As we said in today's announcement, former guest poster Justin Blankenship has graciously agreed to join Level Up's select stable of monthly columnists. In his first post, he applied the insights he gained during his 2001-2004 tenure in the Federal Trade Commission's Mergers 2 division in Washington, D.C., to suss out the antitrust implications of Electronic Arts' intended purchase of Take-Two Interactive. Blankenship declared that the the FTC would likely take a hard look at the deal, and while some were skeptical of his analysis, he was proven right last week when his former employer issued a Second Request for more information on the proposed deal. In his debut monthly column, Blankenship returns to the EA/Take-Two imbroglio to answer some questions that others raised in response to his earlier post and shed some light on the thought process behind the FTC's recent decision. read on.
First of all, thank you to everyone who read my piece about EA's potential acquisition of Take Two, and especially to those of you who took the time to cover the piece or otherwise comment on it. Now that the FTC has issued a Second Request to EA and is clearly taking a hard look at the merger, this seems like a good time to recap where this deal is, and follow up on some interesting points that were raised.
1. "What is a 'Second Request' and what does this mean for EA/Take Two?"
A little background on how the merger review process works is helpful here. Under a law called the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (HSR), any merger or tender offer that exceeds a certain monetary threshold is required to file a Notification and Report Form with both the FTC and the Antitrust Division at the Department of Justice. The Form includes a description of the deal, the parties to the deal, and attaches certain documents relevant to the deal for government review.
Most importantly, the HSR filing starts a 30-day clock running for the government to review the deal during which it is illegal to consummate the merger. The vast majority of deals go through after this 30-day period, or even earlier if the parties have requested an "early termination" of the waiting period.
A much smaller percentage of deals, however, present some competitive concerns that require that the government investigation extend beyond the 30-day waiting period. Those deals receive what's called a "Second Request"--which is what EA got on April 17th.
A Second Request is basically a large discovery request asking for any and all documents, correspondence, and economic data relating to the deal. Depending on the size of the request and the size of the deal, a response to the Second Request can require producing up to hundreds, or even thousands, of boxes of documents. If, for instance, there are any incriminating intra-company emails discussing the possibility of increased profits from a monopoly in the sports division after the merger, that's where they'll be found.
Most importantly, the 30-day waiting period has now been extended indefinitely. That means that even if EA can wrestle control of Take Two from Zelnick, the parties are forbidden from consummating the deal until the FTC has concluded its investigation, which usually takes months, and on rare occasions, over a year.
During this time, the FTC will conduct interviews with competitors, retailers, and consumer representatives to gather opinions on the deal. Economists will pore over economic data to build post-merger pricing models. Toward the end of the investigation, there will likely be depositions under oath of EA, and possibly Take Two, executives and representatives.
In other words, it's just escalated from a run-of-the-mill inquiry to a full-blown investigation. At the conclusion of the investigation, there will be some sort of substantial staff recommendation memo to the Commission itself that could recommend (1) suing to block the deal (seems unlikely); (2) seeking a divestiture of the overlapping products (certainly possible); or (3) taking no action at all (also still a possibility).
This is the hard look I warned about in my original piece. The deal can still go in any number of directions. But it's now unlikely to go anywhere quickly.
2. "If Madden as an NFL exclusive is OK, why is this any different?"
Several people have asked why the Madden exclusive was okay, or why other exclusive licenses in other entertainment industries haven't received the kind of scrutiny that's happening here.
It's important to understand that there is nothing inherently illegal about exclusive licenses. They're a little problematic for consumers when an entity that's already a monopolist--such as most professional sports leagues--leverages its monopoly to another industry--such as videogames or apparel--through an exclusive license. But it isn't illegal.
Section 7 of the Clayton Act applies specifically to mergers and acquisitions, allowing the government to prevent an acquisition if "the effect of such acquisition may be substantially to lessen competition, or to tend to create a monopoly." The language of Section 7, although broad in the enforcement powers it gives to the FTC and the Department of Justice, is limited to mergers and acquisitions.
According to EA Sports' Peter Moore, EA never demanded an exclusive license from the NFL. Instead, the NFL decided that it wanted an exclusive and solicited competitive bids (conveniently following a year in which Madden '05 and NFL 2K5 were competing at previously unheard of low prices). While the Madden exclusive immediately resulted in higher prices for consumers, it didn't implicate Section 7 because it wasn't the result of a merger.
In the Adidas/Reebok deal mentioned in the comments on Level Up, it's my understanding that the merger didn't actually create the monopoly in question. Instead, Reebok's already exclusive deal with the NBA simply passed over to Adidas. There was no lessening of competition because of the merger itself.
In this case, however, EA would be acquiring an exclusive license for several sports leagues where there were at least two competitors in the past, purely as a result of its acquisition of Take Two. That's the difference that puts Section 7, and the broad enforcement powers it gives the FTC, in play.
3. Defining a Product Market: Take Two
There were a lot of comments about my discussion of how a relevant product market is defined, which is not surprising because market definition guides the entire analysis of a merger. The most important point here is that how a relevant product market is defined for antitrust purposes is often NOT the same way that product markets are thought of in a business sense.
The antitrust analysis is not the most intuitive, and I risk diving too deeply into the technical analysis here, but I want to shed a little more light on how the analysis occurs.
As a reference point, I've excerpted some language from Section 1.11 of the Horizontal Merger Guidelines issued by the FTC and Department of Justice (DOJ):
[T]he Agency will delineate the product market to be a product or group of products such that a hypothetical profit-maximizing firm that was the only present and future seller of those products ("monopolist") likely would impose at least a "small but significant and nontransitory" increase in price. That is, assuming that buyers likely would respond to an increase in price for a tentatively identified product group only by shifting to other products, what would happen? If the alternatives were, in the aggregate, sufficiently attractive at their existing terms of sale, an attempt to raise prices would result in a reduction of sales large enough that the price increase would not prove profitable, and the tentatively identified product group would prove to be too narrow.
Specifically, the Agency will begin with each product (narrowly defined) produced or sold by each merging firm and ask what would happen if a hypothetical monopolist of that product imposed at least a "small but significant and nontransitory" increase in price, but the terms of sale of all other products remained constant. If, in response to the price increase, the reduction in sales of the product would be large enough that a hypothetical monopolist would not find it profitable to impose such an increase in price, then the Agency will add to the product group the product that is the next-best substitute for the merging firm's product.
In other words, for antitrust purposes, a "relevant product market" is only defined broadly enough to include those products that constrain the other's prices. The language is a bit of a mouthful, so I'll walk through an example, using hockey videogames again.
An investigative team at the FTC will spend a lot of time talking to competitors and buyers in the industry. During those interviews, the team will ask what would happen if the price of one company's NHL games were raised by five to ten percent. If the answer is that consumers would switch to another product in sufficient quantities to make that price increase unprofitable, then the product market is bigger than just the one game. The same question is then asked with a bigger hypothetical market that would include the next closest substitute: the competitor's NHL game.
That's the $64,000 question: What would consumers do if the price of both NHL games were raised five to ten percent? If consumers would still purchase one of those two hockey videogames in high enough quantities that it would be profitable to make the price increase, that's your product market. If the answer is that consumers would switch in favor of other sports videogames, then the next group of "next-best substitutes" are lumped into the hypothetical market, and the same questions are repeated again.
I want to be clear that I don't have the economic data to answer that question. But the people in the industry who do have that data and track those sales patterns are those whom the FTC will be talking to.
If you've followed the analysis this far, you'll see that a "relevant product market" in antitrust is often much narrower than a product market is defined in business practice. For example, a "relevant product market" can consist of only "office supply superstores" (Staples, OfficeMax, and Office Depot), and not include other big box supply stores who also sell office supplies (Best Buy, Target, etc.) if the economic data suggests that the "office supply superstores" aren't price constrained by the other stores (see the FTC's release on its rejection of the proposed settlement in the Staples/Office Depot merger).
Although we're talking about price increases here, these are only hypothetical questions used for the intellectual exercise of defining a "relevant product market." In reality, it's highly unlikely that consumers would see any direct price increases as a result of this merger. Prices are fairly standard throughout the industry, and gamers are conditioned to seeing $50 or $60 price tags on new games. A $65 lineup from EA Sports would certainly raise eyebrows.
Instead, what you're likely to see, as discussed in the original post, is that prices will decline more slowly than they otherwise would have--which is important in a market where a new version of the product is released every year. The rate of price decline is where you see real price competition occur in the videogame industry. If 2K's NHL game drops its price by $10, it immediately puts pressure of EA to do the same with its product, and vice versa.
But the hypothetical questions that define a "relevant product market" are still important, because an entity that has the market power to raise prices five to ten percent also has the market power to maintain higher prices through the holiday season. Although it's not a direct price increase, it is still a "lessening of competition" that ultimately harms consumers.
4. "Forget price! I just want to play good games!"
Another concern I saw raised repeatedly, especially on message boards, was that EA Sport's dominant position would allow it to become complacent, reducing innovation in future sports titles. That is absolutely a valid concern. It represents a very real harm to consumers, and it's a factor that FTC investigators are unlikely to ignore.
Unlike price, however, the harm to innovation is much more difficult to quantify economically, and therefore rarely gets the same attention in antitrust analysis that price does. But that doesn't mean it's not in the mix.
Ultimately, the same market factors that would allow a hypothetical monopolist to raise price are roughly the same as those that can stagnate innovation. In other words, the same lack of vigorous competition that removes price constraints also removes the incentives for innovation and quality.
Certainly, developers are good people who want to make quality games as a matter of pride. But from a business standpoint, the incentives to pour more resources into innovation simply aren't there for monopolists.
Gamers are clearly more concerned about a lack of quality than they are about a small price increase over the holiday season. I don't blame them, and it's clear that EA is already battling this perception across some of its sports titles. But the analyses discussed above regarding hypothetical price increases also address the same competitive conditions that provide incentives for innovation and quality.
5. "Does the FTC really care about videogames?"
Many gamers expressed a concern about whether the FTC really cares about mergers in entertainment industries.
First of all, I can tell you that the FTC absolutely cares about mergers in entertainment industries. In 2007, the FTC charged Sony BMG with secretly embedding software in audio CDs creating unreasonable intrusions in consumer privacy. In 2004, the FTC, in cooperation with the European Union, gave a hard look to the proposed Sony/BMG music deal, before ultimately granting its approval. In 2000, the FTC took action against the music industry's major players for illegal pricing practices that artificially inflated the price of CDs. And in 2002, a new agreement allocating enforcement areas between the FTC and the DOJ was derailed by Senator Earnest Hollings (D-S.C.) in large part because it ceded antitrust review of entertainment/media to the DOJ entirely, where consumer groups feared that such investigations might be subject to political input from the executive branch. In fact, during that interagency dispute, Commission Mozelle W. Thompson listed "gaming" as one of FTC's areas of expertise he didn't want to see allocated to DOJ.
Just because an industry may be viewed by some as frivolous, that doesn't mean the government doesn't care about preserving competition and protecting consumers in that industry. There are a whole host of reasons why we haven't seen the FTC intervene in a videogame merger yet, not the least of which are that there are still many developers in the industry, and in general, the barriers to entry for new players don't seem particularly daunting, at least for certain types of games. But EA/Take Two is a unique deal in that it gives EA such a large share of the sports market. The FTC has never had to review a videogame merger with these competitive implications before.
Likewise, I wouldn't expect the FTC to ignore the anticompetitive concerns in the sports market just because it represents a small fraction of the overall deal. In his recent comments to Level Up, Wedbush Morgan's Michael Pachter suggested that EA would argue that the consumer benefit from heads-up competition in the sports market is in fact de minimis.
While there's no question that EA would try to make that argument--they certainly wouldn't be the first--they can expect it to get limited traction at best. The FTC devotes plenty of resources to policing mergers of all sizes (hospital mergers in small geographic markets for example), and is unlikely to give the deal a free pass just because the anticompetitive effects are small compared to the overall size of the deal.
Instead, the likely response would be to suggest that EA simply spin off the sports division to another competitor to maintain the head-to-head competition--however small it would be--while preserving the rest of the deal.
6. "Can't some other developer make sports videogames in Take Two's place?"
Maybe, and that's likely to be the second major crux of this investigation. The ultimate wild card here is what do the sports leagues in question want? Do the NHL, the NBA, and the NCAA want only one developer licensee for their leagues, or do they prefer multiple competing products?
If EA wanted to get a pass on this deal, the easiest way to do so would be to assure the FTC, with assistance from the leagues, that those leagues would in fact look for new licensee developers to replace any competing titles lost through the merger.
Would that be enough to protect videogame consumers here? Hard to say. Any new licensee would be starting its development from the ground up, while EA/Take Two would have the source code and the development talent from multiple titles in the genre to draw upon.
Even with a portfolio short of an outright monopoly, an EA/Take Two sports library would be so large that EA could potentially exercise market power in other ways. What if at some point in the future, EA simply told the NHL that it was only interested in making titles for partners on an exclusive basis. Doesn't that put tremendous pressure on the NHL to capitulate to EA and stick with the proven power of the EA Sports brand, rather than grant a license to an unknown developer?
***
As I said in my first piece, I truly don't know what the FTC will actually do here. The ultimate question of market definition is dependent on industry sales data and economic expertise that I'm simply not privy to.
But I can tell you that if the consolidation wave sweeping through the videogame industry continues at its current pace, there will come a day that the industry finds itself dealing with antitrust issues. There are a lot of factors at play in the industry that have kept antitrust at bay. That's been the case for many other technology-driven industries over the years as well. But as a technology-driven industry matures, costs rise, the stakes grow higher, competitors consolidate, and eventually antitrust becomes relevant.
This is the first deal in the videogame industry that I've seen present these issues so clearly. It may not be the deal where the FTC draws a line in the sand. But it's likely to happen someday, so it doesn't hurt to think about these issues now.
At its best, the videogame industry cultivates developer creativity through business models that allow it to take chances and push the medium forward in unexpected and satisfying ways. Because of the immersive nature of games, gamers have a somewhat uniquely emotional connection to these products. Regardless of what the FTC does here, I think it's useful to appreciate the competitive factors that allow these products to thrive, and to understand how the current consolidation wave may affect those conditions.
