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A fight over baby food could have major implications for mergers in mature industries. A federal judge will hold hearings at the end of the month on H.J. Heinz Co.’s contention that it should be allowed to acquire Beech-Nut Nutrition Corp. even though, by most traditional measures, the $185 million deal would be anticompetitive. Heinz and Beech-Nut – a subsidiary of Milnot Holding Corp. – are employing the so-called efficiency defense, which holds that anticompetitive deals should be allowed if the synergies are so great they outweigh any competitive harms. “The court battle will be over efficiencies,” said Marc Schildkraut, a partner at Howrey, Simon, Arnold & White LLP in Washington, D.C., who will help litigate the case. “We are going to see how powerful the argument of efficiencies is.” The argument is significant. As the merger wave continues, fewer companies dominate in many industry niches. Without the efficiency defense, the smaller businesses could never combine into an entity capable of challenging the industry’s big players. “We have not had a straightforward efficiency case reviewed by a court,” said Ilene Knable Gotts, a partner in the New York office of the Wachtel, Lipton, Rosen & Katz law firm. “It will be very interesting.” The efficiency defense was codified in 1997 amendments to horizontal merger guidelines. Federal Trade Commission Chairman Robert Pitofsky even touts its acceptance as a “major” accomplishment of the enforcement agencies during the Clinton administration. Yet Pitofsky warned against abuse of this argument, saying the agency is not going to drop its objections to a merger simply in the name of cost savings to consumers. “That doesn’t mean the net is down and the door is open … for anyone to come in with an efficiency claim,” Pitofsky said. That is certainly what companies are learning. WorldCom Inc. and Sprint Corp., as part of their merger defense, argued their need for size to successfully challenge AT&T Corp. The benefits from this enhanced competition would outweigh the loss of a competitor, they told the Department of Justice, which still sued to kill the deal. Heinz and Beech-Nut knew they faced the same risk. The antitrust agencies hate to see the No. 2 and No. 3 players in an industry merge, as the companies were proposing. The baby food market is highly concentrated – a new player has not entered for 60 years. Novartis AG’s Gerber unit, Heinz and Beech-Nut hold a combined 98% market share. The Herfindahl-Hirschman Index, which measures market concentration, would rise to 5,400 out of a possible 10,000. Any score above 1,800 is considered anticompetitive. In discussion with the FTC this spring, the companies tried to convince the agency to accept the efficiency defense. Pittsburgh-based Heinz and St. Louis-based Beech-Nut argued that, individually, they are too small to challenge Gerber. By combining their operations and their 14% market shares, these regional companies said they could substantially reduce costs and become a national player. They would be able to lower prices and possibly force Gerber to match their cuts, for the benefit of consumers. “The merger of Heinz and Beech-Nut will inject competition into a stagnant market,” they wrote in a July 27 court filing. “It will result in a national brand with national distribution to compete with Gerber, the dominant brand.” The FTC did not bite, and in June, voted to challenge the deal in court. The case is set to start Aug. 30 before Judge James Robertson, in the same District of Columbia federal courthouse where the Microsoft Corp. antitrust case was litigated. Meanwhile, the baby food battle takes place daily in Mount Vernon Square, a working class neighborhood just a mile north of the FTC’s headquarters. Gerber is clearly winning. Three major sources for baby food exist in the community and Gerber is on the shelves at all of them. Heinz is nowhere to be found, while Beech-Nut splits about half the shelf space at Giant Supermarket, a unit of Royal Ahold NV, with Gerber. Gerber and Beech-Nut match prices at Giant. The same-size jar of pureed pears costs 53 for either brand. CVS drug stores devote much less space to baby food. It only offers Gerber, and its prices are comparable to those at Giant. Capitol Supermarket, an independent, devotes about four shelves to baby food and Gerber is the only brand available. Prices are about a dime per jar higher than Giant or CVS. Heinz and Beech-Nut contend they could benefit markets such as Mount Vernon by vying more strongly for shelf space and by cutting prices. Federal Trade Commission lawyers are expected to argue that Heinz is a powerful player in such neighborhoods even though Gerber dominates the shelves. The FTC also contends that the rivalry between Heinz and Beech-Nut serves the consumer through discounts and other incentives to win shelf space. The competition between Heinz and Beech-Nut to be No. 2 puts pressure on Gerber, which risks losing its 70% national market share if it lets either of these aggressive players undercut prices too deeply. The efficiency defense is grounded in the economic theory that mergers that benefit society should be permitted. To determine which mergers deserve approval, economists add all the efficiencies and all the costs to society. Whichever number is higher dictates whether the deal gets done. It does not matter whether efficiencies result in higher profits for the companies or lower prices for consumers In contrast, antitrust regulators take a more consumer-friendly focus, said Albert Foer, president of the American Antitrust Institute, a nonpartisan group that advocates vigorous enforcement of competition laws. The FTC and Justice Department only care about efficiencies passed on to consumers. The FTC contends in its brief in the case that Heinz and Beech-Nut could not prove that their customers would be better off. “Whether consumers receive the benefits of any new efficiencies will depend on the good intentions of the duopolists which control the market,” FTC lawyer Richard Dagen wrote. “Antitrust law, however, prefers the workings of the competitive marketplace to the intentions of dominant firms.” Some observers say that the FTC and Justice Department take such a narrow view of the efficiency doctrine that it is not really a viable defense. “In most instances, the efficiency defense in the guidelines turns out to be a mirage,” said William Kovacic, a professor at George Washington University. “The problem is that they are too hard to present in a credible manner.” Economists certainly cannot agree on whether a merger would produce efficiencies. The FTC and Heinz-Beech-Nut at the end of July exchanged lists of potential witnesses for the trial. Each contained the names of three economists, which means there may be six different views about the value of efficiencies. Janet McDavid, a partner at Hogan & Hartson LLP in Washington, said once the efficiency doctrine is used as an affirmative defense, the companies have already lost the war on the merits of the deal. “I hope never to get to the point where I have to counter the bad stuff with efficiencies,” she said. “It is almost impossible to overcome an overwhelmingly anticompetitive deal with efficiencies.” The antitrust bar is not ready, however, to bury the efficiency defense, even if the baby food companies lose. “Any time two companies are put together there will be an explanation as to how shareholders benefit,” Foer said. “That benefit is an efficiency, so there will always be efficiencies evoked by the parties.” And that is just how McDavid defines efficiencies. She said they complete the story about why a deal is being contemplated. In the 1997 office supply superstore case, Judge Thomas Hogan rejected Staples Inc.’s argument that the efficiencies are so great that the No. 1 office supply warehouse store should be allowed to acquire the second biggest chain. The companies dropped the deal rather than continue the litigation. Some thought the outcome would be different this time. First, the regulators added the efficiency doctrine to the horizontal guidelines after Staples filed for permission to acquire Office Depot Inc. Also the Heinz-Beech-Nut case involved the second- and third-place players rather than the industry leader. “They are not convinced that the No. 2 and No. 3 must merge to benefit consumers,” Foer said. That worry is on target, Foer said. With only two companies, it is much easier to collude on higher consumer prices. They also may feel less need to innovate because there is little threat of an upstart entering the market and stealing share. Kovacic, however, said these worries will always exist and the best way to find out whether the fears are justified is to let some of these transactions proceed. Kovacic praised Heinz and Beech-Nut for pushing the envelope, he and called on the regulators to designate one of these deals as a guinea pig. “The only way to test the efficiency argument is to take some chances,” he said. Copyright �2000 TDD, LLC. All rights reserved.

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