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The fix is in — key learnings from recent vertical merger challenges
2024 PRINDBRF 0065
• Practitioner Insights Commentaries
• February 7, 2024
(February 7, 2024) - McDermott Will & Emery attorneys Jon B. Dubrow, Stephen Wu, Matt Evola and Bailey K. Sanders analyze recent court decisions involving the Federal Trade Commission and Justice Department challenging vertical mergers.
The FTC recently claimed a "major win … as it works to protect competition in health care"1 when Illumina, Inc. announced on December 17, 2023, that it would divest GRAIL, Inc. consistent with a divestiture order from the European Commission.
This announcement came in the wake of the Fifth Circuit's opinion addressing Illumina's appeal of the FTC's decision and order requiring Illumina to divest GRAIL. But a closer examination of the Fifth Circuit's opinion shows that the FTC (and the DOJ) have seemingly lost their larger fight to convince courts to create a very high burden for parties seeking to defend transactions using contractual "fixes" to address competition concerns.
The Fifth Circuit reversed and remanded the FTC's opinion and order for legal error and rejected: (1) the FTC's argument for how a court should treat a 'fix' within the burden-shifting framework of a Clayton Act case and (2) the FTC's view of how much competition any fix must replace.
In doing so, the Fifth Circuit joined courts in California (Microsoft/Activision) and D.C. (AT&T/Time Warner and UnitedHealth/Change Health) in rejecting the FTC's (and DOJ's) arguments for the treatment of fixes in litigation.
Vertical mergers are inherently more difficult for the government to litigate than horizontal merger, and the Fifth Circuit's opinion signals a growing consensus that courts will not ignore fixes when analyzing whether a merger violates Section 7 and the government bears the burden of proof in demonstrating that the transaction, taking account of the fix, is likely to substantially lessen competition.
This means that as long as the agencies are committed to bringing tough antitrust cases, parties willing to litigate proposed fixes — especially in vertical deals — will continue to have opportunities to get deals done. These cases have also clarified the standards applicable to some of the other key issues in vertical merger enforcement.
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A brief bit of background
After not litigating a vertical merger case since the 1970s, the FTC and DOJ have recently tried several matters. Although the following transactions all presented different challenges for the parties, in each case they sought to alleviate competitive concerns with fixes proposed prior to a liability determination.
AT&T/Time Warner2
In 2016, AT&T, a television content distributor via its cable platform and DirecTV satellite service, agreed to acquire Time Warner, a television content creator that licenses its networks to distributors. When the DOJ filed suit to block the deal, Time Warner made an irrevocable offer to distributors to engage in "baseball style" arbitration when it came time to renew licensing agreements for Time Warner networks.
The DOJ argued that the arbitration commitment must be "ignored" until the remedy stage. The District Court, finding that the arbitration offer would have "real-world effect," rejected the DOJ's challenge to the transaction.3 The D.C. Circuit agreed, holding that the agreements should be considered prior to any liability determination.
Illumina/GRAIL4
In 2020, Illumina, a company specializing in the sale of next-generation sequencing ("NGS") platforms used to develop medical testing solutions, sought to reacquire GRAIL, a former subsidiary that had recently acquired a breakthrough device designation from the U.S. Food and Drug Administration for its multi-cancer early detection ("MCED") test.
Notably, several other companies were developing MCED tests, and each of these MCED tests relied on Illumina's NGS platforms for sequencing. In response to concerns from Illumina's customers, GRAIL's potential competitors, regarding their ability to continue to purchase Illumina's NGS products post-merger, Illumina announced it would make available a standardized supply contract (the "Open Offer") to all for-profit U.S. customers.
Among other terms, the Open Offer required Illumina to provide its NGS platforms at the same price and with the same access to services and products as it provided them to GRAIL. The same day Illumina made its Open Offer, the FTC filed a complaint alleging the transaction violated Section 5 of the FTC Act and 7 of the Clayton Act.
After an administrative trial in Illumina's favor, the Commission reversed and determined that Illumina's acquisition of GRAIL was likely to substantially lessen competition in the market for research, development, and commercialization of MCED tests.
Illumina appealed to the Fifth Circuit which, although agreeing with much of the Commission's findings and analysis, held that the Commission erred in treating the Open Offer as a remedy. The Fifth Circuit vacated and remanded the case for further proceedings where the Open Offer would be considered in determining whether the transaction, in light of that offer, was likely to substantially lessen competition.
UnitedHealth/Change Health5
In 2021, UnitedHealth Group, a vertically integrated healthcare enterprise, agreed to acquire Change Healthcare, a provider of data solutions for clinical decision-making and payment processes. The transaction raised both horizontal and vertical issues.
To assuage anticompetitive concerns about consolidation of healthcare IT services and access to competitively sensitive information of rivals, UnitedHealth announced its intention to divest Change's claims processing division and issued a firewall policy addressing the vertical issues -access to competitors' data and data sharing process post-merger. One month later, the DOJ, New York, and Minnesota sued, alleging the transaction violated Section 7 of the Clayton Act.
The DOJ urged the District Court to ignore UnitedHealth's intended divestiture when analyzing whether the merger was likely to substantially lessen competition, and consider it only at the remedy stage. The Court declined to do so and ultimately found that the DOJ had failed to show that the merger was likely to substantially lessen competition in light of the divestiture.
Microsoft/Activision6
In 2022, Microsoft, which sells gaming consoles and subscription services, agreed to acquire Activision, a videogame publisher. The FTC alleged that the transaction violated Section 7 of the Clayton Act because it would give Microsoft the ability and incentive to withhold Activision's popular Call of Duty game from Microsoft's rivals, or to degrade the product when used with non-Microsoft consoles.
To demonstrate its willingness to continue supplying Call of Duty, Microsoft entered into a ten-year agreement with Nintendo to support Call of Duty titles on Nintendo's gaming console, and sought a similar agreement with Sony.
Unpersuaded, the FTC sought an injunction to enjoin the merger. The District Court denied the FTC's request for a permanent injunction.
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A growing caselaw: key takeaways
The UnitedHealth/Change, Microsoft/Activision, AT&T/Time Warner and Illumina/GRAIL cases are instructive for formulating clearance strategies for future deals.
Fixes are analyzed during the rebuttal stage, not the remedy stage, in Section 7 analysis
In determining liability under Section 7 of the Clayton Act, courts apply a burden-shifting framework under which the government bears the initial burden of establishing a prima facie case that the merger is likely to substantially lessen competition in the relevant market.
If the government succeeds in doing so, the burden shifts to the merging parties to present evidence to rebut the prima facie case by showing "the prima facie case inaccurately predicts the relevant transaction's probable effect on future competition or to sufficiently discredit the evidence underlying the prima facie case."7 If that rebuttal is provided, the burden shifts back to the government to produce additional evidence of anticompetitive effects and merges with the ultimate burden of persuasion.
The government argued in Illumina/GRAIL, Microsoft/Activision, and other cases, that any commitments — such as Illumina's Open Offer or Microsoft's agreement to support Call of Duty on third party consoles — should be considered at the remedy stage and not the liability stage.
The courts have rejected the agencies' position and found that proposed fixes should be considered as part of the liability phase of the case and not as a remedy. In Illumina/GRAIL, the Fifth Circuit distinguished cases on which the FTC relied because those cases involved divestitures conditional upon the court's liability determination, but no such condition accompanied Illumina's Open Offer. The Fifth Circuit concluded the fix should be assessed as part of the rebuttal case.
The government must show competition is likely to be substantially lessened despite a proposed fix
Having determined when potential fixes should be considered, courts have also analyzed how they should be considered.
The government has argued that to be relevant, a fix must completely restore competition – as a typical remedy would be expected to. In other words, the proposed fix needs to restore 100% of the pre-merger competition in the market.
But the courts have rejected this argument as contrary to the text of Section 7 of the Clayton Act, which only prohibits mergers that may (which courts interpret as being likely to) result in a "substantial" lessening of competition. If the standard were that a merger needs to be enjoined unless the parties can demonstrate the fix eliminates the potential for any lessening of competition, that would "effectively erase the word 'substantially' from Section 7."8
Courts assess whether a transaction results in both an incentive and ability to undermine rivals
There is no market share presumption of illegality for vertical merger cases either in the case law or even in the new Merger Guidelines. In horizontal cases, the government can establish its prima facie case simply by showing that the merger will significantly increase concentration in the market. In vertical cases, however, there is no such "short cut." The government must instead make a fact-specific showing that the proposed merger is likely to be anticompetitive.
When considering whether a proposed vertical merger is likely to substantially lessen competition, the key question is whether the merged firm will have both the ability and the incentive to harm rivals by foreclosing them from sources of supply or from distribution outlets. The recent cases have provided some clarity around key issues in this assessment.
The government must show that the post-merger firm will have both the incentive and the ability to engage in foreclosure tactics. The courts have rejected the government's strained argument, made in both Illumina/GRAIL and Microsoft/Activision, that it can demonstrate a merger is likely to substantially lessen competition by showing that a merged firm will have either i) the ability to foreclose or ii) the incentive to foreclose. Instead, the government must show that the merged firm has both the incentive and ability to foreclose competition following the deal.9
A merger can be anticompetitive by creating a new incentive to act on a pre-existing ability to foreclose access to a key input. In Illumina/GRAIL, for instance, Illumina argued that, in terms of the ability to foreclose prong, the FTC needed to prove both that i) its NGS platform was a critical input for GRAIL's rivals and ii) the transaction would increase Illumina's pre-existing ability to foreclose.
Under that theory, the government's case would fail if Illumina's NGS was a "must have" item prior to the GRAIL acquisition. The Fifth Circuit rejected this argument, explaining that it is not necessary for a proposed merger to increase the ability to foreclose. If a merger creates an incentive to act on a pre-existing ability to foreclose, the transaction can be anticompetitive.
A merger can be anticompetitive if it creates the incentive and ability to alter the terms of supply for a key input, even if it remains available to rivals. The Illumina court accepted the government's argument that a merger might allow a merged firm to engage in nuanced foreclosure strategies that can be anticompetitive, while also being hard to detect.
In a total foreclosure strategy, the merged firm will simply refuse to sell the critical input to its rivals. In a partial foreclosure strategy, the merged firm may continue to supply the input to the downstream rivals, but may alter the pricing, support or other terms, thereby hindering the firms' ability to compete effectively.
In assessing Illumina's Open Offer to supply its NGS products to MCED developers, the Fifth Circuit credited the Commission's finding that Illumina might be able to engage in foreclosure tactics that are not easily detected by customers (e.g., reducing the level of support services). This assessment supported the FTC's case in several ways.
First, it undermined the effectiveness of the Open Offer because, even with the offer, Illumina might be able to undermine its MCED rivals in subtle ways. Second, it undermined Illumina's argument that it would not have the incentive to engage in foreclosure because doing so would create reputational harm for Illumina. If the steps taken to undermine rivals are not transparent, a company could undertake that strategy without creating reputational risk.
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Thinking ahead to future deals
The takeaways above make clear that vertical merger cases are more difficult for the government to win than horizontal ones.
Thus, when thinking about how to improve the odds of closing similar transactions, companies should consider the following.
•Parties need to be fully prepared to rebut arguments about their ability and incentive to foreclose rivals.
•Parties should consider whether there are structural or behavioral commitments that might address competition concerns while still achieving the goals of the transaction.
•Parties should put such commitments to paper early in order to minimize challenges to the deal.
•Parties should be ready to demonstrate that the commitments are not susceptible to manipulation or delay.
•Parties should be prepared to litigate transactions creating vertical issues because the government is not accepting behavioral remedies, and the legal standards are far more favorable for merging parties than they are in horizontal transactions.
Notes
1 https://bit.ly/42nul0g.
2 United States v. AT&T Inc., 916 F.3d 1029 (D.C. Cir. 2019).
3 United States v. AT & T Inc., 310 F. Supp. 3d 161, 217 n.30 (D.D.C. 2018), aff'd sub nom. United States v. AT&T, Inc., 916 F.3d 1029 (D.C. Cir. 2019).
4 Illumina, Inc. v. FTC, No. 23:60167, (5th Cir. Dec. 15, 2023).
5 United States v. UnitedHealth Grp. Inc., 630 F. Supp. 3d 118 (D.D.C. 2022).
6 FTC v. Microsoft Corp., No. 3:23-cv-02880-JSC, (N.D. Cal. July 10, 2023).
7 United States v. AT&T Inc., 916 F.3d 1029, 1032 (D.C. Cir. 2019).
8 United States v. UnitedHealth Grp. Inc., 630 F. Supp. 3d 118, 133 (D.D.C. 2022).
9 FTC v. Microsoft Corp., No. 3:23-cv-02880-JSC, , at *13 (N.D. Cal. July 10, 2023); Illumina, Inc. v. FTC, No. 23:60167, at *7 (5th Cir. Dec. 15, 2023).
Jon B. Dubrow, a partner and co-head of McDermott Will & Emery's antitrust mergers focus group, advises clients across a host of interrelated antitrust issues, including mergers and acquisitions. He can be reached at [email protected]. Stephen Wu, a partner and co-head of the firm's health antitrust practice group, counsels clients on antirust compliance issues and defends antitrust litigation in federal courts around the country. He can be reached at [email protected]. Matt Evola, an associate at the firm, assists clients with premerger analysis and notification under the Hart-Scott-Rodino (HSR) Antitrust Improvements Act and with defending mergers and acquisitions before the Federal Trade Commission, Justice Department, state antitrust authorities and foreign competition authorities. He can be reached at [email protected]. Bailey K. Sanders is an associate at the firm who focuses on antitrust matters. She can be reached at [email protected]. Dubrow, Evola and Sanders are in Washington, D.C., while Wu is based in Chicago.
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