Three Wholesaler Defendants Engaged In "Subtle" Price Stabilization - Judge

The "most-favored customer" clause included in VHA contracts with Cardinal, Bergen Brunswig and AmeriSource represents a "subtle form of price stabilization," D.C. federal court Judge Stanley Sporkin said in his July 31 ruling in the wholesaler merger trial.

Citing allegations by the Federal Trade Commission that the defendants used the VHA contracts to create a price floor in the wholesaling market, Sporkin declared: "It is obvious that these kinds of actions are inimical to the competitive market system and must cease."

The 1995 VHA contract was described in court by FTC as an example of pricing coordination ("The Pink Sheet" July 6, p. 24). The judge noted that McKesson "was not involved at all in these transactions" and that "there was no evidence at trial that would indicate that the CEOs of Cardinal, Bergen, or AmeriSource were in any way directly involved in these activities."

"Although the court is not convinced from the record that the defendants actually engaged in wrongdoing, it is persuaded that in the event of a merger, the defendants would likely have an increased ability to coordinate their pricing practices," Sporkin said.

Sporkin cited the VHA experience as one of "three compelling examples" presented by FTC "of the way in which significant anti-competitive effects would likely occur if the mergers were to be approved."

The judge granted FTC's motion for a preliminary injunction blocking the proposed mergers of Cardinal with Bergen and McKesson with Amerisource ("The Pink Sheet" Aug. 3, p. 10). The four wholesalers announced Aug. 7 that they have jointly terminated their merger agreements.

"Defendants' own internal documents and public statements, [show] that they perceived that the excess capacity currently in the marketplace was the primary factor fueling so-called 'irrational' pricing."

"If the mergers were to be approved and excess capacity removed from the market, this court finds that pricing pressure would ease and prices would not likely continue to go down," the judge ruled. "In the end, this would inevitably affect competition to the detriment of the American consumer."

Sporkin was also persuaded by FTC's description of the effect its decision to block the McKesson/Alco merger in 1988 had on the wholesaling market. "Back in 1988, if the defendants had made the same representations as they make today - promising not to raise their prices after the merger - competition and pricing in the market could have been expected to remain about the same," Sporkin commented.

"Yet because the FTC chose to block the merger in 1988, the industry experienced nearly 10 more years of competition. As a result of this decision, defendants' customers today pay an upcharge of only 35 basis points, as compared to the 400 basis points of 1988."

The wholesalers' "promise not to raise prices fails to ensure that prices will continue to fall after these mergers - or fall by the amount they would have absent the mergers," he said. "This court is not convinced that the defendants would still vigorously compete with one another after the mergers to continue lowering their prices. In the absence of real competition, it is concerned that the prices set today could in effect become the floor tomorrow."

However, Sporkin criticized FTC's overstatement of its contention that wholesalers would raise prices. "The FTC needlessly overstated its case and scared the American consumer when it announced in its initial press release that these mergers would result in 'higher prices for prescription drugs and a reduction in the timely delivery of these drugs,'" the judge added in a footnote. "The fear that defendants would raise prices above the current levels was never really at issue."

Sporkin did not accept the wholesalers' definition of the product market as the entire $94 bil. pharmaceutical market, but rather chose FTC's narrower definition of the wholesale market.

While recognizing that self-warehousing chains have the ability to replace wholesaler services, Sporkin said "with regard to hospitals, independent pharmacies, and non-warehousing retail chains...the alternatives suggested by the defendants such as captive production [self-warehousing] cannot be included within the relevant product market."

Based on the limited amount of direct purchasing and self-warehousing used by those groups, "it does not appear plausible that other methods of drug distribution that are not currently perceived as real substitutes for the defendants' services would suddenly become so in the event of a merger."

Looking at market share, "even if this court were to define the relevant market to account for captive capacity, the post-merger shares of the defendants would still cross the 30% threshold" for a presumption of illegality, Sporkin said. Even if only independent pharmacies or hospitals were included in the market share analysis, the two merged firms together would have 63% of each of those markets.

The wholesalers argued that ease of entry into the marketplace would offset any anticompetitive practices. Sporkin analyzed the timeliness of entry and found that "opening a new distribution center need not take as long as the government contends" and "there was no evidence that the technology needed by new entrants to compete with the merging defendants would be unavailable to them." New "entry or expansion within the market could plausibly occur within a short enough period of time," he concluded.

Likeliness of entry, however, is less certain, Sporkin said. "Despite the few examples of real success such as the sponsored entry of Walsh Dohmen into a new regional market...the record is more uncertain than defendants state. Although Bindley Western, Neuman, Morris & Dickson, and others have all expanded in recent years geographically and by market share, this growth has been insignificant on a national scale."

Sporkin acknowledged that distribution centers will be readily available after the mergers "and competitive opportunities could well arise if the defendants were to engage in anti-competitive behavior."

However, the amount of regional competition that would move in to take advantage of anti-competitive practices would be insufficient, Sporkin said. "Other small wholesale distributors would certainly win more business away from the defendants," he added. However, "the absence of another national wholesaler in the event of the mergers is too great a competitive loss - which the regional wholesalers cannot sufficiently replace."

Most customers require a primary and secondary wholesaler, Sporkin noted. After the mergers, customers in certain regions would have no choice other than the two merged entities as primary and secondary suppliers, he added.

Sporkin did agree with the wholesalers that the "customers of the defendants possess a significant amount of leverage in contract negotiations" so that the wholesalers "could not easily engage in anti-competitive pricing practices after the mergers without incurring the wrath of its customers."

"Nonetheless," Sporkin said "the existence of the independent pharmacies and the smaller hospitals makes the wholesale market considerably fragmented" and "it is unclear just how important each individual customer, particularly each individual small to medium-sized customer, is to the defendants."

While the wholesalers convinced Sporkin that significant efficiencies would likely result from the mergers, "evidence presented by the FTC strongly suggests that much of the savings anticipated from the mergers could also be achieved through continued competition." Cardinal estimated $220 mil. in savings and McKesson estimated $146 mil.

While "the mergers would likely yield the cost savings more immediately, the history of the industry over the past 10 years demonstrates the power of competition to lower cost structures and garner efficiencies as well."

"The critical question raised by the efficiencies defense is whether the projected savings from the mergers are enough to overcome the evidence that tends to show that possibly greater benefits can be achieved by the public through...continued competition. The defendants simply have not made their case on this point."

Sporkin "explored every opportunity with the parties to find a way to permit the proposed mergers to go forward," the judge wrote. The court appointed Milton Gould (Shea & Gould, New York City) as a special master to attempt to negotiate a settlement, he noted.

The wholesalers were willing to promise not to raise prices and to pass on 50% of savings to customers. "While such undertakings would go a long way toward addressing the public's legitimate concerns, the mere fact that such representations had to be made strongly supports the fears of impermissible monopolization."

Cardinal is moving forward with expansion in a different direction: R.P. Scherer stockholders voted to approve the acquisition of the contract manufacturing and drug delivery company on Aug. 6.

The timing of the judge's ruling on the FTC case was unfortunate for Scherer shareholders, each of whom will receive .95 shares of Cardinal stock in exchange for each Scherer share. Cardinal lost about 10% of its value following the ruling; the wholesaler's shares had climbed as investors anticipated approval from the judge based on some of his comments in court.