Merger Enforcement Guidelines

Draft for Consultation
March 2004

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Part 8 - The Efficiency Exception

Overview

8.1 Section 96 of the Act provides an efficiency exception to the provisions of section 92.⁹¹ When a merger creates or enhances market power, subsection 96(1) creates a trade-off framework in which efficiency gains that are likely to be brought about by a merger are balanced against the anti-competitive effects that are likely to result.⁹²

8.2 As the starting point, when determining the relevant anti-competitive effects for the purpose of performing the trade-off, the Bureau recognizes the significance of all of the objectives set out in the statutory purpose clause contained in section 1.1 of the Act.⁹³

8.3 In general, categories of efficiency that are relevant to the trade-off analysis in merger review include:

• allocative efficiency: the degree to which resources available to society are allocated to their most valuable use;
• technical (productive) efficiency: the creation of a given volume of output at the lowest possible resource cost; and
• dynamic efficiency: the optimal introduction of new products and production processes over time.

8.4 These categories are examined in reference to both gains in efficiency and anti-competitive effects (which include losses in efficiency).

8.5 For the purpose of the trade-off analysis in litigated proceedings before the Tribunal, the Bureau must show the anti-competitive effects of a merger. The merging parties must show all other aspects of the trade-off, including the nature, magnitude and likelihood of efficiency gains, and whether such gains are greater than and offset the anti-competitive effects.⁹⁴ Whether or not a case proceeds to litigation, in order to effectively carry out the analysis, the Bureau seeks information from the merging parties and other sources to enable it to evaluate both gains in efficiencies and anti-competitive effects.

8.6 Merging parties are encouraged to make their efficiency submissions to the Bureau at an early stage of the transaction. This facilitates an expeditious assessment of the nature, magnitude and likelihood of the efficiency gains and of the trade off between relevant efficiency gains and anti-competitive effects.

Gains in Efficiencies

8.7 In order to be considered under subsection 96(1), it must be demonstrated that the efficiency gains "would not likely be attained if the order (before the Tribunal) were made". This involves considering the nature of potential orders that may be made, including those that may apply to the merger in its entirety or are limited to parts of the merger. Each of the anticipated efficiency gains must then be assessed to determine whether these gains are likely to be attained by alternative means if the potential orders are made. Where the order sought is limited to parts of a merger, efficiency gains that are not affected by the order are not included in the trade-off analysis.⁹⁵

8.8 To facilitate the Bureau's review of efficiency claims, the information provided by the merging parties should describe the precise nature and magnitude of each type of anticipated efficiency gain. It should also address the likelihood that such gains will be achieved and why those gains are not likely be achieved if the potential orders are made.

8.9 Objective verification of anticipated efficiency gains should be substantiated by documentation prepared in the ordinary course of business, wherever possible. This includes plant and firm-level accounting statements, internal studies, strategic plans, integration plans, management consultant studies and other available data.

8.10 Section 96(2) requires that consideration be given to whether the merger is likely to bring about gains in efficiency described in subsection 96(1) that will result in (i) a significant increase in the real value of exports; or (ii) a significant substitution of domestic products for imported products. Therefore, firms operating in markets that involve international trade and seeking to use the efficiency exception should provide the Bureau with evidence as to whether the merger will enable them to increase output.⁹⁶

Types of Efficiencies Generally Included

8.11 In its assessment of gains in efficiencies, the Bureau examines efficiencies that result in productive efficiency and dynamic efficiency.

Gains in Productive Efficiency

8.12 Productive efficiencies result from real cost savings in resources, which permit firms to produce more output or better quality output from the same amount of input. In many cases, such efficiencies can be quantifiably measured, objectively ascertained, and supported by engineering, accounting or other data. Timing differences in the realization of these savings are accounted for by discounting to the present value.

8.13 Productive efficiencies include:

• product, plant level and multi-plant level savings in both variable and fixed costs;⁹⁷
• savings associated with integrating new activities within the firm;⁹⁸ and
• savings arising from transferring superior production techniques and know-how from one of the merging parties to the other. ⁹⁹

8.14 When considering cost savings that are either variable or fixed, the Bureau examines claims related to:

• economies of scale: product and plant level reductions in the average unit cost of a product through increased production;
• economies of scope: plant-level savings that arise when the cost of producing more than one product at a given level of output is reduced by producing them together rather than separately;
• economies of density: plant-level savings that arise from more intensive use of a given network infrastructure;
• plant level savings that flow from specialization, the elimination of duplication, reduced downtime, a smaller base of spare parts, smaller inventory requirements and the avoidance of capital expenditures that would otherwise have been required;
• multi-plant level savings that arise from plant specialization, the rationalization of various administrative and management functions (for example, sales, marketing, accounting, purchasing, finance, production) and the rationalization of research and development activities; and
• plant and multi-plant level savings relating to distribution, advertising and raising capital.

Gains in Dynamic Efficiency

8.15 The Bureau also examines claims that the merger has or is likely to result in gains in dynamic efficiency, including those attained through the optimal introduction of new products, the development of more efficient productive processes, and the improvement of product quality and service. It is recognized that attaining dynamic efficiency is crucial to both the general evolution of competition and the international competitiveness of Canadian industries. Because dynamic efficiency is ordinarily extremely difficult to measure, such efficiencies are generally considered from a qualitative perspective.

Deductions to Gains

8.16 Once all efficiency claims have been valued, the costs of retooling and other costs that must be incurred to achieve efficiency gains are deducted from the total value of the efficiency gains that are considered pursuant to section 96(1).¹⁰⁰ Integrating two complex, ongoing operations can be a costly undertaking and ultimately may be unsuccessful. Integration costs are deducted from the efficiency gains.

Types of Efficiencies Generally Excluded

8.17 Not all efficiency claims qualify for the trade-off analysis. The Bureau excludes:

• gains that would likely be attained in any event through less anti-competitive means if the potential orders were made.¹⁰¹ (examples include internal growth, a merger with a third party,¹⁰² a joint venture, a specialization agreement, and a licensing, lease or other contractual arrangement);¹⁰³
• gains that would not be affected by an order, where the order sought is limited to part of a merger;¹⁰⁴ and
• gains that are redistributive in nature, as provided in section 96(3) of the Act. (examples include gains anticipated to arise from increased bargaining leverage that enables the merged entity to extract wage concessions or discounts from suppliers that are not cost justified,¹⁰⁵ and tax related gains).¹⁰⁶

Anti-Competitive Effects

8.18 Subsection 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". The effects to be considered are not limited to resource allocation effects and include all the anti-competitive effects that are likely to arise from a merger, having regard to all of the objectives of the Act.¹⁰⁷ Determination of the relevant anti-competitive effects depends upon the particular circumstances of the merger in question and the markets affected by the merger.

8.19 The Bureau examines all relevant price and non-price effects, including: effects on allocative, productive, and dynamic efficiencies; redistributive effects; effects on service, quality and product choice; impacts on the opportunities for Canadian participation in world markets; and, impacts on the opportunities for small and medium sized enterprises to participate in the Canadian economy.

8.20 In addition to direct effects in the relevant market, the Bureau also considers price and non-price effects in interrelated markets. For example, mergers that are likely to result in increased prices and lower output can impair both domestic and exporting industries that use the merged firm's products as inputs.

8.21 Some examples of potential anti-competitive effects that can result from a merger are described below. This list is not intended to be exhaustive. All of the relevant anti-competitive effects of a merger are considered when performing the tradeoff.

Price Effects

Loss of allocative efficiency (Deadweight Loss)

8.22 A merger that results in a price increase brings about a negative resource allocation effect, which the Bureau generally measures as the deadweight loss on the sum of producer and consumer surplus within Canada. This reflects a loss of allocative efficiency that is contrary to promoting the efficiency and adaptability of the Canadian economy.

8.23 In view of the difficulties associated with estimating both the elasticity of market demand and the magnitude of a material price increase that is likely to be brought about by a merger, various estimates of the deadweight loss are usually prepared over a range of price increases and market demand elasticities.

8.24 The estimate of deadweight loss generally includes:

• any losses to consumer surplus resulting from price increases and/or output reductions due to the merger;
• any losses in producer surplus that arise when market power is being exercised in the relevant market prior to the merger;
• any losses to consumer and producer surplus attributable to interdependent or coordinated pricing by competitors of the merged firm; and
• any losses to consumer and producer surplus anticipated to result in interrelated markets.¹⁰⁸

Redistributive Effects

8.25 Price increases resulting from an anti-competitive merger cause a redistributive effect ("wealth transfer") from buyers to sellers. Providing buyers with competitive prices and product choices is an important objective of the Act.¹⁰⁹ Therefore, the Bureau examines the extent to which the wealth transfer is part of the trade-off analysis.

8.26 There are different ways in which the wealth transfer could be taken into account when evaluating a merger. One approach to the wealth transfer is the "socially adverse effects approach", which attempts to quantify the socially adverse portion of the transfer.¹¹⁰ The type of information that would assist in applying this approach includes detailed information regarding the type of products produced by the merged entity, the nature of their buyers, the uses to be made of those products by their buyers and the socio-economic profiles of their buyers.

8.27 Another approach to the wealth transfer is to consider the redistribution of income from buyers to sellers from a qualitative perspective. ¹¹¹ The Bureau may also consider other approaches, depending on the circumstances of a particular case.

Non-price effects

Reduction in Service, Quality, Choice

8.28 A substantial prevention or lessening of competition resulting from a merger can have a negative impact on service, quality and product choice. Considering these effects is consistent with ensuring that buyers are provided with competitive prices and product choices. Where these impacts cannot be quantified, they are considered from a qualitative perspective.

Loss of Productive Efficiency

8.29 Mergers that prevent or lessen competition substantially can also reduce productive efficiency as resources are dissipated through x-inefficiency¹¹² and other distortions.¹¹³ For instance, x-inefficiency arises when firms, particularly in monopoly or near monopoly markets, are insulated from competitive market pressure to exert maximum efforts to be efficient. The x-inefficiency resulting from a merger can be substantial and may be much larger than the deadweight loss associated with allocative efficiency. Because losses in productive efficiency may be difficult to quantify, such impacts are generally considered from a qualitative perspective.

Loss of Dynamic Efficiency

8.30 Mergers that result in a highly concentrated market may reduce the rate of innovation, technological change, and the dissemination of new technologies with a resulting opportunity loss of economic surplus. Like dynamic efficiency gains, negative impacts on dynamic efficiency resulting from an anti-competitive merger are also difficult to measure and are generally considered from a qualitative perspective.

The Trade-Off

8.31 To satisfy the section 96 trade-off, the efficiency gains must both "be greater than and offset" the relevant anti-competitive effects.

8.32 The "greater than" aspect of the test requires that the efficiency gains be more extensive than or of a larger magnitude than the anti-competitive effects.¹¹⁴

8.33 Both the efficiency gains and the anti-competitive effects can have quantitative (measured) and qualitative aspects to them. To enable appropriate comparisons to be made, timing differences between measured future anticipated efficiency gains and measured anti-competitive effects are addressed by discounting to the present value.¹¹⁵

8.34 There is currently no statutory basis for assuming an equal weighting of redistributive effects, deadweight losses and efficiency gains. ¹¹⁶ Such weighting must depend on the facts of a particular case. Because all gains must be weighed against all effects, the exercise of judgment is required when combining measured gains (effects) with qualitative gains (effects) for the purpose of performing the trade-off. ¹¹⁷

8.35 Merging parties intending to invoke the efficiencies exception are encouraged to address how they propose that qualitative and quantitative gains and effects be combined and weighed for the purpose of performing both the "greater than" and "offset" aspects of the trade-off; and to explain how and why the gains "compensate for" the anti-competitive effects.¹¹⁸

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⁹¹ An amendment to section 96 has been proposed in Bill-C249, which is currently before the Senate Committee.

⁹² The nature of the efficiency exception was considered by the Tribunal in the Hillsdown decision and by the Tribunal and the Federal Court of Appeal in four decisions in the Superior Propane proceedings. While existing jurisprudence provides some guidance on the principles for interpreting and applying section 96, it does not prescribe how the trade-off is to be carried out in all cases.

⁹³ Superior Propane, 2001 FCA 104 (April 4, 2001) (F"FCA1")CA1, ¶ 88

⁹⁴ FCA1, ¶ 154

⁹⁵ This is discussed further below under Types of Efficiency Gains Generally Excluded.

⁹⁶ Increased output in this context is generally only possible with an associated decrease in price.

⁹⁷ Both variable and fixed cost savings are relevant to the analysis because both generate producer surplus (even though it is recognized that generally only variable (i.e. marginal) cost savings lead to price reductions). The component of fixed costs that is not recoverable is not relevant to the trade-off analysis.

⁹⁸ These include reduced transaction costs associated with contracting for inputs, distribution and services that were previously performed by third parties. However, as noted in Superior Propane at ¶ 364-366, this excludes pecuniary savings related to bringing idle equipment into use if such idle capacity will be transferred to third parties.

⁹⁹ While such legitimate production-related savings may exist, it will generally be difficult to demonstrate that efficiencies will arise due to "superior management", that savings are specifically attributable to management performance, or that they would not likely be sought and attained through alternative means.

¹⁰⁰ See for example Superior Propane at ¶ 340 and 380, where the Tribunal deducted certain management fees because they represented compensation payments for providing additional management services.

¹⁰¹ See for example Superior Propane at ¶ 352.

¹⁰² Consideration will only be given to alternative merger proposals that can reasonably be expected to proceed if the potential order is made.

¹⁰³ The market realities of the industry in question will be considered in determining whether particular efficiencies can reasonably be expected to be achieved through less anti-competitive non-merger alternatives. This includes growth prospects for the market in question, the extent of excess capacity in the market, and the extent to which the expansion can be carried out in increments.

¹⁰⁴ Efficiencies expected to arise in other markets that are inextricably linked to efficiencies that the order would prevent in the relevant market may qualify if these efficiencies would also be precluded by the order.

¹⁰⁵ Discounts from a supplier resulting from larger orders that would enable the supplier to achieve economics of scale, reduce transaction costs or achieve other savings may qualify, to the extent that the savings by the supplier can be substantiated. See for example Superior Propane at ¶ 346-348.

¹⁰⁶ See for example Superior Propane at ¶ 376.

¹⁰⁷ FCA1, ¶ 92.

¹⁰⁸ Where the products produced by the merged firm include intermediate goods that are used as inputs in other products, price increases in the intermediate goods can contribute to a distortion of input prices in other products that may result in inefficient production in those markets.

¹⁰⁹ This is consistent with the Federal Court of Appeal which acknowledged the "consumer protection objectives of the Act", the significance of "the availability to consumers of a choice of goods at competitive prices" when determining the effects to be considered under section 96, and the need to take into account "the interests of the consumers of the merged entity's products" when the trade-off is made between efficiencies and anti-competitive effects. See FCA1, s 100, 103, 88 and 109.

¹¹⁰ This approach was applied by the Tribunal in the Superior Propane Redetermination Decision, where the Tribunal gave full weight only to the socially adverse portion of the transfer. See 2000 (Comp. Trib.) 16 (April 4, 2002) Competition Tribunal, April 4, 2002 (hereinafter, "Superior Propane Redetermination"). The Federal Court of Appeal concluded that the application of that approach in that case was within the Tribunal's discretion. See See: FCA 53 (January 31, 2003) Federal Court of Appeal, January 31, 2003 (hereinafter "FCA2").

¹¹¹ This approach was discussed by the dissenting member in Superior Propane.

¹¹² "X-inefficiency" typically refers to the difference between the maximum (or theoretical) efficiency achievable by a firm and actual efficiency attained.

¹¹³ For example, increased market power can lead to rent-seeking behaviour (such as lobbying) which can reduce total welfare when real economic resources are consumed in activities directed towards redistributing income, rather than used in producing real output.

¹¹⁴ See for example Superior Propane at ¶ 449.

¹¹⁵ See for example Superior Propane at ¶ 371.

¹¹⁶ Superior Propane Redetermination at ¶ 340 , ¶ 371.

¹¹⁷ Superior Propane, ¶ 461.

¹¹⁸ FCA1, ¶s 88, 92, 109.