Mergers involving firms in financial difficulty: Some practical tips

Australian approach to firms in financial difficulty

Australian competition law prohibits acquisitions that would have the effect, or likely effect, of substantially lessening competition in any market in Australia. Acquisitions that may raise competition concerns are routinely notified to the ACCC. The ACCC’s Merger Guidelines indicate its current approach.

In analysing any merger, the ACCC considers whether the likely state of competition with the merger (the future ‘factual’) would be substantially less than without the merger (the future ‘counterfactual’).

In most mergers, the future counterfactual is the status quo. However, when firms are facing financial difficulty, the future scenario for the firm may be one of continued competitive decline or even insolvency. The ACCC will take such matters into consideration.

Failing firms

‘Failing firms' are firms that are likely to exit a particular market in the foreseeable future (generally within one or two years) with the productive capacity of the firm also leaving that market. A mere change in ownership due to insolvency is insufficient.

The ACCC formally recognises ‘failing firms’ in its Merger Guidelines, but also requires sufficient evidence. Mere speculation that a merger party could face insolvency is not sufficient. The merger parties must evidence that:

• The relevant firm is in imminent danger of failure and is unlikely to be successfully restructured without the merger.
• In the absence of the merger, the assets associated with the relevant firm, including its brands, will leave the industry.
• The merger will not lead to a substantial lessening of competition relative to a scenario where the firm has exited the market and its customers have shifted elsewhere.

In practice, the ACCC’s approach is one of healthy scepticism to any ‘failing firm’ claims. The merger parties face a high evidential burden. The ACCC is likely to rigorously test the evidence it receives.

The ACCC may be sceptical of any ‘failing firm’ evidence if there are alternative options to successfully restructure the business absent the merger, or if there are other viable buyers that will deliver a more competitive outcome (including buyers of any distressed assets or business).

It is entirely possible that the ACCC may decide that it is better to let a firm fail and for any assets be acquired by a market entrant, then allow a competitor to acquire those assets. The ACCC’s analysis will turn heavily on the particular facts.

Flailing firms

‘Flailing firms' are firms that are facing significant difficulties (financial or otherwise) that are impairing their ability to effectively compete in the foreseeable future, but are not ‘failing firms’.

The ACCC’s Merger Guidelines do not expressly recognise the concept of a ‘flailing firm’, but the future competitive circumstances of firms are a relevant consideration in merger analysis. Again, the focus of the ACCC will be on the level of expected competition, comparing the future factual against the future counterfactual.

The ACCC’s approach in such circumstances is similarly sceptical. The ACCC may be wary that parties have an incentive to overstate any decline in competition absent the merger. That being said, the Federal Court in 2020 accepted that a merger in the telecoms sector would create a firm in a stronger financial position than the merger parties individually, thereby enabling the merged firm to compete more effectively.

All up, parties making arguments based on ‘failing firms’ and ‘flailing firms’ will be required to submit comprehensive evidence and should expect significant ACCC scrutiny.

What approach is the ACCC taking during COVID-19?

The ACCC has provided some guidance on its approach to merger reviews in the context of COVID-19. The ACCC has advised that:

• Each merger proposal will be assessed on a case-by-case basis.
• The ACCC will take into account the present situation, but also the longer term impact on competition by any change in the structure of markets.
• The ACCC’s assessment will go beyond the immediate impact of the COVID-19 crisis on the profits and share value of the merger parties.

This stance is consistent with the ACCC’s approach during the Global Financial Crisis. In response to claims by big business at that time that they may fail unless they merge, the then ACCC Chairman Graeme Samuel commented that:

“Certainly, we need to note the global financial crisis,” but “we also need to be cognisant of the longer term consequences for Australian consumers if we allow excessive concentration of markets...If we were to allow the relatively temporary circumstances of the current crisis to have a longer-term consequence of serious dominance in industries, then I don’t think anyone would thank us in two or three years’ time.”²

The ACCC has recognised failing firm arguments in an economic crisis. The ACCC considered a high profile banking merger during the GFC. The ACCC considered that the facts demonstrated that the target bank would not be as an aggressive competitor into the future if the merger did not proceed. This was the case on the facts even though the target bank had been a market leader on price and innovation (as well as pursuing a rapid expansion plan in Australia). The ACCC allowed the merger, but noted had it not been for the GFC, the outcome of the merger may well have been different.

Approach in the UK and other jurisdictions

Most major jurisdictions, including the United States, European Union, United Kingdom and Canada, recognise ‘failing firm’ arguments in merger control. While differences in approach exist between jurisdictions, such competition regulators generally require evidence of:

• Financial difficulty: One of the merger parties must be facing insolvency or potentially facing exit from the market due to its financial difficulties in the near term.
• No other more competitive purchaser: There are no other alternative purchasers that pose a substantially less anti-competitive outcome to the merger (and, in the United States, the parties must also show they have taken steps to elicit such offers).
• Exit is inevitable: In the absence of the merger, the failing firm’s assets must be likely to exit the market.
• No options to restructure: In the United States, the merger parties must show there are no opportunities for the failing firm to be successfully restructured under bankruptcy law.

The approach taken in the United Kingdom is slightly more expansive. An ‘exiting firm’ is viewed as one facing financial difficulties or where a strategic decision has been made to exit. However in either scenario, inevitable exit from the market must be shown. The Competition and Markets Authority (CMA) applies a strict three-limb test when deciding whether the exiting firm defence applies, regardless of whether the exit is due to financial difficulties or a strategic decision.

In applying its test, the CMA requires compelling evidence that:

• It is inevitable that the firm will exit the market (limb 1).
• There is no substantially less anti-competitive purchaser for the firm or its asset (limb 2).

The CMA then considers the impact of the merger on competition in the market compared to exit, looking at the market structure and the parameters of competition in the market (limb 3).

Exiting firm arguments are only accepted by the CMA if supported by a material body of probative evidence, which the CMA will test thoroughly. To be satisfied that the firm would have exited, for example, the CMA carefully examines a range of material, such as financial data (profitability over time, cash sheet and balance sheet), actions taken by management, contemporaneous internal documents (board minutes, management accounts and strategic plans), contemporaneous analysis by legal, financial and insolvency advisers and external auditors, and evidence from the firm’s debt and equity providers (i.e. banks and shareholders).

The CMA will also scrutinise whether there really was only one alternative purchaser, including by examining the marketing process by which the business was sold. The fact that no other bids were received or that other purchasers were unwilling to pay the asking price may not be sufficient if any alternative offer would have been above liquidation value.

This approach adopted by the CMA is very similar to the approach adopted by the ACCC in Australia. If the CMA concludes there is no realistic prospect of a substantially less anti-competitive alternative to the merger, the merger will be cleared.

Also, like the failing firm test in Australia, the CMA’s analysis is granular and fact-specific. Merger parties face a high evidential bar. Where multiple future counterfactuals exist, the CMA will conservatively select the most competitive counterfactual that is a realistic prospect. This means that a single alternative counterfactual delivering a better competitive outcome than the merger can result in the CMA denying clearance at Phase 1.

By contrast, exiting firm arguments have a better prospect if the merger proceeds to a Phase 2 (in-depth) review as at that stage the CMA ultimately selects the counterfactual that it considers the most likely to have arisen absent the merger.

International response to COVID-19

The international response to COVID-19 is similar to that of the ACCC.

In the United Kingdom, the CMA has established a COVID-19 taskforce to monitor and respond to competition and consumer concerns arising from the pandemic. This includes recently issuing guidance about its treatment of mergers in the context of the COVID-19 pandemic.³ These documents clearly show that there will not be any relaxation of the standards by which mergers are assessed by the CMA or its investigation standards, with the CMA stating that it “remains critical to preserve competition in markets through rigorous merger investigations in order to protect the interests of consumers in the longer term”.

Similar to indications given by the ACCC, the CMA has advised that “even significant short-term industry-wide economic shocks may not be sufficient, in themselves, to override competition concerns that a permanent structural change in the market brought about by a merger could raise”. It will be taking a case-by-case assessment to the impact of COVID-19 on each merger proposal, based on evidence, and beyond speculation about what the impact of COVID-19 may be.

The Canadian Competition Bureau has also recently released new guidance on its approach to failing firm analysis.⁴ That guidance is in the form of a detailed position paper on a transaction that the Bureau cleared on failing firm grounds earlier in the year. While the failing firm arguments in that case were not connected to the COVID-19 pandemic, the position paper provides helpful guidance for parties seeking to rely on such arguments in relation to the crisis in Canada.

At this point in time, comment by the regulators in the US and the European Commission has focussed on the procedural and timing implications for merger reviews. We await with interest any articulation of their policy position on failing firms in this context.

Some practical tips

When engaging with competition regulators, we note the following key points:

• A primary focus of regulators will be on identifying the different future scenarios if the merger does not proceed, including the potential for restructuring and the potential for third party alternative acquirers. The regulators will typically seek to identify the best ‘worst’ alternative scenario as the comparator for the merger, then determine which of those scenarios is sufficiently likely that it can become the future counterfactual.
• The regulator may be willing to let a firm proceed into insolvency if the assets of the firm are likely to be recycled to a market entrant that could maintain competitive tension. A competition regulator will focus on optimal competitive outcomes, not ensuring the survival of firms.
• Given the level of evidence required by regulators, it is prudent to raise failing and exiting firm concerns with competition regulators at an early stage and being prepared for a comprehensive evidential review. The CMA, for example, highlights the importance of discussing the evidence that will be required.
• Irrespective of economic conditions, mergers between close competitors will remain a concern to competition regulators, particularly if they occur in already concentrated markets. While competition regulators may recognise short-term market circumstances, they will also be wary of long-term market outcomes.
• Similarly, competition regulators will remain concerned about any excessive concentration. We can expect all authorities to closely scrutinise any transactions involving the major or dominant supplier in a sector, even if the target is struggling.
• Compelling evidence will be required. Authorities like the ACCC and the CMA are likely to give less weight to company documents created at the time of the merger which set up a failing or flailing firm counterfactual. Evidence of historic and future financial forecasts, evidence of senior executives, internal documents, and potentially expert or industry evidence, will be important.
• In global deals, authorities are likely to consult with their international counterparts on the types of submissions and evidence being led on failing and flailing firm defence.
• Each merger will turn on its own unique facts. To avoid unfortunate surprises, the parties to a merger should have a detailed understanding of the evidence before they approach the regulator. For example, if the firm failed, what would happen to the assets?