News
No room for a woolly argument
First published in NZLawyer, 29 May 2009.
In these trying economic times, declining industries and failing firms are becoming more prevalent. Two recent Commerce Commission decisions highlight this and prove that despite the anti-competitive ramifications traditionally associated with large market share increases, where there is sound and well-supported evidence to overcome the more traditional arguments, the Commission will not stand in the way of necessary rationalisation.
In March, the Commission granted clearance for a deal that resulted in the wool scouring businesses of Cavalier and Godfrey Hirst coming under common ownership.
The transaction was set against a backdrop of a primary industry in serious decline. Historically, New Zealand has had a massive sheep population which supported numerous scouring operations. However, the country's flock has more than halved from its peak of 70 million in 1982. In 1990, there were 20 scouring operations throughout the country, but just six were operating at the time the application for clearance was lodged. Despite steady rationalisation over time, excess capacity has remained at alarmingly high levels for those in the industry, approximately 40% nationally. The applicant in this case, a shareholder in Cavalier, was concerned that without Commerce Commission clearance, an orderly solution could be jeopardised.
The clearance was a significant one. A key New Zealand primary industry was at the forefront and the number of market participants would fall from three to two, which does not generally sit comfortably with traditional competition law theory. In the merger context, the concern is always whether reducing the number of competitors will make the market more vulnerable to tacit collusion. In a market with just two competitors of a similar size and with similar cost structures, the argument is that there is a far greater likelihood of the two reaching some tacit agreement to keep prices at a fixed level than when the market has three, four, five or more players. Any possibility that the two remaining firms, Cavalier and New Zealand Wool Services International (NZWSI), would fall into a cosy duopoly had to be firmly refuted.
However, the Commission determined that the combined impact of expansion by the other scouring business, potential entry, increasing greasy (non-scoured) wool going to China, and the customers' countervailing (negotiating) power was sufficient to counteract the traditional concerns associated with a three to two scenario. The importance of establishing and evidencing the market decline and the positive impact of all of those counteracting market conditions was key to a clearance being granted.
The Commission's decision to grant a clearance accorded with its approach in the earlier Fletcher Building decision. In that instance, the Commission accepted a failing firm argument and gave Fletchers the green light to acquire certain masonry assets from Stevenson Group. While the issues facing the scouring industry were short-medium term, and hence unsuited to a traditional failing firm argument, the wool scouring industry, like Stevenson's masonry business, was nevertheless in a difficult position.
The Commission accepted that the reduction in wool scouring capacity over the past 20 years had not kept pace with the reduction in the wool clip. While the applicant submitted that increasing excess capacity meant rationalisation would be necessary in the next 12-24 months, it was unclear exactly what form that would take without the acquisition. The wool scouring industry had not reached that point, but it was obvious that without some capacity-reducing action, involuntary removal of assets from the market would not be far away.
The diminishing state of New Zealand's wool scouring industry has mirrored the decline of scours world-wide and was undoubtedly a pertinent factor in the Commission's decision. The Commission also took comfort that given the importance of wool scours maintaining high capacity utilisation to achieve operational efficiencies, the threat of entry alone would be a powerful constraint on the combined entity.
Another interesting aspect of the Commission's decision-making process in the wool scours case was its application of game theory modelling to test the incentives which would operate on Cavalier and NZWSI post-transaction. The Commission's model demonstrated that various firm and market-wide factors would mean that, post-transaction Cavalier would be incentivised to increase prices rather than compete. However, the applicant successfully demonstrated that the reality of market conditions (need for volume efficiencies, constraint imposed from the off-shore Chinese scouring market, the threat of entry and significant countervailing power) meant that despite any theoretical incentives to increase price, the market would not permit Cavalier or NZWSI to raise prices to supra competitive levels.
On its face, reducing the number of competitors from three to two (or two to one) will set alarm bells ringing with the regulator. That said, these two recent decisions provide favourable precedent that where an applicant can produce sound and clearly evidenced arguments showing that constraint will remain, then theory can be overcome and much needed rationalisation allowed to proceed.
*Bell Gully acted for the wool scouring applicant and for Stevenson Group.
