The decision serves as a reminder of the uphill battle that merging health care providers have faced since the FTC’s adoption of its current rigid market definition standard in 2007.

The U.S. Court of Appeals for the Third Circuit recently reversed a district court decision that had denied the Federal Trade Commission’s (FTC’s) motion to preliminarily enjoin the merger of two Central Pennsylvania hospital systems.1 In light of the Third Circuit’s decision, the hospitals have abandoned the proposed merger to avoid lengthy and costly litigation before an FTC administrative law judge. This reversal is a reminder that hospital mergers challenged by the FTC face significant, and sometimes insurmountable, hurdles.

The Facts and Proceedings

In spring 2015, Penn State Hershey Medical Center and Pinnacle Health System entered into a strategic affiliation agreement. Hershey is a 551-bed academic medical center, offering a wide array of tertiary and quaternary care. It operates the region’s only children’s hospital and one of only three Level 1 trauma centers in Pennsylvania. Pinnacle, on the other hand, operates three community hospitals, offering a limited number of higher-end services. The hospitals notified the FTC of the merger, and, after an investigation, the FTC issued an administrative complaint, alleging that the merger may substantially lessen competition.

In March 2016, the FTC moved for a preliminary injunction (PI) to prevent the hospitals from closing the proposed merger. After a period of expedited discovery, the district court conducted a five-day evidentiary hearing on the PI motion. The court determined that a PI was not appropriate because the relevant geographic market was too narrowly drawn. Of particular importance to the court’s analysis was the fact that 43.5 percent of Hershey’s patients traveled to Hershey from outside the FTC’s purported geographic area. In fact, more than half of Hershey’s revenues originated outside of Harrisburg. The court also noted that there are 19 hospitals, some of which are closer to patients that currently use Hershey, within a 65-minute drive of Harrisburg. Finally, the court explained that the merging hospitals took steps to prevent post-merger price increases with the two largest commercial insurers in Central Pennsylvania, accounting for 75-80 percent of the commercial patients.

The FTC appealed the decision to the Third Circuit and was granted a stay of the district court’s order pending the appeal. The Third Circuit issued its decision in the FTC’s favor on September 27, and, on October 14, the parties announced that they had abandoned the transaction.

The Decision

In deciding to reverse the district court’s opinion, the Third Circuit concluded that the lower court applied the wrong legal test to determine the relevant geographic market in which to assess the competitive effects of the proposed merger. It then analyzed the standard for issuance of a PI: (1) whether the FTC will likely ultimately succeed on the merits and (2) balancing the equities. The court found that both parts of this standard weighed in favor of the FTC and remanded the case to the district court to enter a preliminary injunction order.

To succeed on the merits, the FTC had to prove that the merger may substantially lessen competition. The district court decided that the FTC failed to allege a proper geographic market, which was fatal to its case. The Third Circuit disagreed, concluding that the district court had improperly applied the hypothetical monopolist test to define the relevant geographic market in three respects: (1) it only examined patients entering the alleged market, (2) it did not examine how insurance companies (payors) would react to the merger, and (3) it incorrectly credited private pricing agreements in its analysis.

The hypothetical monopolist test evaluates whether a hypothetical monopolist could impose a small but significant non-transitory increase in price (SSNIP) in the proposed market. The Third Circuit determined that the district court, rather than applying the hypothetical monopolist test, applied one half of a “discredited economic theory,” called the Elzinga-Hogarty test, when it took into consideration the fact that 43.5 percent of Hershey’s patients came from outside the FTC’s purported geographic market. The Elzinga-Hogarty test evaluates the (1) number of customers who come from outside the proposed market to purchase services inside the market and (2) number of customers from the proposed market who leave the market to purchase services. The Third Circuit stated that this test has been discredited, even by Professor Elzinga, because it relies on the false assumption that patients who travel a distance for medical services constrain the price that hospitals charge to closer patients. The circuit court also noted that the district court even failed to apply the Elzinga-Hogarty test correctly when it did not consider patient outflow data. The FTC had presented undisputed evidence that 91 percent of patients who live in Harrisburg seek services in that area.

The Third Circuit also explained that the lower court’s analysis did not account for the likely response of payors in the face of a SSNIP. Because payors bear the immediate impact of a price increase by a provider, it was an error for the district court to disregard the payor response to a hypothetical monopolist price increase when assessing the relevant geographic market.

Lastly, the Third Circuit stated that the district court should not have considered private agreements entered into with two large payors in its geographic market assessment. The hospitals entered into a five-year contract with one payor and a 10-year contract with another payor to maintain the existing rate structures and price differentials between the hospitals. The district court found these agreements “compelling” and opined that the FTC was essentially asking it to prevent a merger based on what might happen to prices five years in the future. The appellate court was unpersuaded by these agreements. First, it reasoned that the private contracts had no place in the hypothetical monopolist test, which examines what would happen to prices in a hypothetical world. Second, it cautioned that allowing private agreements (that may or may not be enforceable) to impact the court’s analysis could enable defendants to evade the antitrust laws. For all these reasons, the Third Circuit determined that the district court committed legal error in its application of the hypothetical monopolist test.

The court next concluded that the FTC properly defined the relevant geographic market as the Harrisburg area and that it established a prima facie case that the merger would substantially lessen competition in that area. It credited the FTC’s view that payors would have to accept a price increase from a combined Hershey/Pinnacle provider and the testimony of one small payor that, when it did not have either Hershey or Pinnacle in its network, it lost half its members.

Based on a market share test called the Herfindahl-Hirschman Index, the Third Circuit examined Hershey/Pinnacle’s combined shares of the FTC’s geographic market, making the merger presumptively unlawful.

Further, the Third Circuit found unpersuasive the efficiencies relied on by the hospitals and the district court. The hospitals argued that (1) the merger would alleviate the need for Hershey to address its capacity constraints by building a $277 million bed tower, which would lead to capital savings being passed on to patients and (2) the larger health care system would enhance the provider’s efforts to engage in risk-based contracting. The appellate court was incredulous as to whether the efficiencies defense2 was valid since the U.S. Supreme Court has never formally adopted it. Further, without making the decision to adopt the defense, it determined that the hospitals’ purported efficiencies arguments still failed.

After weighing the equities, the Third Circuit remanded the case to the district court to enjoin the merger.3

Lessons Learned

Although the decision is only precedential in the Third Circuit, it remains to be seen whether this opinion will have an impact on other circuits’ rulings. For example, the Northern District of Illinois denied a PI requested by the FTC in a Chicago hospital merger this past summer, and the case is now on appeal to the Seventh Circuit. It will be interesting to see what role, if any, the Third Circuit’s opinion plays in the Seventh Circuit’s ruling. Regardless, this decision serves as a reminder of the uphill battle that merging health care providers have faced since the FTC’s adoption of its current rigid market definition standard in 2007. Some takeaways include:

  • It is critically important to understand how payors, not just patients, view the market and, particularly, how payors (even the smallest) will testify.

  • Private payor agreements to maintain existing rates are not a panacea to the anticompetitive issues raised by a merger.

  • Although efficiencies are recognized by some courts to rebut the presumption of anticompetitive effects, the efficiencies must fit within the government’s Horizontal Merger Guidelines. To be considered by a court:

    • The efficiencies must offset the anticompetitive concerns of the merger. To the extent possible, this offset should be calculated and supported by a credible economic explanation.

    • The efficiencies must be merger specific and not achieved by one of the merging parties alone or by a merger with a different, less-market-concentrating partner.

    • The efficiencies must be verifiable and not speculative.

    • The efficiencies must not arise from anticompetitive reductions in service or output.