short lines

Capita / IBS OPENSystems (and why being a big fish in a small pond isn’t always easier....)
February 2009

In December, the OFT published its full decision to refer Capita Group’s (“Capita”) acquisition of IBS OPENSystems (“IBS”) to the Competition Commission (“CC”).

This article summarises a number of considerations for companies in the software sector which are highlighted by the decision- largely due to competition authorities’ tendency to define software markets very narrowly, which often results in very high market shares.

As explained below, the significance of this is two-fold:

(i) getting competition clearance for mergers can be more difficult and this needs to be factored in when considering acquisitions/mergers in the sector; and
(ii) stricter competition rules govern the way in which companies with high market shares do business.

Some background to the case

Capita provides business process outsourcing solutions and support. Its customers include those in the public sector and social housing. IBS supplies software and support to UK local authorities and housing organisations.

The OFT identified concerns about the impact of the merger on the market for the provision of revenues and benefit software services to UK local authorities (“R&B software”), on which both Capita and IBS operate.

The OFT found that the parties account for a consistently high proportion of newly won contracts. Capita/IBS would face few competitive constraints post-merger, enabling it to raise prices, and reduce service quality or innovation in future. Customers were concerned that having fewer providers would affect their ability to negotiate better terms.

Therefore, the OFT referred the deal to the CC for a detailed, 24-week competition investigation[1].

Key ‘take aways’

High shares of narrow markets

The OFT defined the relevant market very narrowly. It looked at the use of the software (revenue and benefits), the type of customer (local authorities) and where they operated (UK).
If a market is defined narrowly (typically the case with software markets), this increases the likelihood that a company will have a strong market position on it and face fewer competing products/services and providers, e.g. Capita/IBS has a very high share of newly won contracts in the narrow R&B software market.
In fast moving, high tech markets, even a new market entrant can achieve a sizeable market share of a niche market within a relatively short time - it can even have a monopoly if it’s a first-mover and there are no actual/potential substitutes.
Furthermore, the OFT excluded ‘legacy’ contracts from its analysis of R&B software, as these would offer a distorted picture of the present strength of competition to Capita/IBS. It looked only at contracts tendered within the last 5 years, of which the parties had a consistently significant share.

Impact of this on merger assessments

Higher market shares tend to make merger clearance harder to secure.
Market shares are not decisive but the OFT will use shares (usually of sales revenue) as a starting point. Market shares are a key indicator of whether a market is highly concentrated; high concentration suggests that competitive pressure on the merging firms is likely to be weaker.
Comparison of the merged parties’ market shares with those of their competitors may indicate market power and show whether other providers can provide a meaningful competitive constraint. Similarly, the greater the increment to market share resulting from a merger, the more likely it is that the merger will lessen competition.
Capita/IBS involved high market shares, a significant market share increment, and few competing providers. There were high switching costs for customers and barriers to entry/expansion (e.g. the supplier’s track record).
In such a case, it is vital to demonstrate why competition concerns will not arise in practice, point to pro-competitive benefits, and have evidence to back your arguments up. For example, the OFT did not accept some of Capita’s arguments, because it considered that Capita had not provided explanations of some of the data used or certain substantiating evidence. Parties should also give thought up-front to what remedies might be acceptable to the acquirer and to the OFT, should these prove necessary. These issues can be complicated. Therefore, it’s often advisable to get economists on board, to help formulate arguments and respond to the (often complex economic) questions posed by the OFT, and provide supporting evidence.
It’s also essential to take into account the likelihood of third party complaints. Consider how best to communicate news of the deal to your customers/suppliers – their views are likely to be sought by the OFT and any concerns will be investigated fully, as in Capita/IBS.
The Capital/IBS deal also illustrates that parties cannot expect to avoid a competition review if their merger qualifies for investigation. There is no strict obligation under UK merger control to obtain clearance (before or after completion) but parties tend to notify voluntarily for certainty. The OFT obtains information from a variety of sources including the media and third parties and regularly reviews mergers on its own initiative or as a result of complaints. The OFT can effectively force the parties to notify by sending them a request for information – as happened with Capita. Parties may prefer to avoid the administrative burden of having to respond to OFT questionnaires whilst also trying to close a deal by choosing to file at a time convenient to them.
Where a merger is not notified, the OFT nonetheless has up to four months from completion (or of material facts about it being made public or given to the OFT) to look at it and can refer to the CC if, on the balance of probabilities, the merger might result in a substantial lessening of competition (“SLC”).
Parties should evaluate the risks of a reference before signing and reflect this in the documentation. If a deal is likely to result in high concentration, acquirers are generally advised to make completion conditional on the deal clearing and to include an appropriate condition precedent. The CC has broad powers to block, vary or undo deals which lead to a SLC.
As with Capita/IBS, the OFT/CC regularly obtain hold-separate undertakings from the merging parties. They also often require the appointment of a trustee to monitor management of the two businesses during the investigation and prevent the parties from taking any action (e.g. integration) which might prejudice the decision reached.

Impact on ordinary business dealings

How the relevant market is defined, and a company’s share of that market, also directly affects how that company can conduct business.
A company with a dominant position (usually only if has a market share over 40%) – even on a very narrow market – has a special responsibility in how it treats suppliers, customers and competitors. Article 82 of the EC Treaty[2] imposes additional obligations on companies with market power not to act in an exploitative, discriminatory or exclusionary way[3].
Holding a dominant position does not infringe competition law: concerns only arise where market power is used abusively. This means that dominant companies must not price in a manner that is excessive, predatory, or discriminatory, nor can they offer fidelity discounts. Other categories of abuse include certain refusals to supply, making the purchase of one product conditional on the purchase of another unconnected product (tying or bundling) and some exclusivity. However, in general terms, any conduct by a dominant firm which seeks to maintain/exploit its dominant position, hinder market development (e.g. new entry), or eliminate competitors, may be abusive.
With all these points in mind, companies should exercise caution in how internal documentation and correspondence describe the relevant market, the company’s market position, as well as the rationale for any transactions/business strategies. Such documents help inform the OFT’s assessment and parties can be required to provide them during merger reviews and competition investigations.

Next steps

The CC must report by 5 May 2009 on whether the merger has resulted or may be expected to result in a SLC and, if so, what remedies (if any) might be appropriate.

The CC has already indicated that it will explore market definition in greater detail and consider whether the relevant market should be segmented even further e.g. individual modules within each software application or by type of customer (e.g. large and small local authorities and housing associations). The CC will also consider whether to distinguish between the R&B software application and its related services (e.g. training, after-sales support, and maintenance).

In the meantime, the CC is currently seeking comments on the Capita/IBS deal from any interested third parties.

Susannah Sheppard and Rachel Iley

Useful URLs

OFT decision on reference of the Capita/IBS acquisition:
http://www.oft.gov.uk/shared_oft/mergers_ea02/2008/Capita-IBS.pdf
Competition Commission webpage for the Capita/IBS merger inquiry:
http://www.competition-commission.org.uk/inquiries/ref2008/ibs/index.htm

[1]The Enterprise Act 2002 empowers the OFT to refer any completed or proposed mergers which create or enhance a 25% share of supply in the UK (or a substantial part thereof) or where the UK turnover of the target exceeds £70 million.

[2]And the UK equivalent, the Chapter II prohibition in the Competition Act 1998.

[3]The sanction for infringing the rules is a fine and some of the highest fines for breaches of EU law have involved infringements of Article 82.