December 5, 1995

EFFICIENCIES, FAILING FIRMS,
AND THE GENERAL DYNAMICS DEFENSE

Janet L. McDavid
Hogan & Hartson L.L.P.

Washington, D.C.

I want to thank the Commission for the opportunity to appear here today. I also want to thank Chairman Pitofsky for conceiving of these hearing, and the other Commissioners for supporting them. Based on all reports, the hearings have provided an opportunity for the business community, the bar, public interest groups, and academics to provide important views on antitrust policy and enforcement.

I am a proponent of vigorous, but rational antitrust enforcement. I believe that competition, protected by antitrust enforcement, is most likely to produce the best products and services at the lowest price. I also believe that antitrust enforcement during the past six years--under Chairman Steiger and Chairman Pitofsky, and Assistant Attorneys General Rill and Bingaman--has generally struck an appropriate balance between various enforcement philosophies. The changes in enforcement policy that seem appropriate to me are generally at the margin and fairly modest.

I would like to associate myself with the comments of my colleague, Thomas Leary,(1) whose views I share on such issues as the primary importance of competitive effects analysis rather than relying primarily on the artificial precision of HHI analysis, the need for more careful analysis and consistent articulation of the theories and standards that underlie vertical merger enforcement, and skepticism about the need or desirability of the new innovation market theories the agencies are applying.(2)

Today, I want to focus on three issues in merger enforcement: efficiencies, the failing firm defense, and the General Dynamics defense. My comments are based on many years of experience with these issues in private practice, and to some extent to my service with Chairman Pitofsky on the DoD Antitrust Task Force.(3)

Efficiencies

As a matter of style and strategy, I rarely raise an “efficiencies defense” in the sense that it is used in the 1992 Horizontal Merger Guidelines for several reasons. First, it is an affirmative defense on which the merging parties bear a very heavy burden of proof. Second, it is rarely reached unless the agency has already concluded that the merger raises substantial competitive concerns. Finally, I am not aware of many instances in which it has been successful.

My strong preference is to discuss the issue of efficiencies as the business rationale for the transaction. Many industries, including defense manufacturing and hospitals, are characterized by extraordinary over-capacity, and many transactions are motivated by the need to reduce that capacity, achieve economies of scale, and lower costs. Even firms that do not suffer from over-capacity often have a substantial need to lower costs in order to compete more effectively with the other firms in their industry, particularly larger and more successful firms. When I am first retained to advise on a merger, my first questions to my clients always involve their rationale for the transaction, which becomes the foundation for the entire defense of the merger.

I think it might be useful to the Commission and staff to examine a particular transaction in which efficiencies were the entire motivation for the transaction by both parties, and which has achieved substantial efficiencies post-closing. My discussion will be based on publicly available data.

In 1991, my firm was retained to represent General Dynamics in the sale of its Missile Division, which produced both strategic missiles (such as the Advanced Cruise Missile and the Tomahawk Cruise Missile), and tactical missiles, (including the Standard Missile, the Stinger, the Sparrow, and the AMRAAM). Since the end of the Cold War, there had been a dramatic decline in defense spending, with tactical missile procurement down 60% in real dollars between FY86 and FY92. General Dynamics estimated that it had at least 2/3 over-capacity. For example, it had capacity to build 35 Tomahawk Cruise Missiles each month, but was building only 10-15/month. Similarly, it could produce 700 Stinger Missiles/month, but DoD required only 150/month. General Dynamics suffered from excess capacity to a greater extent than many of its competitors because it had constructed its plants on the assumption that it would be the sole source on several major programs, but DoD later introduced a second source. The result was that high fixed costs were being spread over a smaller production base, resulting in increased total costs to DoD. Since GD faced competition on most of its missile programs, if it could not reduce its costs, it was convinced that it would not prevail in upcoming sole-source competitions for those programs because it believed its principal competitor enjoyed a 10-15% cost advantage.

General Dynamics was committed to remaining in the defense business, but only if it was the #1 or #2 firm in each segment so it could achieve what it called “critical mass,” which would allow it to be able to conduct research and development. General Dynamics concluded that it had three basic choices: acquire another missile firm to achieve economies of scale in its plants, sell its business to another missile contractor so it could achieve economies of scale in its plants, or exit the business.(4)

There were a total of ten firms producing missiles for DoD, whom GD’s CEO William Anders characterized as “a gorilla, three chimps, and six marmosets--the number of bananas in the jungle is declining rapidly, and you can be sure the gorilla won’t be the one who starves.”(5) General Dynamics concluded that it should sell its Missile Division to one of the other chimps to create stronger competition for the gorilla - Raytheon - and eventually chose Hughes, which was not a direct competitor on any existing programs. Hughes similarly had about 60% excess capacity in its plant in Tucson, which had a square-mile of space.

General Dynamics and Hughes were both convinced that they could achieve significant economies of scale by combining the GD missile programs with the Hughes missile programs in its Tucson factory, and that a single missile producer could rationalize its facilities most easily. But confidentiality concerns precluded them from discussing competitively sensitive information so they could produce an estimate of cost savings.

The Justice Department investigated the transaction, but eventually allowed it to close, and in late 1991, Hughes acquired GD’s Missile Division for $450 million.(6) In 1992, Hughes moved that business to its plant in Tucson at a cost of about $150 million.(7) In September 1994, Hughes (relying on the GD business it had acquired) was the successful bidder against McDonnell Douglas in a sole-source procurement for Tomahawk cruise missiles valued at about $2 billion.(8) As a result of the consolidation, Hughes had overcome an estimated 10-15% cost advantage enjoyed by McDonnell Douglas and won a procurement that General Dynamics had not believed it could win because of its high overhead costs. The executive in charge of Hughes’ missile business was quoted as saying his bid “is not a giveaway bid . . . [Hughes] is going to make money on it.”(9)

This is obviously a successful efficiencies case in a transaction that the antitrust agencies allowed to close, despite the fact that the parties could not quantify the costs savings they believed they could achieve through the acquisition. I cannot assure you that all claims of efficiencies are as well founded as the claims we made in the General Dynamics/Hughes transaction. This experience does suggest, however, that when cost savings seem plausible, as they did in the GD/Hughes transaction, they should be credited by the antitrust agencies, even if the parties cannot precisely quantify those savings.(10) It should be sufficient for the parties to identify specific categories of efficiencies that they believe they can achieve, and describe how those savings can be achieved, without precise quantification. As Norm Augustine advised the Commission, “To properly analyze potential efficiencies from consolidations, we have found it necessary to conduct detailed examinations of the facilities involved--and to consider carefully a host of legal, social, and political issues. To do so responsibly obviously takes a certain amount of time and can only be accomplished after the companies are combined and all restraints on the full disclosure of sensitive information are lifted.”(11) A few additional comments on efficiencies may be useful. It makes sense to require, as the agencies do, that the efficiencies be merger specific and that there not be a less anticompetitive way to achieve them. In general, it also makes sense to inquire whether they will be passed on to consumers, but this may be more difficult to demonstrate. In those instances in which the merged firm will continue to have significant competition post-merger (even if the industry is highly concentrated), it is probably reasonable to expect that the efficiencies will be passed on to consumers over time because competition will force the merged firm to offer lower prices. Finally, the agencies should recognize that attempting to balance efficiencies against likely price increases will rarely work and implies an unrealistic sense of precision. First, the balance assumes that the agencies can accurately predict the amount of a post-merger price increase, which is rarely the case. It also assumes that the parties can accurately predict the value of cost savings that the merger will allow them to realize. Neither estimate can be made with any accuracy.

The Failing Firm Defense

The failing firm defense is an issue that I have studied for many years, and applied in several transactions. As I have written in the past, the defense should be strictly construed.(12) However, I am now convinced, based on practical experience with the failing firm defense, that the agencies’ construction of certain elements of the defense should be somewhat less rigid.

As you know, as the failing firm defense is construed by the agencies, any offer by a less anticompetitive purchaser that is above liquidation value will be viewed as an acceptable alternative.(13) It is that element of the defense that I think requires more analysis. For example, the agencies should consider whether the alternative purchaser has the capability to run the failing firm as a competitive, on-going business, including infusions of capital that may be necessary to allow research and development and to purchase new equipment. Many firms that purchase a distressed business may intend merely to pocket a predictable revenue stream and not to compete vigorously. In that circumstance, it would not necessarily be clear that such an acquisition truly represents a less anticompetitive alternative.

We can analogize to the analysis the Commission undertakes of prospective purchasers of a divested business. The Commission “seeks to provide relief that will at least return competition to the status quo ante. * * * We will seek divestiture of sufficient facilities to ensure the creation of an ongoing, viable business sufficient to remedy our competitive concerns. * * * We will analyze whether the potential acquirer will be a effective competitor. Thus, we will analyze whether the potential acquirer has assets, financial capability, technical and management skills, and commitment to the market to become an effective competitor.”(14) Isn’t that the same standard that should be applied to evaluate alternative buyers of a failing firm rather than merely requiring that any other purchaser be available?

The Commission has recently undertaken a retrospective analysis of some past divestitures to learn which worked and which did not work. While I am not aware that complete results have been reported, Bill Baer told the ABA Antitrust Section that “early returns indicate that some of the divestitures have been spectacularly successful, and others have been spectacular in a different sense--i.e., they didn’t work so well.”(15) He also said that the results indicated that “divestiture to a person with experience in the industry, although not in the relevant market, is likely to encounter fewer problems than divestiture to someone who is new to the industry.” Those issues would appear equally applicable to alternative bidders for a failing firm. Sale to an alternative bidder will not be less anticompetitive if the acquisition fails.

The Commission should bring some of this experience to its evaluation of alternative purchasers of failing firms. The agencies could make inquiries of alternative bidders to evaluate their future intentions with respect to the acquisition of the failing firm--will they operate it effectively and competitively, including investing in the future, or will they simply harvest a revenue stream? It would be useful, for example, to review the cash flow analyses they prepared in connection with their bid, which may indicate the assumptions they made in valuing the failing firm. It also would be useful to consider its technical and management skills and its commitment to the business, as reflected in planning documents.

The General Dynamics Defense

In United States v. General Dynamics Corp.,(16) the Supreme Court concluded that the acquisition of a coal company did not violate Section 7, despite the fact that the acquisition produced a company with a large market share in a concentrated industry. One of the factors the Court emphasized was that in this case large market share did not accurately reflect the acquired company's future competitive weakness because its coal reserves were either depleted or committed under long-term contracts,(17) which undermined the government's prima facie statistical case. The Court made it clear that mere competitive weakness was not sufficient to prove the failing company defense because the acquired company was both profitable and efficient. Rather, the Court determined that the acquisition would not substantially lessen competition because present combined market shares did not accurately reflect future competitive weakness.(18)

In General Dynamics, the Court did not intend to loosen the requirements of the falling company doctrine. Indeed, the dicta in General Dynamics concerning the failing company doctrine emphasizes the traditional elements of the doctrine.(19) The true significance of General Dynamics is that the Court made a realistic evaluation of the competitive effect of the acquisition of a company that was not a strong competitor, but was not failing.

Some lower courts not only accepted, but even expanded the General Dynamics defense. Some decisions have created a quasi-failing company defense for companies that are merely faltering.(20) Not all decisions, however, followed that trend. Some lower courts have faithfully applied General Dynamics--evaluating only competitive strengths and weaknesses.(21)

The 1984 Merger Guidelines explicitly recognized in Section 3.21, as the Supreme Court had in 1974 in General Dynamics, that current market conditions may not accurately reflect future competition in an industry. Section 3.22 also explicitly recognized that weakened financial conditions could affect a firm's future competitive significance. In the wake of General Dynamics, and to an even greater extent after the 1984 Merger Guidelines discussed financial weakness in Section 3.22, merging firms argued that virtually any kind of financial weakness created a "flailing firm defense," as it was termed by DOJ and the FTC.(22)

This overuse or abuse led to the elimination of the "financial weakness" language when the agencies issued the 1992 Horizontal Merger Guidelines. However, the 1992 Horizontal Merger Guidelines retain the basic General Dynamics concept by recognizing that "recent or ongoing changes in the market may indicate that the current market share of a particular firm either understates or overstates the firm's competitive significance. . . . The Agency will consider reasonably predictable effects of recent or ongoing changes in market conditions in interpreting market concentration and market share data."(23) As a result, it is still possible to argue that a firm's current market share does not reflect its future competitive significance as a means of defending a proposed merger.

In my experience, both agencies are willing to consider arguments under General Dynamics and Section 1.521 of the Guidelines that current market conditions may not accurately reflect future competitive significance. I have advanced such arguments in industries as diverse as defense, hospitals, satellites, computer software, and branded food products. The General Dynamics defense provides an opportunity to explain to the agency current conditions in the industry, and how those conditions might affect future competition. The DoD Antitrust Task Force also endorsed this type of analysis in its Report.(24)

I urge the Commission to retain the General Dynamics defense currently recognized in the 1992 Horizontal Merger Guidelines, and to advise the staff of the importance of this analysis. It provides an important source of flexibility for the analysis of mergers. For example, it allows the agencies to consider the effect on future competition of a firm that does not meet the strict requirements of the failing firm doctrine. It allows consideration of evidence along a spectrum, without locking the agencies into a rigid analysis.

As other witnesses have suggested, it would be useful if the Commission could find some way to provide more information to the bar and business community about the factors that were decisive when the Commission had chosen not to challenge transactions that appear to violate the Merger Guidelines. It is particularly important that the Commission continue to analyze, and publicly articulate, its rationale for challenging or not challenging vertical transactions.

(1) Thomas B. Leary, Testimony Before the Federal Trade Commission (Oct. 17, 1995).

(2) Attached is a copy of an outline on these issues that I prepared for the recent ABA Antitrust Section program, Getting the Deal Through a Competition Review: The Merger Review Process in the U.S. and Abroad, (Nov. 9-10, 1995).

(3) Report of the Defense Science Board Task Force on Antitrust Aspects of Defense Industry Consolidation (April 1994).

(4) William A. Anders, Rationalizing America’s Defense Industry (Oct. 30, 1991).

(5) William A. Anders, Revisiting the Rationalization of America’s Defense Industrial Base (Oct. 27, 1992).

(6) Wall Street Journal Sept. 19, 1994.

(7) Id.

(8) Id.

(9) Id.

(10) In defense industry transactions, of course, DoD can assist the agencies in evaluating claimed cost savings, which lends additional credibility. Perhaps there are other, similar credibility checks that the agencies could use to validate claims of cost savings.

(11) Statement of Norman R. Augustine, President of Lockheed Martin Corporation, before the Federal Trade Commission (Nov. 2, 1995).

(12) Janet L. McDavid, Failing Companies and the Antitrust Laws, 14 Mich. J.L. Ref. 229, 231-48 (1981); ABA Antitrust Section, Merger Treatise, Ch. 7- Defenses (forthcoming).

(13) 1992 Horizontal Merger Guidelines § 5.1 & n.36.

(14) Mary Lou Steptoe, The FTC’s Merger Program: New Remedies and Increased Enforcement (March 14, 1995).

(15) William Baer, A Report on Recent Antitrust Developments at the Federal Trade Commission (Aug. 9, 1995).

(16) 415 U.S. 486 (1974).

(17) Id. at 503-4.

(18) Id. at 507-8, 510-11. The Court stated in General Dynamics:

In Brown Shoe v. United States, we cautioned that statistics concerning market share and concentration, while of great significance, were not conclusive indicators of anticompetitive effects. Congress indicated plainly that a merger had to be functionally viewed, in the context of its particular industry. * * * Statistics reflecting the shares of the market controlled by the industry leaders and the parties to the merger are, of course, the primary index of market power; but only a further examination of the particular market--its structure, history, and probable future -- can provide the appropriate setting for judging the probable anticompetitive effect of the merger.

Id. at 498 (citations omitted). (19) Id. at 506-8.

(20) In United States v. International Harvester Co., 938 F.2d 1206, 1220-21 (11th Cir. 1991), for example, the court held that the acquisition did not violate Section 7 because the acquired company did not have sufficient financial resources to compete effectively. A similar conclusion was reached in United States v. Consolidated Foods Corp., 603 F.2d 694 (8th Cir. 1979), where technological difficulties and limited product variety had resulted in a decline in sales and an impaired ability to compete on the part of the acquired company.

(21) Thus, in FTC v. University Health, Inc., 938 F.2d 1206, 1220-21 (11th Cir. 1991), the court rejected the merging hospitals' claim that one was a "weak company," concluding that it would recognize such a defense only if the hospital could show that its market share was likely to decline sufficiently to undermine the FTC's prima facie case. Accord, e.g., FTC v. National Tea Co., 603 F.2d 694 (8th Cir. 1979) (because the acquired company was such an ineffective competitor and so likely to depart from the market, its present market share inaccurately reflected its future competitive position and the merger should not be enjoined; United States v. Amax, Inc., 402 F. Supp. 956 (D. Conn. 1975) (even under defendant's assumed facts, the merger would result in an unlawfully large market share). The FTC has expressly has refused to follow International Harvester. In re Pillsbury Co., 93 F.T.C. 966 (1979) (Opinion by Commissioner Pitofsky).

(22) See, e.g., 60 Minutes with the Honorable Janet D. Steiger, Chairman, Federal Trade Commission, 61 Antitrust L.J. 187, 194 (1992); Kevin D. Arquit, Perspectives on the 1992 U.S. Government Horizontal Merger Guidelines, 61 Antitrust L.J. 121 (1992). Cases in which a weakened firm defense under Sections 3.21 and 3.22 of the 1984 Merger Guidelines was rejected include FTC v. University Health, Inc., supra, (rejecting "weak company" defense); FTC v. Warner Communications, Inc., 742 F.2d 1156, 1164 (9th Cir. 1984)(allowing defense for a firm that is not failing would undermine strict requirements of defense); United States v. Rice Growers Ass'n, 1986-2 Trade Cas. (CCH) ¶ 67,287 (E.D. Cal. 1986)(plan to exit business is not sufficient absent business failure).

(23) 1992 Horizontal Merger Guidelines § 1.521.

(24) Report of the Defense Science Board Task Force on Antitrust Aspects of Defense Industry Consolidation at 34 & n.82 (April 1994).