The “failing firm” defense as a justification for permitting a merger that may otherwise lessen competition gets considerable play in healthcare transactions. Perilous hospital economics—often brought on by low Medicare and Medicaid reimbursement rates and high uncompensated care costs—are frequently a significant factor in the economic drivers for merging or entering into a partnership with a neighboring hospital. Very few merging firms, however, have been successful in invoking the defense before the federal antitrust agencies. Two recent cases—one in healthcare and the other in the waste disposal industry—provide insights into using the failing firm defense in practice.
Antitrust Agency Standards
The theory behind the failing firm defense is a lesser of two evils. Its premise is that a merger should be permitted because the resulting threat to competition is outweighed by the adverse impacts if the target firm goes out of business and the assets exit the market. According to agency guidance, for the defense to be recognized, the evidence must convincingly establish that the firm:
- Would not be able to meet its financial obligations in the near future;
- Would not be able to successfully reorganize in bankruptcy; and
- Made good-faith efforts to elicit alternative offers that would keep the assets in the market and pose less danger to competition than the proposed transaction.
Defense Fails If There Is a Failure to Elicit Alternative Offers
In June 2017, a Delaware federal judge agreed with the Department of Justice’s (DOJ’s) Antitrust Division that a merger of two waste disposal companies, Energy Solutions Inc. and Waste Control Specialists LLC (WCS), was likely to result in a monopoly, and that the parties could not rely on a failing firm defense.1
After finding that the merger was likely to result in anticompetitive effects in the market for disposal of low-level radioactive waste, the court turned to the failing firm defense. While there was evidence both to support and to counter whether, in fact, WCS was in imminent financial failure, the court found that it did not need to decide that issue because the merging parties had failed to demonstrate that Energy Solutions was the only possible purchaser. WCS argued that it had a “for sale” sign so any interested parties would have appeared, but the court found that the merger agreement’s “no-talk” provision without a fiduciary out amounted to a willful blindness to alternative buyers. According to the court, those provisions prevented WCS from responding to other offers or sharing information that would permit an interested party to formulate a credible bid.
The court also provided some insight into its views on WCS’s financial position and which arguments it considered. The court noted that WCS never made an operating profit and consistently missed projections because it operates with high fixed costs, and decreased disposal volume over the last decade prevented WCS from covering those fixed costs. The court rejected, however, the argument that WCS would be closed if the merger did not go through, because no steps were taken toward closing the facility.
In particular, the court noted that WCS had made several contradictory representations to regulators, investors and the court. WCS: 1) only opened in 2012 and recently executed several long-term disposal contracts; 2) never defaulted on any debt, was current on its various payments, and was meeting payroll and paying bonuses; and 3) invested in future growth opportunities, particularly in the decommissioning market which is expected to grow substantially over the next 20 years. Additionally, as recently as April 2016, WCS represented to regulators that its financial qualifications were adequate to carry out its activities and that auditors believed WCS would still be in business in a year.
Failing Firm Defense Succeeds in Saving Physician Practice Deal
In January 2017, the Federal Trade Commission (FTC) accepted a settlement in the merger of two multispecialty physician practice groups—CentraCare Health and St. Cloud Medical Group (SCMG) in Minnesota.2 The FTC accepted the settlement partially because the merger, coupled with financial payment incentives for departing physicians, was the best opportunity to keep SCMG physicians in the market, as well as ensure ongoing access to care and minimal disruption for patients in the region. The FTC specifically highlighted that: 1) SCMG had no access to credit; 2) physicians had already left SCMG and would continue to do so, absent the merger; and 3) the parties demonstrated that there were no alternative purchasers interested in acquiring the entire SCMG group.
The most important lesson from these two recent attempts by parties claiming the failing firm defense is that failure to demonstrate that the buyer is the only or least anticompetitive option will likely be fatal to the defense, even if the entity is in imminent danger of failing. In particular, a failing firm seeking a buyer should try to avoid “no-talk” or “no-shop” provisions without a fiduciary out in letters of intent or merger agreements, because such provisions will likely be construed as hurdles to identifying reasonable alternative buyers.
Second, financial failure must be probable, and evidence of failure must be concrete, not speculative. A likely future rebound from a financially unstable position may defeat the defense. As the Supreme Court has described it, the firm’s resources must be “so depleted and the prospect of rehabilitation so remote that it faced the grave probability of business failure.”3
Third, consistency is crucial. Statements made by firms to regulators, investors or any other party will be key evidence. When a firm boasts about its financial stability in one context, it cannot turn around to an antitrust agency or court and credibly argue that it is failing.
Fourth, access (or lack thereof) to credit from other sources is critical to the determination of whether the firm is financially stable. In the physician practice group merger, the FTC found that the financially failing party had no access to credit, whereas in the waste disposal deal the DOJ argued that WCS had access to an $85 million revolving credit facility with its parent and that it was not borrowing the maximum amount available.
Finally, evidence that the firm has begun to take steps to exit the market will support a failing firm defense. While the FTC found that physicians were already leaving SCMG’s practice and would continue to do so, the DOJ highlighted that WCS had not yet taken even preliminary steps toward preparing to exit the market and, in fact, had made representations to the contrary.