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Schumann Sasol (South Africa) (Pty) Ltd and Price's Daelite (Pty) Ltd (23/LM/May01) [2001] ZACT 28 (18 July 2001)

.RTF of original document

COMPETITION TRIBUNAL
REPUBLIC OF SOUTH AFRICA


                                                      Case No: 23/LM/May01


In the large merger between

Schumann Sasol (South Africa) (Pty) Ltd

and

Price’s Daelite (Pty) Ltd



REASONS FOR THE TRIBUNAL’S DECISION – NON-CONFIDENTIAL VERSION


Decision

1.      
The Competition Tribunal prohibited the merger between Schumann Sasol (Pty) Ltd (SCHS) and Price’s Daelite (Pty) Ltd (PD) on 1 July 2001. The reasons for the decision follow.

The Proposed Transaction

2.      
Schumann Sasol (South Africa)(Pty) Ltd (SCHS), the primary acquiring firm, will acquire the entire issued share capital of Price’s Daelite (Pty) Ltd (PD), the primary target firm. The shareholders of PD will transfer the entire issued share capital of PD to SCHS.

3.      
Schumann Sasol International Aktiengesellschaft holds 100% of the shares in SCHS. The ultimate holding company of the Sasol Group is Sasol Limited. SCHS does not have any subsidiaries.

4.      
The Leo Goodman Family Trust owns 62,6% of the issued share capital in PD. The Leo Goodman Family Trust also controls Cambridge Candles. PD has no subsidiaries but it does control Price’s Candles (South Africa)(Pty) Ltd and Price’s Candles (Natal) (Pty) Ltd.

5.      
SCHS previously disinvested from the candle manufacturing market in 1995 by selling its business known as Price’s Candles to the Goodman family because, it avers, it wanted to end the situation of being both a major supplier and competitor in the same market as its customers.

6.      
The effect of the current transaction would be to return the parties to the situation that they were in before the Goodman family purchased Price’s Candles from SCHS in 1995.

7.      
The transaction, according to the parties, is the unavoidable consequence of the financial situation of PD, which is heavily indebted to SCHS, and the unresolved disputes between the parties. The parties aver that the transaction is to be viewed as part and parcel of a settlement agreement resolving the disputes between SCHS and the Goodman family.

8.      
SCHS avers that post the transaction PD will continue operations as an independent subsidiary of SCHS with full profit and loss responsibility. Its Board will consist of the Chairman and the Managing Director of SCHS and the Managing Director of PD. According to the parties SCHS will supply PD with wax on an arms length basis.

The Analysis

Vertical Mergers and Competition Law

9.      
We are evaluating a transaction between two firms in a vertical relationship: SCHS, the acquiring firm, supplies candle wax to the target firm, PD, a candle manufacturer. We emphasise this at the outset because our analysis will proceed cognizant of, and in general sympathy with, the characteristically permissive approach taken by anti-trust to vertical mergers, indeed to vertical agreements generally.

10.     
It is relationships between competitors – that is horizontal mergers (and horizontal agreements generally) - that tend to attract the immediate attention of anti-trust enforcement. Vertical arrangements do not, on the face of it, lessen competition in either of the markets in which the contracting parties are active. On the contrary, a strong body of opinion holds that vertical arrangements are frequently competitiveness enhancing, that is, far from diminishing competition, these arrangements actually enable the contracting parties to produce or distribute a better or lower priced product or service. In general then, it is argued, anti-trust proscription of these arrangements confuses the requirement to defend competition, with action essentially designed to defend competitors.

11.     
However, the Competition Act, in common with competition statutes elsewhere, does cover vertical mergers. It does so because it is widely recognized that, under particular circumstances, vertical mergers may impact negatively on competition. Alarm bells will sound where one or both of the parties to the transaction dominate the markets in which they operate. We shall elaborate the reasons underlying these concerns below. Suffice to note that while a vertical transaction involving a dominant firm portends a variety of potentially anti-competitive outcomes, for the purposes of the present transaction it is the prospect of increased entry barriers as well as the possibility of market foreclosure and the related ability to raise rival’s costs that are of most immediate concern.

12.     
It is frequently pointed out that the decision to integrate vertically is a business decision generally made to enhance the efficiency, the competitiveness, of the product or service brought to market. A manufacturer may, in order to secure a reliable source of input, or an improved input, freely elect to provide the input itself. By the same token, a manufacturer anxious to ensure effective distribution of its product, may freely elect to handle distribution itself rather than entrusting it to a third party. This argument is, for the most part, unimpeachable, but it still does not eliminate the necessity for regulating vertical mergers. By analogy, firms are encouraged to expand horizontally in their chosen markets through the pro-competitive provision of superior products but may nevertheless be restrained from expanding through merging with their competitors. By the same token, although a firm’s, even a monopolist’s, pursuit of ‘internal’ vertical integration may excite little anti-trust concern, there may nevertheless be solid anti-trust grounds for proscribing an attempt to integrate vertically through the merger process. Anti-trust scholars, Areeda, Hovenkamp and Solow, identify several reasons for adopting a less sympathetic approach to vertical integration through mergers than through internal expansion.

13.     
What the literature does clearly reveal is that, as with much of anti-trust adjudication, the impact of a vertical merger on competition is acutely sensitive to the facts of the case. At the level of general principle, it is fair to say that vertical mergers raise fewer competition concerns and generates larger pro-competitive gains than their horizontal counterparts. On the other hand, it may be credibly claimed that vertical transactions in which one or both of the parties dominate their respective markets are liable to raise greater anti-trust concerns than those involving firms with relatively small market shares. But this does not take us very far – clearly the evaluation requires a detailed examination of the facts of the case in question and it is to this that we now turn.

The Relevant Markets

14.     
SCHS and PD are in a vertical supplier/customer relationship and the two relevant markets with which we are concerned in this merger are the supply of medium wax to the candle industry in South Africa (the ‘upstream market’), and the production and marketing of household candles in South Africa (the ‘downstream market’). Both SCHS and PD sell their products throughout the Republic. Note that both the Commission and the merging parties agree that the relevant product markets affected by this transaction are the market for candle wax and the market for household candles. They also agree that the relevant geographical market is South Africa.

The upstream market

15.     
SCHS produces and markets hard waxes, that are used in the hot melt adhesive, polymer processing and printing inks industries; medium waxes, that are mainly used in the candle manufacturing industry; and paraffins, that are used in the oil exploration, synthetic rubber and solvents industries.

16.     
Waxes may be divided into different groups based upon the oil content of their respective products with the lowest, fully refined paraffin wax, having an oil content of 0,5% and the highest, slack wax, with an oil content of 5-20%. The higher the oil content, the softer the wax and the less suitable for producing candles.

17.     
Of the different waxes that can be distinguished in the industry, that is, fully refined paraffin wax, semi-refined wax, SCHS medium wax and slack wax, only a wax blended from a combination of slack wax and a better quality semi-refined wax, could be regarded as reasonably substitutable for the medium wax produced by SCHS, in order to produce candles. The medium wax produced by SCHS, which is used for candle manufacturing, is allegedly of a lower quality than the imported semi-refined wax. When the higher quality imported wax is used for candle manufacturing it is first blended with lower quality slack wax.

18.     
The medium wax manufactured by SCHS is manufactured at Sasolburg, using raw material purchased from Sasol Ltd in Boksburg and slack wax from Shell, BP and overseas suppliers. This is a continuous process and the output, which is immediately suitable for use in the manufacture of household candles, must be removed from the factory because candle wax cannot be stored economically. If the wax cannot be sold to candle manufacturers, it must be “cracked” into fuel and sold at a lower realisable value.

19.     
The estimated market shares of participants in the medium wax supply industry are SCHS 75%, Masterrank 8%, G Zabel 6%, Reach Industrial 6%, BP 5% and Shell 2%. Although some submissions claimed that SCHS’s current share of the domestic market for household candle wax was considerably in excess of 75%, it is common cause that its share is no less than 75%.

20.     
Note that most of the competitors mentioned above – all, with the exception of BP and Shell – do not produce wax. They import it and distribute it and account for approximately 20% of the local market. Imported, unprocessed medium wax is not subject to import duties. It appears that, for the most part, the share of imported wax used in the domestic candle market is a residual of that available from SCHS, that is, when SCHS does not have supplies of wax available candle manufacturers resort to the higher priced imported wax which they then ‘extend’ by blending with cheaper (because inferior) South African produced slack wax. Manufacturers of decorative candles – not part of the relevant market - use imported wax, the South African product not being suitable for this segment of the candle market.


The downstream market

21.     
PD produces and markets household candles, which consist of a pack of six white candles each weighing 75g or 450g in total. This candle market must be distinguished from decorative candles. . Candles may not be sold as household candles unless they comply with the specifications laid down in SABS Standard No. CKS60.

22.     
Although possible substitutes for candle-use include oil lamps (paraffin) and electricity the fact of the matter is that, at present, a large portion of the South African population, especially the very poor, still rely on candles for primary lighting purposes.

23.     
The estimated market shares of the five largest participants in the market for the manufacture and distribution of household candles are PD with 42%, Willowton and Cake Mills 13%, Morlite Industries (Buffalo) 11%, Boardman Brothers, t/a Newdons 9% and Sealake Industries 7%. SCHS currently is the only supplier of wax to PD, Willowton and Cake Mills and Morlite Industries, which covers 66% of the household candle market.

24.     
South African manufacturers – both decorative and household candles - are protected from imports by a standard duty of 20% on imported candles. According to the parties imported candles, both decorative and household, account for only 8% of the candles distributed in South Africa.

25.     
The parties estimate that candle manufacturers are operating at 60% of their capacity.

The Act

26.     
The Act requires us to consider mergers in terms of section 12A, which states in subsection 12A(1):

‘Whenever required to consider a merger, the Competition Commission or Competition Tribunal must initially determine whether or not the merger is likely to substantially prevent or lessen competition, by assessing the factors set out in subsection (2), and –

a)      
If it appears that the merger is likely to substantially prevent or lessen competition, then determine -

i.      
Whether or not the merger is likely to result in any technological, efficiency or other pro-competitive gain which will be greater than, and offset, the effects of any prevention or lessening of competition, that may result or is likely to result from the merger, and would not likely be obtained if the merger is prevented; and

ii.     
Whether the merger can or cannot be justified on substantial public interest grounds by assessing the factors set out in subsection (3); or

b)      
Otherwise, determine whether the merger can or cannot be justified on substantial public interest grounds by assessing the factors set out in subsection (3).’

27.     
Section 12A(2) reads:

‘When determining whether or not a merger is likely to substantially prevent or lessen competition, the Competition Commission or Competition Tribunal must assess the strength of competition in the relevant market, and the probability that the firms in the market after the merger will behave competitively or co-operatively, taking into account any factor that is relevant to competition in that market, including –

a)      
the actual and potential level of import competition in the market;
b)      
the ease of entry into the market, including tariff and regulatory barriers;
c)      
the level and trends of concentration, and history of collusion, in the market;
d)      
the degree of countervailing power in the market;
e)      
the dynamic characteristics of the market, including growth, innovation, and product differentiation;
f)      
the nature and extent of vertical integration in the market;
g)      
whether the business or part of the business of a party to the merger or proposed merger has failed or is likely to fail; and
h)      
whether the merger will result in the removal of an effective competitor.’


The Impact of the Transaction on Competition in the Relevant Markets

28.     
By any measure of concentration both SCHS and PD enjoy powerful positions in their respective markets. The Herfindahl-Hirschman index (HHI) that measures concentration and which guides anti-trust investigation and adjudication indicates significant market power in each of the markets in question with an HHI in the upstream market of 5786 points and in the downstream market at 2222 points.

29.     
Furthermore, in the upstream market the single-firm concentration ratio (the C1 ratio) is exceptionally high at 75%. In the downstream market, the C1 ratio is also notably high at 42% and the C3 ratio (the three firm concentration ratio) is 66%.

30.     
Antitrust scholars Areeda, Hovenkamp and Solow observe that in the USA vertical mergers are unlikely to be challenged unless the HHI in the upstream market exceeds 1800, and a large percentage of the upstream product would be sold through vertically integrated retail outlets after the merger. In this case SCHS, in 2000-2001, sold approximately [this evidence is claimed confidentialof its domestic wax supply to PD with whom it has a supply agreement.

31.     
However, as with all vertical transactions, these measures of concentration and indicators of market power do not increase in consequence of the transaction and, hence, by these measures alone, competition cannot be said to have lessened. The question that must rather be asked is whether the transaction allows the parties or one of the parties to prevent competition in the relevant market(s) thus maintaining or extending the anti-competitive structure of both or one of the markets.

32.     
As we shall elaborate, we find that the transaction prevents or lessens competition in the candle wax market, the upstream market, by raising barriers to entry in respect of that market.Furthermore, the transaction significantly increases the capacity of the merged entity to consolidate and extend PD’s already powerful position in the downstream market. We will show that dominating the downstream market allows SCHS to protect its monopoly position in the upstream market for candle wax.

The Impact on Competition in the Candle Wax (upstream) Market

33.     
SCHS are major international producers of candle wax. The company clearly dominates the local market in the product. SCHS insists that its overwhelming interest is in the production of wax. It does not, it says, have a primary interest in the production of candles or in the price of candles except insofar as these impact on its ability to sell wax. In fact in 1995 it exited the local candle market when it sold Price’s Candles to the Goodman family precisely, it avers, to avoid the conflict with its other candle manufacturer customers that was generated by SCHS’s presence in both upstream and downstream markets.

34.     
SCHS’s normal commercial interest in ensuring that its wax enjoys widespread support in the market is intensified by the nature of the product. Firstly, as already noted, wax cannot be economically stored. Secondly, it is a by-product of a larger chemical production process thus constraining, it appears, SCHS’s ability to adjust, in the face of changes in demand, the supply of wax that it brings to market. This has, it appears, dictated a particularly close relationship between supplier and customer manifest in, inter alia, exclusive supply relationships with its major customers, notably, in South Africa, with PD.

35.     
The security and stability of SCHS’s relationship with its market has been disturbed by a conflictual relationship with PD, its major customer. A supply agreement between the parties has been in force since the sale of Price’s to the Goodman family trust in 1995. The agreement essentially provides that PD shall procure the lion’s share of its wax input from SCHS. It is permitted to source a small amount of wax from suppliers other than SCHS.

36.     
It appears, however, that relations between the parties have been fraught with conflict. The upshot is that PD has run up a significant trading debt with SCHS. SCHS has secured its debt by concluding a pledge agreement with the Leo Goodman Family Trust. Moreover, it appears that there has been significant conflict between the parties regarding the terms of the contract and the performance of the contract. These conflicts had been referred to arbitration. The Tribunal has not been provided with details of this conflict. Suffice to say that immediately prior to arbitration SCHS offered, in exchange for settlement of all disputes between the parties and outstanding debt, to acquire PD from the Goodman Family Trust.

37.     
This, as outlined above, is the origin of the transaction before us, one that has been presented by the parties as the inevitable outcome of a commercial relationship gone sour and of a company, SCHS, attempting to settle a conflict with its contracting partner and to exercise its security rights. From the perspective of a major creditor, this presentation of the transaction is perfectly plausible. However, from a competition perspective, it must be given a somewhat different cast, one supported by other concerns articulated by the parties.

38.     
From a competition perspective the transaction is to be viewed as the action of a producer intent upon defending or extending its market share. This motivation is unimpeachable at competition law. Indeed it is, or may be, the very stuff of competition as long as the mechanism for achieving that objective is the provision of a superior or lower-priced product. Our task is to ensure that this otherwise laudable objective is not realized through an anti-competitive mechanism.

39.     
Consider, again, the background: the dominant player in a market is faced with, what appears to be endemic conflict with its major customer. At stake is the potential loss of that customer – it may seek an alternate supplier or it may exit the market altogether. The normal commercial concern that would inevitably accompany that threat is exacerbated by the nature of the product, by, in other words, the imperative to maintain the level of output and to ensure that the output is consumed as soon as it is produced.

40.     
This situation is ripe for competitive entry into the candle wax market. And there are potential competitors on the horizon. There are no tariff barriers and international competition, particularly in the form of Chinese imports, already has a toehold in this market. Moreover, it appears that Shell, a potential alternate supplier of a competing wax product, has recently resolved some significant technical problems at its Malaysian refinery and is eyeing the local market. This is, quite understandably, a situation in which any producer would feel acutely vulnerable, all the more so one with the technical constraints faced by SCHS.

41.     
In the event that PD survives, there exists the real possibility that it may change its allegiance to another supplier, the more so if the arbitration allows it to escape its obligations under the supply agreement. If, on the other hand, PD fails then a large portion of the candle market is unaccounted for. It may be taken up by imports, by new entrants or by producers currently active in the market, producers who have not entered into supply agreements with SCHS. Both of these scenarios are immensely threatening to SCHS’s interests, a threat significantly exacerbated by the nature of the product. As Dr. Barth, the Chairman of SCHS, eloquently expressed it at the Tribunal hearing: “Please imagine just for a moment that the candle industry would decide for 2 months period to buy Chinese wax instead of Schumann Sasol wax.”

42.     
From a competition perspective it is this consideration that has driven SCHS’s decision to acquire its largest customer. When PD’s custom is secured, it, together with the supply agreement with Willowton, secures for SCHS the lion’s share of the South African wax market. There are other mechanisms for achieving SCHS’s objective, but they carry a greater risk of failure. The pro-competitive mechanism preferred by competition law is through the provision of a better or less expensive product. Supply agreements along the lines of that between SCHS and PD is another option. However, as Mr. Barth expressed it “the experience which we made with the selling the business in ’95 to the Goodman family, would not be an argument in favour of trying to do that again.”

43.     
From SCHS’s perspective then the immediate virtue of the acquisition – its narrower financial considerations aside – is that it secures a share of the candle wax market that is not subject, as in the PD situation, to the vagaries of a disputed contract and to the possibility of hold-up by its largest customer. However, from a broader competition perspective it ensures that SCHS’s competitors are reduced to the role of bit players participating at the fringes of the market. They are excluded from the largest part of the market in an area of production subject to scale economies and in which the respective participants – the supplier and customer – place a high premium on certainty of supply and demand. Their only way of entering the upstream candle wax market would be to enter, simultaneously, the downstream candle market. But this is unlikely to happen. Like SCHS, they are not candle manufacturers and, in a market where there is already one dominant candle producer, one owned, moreover, by the dominant competitor in the candle wax market, this approach is fraught with risk. Under the circumstances the competitors are likely to accept their bit player status.

44.     
Confined to the fringes of a monopolized market, the presence of competitors does not represent a threat to SCHS. Quite the contrary, they perform a useful function, and this is precisely why the supply agreements permit the candle manufacturers to purchase a small share of their candle wax from alternative suppliers. As already noted at length, SCHS’s technical constraints do not permit it to fine tune its production levels, to adjust output to short run spikes and troughs in demand. In this circumstance the presence of fringe suppliers is useful – they can be competed with in demand troughs for the fringe of the market; and they can help order the market when demand spikes thus allowing SCHS to avoid having to introduce additional capacity that may not find available demand in down periods. In response to Shell’s re-entry at the fringes of the market Dr. Barth noted that its presence “will then also balance the supply and demand situation so that situations as we had in the past (where) we are not able to meet additional demands for product will then not be repeated.” The entry of a competitor, even a potentially formidable competitor, is welcomed in the firm knowledge that SCHS’s acquisition of the largest candle manufacturer ensures that its competitor remains confined to the fringes.

45.     
We must, in concluding our finding on entry barriers in the candle wax market, respond to one other argument advanced by the parties. It is argued that SCHS already has its dominant position secured by the supply agreements with PD and Willowton. Hence, the argument continues, the acquisition does not disturb the status quo; it does not raise already high entry barriers. We are not persuaded by this argument. A contractual agreement is not immutable. The very proof of that - if any is needed – is provided by the relationship between PD and SCHS. Moreover, even well functioning contractual relationships provide for termination and are subject to re-negotiation and this at least allows a potential entrant to contemplate a substantial presence in this market. As important, it forces the incumbent to contemplate a competitor entering the market. This potential is precluded by the acquisition. Accordingly, the acquisition lessens the potential for competition; it indeed prevents competition, by raising entry barriers above those present as a result of the supply agreement.

46.     
The Commission has proposed that this transaction be approved subject to the imposition of certain conditions. None of the conditions proposed will overcome the heightened entry barriers in the market for candle wax. In fact, the Commission confined its considerations and concerns to the candle market and it does not appear to have considered the transaction’s impact on the candle wax market despite having identified this as one of the markets affected by the transaction. We have not been able to devise conditions designed to cure the effect of the transaction on entry barriers in the candle wax market.

The Impact on Competition in the Household Candle (downstream) Market

47.     
The Commission expressed the view that the proposed deal would diminish competition in the household candles market should the transaction be approved unconditionally. An unconditional approval, in the Commission’s opinion, would lessen the number of participants in the candle production and distribution market in future in what is already a concentrated industry. Future competition, i.e. new entry, could be adversely affected if not totally eliminated. In addition, the Commission provide evidence establishing that, in the past, many new entrants found it impossible to survive in the market place. In the Commission’s view the proposed transaction would not only make new entry highly unlikely, but the potential restriction on competition and anti-competitive practices that could flow from this transaction could also force existing participants, mostly small to medium-sized firms, from the candle production and distribution market.

48.     
As already indicated, SCHS insists that its overriding interest is in the candle wax market. It denies that it has primary designs on establishing a dominant position in candle manufacturing. Far from that being the case, it insists that it is cognizant that its interests as a manufacturer of candle wax (the upstream market) are in potential conflict with a presence in the downstream candle market and that this will temper any prospect of anti-competitive behaviour on its part in that latter market. In support of this contention it points to its withdrawal from candle manufacturing in 1995 and insists that its re-entry into the business of manufacturing candles was forced upon it by its fraught relationship, concretely including its financial relationship, with PD and the likelihood of that company’s imminent demise.

49.     
We will however demonstrate that, from the perspective of the interests of SCHS, the wax producer, there is, nevertheless, considerable incentive for the merged entity to extend its powerful position in the downstream market, the candle market. And we will then show that this transaction provides the wherewithal for an anti-competitive response to that incentive. In other words, we have demonstrated above that, despite its powerful position in the candle wax market, SCHS has strong grounds for feeling vulnerable to potential entry into this market. The acquisition by SCHS of PD, its largest customer, is, we have found, a mechanism for shoring up its dominance of the upstream