Merger Enforcement Guidelines: Part 5 (March 1991)

The Efficiency Exception

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Please Note: This Part no longer applies. Readers should consult the decision of the Federal Court of Appeal in the Commissioner of Competition v. Superior Propane Inc. and ICG Propane Inc 2001 FCA 104. ( PDF: 364 KB)

5.1 Overview

Section 96 of the Act provides an efficiency exception to the provisions of section 92 of the Act.The importance of economic efficiency to the Canadian economy is highlighted in the purpose clause that is set forth in section 1.1 of the Act, which states:

"The purpose of this Act is to maintain and encourage competition in Canada in order to promote the efficiency and adaptability of the Canadian economy, in order to expand opportunities for Canadian participation in world markets while at the same time recognizing the role of foreign competition in Canada, in order to ensure that small and medium-sized enterprises have an equitable opportunity to participate in the Canadian economy and in order to provide consumers with competitive prices and product choices."

The purpose clause makes it clear that competition is not desired as an end in itself, but rather to further various other objectives. The first objective that is mentioned in section 1.1 is the promotion of the efficiency and adaptability of the Canadian economy. In general, maintaining and encouraging competition results in promoting the efficiency and adaptability of the Canadian economy. However, in certain circumstances, the dual goals of maintaining and encouraging competition, on one hand, and promoting the efficiency and adaptability of the Canadian economy, on the other hand, cannot both be advanced.

One such circumstance is highlighted in section 96 of the Act, where it is recognized that some mergers may be both anticompetitive and efficiency enhancing. When a balancing of the anticompetitive effects and the efficiency gains likely to result from a merger demonstrates that the Canadian economy as a whole would benefit from the merger, section 96(1) explicitly resolves the conflict between the competition and efficiency goals in favor of efficiency.

Section 96(1) creates a tradeoff framework, in which efficiency gains that are likely to brought about in Canada are balanced against the anticompetitive effects that are likely to result from the merger. In this context, anticompetitive effects refer to the part of the total loss incurred by buyers and sellers in Canada that is not merely a transfer from one party to another,but represents a loss to the economy as a whole, attributable to the diversion of resources to lower valued uses. This loss is sometimes referred to as the deadweight loss to the Canadian economy. An order cannot be made in respect of a merger where it can be established that the gains in efficiency that will likely be brought about by the merger will be greater than, and will offset, the effects of any prevention or lessening of competition that will result or is likely to result from the merger . Claimed efficiency gains cannot be considered in this trade-off assessment where:

• i) they would likely be attained if the order that would be required to remedy the anticompetitive effect of the merger were made; or,

  (ii) they would likely be brought about by reason only of a redistribution of income between two or more persons.

The types of legitimate efficiency gains that are generally considered by the Bureau are highlighted in Appendix 2. Where the efficiency gains would likely result in a significant increase in the real value of exports or in a significant substitution of domestic products for imported products, this should be documented in submissions made relating to efficiencies.

The foregoing matters and related issues are described in greater detail in parts 5.2 to 5.7 below.

To facilitate expeditious assessment of the nature and magnitude of merger-related efficiencies, merging parties are encouraged to make their efficiency submissions to the Bureau at an early stage of its review of the transaction. It is not necessary to wait until a finding is made that the merger is likely to prevent or lessen competition substantially.

5.2 Gains That Would Otherwise Likely be Attained

The last clause in section 96(1) requires a finding that claimed efficiency gains "would not likely be attained if the order were made". The order referred to is the proposed order requested in the Director's application, or such other order as the Tribunal may make. Where an application has not yet been made, parties can generally obtain from the Bureau a general description of the order, if any, that would likely be sought by the Director. ⁽⁵²⁾

This proviso within section 96(1) requires an assessment of whether each of the particular gains that it is anticipated will be realized subsequent to the merger would likely be attained by alternative means if the order being sought, or that would likely be sought, were made. This assessment generally involves an evaluation of whether any of the gains that are identified as being likely to be realized post-merger would also be likely to be attained through less anticompetitive means such as internal growth; a merger with a third party; a joint venture; a specialization agreement; or a licensing, lease or other contractual arrangement, if the order in question were made. Where some or all of the claimed efficiency gains would likely be attained through these or other means if the order were made, they cannot be attributed to the merger, they would not represent a "cost" of making the order, and they are not considered in the section 96 trade-off analysis.

Similarly, where an order is sought in respect of part of a merger, efficiency gains that would likely be attained in markets that are not the focus of the order are not considered in the balancing process contemplated by section 96(1). They would not be affected by the order. However, where the nature of particular efficiencies that are anticipated to arise in these other markets is such that they would not likely be attained if the order were made, because they are inextricably linked to the efficiencies that the order would prevent in the relevant market, these will be considered in the trade-off analysis. ⁽⁵³⁾

In the assessment of whether efficiencies that have been claimed would likely be attained through a merger with a third party if the order were made, consideration will only be given to existing alternative merger proposals that are less anticompetitive and that can reasonably be expected to proceed if the order in respect of the first proposed merger is made. Efficiencies generally will not be excluded from the balancing process on the speculative basis that they could be attained through a merger with an unidentified third party.⁽⁵⁴⁾

In determining whether particular categories of efficiencies can reasonably be expected to be attained through non-merger alternative means if the order is made, the market realities of the industry in question are considered. In general, efficiencies will not be excluded from consideration on the basis that they theoretically could be attained through internal growth, a joint venture, a specialization agreement, or a licensing, lease or other contractual arrangement. If the common industry practice is such that the alternative in question would not likely be resorted to if the order were made, the efficiencies in question will ordinarily be included in the balancing process. In general, parties should provide a reasonable and objectively verifiable explanation of why efficiencies that are available would not likely be sought by alternative means if the order were made. This is particularly so in the case of economies of scale and other efficiencies that could be attained through internal growth and investment within the reasonably foreseeable future. In assessing whether efficiencies are likely to be attained through internal expansion, the Director considers the growth prospects of the market in question, the extent of excess capacity therein, and the extent to which the expansion can be carried out in increments.

5.3 Gains that are Redistributive in Nature

A second essential characteristic that efficiency gains must have before they are considered in the trade-off analysis contemplated by section 96(1) is that they cannot be brought about "by reason only of a redistribution of income between two or more persons". This provision of section 96(3) recognizes that all gains realized pursuant to a merger do not necessarily represent a saving in resources. For example, gains that are anticipated to arise as a result of increased bargaining leverage that enables the merged entity to extract wage concessions or discounts from suppliers that are not cost justified represent a mere redistribution of income to the merged entity from employees or the supplier, as the case may be. Such gains are not brought about by a saving in resources. This contrasts with the situation where the supplier is able to offer better terms as a result of the fact that larger orders from the merged entity will enable the supplier to attain economies of scale, reduce transaction costs or achieve other savings. Where it can be demonstrated that the source of gains to the merged entity is a legitimate saving for the supplier, the gains will not be excluded from the balancing process by reason of section 96(3).

In addition to gains attributable to increased bargaining leverage, tax related gains brought about by mergers are generally found to represent nothing more than a redistribution of income from taxpayers to the merged entity. Similarly, savings that flow from a reduction in output, service, quality or variety are generally found to represent a transfer of wealth from buyers to the merged entity. The same is true of the increased revenues resulting from a price increase.

The sale of an asset is generally considered to bring about a reallocation, rather than a saving, of resources. However, where the sale of machinery, a plant or other assets facilitates a reduction in ongoing expenditures associated with operating the assets, or results in a lower overall cost of capital to the firm, this source of savings will ordinarily not be excluded by reason of section 96(3).

5.4 "Greater Than" and "Offset"

The words "greater than" are considered to signify that the efficiency gains must be more weighty than, more extensive than, or of larger magnitude than the anticompetitive effects that are likely to result from the merger. By comparison, the term "offset" is considered to suggest that the efficiency gains must neutralize, counterbalance or compensate for the likely anticompetitive effects of the merger.

The expressions "greater than" and "offset" are considered to each have qualitative and quantitative connotations. That is to say, the efficiency gains must be greater than the anticompetitive effects that are likely to result from the merger, in both a qualitative and quantitative sense; and the efficiency gains must offset these anticompetitive effects, in both a qualitative and quantitative sense. To be assessed in terms of "greater than", efficiency gains must be capable of being weighed in similar terms as all or some of the anticompetitive effects that will likely result from the merger. Efficiency gains and anticompetitive effects that cannot be weighed in similar terms will be evaluated in terms of whether the gains offset the anticompetitive effects. This evaluation can be subjective in nature and will ordinarily require the exercise of the Director's discretion.⁽⁵⁵⁾ In short, efficiency gains and anticompetitive effects that can be measured in dollar or other similar terms are weighed to determine whether the "greater than" requirement is met; whereas efficiency gains and anticompetitive effects that cannot be balanced in such terms are compared to determine whether the "offset" requirement is met. Where all of the efficiency gains and anticompetitive effects can be measured in similar terms, and where the efficiency gains are "greater than" the anticompetitive effects, they will also be considered to "offset" the anticompetitive effects. ⁽⁵⁶⁾

5.5 Anticompetitive "Effects"

Section 96(1) requires efficiency gains to be balanced against "the effects of any prevention or lessening of competition that will result or is likely to result from the merger or proposed merger". Where a merger results in a price increase, it brings about both a neutral redistribution effect ⁽⁵⁷⁾ and a negative resource allocation effect on the sum of producer and consumer surplus (total surplus) within Canada. The efficiency gains described above are balanced against the latter effect, i.e., the deadweight loss to the Canadian economy.

The calculation of the likely anticompetitive effects of mergers is generally very difficult to make. This is particularly so with respect to the measurement of losses related to a reduction in service, quality, variety, innovation and other non-price dimensions of competition. Insofar as such losses often cannot be quantified, they receive a weighting that is essentially qualitative in nature. In view of the difficulties associated with arriving at precise estimates of both the elasticity of market demand and the magnitude of the prevention or lessening of competition that is likely to be brought about by the merger, several trade-off assessments are generally performed over a range of price increases and market demand elasticities.

In calculating the magnitude of likely efficiency gains, cost savings are generally measured across the reduced level of output that will be required to bring about the anticipated material price increase. In estimating the extent of negative resource allocation effects of mergers, the Bureau includes the additional losses in total surplus that arise when market power is being exercised in the relevant market prior to the merger. Similar losses that arise as a result of foregone contribution to fixed costs (due to restricting levels of output) are also recognized.

Given that section 96(1) requires efficiencies to be balanced against the effects of "any" prevention or lessening of competition that will result from the merger, anticompetitive effects that are likely to arise in other markets affected by the merger are also considered in the trade-off analysis. However, anticompetitive effects in markets that are not targeted by the order sought generally will not be substantial in nature.

5.6 Increased Exports and Import Substitution

In the determination of whether a merger is likely to bring about gains in efficiency described in section (1), section 96(2) requires that account be taken of whether such gains will result in:

• (i) a significant increase in the real value of exports; or,

  (ii) a significant substitution of domestic products for imported products.

The words "described in section (1)" make it clear that section 96(2) does not operate to expand the class of efficiency gains that may be considered in the trade-off analysis. Accordingly, this provision is simply considered to draw attention to the fact that, in calculating the merged entity's total output for the purpose of arriving at the sum of unit and other savings brought about by the merger, the output that will likely displace imports, and any increased output that is sold abroad, must be taken into account.

5.7 Other Enforcement Policy Matters

5.7.1 Timing differences

Timing differences between the future anticipated efficiency gains and anticompetitive effects must be addressed by discounting back to present constant dollar values by:

• (i) removing the effects of future anticipated inflation; and,

  (ii) applying a standard real discount rate to allow the appropriate comparison of efficiency gains and anticompetitive effects which are likely to occur at different points in the future.

Dollar values for efficiency gains should be presented in terms of constant dollars, i.e., with the effects of inflation removed. Where the prices of products are expected to increase or decrease at more or less than the general rate of inflation, this should be highlighted. The inflation rate assumptions which are employed should also be provided in documentation submitted to the Bureau.

The real discount rate employed to compute present values should be consistent with the discount rates used to evaluate investment projects funded in whole or in part by the federal government. These standard rates are generally found in the Treasury Board's Benefit - Cost Guidelines and similar federal government documents. A range of discount rates should be utilized in order to test the sensitivity of the results to different assumptions regarding the real discount rate.⁽⁵⁸⁾ In general, one of the discount rates employed for sensitivity analysis purposes will be the quot;cost of capital or "industry hurdle rate" for the specific industry in question. The same discount rate is ordinarily applied to the likely efficiency gains and the anticompetitive effects attributable to the transaction.

5.7.2 Costs required to achieve gains

Retooling and other costs that must be incurred to achieve efficiency gains are deducted from the total value of the efficiencies that are considered pursuant to section 96(1).

5.7.3 Documentation of efficiency gains

Objective verification of particular sources of efficiency gains may be provided by plant and firm-level accounting statements, internal studies, strategic plans, capital appropriation requests, management consultant studies (where available) or other available data. To facilitate the Bureau's review of efficiency claims, information provided should describe the precise nature and magnitude of each type of efficiency gain that it is expected will be brought about by the merger.

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^52. It is necessary to know the nature of the order because efficiencies are only considered in the section 96 balancing process if they "would not likely be attained if the order were made"

^53. For example, assume that a merger will affect four markets, A, B, C and D, and that it will likely result in efficiency gains valued at 25 hypothetical units in each of markets A, B and C, respectively. Efficiency gains of 15 units would likely be attained in market D. The only anticompetitive effect is in market A. Accordingly, the order would likely seek divestiture of the acquiree's business in market A. Of the 25 units of efficiencies that would likely be attained in market A, 5 would likely be realized by internal growth or reorganization in the reasonably foreseeable future, and 5 would likely be attained through a distribution arrangement with a third party, if the order were made. None of the efficiencies that are expected to be attained in market D would likely be attained if the order were made, because they are economies of scope that are inextricably linked to some of the efficiencies that would be prevented in market A by the order. All of the efficiencies in markets B and C would likely be attained even if the order were made. Accordingly, the efficiencies that would be considered in the balancing process would be the 15 units in market A and the 15 units in market D that would not likely be attained if the order were made. Ten units in market A, and the entire efficiencies likely to be realized in markets B and C, would not be considered because they would not be affected by the order.

^54. Accordingly, to return to the example discussed in the previous note, if 5 of the 15 units of market A-related efficiencies to be considered in the balancing process could be attained by any merger, but the Director is not aware of any third parties who have expressed a serious interest in proposing an alternative merger, these 5 units would not be excluded from assessment under section 96(1).

^55. Accordingly, if part of the efficiencies likely to result from the merger include dynamic R&D efficiencies, (which cannot be measured in similar terms as any of the likely anticompetitive effects), and if part of the anticompetitive effects likely to result from the merger include a reduction in service, quality or variety, (which cannot be measured in terms that are similar to any of the likely efficiencies), the Director would exercise his discretion in assessing whether the R&D efficiencies would likely "offset" the effects of a reduction in service, quality or variety.

^56. Returning to the example discussed in note 53, if the anticompetitive effects in market A were solely quantitative in nature and were likely to amount to 29 units, the 30 units of legitimate efficiency gains (15 in market A and 15 in market D) would meet both the "greater than" and the "offset" requirement. If there were additional dynamic R&D efficiencies, on one hand, and a reduction in service on the other hand, it would require the exercise of discretion to determine whether, on the basis of the particular facts of the case, it could be concluded that the "offset" requirement was met. If the anticompetitive effects were likely to amount to 30 units, the "greater than" requirement would not be met.

^57. When a dollar is transferred from a buyer to a seller, it cannot be determined a priori who is more deserving, or in whose hands it has a greater value.

^58. At the present time, the federal government is generally employing a rate of 8 percent with 4 percent and 12 percent used for sensitivity testing.

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