Fifth Circuit Accepts Vertical Harm Theory and Establishes Standard for Evaluating Merger Fixes

• Illumina, Inc. v. FTC is a rare case in which a federal appeals court ruled on the legality of a vertical merger.
• The Fifth Circuit held that a vertical merger could be illegal if “the merged firm will have the ability and incentive to foreclose rivals from sources of supply or distribution.”
• The court also established a standard for evaluating certain merger fixes that is more favorable to merging parties than the standard urged by the government.
• In addition, the court rejected the merging parties’ constitutional challenges to the structure and operation of the FTC.

Last week, the United States Court of Appeals for the Fifth Circuit issued its opinion in Illumina, Inc. v. FTC, an appeal from a decision of the Federal Trade Commission (FTC) finding that Illumina’s acquisition of Grail may substantially lessen competition in violation of Section 7 of the Clayton Act and ordering Illumina to divest Grail. The court rejected constitutional challenges raised by Illumina as “foreclosed by Supreme Court authority” and found that “substantial evidence” supported the FTC’s factual findings. However, the court vacated and remanded the Commission’s order because it found that the FTC had “applied an erroneous legal standard” in evaluating the parties’ deal “fix.”

Background

In March 2021, the FTC filed an administrative complaint seeking to block Illumina’s vertical acquisition of Grail. At the time, Illumina owned 14.5 percent of Grail’s voting shares and proposed to acquire the remainder. Illumina closed the transaction in August 2021 while the administrative proceeding was pending.

Grail developed a multi-cancer early detection (MCED) test that relies on “next-generation” DNA sequencing (NGS) platforms sold by Illumina. In its complaint, the FTC alleged that Illumina is “a dominant provider of NGS platforms,” Grail and its competitors “have no substitutes for Illumina’s NGS platforms,” and the acquisition would harm competition in the market for “the research, development, and commercialization of MCED tests in the United States.” Specifically, the FTC alleged that “Illumina will gain the incentive to foreclose or disadvantage firms that pose a significant competitive threat to Grail and to limit the competitiveness of any MCED product” and, as a result, “Illumina will control the fate of every potential rival to Grail for the foreseeable future.”

In an attempt to address the FTC’s challenge, after the litigation commenced, Illumina announced that it was “irrevocably offering” a standard 12-year NGS supply contract providing for “guaranteed access to the latest sequencing products,” “no price increases for the sequencing products covered by the agreement” and “guaranteed lower pricing for the sequencing products by 2025.” Citing this “Open Offer,” among other things, the FTC administrative law judge concluded in September 2022 that FTC complaint counsel “failed to prove its asserted prima facie case that Illumina’s post-Acquisition ability and incentive to advantage Grail to the disadvantage of Grail’s alleged rivals is likely to result in a substantial lessening of competition in the relevant market for the research, development, and commercialization of MCED tests.”

FTC complaint counsel appealed the decision to the commissioners, who conducted a de novo review of the initial decision’s findings of fact and conclusions of law. The Commission, in an opinion authored by Chair Lina M. Khan, reversed the initial decision. Then-Commissioner Christine S. Wilson issued a concurring opinion. The Commission found that complaint counsel established its prima facie case by proving that Illumina had the ability to harm MCED test developers given its position as “the dominant provider of NGS,” and the acquisition increased its incentive to do so. Among other things, after the merger, “Illumina will directly benefit from tilting the innovation race in favor of Grail, the MCED provider that it now 100% owns” because it will now earn margin on the sale of Grail tests. The Commission also found that respondents failed to rebut the prima facie showing with the Open Offer. The majority of the Commission characterized the Open Offer as a proposed remedy that “would need to foresee and foreclose all possible ways Illumina could harm GRAIL’s competitors,” but failed to do so in a number of ways. Illumina, which could have sought review of the Commission’s decision in any federal circuit where it “resides or carries on business,” filed a petition for review with the Fifth Circuit.

The Fifth Circuit’s Opinion

Constitutional Issues

The Fifth Circuit addressed and rejected each of Illumina’s four constitutional challenges to the Commission’s decision.

First, the court rejected Illumina’s argument that the FTC’s decision resulted from an unconstitutional delegation of legislative power allowing the FTC to decide whether to bring an enforcement action either in federal or administrative court without providing guidance on how to make the decision. The court found, however, that the types of actions the FTC can bring in federal court (actions for injunctive relief) differ from those that must be brought in administrative court (actions for “other forms of relief, such as monetary damages”). The court also found that a “public interest” standard – such as the standard for when FTC should initiate an enforcement action – has many times been upheld by the Supreme Court as an “intelligible principle.”

Second, the court rejected Illumina’s argument that the “FTC unconstitutionally exercised executive powers while insulated from presidential removal in violation of Article II.” The court cited Humphrey’s Executor v. United States, in which the Supreme Court “held that the FTC’s enabling act did not run afoul of Article II because, essentially, the FTC was vested with quasi-legislative/quasi-judicial authority rather than purely executive authority.”

Third, the court rejected Illumina’s argument that its due process rights were violated when the FTC acted as both prosecutor and judge because “the Supreme Court has held that administrative agencies can, and often do investigate, prosecute, and adjudicate rights without violating due process.” 

Fourth, the court rejected Illumina’s argument that its equal protection rights were violated “because there is no rational basis for allocating certain antitrust enforcement actions to the FTC and others to the” DOJ. The court held that the “interagency clearance process which allocates antitrust investigations” between the FTC and DOJ “based primarily on which agency has expertise in the particular industry or market” involved was “undoubtedly a rational basis for giving one agency the lead over the other.” 

Section 7 of the Clayton Act

The court used an often-used conceptual “burden-shifting framework” to evaluate whether the effect of a merger “may be to substantially lessen competition or to tend to create a monopoly” under Section 7 of the Clayton Act. In this case, the framework requires the FTC to first “establish a prima facie case that the merger is likely to substantially lessen competition in the relevant market.” If that is established, in order for it to prevail, Illumina must “present evidence that the prima facie case inaccurately predicts the . . . transaction’s probable effect on future competition” or “sufficiently discredit the evidence underlying the prima facie case.” If Illumina is successful in rebutting the presumption, the FTC can still win if it produces “additional evidence of anticompetitive effects.” The FTC bears the “ultimate burden of persuasion,” and, the court observed, “in practice, evidence is often considered all at once and the burdens are often analyzed together.” 

Market Definition

The Fifth Circuit agreed with the Commission’s definition of the relevant product market as being “the research, development, and commercialization of MCED tests.” The court, like the Commission, found that “practical indicia” supported the finding of such a market, including that MCED tests have “peculiar characteristics and uses”; are designed for “distinct customers”; will likely have their own distinct pricing strategy; and that MCED developers, including Grail, see themselves as competing in a distinct market and view each other as key competitors.

The court rejected Illumina’s argument that the market should be limited to only “products that currently exist” and have capabilities that are “identical” to Grail’s, but not include “those that are anticipated or expected” and have only a subset of Grail’s capabilities. Here, the court recognized that the “mere fact that some company, someday may innovate a competing product” would be “too speculative” to affect market definition. However, in this case there was “indisputably ongoing competition to bring additional products to market.” The court also held that “products need not be identical to be in the same market“ but need only to be “similar in character or use.” The court also observed that even tests with lesser capabilities could “take sales away” from Grail “if they were priced lower.” Notably, the court suggested that Illumina’s proposed single-brand market was overly narrow, particularly because the market at issue here is a “research-and-development market.” Moreover, as can sometimes be the case, the court found that a party’s own documents undermined its argument. Here, Grail’s documents reflected that it viewed itself as being in active competition with other MCED-test developers.

Effect on Competition

The Fifth Circuit acknowledged that “courts have used two different but overlapping standards for evaluating the likely effect of a vertical transaction.” One is based on the Supreme Court’s 1962 opinion in Brown Shoe v. United States (which is also the source of the “practical indicia” market definition standard). The other “asks whether the merged firm will have both the ability and the incentive to foreclose its rivals, either from sources of supply or from distribution outlets.” Former FTC Commissioner Wilson, in her concurrence, wrote that “there is no ‘Brown Shoe standard’ in modern antitrust analysis.” In any event, regardless of the standard used, the majority of the Commission, former Commissioner Wilson and the Fifth Circuit all came to the same conclusion: that FTC complaint counsel established a prima facie case that the Illumina-Grail merger is likely to substantially lessen competition.

The court found that as the “monopoly supplier of a key input – NGS platforms – to MCED-test developers,” Illumina had the ability to foreclose its MCED test rivals. And Illumina’s ownership of Grail gave it the incentive to foreclose those rivals because the foreclosure would divert profitable sales from the rivals to Illumina-Grail. As to Illumina’s claim that the threat of reputational damage would disincentivize foreclosure, the court wrote there are subtle ways to “engage in foreclosing behavior” that would not damage its reputation. Moreover, given Illumina’s NGS monopoly, “even if other customers did learn about Illumina’s foreclosing behavior and therefore wanted to take their business elsewhere, they would have nowhere else to turn.”

The court also found that “at least four of the factors” from the Brown Shoe standard “supported a finding of a probable Section 7 violation.” These were: “likely foreclosure, the nature and purpose of the transaction, the degree of market power possessed by the merged firm, and entry barriers.”

The Parties’ Post-Complaint “Fix”

To address the concern that it would engage in foreclosure, after the FTC initiated its enforcement action, Illumina announced an open, irrevocable offer for NGS supply. The parties and the commissioners had differing views on how to treat this Open Offer in the competitive analysis of the merger.

The court found that the Open Offer was “a post-signing, pre-closing adjustment to the status quo implemented by the merging parties to stave off concerns about potential anticompetitive conduct.” The court described this as “somewhere in between a fact and a remedy.” Given the nature of the Open Offer, the court held that “the burden of showing [its] competitive effects [is] on Illumina as part of its rebuttal to the prima facie case” in the liability stage of the case. To meet this burden, “Illumina was required to do more than simply put forward the terms of the Open Offer; it needed to affirmatively show why the Open Offer undermined Complaint Counsel’s prima facie showing to such an extent that there was no longer a probability that the Illumina-Grail merger would substantially lessen competition.” Put another way, to rebut the prima facie case, “Illumina was only required to show that the Open Offer sufficiently mitigated the merger’s effect such that it was no longer likely to substantially lessen competition. Illumina was not required to show that the Open Offer would negate the anticompetitive effects of the merger entirely.”

By contrast, the Fifth Circuit found that the Commission committed legal error when it used a “total-negation” standard that required Illumina “to show that the Open Offer would restore the pre-[merger] level of competition, i.e., eliminate Illumina’s ability to favor Grail and harm Grail’s rivals.” This meant that “[i]n effect, Illumina could only rebut Complaint Counsel’s showing of a likelihood of a substantial reduction in competition with a showing that, due to the Open Offer, the merger would not lessen competition at all.”

In placing the proper analysis of the Open Offer in Illumina’s rebuttal stage, the court reasoned that “the Open Offer is not just a normal commercial supply agreement but instead a direct response to anticompetitive concerns over the Illumina-Grail merger” and should therefore not be treated “as just another fact of the marketplace” to be dealt with at the prima facie stage where FTC complaint counsel has the burden to establish that harm to competition is likely. Nor, according to the court, is the Open Offer “a Commission- or court-ordered remedy, which . . . can be imposed only on the basis of a violation of the law, i.e., after a finding of liability.” Treating the Open Offer as a remedy to be evaluated only after a finding of liability would have required Illumina to prove that the Open Offer would “preserve exactly the same level of competition that existed before the merger.”

Efficiencies

Finally, the court found that none of the efficiencies put forward by Illumina were “cognizable” because they were not merger specific, verifiable or “likely to be passed through, at least in part, to consumers.” Among other rejected efficiencies, the court found that while a royalty reduction was merger specific because evidence suggested that Grail would be unable to achieve a similar reduction from Illumina absent the merger, the company had not shown that the reduction would be passed through to its customers. Further, the court also found that Illumina failed to quantify any benefit from the elimination of double marginalization resulting from Grail no longer having to pay Illumina for NGS. Illumina also failed to substantiate claims of “supply chain and operational efficiencies,” accelerated FDA approval, R&D efficiencies or accelerated international expansion of Galleri.

Significance

Vertical Merger Theory of Harm

Litigated vertical merger cases are rare, and appeals court cases dealing with vertical merger cases are even rarer. The last appeals court opinion in a vertical merger case, in which the D.C. Circuit decided the government’s appeal to its unsuccessful challenge of the A&T-Time Warner merger, was issued in 2019. Before that, it had been decades since the government challenged a vertical deal in court. Therefore, an appeals court opinion in a vertical merger case is noteworthy. Here, the fact that the Fifth Circuit endorsed a vertical theory of competitive harm is especially significant given the dearth of appellate case law in this area. Left unresolved, however, is what specific standard is to be used in evaluating the likely competitive effects of a vertical merger. In general, Brown Shoe was more skeptical of vertical mergers than most current economic theory, but, as the court observed, the outcome in this case did not depend on which standard was used.

Standard for Evaluating Post-Complaint Deal Fixes

It is also significant that the Fifth Circuit articulated a standard for evaluating a deal fix in the circumstances presented in this case that is more favorable to merging parties than the standard the FTC favored. This could be especially consequential in the current merger enforcement environment where the agencies – in particular the DOJ – are much less willing to agree to a negotiated merger remedy, thus requiring the merging parties to “litigate the fix” in court. Indeed, this has been an issue in several recent merger cases, including the FTC’s challenge of Microsoft-Activision and the DOJ’s challenge to UnitedHealth-Change Healthcare.

R&D Market Definition

The court made several observations about the task of defining an R&D market like the one at issue in this case. First, according to the court, because the products at issue are in development and have not yet been sold for a price, certain common market definition tools – such as performing the hypothetical monopolist test or calculating the cross-elasticity of demand – cannot be used because they depend on price. Second, the court wrote that defining an R&D market requires making assumptions about the effectiveness of “anticipated or expected” products, not simply observing the qualities of “products that currently exist.” Third, the court reasoned that given the nature of R&D markets, it may be acceptable to define a market around a group of products even though the products are different in certain ways. Here, Illumina advocated for a single-brand market containing only its tests because other MCED tests were different from Grail’s. The court wrote that “[a]ntitrust law does not countenance such a cramped view of competition, particularly in a research-and-development market.”

Constitutionality

The Fifth Circuit’s holding that Illumina’s nondelegation, executive power, equal protection and due process claims were each “foreclosed by Supreme Court authority” is significant. After recent Supreme Court decisions regarding administrative power, parties to several other FTC actions have also been raising constitutional issues. The fact that the Fifth Circuit – a court that has recently found constitutional infirmities with administrative enforcement in other contexts – sided with the FTC is notable. Given Illumina’s decision to not appeal, this case will likely not be a vehicle for the Supreme Court to revisit these issues.

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