The Federal Trade Commission (“FTC”) and the State of Illinois successfully concluded their challenge to the proposed merger of Advocate Health Care and NorthShore University Health System earlier this month, when the U.S. District Court for the Northern District of Illinois granted the plaintiffs’ request for a preliminary injunction enjoining the health systems from consummating their proposed merger. The parties subsequently abandoned the transaction without appealing the district court’s decision.

The district court had previously denied the motion for a preliminary injunction. It believed that the geographic market proposed by the plaintiffs was too narrow and found the evidence “equivocal” regarding the importance of patients having access to hospitals close to their homes. As such, it held that the plaintiffs had not met their burden of proving a relevant geographic market and thus, did not demonstrate a likelihood of success on the merits. However, in October 2016, the U.S. Court of Appeals for the Seventh Circuit reversed and remanded for further proceedings on the issue of geographic market definition, holding that the lower court erred in its factual findings regarding critical aspects of the geographic market, as well as the remaining preliminary injunction elements that the district court did reach in its first decision.

This decision is notable for several reasons. First, coupled with the Seventh Circuit’s opinion, this decision embraces the FTC’s analytical approach to defining an urban relevant geographic market, allowing the FTC to exclude “destination” hospitals and also to exclude proximate hospitals that they view as insufficient competitive alternatives to the merging parties. Second, the decision supports the FTC’s diversion/willingness to pay bargaining models, even though the judge acknowledged that the FTC’s model always produces a price increase. Finally, the merging parties unsuccessfully advanced an efficiency defense focused upon the offering of a high performance, lower cost network, which they claimed would produce savings that would dwarf any price increase predicted by the FTC’s model. Not only does the decision consequently support the FTC’s hospital merger enforcement program, it is yet another ruling that ups the ante on the ability of merging parties to persuade a court that the proposed efficiencies are sufficient to offset alleged anticompetitive effects.

Background

It was two and one-half years ago, September 2014, when Advocate and NorthShore first executed an affiliation agreement. Advocate, a not-for-profit health system, is the largest hospital system in the Chicago metropolitan area with 11 general acute care hospitals and a children’s hospital. Five of its general acute care hospitals are located in Cook County, Illinois, and two are in Lake County, Illinois. NorthShore is a not-for-profit health system with four general acute care hospitals—three in Cook County and one in Lake County.

The FTC alleged that the proposed merger would result in increased bargaining leverage against health plans for the combined entity, allowing it to raise rates. Consistent with its position in other hospital merger challenges, the FTC also questioned whether the hospitals’ efficiency claims were cognizable or merger specific, noting that the efficiency claims are “not nearly of the magnitude necessary to justify the Transaction in light of its potential to harm competition.”[1]

What was notable from the outset in this case was the fact that it was the first challenge to a hospital consolidation in an urban setting, Chicagoland. So while it is common in many antitrust merger cases, the central dispute here — and the focus of interested observers — was the geographic market definition. The FTC defined the relevant geographic market as the “North Shore Area,” defined as “the area bounded by six [general acute care] inpatient hospitals: [NorthShore] Evanston, Swedish Covenant Hospital, Presence Resurrection Medical Center, Northwest Community Healthcare Hospital, Advocate Condell, and Vista Medical Center East.”[2] According to the Complaint, this area comprised the “main area of competition between NorthShore’s four hospitals and the two Advocate hospitals with which NorthShore most directly competes.”[3] By the FTC’s calculations, approximately 73% of patients residing within the North Shore Area stay there to receive inpatient hospital services. The FTC alleged that the hospitals would collectively control 55% of the market, with the next largest hospital only having 15% of the market. Based on HHI market concentration levels (post-Transaction HHI of 3,517 representing an increase of 1,423 points), the FTC further alleged that the transaction was presumptively unlawful under the 2010 DOJ and FTC Merger Guidelines.

In its original opinion, the district court rejected the FTC’s geographic market definition and denied the preliminary injunction. The court held that the plaintiffs failed to properly define the relevant geographic market, noting that there was no “economic basis” for the exclusion of certain nearby destination hospitals. According to the court, plaintiffs’ economic expert, Dr. Steven Tenn, used “flawed criteria” to exclude certain hospitals from the market. The FTC appealed, arguing that the court “erred by basing its geographic market determination on an analysis of how the candidate market was constructed rather than whether it satisfied the hypothetical monopolist test.”

Seventh Circuit Analysis on Geographic Market

The Seventh Circuit reversed and criticized the district court for improper application of the hypothetical monopolist test to determine the scope of the relevant geographic market and took issue with the lower court’s emphasis on the distance some patients travel for care to assess the boundaries of the relevant geographic market. According to the Seventh Circuit, insurers are the most relevant buyers, noting that “the geographic market question is . . . most directly about ‘the likely response of insurers,’ not patients, to a price increase,” because ‘[i]nsured patients are usually not sensitive to retail hospital prices, while insurers respond to both prices and patient preferences.”[4] The appellate court was further persuaded by testimony from managed care plans that the plan had to include at least one of the merging parties in order to sell a marketable insurance product to employers in the area, and highlighted that such testimony was supported by “strong, not equivocal” evidence that patients generally prefer to receive hospital care locally.[5] Thus, it concluded that the lower court’s focus on hospitals outside of the narrow geographic market failed to properly account for the “silent majority” of patients who seek treatment from local hospitals that would pay supra-competitive prices to receive hospital services close to home rather than travel.

District Court’s Opinion on Remand

In light of the Seventh Circuit’s opinion, the district court reversed course on several fronts. First, it accepted insurers as “the most relevant buyers” of general acute care inpatient services, noting, “[e]ven if it is true that large numbers of patients who live in the North Shore Area travel outside of the Area to hospitals such as Northwestern Memorial for GAC services, it is error ‘to focus on the patients who leave a proposed market instead of on hospitals’ market power over the patients who remain, which means that the hospitals have market power over the insurers who need them to offer commercially viable products to customers who are reluctant to travel farther for general acute hospital care.’” Despite acknowledging some of defendants’ concerns about the credibility of the insurers’ testimony which the court stated “may indeed be self-serving,” it found that the record as a whole supports the view that “insurers genuinely believe that a plan that excludes Advocate and NorthShore is not viable in the North Shore Area.” According to the court, “testimony that an insurer has actually offered a commercially-successful healthcare plan that enrolled large numbers of patients within the North Shore Area but did not include Advocate or NorthShore in its network might have sufficed,” but “the defendants offered no such testimony in this case, nor did they offer any evidence to demonstrate that a healthcare plan that excluded both Advocate and NorthShore would be successful among patients living in the North Shore Area.”

Second, the court accepted the analysis of plaintiffs’ economic expert, Dr. Tenn, regarding the exclusion of certain “destination hospitals” (e.g., academic medical centers and specialty hospitals that attract patients from throughout the Chicago metropolitan area) from the proposed geographic market. While the court had previously found no economic basis for such facilities to be excluded and distinguished them from local community hospitals, it acknowledged that these hospitals are not in the northern Chicago suburbs and could not be used as substitutes to the merging parties by payers seeking to establish a provider network in northern Chicago. The court stated, “although many patients travel from the North Shore Area to these destination hospitals, Dr. Tenn nevertheless excluded them from his analysis because these hospitals cannot fulfill the function of providing local care within the North Shore Area.”

Third, the court accepted Dr. Tenn’s reliance on diversion ratios (which measure patient substitution) even though insurers, not patients, are the most relevant buyers. Diversion ratios demonstrate whether the level of substitution between the hospitals in the North Shore Area is high enough that the merged firm could profitably impose a small but significant non-transitory increase in price (SNIP) in the event of a merger. The court disagreed with the defendants on the appropriate use of diversion ratios, reiterating the Seventh Circuit’s view that “even if diversion ratios show that a proposed geographic market excludes significant competitors, it does not necessarily follow that the geographic market is defined too narrowly.”

Finally, while the court noted that it found that the market concentration evidence alone establishes the presumption of illegality, it cited Dr. Tenn’s report regarding the anticompetitive effect of the merger, noting that the transaction would cause an average price increase of 8% across the six party hospitals in the North Shore Area, resulting in an annual increase of inpatient GAC reimbursement paid to those hospitals of about $45 million.

The court also rejected more general challenges to the FTC’s model. Defendants argued that the model had no predictive power, because as Dr. Tenn admitted, the model always predicts a price increase if diversion ratios and contribution margins are positive. The court, however, found that the model was “useful because it reveals how strong the merged entity’s profit-maximizing incentives to raise price will be based on their levels of substitution and potential profitability,” and thus the “fact that the method predicts at least a small price increase whenever the inputs are positive does not represent a weakness.”

Defendants also argued that Dr. Tenn’s approach was inconsistent with commercial realities in the hospital industry because “hospital systems settle on prices by way of bilateral bargaining with insurers on a system-wide basis”. To defendants, Dr. Tenn’s model’s focus on when a merged hospital system might have an incentive to raise prices at a particular hospital is inconsistent with commercial reality. Dr. Tenn countered by arguing that both a price-setting model and a bilateral bargaining-based model will generate identical predicted post-merger price increases, and he used a price-setting model “for ease of exposition”. The court was unconvinced by the “relatively superficial criticism defendants have made” and concluded that “Dr. Tenn has persuasively demonstrated that the merger is likely to cause a significant price increase resulting in a loss to consumers.”

The defendants’ attempt to rebut competitive effects evidence was also broadly rejected by the court. The evidence in the record regarding payers who expressed support for the merger was viewed by the court as “equivocal, unenthusiastic, and without a factual basis.” The court opined that defendants’ argument that other hospitals could reposition themselves to defeat a price increase was “alluring.” However, the court found that this argument was another version of an argument that the Seventh Circuit had rejected regarding diversion ratios. The court concluded that in light of the Seventh Circuit’s guidance, it “cannot accept that the repositioning of competitors will offset or prevent the anticompetitive effects that Dr. Tenn has identified without stronger evidence than the generalized testimony defendants have offered.”

With respect to efficiencies, the parties’ major argument was that once the merger was consummated, the merged entity could offer a commercially-viable, cost saving narrow network product attractive to large employers. They estimated that savings of consumers would fall between $210 and $250 million in the aggregate, which would greatly outweigh any price increase. The court was unimpressed. It did not believe that the “efficiency” was merger specific and after a battle of experts regarding the true level of savings and the attractiveness of the product to consumers, also concluded that defendants had not carried its burden.

After this ruling, the parties abandoned the transaction. The FTC has now closed its administrative case, and this decision will be the last word on the matter.

A year ago, the district court here had ruled against the FTC. A district court in Pennsylvania had rejected an FTC challenge to the proposed Hershey merger, and the entire FTC hospital merger enforcement program looked like it could be in jeopardy. Now, the Third Circuit reversed in Hershey and entered the preliminary injunction — and the parties abandoned the transaction. The Seventh Circuit and the district court here ruled for the government — and the parties abandoned the transaction. As the current interim FTC Chair Maureen Ohlausen said:

“Historically, the Advocate and NorthShore hospital systems competed vigorously to be included in health insurance companies’ hospital networks. Having reason to believe their merger would increase costs, and harm quality and innovation for patients and their families in the northern suburbs of Chicago, the Commission sued in federal district court and in the FTC’s administrative process. The Seventh Circuit and ultimately the district court agreed, validating the FTC’s analyses and methodologies. With the two hospital systems remaining separate, consumers will continue to reap the benefits of this competition, which include lower prices and higher quality service.”

And the FTC’s antitrust activity in the health care space continues to live and thrive.