Two recent court decisions show that mergers raise competition law risks well beyond the obvious risks arising from the merger itself being considered to substantially lessen competition.
Section 47 of the Commerce Act 1986 prohibits a merger that substantially lessens competition in a market. However, additional serious competition law issues can arise in relation to mergers (or attempted mergers) regardless of whether a proposed merger itself would substantially lessen competition.
The first case (Commerce Commission v First Gas Ltd  NZHC 231) involved the giving by a vendor of an overly wide restraint of trade provision in support of the sale of a business.
The second case (ACCC v Cryosite Ltd  FCA 116) involved the agreement by a vendor to refer new sales enquiries to the purchaser in advance of completion of a proposed merger.
Both cases involved the imposition of million dollar penalties by the courts. The cases are, however, merely two examples of the potential second layer of competition law issues that attend merger negotiations. Some further examples are provided at the end of this article.
Overly wide restraint of trade provisions in support of a merger
The First Gas case was the subject of a judgment by Mallon J on 21 February 2019. The case concerned First Gas’s acquisition of GasNet’s gas distribution network in Papamoa, a suburb of Tauranga.
The case involved two issues.
First, that the merger itself was a breach of s 47 as it had the effect of substantially lessening competition in a market for the construction of gas distribution networks in new subdivisions in the Bay of Plenty. I won’t discuss that part of the case.
The second issue in the case concerned a Commerce Commission allegation that a restraint of trade clause in the agreement was in breach of s 27. The Commission alleged that the restraint of trade was a provision of an agreement that had the purpose, effect or likely effect of substantially lessening competition in the relevant market. The restraint of trade restricted GasNet from re-entering the Bay of Plenty market for five years.
The suggestion that this restraint of trade provision breached s 27 is arguably controversial. When you buy a business it is usually accepted that you can impose a restraint of trade on the vendor to protect the goodwill you are taking over. Section 44(1)(d) contains an exception from s 27 for exactly this.
Section 44(1)(d) says that nothing in Part 2 of the Commerce Act applies to “the entering into of a contract for, or the giving or requiring the giving of a covenant in connection with, the sale of a business… in so far as it contains a provision that is solely for the protection of the purchaser in respect of the goodwill of the business”.
But Justice Mallon said this exception does not apply if the restraint of trade goes further than is necessary.
The judge’s analysis on this point is one sentence only: “The issue here was that the restraint of trade went further than was necessary for this purpose because it purported to prevent GasNet from entering anywhere in the Bay of Plenty (not just the area serviced by the Papamoa delivery point) and for a period of five years.” (para [49(b)]).
It would seem then that the exception in s 44(1)(d) has its limits. A restraint of trade said to be for the protection of the purchaser in respect of the goodwill of the business may not be protected by s 44(1)(d) if it is wider than is really necessary to protect that goodwill.
It is implicit that the judge thought s 44(1)(d) did not apply due to the restraint being wider than necessary both in respect of its geographic scope and its duration.
Here the business that was being sold related to a gas distribution network in Papamoa. The restraint of trade, however, applied not just to Papamoa but to all of Bay of Plenty.
The duration of the restraint of trade (five years) was also mentioned by the judge. Presumably, this was on the basis that the judge considered that this period of restraint was longer than required to protect the purchaser’s goodwill in the business being purchased. The judgment does not suggest, however, what duration of restraint would be acceptable on the facts for the restraint to be protected by s 44(1)(d).
This reasonableness limitation on the exception in s 44(1)(d) is a point of real practical importance to commercial lawyers. It will necessitate a more considered approach to the drafting of restraint of trade provisions in business sale and purchase agreements.
It will be necessary to ensure that the kind of business restrained, the geographic scope of the restraint and time period of the restraint do not go further than is required to protect the goodwill of the particular business to be sold. Failing that, the First Gas case would suggest the parties will potentially be liable for significant penalties for breach of s 27 of the Commerce Act.
The overall penalty imposed in the First Gas case was $3.4 million. This was calculated on the basis of $3.5 to $3.8 million for the breach of s 47, an uplift of $800,000 to $1.1 million for the breach of s 27 due to the restraint of trade and then applying a discount of 25% for cooperation and early admission of breach by First Gas.
The uplift in penalty imposed in relation to the breach of s 27 then was in the region of $1 million. That gives some indication of the potential risks of an overly broad definition of a restraint of trade clause in a sale and purchase agreement.
Gun-jumping: Referring customers to the purchaser before completion of a merger
The Australian Cryosite case was the subject of a judgment of Beach J in the Australian Federal Court on 13 February 2019. The case concerned an attempted sale by Cryosite of its business (which involved the banking of umbilical cord blood and stem cells) to its only competitor Cell Care.
The proposed sale agreement fell over but Cryosite retained a AU$500,000 non-refundable deposit under the sale agreement.
Importantly, the sale agreement provided that prior to completion of the sale and purchase Cryosite would refer all new customer enquiries to Cell Care.
The case has been colloquially termed “gun jumping”. Effectively a transfer of part of the business to the purchaser had occurred before settlement of the sale and purchase (and certainly before the competition regulator had assessed the transaction).
The court accepted that this was technically cartel conduct. The parties were in competition with each other and Cryosite was agreeing not to supply services to new customers in competition with Cell Care. Further, the agreement was effectively a form of market sharing as the parties were agreeing that before settlement of the business purchase Cryosite would only service existing customers and that all new customers would be referred to Cell Care.
Accordingly, even if the merger had gone ahead and didn’t have any competition law issues (under the Australian equivalent of s 47 of the Commerce Act) the parties breached Australian cartel prohibitions in relation to the period up until the sale took place.
A penalty of just over AU$1 million was imposed. But for the poor financial position of the defendant the penalty would likely have been more (the judge allowed the penalty imposed to be paid off in instalments over a 10-year period).
The Australian court’s reasoning in Cryosite seems unimpeachable.
Further, the same outcome would apply under New Zealand’s new cartel laws (passed in August 2017). The relevant provision was contained in an agreement between Cryosite and Cell Care and provided for Cryosite not to supply services to certain customers (new blood bank customers) being services which (but for the agreement) Cryosite and Cell Care were in competition for.
That would amount to a cartel provision under s 30A of our Commerce Act as a provision restricting output in s 30A(3) or a provision allocating markets in s 30A(4).
In terms of s 30A(3), the provision limited the supply by Cryosite of services that Cryosite and Cell Care supplied in competition with each other.
In terms of s 30A(4), the provision allocated the classes of persons to whom Cryosite and Cell Care supplied services in competition with each other by specifying that any new customers would be supplied by Cell Care.
Therefore, if the facts in Cryosite had occurred in New Zealand today, a similar result would be expected. The court would likely find that there was a breach of the cartel prohibition in the Commerce Act and impose a significant pecuniary penalty.
Further, with the passing in April 2019 of the Commerce (Criminalisation of Cartels) Amendment Bill, such conduct will likely in the future amount to a criminal offence (although the provisions for criminalisation will not come into effect for two years).
The First Gas and Cryosite cases show that a merger can raise more competition law issues than just the application of s 47.
Let’s say that your client (company A) is looking to buy out a competitor (company B). The fact that a merger of competing business might raise issues under s 47 is obvious. If necessary, the risk in relation to s 47 might be addressed through an application to the Commerce Commission for clearance or authorisation.
However, the sale and purchase agreement between A and B, or the negotiation of that agreement, might also raise other competition law issues. For example, additional competition law issues might arise if:
- there is an exchange of competitively sensitive information in anticipation of the proposed merger (an example of which has been the subject of prior criticism by the Commerce Commission in Investigation Report on Premerger Coordination between Sonic Healthcare and NZ Diagnostic Group, June 2008);
- there is a proposed moratorium on competition between vendor and purchaser in anticipation of the merger (as occurred in Commerce Commission v New Zealand Diagnostic Group Ltd  NZHC 1226 resulting in the imposition of penalties on New Zealand Diagnostic Group and Pathology Associates Ltd);
- there is an agreement by the vendor to refer new customer enquiries to the purchaser (as in Cryosite) or to exit certain businesses having regard to the proposed merger (as alleged by the ACCC in a case brought in July 2018 against Aurizon and Pacific National); or
- the agreement contains a restraint of trade clause under which the vendor agrees not to compete with the purchaser after completion of the merger (as in First Gas).
Such examples reinforce the importance of considering the potential wider application of competition law in relation to mergers and business sale agreements.
Importantly, the imposition in First Gas and Cryosite of very substantial penalties for anti-competitive conduct associated with a proposed merger (rather than just because of the merger itself) is a firm reminder of the risks involved.
John Land is a senior competition law specialist and commercial litigator at Bankside Chambers in Auckland. Formerly a partner of Kensington Swan for 20 years, he can be contacted on 09 379 1513 or at email@example.com