Charikleia Daouti
Enforcement of the Merger Guidelines:
The Proposed Mergers of Nation’s
Four Largest Drug Wholesalers (1998)
Charikleia DAOUTI
Enforcement of the Merger Guidelines:
The Proposed Mergers of Nation’s Four Largest Drug Wholesalers (1998)
I.Executive Summary
II.The Drug Wholesaling Industry
III.The Proposed Mergers
IV.Federal Trade Commission’s Challenge
A. The Relevant Product Market
B. The Potential Adverse Competitive Effects
1. Increase in Concentration
2. Removing Excess Capacity
3. Coordinated Interaction between Cardinal and McKesson
C. Entry
D. Efficiencies
V.The Merging Firms’ Defense
A. The Relevant Product Market
B. The Potential Adverse Competitive Effects & Efficiencies
C. Entry
VI.The Court’s Decision
VII.Conclusion
I. Executive Summary
On March 3, 1998, the Federal Trade Commission (“FTC”) authorized its staff to seek a Federal District Court preliminary injunction to block the mergers of Cardinal Health, Inc. (“Cardinal”) with Bergen Brunswig Corp. (“Bergen”), and McKesson Corp. (“McKesson”) with AmeriSource Health Corp. (“AmeriSource”). The two proposed mergers would consolidate respectively, the third and second and the first and fourth largest wholesale distributors of prescription drugs in the United States. If both mergers had been allowed to proceed, the nation’s largest wholesalers would have been reduced from four to two, and those two companies would have a combined market share of up to 80% in the drug wholesaling market.
The two mergers were challenged by the FTC, on grounds that they would violate the antitrust laws by significantly reducing competition in the market for prescription drug wholesaling. The effect of the mergers would be, according to the Agency, the increase in drug prices and reductions in services provided to costumers. The Federal District Court for the District of Columbia consolidated the two cases into one, with the consent of the parties, and the case was litigated for approximately seven weeks. On July 31, 1998, the court enjoined, with a preliminary injunction, the proposed mergers and the four parties abandoned their respective transactions.
Judge’s Sporkin’s opinion addressed a number of substantive issues. The court evaluated the FTC’s theory of anticompetitive effects, analyzed the evidence regarding ease of entry to the relevant market and gave consideration to efficiencies generated by the mergers. The purpose of the paper is to present the characteristics of the drug wholesaling business, analyze the parties’ economic arguments and attempt to evaluate the court’s opinion.
II. The Drug Wholesaling Industry
In 1998, the four companies that proposed to merger into two, controlled close to 80% of the drug wholesaling business, or of all drugs dispensed[1]. They were the only wholesale distributors of prescription drugs (“wholesalers”) in the United States who carried out national operations.[2] Wholesalers operate as “middle-men” between national drug manufacturers and local dispensers. They operate delivery of prescription drugs to the dispensers who can therefore fill prescriptions immediately or at least the next day. These dispensers include, among others, hospitals and other institutional costumers, independent drugstores, and large retail chain pharmacies.[3]
The distribution of prescription drugs from manufacturers to dispensers involves purchase and storage of drugs in anticipation of costumer demand, followed by sale and efficient delivery to individual dispensers.[4] More specifically, wholesalers purchase branded and generic drugs from different manufacturers and create an inventory of a full line of those drugs; they subsequently sell them to dispensers and make an overnight delivery to the places where these drugs will be sold to consumers. A retail pharmacist can place an order and receive all drugs needed the next morning, or sooner, without having to order every drug from its own manufacturer. In addition, wholesalers’ services are very important to hospitals, which may need a rare drug on a very short notice; drug wholesalers typically provide 24-hour emergency delivery services.[5]
Wholesalers also provide supplemental services, which include, among others, electronic ordering, electronic invoicing and billing, inventory management systems and reports-analyses of pharmaceuticals purchases. As a result, customers can make better purchasing decisions by confirming the availability and prices of the wholesalers’ stock. In addition, customers may, through computerized information from the wholesaler, negotiate contracts with manufacturers and receive rebates based on product use. Other services include patient counseling programs, local advertising and promotional materials.[6] Costumers use primary and secondary wholesalers. If the former fail to fill the order on time, the latter may do so on a much higher price.[7]
By using wholesale distributors, both manufacturers and dispensers avoid the costs and inconvenience of making small and infrequent direct deals. In addition, dispensers avoid the costs of maintaining drug inventories and warehousing drugs.[8]
Besides wholesalers’ distribution, the same pharmaceuticals are also available through other three channels of distribution. First, distribution is made by the manufacturers who ship the products directly to dispensers and bypass the need for intermediary distributors. Second, distribution is operated by mail-order pharmacies which receive mail or fax orders from individual costumers and dispense the drugs directly to them, anywhere in the United States. Mail order companies usually buy prescription drugs from wholesalers and not directly from manufacturers. “In that sense, mail order operations are a hybrid between the distribution and retail ends of the pharmaceutical industry”.[9] Last, dispensers may undertake the task of distribution themselves; they may internalize the role of a wholesaler by storing the drugs in their own warehouses and by delivering the stored drugs to their stores or hospitals.[10]
In 1997, wholesalers distributed $55 billion, or 58.5%, of the total of $94 billion dispensed in prescription drugs in the United States. The 41.5% was distributed through the other three channels, mostly by direct distribution from drug manufacturers.[11]
III. The Proposed Mergers
On August 23, 1997, Cardinal Health, Inc. and Bergen-Brunswig Corp. entered into a merger agreement,[12] valued at approximately $2.5 billion.[13] Cardinal Health was, at the time, the nation’s third largest wholesaler of “prescription drugs, over-the-counter pharmaceutical products, and health and beauty aids”.[14] Cardinal is an Ohio corporation headquartered in Dublin, Ohio. At the time of the proposed merger, it operated “26 pharmaceutical distribution centers, four specialty distribution centers, one medical/surgical distribution facility, six packaging facilities, and four specialty centers”.[15] Cardinal Health has grown from many acquisitions throughout its history. With the acquisition of Whitmire Distribution in the fall of 1993, Cardinal rose from the nation’s sixth largest wholesaler to third place, with annual sales of $5 billion.[16] The company had also acquired other related businesses in the industry, which included the pioneer manufacturer of automated vending machines which dispense pharmaceuticals and hospital supplies to the staff of medical institutions[17] and the nation’s largest franchiser of independent retail pharmacies.[18] In 1997, Cardinal signed a five-year $9 billion contract to provide drugs for the 1,500 Kmart’s in-store pharmacies.[19] For the 1997 fiscal year, her after-tax net earnings on pharmaceuticals were the highest in the industry[20].
Bergen was based in Orange, California and was, at that time, the country’s largest supplier of pharmaceuticals to the managed care market and the second largest wholesaler of pharmaceuticals in the United States.[21] Since 1978, it expanded by acquiring several other drug wholesalers and became the second largest in 1992 after the acquisition of Dirrfilauer in the southeastern part of the country.[22] At the time of the proposed merger, it operated 31 pharmaceutical distribution centers, an alternate site and depot facilities.
Cardinal proposed to acquire all of the voting shares of Bergen in a stock-for-stock merger. Cardinal and Bergen announced that they would consolidate their 54 distribution centers into 29, including the opening of a few new facilities.[23]
One moth later, on September 22, 1997, McKesson Corp. and AmeriSource Health Corp. also announced their agreement to merge.[24] Their plan of merger was the acquisition by McKesson of all of AmeriSource’s voting shares in a stock-for-stock merger. The goal was the consolidation of their 54 distribution centers into 33, primarily by closing all of AmeriSource’s existing facilities.[25]
McKesson, based in San Francisco, California, was at the time, the largest full-service wholesaler of prescription drugs, both in the United States and Canada.[26] In 1996, it successfully acquired the business and assets of the bankrupt fourth largest wholesaler of prescription drugs. In December 1995, it began to integrate vertically by acquiring businesses related to the distribution of pharmaceuticals and relevant supplies.[27]
AmeriSource was the fourth biggest wholesaler of pharmaceuticals and health care products in the United States. It was headquartered in Malvern, Pennsylvania.[28] At the time of the merger, it operated 19 drug distribution centers and three other distribution facilities for specialty products. The company expanded by acquiring other drug wholesalers, since 1978, and attained national status 1996, last from the four merging companies.[29]
All four companies, as their respective histories indicate, acquired drug wholesale distributors and related businesses to consolidate operations, horizontally as well as vertically, and achieve greater economies of scale. In this case, McKesson’s announced that the merger was determined as a necessity in order to compete with the Cardinal/Bergen post-merger company.[30] However, “rumors abounded that McKesson’s plan was a strategic move designed to force the FTC to block the Cardinal/Bergen Brunswig merger”.[31] Although McKesson’s officials insisted that their merger plan was not related to Cardinal’s, commentators expressed the opinion that the two mergers were linked, and that McKesson wanted the FTC to view the mergers together. If Cardinal’s merger with Bergen had not been blocked, McKesson would have lost its number one place in the industry. It is very likely that the FTC would either allow or block both mergers. In either case McKesson would have retained the top spot.[32]
IV. FTC’s Challenge
The government’s arguments against the proposed mergers focused on product market definition and framed a unilateral effects theory which was supported by unease of entry and lack of sufficient efficiencies.
A. The Relevant Product Market
The FTC argued that the relevant product market is the wholesale distribution of a full line of prescription drugs, which are delivered to the point of sale on a next-day or more frequent basis. The wholesale distribution includes the provision of services related to such distribution. “Narrower markets include drug wholesaling to particular classes of costumers, including hospitals and other institutional costumers; independent drugstores; and chain drugstores”.[33]
The Agency’s market definition claim was based first on the argument that “wholesaling is a unique bundle of products and services”.[34] Testimony submitted by the Agency, showed that defendants developed a package of wholesaling services. In marketing their product, defendants emphasized why this bundle of services is different from other channels of drug distribution[35]. The FTC, focusing on the cross-elasticity of demand between the product and possible substitutes, also presented costumers’ interviewswho stated that they would not seek to purchase directly from manufacturers even if the prices charged from wholesalers increased[36] 5-10% or more.[37] Different types of costumers, when asked, indicated that they found drug wholesalers’ services unique, because only wholesalers can provide a full line of prescription drugs, both branded and generic, and a wide range of brands, delivered to individual sites once everyday or on a more frequent basis, even within few hours after the placement of the order. According to the interviews, these needs cannot be met efficiently by direct purchases from the manufacturers.[38] In addition, the Agency presented evidence which demonstrated the significance of value-added services offered by wholesalers to their costumers.[39]
Further, the Agency put forward a second basis for its product-market-definition claim by arguing that “direct purchasing and self warehousing are not viable options”[40] to drug dispensers. According to depositions, hospitals and institutional costumers cannot make significant direct purchases because of lack of resources and infrastructure and they require a high quality and accuracy of delivery and other services. Independent drug stores and chain pharmacies purchase from wholesalers because it is more cost effective than to buy from manufacturers. Some of the large chains purchase directly from manufacturers and store drugs to their own warehouses but “this self-ware-housing is very different in scope and character from the cluster of services drug wholesalers provide”.[41] All types of costumers stated that they would not switch to direct purchases from manufacturers even in the event of an increase in the upcharge.[42]
Overall, FTC contended that other means of distribution should be excluded from the relevant market because they are not alternatives to which customers would switch in response to the defendants’ exercise of its increased market power.[43]
With respect to the relevant geographic market, the Agency claimed that the nation as a whole was a market. Many costumers identified by the FTC, such as Koeagal and Giampolo,[44] require wholesalers’ services throughout the country. In addition, even local costumers benefit from national competition, because they have access to buying groups, such as MMCAP (representing 30 States), which negotiate for better prices and services at the national level.[45]
B. The Potential Adverse Competitive Effects[46]
“The effect of the proposed acquisition[s], if consummated, may be substantially to lessen competition in the relevant market(s) by, among other things, eliminating an effective competitor, and eliminating or reducing substantial actual competition between Cardinal and Bergen [McKesson and AmeriSource], thereby increasing the likelihood of anticompetitive activity in the relevant market(s) once this [these] acquisition[s] is [are] consummated. Moreover, these anticompetitive effects would be heightened by another proposed merger in the same relevant markets, if McKesson Corporation [Cardinal Health, Inc.] consummates its proposed acquisition of AmeriSource Health Corporation [Bergen Brunswig Corporation]”.[47]
The FTC put forward a unilateral effects theory[48] and further took the position that the merger would also enhance the likelihood of collusion.[49] Before analyzing the theory, the FTC established its prima facie case on the basis that the mergers would significantly increase concentration in the relevant market.[50]
1.Increase in Concentration:[51] According to the FTC, Cardinal’s market share after the merger would increase from 17% to over 40% (increasing the HHI by 775 to 2333) and McKesson’s market share would increase from 24% to about 38% (increasing the HHI by 663 to 2242). If both mergers were consummated, the level of concentration would rise from 1579 to 2996. The merger is presumed to be anticompetitive, if the post-merger HHI is over 1800 and the increase in the HHI is over 100 points.[52] Both mergers would have an overwhelming effect. However, the Agency did not base its case only to the presumption, but also to other evidence that proved that the mergers were in fact likely to reduce competition.
2.Removing Excess Capacity: The Agency presented some of the Defendants’ documents which suggested that the merger was a way to remove excess capacity from the market and to reduce consequently vigorous price competition. Excess capacity compelled the four Defendants to cut prices and improve services. “The Defendants hope that consolidation will be the antidote for their capacity-price problem”.[53] The elimination of excess capacity would lead to higher prices or at least to prices not as low as they would have been without the merger.[54]
The FTC’s economic expert testified that actual “head-to-head competition” between the merging parties had been an important factor in the fall of prices in the recent years and presented to the Court an “economic computer simulation bidding model” that estimated the extent of price increases expected after the merger. Professor Shapiro used “one period sealed bid models” to show that price would increase when the number of bidders decreased.[55] The economic expert also testified “the theoretical relationship between excess capacity and the incentive to compete aggressively”.[56] After the mergers the market would be transformed to one, where each of the two firms could safely “slash capacity and raise prices” with little concern that its sole rival would fail to do the same.[57] However, the court gave no real consideration to these models because their assumptions differed from actual industry conditions and they used some chain pharmacies bids which the court thought were unlikely to sustain anticompetitive impact. Moreover, the economic expert himself noted the limits of these models.[58]
The FTC argued that the elimination of excess capacity harmed consumers by reducing price competition and by decreasing the level of services provided to consumers. The reduction of services would increase health care costs, even if the wholesalers’ prices staid stable.[59]
3.Coordinated Interaction between Cardinal and McKesson: A small part of FTC’s economic expert testimony contemplated coordinated interaction. The Agency asserted that the “four to two situation” would make it easier for the two post-merger national players to coordinate their behavior. Since each firm would already know the prices of the other firm, because of the transparency of the bids in this market,[60] the two firms could enter to a tacit agreement that they will “not go after each other’s customers” by eliminating price competition. The FTC presented additional evidence that proved a history of coordination between the drug wholesaling companies.[61]
C. Entry
Entry in the market is considered “easy” if it would be timely, likely and sufficient to deter or counteract the adverse effects of the merger, in other words to return market prices to their premerger levels.[62] The FTC argued that “substantial and effective entry into the relevant market(s) is difficult”.[63] The Agency claimed that de novo entry as a local or regional wholesaler would involve significant sunk costs in inventory and information systems. In addition, an entering small wholesaler would not be able to face the significant ability of the post-merger firms to obtain drugs with lower variable costs. Entry at a national level would be even more impractical, because it would require huge expenditures to built distribution and information systems able to compete with the national wholesalers.[64] The FTC also pointed out that “fringe” firms would find it too risky or too costly to expand at a national level, and that they had not increased significantly their market shares in many years.[65]