Antitrust Alert: UK Office of Fair Trading Accepts "Failing Firm Defence" in Retail Merger

On 14 May 2009, the Office of Fair Trading (OFT), the UK's competition agency, allowed an application of the "failing firm defence" under UK competition law, thereby clearing the HMV/Zavvi retail store acquisitions to proceed.  The UK is one of the few jurisdictions to have explicitly recognised such a "defence", and this decision comes only 5 months after the OFT restated its guidance on this subject.  The decision demonstrates how the OFT will apply the test to transactions affecting UK markets and reflects the difficult evidentiary burden that a potential purchaser must meet to qualify for the defence.

Background

In the UK, a merger may be blocked by the OFT if it is likely to cause a "substantial lessening of competition".  However, even where there are prima facie competition concerns, the OFT may clear a potentially troubling acquisition if convinced that the target business otherwise is likely to fail and exit the market. 

Zavvi and HMV had been the leading UK High Street retailers supplying home entertainment products:  music, films and games.  Zavvi had been trading at a loss for a number of years, when in early December 2008 its sole supplier went into bankruptcy administration, and Zavvi itself followed.  HMV and Head Entertainment LLP (the former managers of Zavvi) then began to acquire the leases, stock, and goodwill of Zavvi stores across the UK.  HMV acquired 15 of Zavvi's 114 UK stores in the first quarter of 2009. 

At its own initiative, the OFT instigated an enquiry into the acquisitions that had not yet completed.  (The day after the OFT decision, HMV announced it intends to acquire another 8 Zavvi stores.) The decision is worthy of review for its application of the failing firm defence, but also for the fairly unusual analysis of jurisdiction and market definition issues (not the subject of this Alert).  

The "failing firm defence"

The "failing firm defence" may justify an otherwise anticompetitive merger on the basis that, without the merger, the target business would exit the market.  In reaction to the economic downturn, the OFT restated its approach to the application of the failing firm defence in December 2008 (see prior alert, UK Competition Authority Codifies "Failing Firm" Defence to Mergers. The defence requires that it be inevitable that the target business will exit and that there are no realistic alternative purchasers for the target business.  This standard is similar to the failing firm defence under the Merger Guidelines used by the U.S. antitrust agencies.

Compelling evidence

In its review of HMV/Zavvi, the OFT found prima facie competition concerns in relation to seven "Overlap Stores" , which it defined as an HMV store within one mile of a store acquired from Zavvi.  Applying the failing firm defence, in line with its December 2008 guidance, the OFT required "sufficient compelling evidence" that:

 

• It was not appropriate to assess the merger's competitive effect using the "normal benchmark" of comparing premerger and postmerger conditions, because absent the HMV acquisition, the fifteen Zavvi stores would have exited the market.
• If HMV had not acquired the stores, those 15 Zavvi stores would have exited the market, without serious prospect of bankruptcy reorganisation.
• There was no realistic and substantially less anticompetitive alternative to HMV's acquisition.

 

The OFT stated that the fact Zavvi already had gone into administration was not enough to conclude it inevitably would exit the market.  The OFT examined the historical financial position of the company and consulted with the administrator to determine the likelihood of a successful reorganisation.  The OFT decided that, given "the difficult economic and market conditions and the prohibitive level of investment to turn around the Zavvi business", the first limb of its test was met.

 

To determine if there were a less anticompetitive alternative to HMV's acquisition of the overlap stores, the OFT evaluated whether Head Entertainment was a ‘realistic' alternative purchaser.  The OFT did not examine whether HMV's bid was commercially preferable but required that HMV show that, if it had not bid for the stores, the stores still would not have been acquired by Head.  The OFT went as far as checking with the landlords of the Overlap Stores, rightly surmising that they would reassign the Zavvi leases only to a purchasers that they deemed acceptable.  All of the landlords of the Overlap Stores told the OFT they would "not accept offers made by Head […] under any circumstances".

 

Therefore, although the OFT had competition concerns in those seven local markets, because without the HMV merger the seven stores would go out of business, the agency essentially viewed the HMV acquisition not to be the cause of harm in those markets and thus "cleared" the merger.

In practice  

The failing firm defence is likely to be relied upon more frequently in the coming months.  However, businesses that seek to acquire targets in distress should be aware of how difficult in practice it is to establish the failing firm defence, with a very high standard of proof before the OFT can be persuaded of its application. 

Consistent with the approach taken by the European Commission, the OFT has not seen the recession as a reason to weaken its analytical approach to mergers.  Indeed, given the small size of HMV/Zavvi, it seems the OFT is closely monitoring local market developments and will investigate even narrowly defined markets where there is a prima facie concern. 

Purchasers also need to be aware that the OFT will test their arguments with evidence from third parties.  In this case, much of the ultimately useful evidence came from the target's administrator and store landlords.

 

Lawyer Contacts

 

For more information, please contact your principal Jones Day representative or either of the lawyers listed below.

Vincent Brophy
London/Brussels
+32 2 645 15 35
vbrophy@jonesday.com

Marcus Pollard
Brussels
+32 2 645 14 11
mpollard@jonesday.com

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