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 of Cornerstone Research to gain insight into the failing firm defense, which requires a company to demonstrate that it will exit the relevant market, absent the acquisition. Regulatory agencies give credit to claims that prove the company (1) will be unable to meet its financial obligations in the near future, (2) cannot reorganize successfully under Chapter 11 of the Bankruptcy Act, and (3) has made unsuccessful good-faith efforts to find alternative offers of acquisition.
In this interview, Dr. Eastman considers the economic impact of COVID-19, how that impact compares to that of the 2008 financial crisis, and whether the agencies are likely to relax their failing firm defense requirements in response to the pandemic.
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.
What impact can an economic shock, like the one caused by the COVID-19 pandemic, have on a firm’s short- and long-term viability? How might this affect a failing firm defense?
The failing firm defense focuses on the financial stability of a firm in the “near future.” Assessing the definition of “near future” warrants a closer look at firm-specific issues, such as the company’s lifecycle, its industry, and its ability to compete in the relevant market. However, an event like the COVID-19 pandemic poses unique challenges to such an assessment.
COVID-19’s impact on many firms’ topline revenues has been almost instantaneous. Moreover, it has affected entire industries, instead of a subset of firms within an industry. These conditions raise the following questions: Because of the fast and furious impact of COVID-19 on firms’ financial stability, does this affect how we measure the “near future”? Could the time frame be quarters, or weeks, or even days? Since entire industries are affected, can we assume that a thorough shop process to find an alternative buyer, either strategic or financial, requires more or less time than usual?
The answers to these questions depend on the velocity of a firm’s economic decline, how enduring COVID-19-related effects may be, how much time elapses before any recovery begins, and the levels of sales and profitability that industries may regain in that recovery.
Are there lessons to learn from how the failing firm defense was argued and analyzed in the aftermath of the 2008 financial crisis?
During a recession, more firms are likely to experience financial distress, and, potentially, to fail. In the wake of the 2008 financial crisis, however, antitrust authorities were careful to note that the issues raised in a failing firm defense are not unique to an economic downturn.
Certain distinct characteristics of the COVID-19 pandemic make it difficult to compare with the 2008 financial crisis. Even so, the guidance that regulatory agencies around the world have issued for COVID-19 is similar to their approach in 2008. Such communications suggest that antitrust authorities have the same toolbox at their disposal today as they did prior to the pandemic, or in 2008, and will continue to apply those rigorous standards in their assessment of cases.
Two environmental conditions distinguish the 2008 financial crisis from the coronavirus pandemic: timing and scope. Compared to the financial crisis, the effects of the coronavirus and accompanying lockdowns may create an environment of even more accelerated financial decline. The far-reaching nature of the pandemic also affects our ability to assess a firm’s future prospects, given the widespread uncertainty in the market. Usually, we’re able to estimate a firm’s future prospects “all else held equal.” With entire industries in flux and a fast-evolving landscape, it is difficult to assess the viability of a single firm without also analyzing the myriad external changes outside that may be affecting the firm. Though the 2008 financial crisis can provide guideposts, we should exercise caution in comparing the implications of these events.
Can we expect regulatory agencies to show leniency to merging parties that mount a failing firm defense?
As an affirmative defense, the failing firm and exiting assets requirements present high thresholds for merging parties to clear. Regulatory agencies around the world have issued guidance that indicates they will remain uncompromising as they assess the merits of failing firm arguments, even in the face of the COVID-19 pandemic.
What has changed in this climate, however, is a firm’s ability to meet these high standards. In a time of extreme economic uncertainty and large shifts in the market, the risk of near-term failure is not as remote as it was a year ago. In addition, a firm’s survival, whether via reorganization under bankruptcy or other alternatives to a transaction, may be compromised. It is possible that the pandemic may severely limit a financially failing firm’s ability to keep its assets on the market for consumers.
Has the COVID-19 pandemic affected the specific requirements of the failing firm defense?
While we do not foresee changes—either in leniency or substance—to the failing firm requirements, it is obvious that the pandemic is having an enormous and evolving impact on global business.
First, COVID-19 has affected firms’ ability to survive in the near term. Entire industries are experiencing simultaneous financial distress. The recent Amazon/Deliveroo deal and Dean Foods’ acquisition by the Dairy Farmers of America highlight the financial distress in the hard-hit food industry.
Second, it could become more difficult for firms to reorganize in Chapter 11 bankruptcy if the bar for the amount of restructuring required is increasing. There might also be fewer options for a restructuring firm, as financing and partnership opportunities dwindle.
Third, it is unclear whether or not a “good faith” effort to find an alternative to the transaction is entirely achievable via video conference. In the future, we might observe either an elongation of the shop process timeline or a willingness to soften due diligence procedures. Complications like this could limit the pool of willing purchasers and partners.
Some of the industries hit hardest in the pandemic have also historically faced scrutiny from the agencies. Can we anticipate, say, an airline merger facing less scrutiny than it otherwise would?
On both sides of the Atlantic, agencies have so far made it clear that they have not altered nor relaxed their standards for evaluating mergers for antitrust concerns, even in the midst of COVID-19. So, it is hard to imagine that agencies will be more lenient on airline mergers, or on any other mergers for that matter. That said, it is clear that agencies are willing to consider the potential effects of COVID-19 on firms’ ability to stay afloat in the short run, until we see how those firms emerge when the pandemic subsides.
For example, U.S. agencies have kept a watchful eye on consolidation in the healthcare industry, especially the vertical integration of recent years. COVID-19 poses unique challenges to this already complicated landscape, particularly hospitals.
COVID-19 is not a stand-alone failing firm defense. There is considerable uncertainty about the future, both at the macro and micro levels. Firms that are failing due to COVID-19-related hardships must make a compelling argument for how the pandemic drives their ability to mount a failing firm defense, in accordance with antitrust authorities’ guidelines. Agencies are likely to be looking for a clear, concise explanation and supporting documentation from firms to assess the merits of their arguments. Recent events related to COVID-19 have put the agencies on alert that many firms may try to claim a failing firm defense, and the agencies are prepared to provide significant scrutiny.
The views expressed herein do not necessarily represent the views of Cornerstone Research.