Covid-19 has had a staggering impact on the U.S. economy in just eight months. Businesses large and small are struggling to stay afloat, with over 3,600 Chapter 11 bankruptcy filings in the first half of the year.[i] By the third quarter of 2020, the number of Chapter 11 bankruptcies of companies with assets over $1 billion had doubled from the same period in 2019[ii] and the U.S. GDP had fallen 2.4%.[iii] Given the uncertainty surrounding the pandemic, economists predict that a full economic recovery is likely to take years.[iv]
Nevertheless, M&A activity has not dried up entirely. In fact, it is expected to rebound[v] as distressed companies turn to M&A to stay in business and financially sound companies look to grow through strategic acquisitions. This is supported by the increased number of Hart-Scott-Rodino Act filings with the U.S. Premerger Notification Office, just six months after President Trump declared Covid-19 a national emergency. In fact, HSR filings were 12% higher in September 2020 than in September 2019.[vi]
Transactions involving financially distressed firms are likely to become more common over the coming months. Where such transactions involve highly concentrated industries, companies will not be able to rely on the pandemic or its economic fallout to avoid antitrust scrutiny. Indeed, in the wake of the 2008 financial crisis, the U.S. Department of Justice (DOJ) emphasized that “keeping markets competitive is no less important during times of economic hardship” and that “[f]inancial distress, in and of itself, is not an antitrust defense.”[vii] The Federal Trade Commission (FTC) similarly warned that “competition laws need to be implemented at least as strictly during a time of economic crisis as they are otherwise.”[viii]
The agencies have maintained similar views during the current crisis. Drawing comparisons to “the 2008 financial downturn and countless other difficult periods in our nation’s history,” the FTC made clear in April that “‘emergency’ exceptions to the antitrust laws are not needed”[ix] and that it has “not relaxed, and will not relax, the intensity of our scrutiny or the vigor of our enforcement efforts.”[x] Similarly, the head of the DOJ’s Antitrust Division, Makan Delrahim, recently expressed skepticism about claims of financial distress in the merger context. [xi]
In tough times like these, distressed firms facing antitrust scrutiny for transactions in highly concentrated industries may be tempted to rely on the “failing firm defense” when seeking deal approval. But the failing firm defense is neither a simple shortcut nor a “get out of jail free” card. Asserting the defense where it is not truly applicable can undermine a company’s credibility with the enforcement agencies (and ultimately with the court), resulting in a merger that otherwise might have passed muster being challenged and blocked. Firms seeking to rely on the failing firm defense must be able to demonstrate (1) that the target firm’s resources are so depleted and the chance of recovery so remote that it faces the grave probability of imminent failure, (2) that the target firm cannot reorganize under Chapter 11 of the US bankruptcy code, and (3) that, after conducting a good faith search, the target firm lacks an alternative prospective purchaser. Although a strategic buyer who competes with the seller may be willing to pay more than an alternative prospective purchaser that does not pose the same threat to competition, the failing firm defense requires the seller to select the buyer, where available, that poses less of a competitive threat – even if the purchase price is significantly lower.[xii]
The public policy behind the failing firm defense is that it is better to permit a transaction that may reduce competition than to allow the target firm’s assets to exit the market altogether. Because it is essentially a free pass for an otherwise anticompetitive transaction, the failing firm defense is notoriously hard to prove. For example, in United States v. Energy Solutions, the court rejected the defense even though the target firm had never made a profit and relied on a credit line from its parent to pay its bills. The fact that the target’s parent failed to conduct a good faith shop for an alternative buyer, entering instead into an exclusive agreement to sell to the target’s biggest competitor, was enough to torpedo the defense and with it the merger.[xiii]
Although merging parties have struggled to convince the enforcement agencies and the courts to accept the failing firm defense, some have had better luck arguing that one of the merging parties is a “flailing firm” or weakened competitor. The crux of the flailing firm argument is that the government’s market share statistics overstate the transaction’s likely impact on competition, because they do not account for the fact that the weakened target is unlikely to be as vital a competitive constraint on the buyer going forward as it has been until now. Unlike the failing firm defense, which is a complete defense to an anticompetitive merger, the weakened competitor argument has tended to work best in combination with other rebuttal arguments when the government’s case for blocking a transaction is relatively weak. An example of this is the 2004 case, FTC v. Arch Coal. There, defendants Arch Coal and Triton successfully rebutted the FTC’s weak affirmative case by (1) offering to divest one of Arch Coal’s mines to a new competitor in the relevant market, (2) proving that the new competitor plus another fringe competitor would expand sufficiently into the relevant market to defeat a merger-induced price increase, (3) showing that the merger would generate some cost efficiencies, and (4) establishing that Triton “was a relatively weak competitor with no convincing prospect for improvement.”[xiv] More recently, the defendants in New York v. Deutsche Telekom persuaded a federal district court that Sprint’s weakened financial condition, combined with substantial merger-specific efficiencies and DOJ-approved remedies, were sufficient to rebut the plaintiff states’ strong prima facie case that the merger of T-Mobile and Sprint was likely to result in higher prices for consumers.[xv]
What Can Businesses Do?
Firms serious about relying on a failing firm defense or weakened competitor argument should be prepared to present the antitrust agencies with supporting ordinary course documents and expert analysis early in the investigation. If a distressed firm is contemplating a sale, it can take a number of steps in advance to ensure a strong defense in the event the potential buyer presents antitrust risk. First, the distressed firm should consider hiring external advisors to get its house in order prior to a sale. This can include financial experts, auditors, bankers, and even economists. To the extent a company is financially distressed, these experts can assist the company in assessing its financial health, evaluating options to keep the company afloat – including restructuring or a potential auction – and running the auction process if the firm ultimately decides to sell. Documents prepared by outside advisors, including financial statements, budgets, and bankruptcy plans, may ultimately be requested by the U.S. antitrust agencies during a merger review to provide insight into the company’s financial health.
In addition, employees should adhere to the company’s document creation policies to prevent the creation of unhelpful documents that could sidetrack a sale. Documents such as marketing materials, statements to investors or lenders, and confidential information memoranda that contain statements that inflate the distressed firm’s financial health, strategic growth, or market position will be difficult to overcome if the enforcement agencies decide to challenge the transaction. The company’s document creation policies should also apply to news articles, blogs, websites, press releases, regulatory filings, and social media posts, all of which can be used as evidence by U.S. antitrust agencies in a merger challenge. For example, in United States v. EnergySolutions, the distressed company had represented in a regulatory application filed mere months before trial that its “financial qualifications are adequate to carry out the activities for which the license is sought.”[xvi] The government used this representation to undermine the target’s claim that it was a failing firm.
Finally, once the distressed firm is prepared to start the auction process, it must act in good faith to identify a buyer. This means that the seller should not limit the auction to just one potential buyer, exclude potential buyers solely based on a low bid, or agree to exclusivity early in the auction process. By engaging a banker and outside counsel, the seller increases the likelihood of a smooth auction process, including a public announcement of the sale, solicitation of more than one potential bid, and operating a data room for prospective buyers to obtain the information they need.
The Covid-19 pandemic has caused some observers to suggest that the failing firm defense may be more attractive now than ever. It is important to remember, however, that the failing firm defense is a risky gamble that rarely pays off. It is a very high standard that requires a substantial upfront preparation and places the burden of proof on the merging parties. The defense also comes with potentially serious commercial downsides that can prevent a sale to the highest bidder, leaving the seller with less than fair value. As a result, the failing firm defense is best left as the last line of defense for distressed firms that cannot reorganize under Chapter 11.
For those seeking a more strategic defense to potentially problematic mergers during difficult economic times, the “flailing firm” or “weakened competitor” argument is likely to be met with more success. With the right circumstances, preparation and evidentiary support, merging parties that can establish that the target’s competitive impact is waning may succeed in closing a transaction for at or near fair market value. Success is more likely if the merging firms are also able to establish one or more of the following: (i) the transaction will generate substantial merger-specific efficiencies; (ii) other firms are likely to timely and meaningfully enter or expand into the relevant market, replacing the competition that would be eliminated by the merger; and/or (iii) remedies proposed by the merging firms will effectively address any competitive concerns of the antitrust enforcement agencies.
[i] The Eye of the Bankruptcy Storm, NYT DealBook, July 17, 2020, https://www.nytimes.com/2020/07/17/business/dealbook/bankruptcy-filings-pandemic.html.
[ii] Patrick Mathurin, Pandemic Triggers Wave of Billion-Dollar US Bankruptcies, Fin. Times, Aug. 21, 2020, https://on.ft.com/3ja8Atb.
[iii] John Elflein, Coronavirus (COVID-19) in the U.S. – Statistics & Facts, Statista.com, Aug. 21, 2020, https://www.statista.com/topics/6084/coronavirus-covid-19-in-the-us/#dossierSummary__chapter7.
[iv] Economists Warn U.S. GDP Won’t Recover to Pre-Pandemic Levels Until 2022, Forbes, Aug. 24, 2020, https://www.forbes.com/sites/sergeiklebnikov/2020/08/24/economists-warn-us-gdp-wont-recover-to-pre-pandemic-levels-until-2022/#6c7d0b185078.
[v] Curtis Eichelberger & Flavia Fortes, Comment: M&A Deals Expected to Jump in 4th Quarter as US Backlog Loosens in Life Sciences, Tech, and Industrials, MLex, Aug. 18, 2020, https://www.mlex.com/GlobalAntitrust/DetailView.aspx?cid=1216250&siteid=190&rdir=1.
[vi] The Premerger Notification Office received 177 filings in September 2020, which is a 12 percent increase over the number of filings in September 2019. See HSR Transactions By Month available at https://www.ftc.gov/enforcement/premerger-notification-program.
[vii] Carl Shapiro, Deputy Assistant Attorney Gen., U.S. Dep’t of Justice, Antitrust Div., Remarks as Prepared for Delivery to ABA Antitrust Symposium: Competition as Public Policy (May 13, 2009), https://www.justice.gov/atr/speech/competition-policy-distressed-industries.
[viii] J. Thomas Rosch, Comm’r, Fed. Trade Comm’n, Remarks Before New York Bar Association Annual Dinner: Implications of the Financial Meltdown for the FTC (Jan. 29, 2009), at 7, https://www.ftc.gov/sites/default/files/documents/public_statements/implications-financial-meltdown-ftc/090129financialcrisisnybarspeech.pdf.
[ix] Ian Connor, Antitrust Review at the FTC: Staying the Course During Uncertain Times, FTC Blog: Competition Matters (Apr. 6, 2020, 11:36 AM), https://www.ftc.gov/news-events/blogs/competition-matters/2020/04/antitrust-review-ftc-staying-course-during-uncertain.
[x] Ian Connor, On “Failing” Firms – and Miraculous Recoveries, FTC Blog: Competition Matters (May 27, 2020, 10:13 AM), https://www.ftc.gov/news-events/blogs/competition-matters/2020/05/failing-firms-miraculous-recoveries.
[xi] Makan Delrahim, Assistant Attorney Gen., U.S. Dep’t of Justice, Antitrust Div., Remarks as Prepared for Delivery to Kellogg School of Management, Northwestern University Conference on Innovation of Economics: Never Break the Chain: Pursuing Antifragility in Antitrust Enforcement (Aug. 27, 2020), https://www.justice.gov/opa/speech/assistant-attorney-general-makan-delrahim-delivers-remarks-thirteenth-annual-conference.
[xii] See, e.g., United States v. Energy Sols., Inc., 265 F. Supp. 3d 415, 446 (D. Del. 2017).
[xiii] Id. at 434-32, 444-46.
[xiv] F.T.C. v. Arch Coal, 329 F. Supp. 2d 109 (D.D.C. 2004).
[xv] See, e.g., New York v. Deutsche Telekom AG, 439 F. Supp. 3d 179 (S.D.N.Y. 2020).
[xvi] Energy Sols, 265 F. Supp. 3d at 432.