United States: United States v. Arch Coal, Inc.: U.S. District Court Rejects Likelihood of Anticompetitive Post-Merger Coordinated Interaction Among Leading U.S. Coal Producers

In August of 2004, Arch Coal, Inc. ("Arch") successfully rebutted the Federal Trade Commission’s ("FTC" or "Commission") claim that the acquisition by Arch of Triton Coal Company, LLC ("Triton") would substantially lesson competition among leading coal producers in Wyoming’s Southern Powder River Basin ("SPRB"). On August 16, 2004, the U.S. District Court for the District of Columbia rejected the FTC’s request to enjoin the acquisition pending an administrative hearing.¹ Four days later, the U.S. Court of Appeals for the District of Columbia Circuit declined the FTC’s request for an emergency stay of the merger pending appeal.² Arch announced completion of the acquisition that same day.

The decision, rendered after a two-week trial, ended a 16-month long investigation by the FTC, which began shortly after Arch agreed to buy Vulcan Coal Holdings, Triton’s sole owner, for $364 million in May 2003. The FTC informed the Court of Appeals on September 9, 2004, that it would not pursue an appeal of the District Court’s decision. The following day the FTC also abandoned its plans to hold an administrative hearing to review the transaction before an administrative law judge.³

Arch Coal raises important issues regarding coordinated effects analysis and customer testimony for firms contemplating mergers or acquisitions. In particular, the District Court rejected the FTC’s theory of coordinated interaction, finding the agency’s reliance on postmerger output collusion to be a "novel" approach to coordinated effects analysis. This aspect of the Court’s opinion generated much criticism from the FTC, and was ultimately rejected by the Court of Appeals. However, as in the recent United States v. Oracle⁴ decision, the Court found customer concerns regarding the transaction unpersuasive. This is significant as the agencies traditionally place great emphasis on customers’ views when determining whether to challenge a transaction.

Arch and Triton extract coal from Wyoming’s SPRB, which accounts for approximately one-third of the coal produced annually in the United States. SPRB coal is known for its low sulfur content, and is the most economical source of fuel that complies with U.S. Clean Air Act sulfur limitations.⁵ Virtually all SPRB coal is purchased by electric power companies for use in their coal-fired steam generating units.⁶ Coal-fired generating plants account for about 92% of all coal consumption, and produce about 50% of all electric power, in the United States.⁷

SPRB mines are divided into three tiers based on coal quality, heat content, and location, with Tier 1 mines producing the highest British Thermal Unit ("Btu") coal ranging from 8600 to 8900 Btu, Tier 2 mines producing a mid-range Btu ranging from 8300 to 8550, and Tier 3 mines producing a low Btu coal ranging from 7900 to 8450.⁸ At the time of the District Court’s decision, seven companies operated fourteen mines in the SPRB, four of which, including Arch and Triton, the Court considered to be the major producers of SPRB coal, each a Tier 1 producer. The Court recognized RAG American ("RAG") as another significant producer in the SPRB, operating mines only in Tier 2 and Tier 3, and found that the remaining two small mines did not significantly compete with the larger mines.

The assets to be acquired by Arch involved Triton’s North Rochelle mine, which operated in Tier 1, and Triton’s Buckskin mine, which operated in Tier 3. In order to help win regulatory approval, Arch agreed to sell the Buckskin mine, which accounted for about 40% of Triton’s coal production, to Peter Kiewit Sons, Inc. ("Kiewit"), a fringe competitor with mining interests outside the SPRB.

After examination of the evidence, the Court considered, inter alia, (a) the relevant product market, (b) the proper measure of industry concentration, (c) the likelihood of tacit coordination among firms remaining post-merger, (d) the FTC’s concerns regarding elimination of an industry maverick, as well as (e) the potential of fringe competitors to defeat a post-merger price increase by the three remaining large suppliers.

The FTC asserted that the acquisition by Arch of Triton would violate Section 7 of the Clayton Act⁹ and Section 5 of the FTC Act¹⁰ because, inter alia, the acquisition may "substantially reduce competition in the SPRB market … substantially reduce competition in 8800 Btu SPRB coal … [and] would make coordination among SPRB producers, and among producers of 8800 Btu SPRB coal, easier, more likely, more successful, and more durable."¹¹ Due to the low sulfur, ash, and sodium content, as well as exceptionally low mining costs associated with SPRB coal, the FTC argued that SPRB coal has a strong economic advantage in supplying many electric generators compared to coal produced in other regions of the United States.¹² The FTC asserted that 8800 Btu coal produced in Tier 1 is functionally and economically distinct from the 8400 Btu coal produced in Tier 2 and Tier 3 because more 8400 Btu coal must be transported and burned in order to generate the same heat output as would be generated from the same quantity of 8800 Btu coal, and because some customers experienced performance problems such that they could not substitute 8400 Btu coal for 8800 Btu coal, regardless of economics.¹³

However, in both trial testimony and depositions, virtually all of the testifying utilities acknowledged that they can and do purchase and consume both 8800 and 8400 Btu coal, and that even customers having a preference for 8800 Btu coal have used other Btu coal and have benefited from competition between 8800 and 8400 Btu coal.¹⁴ Based on the reluctance of the FTC’s own expert to conclude that 8800 Btu coal is a separate relevant market, and on evidence of significant interchangeability between 8800 and 8400 Btu coal, the Court concluded that the relevant product market is "no broader and no narrower than SPRB coal."¹⁵ The Court reasoned that "[i]n determining interchangeability . . . the court must consider the degree to which buyers treat the products as interchangeable, but need not find that all buyers will substitute one commodity for another."¹⁶

The Herfindahl-Hirschman Index ("HHI") is used by the U.S. antitrust agencies to measure the impact of a merger or concentration within a relevant market.¹⁷ Sufficiently large HHI figures establish a prima facia case that a merger is anticompetitive.¹⁸ The merging parties urged the Court to measure HHI based on reserves of recoverable coal,¹⁹ while the FTC argued that the Court should use loadout capacity²⁰ as well as other factors. Because the Court found reserves, loadout capacity, production and practical capacity²¹ to all be informative, yet imperfect, indicators of the merged firm’s future ability to compete, the Court considered all of the measures in assessing whether the FTC had established a prima facie case for an anticompetitive merger.

Given that all of the measures resulted in an increase in HHI sufficient to indicate significant competitive concerns, and possibly a presumption of an anticompetitive merger, the Court found the FTC had established a prima facie case of an anticompetitive merger.²² However, because the postmerger increases in HHI were "far below those typical of antitrust challenges" brought by the FTC and Department of Justice ("DOJ"), the Court concluded that the FTC’s prima facie case was not strong, and that, by pointing out shortcomings in the HHI measurements, the parties had rebutted that presumption.²³ Thus, the Court concluded that the burden shifted back to the FTC to prove that competitive effects would be likely to substantially lessen competition in the relevant market.²⁴

While the case law concerning Section 7 has developed largely based around theories of coordinated interaction,²⁵ until recently, the agencies alleged coordinated effects only as a secondary theory of harm and relied instead on unilateral effects to establish that the merged entity likely would harm competition.²⁶ In recent years, however, the agencies have placed a new emphasis on coordinated effects analysis as evidenced by the 2003 decision in United States v. UPMKymmene Oyj,²⁷ and the FTC’s 2002 decision not to challenge the merger of certain cruise lines.²⁸

Consistent with the recent emphasis on coordinated interaction, the FTC’s theory in Arch Coal regarding likely harm to competition focused on post-merger tacit coordination among the remaining competitors.²⁹ The FTC theorized that post-merger "the major producers would constrain their production so that increases in supply would ‘lag’ increases in demand, thus creating upward pressure on price."³⁰ The District Court observed that the theory advanced by the FTC required the agency to "show projected future tacit coordination, which itself may not be illegal, which is speculative and difficult to prove, and for which there are few if any precedents."³¹

Perhaps the most significant aspect of the Court’s coordinated effects analysis was that it distinguished coordinated effects challenges based on price coordination from those based on output coordination: "prior coordinated effects challenges to mergers based on alleged output coordination have invariably been accompanied by a coordinated effects theory grounded on price coordination."³² In so finding, the Court reasoned that "[t]he novel approach taken by the FTC in this case makes its burden to establish anticompetitive effects in the post-merger SPRB market more difficult."³³ In other words, the government must meet a higher burden of proof when it attempts to establish that competition is likely to be harmed post-merger as a result of output coordination than when it attempts to establish the likelihood of harm based on post-merger price coordination.

The FTC took issue with the District Court’s coordinated effects analysis, and the subsequent Order of the Court of Appeals found that the FTC’s theory was not novel. The FTC argued that the reasoning of the District Court was inconsistent with much of the legal and economic theory that has developed to analyze the competitive effects of mergers: "the court failed to apprehend the fundamental economic principle that output is the flip side of price."³⁴ The government asserted that the SPRB is a non-cooperative oligopoly,³⁵ and relied on economic literature which declares that a firm in such a market maximizes profits at a higher price when the output of the firm’s rivals decreases.³⁶ According to the FTC, in a market characterized by oligopoly pricing, "[c]ollusion [can be] effectuated by a purely tacit meeting of the minds, a mutual forbearance to carry production to the point where price equals marginal cost."³⁷ The FTC supported its argument by citing to a number of precedents holding that "[w]here rivals are few, firms will be able to coordinate their behavior, either by overt collusion or implicit understanding, in order to restrict output and achieve profits above competitive levels."³⁸

In its request for an emergency order from the Appeals Court to enjoin the transaction, the FTC sharply criticized the District Court, asserting that "[t]he only ‘novelty’ in this matter is the district court’s abandonment of well-established principles of merger jurisprudence – a departure inspired by the court’s failure to grasp the basic economic principle that output restrictions often are the means by which rivals collectively raise prices."³⁹ The Court of Appeals for the District of Columbia agreed with the FTC, noting that "there is nothing novel about the theory it has advanced in this case."⁴⁰

Another important aspect of the coordinated effects analysis concerns the FTC’s argument concerning the degree of coordination necessary to violate the antitrust laws. In its discussion of the potential anticompetitive harm resulting from the acquisition, the Court noted that "a coordinated restriction in production will not necessarily decrease total SPRB coal production."⁴¹ The FTC argued, however, that the coordinated effects theory of harm does not require post-merger output to be less than pre-merger output, nor does it require post-merger price to be greater than the premerger price. Rather, the government has long contended that the coordinated effects theory merely requires a substantial likelihood that, as a result of tacit or express collusion among the remaining firms, price will likely be greater, or "output [] will likely be less than it would have been absent the [a]cqusition."⁴²

While the Court of Appeals agreed that the FTC’s theory of post-merger coordinated interaction based on output restriction was not novel, the Court nonetheless concluded that the FTC had not met the standard for an injunction pending appeal. The decision of the Court of Appeals was guided by the District Court’s fact-intensive opinion, which relied heavily on specific characteristics of the SPRB in determining whether the transaction would result in a substantial likelihood of post-merger coordinated interaction.

In order for a merger to result in anticompetitive coordination among the remaining firms, they must overcome three problems – first identified by Professor George Stigler in 1964 and then set forth in the Merger Guidelines – that stand in the way of coordinated interaction: (1) reaching an understanding as to the terms of coordination, (2) detecting deviations from that understanding, and (3) punishing firms that deviate from the agreed upon terms.⁴³

In reaching conclusions regarding the ability of firms remaining post-merger to meet these conditions, the agencies have traditionally relied on (1) the economic presumption that prices on average tend to be higher in highly concentrated markets, (2) an analysis of a checklist of factors set forth in the 1992 Merger Guidelines which tend to indicate whether a market is conducive to post-merger coordinated interaction, and (3) evidence of prior collusion among industry competitors.⁴⁴

The District Court found a number of market factors conducive to coordination that made tacit coordination by the major SPRB producers feasible. Specifically, the Court found that (1) based on the resulting increase in concentration in the highly concentrated SPRB, "at a minimum the proposed transactions raise significant competitive concerns and … there may even be a presumption of an anticompetitive increase in market power;"⁴⁵ (2) the market has many of the characteristics that facilitate coordinated interaction (e.g., high entry barriers, inelastic demand, availability of key market information);⁴⁶ and (3) SPRB producers have repeatedly evinced their desire to pursue a strategy of limiting production in order to raise prices.⁴⁷

However, the Court ultimately concluded that the following factors tending to impede coordination in the SPRB outweighed the factors conducive to coordination: (1) the transactions increased concentration levels in the SPRB only modestly;⁴⁸ (2) the same number of firms would compete in the post-merger SPRB market as in the premerger market;⁴⁹ (3) a "stronger competitive force" would be substituted for "a relatively weak competitor";⁵⁰ (4) the SPRB market is a competitive market with no historical evidence of actual express or tacit anticompetitive coordination;⁵¹ (5) the acquired company had not been, and was not likely to be, a maverick in the SPRB;⁵² (6) "fringe" producers would be strong competitors in the post-merger SPRB market;⁵³ (7) the heterogeneous nature of SPRB coal and the mines that produce the coal;⁵⁴ and (8) lack of accurate pricing, supply and demand information.⁵⁵

Based on the above, the Court concluded that coordination would be unlikely because a tacit agreement among the remaining competitors would be "difficult to coordinate[,] it would be hard to identify deviations from any agreement to limit production[,] and there is no effective mechanism in the SPRB to discipline producers who deviate from the terms of coordination."⁵⁶

As noted above, one factor in the District Court’s conclusion that the merger would not result in anticompetitive coordinated effects was that the transaction would not eliminate an industry maverick. When analyzing possible anticompetitive effects likely to result from a merger or acquisition, an important consideration is "whether the acquisition ‘would result in the elimination of a particularly aggressive competitor in a highly concentrated market.’"⁵⁷ The Merger Guidelines define a "maverick" firm as "one possessing a greater economic incentive to deviate from the terms of coordination than those of its rivals."⁵⁸ For example, "firms that are unusually disruptive and competitive influences in the market."⁵⁹

According to the FTC, while other producers exercised production discipline in order to stabilize prices in the SPRB, Triton rapidly expanded production at its North Rochelle mine.⁶⁰ The FTC asserted that Arch recognized that an acquisition of Triton would eliminate an "undisciplined" producer and enable Arch more effectively to control production to match demand.⁶¹

However, the District Court found that Triton’s North Rochelle mine "is one of the highest cost mines in the SPRB."⁶² Due largely to debt financing obligations, Triton "bids its North Rochelle coal at a price that covers its cost plus a profit and waits for the market to come to that price as other mines in the SPRB sell out."⁶³ Consequently, "Triton is wholly indifferent to competitors’ production levels or their likely uncommitted tonnage in pricing its North Rochelle coal."⁶⁴

In assessing whether Triton’s behavior in the SPRB was consistent with that of a maverick firm, the Court quoted FTC and DOJ officials: in order to be a maverick in an auction market, a firm must "consistently compete aggressively when it bids, causing other firms to bid more aggressively when it is present."⁶⁵ The Court ultimately concluded that "Triton does not lead or even influence pricing in the market, does not compete aggressively, and does not have a history of bidding on contracts consistent with the behavior of a maverick in the SPRB market."⁶⁶

The FTC alleged that entry and expansion by fringe competitors in the SPRB "would not be timely, likely, and sufficient in its magnitude, character, and scope to deter or counteract the competitive effects of the [a]cquisition."⁶⁷ In particular, the FTC asserted that the transfer by Arch of Triton’s Tier 3 Buckskin mine to Kiewit would not remedy the potential anticompetitive effects, and the "fringe" competitors, Kiewit and RAG, would not be able to constrain a coordinated price increase in the SPRB.⁶⁸

The District Court disagreed with the FTC’s assessment of the SPRB competitive fringe. The Court found that both Kiewit and RAG had "credible plans to expand production significantly and lessen the risk of coordination in the market."⁶⁹ The Court concluded that the evidence demonstrated Kiewit and RAG "could, and likely would, expand production to meet any production constraint by the major SPRB producers."⁷⁰ Accordingly, the Court found "[d]efendants’ have shown that the post-merger fringe capacity in the SPRB would be more than sufficient to absorb any increase in demand caused by any production lag coordinated by the ‘big three’ producers … over the next three years."⁷¹

As is typical in government merger challenges, the FTC presented customer and competitor testimony concerning competition in the SPRB. Much of the testimony indicated that, "as the number of producers [in the SPRB] has fallen, the market has become more conducive to coordinated interaction."⁷² Numerous utilities customers testified that "the SPRB is susceptible to coordinated interaction" and the combination of Arch and Triton likely would "increase the risk of such coordination."⁷³

The District Court placed little weight on the testimony, however, noting that "[c]ustomers do not ... have the expertise to state what will happen in the SPRB market."⁷⁴ The Court’s dismissal of this testimony is significant as customer views play a major role in the analysis of mergers by the agencies.

Surely, customers are not antitrust nor economic experts. As a consequence, customer testimony can often be an unreliable indicator of the likely effects of a hypothetical price increase.⁷⁵ Nonetheless, the FTC took issue with the Court’s conclusion, arguing that strong customer complaints are the leading indicator of whether the FTC will challenge a merger.⁷⁶ The FTC also argued that customer testimony is often influential in the courts.⁷⁷ This case and the recent Oracle decision, however, suggest that customer testimony now is being scrutinized much more closely before being credited by a court in a merger case.⁷⁸

The District Court’s opinion in Arch Coal was not welcomed by government antitrust enforcement officials. If followed by subsequent courts, the decision would substantially raise the bar with respect to the evidence that the agencies must put forth in order to obtain a preliminary injunction. Specifically, the decision increases the government’s burden when attempting to demonstrate potential harm to competition based on evidence of likely post-merger output collusion. In addition, the decision reduces the role of customer testimony concerning the likely competitive effects of mergers and acquisitions.

Considering that the Court of Appeals rejected the District Court’s opinion concerning the FTC’s coordinated effects theory, however, the government is likely to continue to rely upon its traditional legal and economic analyses concerning pricing and output behavior when challenging mergers in concentrated markets. Further, the Court of Appeals did not reject the District Court’s opinion regarding customer concerns. This decision, as well as the government’s recent loss in the Oracle case, suggest a heightened evidentiary standard regarding customer testimony that the government will have to meet in order to rely on customer opinion when attempting to sustain merger challenges in court.

Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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