• EC introduces concept of ‘theory of benefit’
• Guidelines enshrine entrenchment as theory of harm
• Efficiencies must provide wide benefits to consumers

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The proposal for the revision of the EU merger guidelines significantly expands the European Commission’s (EC) interpretation of innovation, investment, entrenchment, and efficiencies, according to a draft version of the document seen by this news service.

The EC has been working on this document for more than a year, with the current version of the draft now circulating inside the institution for comment before it is released to the public for consultation in early May.

The following is a blow-by-blow summary of the 95-page draft.

The text begins with an introduction and guiding principles, including a two-page section on the benefits of scale versus market power.

“The growth and scaling up of firms in the internal market so as to reach the necessary size to compete globally can be pro-competitive and have a positive impact on the EU economy and its competitiveness, including on innovation and investment. This is particularly important in markets where global firms play a significant role and exert significant pressure,” the draft says.

“Mergers can help companies to develop scale which is necessary to compete in certain global industries with high capital intensity and rapid research and development innovation,” it continues.

Next, it says that “the Commission regards scale-enhancing mergers that combine complementary activities from different member states without generating significant overlaps as positive and as contributing to the further integration of the internal market.”

The Commission then gives examples of when “scale enhancing” mergers may contribute to European competitiveness, for instance when offering a new solution in the European Economic Area (EEA) where few global alternatives are available.

Second, the draft says that mergers that result in R&D synergies or enable projects of a magnitude that would not be feasible otherwise may lower investment costs or enhance firms’ overall capabilities.

Third, mergers that accelerate access to scarce talent or critical resources may enable innovation, increase investment and foster the development of new or sustainable technologies, the draft says.

Another way scale may contribute to European competitiveness the draft says is by promoting security and resilience. One example: mergers combining complementary capabilities that increase the merging party’s ability and incentives to invest in the security of critical infrastructure. Another: mergers that secure access to critical inputs, to the extent that they increase the resilience of the internal market. A third example: mergers that enable defense projects that strengthen the internal market for defense and European defense readiness without creating resilience risks.

Theory of benefit

Next, the draft recalls that the Commission bears the burden of establishing whether a merger overall gives rise to a Significant Impediment to Effective Competition (SIEC).

It then says that if the merging parties consider that the merger gives rise to efficiencies, they must articulate and substantiate in due time, a “theory of benefit.”

“A theory of benefit sets out how specific merger efficiencies occur and enhance or maintain effective competition to the benefit of consumers. That is, it explains how the merger may lead to the merging firms profitably decreasing prices, increasing output, innovation, choice or quality, or positively influencing other relevant parameters of competition, such as investment levels underpinning stronger competitive behavior across multiple products or geographies, thereby offsetting, on a lasting basis any harm to consumers brought by the merger.”

While the draft recalls the Commission’s discretion, it says it exercises it “in an even-handed way, in that it relates to assessment of evidence underlying both a theory of harm and a theory of benefits.”

Overall assessment of mergers’ impact

On the basis of an overall assessment of the facts and evidence, the draft says, the Commission concludes whether a merger’s impact on the competitive process is “more likely than not” to result in an SIEC.

The draft says the commission will “assess whether the efficiencies brought about by the merger counteract the negative effects on competition and in particular, the potential harm to consumers that a merger might otherwise have.”

It notes the demonstrated efficiency claims may refer to “efficiencies in the form of sustainability or resilience benefits, innovations with potential to disrupt or transform markets or scale effects that will reduce unit costs or facilitate the financing of necessary investments.”

“The greater, more certain and immediate the negative effects on competition, the more substantial and likely the efficiencies must be, and the more confident the Commission must be that they will be passed on to a sufficient degree to consumers,” the draft says.

“The more market power the merged entity holds, especially in the case of a dominant position, the less likely efficiencies will be sufficient to outweigh competitive harm. It’s highly unlikely that a merger leading to a market position approaching that of a monopoly or a similar degree of market power will result in efficiencies that will sufficiently outweigh the harm caused by the merger,” it continues.

According to the draft, the Commission carries out a balancing exercise to assess whether the efficiencies that fulfill the criteria counteract the harm to competition that might otherwise result from the merger.

Counterfactual

The draft contains three pages on the counterfactual, in which the Commission explains that it examines a merger in light of the law and facts existing at the time of the notification, not hypothetical future events.

The draft says that in most cases, pre-merger conditions are an instructive benchmark to assess the expected effects of a merger on future competition. However, it says pre-merger conditions may not be the relevant counterfactual where “(i) there is a sufficient degree of certainty on future changes in market conditions that are unrelated to the merger, (ii) the prevailing situation at the time of the merger is not representative of normal market conditions or (iii) the target or merging firms would have agreed to alternative merger(s) or agreement(s) absent the merger.”

Innovation and investment

In the second part of the draft, the Commission examines dynamic competitive potential, and it acknowledges that in industries where innovation or investment are an important parameter of competition, a static assessment of market power does not fully capture firms’ competitive strengths and weaknesses.

When it comes to innovation, for these industries, the draft says the EC will also consider other factors, including R&D expenditure, patent production, a company’s innovation track record, investment or technological capabilities, a company’s ability to exploit network effects across products and the high valuation of a target by the buyer, especially compared to its turnover.

On investment assessments, the draft says the Commission will factor in a company’s ability and incentive to invest and expand. This translates into analyses of organizational structures, degrees of vertical integration, the development of complementary products and the geographic scope of operations.

When it comes to loss of investment competition, the enforcer says that a merger can be harmful if it affects the discontinuation, downsizing, delay or redirection of investment projects.

Regarding loss of innovation competition, the draft says the Commission will consider the dynamic competitive potential of R&D projects, the innovation of each of the merging firms, the degree of dynamic competitive interaction between the merging parties in R&D, and the number of remaining competitors with R&D projects with similar characteristics, among other factors.

The Commission also introduces in its draft merger guidelines an “innovation shield” to provide guidance on transactions involving small innovators that should not raise competition concerns.

The draft sets out a detailed list of circumstances in which transactions involving small innovators or R&D projects with dynamic competitive potential are considered not to result in an SIEC.

Foreclosure

Next, there is a section on foreclosure, which includes a discussion of “dynamic incentives”. This section states that the merged entity “may have an incentive to engage in foreclosure not to capture immediate gains, but to strengthen, entrench or extend its market power over time by degrading rivals’ access to critical inputs, customers or complementary products or services. The merged entity may progressively undermine rivals’ ability to compete, effectively deter entry or expansion or diminish rivals’ incentives to invest and innovate.”

“Such dynamic foreclosure incentives may be material even where an assessment based on current diversion ratios, departure rates and margins would not identify a profitable foreclosure strategy,” the draft says.

It goes on to say that “dynamic foreclosure incentives are particularly relevant in markets where competitive viability depends on achieving or maintaining a critical level of scale, data or customer reach, and where competitive advantages tend to be self-reinforcing, for instance, through network effects, data accumulation or control of bottlenecks.”

“They are also material in markets where innovation and investment are important parameters of competition. In a number of such markets, rivals do not challenge an incumbent’s position directly, but enter through adjacent markets to acquire the scale and network effects needed to compete effectively. The merged entity may therefore have an incentive to foreclose rivals or potential entrants at this earlier stage in order to eliminate competitive threats before they materialize, where the merged entity already holds a significant degree of market power or a dominant position. Such dynamic incentives may further support a finding of entrenchment.”

“A merging firm may be motivated to foreclose rivals that are developing an innovative product or service downstream. An innovation race downstream may incentivize the merged entity to foreclose competitors, even if it is not yet active downstream, for example, to gain a first mover advantage or to be the only company able to develop a product downstream for a new or nascent market.”

Entrenchment

Next, the draft discusses entrenchment of a dominant position, saying that “entrenchment occurs when the merged firm gains control over certain assets in a way that structurally creates or reinforces existing barriers to entry and expansion, resulting in reduced market contestability.”

The draft says that a merger may lead to entrenchment in the presence of the following factors. First, at least one of the merging firms is dominant in one or several closely related markets. It says that entrenchment is more likely in the presence of market dynamics that reinforce or protect the merging firms’ position, such as network effects, scale economies or customer inertia. Second, the acquired assets are related to the merged firm’s core markets. Third, the acquired assets are important to effectively compete on the core market, and their control by the merged firm restricts the ability and incentives of rival firms to enter or expand.

Benefits

The draft guidelines then contain a 15-page section on benefits, saying “demonstrated efficiencies will play a key role in the assessment of mergers going forward.”

“The assessment of demonstrated efficiencies is an integral part of the Commission’s overall assessment of the impact of a merger in the internal market. Scale and innovation are critical to compete in innovation-heavy sectors, which are important for the competitiveness of the EU. The assessment of efficiencies therefore follows a forward-looking approach that gives adequate weight to innovation, investment and resilience of the internal market, taking into account the expected change that a merger may bring on the merging firm’s ability and incentive to invest and innovate, as well as adjusting the time periods for the materialization of benefits depending on the characteristics of the market and the case at hand.”

“A merger may allow companies to develop pro-competitive scale, not only through economies of scale, scope or density, but more generally, when a merger combines complementary assets or capabilities, results in procurement synergies or secures access to critical inputs that result directly in new, improved or more affordable products, or confer the ability to increase the incentive of the merged firm to invest and innovate.

Resilience and sustainability

“Resilience and sustainability may benefit consumers in a variety of ways,” the draft says.

In the case of resilience, efficiencies may come from (i) a combination of complementary assets leading to increased security, broader or reinforced infrastructures, or other enhancement that reduces exposure to risks of external disruptions, (ii) access to critical inputs or increased purchasing power to reduce exposure to supply chain disruptions, or (iii), the creation of new or improved products that are more resilient to external disruptions.

Similarly, in the case of sustainability, the draft says efficiencies may come from (i) a combination of complementary assets that reduce the environmental pollution of production processes, (ii) improved access to sustainable inputs, or (iii), the creation of new or improved products that are more sustainable.

To be considered beneficial to consumers, direct and dynamic efficiencies should (i) lead to benefits that are valued by them, and (ii) be assessed not only with sole regard to the companies involved in the merger, but having regard to competition as a whole, the draft says.

Next, there are sections on direct efficiencies and dynamic efficiencies. In both cases, the draft says that efficiencies have to be verifiable, to allow the commission to assess whether they’re likely to materialize, whether they’re timely and whether they’re substantial enough to counteract a merger’s predicted anticompetitive effects.

On benefits to consumers, the draft says for consumers to benefit from the efficiencies of the merger, the efficiencies must benefit substantially the same consumers as those who would otherwise be harmed by the merger, so that they are not worse off as a result of the merger.

Dynamic efficiencies

On the assessment of dynamic efficiencies in particular, the section on verifiability says that “to show that dynamic efficiencies are likely to materialize, the merging parties’ ‘theory of benefit’ should explain and substantiate with a sufficient degree of likelihood that the merged entity would invest or innovate in new or improved products or services, improved distribution or production, or other pro-competitive parameters of competition post-merger, the draft says.

“The theory of benefit should explain as concretely as possible the nature of the investment or innovation in question. Moreover, the impact on the merged entity’s ability and incentive must not be only temporary,” the draft says.

The incentive to invest or innovate depends on the degree to which the investment or innovation would be profitable, the draft says. “The merger may increase the merging parties’ incentive when it alters the trade-off they face between investment or innovation costs on the one hand and potential future profits on the other.”

As to the timeliness of efficiencies, the draft says, “the sooner investment or innovation is expected to materialize after closing, the more likely that investment or innovation is considered timely.”

The draft says that the benefits to consumers from dynamic efficiencies may materialize in a longer time horizon, as long as it’s possible to verify that they will be substantial enough to counteract the mergers’ anticompetitive effects.

To verify whether dynamic efficiencies are substantial enough to counteract a merger’s adverse effects on competition, the draft says that merger synergies should be “quantified” where reasonably possible.

For consumers to be said to benefit, the efficiencies must benefit “substantially the same consumers as those who would otherwise be harmed by the merger, so that they are not worse off as a result of the merger.”

Balancing benefit and harm

Next, there is a section on balancing benefit and harm. The draft says that “here the claimed efficiencies result in benefit that, on a lasting basis, at least offset the harm to competition brought by the merger, the merger will be deemed compatible with the internal market,” the draft says.

“It is sufficient for the commission to establish that efficiencies compensate the harm caused to consumers in the relevant market and not to each individual consumer. However, consumer benefit that accrues only to a small share of the consumers harmed by the merger is unlikely to offset the harm,” the draft says.

Where a merger results in both substantial consumer harm and benefit, the Commission “disposes of a margin of discretion in weighing up different, sometimes incommensurable parameters,” the draft says.

To carry out the balancing exercise, the consumer benefits should, in principle, accrue in all the markets where the merger results in harm, the draft says.

“Harm arising in one geographic or product market or one side of a multi-sided product market cannot be balanced against and compensated by benefits accruing in another unrelated geographic or product market or side of the multi sided market,” the draft says.

The last section of the draft contains a discussion of the conditions under which EU member countries can intervene in mergers that are the EU’s exclusive competence to protect legitimate interests.

The European Commission declined to comment on this article.

by Natalie McNelis and Tono Gil