While the ultimate extent of the impact of the COVID-19 pandemic remains unclear, it seems likely that we will eventually see an uptick in acquisitions involving distressed or failed assets. This article discusses the circumstances in which acquirers of distressed assets may be able to employ the so-called "failing firm" argument to acquire assets that would ordinarily give rise to competition law concerns.
The COVID-19 pandemic is having a significant impact on the global and domestic economy. While sectors such as travel, tourism, and hospitality were hit particularly hard early on, in the final tally there will likely be few industries that emerge from the pandemic entirely unscathed.
Despite the efforts of the Government to offset the financial impact of the pandemic with wage subsidies and other tools, and of regulators such as the New Zealand Commerce Commission (NZCC) to exercise their investigative and prosecutorial discretion in a pragmatic manner (see our 23 March Alert), the unfortunate reality is that once the dust settles, some businesses will not have survived.
A challenge, an opportunity
But while this prognosis presents a great challenge to many market participants, it also presents an opportunity to others. Those businesses that are able to emerge from COVID-19 intact and with adequate financing may get a rare chance to acquire the business assets or operations of those competitors that fared less well.
As ever, such acquisitions will be subject to New Zealand merger control law, which prohibits any acquisition of a business or shares if it is likely to have the effect of "substantially lessening competition in a market".
In ordinary circumstances, the acquisition by one competitor of the business/shares of another will lessen competition, because the target no longer competes independently of the purchaser in the market. This lessening of competition is substantial when the independent competitors remaining in the market after the transaction would not be sufficient to constrain the merged entity from raising its prices or reducing its quality.
In the case of distressed assets, however, the so-called "failing firm" argument can provide scope for acquisitions that may have ordinarily raised competition concerns.
What is the failing firm argument?
The NZCC determines whether a transaction will substantially lessen competition by comparing the likely level of competition in the market if the transaction goes ahead (the "factual"), with the likely level of competition in the market if the transaction does not go ahead (the "counterfactual"). If the factual is likely to be substantially less competitive than the counterfactual, the NZCC is unlikely to be satisfied it can clear the merger.
In adopting the failing firm argument, the parties argue that at least one of their businesses or business divisions is failing, and those assets will therefore leave the market if the transaction did not proceed. On that basis, there is no difference between the levels of competition in the factual and the counterfactual (because the failing firm would cease competing either way), and so the transaction cannot "substantially lessen competition in a market".
Is it a defence?
While the failing firm argument is sometimes (for convenience) called the failing firm "defence", it is not a legal "defence" as such, because it is not specifically provided for in the Commerce Act. Rather the existence of the failing firm argument simply reflects that the merger control analysis is just a forward-looking comparison of the market with and without the merger. The NZCC is required to assess what is likely to happen to the target business, and therefore competition, in the future if the acquisition does not occur.
In that context, the High Court has cautioned that it is important that the NZCC does not impose special doctrines or requirements on applicants arguing that the target is failing in comparison to applicants making other arguments, noting:1
...in our opinion, in New Zealand at least, there is neither the need nor the justification for a [failing firm] "doctrine". Properly applied the Act is perfectly capable of coping, in terms of competition law, with the consequences of the financial or other failure of a participant without the commission of the Court endeavouring to engraft thereon some special doctrinal rules of general application and thus elevating them to a discrete branch of the jurisprudence.
In other words, the High Court's view is that "the question of actual, imminent, or probable failure of a participant in a merger proposal is nothing more than a question of fact to be determined" by the NZCC in the same way that it assesses other arguments in relation to the competitive effects of merger proposals.
This means that the NZCC should take such arguments into account where the relevant facts apply, even if the applicants do not formally or expressly state that they are making "failing firm" arguments.
Despite this, the NZCC's Merger & Acquisition Guidelines include a separate appendix setting out its approach to assessing failing firm arguments.2
The devil in the detail
The NZCC has approved transactions involving failing firm arguments on several occasions.3 However, in its own words, the NZCC "will not… accept failing firm arguments without close scrutiny".4 We do not expect that COVID-19 will cause the NZCC to scrutinise failing firm arguments any less closely than it would in ordinary circumstances.
When assessing failing firm arguments, the NZCC will ask two key questions:
- Has the firm or division in question ceased operations, or will it cease operations imminently or probably?
- What will likely happen to the assets of the firm or division without the merger? Will the assets likely exit the market?
For each question, the NZCC will require supporting evidence. For example:
- To demonstrate imminent cessation of operations, it is not enough to show a trend of declining profits, or a rate of return well below shareholder expectations. Rather, the failing firm must show a trend of negative cash flows over a sustained period. Evidence such as audited financial statements, budgets/forecasts, Board papers, internal strategic plans, capex documents, asset valuations, and independent appraisals of the firm, may be helpful.
- To demonstrate that assets will likely exit the market, the NZCC will require evidence that the firm in question has made reasonable efforts to find a third party purchaser for the firm, the division, or the assets – including the nature of any offers that have been made, and the identity of likely purchasers and the timeframe for any alternative transaction that could take place.
The key points to take away from the above are:
- When acquiring distressed assets, purchasers may be able to take advantage of the "failing firm" argument to undertake acquisitions that would otherwise substantially lessen competition in a market.
- A "failing firm" argument will be scrutinised carefully by the NZCC, and must therefore be supported by robust evidence, including detailed financial information, to be successful.
- We do not expect that the COVID-19 pandemic will cause the NZCC to lower the threshold it applies to assessing failing firm arguments (but it may of course increase the number of instances in practice that meet the NZCC's threshold).
If you would like to discuss how any of the above might affect your business, please contact one of the authors below.