ALERT MEMORANDUM US Agencies Publish Final Revised

Vertical Merger Guidelines If you have any questions concerning this memorandum, please reach out to your regular firm contact or the July 2, 2020 following authors.

On June 30, 2020, the US Department of Justice and (the “Agencies”) published final Vertical Merger Guidelines. Leah Brannon +1 202 974 1508 Draft Guidelines were previously released for public comment on January [email protected] 10. The Guidelines largely reflect the Agencies’ current approach and do Brian Byrne +1 202 974 1850 not appear to represent any significant change in enforcement posture or [email protected] policy. They replace the existing 1984 Non-Horizontal Merger Guidelines, Jeremy J. Calsyn +1 202 974 1522 which were both out-of-date and somewhat misleading. The Guidelines [email protected] represent a largely middle-of-the-road approach, but suggest a slight George S. Cary inclination to view such deals as most likely procompetitive. +1 202 974 1920 [email protected] In connection with the DOJ’s and FTC’s enforcement of Section 7 of the Clayton Act, Daniel P. Culley which prohibits mergers that may substantially lessen , the Agencies +1 202 974 1593 periodically publish official guidance explaining their approach to merger review. Published [email protected] guidelines serve several purposes: (1) providing the public (including practitioners) with Elaine Ewing transparency about how the Agencies analyse cases; (2) explaining complicated economic +1 202 974 1668 [email protected] concepts to courts outside the context of the advocacy of any particular case; and (3) helping Agency staff to be efficient and rigorous by ensuring that they stick to well-supported David I. Gelfand +1 202 974 1690 theories of harm. The 1984 Guidelines have long been out of step with Agency practice1 and [email protected] 2 the bar has been advocating for revisions for some time. D. Bruce Hoffman +1 202 974 1784 As explained below, among other things the new Guidelines (1) eliminate the proposed safe [email protected] harbour found in the draft Guidelines; (2) make it clear that injury to downstream Mark W. Nelson customers, not rivals, is the critical issue in vertical merger review; (3) discuss +1 202 974 1622 complementary and diagonal product mergers in addition to pure vertical transactions; (4) [email protected] clarify the role that efficiencies—especially the elimination of double marginalization—play Kenneth Reinker in Agency decisionmaking; and (5) provide detailed examples of theories of harm. +1 202 974 1743 [email protected]

1 See, e.g., D. Bruce Hoffman, Acting Director, United States Federal Trade Commission, Vertical Merger Enforcement at the FTC, Credit Suisse Washington Perspectives Conference, January 10, 2018, available at https://www.ftc.gov/system/files/documents/public_statements/1304213/hoffman_vertical_merger_speech_final.pdf; Jon Sallet, Deputy Assistant Attorney General For Litigation, Antitrust Division, US Department of Justice, The Interesting Case of the Vertical Merger, ABA Fall Forum, November 17, 2016, available at https://www.justice.gov/opa/speech/file/938236/download. 2 See, e.g., Steven C. Salop and Daniel P. Culley, Revising the U.S. Vertical Merger Guidelines: Policy Issues and an Interim Guide for Practitioners, 4(1) J. ANTITRUST ENFORCEMENT 1 (2015). clearygottlieb.com © Cleary Gottlieb Steen & Hamilton LLP, 2020. All rights reserved. This memorandum was prepared as a service to clients and other friends of Cleary Gottlieb to report on recent developments that may be of interest to them. The information in it is therefore general, and should not be considered or relied on as legal advice. Throughout this memorandum, “Cleary Gottlieb” and the “firm” refer to Cleary Gottlieb Steen & Hamilton LLP and its affiliated entities in certain jurisdictions, and the term “offices” includes offices of those affiliated entities. ALERT MEMORANDUM

Vertical Mergers: Theories of Harm and — Coordinated effects Efficiencies • A firm that purchases a supplier or customer A vertical merger combines firms that do not compete may gain access to information held by that supplier or customer about the firm’s with each other, but rather operate at different levels of a single supply chain. Conventionally, many in the bar competitors. This visibility into rivals’ sales and at the Agencies, as well as antitrust economists, might allow the firms to establish an agreement without express communication (e.g., have believed vertical mergers to be less likely to harm competition than mergers between competitors coordinating prices) and subsequently more (horizontal mergers), and enforcement against vertical effectively discipline rivals that do not follow mergers has therefore been relatively uncommon. the coordinated agreement. Nevertheless, vertical mergers may lead to a number of — Efficiencies competitive concerns, a few of the most prominent of • Vertical mergers can result in a particular kind which are described below: of efficiency called “eliminating double — Unilateral effects marginalization.” Pre-merger, an upstream input supplier and an unrelated downstream • A firm that purchases a supplier of a critical input to its rivals may be able to profitably raise manufacturer each charge a margin on their products, resulting in a final price for the end the price of that input to its rivals or cut those rivals off from the supply of the input entirely consumer that incorporates both margins. If (“foreclosure”). This is because, in response to these two firms merge, the downstream manufacturer will now obtain the inputs it that increase in input prices or lack of input supply, the rivals may increase their needs at cost. As a result, the merged firm is incentivized to lower its prices because this will downstream prices or restrict their downstream sales, and some of the business the rivals lose increase its volume of sales and thus overall as a result may be “re-captured” by the profit, to the benefit of both the firm and of customers. downstream portion of the vertically integrated firm. Whether it will be profitable for the firm • While there may be ways for firms to eliminate to pursue this strategy depends on whether the double marginalization without a merger, for rivals have alternatives for the input and example using contracts with complex price whether the firm expects that it will recapture a schedules or volume targets, there are good sufficient amount of the business its rivals lose reasons to think that eliminating double to outweigh the profits lost through decreased marginalization is less speculative than other sales to the rivals. kinds of efficiencies—including those that may • Other theories of harm arising from unilateral result from horizontal mergers. effects of a vertical merger include denying Unlike horizontal cases, whether a particular vertical rivals scale by cutting off their access to theory of harm holds in a given case tends to be very customers, using access to information about sensitive to the exact conditions of the market in downstream rivals’ future sales to dissuade question. A fact that might be anticompetitive in one them from making competitive moves, or context may, given different market conditions, be raising by forcing new entrants procompetitive in another. For example, if an input to simultaneously enter both the upstream and supplier commands high margins, that may signal that downstream markets. it has significant . That suggests rivals may be dependent on the input, but it also suggests that the scope for eliminating double marginalization

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may be large. It can therefore be difficult to determine may be particularly relevant in the vertical merger the net effect of the fact of high margins without context. detailed economic modeling. — Harm: The Guidelines describe unilateral and What the Guidelines Say coordinated theories of harm similar to those described in the section above, focused primarily The Guidelines lay out the Agencies’ approach to on input foreclosure. The Guidelines state that market definition, address the importance of market where possible the Agencies may use available structure, describe how the Agencies will address data to construct merger simulations to predict the evidence of adverse competitive effects, set forth a expected impact of a vertical merger. number of theories of harm to competition (both unilateral and coordinated), and describe potential — Efficiencies: As described above, elimination of efficiencies including eliminating double double marginalization may occur through a marginalization. vertical merger when an integrated company taking into account both upstream and downstream — Market Definition: The Guidelines continue the revenues sets a lower profit-maximizing price than Agencies’ approach to defining relevant markets it would have set but-for the . as set forth in the Agencies’ Horizontal Merger The Guidelines note that the Agencies may take a Guidelines. The Guidelines introduce a new simple netting approach with respect to pressure to concept of “related product.” A related product is increase prices to rivals and downward pressure one that is situated upstream or downstream from from elimination of double marginalization: The the and is provided by the other Agencies’ evaluation of whether the merger may merging party, and might include such things as an substantially lessen competition “will generally input, a means of distribution, or access to a set of include an assessment of the likely net effect on customers. The Guidelines do not explain how the competition in the relevant market of all changes concept of “related product” is intended to relate to the merged firm’s unilateral incentives.” In to a relevant antitrust market. addition to elimination of double marginalization, — Market Structure: The Guidelines do not contain the Agencies also state that they will consider a presumption of legality for vertical mergers, as further efficiencies that may arise through vertical some commentators have advocated, but neither mergers, such as streamlined production, inventory do they contain thresholds for a presumption of management, or distribution. illegality, as others have suggested. The What Changed from the Draft Guidelines also state generally that the Agencies may use market shares and market structure in — Safe Harbor: The draft Guidelines included a safe assessing the likely effects of a vertical merger. In harbor for deals below 20% market share, which particular, they state “high concentration in the was widely criticized from both sides. Some relevant market may provide evidence about the argued that such a safe harbor would insulate from likelihood, durability, or scope of anticompetitive scrutiny deals that may be anticompetitive; others effects in that relevant market.” that the inclusion of a relatively low safe harbor could be misleading for those who are relatively — Evidence: The types and sources of evidence the unfamiliar with actual Agency enforcement Agencies will consider in assessing the impact of a practice. The final Guidelines do not include a safe vertical merger are similar to those considered in harbor. the horizontal merger context, and the Guidelines largely incorporate by reference the Horizontal — Locus of Relevant Harm: The Guidelines Merger Guidelines on this point. The Guidelines explicitly state that downstream consumers are the also note that pre-existing contractual relationships proper focus of the Agencies’ competitive

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assessment: “The Agencies are concerned with Commentary harm to competition, not to competitors. When a merger involves products at different levels of a The overall orientation of the Guidelines is modestly pro-vertical merger. Even more than for supply chain, the direct customers the Agencies horizontal mergers, practitioners and commentators are will consider are actual and potential buyers of the downstream products.” This is a major policy sharply divided on the effects of vertical mergers. On decision that was implicit but not expressly stated the one hand are those that take the position that in the draft Guidelines. vertical mergers are almost never harmful and bring added efficiency to the market through vertical — Non-Vertical Deals: The Guidelines now clarify integration. Others believe that the prevailing views of that they apply to complementary product and the first group have led to lax enforcement against diagonal transactions, in addition to strictly vertical mergers that have a significant potential to vertical mergers. harm competition, and that this type of enforcement — Elimination of Double Marginalization should be dramatically increased. (“EDM”): The Guidelines’ discussion of EDM The Guidelines take a relatively middle-of-the-road has now been moved from a separate section into approach, in particular declining to create a the more general discussion of efficiencies, as well presumption of legality for vertical mergers, something as being addressed in various other places in the many in the bar had advocated for. Nor do the Guidelines. The Guidelines emphasize that EDM Guidelines take a particularly aggressive view of the is more verifiable than other efficiencies because it effects of vertical mergers, with their discussion of “is not a production, research and development, or elimination of double marginalization in particular procurement efficiency; it arises directly from the suggesting that the Agencies would tend to view this alignment of economic incentives between the efficiency as particularly credible and often tending to merging firms.” The Guidelines also state that lead to a net procompetitive effect. Nevertheless, their “Creditable quantifications of the elimination of statement that “While the agencies more often double marginalization are generally of similar encounter problematic horizontal mergers than precision and reliability to the Agencies’ problematic vertical mergers, vertical mergers are not quantifications of likely foreclosure, raising rivals’ invariably innocuous” suggests a mild inclination to costs, or other competitive effects.” assume that vertical mergers will have procompetitive — Added Detail and Theories of Harm: While outcomes. many commentators criticized the relative paucity The Guidelines now explicitly require a showing of of details in the draft Guidelines, the final harm to downstream customers. Harm to upstream Guidelines provide additional detail, including market participants is not sufficient. This is important through added examples illustrating the theories of because the situation will frequently arise where EDM harm. The Guidelines now also discuss creating or other efficiencies lead to lower downstream prices, the need for two-level entry as a potential harm, while prices to rivals upstream do increase. and describe foreclosure in a bargaining model. The exact role of “related products” will likely need — Foreclosure: The Guidelines have given to be developed through further experience. The additional structure to the section on foreclosure Guidelines introduce the concept of a “related by separately considering whether a merger may product” to describe the particular product that is lead to increased ability to foreclose and incentive vertically related to the relevant market (e.g., if the to foreclose. relevant market is automobiles, a related product might be steel used in their construction or dealerships through which they are sold). The alternative approach

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the Agencies could have taken, which perhaps would customer can facilitate investments where payback is have been the more conventional choice as it would long and conditions are uncertain. not introduce new terminology, would be to simply Additional examples and detail regarding theories define a second market that is upstream or downstream of harm are welcome additions, but the Guidelines of the first. The Agencies’ likely view is that the case still fail to discuss the types of facts that make those law requires proof of a relevant market only for the theories more or less likely to occur. The Guidelines market in which competitive harm is alleged. now discuss how foreclosure interacts with bargaining The Guidelines’ express mention of dynamics, a notable omission from the draft complementary-product mergers is a notable Guidelines given the Department of Justice’s recent change; the Agencies have historically been very loss in its AT&T/Time Warner merger challenge on a hesitant to investigate these types of transactions. In related theory.3 In ruling against DOJ, the District the past, while the EU and other jurisdictions have Court found its blackout-based foreclosure theory of been more aggressive in investigating so-called harm unsupported by the evidence, and expressed “conglomerate effects,” the US Agencies have tended skepticism that the theory was workable at all. to leave any challenges to ex post enforcement of any The Guidelines still do not contain much discussion of potentially anticompetitive practices such as , the types of facts that make the theories they lay out which may be facilitated by a merger of complements. more or less likely to be a problem in a particular case. This has reflected a view within the Agencies that For example, in many instances upstream market these deals tend to have substantial procompetitive shares are not as relevant to whether a merged firm effects and that an ex ante assessment of such a could profitably raise prices or withhold inputs than is transaction will have significant difficulty the ease with which a rival could substitute to a distinguishing between the factors producing different provider of inputs: Withholding an input with procompetitive effects and those that would make a relatively low share can cause rivals to lose sales if anticompetitive conduct more likely to be successful. consumers have strong brand loyalty or a taste for The Guidelines maintain a different approach to variety, or if important downstream rivals are locked- treatment of EDM versus efficiencies more broadly. in to a particular technology. One recent example of While the Agencies generally hold merging parties to a this theory in action is AT&T/Time Warner, where high standard of proof to establish verifiable and DOJ argued that certain Time Warner content like merger-specific efficiencies, it is notable that the HBO or CNN was “must-have” and thus contributed to Guidelines say proof of EDM will be held to the same increased bargaining leverage, regardless of what share (generally lower) standard the Agencies apply to their these networks might have as a portion of total own proof of competitive harm. More generally, the viewing hours. Guidelines’ discussion of the competitive analysis as a By contrast, withholding an input with a very large netting of pro- and anti-competitive effects, by share may not be problematic if the input is eschewing language of burden-shifting, suggests a interchangeable across suppliers, other input suppliers view that is generally pro-merger. can easily expand capacity, and there are not Additional potential efficiencies in vertical mergers, by substantial cost differences between input providers. A contrast, are still left unmentioned. For example, that recent example is the Essilor/Luxottica merger.4 In that access to a guaranteed supplier or a guaranteed case, which combined ophthalmic lens manufacturer Essilor with optical frame manufacturer and optical

3 Complaint, United States v. AT&T, Inc., No. 1:17-cv-02511 (Nov. 20, 2017), https://www.justice.gov/opa/press- release/file/1012896/download. 4 Cleary Gottlieb acted as antitrust counsel to the purchaser, Essilor, in the successful clearance of that vertical merger.

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distributor Luxottica, the FTC’s closing statement “put[ting] a thumb on the scale in favor of vertical explained that the transaction posed little risk of mergers” by overemphasizing their benefits. competitive harm, notwithstanding Essilor’s high share Second, she objects to what she views as a failure in lenses, because it is easy for independent opticians to identify what characteristics make a merger to switch lens providers.5 more likely to be problematic, which she fears will lead to problems both in initiating investigations Other similarly undiscussed topics include the role that and in the competitive assessment. Third, she minimum efficient scale plays in whether or not objects to the Guidelines’ treatment of EDM, denying rivals access to customers will be successful specifically by in her view failing to fully explain or how a merger can remove a potential sponsor of when elimination of double marginalization should new entry. not be expected to materialize, when the benefits The Guidelines also remain generic and steer clear should not be expected to be passed along to of major trends in the enforcement debate. For consumers, and when EDM might produce short- example, it is notable that despite the active vigorous term gains but long-term harms through reducing worldwide debate around digital platforms and data, rivals’ abilities to finance innovation or expansion. this topic is not addressed directly in the Guidelines. And fourth, Commissioner Slaughter’s dissent Statements of FTC Commissioners notes the omission of discussion of buy-side theories of harm, regulatory evasion as a theory of Commissioners Joseph Simons, Noah Phillips, and harm, and how remedies for vertical transactions Christine Wilson of the Federal Trade Commission should be structured and enforced. voted to issue the Guidelines and issued a statement. — Commissioner Chopra: Commissioner Chopra Commissioners Rohit Chopra and Rebecca Slaughter wrote to express concern that the Guidelines voted against issuing the Guidelines and wrote “support the status-quo ideological belief that separately in dissent. vertical mergers are presumptively benign, and — Majority: The majority praised the new even beneficial.” His dissent focuses on potential Guidelines as an improvement over the 1984 harms to new entrants posed by vertical mergers, Guidelines, including because they described including how vertical mergers can suppress the expanded theories of harm that require less than occurrence of new entry. Commissioner Chopra’s full foreclosure and additional means by which comments reflect his view that assessment of harm coordinated effects might arise. They also noted in merger review should be more holistic than it is how the final Guidelines reflected the comments under current practice and doctrine, including by received, including those from Commissioner making value judgments about the characteristics, Slaughter. business models, financial wherewithal and — Commissioner Slaughter: Commissioner stability, and management priorities and skill of Slaughter’s dissent states that the Agencies should the merging firms. not have adopted the Guidelines without further … comment. She also states that the Guidelines have failed “to disavow the false assertion that vertical CLEARY GOTTLIEB mergers are almost always procompetitive.” More specifically, she criticizes the Guidelines for several reasons. First, she faults the Guidelines for

5 Fed. Trade Comm’n, Statement of Federal Trade Commission Concerning the Proposed Acquisition of Luxottica Group by Essilor (Mar. 1, 2018), https://www.ftc.gov/system/files/documents/closing_letters/nid/1710060commissionstatement.pdf.

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