In defence of the failing firm?

Platypuses are elusive animals, and spotting one in the wild can be tricky. But that makes it all the more special when you do. 

Australian Conservation Foundation, “How to spot a platypus” (2024)

A successful “failing firm” defence, which allows a transaction that would have been blocked to proceed on the basis that – absent the transaction – the target would have exited the market, has been as rare and elusive as a platypus in the wild: often sought, rarely sighted. While many deals involve targets in some degree of financial distress (whether “failing” or “flailing”), the evidential burden on parties seeking to invoke this defence is very high, and there have been very few cases where it has been accepted. 

Unusually, a spate of three such cases in different sectors have recently been considered by the CMA, Eurofins/Cellmark, T&L/Tereos, and Roche/LumiraDx, with varying degrees of success:

• The CMA cleared (at notable speed – only 11 days into the Phase  1 review) Eurofins/Cellmark (forensic science services) on the basis of a failing firm defence, allowing Cellmark to be acquired by Eurofins, its largest competitor; 
• The CMA rejected the failing firm defence in T&L/Tereos (packaged sugar) at Phase 1 and referred the case to Phase 2, where the failing firm defence was ultimately accepted; and 
• The failing firm defence was also argued in Roche/LumiraDx (medical equipment for in vitro diagnostics): The case was cleared at Phase 1 on the basis that it did not give rise to competition concerns, but it is interesting to note that, despite LumiraDX being in administration, the defence was rejected.

In this Platypus post, we ask what we can glean from this recent decisional practice. Is there any change in approach that suggests we might see more of these cases? While drawing conclusions can be difficult (especially given that information relating to failing firm arguments are usually highly commercially sensitive and thus redacted from the CMA’s public decisions), the two “successful” failing firm cases do offer some insight. The bar remains extremely high for the CMA to accept a failing firm defence, especially at Phase 1, but where it has been accepted, the supporting evidence has shown not only that the individual firm was failing, but the industry as a whole has faced systemic difficulties. 

Failing firm framework – heads I win; fails you lose?

The CMA’s merger assessment guidelines outline how the CMA conducts its assessment of transactions. For a failing firm defence to be successful, the following cumulative conditions have to be met:

(a) the firm is likely to have exited (through failure or otherwise); and, if so 

(b) there would not have been an alternative, less anti-competitive purchaser for the firm or its assets to the acquirer in question.

In conducting this assessment, only events that would have happened in the absence of the merger under review - and not as a consequence of it - are taken into account.

In practice, it has proven extremely difficult to satisfy these conditions, particularly at Phase 1, as the CMA will need ‘compelling evidence that it was inevitable that’ limbs 1 and 2 above would be met (CMA129, paragraph 3.23, emphasis added). Essentially, the CMA will need to be satisfied to the relevant legal standard that the target has exhausted all options (e.g. changes in management, restructuring, refinancing, sale process) other than an exit. At Phase 2, the threshold is lower with the CMA having to determine what scenario is ‘most likely’, both in relation to limbs 1 and 2 (CMA129, paragraph 3.23).

The result is that failing firm arguments are rarely raised as parties are dissuaded from engaging in such arguments and, even when raised, they are frequently rejected (regardless of the ultimate outcome of the CMA’s investigation). Examples include:

• Alliance Medical/IBA Molecular (2014): where, at Phase 1, the OFT found that it was not inevitable that IBA Molecular would exit the market as there may have been scope to re-structure the business and, at Phase 2, while the CMA was satisfied that IBA Molecular would likely exit the market absent the merger and that there were no alternative purchasers, the CMA considered that IBA Molecular’s exit would be less anti-competitive than the merger, as at least some of its business would have gone to another, smaller competitor of the parties; 
• Poundland Group plc/99p Stores (2015): where the CMA determined that, while 99p had serious operational difficulties, the business was not structurally unsound;
• Sonoco/Wiedenhammer (2015): where the parties argued that both the acquirer and the target would exit the market absent the merger, but the CMA found that both were sufficiently financially profitable to remain active in the market;
• Euro Car Parts/Andrew Page (2018): where, at Phase 1, the CMA determined that, while absent the merger Andrew Page (which was already in administration) would have exited the market, the defence failed on the basis that there existed less anti-competitive purchasers for the Andrew Page business than Euro Car Parts (at Phase 2, the CMA reached a similar conclusion, albeit only in respect of part of Andrew Page’s assets, thus partially accepted the failing firm defence); and
• Danspin/Lawton (2019): where the CMA found that, while Lawton’s parent group was facing financial difficulties, Lawton itself was profitable and thus, absent the merger, the business would have been acquired by an alternative, less anti-competitive purchaser.

The CMA’s approach remains strict even in times of economic turmoil, as outlined during the COVID-19 pandemic, when the CMA made clear in specific guidance that speculative claims based on short-term financial difficulty would not be successful without a material body of supporting evidence. In Amazon/Deliveroo, while the CMA initially accepted a failing firm argument based on liquidity issues at Deliveroo caused by the pandemic, it reversed its findings in its final decision (although the case was ultimately cleared on competition grounds).

In principle, the CMA has also taken steps to ease access to the defence by updating the applicable thresholds in 2021. In particular, the CMA removed the requirement to consider whether the exit of a business would be a substantially less anti-competitive outcome than the merger (had these rules been implemented at an earlier stage, the failing firm defence which was rejected would have been accepted in Alliance Medical/IBA Molecular at Phase 2).

The CMA’s guidelines explain how it carries out its assessment of limbs 1 and 2 and demonstrate the high bar which must be overcome to rely on this defence:

Limb 1 – likelihood of exit

• In determining a firm’s financial health, the CMA will carefully examine its profitability over time, actions of management, evidence from debt or equity providers and, where the firm is part of a larger group, the health of the wider group.
• Being in administration may not be sufficient to demonstrate that exit is inevitable or likely.
• A firm may exit for strategic, non-financial, reasons – the CMA will consider this possibility, provided there is compelling evidence to support it.

As recent reviews demonstrate, there can be a material difference to how this limb is interpreted in phase 1 and 2 (given the need to demonstrate that exit is inevitable). The evidence trail on each of the above issues is therefore critical to the likelihood of success.

Limb 2 – alternative purchasers

• The CMA will seek to identify alternative purchasers who were willing to pay any price above liquidation value. 

If there are alternative purchasers, the CMA will assess whether any other purchaser might produce a better outcome for competition than the merger under consideration. However, the depth of the CMA’s assessment will not be at the same level of detail as the competitive assessment. The CMA may therefore only differentiate between purchasers when this could make a material difference to competitive conditions. 

How do these principles apply in the three recent cases

Systemic industry concerns can provide robust evidence of financial distress

In Eurofins/Cellmark, the parties were active in forensic science services to police forces and government bodies. This industry had been the subject of a 2021 House of Lords report, stating that suppliers were under extreme pressure and suggesting recommendations to improve the delivery of these services, which had not (as yet) been implemented by the Government. This independent report gave credibility to the parties’ submissions regarding Cellmark’s financial difficulties. This was further supported by third parties who overwhelmingly confirmed the pressures faced by suppliers in the industry (and Cellmark in particular). The CMA was convinced that Cellmark was in financial distress, and that it had attempted, unsuccessfully, to refinance and restructure the business. It also confirmed that there were no other potential purchasers despite a thorough sale process. On that basis, the CMA issued its decision to clear the transaction in a record 11 days. The CMA conducted its overall review of the deal very quickly – its pre-notification period lasted about a month and a half, significantly less than standard pre-notification periods (which tend to run for three months or more). The CMA recognised that, ‘[g]iven the financial challenges facing Cellmark, on receipt of [the complete Enquiry Letter response] from the Parties [it] has acted expeditiously in conducting its review of the Merger.’ 

This case is reminiscent of the CMA’s clearance decision in Freshways/Medina, where both parties were suppliers of fresh processed liquid milk (fresh milk), cream and other dairy and grocery products in the UK. Indeed, in that case the CMA also received extensive evidence from industry reports and third parties that the entire dairy supply chain, and milk processors in particular, had been facing significant cost pressures, providing support to Medina’s arguments regarding its financial viability.

Where financial concerns are company-specific, the evidence base is key

The CMA appears more circumspect where financial difficulties do not result from evident exogenous factors. As with a number of other cases where the defence was invoked (including Danspin/Lawton), the CMA rejected the failing firm defences put forward in Roche/LumiraDx and T&L/Tereos at Phase 1.

In Roche/LumiraDx, LumiraDx was in administration at the time of its assessment; however, this was part of a ‘pre-pack’ arrangement or restructuring – whereby the sale of a business is negotiated prior to the business being put into administration. The CMA therefore deemed that the insolvency was a consequence of the merger rather than occurring independently of it (and thus to be excluded from the counterfactual assessment). The CMA found that, while there had been a significant decline in LumiraDx’s recent revenue, this did not indicate that it was in terminal decline and in fact that both parties’ internal forecasts indicated significant growth prospects. This was supported by third parties who considered LumiraDx’s technology to be highly valuable. Given the high bar for providing exit is inevitable at phase 1, the CMA concluded that LumiraDx had not exhausted other options (including by seeking to raise further funds) and thus limb 1 was not met. The CMA ultimately cleared the case on the basis that it did not give rise to competition concerns.

In T&L/Tereos, Tereos’ parent company had entered the UK market on the basis that this was thought to be a more profitable market for its surplus European sugar production than exporting elsewhere. The parties submitted that, absent the merger, Tereos would exit the UK B2C market given the poor financial performance and outlook for the business (rather than go insolvent). At Phase 1, the CMA was not convinced that Tereos’ exit was inevitable, especially noting that its recent forecasts indicated a more positive outlook. In particular the CMA rejected the argument that the decision to sell Tereos constituted evidence that it had otherwise decided to exit the B2C market.

At Phase 2, however, the CMA did accept the failing firm defence. Having regard to the higher threshold of identifying the most likely counterfactual (emphasis added), and with the benefit of more time and resources to assess the evidence, the CMA recognised that Tereos had been loss-making in the last seven years, including the most recent 23/24 financial year and that, absent the merger, it would most likely have diverted its sugar sales elsewhere. While the CMA recognised that Tereos’ outlook had recently improved, this was a result of cyclical increases in sugar prices (globally) and thus the target remained loss-making compared to what it could make selling the sugar elsewhere, e.g. on the European B2B market. The CMA accepted that Tereos had considered restructuring options and changes in business practices, but its outcome remained pessimistic.

It is also worth noting that, following the launch of the CMA’s investigation, the Tereos Board passed a resolution in February 2024 to exit the B2C market if the merger was prohibited (the precise nature of the resolution is redacted – but the broad subject matter can be inferred from the decision). The CMA did not place any weight on this evidence, as in their view it was passed, at least in part, in response to the CMA’s merger investigation.

Key takeaways

While the CMA has accepted failing firm defences in Eurofins/Cellmark and Freshways/Medina, it remains extremely difficult to satisfy the requirements for this defence, especially at Phase 1. The CMA’s decisional practice remains conservative, and the target must have exhausted all alternative financing/commercial options, including finding an alternative purchaser willing to pay more than liquidation value. However, the existence of independent third-party evidence showing that not just the target business, but the industry as a whole, is struggling has been a critical factor in recent cases that have achieved Phase 1 clearance. 

In circumstances where a merger otherwise gives rise to competition concerns, the case of T&L/Tereos indicates that there may be benefit in considering a referral to Phase 2, where the CMA will have more time and resources to consider the issue and the higher burden of proof for the CMA plays to the parties’ advantage, and helps them avoid failure in deploying this defence. But proceeding to Phase 2 may not act as a panacea in all cases - in Spreadex/Sporting Index, currently being considered at Phase 2, the CMA has provisionally rejected the failing firm defence on the basis that, absent the merger, it considered the target likely to have continued to compete under the ownership of an alternative bidder.

For deal planning purposes, this makes “counting” on the failing firm defence a risky strategy in most cases, especially given the requirement for no less anticompetitive purchasers. Critically, this can be difficult to assess as a purchaser, as even where a purchaser has some awareness of the pool of potential purchasers, it will not be in a position to evaluate the likelihood an alternative deal could have been reached at a price above the liquidation value. Given potential purchasers are contacted by the CMA as part of testing any failing firm defence (and may well have an interest in picking up assets on the cheap through a forced divestment process), this creates a real area of potential risk when considering relying on the failing firm defence.