The Viability Of The Failing Firm Defence In Indian M & A Transactions

BY MADHULIKA IYER, FOURTH-YEAR STUDENT AT SYMBIOSIS LAW SCHOOL, PUNE

Introduction

Owing to the economic uncertainty due to the ongoing COVID-19 pandemic, many businesses are in search of potential avenues to wither this impact – one of which is the “failing firm” defence (‘FFD’).  The FFD is employed by businesses in cases where their transactions raise anticompetitive issues. The acquirer argues that this transaction, if approved, is unlikely to have an appreciable adverse effect on competition (‘AAEC’), as the target firm would invariably exit the market, if the transaction remains unsuccessful. Hence, the rationale behind this defence is such that the firm’s dominant position will not be strengthened, instead the post-merger performance would aid in maintaining competition in the relevant market.

As widely documented, the effects of the COVID-19 pandemic on the financial stability of various businesses has been almost disastrous. Therefore, this post seeks to analyse that whether the ongoing pandemic (or any financial crisis) affects the assessment of the FFD, the pro-active role of the Competition Commission of India (“CCI”), and its viability post this outbreak as well.

What is the Failing Firm Defence?

First explored in the case of Kali und Saz (now reflected in the European Union’s Merger Guidelines), this defence lays down a 3-point test, which is as follows –

  • The failing firm must be on the verge of exiting the market,
  • There is no less anti-competitive alternative, and
  • In the absence of this merger, the failing firm would invariably exit the market.

Once these 3 conditions are established, it could be stated that there would be no reduction in competition, and therefore, the proposed combination should be approved. A similar test is applicable in the United States (US) as under Section 11 of its 2010 Horizontal Merger Guidelines.

The Indian Competition Law recognises this concept as well. Section 20(4)(k) of the Competition Act, 2002 (“Competition Act”) recognises the ‘possibility of a failing business‘ as a factor in regulating combinations. The S.V.S. Raghavan Committee Report, also commented that no social welfare loss would occur if the assets of the failing business were to be taken over or combined with another firm. Hence, while it is not regarded as an absolute defence under the law, the CCI considers it as a factor while determining whether the combination would have an AAEC or not.

It is also pertinent to note that this defence is still in a nuanced stage in India, as factors such as what constitutes a failing business, or how the CCI should evaluate this defence remain unclarified.

Implications on the assessment of the FFD due to the pandemic or any financial crisis

While answering the question regarding the implications on the assessment of this defence, due to the ongoing pandemic or any financial crisis, it is relevant to highlight the EU’s Olympic/Aegean Airlines case, wherein a merger cited this defence during the 2007-08 worldwide financial crisis. The party’s defence was initially rejected by the Commission, as the conditions of the test were not fulfilled, nor was there satisfactory evidence to establish actual bankruptcy or that the firm would actually exit the market. The Commission observed that temporary losses were a common feature in a financial crisis, which did not warrant any inference that the firm was “failing” per se.

Notably, the Commission approved the same transaction filed in Aegean/Olympic II two years later, owing to the dismal state of the Greek economy, and its finding that the merger posed no negative impact on competition, or that the firm would exit the market upon failure of the same. With reference to the ongoing pandemic, the Commission has published a ‘Guidance Note’, whereby firms first have to avail assistance, in the manner prescribed, before approaching the Commission. Such form of assistance includes existing instruments deployed from the EU budget in order to support the hard-hit SMEs and small mid-caps, as well as credit holidays, which allow for delayed repayment of loans – which will also be implemented for affected companies under the same instruments, in order to relieve the strain on their finances.

The American stance is even more stringent, whereby firms have a higher burden of establishing bankruptcy, due to the presence of both the “failing” and “flailing” firm defence. The latter indicates those firms who have been weakened, merely due to market competition. During times of financial crisis as well, the standards of this defence have never been compromised upon by the US Justice Department. With respect to the ongoing pandemic, American authorities have called for expedited review of failing firms, whereby parties have a timeline within which they can base their transaction upon, providing clarity to their overall business functioning as well.

The takeover of Bhushan Steel by Tata Steel, shows India’s accepting stance on the FFD. The CCI has approved, without any objection, almost-all mergers, which have significantly increased since the establishment of the Insolvency and Bankruptcy Code, 2016 (“IBC”) as well. Despite their pro-active approach as highlighted above, it is interesting to note that the Advisory issued by the CCI, is void of any specific merger mention, and contains only a general warning for businesses to refrain from violating any provisions under the Competition Act. As stated above, there is also no clarity regarding the FFD, nor has it been provided during the ongoing pandemic either.

The threshold the CCI should establish for the FFD and its importance post COVID-19

It is common knowledge that India is facing an economic slowdown, with the GDP at a decline of 23.9%. Owing to the same, the CCI is faced with an issue of balancing market competition, while also saving essential failing businesses. Another point to note is the suspension of the application of IBC for a year, due to which any combination approaching the CCI during this period, will not go through the rigour of IBC to adduce its bankruptcy, and whether it truly is failing. Hence, the burden of this determination rests solely upon the CCI at this point in time. I believe it is the need of the hour to put forth regulations de-marking the criteria for utilising the FFD in India. The factors the Commission should keep in mind while establishing the same are as follows –

  1. Parties to the proposed combination should be given the chance to put forth their case, with factors such as proof of the possibility of exiting the market upon failure of this combination, proof of no AAEC by demonstrating their nearly bankrupt state or evidence of alternative negotiations with other potential buyers as well. All in all, the factors as considered under the Olympic/Aegean case, would in my opinion provide a holistic approach to the CCI while trying to adduce the true intentions of the parties. With reference to this point, the Canadian Merger Enforcement Guidelines , which suggest that parties can rely on projected cash flows, audited financial statements and proof of continuing operating losses to prove the FFD could also be taken into account. By looking into the same, it can be proved by the parties that the firm truly is failing and is likely to exit the market. Emphasis can also be placed upon other information such as financial analysis memorandums, minutes of the board meetings or even documented negotiations which have taken place with other competitors, in order to prove that there is no less-competitive alternative to the proposed combination and also that the firm is incapable of being reorganised.  
  2. Secondly, factors such as accessibility, price, and cost should be given greater consideration, especially during any financial crisis, as they have higher relevance to consumers as well. Demonstrating the same, during the analysis of the FFD in the minority stake acquisition of Deliveroo ( a food delivery start-up) by Amazon, the Competition and Market’s Authority   in the United Kingdom, adduced  that loss of the food delivery application would have a negative effect on consumers, owing to the possibility of higher prices along with a decrease in quality and choice.
  3. Following the steps of the United States, with respect to their differentiation on “failing” and “flailing”, as highlighted above could also be beneficial to our country. It is evident that the service industry, from airline companies, to the hospitality sector and tourism have bourn the brunt of the pandemic to a greater extent. Hence, adopting different standards or thresholds based on industry-specific impact will also, to some extent, prevent the decline of these industries, and uphold their overall welfare and business functions. One can also seek guidance from the South Korean Free Trade Commission, wherein they adopted a similar approach with respect to the relaxation of merger guidelines, in order to assist their aviation sector.
  4. Lastly, keeping in mind the lack of clarity regarding the FFD and its interpretation in India currently, potential parties could also opt for a pre-consultation with the CCI, in order to clear any ambiguity present in their proposed transaction and its interpretation. Another possibility would be adopting the Green Channel mechanism, specifically for COVID-19 mergers, and transactions citing the FFD as well, under regulation 5A. This possibility was also recommended by the Competition Law Review Committee, although not adopted. There are often circumstances wherein the competition in the market could be best secured by authorising a deal that allows for the assets of the failing firm to remain in the market, in the absence of which the market share of the failing firm will be taken over by the present competitors, and in any event would have an effect on the competitive constraints. Following the basis of this argument, there is no reason to set-back the approval of a combination, involving the acquisition of the failing firm, once the resolution plan has been approved. While some may argue that this possibility would serve as an additional burden on the CCI, I truly believe this mechanism outweighs the inefficiencies present.

Conclusion

At this time, while it is crucial to exercise caution in order to prevent any problematic mergers which may have an AAEC, it is also pertinent to protect businesses which truly are financially distressed and whose exit would impact or cause adverse market reactions. The FFD is one of the potential avenue’s businesses are venturing into, especially during the current economic slowdown. However, the lack of any legislative framework or clarity proves to be a drawback.  Hence, the pro-active role of the CCI in this matter is the need of the hour, in order to provide and maintain a balance between market competition and the considerations for the FFD in merger proposals, as well as its impact and precedence post the pandemic as well.

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