Report of the Advisory Panel on Efficiencies:- Chapter 6 Conclusions and recommendations of the Panel

This chapter outlines the Panel’s conclusions and recommendations. The first four sections of the chapter outline the Panel’s conclusions on the role that efficiencies should play in the administration and enforcement of the Competition Act as it applies to mergers. These conclusions are as follows.

• Despite significant changes to the Canadian economy in the last 35 years, Canada still faces a significant productivity problem, and public policy tools, including competition policy, should continue to be used to promote efficiency.
• Mergers can contribute to improvements in the efficiency of firms and the productivity of the Canadian economy; therefore, merger review should involve regular and explicit consideration of the efficiency gains generated by a merger.
• There may be rare circumstances in which competitive market forces have not resulted in firms’ optimal efficiency. From a public policy perspective, this could justify allowing a merger that substantially lessens or prevents competition to proceed on the basis that it would produce sufficient offsetting efficiency gains; however, the circumstances in which an efficiency defence may apply, and the applicable standards, should be more clearly defined.
• An efficiency defence should not be permitted in the case of a merger-to-monopoly.

The last section of this chapter sets out the Panel’s views on the characteristics that the Canadian competition policy framework should have, in order to ensure that efficiencies are properly addressed. These characteristics are oversight by the Competition Tribunal, accessibility of efficiency gains claims, predictability of outcomes and inclusion of dynamic efficiency as part of the assessment.

This chapter deals only with efficiencies in merger review. The Panel’s conclusions and recommendations respecting efficiencies and strategic alliances are found in Appendix A.

Efficiency gains matter and competition policy should encourage efficiency

The specific concerns that led the Economic Council of Canada to advocate an efficiency defence in 1969 may be less salient today, since the tariff barriers protecting Canadian manufacturers have come down significantly and the Canadian economy is one of the most open in the world. For the most part, Canada’s manufacturers are competitive and efficient, although there is evidence that Canadian manufacturing plants are smaller on average than their foreign counterparts. Nevertheless, given Canada’s productivity gap with the United States and other countries, Canadians should be concerned about manufacturers’ efficiency.

Of greater concern is the services sector, in which the productivity gap with the U.S. and with most Organisation for Economic Co-operation and Development (OECD) countries is larger. On average, Canadian service firms are not nearly as big, competitive or efficient as their American counterparts. In addition, a number of important service industries (e.g. banking, telecommunications and media) still operate in a protectionist environment due to foreign ownership restrictions, very much like manufacturing did in the 1960s.

Canada’s overall productivity, which is directly correlated with living standards, appears to have been slipping recently, heightening the cause for concern. Several factors contribute to Canada’s productivity gap. These include Canada’s lower capital intensity, smaller high technology sector and lower investment in human capital relative to the United States and certain other OECD countries, as described in Chapter 3. Many of these factors are beyond the scope of competition policy to correct.

However, competition policy that permits efficiency-enhancing mergers may be able to address, albeit to a limited degree, one of the factors — that is, the smaller average size of Canadian firms. Indeed, most mergers aim to create value through the better use of resources, and thus contribute to efficiency gains. In certain cases, such a contribution may be significant. There is evidence that mergers and changes of control trigger restructuring that contributes to significant productivity gains.

Canada also has an “innovation gap” with other OECD nations, resulting from Canada’s and Canadian firms’ lower level of investment in research and development. Again, competition policy that permits mergers that would result in dynamic efficiency gains might to a limited degree help close that gap. However, the connection between industry concentration, firm size and innovation varies from industry to industry and within industries. In some cases, concentration has negative effects on innovation and productivity, while it may contribute to innovation and productivity in others. This complex relationship calls for a competition policy framework that allows the impact of mergers on innovation to be considered case by case.

Competition policy is one of several policy tools that may and should be relied on to help the economy (particularly the services sector) improve productivity. Of course, the power of competition policy to promote economic efficiency should not be overstated, as the Economic Council of Canada observed in 1969 (Canada 1969, 197). Competition policy must operate alongside other public policies that promote economic efficiency. Nonetheless, given Canada’s efficiency challenges, taken together with the fundamental objectives of the Competition Act, which include promoting the efficiency and adaptability of the Canadian economy, the Panel believes that competition policy should encourage efficiency.

Merger review should include regular and explicit consideration of efficiency gains

Mergers and changes of control can contribute to significant gains in productivity. Because mergers have the potential to contribute to such gains, the Panel believes that efficiency gains should be a regular and explicit consideration in merger review. The Competition Bureau (and the Tribunal in any review of a Bureau decision) should consider any evidence submitted about efficiency gains as part of its assessment of the competitive effects of a merger — that is, when determining whether a merger substantially lessens or prevents competition. In particular, the Bureau should consider whether efficiency gains counter any of the merger’s negative effects on competition. This could occur, for example, when efficiency gains serve to increase rivalry in a market, prompt price decreases or create other consumer benefits, such as more innovative products. Both productive efficiency gains and dynamic efficiency gains should be considered in this analysis.

The Bureau’s approach should be transparent and consistent, so that merging parties can predict how and whether their efficiency claims are relevant to the assessment of their merger. To this end, the Competition Bureau’s Merger Enforcement Guidelines should be explicit regarding the role and importance of efficiencies in the determination of whether a merger substantially lessens or prevents competition.  In the longer term, in the interests of legal certainty and consistency, the Competition Act should be amended to make it explicit that efficiency gains should be considered in the analysis of whether a merger substantially lessens or prevents competition.

The Panel also expresses its hope that if efficiencies were to become a regular part of merger review, parties would be more willing to bring their efficiency claims forward. As noted in Chapter 2, parties seem to be reluctant to bring forward strong efficiency gains arguments under the current regime, since this may be viewed as an implicit admission that the merger is anti-competitive.

In the context of an application by the Commissioner of Competition to challenge a merger before the Competition Tribunal, the Panel believes that the Tribunal should also consider efficiency gains in the assessment of whether the merger before it substantially lessens or prevents competition.

Canada should maintain an efficiency defence but should better define the applicable standards

The Panel believes that Canada should retain some form of efficiency gains exception, namely an efficiency defence, because in rare but important cases a trade-off between the efficiency gains and a substantial lessening or prevention of competition may be justified. Both productive and dynamic efficiency gains should be considered in this analysis.

There are two principal reasons why the Panel is recommending retaining an efficiency defence. First, the Panel’s research has demonstrated that notwithstanding the opening up of trade with the United States and Mexico and the considerable restructuring of the Canadian economy, Canada continues to lag behind the United States and many other OECD countries in terms of overall productivity. The existence of this major productivity gap is an objective reason for giving efficiency gains relatively more weight in Canadian merger law than they are given in the laws of the United States and many other jurisdictions.

Second, the economic evidence demonstrates that the opening of the Canadian economy since 1969 has not resolved the particular challenge of economic efficiency in the Canadian economy. The economic evidence reviewed by the Panel demonstrates that, while firms in the goods-producing sector are for the most part holding their own against foreign competitors, manufacturing firms are still smaller on average in Canada than their counterparts in other countries, that some trade barriers remain (e.g. in the agricultural sector and in industries that face competition from exporters in non-NAFTA countries where meaningful tariffs remain) and that border effects are an important factor protecting Canadian firms from the full brunt of international competition.

The evidence is particularly clear in the services sector, which lags significantly behind that of the U.S. and other countries in terms of productivity and accounts for the lion’s share of Canada’s productivity gap. The reasons for the relatively lower productivity of the Canadian services sector are manifold. One contributing factor is the continued existence of foreign ownership and other regulatory restrictions in “strategic” sectors (including banking, telecommunications, media, book selling and air transportation). By definition, these foreign ownership and entry restrictions limit not only competition in the Canadian market but also the ability of Canadian firms to merge with their domestic counterparts. Another factor is the smaller size of Canadian service firms in general. The Panel believes that in industries in which competitive forces have not led to the creation of efficient firms and markets, other mechanisms should be considered in order to improve efficiency, including allowing mergers that significantly reduce competition but that also generate sufficient efficiency gains.

Conceptually, an efficiency defence may be justified when a merger causes the combined entity to increase its overall efficiency, moving it closer to global standards, as was shown in Chapter 3 with the inverted-U relationship. However, the circumstances that would lead to an industry being structured such that firms are constrained to operate below the optimal point are probably rare, since market forces normally push an industry to operate at its most efficient level. In such circumstances, the scale of firms is smaller than optimum. This is the effect that the Economic Council attributed to tariffs in the 1960s. Today, border effects and, in some sectors, restrictions on foreign entry and foreign competition, may be having the same effect (although the Panel does not wish to restrict the application of a trade-off just to the so-called “constrained” sectors identified in Chapter 3).

The Panel believes that the situations in which increased concentration would be associated with efficiency gains of such a magnitude that they would offset a lessening of competition (and the trade-off would thus generate social benefits) would be rare. However, the existence of an efficiency trade-off as a policy tool that could be used in special circumstances is consistent with the unique features of the Canadian economy. These features include its size, its geographical trade patterns and the numerous public policies that act upon the economy and give it its own unique structure.

The Panel emphasizes that its recommendation that an efficiency defence be retained does not mean that concentration should trump competition. To mount a successful defence, it would be necessary for the merging parties to demonstrate that the benefits of a merger (the efficiency gains) outweighed the costs of the merger (the harm to competition in the industry). The Panel’s overall impression is that an efficiency defence would and should only apply rarely.

The Panel believes that the Competition Bureau should take into account the strength of the merging parties’ efficiency claims and the likelihood that a trade-off is justified when deciding whether to challenge a merger before the Competition Tribunal. This is because public funds should not be spent litigating a case in which the efficiency gains would justify the merger. When there is genuine concern about whether the efficiency gains justify the merger, the Competition Tribunal should be the independent arbiter of the matter.

The Panel recognizes that in some protected sectors a specialized regulator may also exercise merger review powers. However, except in very limited circumstances the Competition Bureau also has jurisdiction to review mergers in regulated industries. The Panel is firmly of the view that when the Bureau reviews such mergers it should address both the effects of the merger on competition and the efficiency gains the merger generates, including whether the efficiency gains offset any negative effects on competition. Indeed, the evidence demonstrates that foreign ownership and regulatory restrictions contribute to the lower productivity of the Canadian economy, which means that the Bureau’s assessment of the degree to which a merger in a regulated industry contributes to efficiency gains is critically important.

In 1969, the Economic Council advocated the use of competition policy to promote efficiency because it was unable to directly address the principal source of inefficiency in the Canadian economy — namely, tariffs. Today, tariffs are no longer a major concern, but numerous other public policies and regulations have the effect of shielding certain industries from competition in the same way that tariffs protected industries in 1969. One might question whether many of these regulatory restrictions continue to serve the public interest, given their negative effects on the efficiency of the Canadian economy; however it did not fall within the Panel’s mandate to examine these matters. The Panel was only asked to address the issue of how efficiencies should be treated under the Competition Act and, in this regard, has concluded that in rare cases it may serve the public interest to allow a merger that creates sufficient offsetting efficiency gains, even when that merger substantially lessens or prevents competition. As stated previously, the Panel believes that an efficiency defence may be justified in any sector — regulated or not — when barriers of some sort maintain it below its optimal efficiency point.

The Panel is not satisfied with the current standard, resulting from the Superior Propane case, for weighing efficiency gains against anti-competitive effects. At present, the Competition Act is silent on the issue of the standard. The Federal Court of Appeal in the Superior Propane case endorsed a standard called “balancing weights” as one possible standard that would meet the Court’s requirements to weigh efficiency gains against effects, measured in light of all the purposes of section 1.1 of the Act. However, many view this standard as cumbersome and unpredictable. The Panel agrees. Applying the balancing weights standard is highly complex, since it requires the Competition Tribunal and the Competition Bureau to determine whether there are any adverse effects of the redistribution of wealth resulting from a merger. It also requires them to do a “weighted” balancing of efficiencies against effects, with weights that may vary from case to case. Moreover, the Federal Court suggested that while the balancing weights standard met its requirements, “the same standard may not be equally apposite for all mergers” (Superior Propane, first appeal, para. 140). As a result, it may not even be clear what standard applies to a particular merger. It is the Panel’s opinion that there should be a clear, predictable and politically acceptable standard that the Tribunal applies when weighing efficiency gains against anti-competitive effects.

The Panel is of the view that Parliament should define, in clear terms, the standard that any trade-off would have to meet, since this is fundamentally a policy question of who should benefit from the efficiency gains of an otherwise anti-competitive merger. Specifically, the issue of the standard bears on how the Tribunal should take into account the negative impact of a lessening of competition on one segment of the Canadian population (i.e. customers) when assessing the benefits that efficiency gains may bestow on other segments.

The Panel also stresses the importance of ensuring that the existence of an efficiency defence, which is likely to apply rarely, does not detract from the Bureau and Tribunal regularly considering pro-competitive efficiency gains when assessing the competitive effects of a merger. In other words, parties should not be required to invoke the defence in order to have their evidence of efficiencies considered. Efficiencies should be a regular consideration in the assessment of whether a merger substantially lessens or prevents competition, to the extent that they are relevant to that assessment. The Panel does not recommend incorporating industrial policy concerns, such as import substitution or export enhancement (currently found in section 96(2) of the Act) in the efficiency trade-off. Nonetheless, it should be clear, as it is under the current law, that efficiency gains and effects outside Canada are not to be taken into account as part of the trade-off (Superior Propane, redetermination decision of the Competition Tribunal, paras. 196–198).

The efficiencies defence should not be used in merger-to-monopoly situations

The Superior Propane case had the paradoxical result of authorizing a merger that led to a near-monopoly. The irony of having the Competition Act justify a monopoly was not lost on most observers. An efficiency defence should not apply in cases in which a merger leads to the creation of a monopoly. The Panel believes that monopolies inevitably lead to a loss of productive efficiency. This is in addition to the loss of allocative efficiency (deadweight loss) resulting from the higher post-merger price of the monopoly’s products or services (although this can be prevented with the proper regulations). Given that evidence suggests that competitive pressure contributes both to efficiency in general and to dynamic efficiency in particular, it would be inappropriate to allow efficiency gains to justify a merger when competitive pressure was all but removed. Among other things, the Panel notes that serious concerns respecting x-inefficiency may arise when a merger leads to a monopoly.

The traditional theory of the firm asserts that in monopoly situations shareholders reap the additional benefits that come from restricting demand and shrinking consumer surplus. The agency theory of the firm, in contrast, argues that management is in a position to intercept a portion of these benefits and use it for its own welfare.³⁰As a result, x-inefficiency increases and resources are misallocated. There is significant evidence in the literature that correlates low productivity and monopolies. The OECD recently looked at Canada’s utilities, which are mostly regulated monopolies, and concluded that they make a significant contribution to the lower efficiency of the Canadian economy (Maher and Shaffer 2005).

While there may be circumstances in which allowing a merger to proceed based on an efficiency gains trade-off may contribute to a lasting improvement in efficiency, a merger-to-monopoly will generate its own inefficiency in the long run. Although this can be difficult to measure and although parties may argue that inefficiency will not occur in their specific case, the eventual efficiency losses resulting from the absence of competitive pressure are likely to be significantly larger than any short term gains in efficiency resulting from the greater scale or scope of the merged entities. The Panel therefore believes that a trade-off between efficiency gains and competitive pressures is acceptable, but not when competitive pressure is completely or almost completely eliminated.

The Panel notes that numerous participants in the Competition Bureau’s recent consultations expressed concerns about whether and how monopoly can be legally defined. While there are differences of degree, the Panel does not consider the term monopoly to be qualitatively different from other terms used in the Act, such as substantial lessening or prevention of competition (used in the merger provisions), undue lessening or prevention of competition (used in the conspiracy provision) or substantial or complete control of a class or species of business (used in the abuse of dominance provision). All of these terms have been defined through enforcement practice and case law. Monopoly can also be so defined.

The Panel notes that some of the competition law bills debated in the 1970s (C-42 and C-13, 1977) contained language that would have prevented the efficiency defence from applying in situations in which a merger would have led the merging parties to enjoy “virtually complete control … in respect of a product in a market,” which seems to the Panel to be something akin to a bar on the use of an efficiency gains defence in a merger-to-monopoly situation. Thus, while the Panel acknowledges that it may be challenging to draft an enforcement policy or legislative or other provision limiting the efficiencies trade-off to situations in which a merger does not create a monopoly, it does not think that the drafting challenges are insurmountable.

Other characteristics of the framework for treating efficiency gains

The Panel’s mandate requires it to express its views on “the characteristics that the Canadian competition policy framework should have, in order to ensure that efficiencies are properly addressed.” A number of these characteristics (e.g. regular consideration of efficiency gains by both the Competition Tribunal and the Competition Bureau) are discussed above. Others are set out below.

The Panel has made no attempt to list all possible characteristics of an effective regime. Rather it has focused on those it views as most important based on its economic analysis and in light of the general public policy and business experience of the Panel members. A number of these desirable characteristics are already present, to a lesser or greater degree, in the current legislative regime.