assets.
Host: Oh interesting, so they would in theory be forced to choose another suitor who was willing to pay much less.
JE: That's right and that's why a lot of firms can't demonstrate that they've satisfied this prong because they haven't actually attempted a shop like that. Most people don't want to do a shop like that.
Host: I can imagine why. I have a question for you on price. If the transaction is priced in a way that's attractive to the target, doesn't that in and of itself suggest that it's not actually on its last leg?
JE: Not necessarily. So the buyer might be willing to offer a high price because they know that by doing so they can eliminate a competitor and then increase prices for customers and extract monopoly rents. So that alone is not enough. That said, if a target firm is sitting on valuable assets that are objectively valuable the antitrust enforcement agencies in the courts are going to tend to be skeptical of the failing firm defense and that's because with really valuable attractive assets it is likely that the firm could take steps to either improve its management, access more capital, or maybe find an alternative buyer that isn't its largest competitor.
The Flailing Firm Defense
Host: That's the failing firm defense there is a related legal argument called the flailing firm defense. What is that?
JE: That is an argument that's sometimes called the weakened competitor defense and it's not as strong of a defense as the failing firm defense. The failing firm defense is a get out of jail free card. If you can prove it, it is an absolute defense. It's a “government go away,” but that's why it's hard to prove. The crux of the flailing firm argument is that, hey government you're telling us that if you if this merger takes place the two of us are going to have 65 percent of the market and you can't allow that because that's anti-competitive and what we're here to tell you is that that 65 is not really 65. You're adding the 40% that the strong firm has plus the 25% that the weaker firm has but that 25% doesn't really accurately reflect the target firm's competitive strength going forward.
Host: Oh interesting. So, instead of 25%, the target was actually heading really quickly down to 5%, so it's really more like we're only adding a five percent market share.
JE: Exactly right. |And if that target firm can actually show that, they can demonstrate a trend of falling share, a trend of losing customers, a trend of being unable to invest in their infrastructure, a trend of being unable to deal with worsening financial performance over several quarters, that argument might have some sway. And the regulators tend to credit that argument more if there are other factors also at work. For example, if there are other firms that are entering this market, or if the merger would also generate great cost savings or efficiencies, or if the merging parties have offered some remedies to address some of the competitive concerns. So it's one factor out of many that the agencies or court might look at to say “okay this is enough to rebut the government's argument that this merger is likely to harm competition.”
Host: Can the flailing firm defense be used as well by the acquirer to say, look not only is the target not as rich of a market share as as you think it is but neither are we. We're headed down quickly as well.
JE: That's a really interesting argument and that the two of them together would be stronger and kind of shore each other up. Yeah I think that is an argument that could be made. I know that there's been some discussion in the antitrust bar as to whether or not the declining industry could be a defense to an anti-competitive merger and there was a recent case, FTC v. Peabody Coal where the court in that case rejected that particular argument and instead said look, these parties did not present evidence that either of these firms was failing or flailing and the fact that an industry may generally be in decline is not a defense to an anticompetitive merger but that might be an argument that we will increasingly hear going forward.
COVID-19 & the Failing Firm Defense
Host: So the failing firm defense / flailing firm defense sound like difficult tests to meet, how is that being impacted do you think by the Covid-19 economy?
JE: Well, both of the U.S. antitrust agencies have said that they're not willing to loosen their standards for how they evaluate these defenses. But that said, I think that it might be easier for firms to meet elements of these defenses. Unfortunately because of the economic situation for example, I think it'll be easier for some firms in certain industries to be able to show that there is a grave probability of imminent failure.
Host: Julie, what would you say, what advice or tips would you give to a company that was going to be attempting this challenging defense?
Failing Firm Defense – Advice to Companies
JE: What I would say to firms that are really thinking about relying on these defenses is that they need to critically assess whether they can truly meet the high bar for proving the defense and undertake the preparation to do so. Hiring a financial expert to really evaluate the financial health of the company may help it to evaluate restructuring options and to run the auction process if the firm actually decides to sell. I think the target firm should also be mindful that the U.S. antitrust agencies are very practiced at testing defenses like these and if there's anything in the targets marketing documents or statements to investors or even tweets by its highly level executives that are touting how well it's doing, that the agencies will will look at those documents and view those documents as undermining these defenses. So, I think it really requires a truly critical self-assessment of whether the firm can meet that high bar.
Host: Julie Elmer, thank you for joining us today at TalksOnLaw
JE: Thank you, great to be here, Joel.