There is always a first time: The European Commission applies the failing firm defence to an unprofitable division in NYNAS/Shell/Harburg Refinery

By a II-Phase decision the European Commission has unconditionally cleared the proposed acquisition of the Shell's Harburg refinery assets by Nynas by applying the failing firm defence (FFD) to an unprofitable division and also taking into account the economic efficiencies expected from the merger (Case No COMP/M.6360, NYNAS/Shell/Harburg Refinery).

The failing firm defence under EU Competition Law

Under the EU Merger Regulation the FFD may be invoked by the parties to an otherwise problematic merger to have that transaction cleared, when there are no causal links between the merger and the deterioration of competition. The Commission has crafted a three-limb test that sets out the three cumulative criteria that must be met in order for the FFD to apply: i) the firm would in the near future exit the market due to financial difficulties unless taken over by another firm; ii) there is no alternative purchase than the notified merger; and iii) in the absence of the merger, the assets of the failing firm would inevitably exit the market (Guidelines on the Assessment of Horizontal Mergers, [2004] OJ C31/5).

Although the Commission does not rule out the application of the FFD to unprofitable divisions of healthy firms, it made it clear that in these cases the burden to prove the defence of the lack of causality must be especially high. The Commission fears that when the FFD is invoked with respect to a merger involving a failing division, firms may strategically shape the balance sheet of the division to obtain a clearance decision on the basis the difficulties of that division. Therefore, the Commission strictly administers the above thee-limbs test and accepts the FFD only when the closure of the ailing division is imputable to a real economic failure, rather than a management decision (Failing Firm Defence, note by the European Commission, DAF/COMP/WD (2009) 100). Before NYNAS/Shell/Harburg Refinery, the FFD was unsuccessfully pleaded by the parties to mergers involving unprofitable divisions in Bertelmann/Kirch/Premiere (Case IV/M.993), Rewe/Meinl (Case IV/.1221) and NewsCorp/Telepiu (Case COMP/M.2876). Unsurprisingly, in all these cases the parties failed to prove to the requisite evidentiary standards that the notified mergers met the three criteria for the application of the FFD.

The facts of the case

In February 2013 the European Commission was notified a merger involving the acquisition of the Shell's Harburg refinery assets, a base oil manufacturing plant (BOMP), by Nynas. Believing that the merger was likely to give rise to serious competition problems, in March 2013 the Commission started a Phase II investigation and in July 2013 it issued a statement of objection.

The Commission identified the relevant markets affected by the notified merger in the markets for the sale of naphthenic base, process oil and transformer oils (TFO). Nynas and Shell were, respectively, the first and the second largest suppliers of those products. The Commission took the view that Nynas would have a dominant position in the post-merger markets, being the only supplier of naphthenic base and process oil and the largest producer of TFO in the EU. Its only credible competitor would be the US firms Ergon with no production facility in the EU. To deal with the competition concerns raised by the Commission, the merging parties pleaded the FFD and also claimed that the merger would generate economic efficiencies.

The decision of the Commission

The Commission found that the NYNAS/Shell/Harburg Refinery merger fulfilled all the criteria in the three-limbs test for the application of the FFD. Shell met the first limb of the test by showing that it was not profitable to run the Harburg refinery in its current set-up. It declared that its business strategy was to leave the naphtenic industrial oil sector to refocus on more profitable activities and that it would close in any event the BOMP, absent the merger. The internal data submitted by the seller indicated that running the BOMP was costlier than close it, as reflected by the fact that the net present value (NPV) of closing the assets was higher than the NPV of continuing operation. Accordingly, the Shell decision to close the BOMP was economically rational. In addition, Shell already started to convert the refinery into a terminal and substantial investments would be needed to re-open it.

As for the second limb, the Commission engaged in a thorough analysis on the potential purchasers of the BOMP. Apart from Nynas, only Ergon might be interested in the refinery assets and in 2011 it entered into negotiations, though unsuccessful, with Shell for the purchase of those assets. Yet, the Commission found Ergon to have little or no incentives to buy the BOMP. First, Ergon still had unused capacity at its US-based Vicksburg plant. Second, in case of the prohibition of the notified merger, the BOMP would in any event go out of the market without increasing the capacity production of competitors. Therefore, the Commission ruled that no other firms than Nynas had the ability and incentives to take over the refinery assets. In the light of the above, the Commission concluded that, absent the merger, the BOMP would be likely to exit the market due to its poor financial performance and the lack of alternative buyers.

Then the Commission carried out a counterfactual, comparing the market competition in case of implementation of the merger (the merger scenario) and in case of prohibition of the transaction (the non-merger scenario). In the non-merger scenario the BOMP would be likely to exit the market, leading to a reduction in the EU production capacity well below the EU demand level. Thus Nynas would have insufficient capacity to meet the EU demand, including the customers previously supplied by Shell. To supply the EU clients, Nynas should rely on costly imports or renounce to the more profitable non-EU sales. Either of these two options would constitute an opportunity costs for Nynas, with the result that it would have lower incentives to compete aggressively in the EU. Moreover, using the spare capacity at its US Vicksburg plant, Ergon would be likely to expand its market share in the EU and become a larger second market operator, without facing any competition pressure from Shell and capacity-constrained Nynas.

In the merger scenario, on the other hand, Nynas would have very high market shares that, however, could not be regarded as a reliable proxy of the possible anti-competitive effects of the merger. Indeed, by allowing the merger, the Harburg refinery assets would remain in the market and Nynas would also increase its capacity production. In other words, post-merger Nynas would be more competitive, being capable to supply all its EU customers base with EU production, which would be a cheaper option than relying on additional imports from non-EU countries. For these reasons the Commission believed that the prices in the merger scenario would be lower than prices in the non-merger scenario.

Finally, the Commission examined the economic efficiencies expected in the merger scenario. Nynas argued that by purchasing the BOMP it would obtain the much needed capacity to supply the EU demand. As a result, it could replace costly imports from third countries with cheaper EU production. The Commission acknowledged that the increase in capacity would result in verifiable cost savings for Nynas. It accepted the internal documents submitted by Nynas indicating that the Harburg plant would have lower variable costs than imports from third parties. Consistently with its decisional practice, the Commission viewed the variable costs claimed by Nynas as relevant for the assessment of merger efficiencies. Variable costs are an important factor in setting prices and the Commission found that Nynas would have the ability and the incentives to pass a share of the cost savings, generated by lower variable costs, to consumers by charging lower prices.

Conclusive remarks

Since BASF/Pantochim/Eurodiol (Case M.2314) NYNAS/Shell/Harburg Refinery is the first case in which the Commission accepted the FFD and, even more importantly, it is the first ever case in which the FFD was applied to a failing division. Though the viability of Shell was not put in jeopardy by the loss-making Harburg BOMP, the seller succeeded in proving that its decision to close the plant was due to a real economic failure. In addition, the parties demonstrated that the proposed merger would have a positive competition impact. Enjoining the merger, the BOMP plant would be likely to leave the market, thereby leading to higher prices relative to those expected in the merger-scenario. On the other hand, through the implementation of the merger, Nynas, a niche operator that was in need to expand its production capacity to meet the increasing global demand, would strengthen its market competitiveness. And it would also benefit from economic efficiencies in the shape of lower variable production costs.

On balance, it cannot be argued that in NYNAS/Shell/Harburg Refinery the Commission adopted a more lenient approach to the FFD; rather, it seems that the clearance decision depended on the specific facts of the case and may not be easily applied to other merger cases.