NEW YORK (The Deal) -- Sysco (SYY) chief executive Bill DeLaney is gearing up for a big court fight over the Federal Trade Commission's lawsuit to block his company's $8.2 billion deal to buy rival broadline food distributor US Foods.
Although Sysco and US Foods clearly understood their deal carried antitrust risk, they had been optimistic about getting federal approval because in recent years a handful of transactions that appeared to be presumptively anticompetitive were cleared by regulators after the parties showed that their customers were being serviced by a variety of competitors.
Those deals included the Office Depot (ODP) merger with OfficeMax in 2013, cleared after the FTC found that the office supply business is no longer dominated by specialized bi- box retailers but has competition from general retailers and online providers. Another was the commission's 2012 unconditional approval of Express Scripts' (ESRX) $28 billion purchase of rival pharmacy benefits manager Medco Health Solutions. In the Medco deal, the FTC found that despite the already high market shares held by the big three pharmacy benefit managers, which included the merging parties and CVS Health (CVS), there was also new competition from a growing number of health plan-owned PBMs and smaller stand-alone PBMs.
Given those FTC approvals, it's understandable why DeLaney was taken aback by the government's challenge to his transaction. Like the OfficeMax and Medco transactions, acquiring US Foods would combine his firm with a very similar, very large competitor. But also like those deals, his customers were being served by numerous competitors with different business models, sizes and geographic footprints than his company's. When the FTC announced its challenge to the US Foods deal on Feb. 19 he accused the commission of disregarding "the existence of myriad local suppliers, including broadline companies, specialty companies, cash-and-carry, and club stores with whom Sysco and US Foods compete on a daily basis."
Bruce Sokler, chairman of the antitrust section at Mintz, Levin, Cohn, Ferris Glovsky and Popeo, said he's not surprised by DeLaney's frustration. Transactions between close competitors these days are likely to fall into a gray area when it comes to predictability. "The regulators' views on markets are evolving and they have been demonstrating a decided willingness to take fresh looks," he said. "That the Office Depot/OfficeMax deal would have had a different result 15 years ago shows that."
However, the regulators' willingness to rethink how they decide which companies are considered part of any given market doesn't always work in favor of merging parties, Sokler noted. AT&T (T) learned that lesson the hard way when the Department of Justice scotched the company's plan to acquire T-Mobile US (TMUS) in 2011, in large part because the DOJ found there was a national market for wireless service. Previously, wireless deals had been judged based on how they affected competition in individual local markets.
Sysco too was caught off guard by the FTC's assertion that there was a national market for food distribution to institutional clients such as Sodexo that provide food management to schools, nursing homes, military installations and other institutions.
"Sysco was not the first time regulators looked at antitrust issues in terms of national customers and contacts," Sokler said. "In Medco/Express Scripts they found there were certain types of accounts that were national and when they looked at the bids for that business, other people besides the big three were finalists and that the market would still be competitive for those types of customers. Apparently the FTC staff came to the opposite conclusion with Sysco/US Foods."
Sysco officials and their lawyers have made clear they intend to fight the FTC aggressively in court. The fate of the merger is likely to be decided during a trial that begins May 5 and could last up to seven days. That trial is intended to decide only the FTC's request for a temporary order halting Sysco's plan to close the deal while the FTC holds an in-house trial to decide whether the merger should be permanently barred. But Sysco attorney and O'Melveny & Myers partner Richard Parker has said his team will present such a compelling case that the federal judge will deny the FTC's request for a preliminary injunction and once the merger closes the FTC will drop its in-house attempt to break up the merger.
"We expect to prevail in that case and would expect such a strong opinion from the judge that the [FTC's] administrative trial will never happen," Parker said.
If the FTC wins the preliminary injunction, Sysco is expected to cancel the merger rather than keep fighting.
The FTC, in its complaint challenging the merger, argued that "Sysco and US Foods are unambiguously each other's closest competitor." The commission added that some national customers consider the companies, with their "similarly vast networks of distribution centers, sales forces, fleets of delivery trucks and other competitive advantages," the only viable options for their broadline distribution needs.
Broadliners have the large product portfolios and sales forces, private label products and customer service that other types of distributors don't have, according to the FTC. Other features that national customers get from Sysco and US Foods are centralized contracting, consistent pricing, a single point of contact, consistent product availability, single reporting and auditing, efficient contract administration and volume discounts, the FTC said.
Few members of the antitrust bar who spoke to The Deal share Parker's outrage over the FTC's challenge. They say U.S. District Judge Amit P. Mehta will decide the case on specifics of the transaction and that it's too early to judge the strength of the FTC's case.
Jonathan Gleklen, head of Arnold & Porter's U.S. antitrust practice group, said each antitrust review turns on the unique facts of the transaction.
"I don't think the Sysco case is inconsistent with other deals" that got approved, he said. "Antitrust is very fact-focused. The parties to every deal need to figure out who their competitors are and whether they price in response to discounting by other players. That is knowable by the parties when they do a deal."
Unpredictability emerges when the FTC also factors in what customers will say about the merging parties' business practices and how the deal will affect them. "What customers will tell the government is harder to know before you do the deal," Gleklen said.
The uncertain nature of what the regulators will conclude or what customers will say predates today's world of new online competition and rapidly changing technology that merging parties are contending with.
Gleklen pointed out that the FTC in 2002 challenged plans to merge Claussen Pickle and Vlasic Pickle. The FTC said the deal would have created a monopoly in the market for refrigerated pickles and rejected the companies' argument that unrefrigerated pickles marketed by other providers ensured that the pickle market would remain competitive.
"Maybe it was obvious to some that refrigerated and unrefrigerated pickles don't compete, but I presume the parties wouldn't have done the deal if they hadn't had a good argument that pickles compete with pickles," Gleklen said
There's always one question merging parties should ask, he added: "Who competes with you and who constrains your pricing?"
Ken Vorrasi, co-chair of the antitrust practice at Drinker Biddle & Reath, said merging parties should start trying to convince regulators of a market's changing dynamics early in a competition review. "It doesn't mean the government will ultimately agree, but that can improve the odds."
Parties will have an uphill battle, however, if they paint their customers as monolithic, Vorrasi said. In the Sysco case, the notion that customers can be segmented into groups that might not be served adequately by local food distributors and cash-and-carry stores is not an implausible one for the FTC to make, he said. There are large and small and nationwide customers, and a deal could inflict anticompetitive effects on one segment and not on another.
Sysco has argued that the FTC's assertion that there is a national market for broadline distribution services is mistaken, that food in the U.S. is distributed in local markets with a lot of choices and that the FTC excluded buyers that purchase products from so-called "cash and carry" wholesalers such as Restaurant Depot that require customers to pay for and pick up their purchases in person. In arguing harm to local markets the FTC counted only the distributors based there and excluded outside distributors willing to ship long distance.
But Vorrasi cautioned that the FTC hasn't come up with its arguments in a vacuum. "Where is the FTC getting that information? It's almost always the customers in a market. Hyatt (H) is not going use some cash-and-carry in Poughkeepsie to service hotels in New York City," he said.
For all the arguments on the FTC's side, Mintz, Levin's Sokler cautioned that the case isn't a slam dunk for the government. He noted that the commission vote to bring the case was split along partisan lines, and he argued that the decision to argue that the deal not only harmed customers who buy nationally but also to "bolster" the complaint with the additional charge that many local markets were being harmed shows that the FTC was wary of bringing a case that focused only on the national harms.
Roxann Henry of Morrison & Foerster said the agencies have been more willing to explain their rationale for merger decisions in recent years, as evidenced by their update of the horizontal merger guidelines in 2010 and their increasing use of closing statements to explain why a deal was cleared.
The Sysco litigation may add to that transparency if there isn't a settlement with the government.
"It all comes down to the facts of an individual case and obviously we may learn a whole more about this one if it goes to trial," Henry said. Market definition is a hot topic and this case will be watched very closely in the antitrust bar, she added.