Legal Alert: New Defense Department Guidance on Mergers and Acquisitions

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1 by Jeffrey P. Bialos October 8, 2015 On September 30, the U.S. Department of Defense (DoD or the Department) issued new guidance that reaffirmed its earlier view that it would not look favorably on mergers of top tier defense firms. The Department declared its intent to work with Congress on possible legislation that would fill the gaps in existing antitrust law and provide additional authorities to help preserve the innovation that has been central to the U.S. defense industrial base. The guidance reflected DoD s articulated concern about the continuing march toward greater consolidation in the defense industry at the prime contractor level in the context of declining defense budgets and its desire to ensure the presence of a sufficient number of contractors to provide an innovative and affordable war fighting capability. Executive Summary The thrust of the new DoD guidance is that the recent U.S. government decision to clear, without a full investigation, the Lockheed Martin acquisition of Sikorsky does not mean open season for parties to engage in large defense mergers. Rather, the guidance, in the form of a statement made by Under Secretary of Defense for Acquisition, Technology and Logistics (AT&L) Frank Kendall and related comments by Secretary of Defense Ashton Carter, raised significant policy concerns over acquisitions like the Lockheed/Sikorsky transaction i.e., transactions that might allow one or more large prime contractors to dominate large parts of the defense industry. The DoD statement also makes it clear that while the Lockheed/Sikorsky deal one of the most significant defense mergers in years technically does not trigger anti-trust concerns under existing law, the Defense Department will seek additional legal authority from Congress to investigate and resolve the significant policy concerns raised by such transactions. While today s antitrust laws allow the U.S. antitrust agencies (the Justice Department and the Federal Trade Commission (FTC)), working with the DoD, to challenge transactions that adversely affect competition in particular relevant markets, the type of broader concerns that DoD has now raised about the overall power such a large firm would have due to its strong positions in multiple markets are at the edge of existing antitrust authority. Thus Under Secretary Kendall has referred to the possible need to add national security considerations into the antitrust law to address these types of situations. With respect to existing legal authority, this new DoD guidance on prime level mergers is not a radical departure in direction or process. However, it does clearly signal a heightened level of DoD concern over the national security implications of defense mergers when evaluating mergers on antitrust grounds i.e., the need to maintain a competitive defense industrial base and the innovation and affordability it can bring to the war fighter. In effect, DoD is taking the view that today s defense industrial structure is at a tipping point, and future large-scale consolidation could adversely affect competition. However, DoD s announcement that it will work with Congress to seek additional authority to block defense mergers on policy grounds beyond the four corners of the antitrust law is new and undoubtedly will be subject to close scrutiny by Congress and the defense industry. While unstated, the DoD guidance clearly suggests that the Department would like additional authority to undertake fuller investigations (with the submission of additional information by the parties) when these policy issues arise. Simply put, the policy question is whether it makes sense to authorize DoD to intervene, beyond the scope of existing antitrust laws, to stop a merger if DoD determines it may create a contractor or contractors whose sheer size and dominant positions in multiple product areas may create a market structure that is adverse to competition, and the innovation and affordability it can bring to defense markets. This communication is for general informational purposes only and is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult independent counsel before making any decisions or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between Sutherland and the recipient.

2 The Policy Context The new DoD statement reaffirms the guidance then-under Secretary of Defense for Acquisition, Technology & Logistics Ashton Carter gave in 2011, when he stated that the Department will likely not support further consolidation of prime level weapons systems contractors. Carter also said that the Department would welcome other merger proposals (i.e., other than prime-to-prime consolidations) and will review them on a case-by-case basis to ensure that the Department s interests are taken into account. At the time, Carter told Bloomberg News that the Defense Department today is down to about five or six very large prime contractors who bid on many, many of our jobs and, in the interest of competition, we are not interested in seeing further consolidation and reduction in that number.but with that exception just about everything else is on the table. At the time, DoD faced the prospect of significant mergers and acquisitions in the defense industry as U.S. military operations in Afghanistan and Iraq wound down, and the country entered an era of budgetary austerity. Thus the Department s guidance was designed to avoid a period of large-scale consolidation like the one that resulted from the peacetime defense cuts in the 1990s (following the so-called Last Supper meeting between DoD and industry) while recognizing that, in an environment of fiscal restraint and shrinking demand, some further sub-tier consolidation was warranted. In the years since the DoD guidance was issued, there has been a gradually increasing trend toward consolidation in the defense and aerospace sector, with the GenCorp/Aerojet acquisition of Pratt & Whitney Rocketdyne in 2012, the ATK/Orbital merger in 2014, and a growing number of second tier defense hardware and defense service sector mergers and acquisitions. While several of these acquisitions raised challenging horizontal and vertical integration issues under the antitrust laws and were subjected to detailed investigation by the U.S. antitrust authorities (in cooperation with DoD), in the end they were not challenged based on the application of antitrust rules to the relevant facts and circumstances. It is in this context that Lockheed Martin, the nation s largest defense contractor, announced in June 2015 its intention to acquire Sikorsky, the leading U.S. producer of helicopters for military and commercial applications. Somewhat surprisingly, the Justice Department cleared the transaction in late September 2015 without issuing a so-called second request under the Hart-Scott-Rodino Antitrust Improvements Act (HSR Act), which allows Justice to fully investigate the impact of the proposed acquisition. DoD s New Guidance and Its Implications The key points made by DoD in its new guidance are set forth below along with some initial thoughts on their implications for the industry. Post-Lockheed-Sikorsky, It Is Not Open Season for Parties to Undertake Large, Prime Level Defense Mergers. At its heart, the DoD guidance makes it clear that the Department stands by its earlier guidance that it looks unfavorably on future mergers among top tier defense firms. In other words, the approval of the large Lockheed Martin-Sikorsky deal without a full investigation under the HSR Act (i.e., a so-called second request requesting supplemental information from the parties) should not be read as changing the pre-existing DoD policy. Indeed, if a statement like this had not been issued soon, numerous observers in the industry may have viewed the expeditious U.S. government approval of the transaction as a policy change especially coming on the heels of the approval of the ATK/Orbital transaction last year. Thus, the DoD statement is designed to reject that view.

3 Other Mergers Subject to Case-by-Case Review. Moreover, in the absence of any new guidance, the preexisting DoD guidance on non-prime mergers still stands namely, that DoD will review acquisitions of mergers between subsystem or service firms case by case based on traditional antitrust principles. Similarly, while the DoD guidance focuses on mergers among primes, there is no clear indication that prime level firms acquisitions of subsystem suppliers or other small and medium businesses are subject to a negative policy tilt. These types of acquisitions are part of normal market processes and can be pro-competitive in many situations. Thus, these cases will continue to be assessed on a case-by-case basis under the antitrust laws. Consolidation Trend as the Driving Force of DoD s Unfavorable View of Prime Level Mergers. DoD also made it clear that the trend toward fewer and larger prime contractors is what underlies its policy. As DoD stated, this consolidation has the potential to affect innovation, limit the supply base, pose entry barriers to small, medium and large businesses and ultimately reduce competition resulting in higher prices to be paid by the American taxpayer in order to support our warfighters. Indeed, the ultimate Department concern, expressed in the guidance, is that [i]f the trend to smaller and smaller numbers of weapon system prime contractors continues, one can foresee a future in which the Department has at most two or three very large suppliers for all the major weapons systems that we acquire. The Department would not consider this to be a positive development and the American public should not either. Secretary Carter made similar comments when he stated that [i]t was important to avoid excessive consolidation in the defense industry to the point where we did not have multiple vendors which could compete with one another on many programs. Acquisitions Like Lockheed/Sikorsky Raise Significant Policy Concerns Beyond the Antitrust Laws. While DoD was careful to state its view that the Lockheed/Sikorsky transaction does not trigger anti-trust concerns under existing law, it also clearly signaled that it approved the transaction begrudgingly and would have preferred a deeper investigation (i.e., a second request under the HSR Act) in order to fully examine the significant policy concerns raised by these types of transactions. Such a second request typically involves submitting, to the relevant antitrust agency handling the transaction (Justice of the FTC), a substantial volume of documents by parties to the transaction. DoD Concerns Over the Power of Large, Dominant Contractors. In particular, what rings through the DoD statement is a strong concern that the creation of a contractor that is dominant in a number of markets will be adverse to competition among primes across the board. In this regard, DoD observed that the Lockheed/Sikorsky transaction is the most significant change at the weapon system prime level since the large scale consolidation that followed the end of the cold war. This acquisition moves a high percentage of the market share for an entire line of products military helicopters into the largest defense prime contractor, a contractor that already holds a dominant position in high performance fixed wing aircraft due to the F-35 winner take all approach adopted over a decade ago. Mergers such as this, combined with significant financial resources of the largest defense companies, strategically position the acquiring companies to dominate large parts of the defense industry. (Emphasis added.) Needless to say, these are telling comments about a merger that had been approved reflecting the extent of DoD s concerns. With Size Comes Power. At the heart of DoD s concern is its view that [w]ith size comes power, and the Department s experience with large defense contractors is that they are not hesitant to use this power for corporate advantage. (Emphasis added). This striking sentence reflects an underlying view that such size (as apparently measured by the share of contracts a firm holds in product lines) would not be benign in nature and would strongly incentivize firms to act anti-competitively. Moreover, while unstated by DoD, it could be argued that certain acquisitions could create an industrial structure inherently adverse to competition even if a large, powerful firm does not directly use its power to adversely affect competition. For example, if a single prime level defense

4 contractor had the lion s share of contracts across a range of product areas, consider whether a subsystem supplier would be willing to team with a competing prime for the next award even if the dominant prime did not directly object or demand exclusivity. Interestingly, the statement also implies a concern that DoD s position as the sole buyer in many of these industries may not be sufficient countervailing market power to control such large firms. DoD s Concerns Over the Large Size and Broad Power Are on the Edge of Existing Antitrust Authority. For a number of reasons, it is difficult to utilize the existing antitrust laws to challenge the type of significant policy concern that DoD has expressed about transactions like Lockheed/Sikorsky. o First, the antitrust laws focus on the impact of a transaction on competition in a particular relevant market or markets. The antitrust agencies evaluate the horizontal effects (i.e., does the merger result in undue concentration and market power of the parties in that particular market) and the vertical effects on the supplier base in that market. In this regard, for example, the Lockheed/Sikorsky transaction does not raise the traditional types of horizontal consolidation issues found in mergers (i.e., because it is not a merger between two competing helicopter prime contractors). Rather, the transaction was vertical in nature (i.e., between Sikorsky, a helicopter prime, and Lockheed, which supplied subsystems for helicopters). Vertical mergers may raise greater concerns in the defense industry than in other markets since concern with preserving innovation rather than pricing issues may be paramount. Nevertheless, the reality is that few mergers have been prohibited on grounds of anticompetitive vertical integration because anticompetitive effects are difficult to prove and there may be more demonstrable efficiencies. In this case, while Justice apparently reviewed whether the combined company s power to deny Lockheed s subsystem capabilities to other helicopter firms would be anti-competitive (i.e., whether other reasonable substitutes were unavailable), this theory apparently did not offer a sufficient basis for a second request. o Second, the antitrust laws generally have not been successfully invoked to challenge mergers solely on the basis of the size or financial resources of a firm or its ability to leverage its position in some markets to create a competitive advantage in other markets. Bigness is not necessarily bad under the antitrust laws unless it can be shown that the combined firm will acquire actual market power that will allow it to dominate or maintain dominance in a particular product market. In practice, challenges to so-called conglomerate mergers (i.e., between firms that are not direct competitors or do not have supply relationships) have been rarely mounted, particularly in recent years, and have been largely unsuccessful. Early antitrust theories that conglomerate mergers may entrench the position of a dominant firm in the market for example through increased financial resources have largely been eliminated by the U.S. antitrust agencies as a basis to challenging non-horizontal mergers. o Third, while the Clayton Act prohibits mergers whose effect may be substantially to lessen competition, or to tend to create a monopoly in a product market (emphasis added), in practice the U.S. antitrust authorities and the courts tend to require hard evidence that a merger is actually likely to lessen competition and create anticompetitive effects. In short, a policy concern, even significant, that a vertical or conglomerate merger will create an industrial structure not conducive to competition generally would not cut it. Rather, it is apparently the view of the antitrust agencies (the Justice Department and the FTC) that any such adverse competitive effects can be addressed after the fact. That is, the antitrust agencies can directly attack exclusivity agreements, or tying or reciprocity arrangements to the extent they constitute unreasonable restraints of trade under the antitrust laws outside of the merger context.

5 While the FTC has the authority to, and has in practice examined national security considerations under its public interest standard in a number of defense transactions, it has relied on such considerations only as the basis to clear acquisitions otherwise found to be anti-competitive. Existing laws do not provide any national security or public interest basis for challenging transactions that otherwise do not raise specific antitrust concerns. In sum, while it may be possible that these types of claims could be brought in the context of a particular transaction, the challenges to such claims under the existing antitrust laws generally would be significant in light of the prevailing precedents and practice. DoD s Request for Additional Legislation. In light of the limitations of existing antitrust law, DoD stated that it is convinced that we should work with Congress to explore additional legal tools and policy to preserve the diversity and spirit of innovation that have been central to the health and strength of our unique, strategic defense industrial base, particularly at the prime contractor level. Under Secretary Kendall has suggested the idea of adding national security considerations into the antitrust law to address these issues, and noted that his staff is working on developing policy alternatives. The Nature and Prospects of Additional Legislation Remains to Be Seen. Whether and to what extent Congress will seriously consider any expanded authority to challenge mergers on the basis of significant national security concerns remains to be seen. Several preliminary observations are set forth below: o Public Debate is Likely. First, a robust public discussion on this proposal is expected and indeed, it has already begun. Some may argue that there are cogent reasons for limiting the authority to block mergers to the traditional boundaries of the antitrust law and some may raise concerns over affording DoD meaningful discretion in this area. o Standards and Processes Will Be Central Issues. Second, even if Congress were to accede to DoD s views, a number of questions would arise in crafting any such legislation. These issues include the breadth of DoD authority (i.e., what standards would apply and guide or bound its exercise of national security discretion) and whether DoD would have independent authority to investigate or block acquisitions on such grounds (i.e., outside the normal antitrust procedures managed by the U.S. antitrust agencies under the HSR Act). o Enhancement of Additional Non-Merger Tools to Address Industrial Base Concerns. Another question is whether DoD should sharpen and better utilize policy tools outside the merger review context to address whether there is sufficient competition in the defense industrial structure to provide innovative and affordable weaponry. Thus, for example, it is possible that industrial base issues and other policy concerns could be more systematically considered in shaping major acquisition strategies. Similarly, specific applications of market power e.g., through exclusivity arrangements could be forbidden before the fact or (if necessary) challenged on antitrust grounds after the fact. * * * In sum, the new DoD guidance authoritatively answers the question of whether the recent U.S. decision not to challenge the Lockheed/Sikorsky deal on antitrust grounds signals a change in DoD policy toward prime level mergers. Clearly, DoD continues to look unfavorably on such mergers. At the same time, DoD, working with the U.S. antitrust agencies, will also continue to review other mergers and acquisitions in the defense industry on a case-by-case basis in accordance with traditional standards (i.e., with no adverse policy tilt). Finally, the new DoD guidance now has opened

6 the door to a broader debate over whether additional authority is needed for circumstances where DoD has policy concerns about such mergers but no existing legal authority to challenge them. About the Author A Partner in the law firm of Sutherland Asbill & Brennan LLP, Jeff Bialos works on a wide range of aerospace and defense matters, including mergers, acquisitions, joint venture, and other collaborative activities, antitrust, international legal and regulatory matters, export controls, industrial security, government contracts, and public policy issues. He advises firms and Boards of Directors on these issues. Mr. Bialos served in the U.S. government in several capacities, including most recently as Deputy Under Secretary of Defense for Industrial Affairs and was awarded the Department of Defense Distinguished Public Service Medal for his service. Mr. Bialos has authored and co-authored numerous articles and co-authored several books on national security and international legal and policy topics. Mr. Bialos received his J.D. degree from the University of Chicago Law School, a Master s degree in Public Policy from the Kennedy School of Government at Harvard University, and an A.B. in history, magna cum laude, from Cornell University s College of Arts and Sciences.