Companies contemplating mergers should review the effect of the transaction on each customer type, application and product, not just on the broad customer base.

The U.S. District Court for the District of Columbia recently granted the Federal Trade Commission’s (FTC’s) motion to preliminarily enjoin the merger of Staples and Office Depot, the country’s two largest brick-and-mortar retailers and distributors of office supplies.1 Here, the FTC’s strategy followed closely its successful strategy in the Sysco/U.S. Foods merger challenge — a market definition based on a focused group of customers and their preferences.2 The injunction caused the companies to abandon the merger, which they argued was necessary to allow them to survive in a digitizing world.

Background

Shortly after the parties’ February 2015 announcement of the proposed Office Depot and Staples merger, the FTC began its investigation. Ultimately, the commissioners authorized the FTC to seek a preliminary injunction enjoining the merger.

Interestingly, the FTC’s theory was not based on the loss of competition in the overall retail market for office supplies, which is not heavily concentrated. Rather, the FTC claimed that the proposed merger would eliminate competition in the business-to-business (B-to-B) market for office supplies — in essence, large businesses purchasing office supplies for their own use and desiring nationwide coverage and certain other specific services. Specifically, the FTC focused on companies that spend $500,000 or more annually on office supplies in the United States.

Here, as in the Sysco/U.S. Foods merger, the FTC’s focus was on a narrow segment of customers and the argument that, despite the existence of other significant competition, the merging parties were each other’s closest competitor. The merger of the two closest competitors, according to the FTC, would cause these purchasers significant harm because it would allow a combined Staples/Office Depot to raise prices to this particular set of customers.

The FTC also argued that the relevant market was a cluster market of “consumable office supplies,” such as pens, paper clips and copy paper, and left out of this definition other items, such as ink and toner. Staples/Office Depot in turn argued that this market was a “gerrymandered and artificially narrow product market limited to some, but not all, consumable office supplies sold to only the most powerful companies in the world.”3

After the FTC presented its case in chief, the defendants opted not to put on a defense, arguing instead that the FTC had failed to establish that the proposed merger was likely to reduce competition in any relevant market.

The Decision

As in virtually all merger cases, here, the critical question was the definition of the relevant market. Although the parties agreed that the geographic market was the United States, the product market definition was hotly contested. Initially, the court focused on certain “practical indicia”4 — (1) industry recognition of the market as a separate economic entity, (2) distinct prices and sensitivity to price changes and (3) distinct customers requiring specialized vendors with value-added services. The court concluded that these factors supported a finding that large B-to-B customers constitute a separate market.

In addition to finding that office supply vendors identify customers according to their annual spend as a separate target group, the court noted that large B-to-B customers used a distinct process to purchase and negotiate pricing (requests for proposals, resulting in multiyear contracts to avoid regional price differences and lock-in prices on core items) and determined that they received distinct prices and were highly sensitive to price changes. As in Sysco/U.S. Foods, the court found that the customers comprising the FTC’s defined market require different services than other customers, such as sophisticated IT capabilities, personalized customer service and expedited delivery capabilities.

The court expressly rejected the defendants’ contentions that the relevant market was gerrymandered by excluding products such as ink and toner. Because ink and toner are not subject to the same competitive conditions (due to the rise of managed print services provided by vendors like Xerox and Hewlett-Packard) as the other products in the cluster market, the court found that those products were properly excluded from the relevant market.

Next, the court used the Herfindahl-Hirschman Index (HHI) to predict the likely effects of the proposed merger on competition within the large B-to-B customer market.5 Relying on the FTC’s expert’s calculations of market shares, the court referred to the combined entity’s 79 percent total market share as “striking” and deemed the post-merger HHI as presumptively illegal.6 Importantly, the court was also persuaded by (1) win/loss data, suggesting that Staples and Office Depot are often the last two bidding against each other and that both companies win large B-to-B customer bids more frequently than other bidders and (2) the parties’ ordinary course business documents, which include comments like “there are only two real choices for them” and “For core office supplies we often compare ourselves to our most direct competitor, [Office Depot].” In fact, ordinary course business documents showed that Staples and Office Depot themselves had used the proposed merger to pressure their customers to lock in prices based on the expectation that prices offered by the combined entity would be higher.

The merging parties’ primary argument that the merger would not have anticompetitive effects was the growing strength of Amazon Business, and Staples and Office Depot likened their fate to brick-and-mortar companies that had failed, such as Circuit City and Blockbuster. The court rejected this argument as highly speculative, noting that Amazon Business does not yet have the capabilities to successfully compete for these large B-to-B customers, including the abilities to compete for requests for proposal, commit to guaranteed pricing and provide dedicated customer service support. Similarly, the court rejected regional competitors as a viable restraint on the merged entity on a nationwide basis.

Although the court addressed the arguments raised by Staples and Office Depot, it did not have the benefit of the defendants’ expert or fact witness testimony because of the defendants’ decision to rest at the close of the FTC’s case. Putting the expert testimony aside, however, based on the evidence and arguments made during the FTC’s case, the court granted the requested preliminary injunction, relying heavily on the testimony of large B-to-B customers and competitor witnesses (including Amazon) as well as the defendants’ ordinary course business documents. Staples and Office Depot have since abandoned their deal.

Lessons

The court’s decision highlights a few important points. First, in any kind of concentrated market, it will be difficult for a merger of the firms with the largest and second-largest market share to avoid FTC scrutiny. As in the successfully challenged Sysco/U.S. Foods merger, the FTC defined the market based on the characteristics and preferences of a fairly narrow segment of customers and focused on the competitive harms to this distinct group alone.7 Companies contemplating mergers should review the effect of the transaction on each customer type, application and product, not just on the broad customer base.

Second, when the merging parties view themselves as each other’s closest competitor for any particular segment of the business, the transaction will likely face a substantial challenge.

Third, a defense resting on the alleged future strength of relatively marginal competitor and changed market conditions should be based on compelling evidence. Puffery, marketing or bold statements made by the competitor about its plans will likely not be enough, particularly with respect to competition from digital companies.