On 20 April 2010, a draft new version of the Horizontal Merger Guidelines (Guidelines) used by the Department of Justice and the Federal Trade Commission (the Agencies) to analyze horizontal mergers was released for public comment. Whereas the existing guidelines, which date from 1992, sought to provide a precise, step by step framework for analyzing horizontal mergers — centered around defining a "relevant market" and measuring market concentration — the new proposed Guidelines embody a much more flexible approach. The new Guidelines place less emphasis on market definition and can be likened to a "tool box" of techniques for analyzing the competitive implications of horizontal mergers. This new analytical approach has important implications for analyzing mergers and acquisitions in the pharmaceutical industry.
Importantly, the methods for analyzing horizontal mergers and acquisitions that are set forth in the new proposed Guidelines already constitute the current practices at the Agencies. Accordingly, while several notable changes in the Guidelines can be observed as compared to the 1992 Guidelines, most of these changes have already occurred at the Agencies. As a result, the new Guidelines are more of an effort at transparency than to effect fundamental future change. The impact of the Guidelines will also be restrained by the fact that courts hearing merger challenges may continue to consider market definition central to the antitrust assessment of mergers. Below we describe several proposed changes to the Guidelines that are particularly relevant for pharmaceutical transactions.
Changes Impacting Pharmaceutical Transactions
- Direct Evidence of Competitive Effects in Pharmaceutical Markets
Applying traditional market definition analysis to pharmaceutical markets is frequently like fitting a square peg into a round hole. Different drugs compete with one another to varying degrees and at various points in the product life cycle. Trying to draw a precise line as to which drugs are "in" and which are "out" of the market can be arbitrary. The draft new Guidelines recognize this, explaining that setting a precise boundary for the "market" results in an oversimplification that "cannot capture the full variation in the extent to which different products compete against each other." (Guidelines § 4.) On the other hand, the use of the market definition paradigm has been useful, among other reasons, to provide a discipline for competitive analysis.
The new Guidelines' express willingness to forego market definition is designed to give increased legitimacy to a trend at the Agencies to focus mainly on the likely real-world competitive effects of mergers and acquisitions. For example, where a pharmaceutical company seeks to acquire a drug that competes closely with one of its drugs (or, for a drug in the pipeline, is likely to do so following FDA approval), but there are several competing drugs manufactured by others to treat the same condition on the market or in the pipeline, the new Guidelines indicate that the Agencies are likely to focus on whether the acquisition may harm competition for customers whose top two choices are the drugs made by the acquiring and target companies. (Guidelines §§ 2.1.4, 3.) The new Guidelines explain how the Agencies may proceed with such theories of competitive harm without defining the "relevant market" to exclude several important competing drugs. Of course, the Agencies would still need to address the competitive significance of these other competing drugs.
As a stylized example of where it might be useful to the Agencies to avoid precisely defining a market, one could imagine an acquisition by a brand name manufacturer of a potential generic substitute for one of its drugs. In such a case, the Agency would point to the competitive effects of the transaction — i.e., the possibility that the brand name manufacturer won't introduce (or will delay introducing) the generic and the corresponding impact on prices, without having to explain why the "market" should be drawn to exclude the important brand name drug alternatives to the drug in question. Other types of "competitive effects" that the Agencies may focus on in merger challenges include evidence of head-to head-competition between the merging parties' drugs that resulted in lower prices (an effect that would arguably be lost by the merger) or, if the challenge is to a consummated transaction, evidence showing that one (or both) of the competing drugs' prices was increased post-merger.
- Expanded Discussion of Price Discrimination
In a similar vein, the revised Guidelines illustrate a greater willingness on the part of the Agencies to pursue theories of competitive harm based on alleged effects on narrow categories of customers that can be specifically targeted for a price increase. The Guidelines provide that "[w]here price discrimination is feasible, adverse competitive effects on targeted customers can arise, even if such effects will not arise for other customers." (Guidelines § 3.) They continue: "[w]hen discrimination is reasonably likely, the Agencies may evaluate competitive effects separately by type of customer." (Id.) (emphasis added). This suggestion that the Agencies might focus on narrow categories of customers in markets characterized by price discrimination is important for firms such as pharmaceutical companies that operate in markets with high R&D costs and relatively low manufacturing costs. In such markets, there is frequently a strong incentive to supply product to as many customers as possible, and this can lead manufacturers to try to "price discriminate" by providing special discounts to customers unwilling to pay the prices paid by others. The new Guidelines suggest that the Agencies will examine the impact of any transaction on the prices paid by each category of customers.
- Shift in Emphasis from "Coordinated Effects" to "Unilateral Effects"
Competitive harm from "coordinated effects" occurs where the higher market concentration post-merger leads to a greater chance of concerted action between the firms remaining in the market. Competitive harm from "unilateral effects" relates solely to a reduction in competition between the merging parties. More specifically, where the producer of one product acquires a close substitute product, it may have an incentive to increase prices on one of the products post-acquisition because some of the resulting lost sales will be captured by the substitute product. Because pharmaceutical markets are often characterized by highly differentiated products and fierce competition between competitors, mergers and acquisitions in these markets more frequently raise issues of unilateral effects than coordinated effects — especially if the firm is acquiring a close substitute. While prior versions of the Guidelines emphasized "coordinated effects" as a central concern of merger review, the new proposed Guidelines place much more emphasis on "unilateral effects." This increased focus on unilateral effects reflects current Agency practice, but leads inevitably to increased scrutiny of transactions in sectors like the pharmaceutical industry — especially, as noted, where the merging parties sell differentiated products that may be viewed as close substitutes for one another.
- High Margins
In evaluating the potential for post-merger "unilateral effects," the new Guidelines explain that the Agencies will consider whether a merger is likely to lead to "upward pricing pressure" on the price of one (or both) of the merging parties' products. (Guidelines § 6.1.) One key technique described in the Guidelines for assessing the potential for upward pricing pressure is to calculate the amount of revenue that a merging party could recapture from the second party's product in the event that the first party raised its price. This amount is highly influenced by the size of the margins earned by the second party on its product.
In pharmaceutical markets, products are frequently sold at high margins because most of the costs of selling a product come from R&D costs, not manufacturing costs. These high margins typically have nothing to do with whether a particular market is competitive or not. Even the most highly competitive drug markets, for example, will include numerous competitors that are earning apparently high margins (not taking into account R&D costs). But because the technique described above will indicate greater "upward pricing pressure" for products with higher margins, this technique (if applied mechanically) is more likely to suggest competitive problems with mergers and acquisitions in pharmaceutical markets as compared to many other industries. The Guidelines' concern with high margins can also be seen in Section 2.2.1, which states that "if a firm sets price well above marginal cost, that normally indicates either that the firm is coordinating with its rivals or that the firm believes its customers are not highly sensitive to price." Pharmaceutical companies know that this is not the case in their industry. Based on our conversations with the agencies, we expect the agencies to revise Section 2.2.1.
- Effects on Innovation
Although the Agencies have regularly focused on how a proposed merger or acquisition might affect innovation, that concept was not well articulated in the 1992 Guidelines. The draft Guidelines specifically identify innovation as an issue to be addressed in the merger review. The Guidelines note that in some transactions, a merger may reduce incentives to continue with existing product development efforts and thereby reduce innovation, while in other cases, it may bring together complementary capabilities that may spur greater innovation. Obviously, these issues are frequently important in analyzing pharmaceutical transactions, where the combination of product development initiatives may lead to the faster development of new products. As in all issues in merger analysis, the outcome will be highly fact-specific.
- Partial Acquisitions
Although partial acquisitions have been the subject of enforcement actions at both agencies, the draft Guidelines for the first time discuss the potential competitive effects of such acquisitions. These include: (1) giving a minority owner the ability to influence the competitive conduct of the target firm, (2) reduced incentives to compete because of profits gained through the minority interest, and (3) the exchange of competitively sensitive information, which may facilitate coordination.
The new draft Guidelines indicate a tendency on the part of the Agencies to define narrower markets, and a willingness to challenge horizontal mergers or acquisitions based on an alleged impact on a narrower set of customers. These and other changes indicate increased scrutiny of M&A transactions in pharmaceutical markets, although that does not mean that the Guidelines portend a dramatic change in future enforcement levels. As noted, these changes to the Guidelines reflect current agency practice as it has evolved over the past two decades. As participants in the pharmaceutical industry can attest, the Agencies already aggressively investigate pharmaceutical transactions. The possibility of dramatic change is, moreover, tempered by the influence of long-term career staff and by the oversight of courts, which tend to rely on precedent (and, as noted, may resist discarding the centrality of market definitions to merger analysis). Accordingly, a key effect of the new Guidelines is to clarify our understanding of how the agencies are actually operating, and provide a measure of explanation for the high level of Agency enforcement activity in the pharmaceutical industry.
While it also presents some risks, the more holistic approach advocated by the draft Guidelines also creates opportunities for defense counsel. The limitations inherent in "market definition" arguments can also apply to defensive arguments, and there is frequently a very good story to tell concerning the likely competitive effects of an M&A transaction. Indeed, for years our practice has been to focus on competitive effects rather than defining markets and calculating concentration levels. In making such arguments, defense counsel will now be equipped with a more precise and transparent understanding of the considerations that the Agencies are actually taking into account in evaluating whether to challenge a proposed merger. Moreover, there is nothing to stop defense counsel from focusing on market definition with the Agencies on the basis that, if the merger is ultimately litigated, that is how the courts will analyze it.