Sunday, 15 January 2012

Messcash: A Comedy of Errors


This article first appeared in the CCH Australian Competition & Consumer Law Reporter, Issue 636, 14 October 2011, pp. 1-6.

Introduction[1]
On 25 August 2011, Emmett J of the Federal Court in Australian Competition and Consumer Commission v Metcash Trading Limited (2011) ATPR  42-368; [2011] FCA 967 decided that Metcash’s proposed acquisition of Franklins would not substantially lessen competition in breach of section 50 of the Competition and Consumer Act 2010 (CCA) (formerly the Trade Practices Act 1974).[2]  Indeed, Emmett J found that the proposed acquisition was likely to enhance competition. 

Subsequently, many commentators in the media trumpeted Emmett J’s decision as a triumph of practical, commercial common-sense reasoning over the Australian Competition and Consumer Commission’s (ACCC) increasingly hypothetical and theoretical approach to merger analysis.[3] The commentary went so far as to suggest that the ACCC’s entire approach to merger analysis would have to change in the light of Emmett J’s judgment.

On 20 September 2011, Jacobsen J denied the ACCC’s application for an interim injunction to prevent the sale.[4]  The ACCC’s appeal will be considered by the Full Federal Court over three days, commencing on 24 October 2011.[5]

A Comedy of Errors
The reality is that Emmett J’s judgment in the Metcash case is deeply flawed and highly unlikely to survive an appeal. The court appears to have ignored binding precedent in relation to market definition and made a number of significant legal and analytical errors in applying the relevant legislation.

Unfortunately, the ACCC also made a number of significant errors in the way it ran its case. These errors ranged from pleading errors to major strategic errors such as selecting the wrong counterfactual prior to the trial and then having to switch to a new counterfactual during the trial.

Background to the case
In July 2010, Metcash entered an agreement to purchase the Franklins Supermarket business for $215m. 

The ACCC opposed the proposed acquisition because it believed it would substantially lessen competition. The ACCC subsequently commenced legal proceedings in the Federal Court to prevent the acquisition from proceeding.

Metcash is a specialist wholesaling company which supplies groceries, fresh produce and liquor products on a national basis.  Metcash supplies independent retailers with grocery products principally under the IGA brand and owns a number of private labels which it makes available to its retail customers.

Franklins operates as both a vertically integrated retailer and an independent wholesaler. Franklins is vertically integrated through its ownership of 80 supermarkets in NSW. It also operates as an independent wholesaler to 10 Franklins franchises in NSW.  Franklins owns the No Frills brand which it makes available to its company owned and franchise stores.

The ACCC’s case
The most significant error made by the ACCC in its case was its failure to amend its pleadings in relation to the relevant market prior to the trial commencing. 

The ACCC initially pleaded that the market was the market for the wholesale supply of packaged groceries to independent supermarkets in NSW and the ACT.  However, a problem arose when the expert for the ACCC, Dr Christopher Pleatsikas, appeared to define a different market to the ACCC’s pleaded market in his expert report. Dr Pleatsikas defined the market as the market for the supply of wholesale services for dry groceries (at {121}).

In order to understand the difference between the ACCC’s pleaded market and the market found by the ACCC’s expert, one has to understand the goods and services which Metcash supplies to its customers. 

Metcash effectively charges its customers for three different things:

·       dry groceries;
·       a service fee for providing a wholesaling service; and
·       a fee for freight. 

In other words, while Metcash charges its customers for the dry groceries (goods), it also charges its customers for two related services – ie wholesaling services and freight services.

The problem for the ACCC arose when Metcash’s lawyers wrote to the ACCC on 2 March 2011 pointing out the discrepancy between its pleaded market and the conclusions contained in its expert report (at {122}).  Metcash’s lawyers invited the ACCC to amend its pleadings at that stage to reflect the market described in the ACCC’s expert report, but the ACCC declined to do so.

Subsequently on the ninth day of the hearing, the ACCC sought leave from Emmett J to amend its pleading to make the same amendment which Metcash’s lawyers had suggested that it make three weeks previously.  Justice Emmett refused the ACCC’s application for leave to amend its pleadings (at {123}).

Justice Emmett’s decision not to grant leave to the ACCC to amend its pleading had profound consequences for the way in which the case was run.  Indeed, the court’s decision meant that the case was effectively fought by the parties on the wrong market definition – ie that the ACCC was concerned that following the acquisition, Metcash would be able to increase the wholesale prices of groceries to independent retailers by between 5-10%. However, the ACCC’s true concern was that following the acquisition, Metcash would be able to increase the price of wholesaling services to independent retailers by between 5-10%.

The practical difference between these two markets is significant. In the pleaded market, the ACCC would have had to prove that Metcash had the ability, following the acquisition, to increase its prices for dry grocery supplies by between 5-10%, which would have amounted to a doubling of its profit margin. However, under the alternative wholesale services market, the ACCC would only have been required to prove that Metcash could have increased its wholesale service fee from, for example, 3% of the value of the groceries supplied to its independent retailers to 3.15% to 3.3%. Obviously it would have been much easier for the ACCC to prove the latter.

Ultimately, the ACCC attempted to circumvent this pleading problem by arguing that the market it has pleaded was effectively the same as the wholesale services market. However, Emmett J did not accept this argument.

The other significant mistake made by the ACCC in the case related to the selection of its counterfactual.  The ACCC claimed prior to hearing, and for the first few days of the hearing, that SPAR was the likely counterfactual in the event the proposed acquisition by Metcash did not proceed. However, it should have been abundantly to the ACCC, based on even a cursory review of SPAR’s financial accounts, that it simply did not have the financial resources to purchase the Franklins business.  SPAR’s total wholesale sales of groceries in each of the 2009 and 2010 financial years was only $150 million (at {76}).[6]

On the other hand, the strength of the alternative consortium headed by Supabarn made it a much superior counterfactual to SPAR.

Not only did the Supabarn-led consortium have greater financial resources, but it had significant wholesale grocery volumes which it could have redirected to Franklin’s wholesale operations. The addition of this volume would have significantly enhanced the overall efficiency of Franklins’ wholesale operations and driven down the costs of providing wholesale services. 

Mr Perlov, the Managing Director of Franklins advised TMT, the advisers to the Supabarn-led consortium, that the Franklins wholesale operations were currently operating at only 60% capacity and that it needed another 20 good stores to achieve scale efficiency (at {373}).  The consortium itself could have added 13 quality stores to the Franklins wholesale operation overnight.

Unfortunately, the ACCC did not recognise that the Supabarn-led consortium was the most likely counterfactual until after the trial had commenced.  The ACCC had to change its position mid-way through the trial by abandoning SPAR and embracing the Supabarn-led consortium as its preferred counterfactual.  The ACCC’s decision to change counterfactuals in the middle of the case significantly undermined the credibility of its arguments in favour of the Supabarn-led counterfactual.

Federal Court Judgment
The first unfortunate decision made in the conduct of the trial was the refusal by Emmett J to allow the ACCC to amend its pleadings.  In deciding not to allow the ACCC to amend its pleadings, the court treated the ACCC as a private litigant to private proceedings, rather than a public interest litigant. The court appears to have taken the view that because the ACCC had not amended its pleadings when it had a chance to do so prior to the commencement of the trial, it had lost its opportunity to do so once the trial started.

Despite the ACCC not being permitted to amend its pleadings to include the wholesale services market, the ACCC still had every right to expect that they would be successful in establishing the market which they had pleaded – namely the market for the supply of wholesale groceries to independent grocers. This was because there was a clear binding precedent which should have determined the issue in the ACCC’s favour.

In 1996 the Full Federal Court handed down its judgment in Davids Holdings Pty Limited & Ors v Attorney-General of the Commonwealth (1994) ATPR 41-304 In this case, Davids was proposing to acquire another independent wholesaler, Queensland Independent Wholesalers.  Therefore, the market definition issues considered in the Davids case were identical, in product and functional terms, to the market definition issues raised in the Metcash case.

The Attorney-General[7] was successful in arguing both at first instance and before the Full Federal Court, that the relevant markets in the Davids case were:

·       the market in Queensland and northern NSW for wholesaling  groceries by independent wholesalers to independent retailers; and

·       the market for retailing groceries, including independent retailers and chain stores.

Not only did the court in Metcash define a different market to the market found by the Full Federal Court in the Davids case, but Emmett J did not discuss the Davids case in his judgment.  It is surprising that Emmett J did not at least try to distinguish the Davids decision as it related to market definition before defining a completely different market.

Unfortunately it is not a simple exercise to state with precision the market which Emmett J ultimately found in the Metcash case.  This is because his description of the relevant market is far from clear. However, it would appear that Emmett J defined the relevant market as follows:

·       the national market for the supply of packaged groceries, encompassing both the wholesale supply of groceries and the retail supply of groceries by independent grocers and vertically integrated chains.

The other significant mistake which the court made in the Metcash case relates to the appropriate counterfactual test to apply in merger cases.  In his judgment, Emmett J defined the counterfactual test as involving the following two-step process (at {146}):

·              “that it is more probable than not that one of the Commission’s counterfactuals will come to pass if the proposed acquisition does not proceed; and

·              that there is a real chance that, if the proposed acquisition does proceed, that would result in a substantial lessening of competition compared to the scenario in which one of those counterfactuals comes to pass.”

While Emmett J cited French J’s decision in the AGL case[8] as establishing the relevant test for assessing competing counterfactuals, a close reading of the two tests shows that Emmett J’s formulation is significantly different to the French test.

In AGL, French J explained the test for assessing the counterfactual as follows:

“The ACCC submits that AGL must satisfy the Court that its hypothesis against any likely substantial lessening of competition in any relevant market is more probable than the competing hypotheses which are advanced to suggest a real chance of competition being substantially lessened in any such market. I accept that formulation of the approach which should be taken in this case. I accept also the proposition advanced by the ACCC that AGL is not entitled to relief if:

(a) the Court is left in a position of uncertainty about the competing hypotheses; or

(b) the Court concludes that the hypotheses suggesting a real chance of competition being substantially lessened are more probable than the opposing hypotheses.[9]

The formulation established by French J in AGL is that the counterfactual has to be “more probable” than the competing hypothesis. This is clearly a relative test which looks at the likelihood of one of two competing hypothesis eventuating. 

However, Emmett J described the counterfactual test differently as requiring that the court be satisfied that the counterfactual be “more probable than not.”  This is an entirely different test to the test established in AGL.

The French test looks at how probable one counterfactual is when compared to another counterfactual.  This means that a counterfactual with say, a 30% chance of occurring would be selected as the counterfactual if the competing counterfactual only had a 20% chance of occurring.  However, under Emmett J’s formulation the only way that any counterfactual could succeed is if its probability of occurring was more than 51% - ie more probable than not.

The mistake of using this test was further compounded by Emmett J’s application of the test to the relevant facts. In his judgment, Emmett J set out an extensive range of factors which the ACCC’s counterfactual would have to meet in order for it to be considered as the likely counterfactual.  The actual application of the test to the facts raised the standard of proof significantly higher than even the balance of probabilities. Indeed the standard bears more resemblance to proof beyond reasonable doubt.

Furthermore, Emmett J did not apply his counterfactual test with the same rigour to the counterfactual put forward by Metcash and Franklins – namely, that there would be a store sale if the acquisition did not proceed.

Conclusions
The claims that Justice Emmett’s judgment represents a triumph of common sense over economic theory are entirely misplaced. Nothing could be further from the truth. 
It was the ACCC which argued a common-sense market definition. The ACCC asked the simple question – to whom will independent grocers turn if Metcash increases its wholesale grocery prices? The ACCC believed that these independent retailers would have nowhere to turn because Franklins was their only viable potential source of wholesale supply.  

In reality, it was the court in the Metcash case which defined the more economically theoretical and speculative market.  The court found that because competition at the wholesaling level is constrained by downstream competition at the retail level, that the functional dimension of the market should be broadened to include this downstream retail competition. Put another way, the court found that Metcash would not increase its prices to its independent retail customers because it would recognise that if it tried to increase its prices to these captive customers, this action would make these customers uncompetitive against Coles, Woolworths and Aldi stores at the retail level which would in time force these customers out of business.    

It is highly unlikely that the decision in the Metcash case will survive an appeal, despite Jacobsen J’s recent comments. The court has made too many fundamental legal and factual mistakes for the judgment to be allowed to stand. 

The remaining question is why has both the ACCC and the court made so many apparent errors.  The simple explanation is “time”.  It is not possible for the ACCC to prepare a merger case properly in the very short time frames imposed upon it by the court.  In both the AGL case and the Metcash case, the ACCC had only a couple of months to fully prepare its cases. It is no coincidence that the ACCC lost both of these cases quite comprehensively.   The court will also struggle to properly adjudicate on all the relevant (and irrelevant) issues raised during a merger case. 

Given the importance of merger analysis under section 50 of the CCA – namely to ensure the future competitiveness of Australian markets in the medium to long term – more time should be given to both the ACCC and the court to get the decision right.

Postscript
On 20 September 2011, the Full Federal Court handed down its decision in Australian Competition and Consumer Commission v Metcash Trading [2011] FCA 1079[10], rejecting the ACCC’s appeal against Emmett J’s judgment. Accordingly, my prediction that Emmett J’s judgment would not survive an appeal has proven to be incorrect. 

I will be discussing the Full Federal Court’s Metcash decision in an upcoming post, where I will be arguing that the Court’s decision should be characterised as Act 2 (and fortunately the Final Act) in the Messcash Comedy of Errors.  



[1] I acted for TMT, the financial adviser to the Supabarn led consortium, in the Metcash case.
[2] Australian Competition and Consumer Commission v Metcash Trading Limited [2011] FCA 967 (25 August 2011) -
http://www.austlii.edu.au/au/cases/cth/FCA/2011/967.html

[3] For example Bryan Firth, “Metcash black eye puts ACCC's new boss Rod Sims in a spot”, The Australian, http://www.theaustralian.com.au/business/opinion/metcash-black-eye-puts-acccs-new-boss-rod-sims-in-a-spot/story-e6frg9kx-1226122403750

[4] Australian Competition and Consumer Commission v Metcash Trading Ltd [2011] FCA 1079 (20 September 2011) -
http://www.austlii.edu.au/au/cases/cth/FCA/2011/1079.html

[5] See Postscript at end of article.
[6] I expressed the view to the ACCC’s lawyers prior to the Metcash trial commencing that they were arguing the wrong counterfactual and should change their focus from SPAR to the Supabarn-led consortium.
[7] The Davids proposed acquisition of QIW was challenged under section 50 of the Trade Practices Act 1974, by the Commonwealth Attorney General.
[8] Australian Gas Light Company v Australian Competition and Consumer Commission (No. 3) [2003] 137 FCR 317.
[9]  AGL at 356.

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