A periodic feature by Cornerstone Research, in which our affiliated experts, senior advisors, and professionals, talk about their research and findings.
We interview Greg Eastman and Ceren Canal Aruoba of Cornerstone Research about failing firm defenses. Dr. Eastman and Ms. Canal Aruoba explain the Horizontal Merger Guidelines’ criteria for clearing the bar of an affirmative defense; describe specific approaches that financial experts use to analyze allegedly failing firms’ assets; and consider the varied challenges that merging parties face in mounting this defense.
Dr. Eastman has been retained as a testifying expert to perform profitability analyses and assess whether firms are failing and their assets are likely to exit the relevant market. He was the Department of Justice’s testifying expert in United States v. EnergySolutions Inc. et al.
Ms. Canal Aruoba consults on antitrust and competition matters with a focus on the failing firm defense and efficiencies analyses. She supported Dr. Eastman’s rebuttal of the merging parties’ failing firm defense in United States v. EnergySolutions Inc. et al. Ms. Canal Aruoba has addressed similar issues in the healthcare, food, and online gaming industries.
Ceren, can you explain the role of the Horizontal Merger Guidelines in failing firm defenses?
The driving force behind the Horizontal Merger Guidelines (Guidelines) is that mergers enabling the creation or enhancement of market power should not be permitted. The Guidelines allow special consideration, however, for mergers that involve firms experiencing financial failure. The reasoning is straightforward: if a firm’s market share is trending towards zero, merging with a competitor is unlikely to enhance that competitor’s market power. Similarly, if one of the merging firms was already facing “imminent failure,” the Guidelines stipulate that consumers would be better off after a merger that keeps the assets of that failing firm—its choice set of products, services, and so forth—intact in the relevant market.
The bar to clear this affirmative defense is high. To support a failing firm defense, and credibly claim that a firm’s assets are in danger of exiting the relevant market, merging parties must affirmatively show that the target firm meets all of the following criteria, as laid out in the Guidelines:
- “[Inability] to meet [the firm’s] financial obligations in the near future”;
- “[Inability] to reorganize successfully under Chapter 11 of the Bankruptcy Act”; and
- “Unsuccessful good-faith efforts to elicit reasonable alternative offers that would keep [the firm’s] tangible and intangible assets in the relevant market and pose a less severe danger to competition than does the proposed merger.”
Greg, what analytic approaches do financial experts and regulators use to conduct failing firm assessments?
The Guidelines focus on the exit of the assets of the failing firm, not necessarily on the exit of the failing firm itself. Because of this, one needs to perform a multifaceted inquiry to understand both the assets themselves and the allegedly failing firm’s financial incentives to keep those assets in the market. Financial experts and regulators can analyze the merging parties’ financial statements, regulatory filings, and internal documents, as well as the parties’ behavior and testimony, to evaluate the likelihood of the firm’s assets exiting the market.
A review of the firm’s financials within the context of its competitors can yield valuable information. Specifically, competitive analyses of industry trends can help to distinguish between firm-specific structural problems that might lead the firm’s assets to exit, and broader economic conditions.
It is also important to be aware of how the “shop” process works during the normal course of business and how it might vary depending on different factors. Understanding this process can help to assess the Guidelines’ criterion of “good-faith efforts to elicit” reasonable alternative offers.
In a normal shop process, the goal is to maximize the sales price for the assets and the firm. This goal might need to be reconsidered in the context of acute financial distress or an imminent failure. By analyzing the efforts put into the shop process, financial experts and regulators can determine whether it meets the industry norm. It is also helpful to investigate the value of the assets being sold, the types of buyers being targeted, and the provisions being stipulated in the merger agreement.
Greg, walk us through some of the challenges you have faced as a testifying expert when working on failing firm defenses.
The analysis begins by collecting a comprehensive set of case facts and the recent history of the firm and its industry. Telling a story about the firm’s future requires not only a careful review of the case documents but also a deep understanding of the industry at issue. For example, the concept of exiting assets, and their implications for the relevant market, is critical to any failing firm defense analysis. However, what an asset is, and what that asset’s “exit” might look like, can differ significantly from case to case, and may have considerable implications for the financial viability of the allegedly failing firm. The financial and economic analyses you would want to consider—in addition to any analysis of the “shop” process—may differ depending on the firm’s assets. For example, the analytic approach for intangible assets (e.g., human capital such as physicians) is likely to be different from the one needed to evaluate tangible assets (e.g., a manufacturing plant).
Furthermore, deep understanding of the industry at issue is critical to a comprehensive failing firm analysis, because considerable uncertainty is embedded in these analyses. For example, the Guidelines require the failing firm to be unable to meet its financial obligations in the “near future,” but they never define what the “near future” is. This increases the need to consider timing and how to assess a reasonable interpretation of “imminent failure.” In certain circumstances, “near future” may be related to the next payroll obligation or to the next debt payment.
More generally, one may need to understand the expected lifespan of a business. On one hand, a company relatively early in its lifecycle might be losing money consistently as it makes investments to grow the business and achieve proper scale, but it could have strong growth prospects. On the other, a mature company in a stagnant industry might have a long history of earnings, but could face a prospect of failure if it has not innovated successfully to keep up with changing customer preferences. How one would view the earnings or losses in each scenario, and what “near future” would mean for each company, might be different.
What issues are particular to these types of cases?
The existence of the Guidelines’ three criteria would seem to suggest that failing firm analyses are clear-cut. The criteria are very fact-specific, but the facts depend on the particular company, industry, and circumstances at issue. There is no one-size-fits-all solution. Having said that, Greg and I have seen interesting issues arise across the many different kinds of cases we have worked on together.
Here’s an example. In certain instances, the acquiring firm has agreed to pay a considerable amount of money to acquire the allegedly failing firm. This suggests that the failing firm has value. It would be economically irrational to exit a market when there is a significant positive value for the firm, which thus calls into question whether or not the allegedly failing firm (and its assets) would exit the market absent the merger, unless the merger creates the significant value. From there, we must consider if the acquisition price exceeds the liquidation value of the failing firm’s assets. The answer to that question is very fact-dependent.
Furthermore, the concept of liquidation value—the restriction on assets’ valuation for use outside the relevant market—raises another interesting point related to the “shop” processes the allegedly failing firm pursues, and which potential buyers it targets.
In the normal course of business, potential buyers are usually either strategic or financial. A strategic buyer tends to be a firm that is managing existing operations in the same or related industries. A financial buyer tends to be a private equity firm or other fund investor that often plans to own, grow, and/or improve the acquired firm for only a few years before reselling it.
In situations where the allegedly failing firm is experiencing financial stress due to structural economic issues, as opposed to access to capital, the question of who can provide a “reasonable” offer to satisfy the Guidelines’ requirements and keep the failing firm’s assets in the market becomes a difficult question to answer. A strategic buyer would be an obvious option, but they could be a direct competitor to the allegedly failing firm and draw scrutiny from antitrust authorities.
Given the many complexities inherent in the failing firm defense, what, in your view, must financial experts keep in mind as they undertake these analyses?
I would say that a certain level of comfort with future-looking statements is required to analyze whether a firm clears the high bar of a failing firm defense. Such statements include forward-looking economic and financial materials, internal projections, third-party assessments, public statements about investments and growth prospects, and the like. The challenging part for everyone involved is figuring out how much weight to assign to each predictive estimate when assessing a firm’s future prospects.
I would also add that the level of uncertainty varies significantly depending on the industry and the company at issue. For example, in growing industries, with technologies that are unproven or not-yet-established, it is difficult to forecast future sales/prospects. This is because novel technologies could be associated with novel trajectories and unexpected recoveries. And most of the time, it is a strategic partner, not a financial one, that possesses the knowledge and resources to shepherd a failing firm to recovery. It is speculative to determine whether we are facing a killer acquisition that stifles the next big thing, or if an acquisition offers life support and an eventual path to recovery to an ailing company. Merging parties and regulatory agencies generally come out at the opposite ends of this discussion.