Dec 2007

Why the Commission Must Appeal The High Court Decision

On 5 December the High Court released the public version of its 29 November judgement granting clearance to both Woolworths and Foodstuffs to acquire The Warehouse.

The High Court decision will be seen by many as confirmation of the inappropriateness of appeal rights by way of a rehearing (as opposed to referral back to the expert tribunal with appropriate instructions).  The Court has shown a preparedness to make findings that are not only contrary to intuition and to those made by the Commission as the expert tribunal but that even The Warehouse itself was not in a position to make.  The Court may be right but they, the Commerce Commission, consumers and the participants are entitled to assurance and greater clarity from the Court of Appeal.

In a nutshell, the High Court has determined that The Warehouse is not, and has no serious prospect of ever being, a meaningful competitive force in the supermarket sector.  This finding was made despite the fact that The Warehouse is already a competitive force in three locations and has proven capacity to expand.  Further, its Board of Directors and Chief Executive are on record expressly confirming that they are keeping all options open.  It is unlikely that a court would have been as bold as our High Court has been in any other country (and we are not overlooking the fact that the Court was assisted here by an expert Australian economist).

It is not for us to say the High Court was wrong.  In large part the key issues are factual, not legal.  But we can say, on the basis of the published decision, that the decision is far from demonstrably correct.  We also consider that the issues raised are extremely important issues and that they must be tested on appeal.

It is, of course, more difficult for an appellate court to reverse a lower court decision on the basis of different findings of fact (as opposed to errors of law) but here the Court of Appeal will have all of the evidence that was before the High Court.  In any event, the High Court determined that it was not at any disadvantage to the Commission in assessing the evidence and the Court of Appeal should reach the same views.

The High Court has sought to suggest that the evidence available to it was dramatic but (1) it was really only a continuation with slight variations on earlier evidence (and we have prepared this FYI on the assumption that every matter not available in the public version of the decision is strongly supportive of the supermarkets’ case), (2) The Warehouse itself does not consider that that information is such that it must exit the market, (3) the expert Commission was aware of the new facts and still opposed the appeal, and (4) nowhere does the Court indicate that evidence provided by the applicants and The Warehouse relating to conduct undertaken when The Warehouse is “in play” might need to be viewed with even a scintilla of scepticism. 

Overseas, it is generally accepted that evidence put forward by direct stakeholders should generally be discounted as self-serving.  A prime example of where scepticism might have been called for is in relation to conduct by the applicants in the face of entry by The Warehouse.  Many will consider it extremely unlikely that the incumbents would have shot themselves in the foot by providing evidence of competition when they were seeking clearance.   Any short-term pain would presumably be handsomely rewarded by the perceived longer-term gains.  Another example is the Court's evident unquestioning acceptance that Woolworths and Foodstuffs are genuinely interested in acquiring The Warehouse to progress their interest in the general merchandise sector.  The possibility that the true motivation might be "protective" is not discussed.  If the true motivation is “protective” then the Court’s findings in relation to the viability of the Warehouse Extra concept are even more remarkable.

In almost every critical respect, the Court appears to have sided with the applicants on grounds that will, if they do nothing else, raise legal and regulatory eyebrows.  We comment upon some of these below.

High Court:

“The Court cannot decline a clearance on the basis of being "not satisfied" because it is not certain what developments might take place in the market and because of that uncertainty it wishes to allow time for further developments to take place.  The Court must make up its mind on the evidence whether the proposed acquisition is or is not likely to have the effect of substantially lessening competition in any market.”

This statement is absolutely true but underlying it is an inherent criticism of the Commission.  It also misrepresents, or takes out of context, the Commission's submissions, which were simply that if it is left in a state of doubt about competitive impact it is required to decline clearance.

One has obvious sympathy for the Court and the applicants in this respect.  As a practitioner one reacts against a literal interpretation of statutory provisions that would permit the Commission to conduct a meandering and aimless review and still deny clearance simply because it was not satisfied.  But that has never happened and will never happen in New Zealand and, whilst the Commission must proceed reasonably and with due skill, the legislation was intentionally drafted so as to leave the Commission and the competitive process  with "the benefit of doubt".

To be precise, the Commission clearly must make its decision in the context of an application and clearly may not defer it "to allow time for further developments to take place" but that is not to say that future potential eventualities can not be taken into account.  Nor did the Commission appear to even suggest this.

The Court found that it was not clear to it if there are situations where, if all information is available, the Commission or the Court is entitled to say “we are not sure” and therefore we are “not satisfied”.

Perhaps nothing really turned upon this as the Commission's stance was that it had not made an "in doubt" decision; rather, it had made a "positive" decision.

However, having considered the decision as a whole one is left with an uneasy feeling that the burden and standard of proof were not really addressed (other than in a footnote and in a comment to the effect that the Court considered it unhelpful to focus on the burden of proof) but that they may well have been pivotal.  Frequently, the Court concluded that evidence was inconclusive or not proven.  Invariably, as a consequence, the Court “sided” with the applicants.  Is this appropriate in a competition law forum?  Does it fairly reflect the statutory mandate to decline clearance unless satisfied of the absence of anti-competitive effect?  Who should have the burden in an appeal like this?

High Court:

“We consider that there is a real prospect that the Warehouse Extra will be abandoned when it is reviewed in [          ].  There is also a real prospect that the Warehouse Extra will instead continue to be trialled for a further period and then abandoned without any further stores rolled out.  We consider there is not a real and substantial prospect that the Warehouse Extra will continue for long enough to establish the necessary halo on which the concept depends.  Because of that, we consider that the roll out of more Extra stores on a scale that would make the concept sustainable is not "likely" to occur.”

The conclusion that there is no real and substantial prospect that the Warehouse Extra will continue is, without doubt, the essence of the High Court decision.  It is also a remarkable determination and one that does not entirely hit the mark.

We have suggested earlier that the notion of an appellate court making this finding in the face of clear opposition by the Commission indicates that all is not well with the approach to appeals under the Commerce Act.  But it is also not a conclusion that should lightly be reached given that the evidence, however strong, is (1) evidence given by the protagonists and (2) evidence of circumstances arising whilst at all or virtually all material times the applicants have had their eye on The Warehouse.  (The Court did not, for example, question why the supermarkets had not previously considered acquiring The Warehouse when the acquisition cost was lower and when it had no interest in expansion into supermarkets.)

The Chief Executive of The Warehouse provided evidence to the effect that he considered the Warehouse Extra concept to be viable.  Indeed, immediately after the publication  of the decision he felt obliged to repeat his view that The Warehouse was still waiting for the "halo effect" (where grocery customers increase foot traffic and sales of general goods) and that it was too early to gauge the success of the Extra format.  (Herald, 6 December 2007, C3).  He may well have considered himself obliged to do so as the High Court's findings called into question whether The Warehouse had complied with its continuous disclosure obligations under the listing rules of the stock exchange.  Surely, in these circumstances, the High Court should be slow to determine that the concept is doomed.

But, even giving the Court and the applicants the benefit of all doubt and even assuming that the evidence when properly assessed does support a determination that the Warehouse Extra format has no meaningful prospect of success, should that have been determinative?

We suspect not:

• On the face of the evidence, the existing Warehouse Extra outlets will be continued for some time.  There has to be a real and substantial prospect that they will positively contribute to the competitiveness of their local markets for at least the next few years.  (The Court found that this is not so, but is that finding plausible?  Certainly the acceptance that Whangarei should be treated as the test market and complete reliance upon the absence of incumbent supermarket reactions in Whangarei appears to raise serious questions.)
• Even if the Warehouse Extra concept as currently formulated is doomed to fail, The Warehouse remains the most likely next entrant into supermarkets.  Indeed, the popular view is that it is the only potential new entrant.  Is there not at least  a real and substantial prospect that economics may change over time?  Might not general merchandise begin to struggle?  Might not new owners have different strategies?  Might not supermarket margins under a cosy duopoly escalate to such a level that rewards from entry become attractive?  (In these contexts the word “might” should be taken almost literally.  We are not considering probabilities here.)
• Woolworths and Foodstuffs gave evidence to the effect that The Warehouse was viewed as more of a threat before it entered than after it had.  Even if the Warehouse Extra concept is not timely, is it not in the best interests of competition that that threat, having been acknowledged, should be allowed to remain?

High Court:

“For completeness, and although we consider that this is not a real prospect, we have also considered the likely state of competition in the event of a roll out of more Extra stores on a scale that would be sustainable for The Warehouse.  We consider that the constraint from the Warehouse Extra, once rolled out to 15 stores, would not provide a material constraint on Woolworths or Foodstuffs.”

The Court found that the difference in the anticipated level of competition under the factual (Woolworths or Foodstuffs buying The Warehouse) and under the counterfactual (The Warehouse remaining independent), was not substantial.  The Court did not need to consider this issue because it had already determined that there was no real and substantial prospect that the Warehouse Extra would continue.  Clearly, even if it had thought there was a real prospect that the Warehouse Extra would continue the Court would still have granted clearance on the grounds that such continuation would have insubstantial competitive relevance.

Again, this is a remarkable determination.  It appears to be based on a view that there is no real and substantial possibility that the Warehouse Extra could ever be a price leader or seek to shake up the opposition with a view to obtaining a significant market share.

Without doubt, the incumbents have duopsony buying power that might squeeze a new entrant, and possibly one need not be cynical about evidence to the effect that suppliers were not in practice providing the necessary price support to The Warehouse, but:

• Is there not a real and substantial prospect that suppliers might, over time, change their attitudes (it is rational for them to seek to break up the duopoly but understandable that they would be cautious in the short term, as the evidence before the Court makes clear)?
• Is there not at least a real and substantial prospect that The Warehouse could become a price leader, a mover and shaker etc.  Indeed, is that not its forté?

One must be wary of adopting overseas practices in a New Zealand context.  It is, however, noteworthy that in the United States the Courts have found that "typically in an oligopolistic situation the entry of a large firm as a new competitor necessarily has pro‑competitive effects, at least to the extent of 'shaking things up' or engendering 'competitive motion'."  This is not law; it is a reflection of market place realities.  It is, however, not an observation  that would have been shared by the High Court in the present context.

In this context the Court had to compare the competitive outcomes under the factual (acquisition by Woolworths or Foodstuffs) with competitive outcomes under the counterfactual (no such acquisition and successful roll out of the Warehouse Extra).   Necessarily therefore the Court had to have regard to the present state of competitiveness in the market and yet it had really made no findings in this respect. 

The Court had determined that, although there was evidence to the effect that competition between Woolworths and Foodstuffs was not as "tough" as it potentially could be, it did exist.  The Court appeared to be satisfied that no further inquiry was called for once it had determined that the practices of the supermarkets were in line with what would be expected of firms that provide differentiated products, like luxury car makers.  This analogy and this conclusion in the face of strong submissions as to the existence and, most relevantly, the potential existence of tacit collusion will surprise many.  Having found the Commission's evidence on collusion to be "inconclusive" the Court concluded that there is no real and substantial risk of tacit collusion at any time in the future.  Has there been a leap of faith?

So too, having found that the evidence is not inconsistent (is this an acceptably strong finding?) with Woolworths and Foodstuffs being involved in reasonably vigorous and workable competition, further inquiry into whether a finding of that nature meets the statutory requirement that the Court must be satisfied as to competitive consequences and into the likelihood of changes in future was not seriously undertaken.

Inherently, therefore, the Court has not seen any reason to question why the levels of competitiveness in the future might change as a result of The Warehouse being acquired by Woolworths or Foodstuffs.  This appears to ignore the considerable body of evidence to the effect that, left unchallenged and unchallengeable, duopolies in many markets tend to gravitate to a cosy state rather than to a state of internecine rivalry.  There is no serious analysis of this in the decision and yet we suspect that it is a critical consideration.  It might be fair to observe that the size of the New Zealand economy is particularly conducive to duopolies and that there are many instances of "cosiness".

It may be salutary to consider precisely what "all the reasons" were that caused the High Court to conclude that, even if successful, an independent Warehouse Extra operator would make no material difference to competition.  One might expect that, if the Court has been able to reach such a counter-intuitive conclusion¹ then, noting its obligation to be satisfied that there is no real and substantial question about this, the reasons would be cogent.  We consider those reasons below.

We should first note the Commission's submissions, which accord with likely intuitive conclusions.  They were:

• The Warehouse has the necessary attributes of a maverick;
• The Warehouse operates a different business model, has some economies of scope advantages, and making profit on food is not its primary objective;
• The Warehouse has already caused destabilising or unsettling effects on the local markets;
• These effects will grow under the counterfactual.

In passing, the Commission appears to have focussed exclusively upon the Warehouse Extra concept.  We question whether such focus was appropriate.  It infers that, if The Warehouse had in fact never commenced a supermarket operation, there would have been no issues under the Commerce Act.  This is far from necessarily so.

1 The intuitive conclusions are, we consider, well represented by Bryan Gaynor in “No Extra
room between the behemoths - High Court ruling means the supermarket sector will remain
in the grip of a powerful duopoly for a long time to come” Weekend Herald, 8 December
2007, C2.

Woolworths submitted that:

• The most significant constraint on Woolworths and Foodstuffs will be each other;
• Pak'n Save is and will continue to be the price leader;
• The Warehouse is not a "maverick" with the incentive and ability to affect competition in the market;
• Even if The Warehouse had a 5% market share (it is not always clear whether references are to national or local market shares), it would be too small to have anything other than an extremely small effect on prices;
• Woolworths' pricing policy in local areas is not attributable to the Warehouse Extra;
• The proposed merger is not likely to lead to co-ordinated or non-co-ordinated effects on competition.

The Court found (in some respects appearing to go beyond even Woolworths' submissions):

• The pricing impact when a Warehouse Extra is opened is the same regardless of whether it is in  a location where a Pak'n Save is also located;
• The evidence indicates that Woolworths considers it worthwhile to observe the Warehouse Extra, not that Extra has led to a material change in Woolworths' competitive strategy;
• The impact at Sylvia Park is difficult to gauge.  What is clear is that the market share remains very small;
• Foodstuffs has not responded to the presence of the Warehouse Extra at Sylvia Park;
• Any price change in response to the Warehouse Extra at Whangarei is well below the level at which the Court would have concern;
• Neither Foodstuffs nor Woolworths has responded to the Warehouse Extra in Te Rapa;
• There is nothing in the evidence that indicates that the Warehouse Extra would cause pricing impacts of 2% or greater in the local markets;
• The Warehouse Extra does not aim to be a main player in food (it seeks to get to 3% of the market), it does not intend to be a price leader;
• The Warehouse Extra does not intend to behave as a maverick;
• The one-stop convenience model has provided innovation but that innovation has not had the effect of constraining Woolworths or Foodstuffs.

It is not appropriate for us to suggest that those determinations were not correct (i.e. that they were not  available to the Court on the evidence).  However, we are not persuaded that, even if correct, they are sufficient and, more relevantly, it is clear that the Court was immensely influenced by competitive responses by Woolworths and Foodstuffs to the Warehouse Extra outlets that have been opened.  The first such outlet was opened in June 2006 at Sylvia Park.  The second opened in November 2006 at Whangarei and the third opened in Te Rapa in August 2007.

At all or almost all material times The Warehouse has been known to be potentially "in play". Woolworths lodged its clearance operation on 17 January 2007.  Clearly, it had for some time prior to that been considering the acquisition of The Warehouse.  The Te Rapa store actually opened in the period between the denial of clearance and the High Court trial.

Should the Court have placed almost complete reliance upon evidence of market conduct in this climate and context?  Is it not reasonably likely that the intending purchasers would have known that they could not respond aggressively to new entry if they were serious about their purchase intentions?  If not actually likely, is there not at least a real and substantial risk?

If evidence as to conduct is correctly to be viewed with at least a degree of cynicism then what remains of the Court's reasons?

What appears to remain is that The Warehouse’s strategy is to achieve a 3-5% market share and that it does not aim to be a main player in food or a maverick.  How probative are these observations?

The Warehouse's intentions are not of significant evidential value.  Firstly, they too are intentions expressed in a context when The Warehouse itself is obliged to maximise its market capitalisation and where being “unavailable” to its two primary suitors would hardly assist in that respect.  But secondly, and of equal relevance, intentions change over time.  There is certainly a real and substantial prospect that they will.  The Court appears to have had a singular focus upon the past and the present and no serious regard for the future.

There is one other aspect of the Court’s approach that justifies comment.  This was the finding that any price impact the Warehouse Extra will have on existing competitors in the markets in which it will be present is likely to be minimal and below the level at which the Court would have concern.

Even leaving to one side the correctness of adopting a “likelihood” test in this context, it is very clear from the judgement that the Court found likely price impact to be materially below the 3-5% for which the Commission contended.  The Court determined that it could place no weight on the Commission’s evidence indicating price effects at this level but does not indicate what evidence it can rely upon.  (Is a successful appeal assured whenever the applicant can discredit the Commission’s expert evidence even if all other evidence is similarly unreliable?)

However, for now, the question we wish to pose is whether the Court (assisted by its expert economist) has not been unduly seduced by the belief that arithmetic precision is possible or even desirable in such a context.  It is clearly a useful exercise but where experts differ should the Commission’s conclusion that it is not satisfied as to the absence of anti-competitive effect be so readily over-ruled and, if so, should not the bases for such an over-ride be beyond serious question?

For those reasons we consider that the Commission might reasonably conclude that the Court had not had sufficient regard to the Commission's submissions and that further clarity should be sought from the Court of Appeal.

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