Editor’s Note: On September 27, 2016, the Third Circuit handed the Federal Trade Commission (FTC) a significant victory in its campaign against hospital consolidation, reversing a District Court decision that denied a preliminary injunction against the merger of Penn State Hershey Medical Center (Hershey) and PinnacleHealth System (Pinnacle).1 The decision restores the FTC’s 8-year winning record in challenging hospital mergers and sets a high bar for providers considering transactions in concentrated markets. In the following two-part article, Manatt takes a look at the FTC victory and its implications. Part 1 provides an overview of key points, while Part 2 digs into the details to offer an in-depth analysis.

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Part 1: The FTC Gets Its Mojo Back

Hershey, a leading academic medical center and teaching hospital in Hershey, PA, and Pinnacle, a provider of cost-effective primary and secondary services over three hospital campuses in nearby Harrisburg and Mechanicsburg, PA, first announced their proposed merger in June 2014. After an extensive investigation, the FTC commenced administrative proceedings against the transaction in December 2015 and, with the Commonwealth, sought a preliminary injunction in District Court in Pennsylvania. In May 2016, the District Court denied the injunction.

The Third Circuit rejected the District Court’s reasoning on all counts: market definition, the relevance and persuasiveness of the parties’ 5-year contracts with payers, whether the claimed efficiencies were cognizable and potentially sufficient to overcome the government’s prima facie case, and how the equities should be balanced in an FTC preliminary injunction proceeding. (See Part 2 of this article for a detailed analysis.) In response, on October 14 Hershey and Pinnacle announced that they had ended their efforts to integrate, citing “the time and cost associated with continuing litigation.”

The key takeaways from the decision are discussed below:

1. The FTC’s Approach to Hospital Merger Challenges Is Confirmed.

The decision endorses the FTC’s current approach to hospital merger cases, which the agency has been following since its 2004 case against Evanston Northwestern’s acquisition of Highland Park Hospital in Illinois. After a string of successes in several challenges from 2008 to 2014, the 2016 District Court losses in the Hershey/Pinnacle challenge and another merger challenge against the Advocate and NorthShore in Illinois had brought the agency’s approach into question. The Third Circuit decision—written in very strong terms—confirms the effectiveness of the current approach going forward.

2. Payer Testimony Is Important.

The Third Circuit’s decision states clearly that the focus of the inquiry into hospital market definition is on payers, not patients, and rejected the District Court’s reliance on patient flow data. Central to the Third Circuit’s reversal was payer testimony to the effect that insurers would have no choice but to accept a price increase from a combined Hershey/Pinnacle in lieu of excluding the hospitals from their networks, and that it is unlikely that payers could successfully market a network excluding the combined system to employers. Particularly persuasive was a “natural experiment” where a payer marketed a network that initially included Pinnacle, but subsequently lost Pinnacle. Even after offering a substantial discount, the loss of Pinnacle still resulted in the loss of over half of the plan’s members to other plans.

3. The Bar for Efficiencies Is Higher Than Ever.

The Third Circuit gave short shrift to the hospitals’ claims that the merger would allow them to avoid capital investment in a new bed tower and enhance their move toward risk-based contracting. The court endorsed agency requirements that efficiencies be merger-specific, verifiable and not themselves result in anticompetitive outcomes. The court required the efficiencies to offset the anticompetitive harm in this case to be “extraordinary” and held the claims to a high level of proof, which was found lacking. In particular, the claim that the merger would allow a party to avoid increasing capacity—usually considered a procompetitive outcome leading to lower prices—could not be a cognizable efficiency. Claims about risk-based contracting were either too speculative or not merger-specific, because the hospitals already were able to engage in this conduct or enter into collaborations short of a merger to do so.

4. The ACA Is Not an Excuse.

The District Court decision in Hershey/Pinnacle was notable in acknowledging and giving credence to concerns that healthcare policy was driving hospitals to “unite and survive,” a defense sometimes scornfully referred to as “the ACA made me do it.” The FTC has consistently rejected this concept in numerous speeches, advocacy letters and merger challenges. The agency’s position is that there is nothing in healthcare policy that displaces the antitrust laws, and collaborations seeking to advance the aims of healthcare policy can be equally effective operating within the existing antitrust framework. The Third Circuit recognized the existence of “extrinsic factors” that may encourage hospital mergers, but effectively took the courts out of this debate, noting that such issues are “not within our purview.”

5. The Decision Gives the FTC a Boost in Its Illinois Appeal.

The decision will assist the FTC in its appeal to the Seventh Circuit Court of Appeal against the lower court’s denial of an injunction against the Advocate/NorthShore merger in Illinois. Both sides already have submitted letter briefs bringing the Third Circuit’s decision to the attention of the Seventh Circuit panel. In oral argument before the Seventh Circuit in August, Judge Wood already had expressed doubts about the District Court’s application of the horizontal monopolist test2 to the market definition in that case. Although the particular market facts differ, the Third Circuit decision increases the odds that the Seventh Circuit will rule in similar terms.

Part 2: A Detailed Analysis of the FTC’s Third Circuit Victory

1. Market Definition

The parties agreed that the relevant product market was the provision of general acute care services sold to commercial payers. The field of battle was over geographic market definition. The parties and the District Court agreed that the hypothetical monopolist test outlined in the FTC and Department of Justice (DOJ) 2010 Horizontal Merger Guidelines3 should be applied, but the Third Circuit found that the District Court failed to articulate and apply the test properly. The hypothetical monopolist test approaches market definition from the perspective of a “hypothetical monopolist” operating in the proposed market; that is, a single provider of general acute care services in the proposed geographic area. If a hypothetical monopolist could impose a small but significant nontransitory increase in price (SSNIP) in the proposed market, the market is properly defined. If, however, customers would respond to the SSNIP by shifting to suppliers outside the proposed market, then the market is drawn too narrowly.

The District Court expressed its aim in geographic market definition as being able to identify an area in which “few patients leave…and few patients enter.” Relying on evidence of substantial numbers of patients coming into the geographic area from outside the FTC’s proposed market (four counties in the Harrisburg area), the District Court found the market too restrictive. The Third Circuit rejected the District Court’s conclusions, finding that “relying solely on patient flow data is not consistent with the hypothetical monopolist test”4 because it ignores the commercial realities of healthcare markets in which insurers—not patients—pay for services.

Although price increases may eventually be passed on to patients through higher premiums, the effect is not felt immediately and is unlikely to impact patient choice directly. Accordingly, the Third Circuit found that the hypothetical monopolist test must be applied “through the lens of the insurers.”5 On this basis, the Third Circuit found that the government had adequately met its burden of proving geographic market through the use of extensive payer testimony to the effect that payers relied on competition between Hershey and Pinnacle and that they could not successfully market a plan in the Harrisburg area without Hershey and Pinnacle.

2. Contracts with Payers

The District Court had discussed with approval contracts that the parties had entered into with two of Central Pennsylvania’s largest payers to maintain the existing rate structure for five years. The District Court commented that, because these agreements would maintain the status quo for at least five years, it could not make predictions of the potential impact of the transaction particularly in an industry undergoing rapid change, such as the healthcare system.6

The Third Circuit disagreed, noting that the antitrust laws (and in particular the language of Section 7 of the Clayton Act under which the government had challenged the transaction) explicitly call on the courts to make predictions as to the future. In addition, the Third Circuit stated that private pricing agreements, such as those the parties entered into with payers should not be considered in the market definition analysis at all.7

3. Efficiencies

The Third Circuit discussed the hospitals’ efficiency claims in terms very similar to the Ninth Circuit in St. Luke’s.8 Both courts expressed doubts as to whether an efficiencies defense exists at all. The Third Circuit reached no conclusions on this subject, however, since it found that the hospitals could not clearly show that their claimed efficiencies offset the anticompetitive effects of the merger.

In order to be recognized by the court, efficiencies need to meet the requirements of the FTC and DOJ Merger Guidelines; that is, they need to be merger-specific, verifiable and not speculative, and not arise from anticompetitive reductions in output or service. In this case, the main efficiencies were the avoidance of significant capital investments in additional beds by Hershey and enhanced ability to engage in risk-based contracting. The court rejected both of these claimed efficiencies.

The court found that the capital avoidance efficiency was not cognizable because the need for additional beds was ambiguous, and failing to invest in additional capacity is potentially an anticompetitive reduction in output. The claimed enhanced ability to participate in risk-based contracting was not necessarily merger-specific, had not been demonstrated to result in benefits that would be passed on to consumers, and was too speculative.

4. Equities

Finally, the court considered whether the harm that the public would suffer if the merger were delayed would be greater than if the injunction were not issued.

The hospitals attempted to claim that if the injunction were issued, they would abandon the transaction entirely (which has in fact proved to be the case) and the public would then lose any benefits to be derived from the merger. The court dismissed this as being in the hospitals’ control, since if the merger makes economic sense now, it would be equally sensible following an FTC adjudication. In any event, this was not sufficient to overcome the strong public interest in the effective enforcement of the antitrust laws.

5. Impact of the Affordable Care Act (ACA)

One interesting aspect of the District Court’s decision had been dicta concerning the importance of “the evolving landscape of healthcare” and the climate created by government healthcare policy that “virtually compels institutions to seek alliances such as the Hospitals intend here.”9 For the first time, a court appeared to credit providers’ arguments that healthcare policy has strengthened incentives to consolidate and that they should be permitted to do so despite the antitrust laws. The Third Circuit rejected this idea, stating that “[o]pining on the soundness of any legislative policy that may have compelled the Hospitals to undertake this merger is not within our purview.”10