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Aerospace & Defense Series: Behavioral Remedies Remain a Viable Solution for Vertical Mergers in the Defense Industry

Summary

The recent FTC decision in the Northrop Grumman / Orbital ATK matter has shed light on the agency’s vertical merger enforcement policy and outlined a path to antitrust merger clearance for the Aerospace and Defense industry. The FTC’s June 5 consent decree shows behavioral remedies remain a viable solution if the parties can prove both that the DoD would benefit from the transaction and that those benefits would be lost if the agency required a divestiture.

In Depth

A recent decision at the US Federal Trade Commission (FTC) has shed light on the agency’s vertical merger enforcement policy and outlined a path to antitrust merger clearance for the Aerospace and Defense industry. Despite recent remarks from both the FTC and the US Department of Justice Antitrust Division (DOJ) denouncing behavioral remedies as a way to “fix” anticompetitive issues in vertical transactions, the FTC’s June 5, 2018 consent decree with Northrop Grumman and Orbital ATK shows behavioral remedies remain a viable solution if parties can prove the Department of Defense (DoD) will benefit from the transaction, and that those benefits would be lost if the agency required a divestiture to resolve the competitive concern. Merging parties in the Aerospace and Defense industry would be wise to follow the FTC’s reasoning and present evidence to the agency highlighting: 

  1. Merger-specific cost savings guaranteed to flow through to customers
  2. Higher quality products at lower prices resulting from the merger
  3. That a divestiture would eliminate those cost and quality benefits to consumers

I. Vertical Mergers and Their Concerns

A vertical merger occurs when two firms at different levels of the supply chain combine. The most prominent competitive concern in a vertical transaction is what is referred to as input foreclosure. Under this theory, a downstream system supplier merges with an upstream manufacturer of an “essential” input, giving the merged entity the ability to competitively disadvantage its systems rivals by raising their cost for the essential input or refusing to supply the input altogether. For instance, in the Northrop Grumman/Orbital ATK acquisition, Orbital ATK provided Northrop Grumman as well as its competitors for DoD missile systems with Solid Rocket Motors, a component necessary to compete as a missile supplier. Under the input foreclosure theory, a merged Northrop Grumman/Orbital ATK would be able to deprive its competitors of Solid Rocket Motors and therefore foreclose them from competing effectively to supply missiles.

II. Vertical Merger Remedy Policy

Both the FTC and DOJ have publicly announced a shift in policy away from using behavioral remedies as a “fix” for competitive concerns in vertical transactions. Rather than remedying a transaction with a behavioral remedy, the agencies have indicated they would require divestitures to solve the competitive concerns. The agencies often cleared vertical mergers in the past utilizing remedies such as information firewalls, nondiscrimination commitments and mandatory licensing. Under the new administration however, there has been a focus on “deregulation,” and the antitrust enforcement agencies are moving away from remedies requiring high levels of oversight. Assistant Attorney General Makan Delrahim has been the movement’s strongest advocate, criticizing the regulatory nature of behavioral remedies. In his view, if a transaction is unlawful, it should be blocked or fixed by a divestiture to remedy the competitive problem. The director of the FTC’s Bureau of Competition, Bruce Hoffman, likewise expressed dissatisfaction with how conduct remedies can require constant monitoring. Mr. Hoffman did not completely foreclose the idea of a behavioral fix, stating that under appropriate circumstances a behavioral remedy can prevent competitive harm while allowing the benefits of integration. 

III. Northrop Grumman/Orbital ATK Indicates Behavioral Remedies Can Still Be Appropriate for DoD Contractors

At issue in Northrop Grumman’s acquisition of its supplier, Orbital ATK, was whether the transaction would result in competitive harm to the DoD by reducing competition for missile systems. The government alleged that the combination would give “Northrop the incentive and ability to discriminate against competitors” by denying them access to Orbital ATK’s Solid Rocket Motors, or by disadvantaging those competitors through other predatory means. However, instead of requiring that Northrop Grumman divest the Solid Rocket Motor division, the FTC apparently recognized the potentially significant synergies from combining the two product lines and carefully tailored a behavioral remedy to preserve the benefits of the transaction for DoD while also preventing the combined company from blocking its rival missile suppliers. The FTC’s consent order requires Northrop Grumman to supply other missile competitors with Solid Rocket Motors on a non-discriminatory basis and to erect information firewalls to prevent improper flow and use of rival missile suppliers’ data. Although the FTC made clear that it typically disfavors such behavioral remedies, it cited the special characteristics of the defense industry and strong potential for procompetitive effects as reasons why a behavioral approach was appropriate. Specifically, in a statement issued by Deputy Director of the FTC Bureau of Competition Ian Connor, the FTC paid close attention to factors including: (1) DoD was the lone buyer of missile systems, (2) the winner-take-all characteristic of bidding in the industry, (3) the need for sophisticated products to achieve national security objectives, (4) the combination offered potentially significant cost savings to DoD and (5) the benefits to DoD would have been lost if Northrop Grumman were required to divest the Orbital ATK Solid Rocket Motor business under a structural remedy.

IV. Path to Clearance

Although the defense industry’s unique characteristics make it more likely for a behavioral remedy to save a deal, businesses will still have to present significant evidence that the combination will create synergies that are guaranteed to flow through to customers. The synergies advanced will have to be merger-specific, meaning that they would be unachievable absent the transaction. Parties should also make clear that requiring a divestiture to resolve the vertical integration concern would foreclose the merged entity from achieving those efficiencies and that this would significantly harm DoD objectives. The statement by the FTC in the Northrop Grumman/Orbital ATK matter suggests that the agency will put a strong emphasis on parties demonstrating that savings will ultimately pass through to customers. The gains made from economies of scale and scope, and eliminating markups along the value chain, are of little concern to the agencies unless the parties show it will likely benefit consumers. It remains to be seen whether the DOJ will take a similar approach, but Mr. Delrahim left this path open in his earlier speech stating the DOJ’s preference for divestitures. 

V. Practical Implications

Government contractors should consider a number of practical steps that can help them obtain clearance for their transactions. Any industry can apply these suggestions, but they appear to be particularly applicable in the defense space.

  1. Conduct an in-depth synergy analysis. As shown from the Northrop Grumman/Orbital ATK transaction, the agencies are potentially open to a behavioral fix so long as it is backed by verifiable synergies. The government will credit synergies or efficiencies only where they are merger-specific, verifiable and not the result of anticompetitive reductions in output or service. Businesses should think early about producing as much concrete evidence as possible to demonstrate the benefits of the deal, including studies laying out factors such as:
    • Areas where they will be able to reduce costs by operating as a vertically integrated business;
    • Ways in which, under the government contracting regulations, vertical integration will result in lower prices to the customer, such as the elimination of “fee on fee” from a vertically integrated operation; and
    • Other ways in which customers will benefit. 
  2. Demonstrate that savings will flow through to consumers. The agencies will only credit synergies or efficiencies that benefit customers, not just the merging parties. One way parties could document these benefits would be by referencing government accounting or other aspects that ensure savings get passed to consumers. 
  3. Show that a divestiture would eliminate the benefits to the DoD. Parties must show the agency that a divestiture would eliminate the cost reductions, synergies and quality enhancements the DoD would realize under the deal. This will help convince the agency that a behavioral fix is both procompetitive and welfare enhancing.

All in all, the recent decision by the FTC in Northrop Grumman/Orbital ATK shows that despite the baseline approach from the FTC and DOJ that behavioral remedies are highly disfavored, they remain a viable approach for transactions impacting the DoD if parties can prove consumer benefits can only be achieved through the vertical combination and would be eliminated if a divestiture were required.

© 2018 McDermott Will & Emery

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About this Author

Jon B. Dubrow, Corporate Lawyer, Mergers and Acquisitions Attorney, McDermott Law
Partner

Jon B. Dubrow is a partner in the law firm of McDermott Will & Emery LLP and is based in the Firm's Washington, D.C. office.  He focuses his practice on defending mergers, acquisitions and joint ventures before the Department of Justice, the Federal Trade Commission and foreign competition authorities, as well as antitrust and commercial litigation.  Jon also provides counseling on distribution issues and a wide variety of other competition-related matters.

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