The European Commission is increasingly concerned with how market consolidation could harm innovation. It has therefore dramatically changed the way it examines its impact. How the European Commission looks at the effect of horizontal mergers on innovation is one of the important policy changes championed by European Commissioner Margrethe Vestager, who explained that EU merger control rules “are there to protect innovation” and that this objective “is important in [our] merger policy”.
The Commissioner’s public interventions have accompanied the rise of a novel theory of harm, which posits that horizontal mergers could ‘lead to a reduction of innovation’ in an industry. This was its position in the recent Dow/ DuPont and Bayer/Monsanto mergers, where the Commission found that each transaction would have ‘significantly reduced competition in a number of markets’ and ‘significantly reduced innovation’. As part of the remedy package, both Dow and Bayer committed to divest important lines of their global R&D organisations. Although assessing the effects of mergers on innovation is not new, under Vestager’s leadership the Commission’s approach to the impact on innovation has changed dramatically.
Pipeline problems
The Commission’s novel approach has its roots in pharma mergers. There, the Commission has traditionally examined whether a proposed merger creates an overlap between a pharmaceutical product actively marketed by one of the parties with a pipeline product developed by the other party (‘market-to-pipeline’) or whether the parties separately developed pipeline products that would eventually compete on the market (‘pipeline-to-pipeline’). Importantly, pipeline products covered only those products at a relatively late stage of their development, typically By Axel Schulz in phase 3 development, thus with a good chance of launch within two to three years. For example, in the Pfizer/Hospira merger, the Commission found that the proposed transaction raised competition concerns because Pfizer was developing a competing medicine to Hospira’s. Specifically, Hospira was selling Inflectra, an infliximab biosimilar used to treat several chronic inflammatory diseases, notably the inflammation of Crohn’s disease, while Pfizer was in an advanced stage of developing its own biosimilar for infliximab.
The Commission was concerned that Pfizer would likely discontinue its efforts to bring its new medicine to market, reducing competition. As a remedy, Pfizer divested its development programme. In Johnson & Johnson/Actelion, the merging parties were separately developing new treatments for insomnia, using the same novel mechanism of action. The Commission was concerned that post-merger, J&J would have the ability and incentive to delay or abandon one of these programmes and thus required that Actelion’s insomnia research programme be divested. In the US, the Federal Trade Commission (FTC) has followed a similar approach. For example, in Thoratec/ HeartWare, Thoratec was marketing a successful heart pump while HeartWare’s device achieved promising clinical trials. The FTC challenged the merger, alleging harm to innovation and to future price competition.
Dramatic shift
Moving away from the traditional approach, in the merger between Dow and Dupont, the Commission found the innovation competition for pesticides would be reduced, leading to the divestiture of DuPont’s global R&D organisation in pesticides to clear the merger. The Commission’s approach here marks a dramatic shift in the examination of the impact of mergers on innovation.
By not focusing on specific product overlap, it considered the impact on innovation ‘as a whole’, finding that Dow and DuPont would likely reduce their R&D budget post-merger, leading to fewer new products brought to the market. But is it that simple? First, if the Commission found that a ‘merger between important rival innovators is likely to lead to reduction of innovation’, how is innovation measured? Surely in the launch of potential new products. But future new products (or products in an advanced-stage of development) were not a focus of Dow/DuPont. Can innovation be measured by R&D expenditures? Maybe. But R&D expenditures do not automatically translate into a guaranteed number of new products.
Billions can be spent on R&D activities, often without immediate, or any, results. In the pharmaceutical industry, a recent study shows that only 9.6% of drugs in phase 1 are approved by the US FDA. The chance of success increases to 15.3% in phase 2 and 49.6% in phase 3. Second, ‘innovation should not be understood as a market in its own right, but as an input activity for both the upstream technology markets and the downstream [product] markets’. If that is the case and the goal of merger control is to protect competition between ‘downstream products’, would it not be necessary that the innovations worth protecting, although inherently uncertain, are at least identifiable with existing or pipeline products? Third, merger control is inherently forward- looking and requires making predictions, which become increasingly imprecise the further into the future one looks. In past cases, it seemed justified that the competitive assessment focused on pipeline products, especially when these products were expected to hit the market in two/three years. Equally, merger-specific efficiency arguments are typically accepted within such a time frame, so they can be verified with at least some degree of predictability.
In contrast, between the moment new molecules are discovered and the point that firms can launch a new product, more than ten to 12 years can pass. It is extremely difficult to make any sound predictions so far into the future. Fourth, firms undertake R&D investments when they expect high returns. Expected returns on such investments depend on the number of firms engaged in the same ‘innovation space’. Obviously, the more firms that are involved, the lower the expected returns. Indeed, when a firm is the only one contemplating a research programme, it can expect greater reward than when others are pursuing the same research agenda. Therefore, eliminating a rival can increase the chance that the merged firm will undertake the necessary investment to pursue an ambitious R&D programme.
Finally, what can be an adequate remedy in such cases? Prohibit the merger as in Thoratec/ HeartWare or enforce a company’s entire R&D organisations to be divested, including its discovery pipeline and the expertise within its workforce? Contrary to past cases, where pipeline products were sold to third parties, forcing the sale of an entire R&D organisation appears far more radical. But will this type of remedy be successful? Will the R&D organisation be equally successful under its new owner? Will the scientists stay or leave for new ventures? Only time will tell.
In the 1995 AMP/Wyeth merger, the parties divested one of the two development programmes for rotavirus vaccines to the Korean Green Cross. More than ten years later, GSK launched a rival vaccine, while the Korean Green Cross never did. In Ciba-Geigy/Sandoz, the FTC was concerned that the merger could impair the development of gene therapy, a market that the FTC forecast to be worth US$45bn within 20 years from then. Although the parties divested one of the gene therapy programmes to Aventis, the market for gene therapy is still very small and Aventis has not launched a product in this space. Predicting the future isn’t so easy after all.
Business impact The Commission’s novel theory on innovation competition has its roots in pharma mergers, and it seems likely that this theory will be applied to pharma mergers in the future. So, how can merging parties in the pharmaceutical sector be prepared for these changes? Pharmaceutical companies should consider overlaps in innovation activities, even if there is no prospect of developing concrete products in future. Focusing on pipeline products is no longer enough to assess the regulatory risks posed by a transaction.
Further, since the Commission’s assessment relies heavily on internal documents, the parties should describe their R&D activities with care, highlighting the potential efficiencies of merging them. The parties should emphasise the complementarity of their R&D assets, which could lead to an increase in innovation. At the same time, highlighting the benefit of eliminating duplicative activities could backfire, as the Commission might interpret such a plan as a clear intent to reduce innovation competition. Finally, mergers that may be prone to the Commission’s theory on innovation are likely to face an even longer pre-notification period.