Steve Salop explores the anticompetitive innovation behind weight-loss giant Novo Nordisk’s offer to acquire Metsera. Novo’s proposed contract presents a new tactic by which firms with market power can preclude rival mergers that will lead to procompetitive entry.
The growing market for GLP-1 weight-loss therapeutics is a duopoly of Novo Nordisk and Eli Lilly. Metsera is one of the few American biotechnology companies developing next-generation drugs in this space. While still moving though the Food and Drug Administration’s pipeline for approval and clinical development, Metsera’s products are promising. Given these prospects, Metsera also would benefit from access to the financing, FDA expertise, and the distribution experience of a larger pharmaceutical company. After negotiating with numerous companies, it settled on an offer from Pfizer, whose own GLP-1 product development had failed. The Federal Trade Commission analyzed the proposed merger under the Hart-Scott-Rodino (HSR) Act and, finding no competitive problems, cleared the transaction in October, ahead of Metsera stockholders’ scheduled approval and closure of the deal before the end of November. Metsera had previously rejected a higher offer from Novo in light of the enormous antitrust risk of that horizontal combination.
Faced with this likely increase in competition, on October 30 Novo threw a Hail Mary pass: an even higher offer with a novel, risk-shifting payment structure. Novo’s offer involved an immediate cash payment in advance of actually completing the merger, cash it would not recover if the FTC blocked the deal. In other words, Novo would bear the risk of an FTC injunction. The offer was also structured such that Novo would initially receive only non-voting convertible preferred stock, which would appear to avoid an HSR filing that would delay the transaction. According to the offer, if the FTC blocked the transaction, Metsera’s shareholders could keep the money they have already received. However, Metsera’s shareholders would have to repay the money if it ever accepted another offer during the life of the contract—30 months—even in the case that the FTC blocked the transaction.
Metsera’s Board announced on October 30 that it had accepted Novo’s proposed contract , along with an indemnification provision to protect themselves. On October 31, Pfizer filed a breach of contract lawsuit against Metsera and asked the court for a temporary restraining order to prevent Novo from triggering its purchase of the convertible preferred stock. On Monday, November 3, Pfizer also filed an antitrust lawsuit alleging that the proposed acquisition was an illegal trifecta, violating Section 7 of the Clayton Act (anticompetitive merger), and Section 1 (anticompetitive agreement) and Section 2 (attempt to monopolize) of the Sherman Act. Pfizer also made a new and higher counteroffer. On November 4, Novo topped Pfizer’s new offer with a price said to equal $10 billon, which the Metsera board of directors tentatively accepted. On the same day, the Delaware court refused Pfizer’s request that it issue a temporary restraining order on the breach of contract claim and immediately block Novo’s pay-in-advance plan.
Although the FTC is operating at a minimum level due to the federal government shutdown, it responded with a letter to Novo’s and Metsera’s counsel, warning them that the use of this two-step acquisition financing structure for the purchase of non-voting convertible preferred stock raises serious risks of violating HSR reporting requirements. The risk derives from the fact that Novo will have some control over Metsera’s decisions before completion of the acquisition, and the structure may limit Metsera’s ability and incentive to compete. In this regard, Pfizer’s antitrust complaint alleged that the agreement requires Metsera to obtain Novo’s consent for any capital expenditures over $2.5 million or to enter into licensing agreements with third parties. Pfizer also alleged that Metsera is also limited by the agreement in its ability to grant employees equity awards and bonuses. If these allegations are true, Novo would have substantial influence over Metsera’s ability to innovate even though Novo’s convertible shares were non-voting. And, of course, Novo’s passive ownership interest in a competitor would reduce its own competitive incentives. However, the FTC’s monetary civil penalties for such gun-jumping violations have been quite low in previous cases, so it is not clear why the letter would matter. Thus, the only effective remedy would be an immediate injunction of the two-step structure—though the FTC did not make that threat.
The saga came to an apparent close on November 7. Pfizer topped Novo’s last offer by five cents per share and Novo did not counter. Metsera’s board accepted Pfizer’s offer, saying that the Novo offer came with too much legal and regulatory risk, which was what they also said in rejecting Novo’s initial offer months before. In the end, Pfizer apparently has paid $10 billion: double its initial bid. Competitive entry was not deterred in fact, so not a bad ending for consumers.
Antitrust concerns
This episode raises an interesting issue for antitrust economics and law. Structuring a purchase agreement, as Novo did, to deter a counteroffer is not inherently anticompetitive. Sellers can generally be counted on to protect themselves. The financial structure can lead the seller to obtain a better deal, either because the initial buyer would pay more to get the protection or subsequent counterbids would be higher. The difference here is based on a combination of facts. First, the FTC would very likely have blocked Novo’s proposed acquisition. Second, the first step of the transaction, in which Novo makes a large advance payment that so raises the cost of a counteroffer during the contract duration of 30 months that the counteroffer would be deterred, even if the FTC enjoins the merger and the parties abandon the deal during this period. Third, the deterred counteroffer would have come from a potential competitor—Pfizer—that would enter the market with the merger, compete with Novo, and increase consumer welfare.
In economic terms, Novo’s advance payment contractual structure was an exclusionary contract that would raise dramatically barriers to entry likely to a prohibitive level. While Pfizer’s counterbid came before the contract was signed so that its winning bid was not deterred in the end, the antitrust fear is that this type of structure could, in future situations, so substantially raise the cost of competitive counteroffers that future targets, like Metsera here, would not be acquired by someone else for the duration of the contract, even after the proposed merger was predictably enjoined by the FTC. In this outcome here, leading firms like Novo would be able to maintain its duopoly market share and supra-competitive profits despite being unable to actually purchase the target. This would be a killer non-acquisition, not a killer acquisition of the kind studied by Colleen Cunningham, Florian Ederer, and Song Ma, in which the acquiring firm kills the innovation program of the potential rival after buying it.
The anticompetitive incentives of Novo’s exclusionary contract
To explain the incentives created by this type of advanced payment contractual structure, consider this example. Suppose that the seller’s value as a standalone competitor is $4 billion. Suppose that the initial buyer offers $8 billion to be paid upon signing the contract and distributed to the shareholders. This advance payment will not be refunded if the merger is blocked by the FTC or abandoned by the buyer during the 30-month duration of the contract. But it must be refunded if the seller terminates the deal and sells to a different buyer during this period.
Given these terms, suppose that after the seller accepts and signs the deal and the shareholders are paid, after which the merger is blocked by the FTC or collapses. Will another buyer step up and acquire the seller’s company? A new buyer would have to offer the seller at least $12 billion, which is equal to the seller’s $4 billion value as a standalone company plus the $8 billion already received that would have to be refunded. This high minimum bid likely would be enough to deter that new bid, which would have come from a potential entrant into the market. Thus, the structure would produce a strategically advantageous outcome for a duopolist or dominant firm fearing entry.
The duration of Novo’s contract was only 30 months. But even just delaying Metsera’s entry by deterring Pfizer’s acquisition could be profitable. Metsera potentially would lose its best window of opportunity. Spending $8 billion (less whatever price it would receive when divesting its convertible shares) to deter entry may be a very economical investment for Novo if entry would significantly increase competition and permanently cut into its duopoly profits. In short, for Novo, it could be a “Heads I win, tails you lose” outcome.
Naked exclusionary rights contracts
If one assumes that Novo’s acquisition of Metsera would surely have been blocked by the FTC, then its offer amounted to the attempted purchase of what might be termed a naked exclusionary right—that is, a payment made by a firm to an input supplier to refuse to sell to the firm’s competitor when the firm itself does not purchase from that supplier. As Thomas Krattenmaker and I note, Alcoa allegedly purchased naked exclusionary rights in the early 20th century by paying some hydropower companies not to sell electricity to other aluminum competitors, even though Alcoa did not buy electricity from them. If a rival or new entrant wanted that power company to sell it electricity, it would have to pay enough to compensate the power company for the damages associated with breaching its contract with Alcoa, which would entail returning at least Alcoa’s payment, and likely more. If this power supply were critical to the new entrant, the higher cost of paying the damages for a breach of contract would effectively create a barrier to entry, as modelled by Philippe Aghion and Patrick Bolton.
Similar payments for exclusion have been made to the rivals themselves. The Palmer v. BRG antitrust case involved a market allocating non-competition payment by the dominant provider of bar law review courses in Georgia to a new entrant. The FTC’s Actavis pay-for-delay antitrust case attacked the purchase of an exclusionary right, though it was not stark naked. In that case, a patent monopolist settled its patent infringement action against the generic entrant by making a payment to the entrant in exchange for a delay in its entry until six months before the patent expired. Such settlements do eliminate future litigation costs, and some delays may be justified if the patent may actually have been infringed. However, as explained by Aaron Edlin and his coauthors, the length of the delay in Actavis suggested a very low likelihood of infringement and likely substantial competitive harm to consumers.
Vertical merger contracts as naked exclusionary rights
This economic analysis of this structure can also be explained in the context of a standard vertical merger hypothetical involving a breach of contract issue. Suppose that Firm M is a monopolist in the industry with monopoly profits of $400. Firm E is a potential entrant, but it lacks a viable product. If Firm E enters successfully, Firm E will earn profits of $100 and firm M’s profits will fall from $400 down to $200. Consumer welfare will rise by $100 (assuming for now a market of just the two firms) as a result of the increased competition generated by the entry of Firm E.
In order to enter successfully, suppose that Firm E must acquire a technology asset owed by Firm U. Assume that Firm U’s technology asset has no value to Firm M because it already has its own comparable asset. Assume further that this asset has a value to Firm U of only $10. Suppose next that Firm E offers Firm U a price of $55 for the asset, which Firm U suggests that it will accept, but with the caveat that it will entertain other superior offers. Facing a profit reduction of $200 if Firm E successfully enters the market, Firm M devises the following anticompetitive strategy: Firm M offers to pay $95 to firm U in exchange for firm U’s contractual promise not to sell the asset to Firm E.
Assume next that Firm U accepts this deal and deposits the $95 payment in its account. This places Firm E in an impossible position. In order to obtain the asset, it must not only pay Firm U more than the $10 standalone value of the asset. It must also compensate Firm U for the $95 that in breach of contract damages that it will need to pay to Firm M. That is, Firm E must offer Firm U at least $105. In this example, this $105 minimum bid exceeds the profits that Firm E would earn from entry, so Firm E walks away, its entry successfully deterred. As a result, Firm M retains its monopoly and nets profits of $305 (i.e., $400-$95), which still greatly exceed the $200 profits that it would have earned had entry occurred. Firm U effectively shares in these monopoly profits as result of the $95 payment. Firm E loses the opportunity for its otherwise viable and procompetitive entry. Most importantly, consumers lose the benefit of the competition that Firm E’s entry would have achieved.
To be clear, the $95 paid by Firm M to Firm U is not a payment for Firm U’s valuable asset. Firm M does not value the asset and does not acquire or use it. Instead, the $95 is paid solely to induce Firm U to withhold the asset from Firm E. It is the purchase of a naked exclusionary right, intended to raise Firm E’s cost of entry to a prohibitive level.
While the example is simplified, it runs parallel to Novo’s strategy. In the hypothetical, Novo is Firm M (the monopolist), Pfizer is Firm E (the potential entrant), and Metsera is Firm U (the owner of the critical technology asset). The payment to Firm U not to sell the asset to Firm E corresponds to Metsera’s incentives resulting from the advance purchase of the convertible stock.
What comes next
While it failed here, the Novo advance payment structure may turn out to be a (anticompetitive) contractual innovation. We can expect it to be imitated by dominant firms whose supracompetitive profits are existentially threatened by new entry. It certainly can be profit-maximizing for a dominant firm or leading oligopolist to pay off a target to deter entry, at least if that strategy will be subject only to toothless civil penalties for HSR gun-jumping violations, rather than as an exclusionary agreement subject to antitrust damages or possibly even criminal charges. Thus, the immediate question is whether the antitrust authorities will have the ability and incentive to increase their threat level by a policy commitment to block such deals.
Author Disclosure: Steven Salop is Professor of Economics and Law Emeritus and Senior Consultant at Charles River Associates. He consulted with an outside investor on this matter but not with any of the parties.
Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.
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