IHL155 p46-51 EU CPF

31/10/07

15:37

Page 46

EU & Competition

Outsourcing and competition law Outsourcing can help to simplify businesses in an increasingly global work environment, yet parties to outsourcing agreements must be aware that their arrangements can have a complex relationship with competition rules. Adrian Magnus, Eran Tsafrir and Simon Albert investigate

and procurement services being taken over by Exel were mainly provided to the Department of Health by in-house arm’slength bodies, and had extremely limited turnover from sales of such services to third parties. However, it was possible to attribute an open market value to these in-house services, and this market value exceeded the £70m turnover threshold for UK merger control.

CAN AN OUTSOURCING TRANSACTION BE subject to EU or UK merger control? Can exclusivity provisions in an outsourcing agreement infringe competition law? Outsourcing arrangements can give rise to competition issues, including merger control, exchanges of information, and the enforceability of exclusivity and non-compete provisions. This article considers these issues and provides some practical tips. MERGER CONTROL Outsourcing arrangements may constitute a merger that is subject to UK or EU merger control. An example is the Office of Fair Trading’s (OFT) Exel Europe Ltd/NHS Logistics Authority/NHS Purchasing and Supply Agency decision of July 2006. Exel Europe Ltd (Exel) is a UK subsidiary of Deutsche Post AG, whose core activities in the UK are contract logistics (including warehousing and distribution) and freight forwarding. Exel was to take over the supply of certain logistics and procurement services for consumable products that had been provided to the Department of Health by the NHS Purchasing and Supply Agency and NHS Logistics. This included assets such as IT and office equipment, contracts and the right to use certain NHS intellectual property, as well as up to 1,600 employees. The OFT held that the transaction was subject to UK merger control. The logistics

By Adrian Magnus, partner, and Eran Tsafrir and Simon Albert, associates, Berwin Leighton Paisner LLP

46 The In-House Lawyer November 2007

EU merger control A major outsourcing arrangement will be subject to EU merger control if it involves a ‘concentration’ with a ‘Community dimension’. Article 3 of the EC Merger Regulation (No 139/2004) states that a ‘concentration’ includes the acquisition of direct or indirect control of all or part of an enterprise or ‘undertaking’. So, if an outsourcing supplier – in addition to taking over a previously internal activity – acquires associated assets which ‘constitute a business with a market presence, to which a market turnover can be clearly attributed’, the arrangement will constitute a concentration (Commission Consolidated Jurisdictional Notice (the Notice)). However, there will not be a concentration if no assets or employees are transferred to the supplier, or if that supplier acquires only a right to direct the customers’ assets and employees, which will be used exclusively to service the customer. A concentration may also arise where the outsourced

activity has been structured as a ‘fullfunction’ joint venture on a lasting basis, operating independently on the market, that goes beyond one specific function for its parents and does not rely on them for its sales and purchases (see for example, the European Commission’s decisions in IBM Italia/Business Solutions/JV and EDS/Lufthansa). The Commission also applied these principles in its Flextronics/Nortel decision of October 2004. This case concerned the acquisition by Flextronics International Ltd of some of Nortel Network Ltd’s manufacturing assets, employees and related supply-chain activities. Flextronics is a provider of electronics manufacturing services to original equipment manufacturers in the telecommunications, networking, consumer electronics, computer and medical device industries. Electronics manufacturing services turn out various types of electronic products on an outsourced procurement basis. Nortel Networks Ltd is a supplier of products and services that support the internet and other public and private data, voice and multimedia communication networks. The Commission decided that the transaction implied the acquisition by Flextronics of control of parts of Nortel and as such amounted to a ‘concentration’. In the Notice, the Commission provides details of its approach to such arrangements. The Notice states that

IHL155 p46-51 EU CPF

31/10/07

15:37

Page 47

EU & Competition

for an outsourcing arrangement to constitute a concentration, the assets previously dedicated to the in-house activities of the customer must enable the supplier to provide services, not only to the outsourcing customer, but also to third parties. This may be either immediately or ‘within a short period after the transfer’ (normally up to three years, but depending on the specific conditions of the market in question). This will be the case if the transfer relates to an internal business unit or a subsidiary that already provides services to third parties. If third parties are not yet supplied, the assets transferred should (in the case of manufacturing) contain production facilities, the product know-how and the means for the purchaser to develop market access within a short period (eg including existing contracts or brands). Where services are concerned, the assets transferred should include the required know-how (eg relevant personnel and intellectual property) and facilities that allow market access (eg marketing facilities). To be a concentration, the assets transferred therefore have to include at least those core elements that would allow a market presence. Many transfers of in-house facilities to an outsourced supplier will not meet these criteria. An outsourcing arrangement constituting a concentration will only be subject to EU merger control if it has a ‘Community dimension’, ie if the turnover of the relevant parties satisfies certain turnover thresholds. Satisfying these thresholds requires, in particular, that the combined worldwide turnover of the parties exceeds €2.5bn, each of them has an EU turnover exceeding €100m and they must not both achieve more than two-thirds of their EU turnover in one and the same EU member state. In relation to outsourcing transactions, turnover of the ‘relevant parties’ means the turnover in the preceding financial year of the whole of the supplier’s group and the part of the customer’s business that is being outsourced. Where EU merger control applies, UK merger control will usually not apply. Turnover is usually calculated from the most recent financial year’s audited accounts. However, the Notice states

that, where an outsourcing transaction involves a business unit which only had internal revenues in the past:

‘UK merger control applies to outsourcing transactions which cause two or more

‘… the turnover should normally be calculated on the basis of the previously internal turnover or of publicly quoted prices, where such prices exist.’

enterprises to cease to be distinct, if one of two jurisdictional tests is satisfied.’

Where this does not appear to correspond to a market valuation or the expected future turnover, the Notice adds: ‘… the forecast revenues to be received on the basis of an agreement with the former parent may be a suitable proxy.’ Subject to limited exceptions, the Commission has exclusive jurisdiction over concentrations with a Community dimension. Notification of such transactions to the Commission is mandatory and the parties cannot complete the transaction before EU merger clearance has been obtained. According to the EC Merger Regulation, the Commission will assess whether the arrangement in question: ‘… significantly impedes effective competition, in the Common Market or in a substantial part thereof, in particular as a result of the creation or strengthening of a dominant position.’

issue. In that decision, the OFT concluded that the transaction did involve ‘enterprises ceasing to be distinct’. The outcome was different in the OFT’s University College London Hospitals NHS Foundation/HCA International Ltd decision (October 2006). Here, the OFT held that the relevant outsourcing transaction did not involve ‘enterprises ceasing to be distinct’, because: ■

At the time of writing, no outsourcing transactions have been blocked under EU merger control. UK merger control UK merger control applies to outsourcing transactions that cause two or more ‘enterprises’ to cease to be distinct, if one of the two jurisdictional tests considered below is satisfied. An ‘enterprise’ – as defined by the Enterprise Act 2002 – means ‘the activities or part of the activities of a business’; typically the assets and records needed to carry on the business, together with the benefit of existing contracts and/or goodwill. The transfer of customer records is likely to be important in assessing whether an enterprise has been transferred. Exel illustrates the OFT’s approach to the

■

■

The transaction concerned the commercial leasing by University College London Hospital Trust (UCLH) to HCA International Limited (HCA) of premises, which were vacant (except for very limited outpatients visits), for an initial period of five years for use as a private patient unit. HCA could access and use a linear accelerator and MRI scanner for an initial period of five years, but the equipment was not in working order and no title to this equipment was to pass from UCLH to HCA. UCLH had agreed to allow HCA to use certain UCLH facilities (including two bunkers and a scanner room) and support services relating to the operation and administration of a private patient unit (eg pathology, facilities management, IT and

IBM Italia/Business Solutions/JV (Case COMP/M2478) [2001] OJ C278/3 EDS/Lufthansa (Case IV/M560) [1995] Flextronics/Nortel (Case COMP/M3583) Commission Decision 2004/322/04 [2004] OJ C322/8 Hewlett Packard/Synstar (Case COMP/M3555) [2004] OJ C249/4 >

November 2007 The In-House Lawyer 47

IHL155 p46-51 EU CPF

31/10/07

15:38

Page 48

EU & Competition

telecommunication services) for an initial period of five years. ■

While UCLH was to second some support staff to the private patient unit, no employees would be transferred to HCA. They would remain employees of UCLH. No medical staff would be transferred to HCA.

■

No goodwill, customer details or other business assets had been or would be transferred to HCA.

■

Case C-234/89 Stergios Delimitis v Henninger Bräu AG [1991] ECR I-00935 Case C-214/99 Neste Markkinointi Oy v Yötuuli Ky and others [2000] ECR I-11121 BP Kemi/DDSF (Case IV/29.021) Commission Decision 79/934/EEC [1979] OJ L286/32 Esso Petroleum v Harper’s Garage [1967] UKHL 1 Panayiotou (aka George Michael) v Sony Music [1994] EMLR 229

No liabilities had been or would be transferred.

There are two alternative jurisdictional tests under UK merger control. The first is a ‘turnover test’. This is satisfied in relation to outsourcing arrangements if the UK turnover of the part of the customer’s business being outsourced exceeds £70m. The second is the ‘share of supply test’. This is satisfied in relation to outsourcing arrangements if, as a result of the transaction, the supplier and the part of the customer’s business that is being outsourced together supply 25% or more of all the goods or services of a particular description supplied in the UK (or in a substantial part of it). The share of supply test is much less clear-cut than the turnover test and narrow descriptions of services can make it fairly easy to satisfy. Whether there is a substantive merger control issue will depend on the position of the parties in the relevant product or service and geographic markets. Subject to limited exceptions, the OFT has a duty to refer mergers that satisfy either of the above jurisdictional tests to the Competition Commission (CC) for further investigation where the relevant merger has resulted (or may be expected to result) in what the Enterprise Act refers to as a ‘substantial lessening of competition within any market(s) for goods or services in the UK’. The CC can block the merger, clear it, or clear it subject to conditions, eg divestment. It is not compulsory to notify a qualifying merger to the OFT, but it is risky to complete a transaction that

48 The In-House Lawyer November 2007

qualifies for UK merger control without obtaining merger clearance from the OFT. The buyer could be forced to sell all or part of the business acquired. The authorities may also impose severe restrictions on the buyer’s ability to deal with the acquired business while a competition investigation is carried out. For an outsourcing transaction, this could prevent the transfer of the relevant people and assets to the supplier and frustrate both parties’ commercial objectives, by preventing the supplier from performing its obligations to the customer. Merger decisions in outsourcing cases to date have not required the authorities to reach a conclusive view on the relevant market, as the transactions investigated did not give rise to competition concerns, regardless of the way the relevant market was defined. See, for example, the OFT’s decisions in Exel, Vertex/Marlborough Sterling and Northgate/Systems Solutions. This may change over time if relevant markets become more concentrated. However, several of these merger decisions concern (and include useful guidance on) market definition in IT service markets, a major outsourcing market. See, for example, the Commission’s decisions in Hewlett Packard/Synstar and IBM Italia/Business Solutions/JV. PROHIBITED ANTI-COMPETITIVE AGREEMENTS Article 81(1) of the EC Treaty and Chapter 1 of the Competition Act 1998 prohibit agreements that have the object or effect of preventing, restricting or distorting competition and which may affect trade between EU member states or within the UK, respectively (the socalled ‘Prohibitions’). Breaches of those Prohibitions are punishable with heavy fines (up to 10% of turnover). Infringing agreements are unenforceable and the parties to them may be sued for damages. Under the Enterprise Act, individuals who are involved in a breach of competition law may be disqualified as directors for up to 15 years and, in the case of serious infringements (involving price fixing, market sharing and bidrigging) may be subject to unlimited fines and up to five years’ imprisonment.

EXCLUSIVITY AND NON-COMPETE CLAUSES Outsourcing arrangements commonly contain exclusivity and non-compete provisions. These may restrict competition and must therefore be considered in the light of the Prohibitions. The competition law analysis of such provisions depends on whether the transaction is a ‘concentration’ for competition law purposes (see above). Ancillary restraints Obligations that are ‘directly related and necessary to the implementation of a concentration’ (or ‘ancillary restraints’) are deemed not to fall within the scope of the Prohibitions. They will be automatically covered by any Commission merger clearance decision authorising a transaction. It is up to the parties to assess whether a restriction is ‘directly related and necessary’. The Commission’s Notice on restrictions directly related and necessary to concentrations, from which the above definitions are taken, sets out the Commission’s practice in relation to ancillary restraints. The OFT’s approach, as outlined in its ‘Mergers: Substantive Assessment Guide’, follows the Commission’s Notice on restrictions (whether or not the merger is notified to the OFT). Covenants by the vendor not to compete with the business being sold or transferred are generally permissible, provided they are limited both in scope (as to the product and geographic area covered) and in duration. In an outsourcing transaction, these would prevent the customer from resuming in-house provision of the services. The Notice on restrictions states that when the transfer includes both goodwill and know-how, a vendor noncompete covenant for up to three years is permissible. When only goodwill is included (ie no know-how is transferred), a vendor non-compete covenant can only be justified for up to two years. If the transfer is limited to physical assets (eg land, buildings or machinery) or to exclusive intellectual property rights, a vendor non-compete covenant will not be permissible as an ancillary restraint. Purchase or supply obligations (and service agreements) between vendor and

IHL155 p46-51 EU CPF

31/10/07

15:38

Page 49

EU & Competition

purchaser – which are aimed at guaranteeing the quantities previously supplied – can be justified for up to five years. Obligations providing for fixed quantities, possibly with a variation clause, are permissible as ancillary restraints, but obligations providing for unlimited quantities, exclusivity or conferring preferred-supplier or preferredpurchase status are not treated as ancillary restraints. They therefore have to be considered separately (see below). Arrangements that are not concentrations and contain exclusivity or non-compete provisions may infringe the Prohibitions, which, as mentioned above, will affect the enforceability of the arrangements and have other potentially serious consequences. It is therefore necessary to consider whether those agreements have an appreciable effect on competition and/or are exempted from the Prohibitions. Agreements of minor importance Arrangements are only prohibited under competition law if they have an ‘appreciable’ impact on competition. The Commission’s Notice on agreements of minor importance (the de minimis Notice) provides that agreements will generally not appreciably restrict competition if: ■

■

the parties’ aggregate market share on any relevant ‘affected market’ does not exceed 10% in the case of actual or potential competitors, or 15% in the case of non-competitors; and the agreement does not contain any ‘hard-core’ restrictions (eg price-fixing or market-sharing arrangements, or those allocating markets or customers). In determining whether an agreement has an appreciable effect on competition, the OFT will refer to the Commission’s approach, set out in the de minimis Notice.

Many outsourcing arrangements will therefore be treated as of ‘minor importance’ for competition law purposes and therefore do not infringe the Prohibitions. However, market definition is crucial to this. A supplier operating in a narrowly defined service market may have a market share of more than 15%. Exclusive agreements

between that supplier and its customers may therefore have an appreciable effect on competition and require further competition law analysis to determine whether, for example, exclusivity provisions are enforceable. Arrangements that are not covered by the de minimis Notice, but contain restrictions on competition, may still be exempted from the Prohibitions by virtue of an individual or block exemption.

‘Where the parties’ market shares are too high for the de minimis Notice to apply, an exclusivity obligation lasting over five years may be prohibited under Article 81(1) of the EC Treaty.’

Individual exemptions To benefit from an individual exemption, an arrangement must satisfy several conditions, set out in Article 81(3) of the EC Treaty, designed to ensure that the economic benefits provided by the arrangement outweigh its negative effects on competition. These require that the agreement in question: ■

■

contributes to improving production or distribution, or to promoting technical or economic progress, while allowing consumers a fair share of the resulting benefit; and does not impose restrictions that are ‘not indispensable’ to the attainment of those objectives, or give the parties the possibility of eliminating competition in respect of a substantial part of the products or services in question.

Block exemptions Where an arrangement is covered by a block exemption, these conditions are presumed to be met. An outsourcing agreement will fall within the scope of the Commission’s Vertical Agreements Block Exemption (VABE) where the supplier’s share of the relevant market does not exceed 30% and the arrangement does not contain certain specified ‘hard-core restrictions’. The VABE does not normally apply to vertical agreements between competitors, but can apply where the buyer does not provide services competing with those it purchases from the supplier – for example because the buyer has outsourced all those services to the supplier. For the purposes of the VABE, a noncompete obligation in an outsourcing arrangement means any obligation on the

customer not to compete with the contract services, or any obligation on the customer to purchase from the supplier more than 80% of the customer’s total purchases of the contract services (or substitutes for them). An obligation on the customer to buy specified services only from the supplier – ie an exclusive purchasing obligation – will therefore be a ‘non-compete provision.’ Such a noncompete provision will only benefit from the VABE if its duration does not exceed five years. An indefinite obligation - such as one which will automatically be renewed after five years – will not benefit from the VABE. The VABE is due to expire on 31 May 2010. Where the parties’ market shares are too high for the de minimis Notice to apply, an exclusivity obligation lasting over five years may be prohibited under Article 81(1). EU case law shows that if the duration is ‘manifestly excessive’ in relation to the average duration of contracts concluded in the relevant market, the Article 81(1) prohibition will apply (see for instance Stergios Delimitis v Henninger Bräu AG, Neste Markkinointi Oy v Yötuuli Ky and others, and BP Kemi/DDSF). Within the UK the common law principle of restraint of trade may also apply, for instance where the duration and/or geographic scope of a restriction goes further than necessary

November 2007 The In-House Lawyer 49

>

IHL155 p46-51 EU CPF

31/10/07

15:38

Page 50

EU & Competition

to protect the legitimate interests of the parties and/or where the restriction is contrary to the public interest. See for example Esso Petroleum v Harper’s Garage and Panayiotou (aka George Michael) v Sony Music. Where the outsourced supplier needs to use the customer’s technology or equipment to provide services to that customer, certain provisions in the agreement may benefit from the Commission Notice of 18 December 1978 concerning its assessment of certain subcontracting agreements. This applies where a contractor (customer) entrusts a sub-contractor (supplier) with the supply of services, manufacture of goods, or performance of work under the contractor’s instructions, to be provided to the contractor. The 1978 Notice states that the Prohibitions do not apply to clauses whereby technology or equipment provided by the contractor may not be used except for the purposes of the subcontracting agreement, or may not be made available to third parties, or whereby services resulting from the use of that equipment or technology may be supplied only to the contractor. In each case, this applies only where the technology or equipment is necessary to enable the sub-contractor to supply the services, not when the sub-contractor already has them at its disposal, or could obtain access to them under reasonable conditions. However, many outsourced suppliers will be selected precisely because of their technology or equipment. Exclusive purchasing and/or supply obligations can be valid for more than five years under the Commission’s Specialisation Block Exemption, which is due to expire at the end of 2010. In an outsourcing context, this can apply to ‘unilateral specialisation agreements’, when two competitors agree that one will stop producing (or not produce) certain products or services and will buy them from the other. It can also apply to ‘reciprocal specialisation agreements’, when two competitors agree that each will stop producing (or not produce) different products or services and will buy them from one another. In each case, the block exemption applies only if the parties’ combined market share does not exceed 20% and the arrangement

50 The In-House Lawyer November 2007

COMPETITION ISSUES IN OUTSOURCING: PRACTICAL TIPS ■

Consider the structure of the arrangement and whether it would constitute a ‘concentration’ or merger.

■

Consider the potential application of merger control as early as possible.

■

Carefully consider the allocation of regulatory risks, including whether the transaction is to be conditional on merger clearance.

■

If merger control is relevant, allow time to resolve jurisdictional issues, gather market information and for pre-notification contacts with the competition authorities.

■

Check the legitimacy of the relevant transaction under competition law before any information exchange takes place relating to it, especially when outsourcing to a competitor.

■

Agreements by the customer not to compete with a business transferred to the supplier are justifiable for up to three years if know-how is transferred, or two years if goodwill alone is transferred, if the transfer amounts to a ‘concentration’.

■

Exclusive purchasing obligations on the customer may benefit from the Vertical Agreements Block Exemption where they do not last for more than five years and the supplier’s market share is not over 30%.

■

Exclusive purchasing and supply obligations may be imposed for more than five years under the Specialisation Block Exemption if the parties’ combined market share is not over 20%. If market shares are higher than 20% and the duration is excessive compared with the market average, exclusivity may infringe competition law.

■

Outsourcing arrangements may be ‘of minor importance’ for competition law purposes if the parties’ market shares are low enough and no ‘hard-core’ restrictions are included.

■

Information exchanged between competitors should be kept to the minimum required to negotiate, conclude or give effect to the relevant transaction, with appropriate information barriers established to restrict information to those who need to know it for those purposes.

■

Where information has to be exchanged to enable a successor supplier to take over from an incumbent supplier, ensure this happens via the customer (or with the customer’s express knowledge and consent) and that the exchange of information is confined to what is necessary to serve that customer.

does not contain any hard-core restrictions on competition. Where an outsourcing arrangement involves one competitor outsourcing to another, the Commission’s Notice on horizontal co-operation agreements (the HCA Notice) may well be relevant, provided that the arrangement may generate efficiency gains which adequately benefit consumers.

Outsourcing the production of goods or services is considered in detail in the HCA Notice, for instance as ‘unilateral’ specialisation agreements (where one party agrees to purchase the relevant products from the other, while the other party is obliged to produce and supply those products). The HCA Notice allows the parties to an outsourced production agreement to

IHL155 p46-51 EU CPF

31/10/07

15:38

Page 51

EU & Competition

agree on the ‘output directly concerned by the production agreement’ (such as the agreed amount of outsourced products) despite the normal prohibition on agreements which limit output or share markets or customer groups. The HCA Notice states that where the outsourced element represents only a small proportion of the parties’ total costs, or only a small proportion of the costs of the final product, it is unlikely to lead to co-ordination of their competitive behaviour or to infringe the Prohibitions, although the position of the parties in the markets concerned is still an important issue. Market concentration and market shares are also relevant factors. INFORMATION EXCHANGE Competition law requires businesses to act independently and not to co-ordinate their behaviour with their competitors. Exchanges of information between actual or potential competitors may therefore breach the Prohibitions where the object or effect of the information exchange is to influence competitors’ competitive conduct, or to

disclose a competitor’s plans or intentions, thereby making that market artificially transparent. This will be particularly relevant where a customer outsources services to a competitor, or on a transfer of outsourced services from one supplier to a competing successor supplier. In the former case, the customer and its prospective supplier or suppliers will be discussing many details of the customer’s business, including its required services, service levels and costs, which would not normally be disclosed by one competitor to another. In the latter case, negotiations leading to the transfer of services from the incumbent supplier to the successor supplier (who are likely to be competitors), will involve a degree of information exchange (perhaps via the customer) concerning the outsourced business. It is not always easy to distinguish legitimate exchanges of information from prohibited ones. The analysis should be carried out on a case-by-case basis, taking into account the nature and type of the information exchanged, the level and aggregation of the information, the

period to which the information relates and the structural characteristics of the market on which the exchange takes place. In the context of outsourcing, various tips are set out in the box opposite. In general, however: ■

commercially sensitive information that may influence the competitive conduct of actual or potential competitors (such as information regarding pricing policies, investment plans or capacity), or that discloses a competitor’s unpublished competitive intentions, should not be exchanged; and

■

information that is historical, anonymous, aggregated, independently compiled and publicly available may be exchanged.

By Adrian Magnus, partner, and Eran Tsafrir and Simon Albert, associates, Berwin Leighton Paisner LLP. E-mail: [email protected], [email protected], [email protected].

November 2007 The In-House Lawyer 51