Since the early 1990s, the Federal Trade Commission (FTC) has vigorously pursued litigation in federal courts to challenge hospital mergers it views as anticompetitive.1 Courts dealt the Agency a protracted series of defeats in the mid-1990s, but recent years have brought renewed success.2 Meanwhile, increased regulations and rising costs under the Affordable Care Act3 have pressured hospitals to consolidate, raising the stakes in this area of antitrust law.4 The resulting wave of mergers has not gone unnoticed.5 Recently, the Third Circuit entered the fray in FTC v. Penn State Hershey Medical Center,6 ordering a preliminary injunction to halt the merger of two Pennsylvania hospital systems.7 The Third Circuit’s opinion helpfully clarified the FTC’s favored approach for defining the relevant geographic boundaries in hospital merger analysis. But in dismissing the hospitals’ claim that the efficiencies gained from the merger would outweigh its alleged anticompetitive harm, the opinion left important questions unresolved: first, whether to formally adopt the efficiencies defense; and second, the extent to which the benefits from greater efficiencies must be shown to flow to consumers in order to be cognizable.
Penn State Hershey Medical Center and PinnacleHealth System operate “the two largest hospitals in the Harrisburg, Pennsylvania area.”8 The hospitals finalized plans to merge in March 2015.9 Following an investigation, the FTC sued to enjoin the merger pending its separate administrative adjudication.10 The Agency argued that the merger would decrease competition in the Harrisburg area, resulting in “increased healthcare costs and reduced quality of care.”11
The district court denied the FTC’s motion for a preliminary injunction.12 A preliminary injunction is warranted where, “weighing the equities and considering the Commission’s likelihood of ultimate success, such action would be in the public interest.”13 Focusing on the FTC’s likelihood of success on the merits, the court first considered whether the FTC had defined a valid geographic market — the area in which the merger’s effects are to be considered.14 Looking to the government’s Horizontal Merger Guidelines methodology for determining the relevant geographic market, the court invoked the so-called hypothetical monopolist test.15 Under this test, the relevant geographic market is the smallest area in which a single firm — the hypothetical monopolist — could raise its prices without consumers resorting to firms outside the area to defeat such a price increase.16
Applying the test, the court found that the government failed to adequately prove its proposed relevant geographic market, a four-county area surrounding Harrisburg.17 The court first emphasized that 43.5% of Hershey’s patients travel to the hospital from outside of the region, suggesting that the FTC’s proposed market failed to properly account for where the hospitals “draw their business.”18 Next, it found that if a hypothetical monopolist raised prices, customers would turn to alternative options, including nineteen hospitals located within about an hour’s drive.19 Finally, the court found it persuasive that the hospitals, in entering into private agreements with central Pennsylvania’s two largest health insurers, committed to refrain from increasing postmerger rates for at least five years.20 Concluding that the FTC “failed . . . to show a likelihood of ultimate success on the merits,” the court denied the injunction.21
The Third Circuit reversed.22 Writing for a unanimous panel, Judge Fisher23 began by noting that, although a district court’s factual findings are generally accepted unless clearly erroneous, “where a district court applies an incomplete economic analysis or an erroneous economic theory to those facts that make up the relevant geographic market, it has committed legal error subject to plenary review.”24 Concluding that the district court “erred in both its formulation and its application” of the hypothetical monopolist test,25 the panel focused on three analytical missteps.
First, the panel reasoned that when the district court relied “solely on patient flow data,”26 it was actually applying the discredited Elzinga-Hogarty approach to market definition,27 rather than the hypothetical monopolist test it purported to follow. In emphasizing that large numbers of the hospitals’ patients resided outside of the four-county area, the district court failed to recognize that this fact “says little about what the (silent) majority of ‘non-travelers’ would do in response to a post-merger price increase.”28 Second, the panel noted that the district court ignored the likely response of insurers to a hypothetical monopolist’s price increase.29 The district court therefore overlooked that healthcare-market competition comes in two stages: in the first stage, hospitals compete for inclusion in an insurance plan’s hospital network; only in the second stage do hospitals compete for a plan’s individual enrollees.30 At the first stage, insurers (not patients) negotiate directly with hospitals, so the hypothetical monopolist test should focus, at least in part, on insurers.31 Third, the panel concluded that the district court was wrong to rely on the pricing agreements negotiated between the hospitals and the two insurers.32 Because actual, real-world privately negotiated contracts have no bearing on what a hypothetical monopolist could achieve, such agreements “have no place” in geographic market analysis.33
The panel determined that the FTC’s proposed four-county area was in fact a properly defined geographic market.34 Further, because merging the hospitals would significantly increase market concentration,35 the panel found the merger to be “presumptively anticompetitive.”36 The FTC had thus successfully established its prima facie case, leaving the panel to consider whether the hospitals’ rebuttal arguments sufficiently disputed the Agency’s likelihood of success on the merits.37 The hospitals’ efficiencies-based defense centered on two claims: first, that the merger would eliminate the need to construct a $277 million bed tower; and second, that the combination would improve the hospitals’ ability to utilize risk-based contracting.38 Skeptical that efficiencies could ever justify an otherwise anticompetitive merger, the panel emphasized that if efficiencies were to be credited, they “must be merger specific, verifiable, and must not arise from any anticompetitive reduction in output or service.”39 Because each of the asserted efficiencies failed to meet this standard, the panel rejected both claims.40 Concluding its analysis with a holding that the equities on balance favored granting the injunction, the panel reversed and remanded with directions to preliminarily enjoin the merger.41
In Penn State Hershey, the Third Circuit endorsed the FTC’s favored approach to defining geographic markets in hospital merger cases: using a hypothetical monopolist test that focuses on how insurers would respond to a price increase.42 The opinion’s thorough application of this test — and its critique of how the district court got the test wrong — sets forth helpful guidance for healthcare-merger planning and antitrust enforcement. But in rejecting the hospitals’ claimed efficiencies, the decision created uncertainty concerning the viability of any future efficiencies defense. It did so in two ways: first, by declining to decide whether to formally adopt the efficiencies defense; and second, by indicating a strict requirement that any efficiencies must be shown to benefit consumers in order to be credited.
An efficiencies defense is based on the idea that the cost savings achieved by a merger could yield social savings that would more than compensate for the social loss created by the exercise of increased market power.43 Law and economics commentators have long called for judicial recognition of an affirmative efficiencies-based defense in merger analysis.44 Since 1984, revised versions of the Merger Guidelines have come to treat the efficiencies defense as an “integral part of the competitive effects analysis.”45 Gradually, courts have followed suit.46 But in Penn State Hershey, the Third Circuit remained unconvinced. Expressing skepticism “that such an efficiencies defense even exists” and highlighting Supreme Court precedent it viewed as disapproving of the concept, the panel declined to “decide whether to adopt or reject the efficiencies defense.”47
As an initial matter, the panel’s portrayal of three 1960s-era cases likely overstated the purported hostility of the Supreme Court toward the efficiencies defense.48 The Court has not directly spoken on the issue of efficiencies in the context of horizontal mergers since the early 1970s, and changes in the philosophy of antitrust law over subsequent decades suggest it would now take a more accommodating position.49 In other antitrust contexts, the Court has shown an increasing recognition of the importance of efficiencies.50 Such developments indicate that, in relying on outdated Supreme Court precedent, the panel’s skepticism of the efficiencies defense was misplaced.
Despite declining to formally adopt or reject the efficiencies defense, the panel nonetheless conducted its own analysis of the hospitals’ purported efficiencies, determining that they were “insufficient to rebut the presumption of anticompetitiveness.”51 In articulating the requirements of the efficiencies defense, the court largely adopted standards previously espoused by other appellate courts and modeled on the Merger Guidelines.52 But the Third Circuit emphasized an additional requirement: clear evidence that the benefits from claimed efficiencies will ultimately be passed on to consumers. While a handful of district court opinions have indicated such a requirement,53 no appellate decision prior to Penn State Hershey had so explicitly embraced a strict consumer pass-through condition.54
The debate over a consumer pass-through requirement for cognizable efficiencies has divided economists as well as antitrust law practitioners. Many — including several experts within the antitrust agencies55 — have argued for a “total welfare” approach to efficiencies, which would view all merger-generated efficiencies positively, whether or not they would be immediately passed on to consumers.56 Alternatively, a “consumer welfare” approach would count efficiencies only to the extent they would be passed on to consumers.57 Such efficiencies would principally take the form of lower prices, but could also consist of higher-quality products or improved service. While the Merger Guidelines prioritize efficiencies that enhance consumer welfare,58 they “reject[] a rigid requirement that cost savings be ‘passed on’ to consumers”59 and suggest an openness to recognizing longer-term efficiencies that do not necessarily benefit consumers in the short run.60
Adopting a seemingly stricter standard than the Merger Guidelines, the panel’s commitment to a consumer welfare approach pervades its efficiencies discussion. Indeed, in rejecting the hospitals’ bed-tower efficiencies claim, the panel concluded that the purported savings were unverifiable because the hospitals failed to provide “clear evidence showing that the merger will result in efficiencies that will offset the anticompetitive effects and ultimately benefit consumers.”61 And in addressing the defense that the merger would improve contracting with payors, the panel specified that “the Hospitals must demonstrate that such a benefit would ultimately be passed on to consumers.”62
The court’s insistence that “[a]n efficiencies analysis requires more than speculative assurances that a benefit enjoyed by the Hospitals will also be enjoyed by the public”63 raises practical difficulties for proving an efficiencies defense.64 Given the panel’s observation that “patients, in large part, do not feel the impact of [healthcare] price increases,”65 it is unclear from an evidentiary standpoint how a merging party could convincingly show that an efficiencies-generated price decrease would sufficiently pass on a “tangible, verifiable benefit to consumers.”66 Nor is it clear whether a showing of lower prices to insurers resulting from efficiencies would suffice. Such challenges in surmounting the consumer pass-through requirement suggest why former FTC Chairman Robert Pitofsky referred to the requirement as a “killer qualification.”67
Penn State Hershey thereby creates two layers of uncertainty for parties contemplating an efficiencies defense in the Third Circuit. First, the panel’s nondecision on adopting the defense leaves market participants in the dark on whether merger efficiencies will be granted any consideration whatsoever. Second, even if a court were to accept the defense in the future, the precise contours of the difficult-to-satisfy consumer pass-through requirement remain unspecified. As a practical matter, the impact of litigated merger cases — which tend not to be reflective of the majority of merger matters brought before agencies68 — plays out in negotiations between the merging parties and the agencies during the merger notification process.69 Although efficiencies claims are considered and sometimes lead to the agency deciding not to challenge a merger,70 the Third Circuit has given antitrust agencies more leverage to confidently raise their requirements for cognizable efficiencies — for example, by insisting on a stricter showing of consumer pass through than suggested by the Merger Guidelines. The functional impact of Penn State Hershey on the future of the efficiencies defense will therefore largely depend on how antitrust regulators exercise their increased discretion in assessing proposed efficiencies.