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Milking it: rare success of failing firm defence in UK Phase 1 merger inquiry


At the end of March 2022, the UK Competition and Markets Authority (CMA) announced the unconditional clearance at Phase 1 of Freshways group's (Freshways) acquisition of the Medina group (Medina).

This dairy processing and products merger provides a rare example of a deal being cleared on the basis that the target firm would otherwise exit the market absent the transaction – the so-called "failing firm defence". However, it seems unlikely that this decision represents a lowering of the high evidential bar set for a successful failing firm defence, nor does it necessarily indicate that the CMA will be more receptive to these type of arguments as UK businesses start to feel the full impact of the COVID-19 pandemic and the crisis in Ukraine.

Here are our key takeaways from the published summary of the CMA's decision.

Skimming past it?: first use of the CMA's condensed two-limb test

The decision marks the first successful use of the CMA's revised test for the failing firm defence – described as "the exiting firm scenario" - in the CMA's revised merger assessment guidelines published in March 2021.

The underlying logic of the failing firm defence is that, if one of the parties to the transaction would have failed without the deal, there cannot be a substantial loss of competition as a result of the merger (as the firm would not have subsisted as a credible competitor in any event). Under the CMA's revised 2021 guidelines, to avail themselves of this defence, the parties must fulfil a two-limb test – namely, they must prove that:

1. Limb 1 – Likelihood of Exit – the firm in difficulty would have exited the market absent the merger (through financial failure or otherwise); and, if so 

2. Limb 2 – Alternative Purchasers – there would not have been an alternative, less anti-competitive purchaser for the firm or its assets to the acquirer in question.

In so doing, the CMA has seemingly condensed its failing firm test from three limbs to two. Previously – in contrast with current EU guidelines – the CMA also separately compared the competitive impact of the relevant firm's market exit, as compared to the outcome that would arise from the acquisition. Historically, this additional third limb of the test focussed on whether, absent the merger, the exiting firm's sales would be dispersed across several firms (supporting broader competition) or mostly transferred to the acquirer (achieving a similar outcome to the merger, indicating that it would have little impact). But in this case, implementing the new condensed test above, this third line of enquiry is entirely absent from the CMA's summary decision.

However, caution should be exercised before concluding that the CMA's shortening of its test is likely to lower the bar for a successful failing firm defence. Prior to the revised Guidelines, the CMA had already issued COVID-19 guidance for failing firms, which made clear that this third limb of its (then current) test would be applied flexibly in practice, considering the broader impact of the merger in light of the overall market structure and all parameters of competition (not just sales). Rather, the third limb of the CMA's old failing firm defence is therefore more likely to be subsumed into the CMA's overarching, holistic competitive assessment of the transaction.

Udder failure: financial difficulties longstanding & well-documented

Further to limb 1 of the test (would the firm have exited?), the CMA reviewed a broad range of internal financial records (management accounts, weekly cashflow, etc.), external advice and third-party evidence from lenders which demonstrated that Medina had been in financial difficulty for some time (e.g. breaching key financial covenants, delaying payments to trade creditors and being unable to obtain re-financing) – despite it reaching out to a large pool of potential lenders and significant efforts to cut costs. Notably, the CMA's monitoring trustee indicated that Medina would cease trading imminently during the ongoing merger investigation without further assistance. The CMA was therefore satisfied that Medina had exhausted all realistic options to remain viable prior to the merger and that its market exit would be inevitable.

Make sure pre-transaction cooperation doesn't curdle the CMA's assessment

Prior to the transaction, Medina entered into joint purchasing arrangements with, outsourced milk processing and packaging to, and took loans from Freshways in order to rationalise operations, cuts costs and stay viable. Such sort of pre-deal cooperation caused by financial difficulty can raise issues for any subsequent merger control assessment, including as regards the applicability of the failing firm defence:

a) While not an issue this case, such pre-deal arrangements can deemed to confer 'material influence' to the counter-party, such that they are – in and of themselves – deemed to be a transaction subject to UK merger control. (For example, convertible loan notes have been sufficient to give to give an acquirer material influence prior to a main takeover years later).

b) The CMA will also consider whether pre-deal cooperation between the parties: (i) contributed to the inevitable exit of the firm from the market; or (ii) meant that alternative, more pro-competitive purchasers for the firm's business or assets were not forthcoming. If so, the failing firm defence may not be available. 

In this case, Medina did not market itself or engage other potential purchasers prior to the sale to Freshways. The CMA noted that, absent a meaningful sales process, it would not typically be able to confirm that there was no realistic prospect of a less anti-competitive purchaser (limb 2 of the test described above). Ultimately, however, the CMA got comfortable that contemporaneous documents (including those prepared by lenders' advisers) and market feedback demonstrated that there were no credible alternative purchasers (even for only certain of Medina's assets) that would run the business as a competitor. The CMA notably contacted all liquid milk processors and wholesalers competing in the UK to confirm this.

Whey too hard?: high-hurdle for test remains, despite ongoing economic difficulties

Particularly at Phase 1 (as opposed to after an in-depth Phase 2 investigation), the evidential bar for satisfying the CMA's failing firm test remains high – e.g. the firm's market exit must be inevitable, as opposed to merely the most likely outcome (the standard used at Phase 2). Despite the parties' success at Phase 1, the case does not suggest that the CMA might be more receptive to "failing firm" arguments following the ongoing economic ructions caused by the COVID-19 pandemic and now the crisis in Ukraine. Rather, this seems to have been a clear-cut case involving a national, more traditional (i.e. less dynamic) groceries goods market and which was supported by a substantial amount contemporaneous evidence, both internal and external and from across a number of years.

As mentioned above, in April 2020, the CMA published COVID-19 specific guidance which largely restated its current practice regarding the failing firm defence and made clear that this would not change in light of the prevailing economic difficulties. In particular, it made clear that speculative claims based on short-term financial difficulty would not be successful without a material body of supporting evidence. Subsequently, despite initially accepting such arguments, the CMA reversed its decision that Amazon's minority investment into Deliveroo could profit from the failing firm defence based on liquidity issues caused by the pandemic (even if the deal was ultimately cleared for different reasons). The CMA's decision to block the merger between JD Sport and Footasylum, even when asked to reconsider its decision by the Competition Appeal Tribunal, further demonstrates the difficulties parties may face before the CMA when seeking to rely on financial difficulties and changed trading conditions caused by recent market disruptions as a means to allay competition concerns about a transaction.


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