Art of the deal: the merger settlement process at the Federal Trade Commission.

• Author: Coate, Malcolm B.

1. Introduction

   Two firms, competing with each other in at least one line of business, face a complicated regulatory regime if they attempt to merge. Under the Hart-Scott-Rodino (HSR) Act of 1975, almost all large transactions in the United States are subject to review by either the Department of Justice or the Federal Trade Commission (FTC). In the event an enforcement agency objects to the transaction, several outcomes are possible: (i) The parties could give up and abandon their transaction, (ii) take the case to a federal court and litigate the dispute to a conclusion, or (iii) the firms could settle their differences with the enforcement agency. All settlements, however, are not the same. In particular, agencies have shown some willingness to accept "compromise" settlements, defined here as consents that do not fully resolve the relevant competitive concerns. The purpose of this study is to model the interaction between an antitrust agency and firms seeking to consummate mergers. In doing so we will attempt to answer an important question in antitrust regulation: What attributes drive the final outcome of a merger challenge?

   This paper will model interactions between the FTC and private parties interested in consummating horizontal mergers that may adversely affect competition in at least one relevant market. This decision to fight, fold, or settle is somewhat more complicated than an action for damages, because the prospective nature of the alleged competitive injury gives the defendant an opportunity to abandon the transaction before the injury occurs. Moreover, the conglomerate nature of most mergers creates a possibility for a "strong" settlement to resolve competitive concerns while allowing the firm to quickly consummate the innocuous portions of the transaction. Compromise settlements also are possible, under which the consent offers partial relief. The maximum-likelihood estimation procedure used in the paper is derived directly from a game-theoretic analysis that models the outcome of the interaction between merging firms and the FTC. This allows for formal estimation of "utility functions" for both merging parties and the FTC. Estimating the structural equations of the model offers more detailed insight into the regulatory system.

   We have two basic hypotheses with respect to this process. First, the underlying opportunity costs, the legal merits of particular cases, and possibly the political ramifications of enforcement decisions drive FTC decisions. Second, firms' decisions depend not only on the competitive merits of the FTC's case, but perhaps more importantly on both the financial issues relevant to the specific transaction and how the nature of the case fits into the merger review process.

   Section 2 presents the background for the analysis by discussing the institutional structure of the FTC, explaining the merger review process, describing the hostage effects that may affect a firm's response to an FTC enforcement decision, and introducing the idea of a compromise settlement. Section 3 models the game-theoretic interaction between firms and the FTC and then explores an econometrically tractable method of estimating the underlying utility functions for the players in the game. Section 4 describes the data and specifications to be used. Results of the maximum likelihood estimation are presented in section 5. Concluding comments are in section 6.

   We hope to shed light on an important aspect of the U.S. merger review process. We also suggest that our results may have broader consequences. Since the mid-1980s, a large number of countries have established formal antitrust procedures. The results here may be of assistance to those policy regimes as well.

2. Issues in Merger Enforcement

   Background on the FTC

   The FTC is a government agency charged, along with the Department of Justice (DOJ), with enforcing U.S. antitrust laws. The bulk of the casework involves the evaluation of proposed horizontal mergers. To interdict a proposed merger, the FTC (or the DOJ) must obtain an injunction from a federal district court and, if required, defend the injunction in the relevant court of appeals. If the court declines to issue the injunction (or the appeals court reverses the injunction), the firms are free to merge, although the FTC may undertake further administrative action against the merger.

   Commission decisions are made by a majority vote of the commissioners, each of whom is appointed by the U.S. President, subject to Senate confirmation, for terms of up to seven years. The Commission is authorized to have five members, not more than three of whom may belong to the same political party. In each matter, the Commissioners usually receive separate memoranda from both the staff and senior management of both the Bureau of Competition (BC, the lawyers' bureau) and Bureau of Economics (BE, the economists' bureau) to assist in their decision-making process. (1) These memos are usually supplemented with "white papers" submitted on behalf of the merging parties and, on occasion, formal complaints advanced by "injured" third parties. (2)

   What may be called the "modern" merger review enforcement period began in 1982 with the adoption of that year's Merger Guidelines. (See, for example, Viscusi, Vernon, and Harrington 1992.) (3) These guidelines, supplemented with a series of minor revisions, present the agency staff, the merging parties, and the courts with an organized construct for how to conduct a merger evaluation. Together with the HSR Act, they acted to create a systematic regulatory structure for mergers, which is the focus of our study.

   Overview of the Merger Review Process

   A small fraction of proposed mergers, if consummated, may threaten competition and present a risk of antitrust injury. If the firms recognize the potential injury, they have the option to abandon the transaction. If the firms desire to proceed, the HSR Act, in most cases, requires them to notify the government of the proposed transaction and observe a 30-day waiting period. (For further details on the HSR Act, see Johnson and Parkman 1991.) If a merger raises concerns, the government can issue a request for additional information and further delay the process. At the end of the investigation, the government will either challenge the transaction or close the investigation. (See Kolasky and Love 1997 and Waller 1998 for further details.) Coate, Higgins, and McChesney (1990), Coate (1995b), and Coate (2002) have consistently found the FTC's decision to move against a merger depends on case-specific facts and political considerations. The Commission is more likely to challenge the transaction if the Herfindahl Index (4) is over the Merger Guidelines' threshold of 1800, if barriers to entry exist, or if other structural factors make the market conducive to anticompetitive behavior.

   If the government decides to challenge the merger, the parties have three choices. They can "fight" by forcing the government to obtain a court order to block the transaction through litigation, "fold" and abandon the transaction, or seek to "settle" by entering into a consent agreement with the government and address the competitive concern. Not all settlements, however, completely resolve the relevant competitive concerns.

   The final stage in the horizontal merger enforcement process is litigation. Studies (Coate 1995a; Kleit and Coate 1993) of federal judicial merger decisions made after the issuance of the 1982 Merger Guidelines have found that to prevail in a merger case, the government must show high concentration (as measured by the relevant Herfindahl statistic) and barriers to entry in the relevant market. Even in these cases, if the Herfindahl is not well over 1800, evidence on structural factors conducive to competition can be dispositive. Thus, it appears that proxies for the merits of a case have a significant impact on the outcome of litigation. (We note that merging firms have won roughly half of the litigated cases.)

   Factors that induce firms to avoid fighting the FTC regardless of the merits of the case are an important aspect of the regulatory process. For example, litigation against the FTC may force the firm to incur substantial costs if the firm forgoes a settlement that would bring the process to a quick resolution. These costs could include the loss of skilled workers worried about their future employment, the reduction in sales as valued customers forge new business relationships, or the enhanced risk associated with the financing of the transaction. In effect, the FTC can often hold hostage the bulk of the transaction unrelated to the competitive concerns, for it can prevent integration of any of the firm's assets pending judicial resolution of a challenge to a small part of the merger. Moreover, the acquiring firm could incur a reputational cost from putting up an active defense against the regulators. Thus, the desire by firms to resolve the antitrust problem quickly can place the FTC in a strong negotiating position. Coate, Kleit, and Bustamante (1995 [CKB]) model this problem through the use of a reduced form multinomial logit model. The reduced form nature of the model, however, precluded an estimation of utility functions for the involved parties. Our structural model allows us to break out the particular effects by plaintiff and defendant.

   We note that this situation would be different in a textbook example of a merger involving two firms competing in a highly concentrated market, because that scenario leaves no assets unrelated to the competitive concern to hold hostage. In the modern world of conglomerate firms, a merger almost always involves both competitive overlaps and wide areas where the firms are not related at all. In such acquisitions, firms would desire to consummate the noncontested portion of the merger quickly and deal with the contested portion later. No simple legal mechanism exists, however, to...