The Office of Fair Trading (OFT) has cleared the proposed acquisition of fifteen former Zavvi stores by HMV plc on the basis of the 'failing firm defence'. Zavvi, formerly a leading national retailer of entertainment products, was formed after a management buy out of the Virgin Megastore division of the Virgin Group in September 2007, but went into administration at the end of last year.  

This case is particularly interesting because, prior to Zavvi going into administration, both it and HMV were leading national retailers of entertainment products, with overlapping stores in a large number of local areas across the UK. However, the application of the failing firm defence means that the Zavvi acquisition is cleared without the OFT needing to conduct a detailed market analysis under its normal merger control procedure.  

What is the failing firm defence?  

The ‘failing firm defence’ in the UK is a defence under the Enterprise Act 2002 which parties to a merger may seek to rely on to persuade the OFT that a merger raising substantive competition concerns should be cleared and not, therefore, referred to the Competition Commission (CC) on the basis that the target business will exit the market if the merger does not go ahead. The rationale for accepting such claims is therefore that any harm to competition would result even without the merger, and so should not be attributed to it.  

OFT restatement of its position on 'failing firms'  

The challenges of the current economic climate, particularly the lack of financing and the sharp increase in the number of UK companies facing insolvency, have brought this defence to the fore, with an increased number of ‘failing firm’ candidate cases in the UK. To address this, in December 2008, the OFT issued a restatement of its position on 'failing firms', codifying its standpoint, and confirming that there is no intention for the criteria of the ‘failing firm’ defence to be relaxed in any way. The restatement has the expressed aim of promoting consistency and transparency and providing businesses with the necessary means to assess regulatory risks.  

The restatement also confirms the OFT’s willingness to provide informal advice, upon application by the parties, on how the ‘failing firm’ criteria may apply in appropriate cases, specifically in relation to the issue of whether a target business can be regarded as a ‘failing firm’. The advice that the OFT may offer, however, is limited insofar as it is non-binding on the OFT and its accuracy is wholly dependent on the information provided by the merging parties. In addition, as the restatement makes clear, certain issues, such as whether there is a realistic and substantially less anti-competitive purchaser for the target business, are not amenable to informal advice and cannot be assessed outside the context of a market test involving third parties. The Zavvi acquisition is the first time the defence has been successfully argued since the OFT clarified its policy in this area.  

The requirements for the defence  

Winning on ‘failing firm’ grounds involves satisfying a notoriously demanding test, which explains why there have been relatively few successful ‘failing firm’ claims in the UK – this is only the fifth time the OFT has applied the defence to date. The OFT will only clear a transaction on a ‘failing firm’ basis where it has sufficient compelling evidence that the following two conditions are met:  

  1. Inevitable exit of the target business absent the merger  

The parties must, first of all, prove that without the merger the target business would inevitably exit the market in the near future. In the majority of cases, this will be because of the parlous financial situation of the target business: firms that are in liquidation will usually pass this test; but even firms that are not yet in liquidation or administration may also qualify, and there could equally be other valid grounds, such as a change in the seller’s corporate strategy. Key to this condition is demonstrating that there is no serious prospect of the target business being reorganised, and that all options for re-financing have been explored and exhausted. In the present case, which was investigated by the OFT on its own initiative, the parties satisfied the regulator that without the merger the fifteen stores in question would inevitably have exited the entertainment retail market as a result of Zavvi's collapse.  

  1. No realistic and substantially less anti-competitive alternative  

The second condition is that there must be no realistic and substantially less anti-competitive alternative to the merger. To clear this hurdle, the parties are required to show that there are no other realistic purchasers whose acquisition of the target business would produce a substantially better outcome for competition. Demonstrating this necessitates proof that all possible alternative bidder options have been explored. In the case of Zavvi, the parties were able to provide compelling evidence that there was no other realistic entertainment retail purchaser for the fifteen stores. However, this may not always be the case, and there is always the possibility that in certain circumstances it may be better for competition if the failing firm fails and the various rivals compete for its market share and assets (as opposed to their wholesale transfer to the purchaser).  

Conclusion  

The HMV/Zavvi case is an interesting contrast to a case earlier this year, where the OFT decided, in accordance with its restated policy, not to accept the failing firm defence in deciding to refer the Holland & Barrett/ Julian Graves merger to the CC. The OFT believed that the acquisition of Julian Graves resulted or could be expected to result in a substantial lessening of competition within the UK specialist health food products market. In addition, the OFT found that the parties are each other's closest competitor and that the merged entity would not face sufficient constraint from any other retailers. There was also good evidence of other viable purchasers.  

The OFT adopts a cautious, stringent approach in assessing ‘failing firm’ claims and the ‘sufficient compelling evidence’ standard required to demonstrate that the ‘failing firm’ criteria are satisfied is a tough test to meet.

The OFT only accepts independently verifiable evidence for its assessment and will not rely on self-serving speculation from the parties.  

Despite the current economic climate, it seems unlikely that the OFT will show greater leniency in the application of the ‘failing firm’ defence. As the OFT stated in its restatement “the OFT will not, regardless of prevailing economic and market conditions, relax the 'sufficient compelling evidence' standard required to demonstrate that a merger between close competitors is not itself the cause of any SLC (substantial lessening of competition)”.  

Nonetheless, as this case shows, the standard applied by the OFT is attainable in practice if the necessary facts and evidence are produced and meritorious cases may proceed through clearance by the OFT relatively swiftly, without requiring a detailed market analysis by the regulator, as was the case in the Zavvi merger.