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Merge & Purge

These days, getting a big deal past antitrust regulators often means shedding some of your best assets.

9Oct

In the months after fiber-optics giant JDS Uniphase Corp. agreed to acquire E-Tek Dynamics Inc. in a $15 billion merger last January, executives at the two companies had lengthy discussions with another interested party: lawyers from the antitrust division of the Department of Justice.


"Much of the time initially was taken up educating the Department of Justice in great detail about our markets and technologies," says Tony Muller, executive vice president and CFO at JDS Uniphase, based in San Jose, California. "They spoke with competitors, they learned very quickly, and then they formed their own judgments."


In the end, the Justice Department learned enough to conclude that the merger would create competitive problems in a pretty arcane area: the thin film filters that are crucial components of so-called wavelength division multiplexers. The combined company would control 80 percent of the world's production of such filters.


So the parties agreed to divest E-Tek's rights of first refusal to purchase thin film filters from certain vendors.


The episode is indicative of how U.S. antitrust regulators are plumbing every nook and cranny of proposed mergers in search of possible anticompetitive outcomes. The latest example: America Online Inc. could be forced to open its instant- messaging service to rivals as a condition for approval of its merger with Time Warner Inc. But more often than not, the remedy is a divestiture. Indeed, the number and size of divestitures have expanded notably since the Federal Trade Commission (FTC) issued a groundbreaking report in August 1999 that suggested companies were sabotaging the future prospects of agreed-to divestitures. In 2000 alone, more than a dozen major divestitures have been ironed out.


Amid all the antitrust clamor surrounding the marketing practices of Microsoft, the new tack on divestitures has gone largely unnoticed. But companies may have far more to learn from the consent decrees agreed to by such companies as JDS Uniphase, Fleet/BankBoston, and BP Amoco than they do from the ongoing Microsoft saga. Combined with the increasing activism of the European Union regulators, the new thinking on divestitures is affecting the way mergers, acquisitions, and other crucial transactions receive approval.



Meaningless Divestitures

To be sure, the new policies haven't stopped companies' rush down the wedding aisle. According to Thomson Financial Securities Data, in 1999 mergers worth $1.6 trillion were consummated, up from $625.4 billion in 1996. The number of Hart-Scott- Rodino premerger filings rose to 4,342 in 1999, from 2,617 in 1995. But many deals are now subject to a tough-minded posture that is a direct result of a study commissioned in the late 1990s by Bill Baer, then head of the FTC's Bureau of Competition. The study covered some 35 divestitures agreed to between 1990 and 1994. As the regulators sifted the data, it became clear that something was awry with the current approach to divestitures. "The divested assets didn't survive in the markets," says Baer, now a partner at Washington, D.C., law firm Arnold & Porter.


The FTC found that companies employed a variety of strategies that undermined the stated goal of divestitures. Firms sold off nonviable businesses or impaired assets. In some cases, the buyers that companies found were either not qualified or lacked industry experience. In a few instances, companies simply launched or started rival products after the divestiture. Worse still, in the FTC's eyes, the buyers of divested assets were frequently bound to the former owners as customers or suppliers. "There was a very strong correlation between failure and divestitures, where the buyer of the assets was somehow dependent on the company for know-how, intellectual property, and ongoing supply," says Baer.


Even as the study was being compiled, further evidence was emerging that divestitures didn't always work. When MCI Communication Corp. and WorldCom Inc. merged in 1997, they agreed to spin off some of their Internet backbone assets to Britain's Cable & Wireless. But in the months that followed, that business suffered. Cable & Wireless charged that MCI WorldCom had failed to transmit key employees and contracts in the deal. "They [the regulators] think they got their pocket picked on that one," says William Kovacic, professor of antitrust law at George Washington University Law School, in Washington, D.C.



Tougher Stance

After the study was released, both the FTC and the Justice Department began enforcing a tougher set of guidelines. (The two agencies divide antitrust matters between them, based on precedent and the strength of in-house expertise. The Justice Department takes cases involving airlines, aluminum, and radio, for example, while the FTC handles oil and pharmaceuticals.) In some instances, regulators have blocked deals, and in others they have placed the onus on companies to propose divestitures that meet their concerns.


The months since then have seen significant divestitures. In order to gain approval for their $16 billion merger, for example, Fleet Financial and BankBoston agreed to the largest divestiture in banking history--306 branch offices, with $13.2 billion in deposits in Massachusetts, New Hampshire, Rhode Island, and Connecticut. And when waste-
collection giants Allied Waste Industries Inc. and Republic Services got together last spring, they were required to sell off operations in 15 locations and change existing contracts in 14.


Other divestitures have reached beyond physical assets to involve intellectual property, technology, licenses, and contracts. In order to complete their $90 billion merger, Pfizer Inc. and Warner- Lambert sold Pfizer's head-lice treatment business to Bayer Corp. and Warner's Alzheimer's drug Cognex to First Horizon Pharmaceuticals. In addition, they agreed to end Warner's agreement with Forest Laboratories to co-promote Celexa, an antidepressant.


The authorities have also not hesitated to take massive companies to court. After negotiations broke down, the FTC last February sued to stop the proposed merger of BP Amoco and Arco, saying the deal would boost prices for gas and other petroleum products. Two months later, BP Amoco capitulated, agreeing to sell off Arco's Alaska oilfields to Phillips Petroleum for $7 billion.


According to Allied Waste Industries CFO Peter Hathaway, the Justice Department uses specific benchmarks to analyze the level of competition in a market, and because of the high volume of deal making, "any acquirer may begin to bump up above those benchmarks."


Not surprisingly, in the face of these tougher demands, some parties have dropped their plans. Last December, Dutch supermarket chain Royal Ahold NV abandoned its efforts to acquire Pathmark Stores Inc. after nine months of haggling with regulators, saying it couldn't find a buyer that was acceptable to the government. "They [the FTC] took a hard position, and would not accept the deal that the parties wanted to cut," says Albert Foer, a veteran antitrust attorney who served on the FTC in the 1970s and is now president of the Washington, D.C.-based American Antitrust Institute, a nonprofit advocacy organization.



Evolution or Revolution?

Regulators insist the new posture is more evolutionary than revolutionary. "Many people have reacted to the divestiture study and subsequent actions as though there has been some fundamental change in our approach," says Molly Boast, senior deputy director of the FTC's Bureau of Competition. "That's simply not true."


While companies may be more likely to hear a "no" from federal regulators today, she explains, that's not a final answer. After they conduct preliminary investigations, government lawyers will lay out the areas in which they have competitive concerns. "You're free to try to talk us out of it, or you can come to us with what you think would be the appropriate remedy," says Boast. "It's not as though we're incapable of devising remedies."


Some critics think the FTC's newfound posture doesn't go far enough. "I'd say that when it comes to antitrust, the FTC has been weak," comments James Love, director of the Consumer Project on Technology, a consumer advocacy group in Washington, D.C. Love notes that in such areas as oil and pharmaceuticals, a wave of mergers was soon followed by waves of price increases. "How many mergers did they actually stop?" he asks. The answer: very few.


But others say the agencies now approach the process more like hard-boiled private litigators and less like public regulators. Says Joe Sims, a Washington, D.C.-based partner in the law firm of Jones, Day, Reavis & Pogue: "Once they come to a conclusion about what the right answer is, they take the view that they get to use whatever tools, leverage, and power they have to accomplish that result, which is what a private litigant would do." And as Microsoft found, litigating against the government's antitrust legal eagles can be a long, drawn-out affair.



Doing Battle

How can companies prepare themselves for this new environment? First, hire a lawyer who understands the business you're in. "I think it's very important before going in to a merger to have the advice of counsel who has made a similar investment to understand the products and the technologies and the markets," says JDS Uniphase's Muller.


Second, take an inventory of your assets, and consider exactly what you may be willing to part with to get a deal done. "In factoring in the purchase price, more weight has to be placed on the possibility or risk that the government will extract more significant concessions," says Baer.


This inventory must include the full range of relationships that every line of business has. "People have to think about what other business entanglements the part of the business likely to be divested has," says Boast. "Does it have contracts they can't get out of? Does it have joint-venture relationships it can't undo? "


Consider again the proposed merger between AOL and Time Warner. The combined entity's vast assets will include a slew of joint ventures, alliances, agreements, partnerships, and stakes in other companies, such as DirecTV. This knot may prove particularly difficult to untangle. The merger, announced in January, is still on track. But it may take many more months to complete.


The government is also placing a premium on qualified buyers and continuing relationships. Observers say that may not bode well for the proposed merger of UAL Group and US Airways. To answer concerns that the combined firm would have too much market power, the companies agreed to spin off a package of assets (mostly Washington, D.C.-area routes) to BET Holdings chairman Robert Johnson. The move would make the politically connected Johnson the first African-American airline owner.


"That is not going to work, no matter what its socioeconomic or political attractiveness," says Kovacic. Among the main lessons learned from the FTC study is that a purchaser's industry track record is a crucial indicator of success. And Johnson, who served on US Airways's board, has never run an airline. Moreover, the agreement calls for the new entity, DC Air, to lease plants and other crucial operating needs from the combined entity.


Finally, don't expect this new tough stance to end any time soon. Experts say Corporate America should not count on a potential change in Administrations for relief. Even if Republican nominee George W. Bush, who is generally more friendly to big business than is Al Gore, were to be elected in November, his appointees wouldn't be in place until well into 2001.


Besides, antitrust enforcement tends to depend more on the personality of top regulators than on the guiding philosophy of an Administration. After the laissez-faire Ronald Reagan was elected in 1980, his antitrust appointees nonetheless pursued AT&T to its breakup. "It really matters who gets appointed to those jobs, and we don't know who that will be," says Philip Verveer, a partner with law firm Willkie Farr & Gallagher, and a former staffer at both the FTC and the Justice Department.


Still, antitrust experts believe the heightened focus on divestitures will not dampen the continuing surge in consolidation coursing through industries from food stores to automobiles. The new posture is more like a yellow light than a red. But that doesn't mean there will be no bumps in the road. As New York University law professor Eleanor Fox puts it, "I think they just have to be prepared for a tougher bargainer on the other side."



Daniel Gross is a freelance business writer based in New York.



Vertical Leap


Recent rumblings in Washington, D.C., about the supermarket industry should give corporate victims of anticompetitive marketing practices in other industries cause to hope- -and perpetrators reason to fear-- that regulators' hands-off approach to so-called vertical collusion between manufacturers and retailers is a thing of the past.


The supermarket industry may prove an ideal test case. In the 1970s, food manufacturers began paying retailers to advertise their products. By the 1980s, supermarkets began to expect these payments, and then to demand them. Now it's common practice for them to establish fees based on the space products take up in a warehouse. These one-time charges for warehouse "slots" are known as "slotting allowances."


On the West Coast, reports Scott Hannah, CEO of Bellevue, Washington-based Pacific Valley Foods, a small frozen-fruit and -vegetable company, slotting prices have risen threefold over the past decade, from $25 per store per item to at least $75. And he cites payments as high as $300 in the East.


The trend reflects supermarket-industry consolidation, initiated by Kohlberg Kravis & Roberts & Co.'s leveraged buyout of Safeway Inc. in 1989. And the move into the grocery business by Wal-Mart Wholesale Corp. and Costco Stores Inc. has further squeezed the independent grocers. Meanwhile, say critics, antitrust regulators have looked the other way.


"The rush to bigness, the Wal-Mart phenomenon, and a lot of the M&A activity are spurred by the lack of enforcement of Robinson-Patman," charges Jay Campbell, CEO of the Associated Grocers of Baton Rouge, a privately owned grocery wholesaler operating in Louisiana, Texas, Mississippi, and Alabama. (Robinson-Patman is the federal antitrust law passed in 1936 that prohibits sellers from charging competing buyers different prices for the same goods.)


In late May, however, the FTC conducted a two-day workshop on issues surrounding slotting allowances, and discussed marketing violations that have the effect of raising prices for consumers. "It is not an antitrust issue if supermarkets get richer at the expense of manufacturers," notes David Balto, an assistant director for policy at the FTC.


And while the Robinson- Patman Act has rarely been applied during the past 30 years, the FTC invoked it last March in an enforcement action against McCormick & Co. The Feds charged that the spice company's payment of variations of slotting allowances was designed to keep competing spice makers out of the marketplace.


Most important, the regulators' action focused on a vertical relationship--the one between manufacturer and retailer--as opposed to the more typical antitrust concern over horizontal relationships. "Vertical relationships went out of vogue in the 1980s, when the Chicago school--the theoretical underpinnings of antitrust enforcement--took over," says Albert Foer, president of the American Antitrust Institute. (Foer was referring to the University of Chicago economists whose extreme laissez-faire approach to antitrust dominated the Reagan Administration's policy- making.)


"That was an exception, and we are recovering from it," argues Foer, pointing to the bipartisan consensus on Capitol Hill. "Just look at what happened when Microsoft went to Congress to derail the Justice Department's suit. They found no support." -- Jinny St. Goar



At Europe's Door


Last June, the bold efforts of telephone executive Bernard Ebbers to merge WorldCom Inc. with Sprint Corp. came under a multifront attack. On June 21, word leaked that the European Union's antitrust regulators in Brussels would block the transaction on the grounds that it would create a giant with a stranglehold over Internet traffic. Six days later, the U.S. Department of Justice sued to block the deal, citing its potential adverse effects on U.S. long-distance rates. The one-two punch sent both parties back to the drawing board.


The scuppered WorldCom- Sprint deal is representative of the way European regulators are now exerting influence on transactions between U.S. companies. Under the leadership of commissioner Mario Monti, a highly regarded Italian economist, and his predecessor, the Belgian socialist Karel van Miert, the European Union's competition directorate has become a more prominent player.


The EU reviews mergers between U.S. and European companies. But the EU also claims jurisdiction over companies with significant sales in the 15-nation European Community, regardless of their location. The Europeans, notes New York University law professor Eleanor Fox, "have become more aggressive lately, and are more willing to apply their law extraterritorially." For example, the EU has also served notice that it will be looking into the America Online Inc. and Time Warner Inc. deal.


The EU's role presents a challenge--and not simply because it constructs one more set of hoops for companies to jump through. For when it comes to antitrust, the EU operates in a fundamentally different manner than the United States.


"The EU officials have more discretion than their U.S. counterparts, because the possibilities for judicial review are much weaker there," says William Kovacic, professor of law at George Washington University, in Washington, D.C. Essentially, the competition directorate advises Monti, who makes a decision that can be appealed in the European Court of First Instance. Companies that don't find relief there can appeal to the EU's Court of Justice. But the wheels of justice turn far more slowly in Brussels than they do in Buffalo. "If you want to challenge what the EC is doing on your merger, you have to be willing to let your deal hang in suspension for a longer time," Kovacic adds.


Paradoxically, the EU runs its preliminary reviews at a faster pace, which forces companies to provide information and responses quickly. "It creates a very complicated situation for major transactions, because the EU operates on a timetable that is, by our standards, pretty tight," says antitrust lawyer Philip Verveer.


To compound matters, the two regulators may zero in on different aspects of the deal. In the case of Sprint-WorldCom, the Europeans examined competition in Internet access while the United States focused on long-distance rates. And in 1997, after the FTC approved the proposed merger of The Boeing Co. and McDonnell Douglas, the EU demanded-- and received--concessions. Boeing agreed to abandon exclusive relationships that committed American, Delta, and Continental to fulfill all their aircraft purchase needs for the next 20 years from Boeing.


Today, deals must pass muster not only in Brussels, but also in Canada, Brazil, South Africa, Mexico, and South Korea. Some 80 countries now have antitrust authorities, and about 40 have premerger notification requirements. When they agreed to merge in 1998, Exxon Corp. and Mobil Corp. had to notify antitrust authorities in nearly three dozen countries. Many of the nations that have recently developed antitrust policies are taking their lead from Brussels, not Washington. "The European model is the one that is being adopted in most of the new competition systems around the world," says Kovacic.


But it's the D.C.-Brussels connection that CFOs should track most closely. The Washington agencies coordinate closely with the EU. "The business community underestimates the degree to which transactions with significant effects in the United States and Europe end up having the investigating staffs talking regularly and comparing notes," says Bill Baer, former head of the FTC's Bureau of Competition.


All of which means companies and their lawyers may have less ability to tailor their arguments to the different audiences. Ten years ago, experts say, you could make one argument in the United States and a nearly opposite argument in Europe. That will become increasingly difficult. And some experts believe the policies of the United States and Europe are growing similar, even as their procedures differ. "What is probably most significant is the degree to which there is increasing convergence in approach," adds Baer.

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