United States: United Technologies/Raytheon Highlights Key Issues In Aerospace And Defense Industry Merger Review

The DOJ Antitrust Division's recent challenge to the United Technologies/Raytheon merger highlights a few key considerations for antitrust reviews of aerospace and defense industry transactions. The case is a useful illustration of important principles applicable to this unique industry.

IN DEPTH

The DOJ Antitrust Division's (DOJ) recent challenge to the United Technologies (UTC)/Raytheon (RTN) merger highlights a few key considerations for antitrust reviews of aerospace and defense industry transactions. The case is a useful illustration of important principles applicable to this unique industry.

First, the case highlights that defense product markets will be narrowly defined based on the specific product application, and suppliers of the same type of system may be in different antitrust markets if they supply the system for different applications (e.g., aircraft versus ground vehicle). Second, the case shows that theories of harm from vertical integration are flexible, and they frequently focus on whether a transaction will create the incentive and ability for a company to use its control over one capability to foreclose competition in another product market. Vertical issues often arise in the aerospace and defense industry because of the frequent subcontracting and teaming relationships among firms at different levels of the supply chain in order to create the highly complex products demanded by military and other government customers.

This is the first aerospace and defense merger review since the DOJ and Federal Trade Commission (FTC) released their new draft Vertical Merger Guidelines in January, and it provides a useful practical application of some of the key principles and theories outlined in those guidelines.

Aerospace and defense product markets are narrowly defined. The agencies define relevant antitrust product markets based on demand side substitution. If one product can readily be substituted for another to serve the same application, then they are likely to be in the same antitrust product market. On the other hand, products that may initially appear quite similar but have unique characteristics that make them suitable for different applications are likely not going to be in the same relevant product market.

DOJ evaluated military GPS receivers as part of the UTC/RTN transaction. DOJ concluded that "[m]ilitary GPS systems for aviation/maritime applications and military GPS systems for ground applications (e.g., tanks or trucks) serve different functions and cannot be substituted for one another." For example, DOJ noted that there are "different power, performance and form factor requirements for aviation/maritime GPS systems and ground GPS systems. Customers therefore cannot substitute an aviation/maritime GPS system for a ground GPS system (or vice versa) without sacrificing important functionality." In short, DOJ found that the requirements for a ground GPS system were significantly different than the requirements for an aviation/maritime system. While both may need to provide location information using GPS signals in a secure environment, they are not substitutable. DOJ likewise challenged the transaction in airborne military radios, finding that military radios have different requirements than commercial radios, and airborne radios have different requirements and capabilities than ground or naval radios.

DOJ's application of the market definition principles in the Horizontal Merger Guidelines appears to be fairly straightforward in this case, but it is a useful reminder of how those principles are applied in the aerospace and defense industry. Market definition is a highly fact-driven exercise, and when the products involved have a common base technology but are then specialized for usage in different applications, those different applications likely will be found to represent separate relevant product markets.

Theories of anticompetitive effects from vertical combinations are flexible. The draft Vertical Merger Guidelines published by the FTC and DOJ earlier this year provide insight into the antitrust enforcers' theories of harm from vertical integration. Vertical integration that forecloses access to inputs or customers and either raises rivals' costs or, at the extreme, precludes their ability to compete at all, are the core theories of vertical harm. Given the ubiquity of subcontracting and teaming relationships, aerospace and defense industry transactions frequently raise vertical antitrust issues. (See https://www.antitrustalert.com/2020/02/articles/doj-developments/aerospace-and-defense-series-doj-and-ftc-vertical-merger-guidelines-will-impact-government-contractors/.) The DOJ's challenge to the UTC/RTN transaction demonstrates the flexibility of vertical theories of competitive harm.

The key issues in a vertical theory include whether the merger creates the incentive and the ability to withhold or condition access to key inputs in a way that not only hurts rivals, but also harms competition more broadly in the market. The DOJ's UTC/RTN complaint describes its theory of competitive harm arising from the combination of RTN's focal plane array and electro optical (EO)/infrared (IR) payload business with UTC's large space-based optics business. According to the DOJ's complaint, certain types of spacecraft have imaging payloads that include two key elements: "The components of an EO/IR reconnaissance satellite payload are advanced versions of the components found in consumer digital cameras: an optical system-a lens or mirror-focuses light onto an electronic detector, known as a focal plane array (FPA), which converts light to digital images for transmission via radio signals. Optical systems and FPAs are critical inputs in EO/IR reconnaissance satellite payloads."

DOJ alleged that RTN has benefited from decades of investment in its technologies funded by the US government or prime contractors, and is the leading supplier of FPAs for capturing EO images (visible light) and one of two leaders for IR applications. DOJ alleged that UTC is one of two suppliers of large optical systems.

DOJ alleged the combination of UTC and RTN would result in several anticompetitive effects.

• Theory 1. RTN could use its dominant FPA position to force the use of the UTC large optical systems.
  • There may be applications for which RTN's FPA must be used, because the payload will process visible (EO) light where only RTN has fully developed capabilities, according to DOJ.
  • If RTN's FPA must be used on a payload, UTC/RTN could condition access to or pricing of the RTN FPA on a customer also using the UTC large optical system, even if it might not offer the best quality or lowest price for the application.
  • DOJ notes that the merger creates a change in incentive by combining the FPA provider and large optics provider under common control.
• Theory 2. UTC could use its dominant large optical position to force customers to use RTN's EO/IR payload capability.
  • There may be applications for which UTC's large optical system must be used as part of a payload because the government customer directs its use.
  • If UTC's large optical system must be used on a payload, UTC/RTN could withhold access to that optical system from its rivals, or increase the prices charged for that optical system, either of which would reduce competition at the EO/IR payload level.

Thus, there are two different theories of harm created by the vertical combination of RTN's FPAs and UTC's large optical systems. Under one theory, UTC/RTN could use its dominant position as an FPA supplier to force a customer to take the UTC optical system. Under the second theory, RTN could withhold access to the UTC optical system in order to disadvantage companies seeking to compete with RTN as a payload supplier (combining the FPA and the optical system).These two different theories show the inherent flexibility in vertical antitrust analysis. Both hinge upon the merger changing the incentives, either to select a component or to supply a component, from what applies prior to the transaction. If the DOJ or FTC (which also performs antitrust reviews of aerospace and defense transactions) determines that the merger creates the incentive and ability for the merged company to execute this type of strategy, the agency will seek to eliminate the potential anticompetitive harm arising from that aspect of the transaction.DOJ under the Trump administration has required structural relief, meaning a divestiture, to resolve vertical concerns. In the UTC/RTN matter, having found that combining the UTC large optical system capability with the RTN FPA and payload business created competitive concerns, DOJ required a divestiture of the UTC large optical system business. That relief would maintain the premerger competitive dynamic in which the UTC large optical system business was not owned by the same company that owned the RTN FPA and payload business. Historically, DOJ and FTC have resolved vertical issues with restrictions on the post-merger company's conduct (i.e., a "behavioral remedy"). For example, FTC imposed a behavioral remedy to resolve its vertical concerns with the Northrop Grumman / Orbital ATK transaction. However,, the pendulum has swung toward DOJ requiring a divestiture of one of the businesses creating the vertical concern (i.e., a "structural remedy").

DOJ's press release announcing the settlement noted that "[t]hese horizontal and vertical concerns are resolved by the Division's structural remedy, which includes the divestiture of three separate business units." This is consistent with the policy announced by Assistant Attorney General Delrahim when he took office in 2017. In one of his first actions, AAG Delrahim stated a new DOJ policy: that it would no longer accept behavioral remedies limiting a merged company's conduct but instead would insist on structural remedies (i.e., divestitures) to resolve any competitive issues created by M&A transactions.The UTC/RTN merger does not make new law or announce new legal principles, but it serves as a useful example of the application of antitrust principles in the context of aerospace and defense merger reviews.