EU Merger Policy: The Substantive Test [1]

by Alberto Di Felice

January 2007

The major change in the new text of the Merger Regulation involves the role of the so-called “dominance test.” The previous version of the regulation required proof of dominance before the impact of a merger on the relevant market could be further assessed. Article 2(3) prohibited “a concentration … which creates or strengthens a dominant position as a result of which effective competition in the common market or in a substantial part of it is significantly impeded.” In the light of a judgment by the American Federal Trade Commission, [2] the European Commission decided to adopt a new standard that could allow intervention even if a dominant position was not created. As we will see, this change is especially relevant in the case of non-coordinated effects in oligopoly markets. The new regulation tries to balance the Commission’s previous experience in determining dominance with a test that closely resembles the more flexible “substantially lessening competition” requirement under U.S. law. The new text of Article 2(3) provides that “a concentration which would significantly impede effective competition in the common market or in a substantial part of it, in particular as a result of the creation or strengthening of a dominant position, shall be declared incompatible with the common market.” As can be seen, the new regulation gives prominence to a competition-based test while retaining the old dominance test. However, it is still true that a finding of dominance remains the crucial factor in the vastest majority of cases.
The substantive assessment on which decisions are based is a forward-looking evaluation of the market conditions expected post-merger. Following the paramount CFI judgment in the Airtours case, which found glaring fallacies in the Commission’s argumentation, the Commission has been forced to make its decisions more economically accurate. Mergers differ according to the nature of the markets in which the merging firms operate. Each type of merger therefore needs to be analyzed using the appropriate economic theory tools.

Horizontal Mergers

The clearest example of the creation or strengthening of a dominant position occurs in horizontal markets. A horizontal merger is the consolidation under single ownership of two or more separate businesses that operate in the same industry—for example, two soft drink companies merging to form a single firm.
A pre-requisite for the determination of dominance is the delineation of the relevant product and geographical markets. A relevant product market consists of products or services which are close substitutes in consumers’ eyes under conditions of effective competition. The geographical market is the area in which the firms operate and where homogeneous conditions for competition can be found that are distinguishable from those in neighboring areas.
Market shares are essential figures to consider. Their ability to create market control—i.e., the ability to influence the price, quantity, or other aspects of a market—is to be calculated accordingly with the conditions of competition in the relevant market and has to be determined on a case-by-case basis taking into account a number of factors. This is because market conditions can limit a firm with a large market share if the market is sufficiently competitive. Thus, in theory, a firm with a 100% market share in a contestable market where entry and exit for competing firms are relatively costless would not be dominant. However, in practice, a market share of above 60% is usually rather reliable evidence of dominance. Competitive advantage originates when consumers have limited bargaining power to prevent price rises as they cannot, or find it costly to, switch to alternative suppliers, nor sponsor the entry of new firms; current competitors, on the other hand, cannot increase supply if the merged entity raises prices, while barriers to entry hinder future competition from other firms.

Oligopoly Markets

A dominant position can also be found in oligopoly markets. An oligopoly is characterized by a small number—as few as two—of relatively large firms that dominate the industry. Because an oligopolistic firm is relatively large compared to the overall market, it has a substantial degree of market control. Relative size and extent of market control means that interdependence among firms in the industry is a key feature of oligopoly. The actions of one firm depend on and influence the actions of another. Such interdependence creates a number of interesting economic issues. One is the tendency for competing oligopolistic firms to turn into cooperating oligopolistic firms—for example, by collectively raising prices. When they do, inefficiency worsens and antitrust intervention is needed. Alternatively, oligopolistic firms tend to be a prime source of efficiency and innovation.
The concept of “collective dominance” is designed to deal with situations where a small number of firms increase, or are highly likely to increase the possibility of collusion, either explicit or tacit. All is needed is that, “in view of the actual characteristics of the market and of the alteration in its structure that the transaction would entail, the latter would make each member of the dominant oligopoly, as it becomes aware of common interests, consider it possible, economically rational, and hence preferable, to adopt on a lasting basis a common policy on the market with the aim of selling above competitive prices, without having to enter into an agreement or resort to a concerted practice within the meaning of Article 81 and without any actual or potential competitors, let alone customers or consumers, being able to react effectively.” [3]
In the aforementioned Airtours judgment the CFI specified the conditions for collective dominance:
• The market must be sufficiently transparent to enable monitoring by the oligopolists of the adoption and maintenance of a common policy (anti-competitive effects are stronger when products are homogeneous, prices transparent, demand steady, technology mature)
• The presence of adequate retaliation constituting a deterrent for deviation in order to render the tacit co-ordination sustainable
• The absence of actual or potential countervailing power exerted by competitors and buyers

Non-Coordinated Effects

Concentrations can occur between undertakings in an oligopolistic market which would not lead to the creation or strengthening of a collective dominant position (coordinated effects) but which would nonetheless lead to higher prices (non-coordinated effects) without the creation of any dominant position. For example, a merger between the second and third largest competitors on a market with only three players might not lead to the creation of a single dominant position, but it might substantially lessen competition on the market by eliminating the rivalry between the merging firms and the competitive constraint that they had exercised both on each other and the market leader.
In such cases, the old formulation of Article 2(3) ECMR did not allow intervention as the merging parties would not have reached a dominant position on the market. The new wording clearly establishes that a merger may be prohibited even if it does not create or strengthen a dominant position if a significant impediment to effective competition is established.

Vertical Mergers

A vertical merger is a concentration between firms which operate in the same industry but at different stages in the production cycle, so that one’s product is a necessary component or complement of the other’s. An example of a vertical merger is that of a soft drink company merging with a sugar production company. The soft drink company uses the output of the sugar company as an input in the production of soft drinks. Lately, an increasing body of case law has been dealing with vertical mergers in the media sector.
The motive for vertical mergers is frequently to obtain a secure supply of a raw material or to secure an outlet for the sale of products. Vertical mergers may raise some competition concerns. The predominant fear is that vertical mergers may “foreclose” the market or a source of supply to competitors. For example, a merger between a manufacturer of a product and a supplier of an essential component for that product may deny rivals access to needed inputs or raise their costs of obtaining them. The foreclosure effect will be acute where there are few or no other suppliers of the essential components. Similarly, the acquisition by a manufacturer of a distributor may make it more difficult for competitors to distribute their products.
It is interesting to note that, contrary to European practice, U.S. competition law considers vertical mergers relatively harmless when it comes to inefficiencies that result from market control. Because a vertical merger is between two firms at various stages in the production of a single good, competition is regarded as largely unaffected. Each market usually remains as competitive after the merger as before.

Conglomerate Mergers

A conglomerate merger arises when two or more firms in different markets join together to form a single firm. While different, markets must be in some way related, so that a firm dominant in one market can use its position to gain a competitive advantage in a neighboring market by means of product bundling, price discrimination and/or predatory pricing (leveraging). Competition risks are greater if the merged entity will be able to offer a wide portfolio of products (portfolio effect). An example of a conglomerate merger is that between an athletic shoe company and a soft drink company. The firms are not competitors producing similar products (which would make it a horizontal merger) nor do they have an input–output relation (which would make it a vertical merger).
The concerns here are not for the immediate impact on consumer welfare, but for the exclusionary or foreclosure effect on rivals which compete in the neighboring market and not in the product market where the merged entity is dominant. For anti-competitive risks to arise markets must be related, the merged entity must be dominant in at least one market and competitors and consumers must be weak.
As such mergers do not result in horizontal overlaps or vertical effects, however, they do not so obviously raise competition problems. Similarly to the case of vertical mergers, European and American practices diverge. U.S. law considers conglomerate mergers as relatively harmless. Because a conglomerate merger is between two firms in different industries, the degree of competition within each industry is thought to be largely unaffected. Notwithstanding such arguments against conglomeracy and criticisms of its policy toward conglomerate mergers, the European Commission has been adamant in defending a stricter approach.

Commitments and Remedies

In many cases where the Commission considers that a concentration will significantly impede effective competition, the parties may agree to modify the original concentration plan and offer commitments to the Commission. It is crucial, however, that the commitments offered satisfy the Commission that the remedies are sufficient to restore the conditions of effective competition in the common market on a permanent basis. Commitments may be submitted and accepted both at Phase I, prior to initiation of proceedings, and in Phase II proceedings.
Commitments concluded may relate to the structure of the concentration or to the behavior of the parties, i.e., they may be structural or behavioral. A structural remedy ordinarily requires divestiture of the activities of an existing viable business that can operate on a stand-alone basis. Alternatively, a commitment by the parties to terminate or not to engage in exclusive agreements which would otherwise have foreclosure effects post-merger, or remedies to facilitate market entry through the grant to competitors of access to infrastructure or technology, or through the licensing of intellectual property rights might have a sufficient effect on the market to restore effective competition.

Criticisms

The Commission’s work has been subject to several criticisms, both from the European Courts and from economic commentators.
One of the major problems seems to be the Commission’s appraisal of efficiencies. In some cases involving conglomerate mergers, the Commission has accepted that efficiencies would result from a merger but that these efficiencies would enable the merging parties to offer their products at lower prices which would damage competitors. In GE/Honeywell, for example, the Commission was particularly concerned that the merged entity would be able to offer low bundled prices for those that purchased both its aircraft engines and its avionics and non-avionics systems. [4] The focus that the Commission placed on the harm that would result to the new entity’s competitors led some commentators to take the view that the decision was indicative of a hostile approach to mergers that create efficiencies and as protective of competitors rather than competition.
One troubling area is the Commission’s tendency to see product innovation arising from a proposed merger and to define a narrow market under a presumption of dominance in the new product market, even before the new market comes to life. What is striking about the Commission’s approach is the way the Commission often treats innovation as a competition problem and its willingness to define markets and dominance in emerging markets: A merged entity which does not have a dominant position in an existing market can nonetheless be found prospectively dominant in a market which the merger is predicted to create, but which is nonexistent at the time of the merger. Examples in information markets, such as on-line services, are especially salient.
In Airtours, the most damning criticism was reserved for the failure of the Commission to undertake analysis properly and satisfy the evidentiary standards required in law. The core criticism made by the CFI concerned the economic soundness of the Commission’s analysis, and absence of economic evidence. The principle flaw was the willingness to establish an adverse outcome of a merger simply by reference to its theoretical possibility, which was inadequately supported by facts. The Commission had failed to establish a convincing justification for its decisions, either through economic analysis or economic evidence.
The effectiveness of the Court’s rulings in underlining procedural flaws has  stressed the importance of tighter judicial scrutiny and has provided clear guidance on the requisite legal standard.
Another sensitive area is the interaction between merger and antitrust rules. The existence of antitrust law, and commitments given by the parties not to engage in anticompetitive actions, should have a persuasive effect on the Commission’s decision, for the reason that ex-post intervention is still possible. One problem with this criticism, though, is that merger law is an ex-ante system of control designed to ensure competitive market structures and avoid the need for behavioral antitrust rules. Dealing with conglomerate mergers, however, it is important to note that the market structure is not modified, and that competition concerns only arise because of possible future actions on the part of the merged entity. In such cases, behavioral commitments should suffice.
Finally, in some particularly sensitive merger cases there is a fear that political and other considerations may enter the decision-making process. These worries arise because the final decision in Phase II is made by the College of Commissioners; more to the point, in Phase I DG Competition also consults the Directorates-General concerned with the merger. This has led to some calls for the creation of an independent European cartel office or competition tribunal.

NOTES

1. The following discussion is largely based on Giorgio Monti, “Merger Policy,” in European Union Law (Cambridge, U.K.: Cambridge University Press, 2006), pp. 1089–113, and on definitions taken from http://www.amosweb.com/ [↩]
2. Federal Trade Commission v. Heinz 246 F.3d 708 (2001). [↩]
3. Case T-342/99, Airtours v. Commission (2002), para. 61. [↩]
4. Case COMP/M.2220 General Electric/Honeywell, OJ 2004 L48/1. [↩]