Is The Government Losing Its Merger Home Field Advantage?

The conventional wisdom is that the government has a significant advantage when challenging mergers in court, and that this advantage is especially difficult to overcome when the government presents major customer witnesses opposing the transaction. However, three recent government court losses in which the Federal Trade Commission (FTC) or Department of Justice (DOJ) teamed up with state attorney generals challenge that conventional wisdom. In each case, the trial judge subjected the government's theories and proof to close and skeptical analyses. Two courts discounted the testimony of major customers presented by the government and two courts gave considerable weight to “fixes” entered into by the defendants that lessened the alleged anticompetitive effects of the challenged transactions.

These three cases will clearly influence the parties' strategies in merger challenges, particularly with respect to customer opposition, fixes, market definition and proof of anticompetitive effects.

U.S. v. Oracle Corporation

It appeared that DOJ had everything going for it in this case ' the active involvement of 10 state attorney generals, strong opposition from major customers, the assistance of PeopleSoft, the targeted company in this hostile takeover, high market shares and a top-notch expert economist. However, in a lengthy and detailed 164-page opinion, the court concluded that plaintiffs had failed to establish the central elements of their case: the product market and anticompetitive effects. 311 F.Supp. 2d 1098 (N.D. Cal. 2004).

Plaintiffs' alleged product market consisted of certain types of enterprise resource planning (ERP) system software products able to meet the needs of large and complex enterprises with “high functional needs.” According to the plaintiffs, only three companies, Oracle, PeopleSoft and SAP, could meet the needs of these large enterprises. The plaintiffs argued that the new firm (with combined shares of 48% and 70% in the alleged markets) could raise prices without concern about competition.

Court Rejects Presumption in Merger Guidelines. Based on an extensive review of the case law and literature, the court rejected the DOJ/FTC Merger Guidelines strong presumption of anticompetitive effects if the market share of the new firm is least 35%. According to the court, in a case involving differentiated products, the plaintiff must prove that the merging parties would have essentially a monopoly or dominant position.

Court Rejects Testimony of Major Customers. Representatives of DaimlerChrysler, Pepsi Americas, Nextel, Greyhound Lines, Neiman Marcus, Verizon, Cox Communications and IBM testified in support of plaintiffs' product market and theory of anticompetitive effects. The court found their testimony largely unhelpful in that it focused on customer preferences, not on what they could do in response to an anticompetitive price increase post-merger: “unsubstantiated customer apprehensions do not substitute for hard evidence.”

As the court stated: “Drawing generalized conclusions about an extremely heterogeneous customer market based upon testimony from a small sample is not only unreliable, it is nearly impossible” and “the most persuasive testimony from customers is not what they say in court, but what they do in the market.”

Plaintiffs' Witnesses Stricken with “Lawson Amnesia.” The court was particularly critical of several plaintiffs' witnesses for “Lawson Amnesia” ' the inability to remember Lawson Software as a competitor to Oracle and Peoplesoft, even when presented with documents describing that competition. As the court remarked with respect to the third witness with this affliction: “Lawson Amnesia appeared to have claimed yet a third victim” and the court finds the “testimony concerning Lawson's absence from the up-market [high function market] largely incredible.”

Court Rejects Testimony of Plaintiffs' Expert. The court rejected the testimony of plaintiffs' principal expert economist because he failed to establish an “articulable” product market and failed to provide a basis for distinguishing between high-function and mid-market software products. The court faulted plaintiffs' product market definition for excluding, inter alia, the following alternatives: outsourcing, so-called “mid-market” vendors such as Lawson, AMS, and Microsoft, and best of breed solutions (i.e., selecting a software product from a specialized vendor rather than purchasing a bundle from Oracle or PeopleSoft).

Defendant's Experts Pick Apart Plaintiffs' Market “Piece By Piece.” Defendant's expert witnesses did not propose an alternative product market definition but rather “picked apart plaintiffs' market definition piece by piece.” For example, defendant's expert focused on the fact that DOJ, two weeks after bringing this case, chose to buy high function software for $24 million from AMS, a company excluded from plaintiffs' product market, because DOJ ranked AMS better than Oracle or PeopleSoft.

DOJ Decides Not To Appeal. On October 1, the DOJ announced it would not appeal, conceding that the detailed factual findings would receive great deference in the appellate process.

FTC v. Arch Coal

The FTC loss in this case was based on the court's rejection of customer testimony, a close analysis of the relevant facts and law in a detailed 89-page opinion and the acceptance of a pre-litigation “fix.” No. 04-0534 (D.D.C. Aug. 16, 2004). In this challenge, the FTC and six state attorney generals sought a preliminary injunction against the proposed acquisition by Arch Coal, Inc. (Arch) of two mines in the Southern Powder River Basin (SPRB) region of Wyoming from Triton Coal Company (Triton). Arch and Triton were two of five significant companies that mine a special high BTU coal in this area. In the face of opposition from the FTC, the parties entered into a pre-litigation “fix,” an intended divestiture of a mine to a new player that they claimed would maintain competition.

Court Rejects Expert's “Reluctant Conclusion” of Narrower Market. Although plaintiffs' argued for a product market narrower than SPRB coal, the court noted that plaintiffs' expert reached this conclusion “very reluctantly” and that there was substantial evidence of substitutability. The court rejected the narrower product market even though some buyers could not substitute.

Plaintiffs not Entitled to Presumption of Illegality. The court concluded that the SPRB market was highly concentrated and that the proposed acquisition of Triton by Arch “may raise significant competitive concerns ' although just barely” due to the small increase in concentration. While the FTC had established a prima facie case of illegality, the prima facie case was deemed “marginal” and “less than compelling” by the court, and the defendants easily rebutted the presumption of illegality by demonstrating the shortcomings of the market concentration statistics relied upon by the government.

Court Considers Intended Divestiture. Importantly, in analyzing concentration and alleged anticompetitive effects, the court took into account Arch's planned divestiture of an SPRB mine to a new competitor, even though the future divestiture was based on a contractual commitment. Throughout its opinion, the court noted that the number of competitors in the SPRB pre- and post-merger would remain the same due to the planned divestiture.

“Novel” Coordinated Effects Theory Rejected. Plaintiffs argued that the challenged transactions would facilitate coordinated conduct by substantially increasing the risk that SPRB producers would engage in coordinated output-constraining behavior. The court was not persuaded, declaring that the plaintiffs' “coordinated effects” theory based on output reduction (and not on price coordination) was “novel” and that the FTC's burden to establish anticompetitive effects was therefore more difficult. The court concluded that the government had failed to demonstrate that enhanced coordination was likely. As in Oracle, the court conducted a very detailed analysis of the evidence.

Public Comments About Prod-uction Discipline are “Lynchpin” of FTC's Case. The court closely scrutinized the likelihood of anticompetitive coordination because of public statements made by Arch and competitors about the need to discipline production. As the court said, the “lynchpin” of the FTC's case was the comments and actions of Arch with respect to “production discipline.” The court however concluded that despite these statements, other producers chose not to follow Arch.

Court Dismisses Customer Testimony. The district court also dismissed testimony from sophisticated SPRB coal customers regarding their fears that the challenged transaction would cause prices to rise, observing that antitrust authorities do not accord “great weight to the subjective views of customers in the market.” As the court stated:

“while the Court does not doubt the sincerity of the anxiety expressed by SPRB customers, the substance of the concern articulated by the customers is little more than a truism of economics: a decrease in the number of suppliers may lead to a decrease in the level of competition in the market. Customers do not, of course, have the expertise to state what will happen in the SPRB market, and none have attempted to do so. The Court therefore concludes that the concern of some customers in the SPRB market that the transactions will lessen competition is not a persuasive indication that coordination among SPRB producers is more likely to occur.”

Court of Appeals Rejects Emergency Appeal, but Case may Continue at FTC. On Aug. 20, 2004, the Court of Appeals denied the FTC's emergency motion for an injunction pending appeal but agreed with the FTC “that there is nothing novel about the theory it has advanced in this case.” Arch and Triton closed the transaction and the FTC dismissed its court appeal. However, the FTC has challenged the acquisition in an administrative proceeding at the FTC and can require divestiture if this challenge is upheld by the full FTC and a court of appeals. Currently the matter has been withdrawn from adjudication while the full FTC considers how it wishes to proceed in light of the court's opinion.

U.S. v. Dairy Farmers of America

In this case, the DOJ and the Commonwealth of Kentucky challenged Dairy Farmers of America's (DFA) acquisition of a 50% interest in Southern Belle Dairy Co., LLC (Southern Belle). The DOJ and Kentucky contended that DFA's partial acquisition of Southern Belle, combined with DFA's 50% interest in the entity that owns the competing Flav-O-Rich plant in London, Kentucky, would substantially lessen competition in the sale of milk to Kentucky and Tennessee schools. The two companies had pled guilty to price fixing in 1992 and the Kentucky Attorney General was very concerned about a decline in competitive bids at local school districts, especially since the two companies were often the only competitors.

Defendants' Post-Litigation Fix. After the plaintiffs' complaint was filed, the defendants devised a “fix” whereby DFA exchanged its interests in Southern Belle for non-voting preferred capital interests. DFA would thus have no right to vote on any matter or participate in Southern Belle's management. As a result, the court found that the balance of control in the relevant market did not shift to DFA because DFA's non-voting interest did not give it any control over the business decisions of Southern Belle.

Anticompetitive Effects Rejected as “Ephemeral Possibilities.” The plaintiffs argued that the acquisition of 50% interests in Southern Belle and in NDA, the entity that owns the Flav-O-Rich plant, gave the dairies the incentive and opportunity to collude and diminish competition among themselves. This argument was rejected. According to the court, the plaintiffs “simply substituted the concepts of incentive and opportunity, but without any explanation or evidence of how these might be exercised or whether they exist.” Noting that the operating agreements for both Southern Belle and NDA “did and do firmly leave the operating aspects of the company” with others, the court concluded that there was no mechanism by which the alleged adverse effects of DFA's acquisition of a non-operational interest in Southern Belle could be brought about. According to the court, this incentive and opportunity theory “deals in 'ephemeral possibilities,' and does not establish a reasonable probability of diminished competition.” The court granted summary judgment in favor of DFA (No. 03-206 KSF (E.D. Ky. Aug. 31, 2004)) and the plaintiffs have appealed.

Conclusion

The principal impact of these cases on merger challenges is:

• Stronger precedent for according less weight to customer opposition, even though customer concerns will still be significant;
• Constructing and presenting fixes to the court will merit more consideration;
• The government will have to pay closer attention to product market definition; and
• The government will have to prepare a strong case of actual anticompetitive effects, and not rely on presumptions based on market shares.

The conventional wisdom is that the government has a significant advantage when challenging mergers in court, and that this advantage is especially difficult to overcome when the government presents major customer witnesses opposing the transaction. However, three recent government court losses in which the Federal Trade Commission (FTC) or Department of Justice (DOJ) teamed up with state attorney generals challenge that conventional wisdom. In each case, the trial judge subjected the government's theories and proof to close and skeptical analyses. Two courts discounted the testimony of major customers presented by the government and two courts gave considerable weight to “fixes” entered into by the defendants that lessened the alleged anticompetitive effects of the challenged transactions.

These three cases will clearly influence the parties' strategies in merger challenges, particularly with respect to customer opposition, fixes, market definition and proof of anticompetitive effects.

U.S. v. Oracle Corporation

It appeared that DOJ had everything going for it in this case ' the active involvement of 10 state attorney generals, strong opposition from major customers, the assistance of PeopleSoft, the targeted company in this hostile takeover, high market shares and a top-notch expert economist. However, in a lengthy and detailed 164-page opinion, the court concluded that plaintiffs had failed to establish the central elements of their case: the product market and anticompetitive effects. 311 F.Supp. 2d 1098 (N.D. Cal. 2004).

Plaintiffs' alleged product market consisted of certain types of enterprise resource planning (ERP) system software products able to meet the needs of large and complex enterprises with “high functional needs.” According to the plaintiffs, only three companies, Oracle, PeopleSoft and SAP, could meet the needs of these large enterprises. The plaintiffs argued that the new firm (with combined shares of 48% and 70% in the alleged markets) could raise prices without concern about competition.

Court Rejects Presumption in Merger Guidelines. Based on an extensive review of the case law and literature, the court rejected the DOJ/FTC Merger Guidelines strong presumption of anticompetitive effects if the market share of the new firm is least 35%. According to the court, in a case involving differentiated products, the plaintiff must prove that the merging parties would have essentially a monopoly or dominant position.

Court Rejects Testimony of Major Customers. Representatives of DaimlerChrysler, Pepsi Americas, Nextel, Greyhound Lines, Neiman Marcus, Verizon, Cox Communications and IBM testified in support of plaintiffs' product market and theory of anticompetitive effects. The court found their testimony largely unhelpful in that it focused on customer preferences, not on what they could do in response to an anticompetitive price increase post-merger: “unsubstantiated customer apprehensions do not substitute for hard evidence.”

As the court stated: “Drawing generalized conclusions about an extremely heterogeneous customer market based upon testimony from a small sample is not only unreliable, it is nearly impossible” and “the most persuasive testimony from customers is not what they say in court, but what they do in the market.”

Plaintiffs' Witnesses Stricken with “Lawson Amnesia.” The court was particularly critical of several plaintiffs' witnesses for “Lawson Amnesia” ' the inability to remember Lawson Software as a competitor to Oracle and Peoplesoft, even when presented with documents describing that competition. As the court remarked with respect to the third witness with this affliction: “Lawson Amnesia appeared to have claimed yet a third victim” and the court finds the “testimony concerning Lawson's absence from the up-market [high function market] largely incredible.”

Court Rejects Testimony of Plaintiffs' Expert. The court rejected the testimony of plaintiffs' principal expert economist because he failed to establish an “articulable” product market and failed to provide a basis for distinguishing between high-function and mid-market software products. The court faulted plaintiffs' product market definition for excluding, inter alia, the following alternatives: outsourcing, so-called “mid-market” vendors such as Lawson, AMS, and Microsoft, and best of breed solutions (i.e., selecting a software product from a specialized vendor rather than purchasing a bundle from Oracle or PeopleSoft).

Defendant's Experts Pick Apart Plaintiffs' Market “Piece By Piece.” Defendant's expert witnesses did not propose an alternative product market definition but rather “picked apart plaintiffs' market definition piece by piece.” For example, defendant's expert focused on the fact that DOJ, two weeks after bringing this case, chose to buy high function software for $24 million from AMS, a company excluded from plaintiffs' product market, because DOJ ranked AMS better than Oracle or PeopleSoft.

DOJ Decides Not To Appeal. On October 1, the DOJ announced it would not appeal, conceding that the detailed factual findings would receive great deference in the appellate process.

FTC v. Arch Coal

The FTC loss in this case was based on the court's rejection of customer testimony, a close analysis of the relevant facts and law in a detailed 89-page opinion and the acceptance of a pre-litigation “fix.” No. 04-0534 (D.D.C. Aug. 16, 2004). In this challenge, the FTC and six state attorney generals sought a preliminary injunction against the proposed acquisition by Arch Coal, Inc. (Arch) of two mines in the Southern Powder River Basin (SPRB) region of Wyoming from Triton Coal Company (Triton). Arch and Triton were two of five significant companies that mine a special high BTU coal in this area. In the face of opposition from the FTC, the parties entered into a pre-litigation “fix,” an intended divestiture of a mine to a new player that they claimed would maintain competition.

Court Rejects Expert's “Reluctant Conclusion” of Narrower Market. Although plaintiffs' argued for a product market narrower than SPRB coal, the court noted that plaintiffs' expert reached this conclusion “very reluctantly” and that there was substantial evidence of substitutability. The court rejected the narrower product market even though some buyers could not substitute.

Plaintiffs not Entitled to Presumption of Illegality. The court concluded that the SPRB market was highly concentrated and that the proposed acquisition of Triton by Arch “may raise significant competitive concerns ' although just barely” due to the small increase in concentration. While the FTC had established a prima facie case of illegality, the prima facie case was deemed “marginal” and “less than compelling” by the court, and the defendants easily rebutted the presumption of illegality by demonstrating the shortcomings of the market concentration statistics relied upon by the government.

Court Considers Intended Divestiture. Importantly, in analyzing concentration and alleged anticompetitive effects, the court took into account Arch's planned divestiture of an SPRB mine to a new competitor, even though the future divestiture was based on a contractual commitment. Throughout its opinion, the court noted that the number of competitors in the SPRB pre- and post-merger would remain the same due to the planned divestiture.

“Novel” Coordinated Effects Theory Rejected. Plaintiffs argued that the challenged transactions would facilitate coordinated conduct by substantially increasing the risk that SPRB producers would engage in coordinated output-constraining behavior. The court was not persuaded, declaring that the plaintiffs' “coordinated effects” theory based on output reduction (and not on price coordination) was “novel” and that the FTC's burden to establish anticompetitive effects was therefore more difficult. The court concluded that the government had failed to demonstrate that enhanced coordination was likely. As in Oracle, the court conducted a very detailed analysis of the evidence.

Public Comments About Prod-uction Discipline are “Lynchpin” of FTC's Case. The court closely scrutinized the likelihood of anticompetitive coordination because of public statements made by Arch and competitors about the need to discipline production. As the court said, the “lynchpin” of the FTC's case was the comments and actions of Arch with respect to “production discipline.” The court however concluded that despite these statements, other producers chose not to follow Arch.

Court Dismisses Customer Testimony. The district court also dismissed testimony from sophisticated SPRB coal customers regarding their fears that the challenged transaction would cause prices to rise, observing that antitrust authorities do not accord “great weight to the subjective views of customers in the market.” As the court stated:

“while the Court does not doubt the sincerity of the anxiety expressed by SPRB customers, the substance of the concern articulated by the customers is little more than a truism of economics: a decrease in the number of suppliers may lead to a decrease in the level of competition in the market. Customers do not, of course, have the expertise to state what will happen in the SPRB market, and none have attempted to do so. The Court therefore concludes that the concern of some customers in the SPRB market that the transactions will lessen competition is not a persuasive indication that coordination among SPRB producers is more likely to occur.”

Court of Appeals Rejects Emergency Appeal, but Case may Continue at FTC. On Aug. 20, 2004, the Court of Appeals denied the FTC's emergency motion for an injunction pending appeal but agreed with the FTC “that there is nothing novel about the theory it has advanced in this case.” Arch and Triton closed the transaction and the FTC dismissed its court appeal. However, the FTC has challenged the acquisition in an administrative proceeding at the FTC and can require divestiture if this challenge is upheld by the full FTC and a court of appeals. Currently the matter has been withdrawn from adjudication while the full FTC considers how it wishes to proceed in light of the court's opinion.

U.S. v. Dairy Farmers of America

In this case, the DOJ and the Commonwealth of Kentucky challenged Dairy Farmers of America's (DFA) acquisition of a 50% interest in Southern Belle Dairy Co., LLC (Southern Belle). The DOJ and Kentucky contended that DFA's partial acquisition of Southern Belle, combined with DFA's 50% interest in the entity that owns the competing Flav-O-Rich plant in London, Kentucky, would substantially lessen competition in the sale of milk to Kentucky and Tennessee schools. The two companies had pled guilty to price fixing in 1992 and the Kentucky Attorney General was very concerned about a decline in competitive bids at local school districts, especially since the two companies were often the only competitors.

Defendants' Post-Litigation Fix. After the plaintiffs' complaint was filed, the defendants devised a “fix” whereby DFA exchanged its interests in Southern Belle for non-voting preferred capital interests. DFA would thus have no right to vote on any matter or participate in Southern Belle's management. As a result, the court found that the balance of control in the relevant market did not shift to DFA because DFA's non-voting interest did not give it any control over the business decisions of Southern Belle.

Anticompetitive Effects Rejected as “Ephemeral Possibilities.” The plaintiffs argued that the acquisition of 50% interests in Southern Belle and in NDA, the entity that owns the Flav-O-Rich plant, gave the dairies the incentive and opportunity to collude and diminish competition among themselves. This argument was rejected. According to the court, the plaintiffs “simply substituted the concepts of incentive and opportunity, but without any explanation or evidence of how these might be exercised or whether they exist.” Noting that the operating agreements for both Southern Belle and NDA “did and do firmly leave the operating aspects of the company” with others, the court concluded that there was no mechanism by which the alleged adverse effects of DFA's acquisition of a non-operational interest in Southern Belle could be brought about. According to the court, this incentive and opportunity theory “deals in 'ephemeral possibilities,' and does not establish a reasonable probability of diminished competition.” The court granted summary judgment in favor of DFA (No. 03-206 KSF (E.D. Ky. Aug. 31, 2004)) and the plaintiffs have appealed.

Conclusion

The principal impact of these cases on merger challenges is:

• Stronger precedent for according less weight to customer opposition, even though customer concerns will still be significant;
• Constructing and presenting fixes to the court will merit more consideration;
• The government will have to pay closer attention to product market definition; and
• The government will have to prepare a strong case of actual anticompetitive effects, and not rely on presumptions based on market shares.