Could a District Court ruling against the FTC in a hospital merger challenge revive the failing firm defense?
In late June Novant announced it would abandon attempts to buy two Community Health Systems (CHS) hospitals in North Carolina. This announcement followed a preliminary ruling in Federal District Court for Novant and a subsequent appellate court ruling for the Federal Trade Commission (FTC). Regardless of the final outcome of the merger, the preliminary Novant win is significant because it represents a successful use of the often cited, rarely successful, "failing firm" defense – which parties can potentially use to push through a merger that would otherwise create an unacceptable amount of marketplace concentration.
History of the Case
On March 25, the FTC filed a request for a preliminary injunction with the United States District Court for the Western District of North Carolina to block the sale of two hospitals owned by CHS to Novant Health. In the filing, the FTC argued for the injunction for two reasons: one, that the deal was unlawful "because it would result in a combined entity with an eye-popping 64% share of the market in the Eastern Lake Norman Area" where "The Supreme Court has held that mergers are presumptively unlawful if they result in a single entity controlling a 30% market share." And two, that the deal "would immediately wipe out … competition" between Novant Huntersville and Lake Norman Regional (one of the hospitals being purchased) "reducing defendants' incentives to invest in quality and leaving fewer options for patients."
In early June, Federal Judge Kenneth Bell ruled twice against the FTC's request for a preliminary injunction, citing the failing firm defense and the Court's belief that the target hospitals would likely close if the merger did not go through.
After the FTC appealed the rulings, on June 18, the Fourth Circuit Court of Appeals, in a 2-1 split decision, temporarily blocked the deal until it reached a final decision on the transaction. Following this ruling, Novant announced it would abandon the merger, stating that "with the FTC's continued roadblocks, we do not see a way to finalize this transaction."
Elements of the Failing Firm Defense
Novant's successful use of the failing firm defense, at least at the District Court level, makes this case significant because to make a successful failing firm claim the claimant must meet a high evidentiary burden. Hospitals, in particular, have rarely met the burden to show that the business is at imminent risk of failure and to show that no other purchasers exist.
The Clayton Act prohibits mergers and acquisitions that would significantly harm competition or tend to create a monopoly. When antitrust enforcers challenge a merger, one valid defense that the parties to the merger can use is the “failing firm defense”. When using this claim, the parties must show that the merger is not anticompetitive because, without the acquisition, the entity being acquired would fail, thereby exiting the market. If the target entity leaves the market, the intended purchaser's market power would grow even without the acquisition.
Claimants need to meet specific criteria to successfully use the failing firm defense. First, that the target entity must be in imminent danger of business failure. Second, that the entity can't successfully use bankruptcy to reorganize. Finally, that good faith efforts have been made to find an alternative purchaser that would create less competitive harm. The FTC and DOJ explicitly included the failing firm defense in every version of the Horizontal Merger Guidelines since 1982 and also included it in the recently released 2023 Merger Guidelines. The merger guidelines do not establish the legal standards for a failing firm defense, but rather describe how the FTC and DOJ will interpret and apply the precedent set by the Supreme Court in Citizen Publ’g Co. v. United States, 394 U.S. 131, 138 (1969) and Int’l Shoe Co. v. FTC, 280 U.S. 291, 302 (1930). The FTC has expressed skepticism regarding the failing firm defense, noting the miraculous recovery powers of many entities that were claimed to be on the verge of imminent collapse when merging parties attempted to use the defense, adding that "if you want the Bureau to accept such an argument in your case, you had better actually be failing, and able to prove it."
Application of the Failing Firm Defense to the Novant Case
In issuing the preliminary injunction, the District court acknowledged that the post-merger market percentages were sufficient to presume the merger was anticompetitive, determining that the FTC would likely meet the burden to show the merger would result in a firm controlling an undue percentage share of the relevant market. However, the Judge ruled that the targeted hospitals would likely close soon and that CHS had conducted a reasonable search for alternative buyers. The court also found that the merger was unlikely to create immediate competitive harm, as Novant had committed to not increasing prices at the acquired hospitals for three years. The court also noted the benefit to the community in keeping the hospitals open, which would allow patients to continue to have access to these facilities and providers, and that closure would eliminate critically needed inpatient psychiatric services. The ruling added that the reimbursement rates paid by insurers at the facilities would likely substantially rise after Novant integrated those hospitals into their existing insurance contracts. The Judge noted that he was only ruling on the preliminary injunction, not the final merits of the acquisition.
The Court did not specifically examine the risk of bankruptcy for these facilities. Instead, it focused on the likelihood of the hospitals exiting the market, finding that both target hospitals were likely to close. The Court's ruling suggests that claimants could successfully use the failing firm defense without strictly adhering to every element in the guidelines.
Significance
Some law firms who practice in the area noted that this case may give new life to the failing firm defense both because the defense is so rarely successful and because the Court did not require the merging parties to meet all of the criteria specified in the Merger Guidelines. While the guidelines require the acquisition target to “have a grave probability of a business failure", the Court only determined that the facilities would "likely close in the foreseeable future." The Court's ruling did not evaluate the possibility of the facilities' likelihood of reorganization through bankruptcy, and held that attempts to search for an alternate buyer only needed to be "reasonable."
This ruling may give acquiring entities additional hope when making claims that the procompetitive effects of an acquisition of a failing firm outweighs the anticompetitive harms. Other courts, including the Circuit Court of Appeals in this case may take a more conservative stance on applying the failing firm defense, so the final impacts of the ruling in this case remain to be seen.