The ‘failing firm’ defence in difficult times

Given the current economic climate, competition authorities are expecting a possible increase in the use of the ‘failing firm’ defence. The doctrine provides potential opportunities for businesses to acquire competitors, which in normal circumstances would be regarded as anti-competitive. The basic rationale behind the doctrine is that since the failing firm would have left the market anyway due to its financial collapse, any harm to competition caused by the loss of an independent market player would arise regardless of the merger.

The doctrine therefore potentially allows a business to acquire its struggling competitor, which is on the brink of administration or liquidation. The defence is worth considering by any administrator or liquidator of a business. Competitors are likely to pay the highest prices for assets and so a merger with a competitor could be an appropriate solution to save a deteriorating business.

While the doctrine may facilitate an acquisition of a failing competitor, which would otherwise be problematic, meeting the criteria can be a challenging task. Generally speaking, regulators are not prepared to relax their application of the doctrine, even in this economic downtown. Their key concern is that acquisitions by competitors can lead to greater market power, potentially resulting in higher prices for consumers, lower quality and less consumer choice.

Qualification for the failing firm defence

If a merger meets certain jurisdictional thresholds (often based on turnover or market share), the parties must notify the European Commission or the relevant national competition authority so that the merger can be subject to its assessment. In EU merger control practice, the failing firm doctrine was developed in the mid-1990s in Kali and Salz [1998] and BASF/Eurodiol/Pantochim [2001]. The doctrine is not made explicit in the EC Merger Regulation 139/2004 (the Regulation), but the Horizontal Merger Guidelines 2004/C 31/03 (the Guidelines) provide some guidance on how the Commission assesses mergers under the Regulation and set out the criteria for the failing firm defence as follows:

  1. the allegedly failing firm would in the near future exit the market because of financial difficulties if not taken over by another undertaking (it must be likely that the firm will enter into bankruptcy or equivalent proceedings, if not for the merger);
  2. there is no less anti-competitive alternative purchase than the notified merger (there must not be other realistic purchasers whose acquisition would produce a substantially better outcome for competition); and
  3. in the absence of the merger, the assets of the failing firm would inevitably exit the market (it has to be assessed whether the production assets are likely to remain in the market in their current use or liquidated and re-allocated for another more efficient use).

The assessment involves comparing the competitive effects of two hypothetical situations: post-merger and no merger. The basic requirement for the defence is that the harm to competition following the merger cannot be said to be caused by the merger. This arises where the harm to the competitive structure of the market would be at least to the same extent if the merger had not taken place. Due to the exceptional nature of the failing firm defence, businesses that are considering acquiring a failing competitor should therefore be clear about the implications of a proposed merger. The comparison between the two situations is not always clear cut and may involve in-depth market analysis.

Evidence of the failing firm criteria

Previous merger cases have illustrated that the Commission or national competition authority consider the following points as evidence supporting that the failing firm grounds are met:

  • financial status of the company, eg administrators or liquidators appointed;
  • audit reports that show cash flow difficulties;
  • inability to raise capital and secure credit, and frequent breaches of banking covenants;
  • lack of new customer orders and obsolete stock;
  • the failing company made good faith effort in eliciting offers from other competitors other than the proposed acquirer, eg information memoranda distributed to competitors and advice from accountants;
  • the market being worse if the company was allowed to fail, eg customers with outstanding orders that would lose their deposits; and
  • internal correspondence and documents, prior to merger negotiations, which show that the prospect of re-organising the company has been realistically considered and dismissed.

It is important for parties planning a merger, and considering use of the failing firm defence, that relevant documents and correspondence should be filed safely and not discarded. Negotiations with other competitors should be well recorded. Notifying parties should also be aware that regulators will rely heavily on evidence from third parties in testing the doctrine. In the HMV case (summarised on p42), evidence provided by the failing company’s administrator and the store landlords were particularly significant in assessing the criteria. There is a high burden of proof to show that the competitor has financial difficulties and to demonstrate the competitive effects of the merger. Failure to meet the failing firm grounds can result in the merger being prohibited by the Commission or national competition authority.

Defence in difficult times

As economies in Europe are experiencing troubling times, the question is whether the Commission will loosen its application of the doctrine. In 2009 Neelie Kroes, European Commissioner for Competition, described the Commission’s stance:

‘As regards mergers, the Commission is continuing to apply the existing rules, taking full account of the economic environment. Our rules provide the necessary flexibility to deal with decisions that require fast treatment, such as transactions which are part of rescue operations, in order to enable immediate implementation of these transactions. On substance, the EU merger control rules allow the Commission to take into account rapidly evolving market conditions and, where applicable, the failing firm defence.’

It seems that the Commission takes into account the economic climate in applying merger rules and recognises the need for flexibility in urgent situations. However, this is not necessarily a more relaxed approach towards the doctrine.

While European economies such as Greece and Spain are becoming increasingly unstable, the relevance of the failing firm defence has become more apparent as more companies are heading towards insolvency. Competition authorities have recently been feeling pressure to adapt their policies to reflect changing market conditions. Last year, the Organisation for Economic Co-operation and Development published the ‘Competition and Financial Markets 2009’ report, highlighting competition issues arising from the current financial crisis. Despite the perceived availability of the failing firm defence in such weakened times, the Commission contributed to the report by commenting that so far there has not been a case brought before it where the failing firm defence has been raised as a result of the economic conditions. The primary reason for this is that governments have been intervening under state aid rules to rescue banks and subsidise industries. In addition, banks are not generally inclined to call in loans when asset values are at rock bottom.

The Commission also indicated in the report that while existing merger policies remain unchanged, it may grant a derogation from the stand-still obligation pending the merger review to accommodate the rapidly evolving market conditions. This will allow parties to complete the merger before obtaining the Commission’s clearance, which may helpfully resolve situations where there is a need for urgent rescue deals.

OFFice of Fair Trading (OFT)’s approach

Focusing on the position in the UK, the OFT published a restatement on 18 December 2008, which codified its position in relation to the failing firm defence. Similar to the Commission’s guidelines, the OFT will clear a merger based on failing firm claims where it has ‘sufficient compelling evidence’ that:

  1. the business in question would inevitably have exited the market with no serious prospect of being reorganised; and
  2. that there was no realistic and substantially less anti-competitive alternative to the merger.

Generally, the OFT has applied the doctrine strictly. The assessment is mainly factual as the OFT measures the effects attributable to a post-merger situation and a merger absent situation. The OFT has indicated that it will take into account prevailing economic and market conditions in assessing the evidence provided by notifying parties. However, the OFT has stressed that it will not soften its requirement for ‘sufficient and compelling evidence’. John Fingleton, chief executive of the OFT, recently commented that the OFT ‘will continue to scrutinise such claims carefully to ensure competition is protected’.

The OFT has suggested in recent cases that an in-depth analysis may not be necessary where clear evidence of failing is put forward early in the process. It has also emphasised that it will not treat completed transactions more favourably than anticipated mergers. Companies may wish to take advantage of the OFT’s informal advice available in certain cases. The OFT can advise on whether a company qualifies as failing, and can help a company devise solutions that are efficient and that do not lessen competition.

Described below are two recent cases illustrating the way the OFT and Competition Commission (CC) has addressed notifying parties invoking the failing firm defence.

Long Clawson’s acquisition of Millway Stilton

The OFT rejected the failing firm argument pleaded when Long Clawson Dairy Ltd (Long Clawson) acquired Millway Dairy Crest (Millway) in July 2008. It was concerned that the merger caused a reduction from three to two large Stilton producers, which could cause a price increase that would be passed on to customers. The OFT referred the case to the CC, which subsequently approved the merger on the basis that Millway was a failing firm. In its final report, the CC found that Millway had been making significant financial losses for many years due to the introduction of a new cheese production process, which affected the quality and consistency of its cheese. In the CC’s assessment of the competitive effects of the merger, the report stated that one of the reasons for its decision was that the merger would not change the incentives for remaining producers to invest in capacity expansion compared with the position absent of the merger. Although Long Clawson’s closest competitor following the merger had limited capacity, this would be the same if there was no merger. The CC therefore confirmed that it did not expect the merger to result in a substantial lessening of competition in the blue Stilton market in the UK.

HMV’s acquisition of Zavvi stores

This matter involved two competitors in the UK entertainment products industry. Zavvi Retail Ltd (Zavvi) entered into administration in December 2008 and HMV Group plc (HMV) subsequently took over 15 Zavvi stores. In carrying out its assessment, the OFT found no competition concerns at a national level, but there were overlaps with existing HMV stores at a local level. The OFT considered Zavvi’s consistent financial losses over the previous years and the level of investment required to turn the business around in the market conditions. In assessing whether there would be any alternative realistic purchaser, the OFT had to consider whether the store landlords, who partly controlled the Zavvi stores, would accept any potential purchasers. There was no market interest for three of the overlap stores and the rejected offers showed that there was no realistic alternative. The OFT was therefore satisfied that without the merger, the stores would have inevitably exited the market and there was no less anti-competitive alternative to the merger. There was sufficiently clear evidence of the failing of Zavvi, which led the OFT to conclude that an in-depth analysis was not required.

The HMV case is only the fifth merger under the Enterprise Act 2002, which the OFT has cleared on the basis of the failing firm defence. This demonstrates that the OFT is maintaining its strict approach in applying the doctrine. However, the above cases show that if the necessary information is provided, the defence is attainable in appropriate circumstances.


In summary, the unstable financial environment does not give an automatic green light to rely easily on the failing firm defence. The failing firm defence is more a question of economic reality. During a weakened economy, large market players may be thinking that this creates ripe opportunity to acquire a financially distressed competitor by invoking the defence. Equally, board members and shareholders of the failing competitor may be feeling desperate for a rescue deal. However, companies should be wary of being accused of dressing up a business as failing to benefit from the defence. Both the commission and national competition authorities have stressed that evidential requirements will not be loosened.

Recently, there may have been a degree of flexibility among competition authorities when applying their substantive requirements. Prevailing economic conditions may now mean it is easier to demonstrate that exit is inevitable or that there are no realistic alternative purchasers. Ultimately, however, the doctrine is still limited. Merging companies would still need to overcome the high burden of proof in evidencing its financial position and effects on competition. To avoid the risk of offending competition regulation, legal advice on merger control should be sought as soon as possible if a business is considering taking over a struggling competitor.