Third Circuit Reverses Penn State Hershey Decision in Major Win for FTC

On May 9, 2016, District Judge John E. Jones, III, of the Middle District of Pennsylvania denied the FTC and the Commonwealth of Pennsylvania's motion for a preliminary injunction to block the merger of Penn State Hershey Medical Center and PinnacleHealth System.¹ On September 27, 2016, a three-judge panel of the Third Circuit unanimously reversed that decision, finding in favor of the plaintiffs on all the key issues on appeal. Most significantly, the appellate decision represents a clear victory for the FTC on the core issue of geographic market definition in hospital merger cases. The Third Circuit found that Judge Jones had committed reversible error when he "fail[ed] to properly formulate and apply the hypothetical monopolist test" for determining the relevant geographic market, and that this error rendered his analysis "economically unsound and not reflective of the commercial reality of the healthcare market."² The court also raised questions about the availability of an "efficiencies defense" as a cognizable defense to an otherwise anticompetitive transaction, an issue that may have resonance beyond just the jurisprudence of hospital mergers.

The Third Circuit remanded the case to the district court to enter the preliminary injunction requested by the government, and enjoined the proposed merger pending the outcome of the FTC's administrative trial on the merits. On October 14, 2016, the defendant hospitals announced they were abandoning their efforts to merge.³

The District Court Decision

Judge Jones (and all the parties) agreed that the proper test for determining the geographic market in this case was the "hypothetical monopolist" test.⁴ The "hypothetical monopolist" test asks whether a hypothetical monopolist of a purported geographic market would be able to impose a small but significant non-transitory increase in price (SSNIP) without prompting sufficient market response to defeat the price increase. In the context of a hospital merger, if patients or health insurance payors would resist the proposed increase by taking their business elsewhere in numbers sufficient to defeat the increase, then the proposed geographic market has not sufficiently captured all of the reasonable alternative providers. If, on the other hand, the hypothetical monopolist could succeed in obtaining the increase, then the market is properly defined.

Judge Jones rejected the motion for a preliminary injunction in large part because he found that the government's proposed "Harrisburg Area" geographic market was "unrealistically narrow" as applied.⁵ Judge Jones rested this conclusion primarily on the fact that 43.5% of Penn State Hershey's patients traveled to the hospital from outside the Harrisburg Area. The court also ascribed significance to the fact that the defendant hospitals had recently entered into temporary price-protection agreements with two of the largest area health insurers that prevented rates from increasing for five years for one insurer and ten years for the other.⁶ The court posited that the existence of these agreements meant, in effect, that a "hypothetical monopolist" of the Harrisburg Area would not be able to raise prices for at least five years.

The district court opinion found the FTC's failure to properly define the geographic market dispositive, but nonetheless weighed what it described as "equities," in finding that a "compelling efficiencies argument" also counseled in favor of denying the FTC's preliminary injunction request.⁷ In particular, the court credited the hospitals' argument that the merger would permit them to alleviate capacity constraints and consequently avoid building a new 100-patient bed tower.⁸ Judge Jones' decision concluded with an unusually pointed critique of the FTC's hospital merger enforcement priorities, and suggested that the Affordable Care Act and other federal regulatory policies had "created a climate that virtually compels institutions to seek alliances such as the Hospitals intend here."⁹

The Third Circuit Decision

The Third Circuit overruled Judge Jones in every important aspect of his opinion. The core of the Third Circuit opinion catalogued three key errors in the lower court's analytical approach to defining the relevant geographic market and instead adopted the FTC's approach to the "hypothetical monopolist" test.¹⁰

First, the Third Circuit criticized Judge Jones' reliance on patient flow data in his analysis of the geographic market. It found that "by relying almost exclusively on the number of patients that enter[ed] the proposed market, the District Court's analysis more closely align[ed] with" what it termed "a discredited economic theory"¹¹ that analyzes patient inflow and outflow from a purported geographic market as a means to determining the relevant geographic market for hospital mergers.¹²

That mode of analysis—known as the Elzinga-Hogarty test—was originally developed in the 1970s to assess geographic markets in markets for goods such as coal and beer. Later, it became used for drawing geographic markets in hospital transactions and, as the Third Circuit noted, it became the "preferred method" for doing so. The court stated, however, that "subsequent empirical research" demonstrated that utilizing patient flow data led to "overbroad markets with respect to hospitals."¹³ The Third Circuit thus concluded that "relying solely on patient flow data [was] not consistent with the hypothetical monopolist test."¹⁴ The Third Circuit also noted that, even if one were to consider the Elzinga-Hogarty test as an appropriate test for the geographic market in hospital cases, it had been misapplied by Judge Jones. In particular, by "citing only patient inflows and ignoring patient outflows" (i.e., the undisputed fact that 91% of Harrisburg residents received care in Harrisburg), the court below had created a "misleading picture" of the geographic market by considering only half of the equation.¹⁵

Second, the Third Circuit found that the district court fundamentally misunderstood competition in the hospital market because, by focusing almost exclusively on patient flow data, it had ignored the key role played by insurance companies. The Third Circuit endorsed the "two-stage model" of healthcare market competition described by the FTC—namely, that hospitals compete for placement in insurer health networks and then compete to attract individual members of insurer health plans. Given that market structure, the Third Circuit held that a proper geographic market definition must focus on the health insurance payors who will "feel the impact of any price increase" as opposed to patients, who are "largely insensitive to healthcare prices because they utilize insurance."¹⁶ In contrast, Judge Jones' decision "failed to properly account for the likely response of insurers in the face of a SSNIP" and, indeed, "completely neglected any mention of the insurers in the healthcare market" in his decision.¹⁷

Third, the Third Circuit held that Judge Jones also erred in considering the price-protection agreements the hospitals had entered with area insurers as part of his analysis of the geographic market. The Third Circuit agreed with the FTC's position that actual private contracts are not appropriately considered as part of an analysis, which at its foundation seeks to answer whether a hypothetical monopolist could impose a SSNIP. The Third Circuit held that considering such contractual arrangements was analytically improper, and would also create practical problems by "enabl[ing] antitrust defendants to escape effective enforcement of the antitrust laws" by simply entering similar agreements.¹⁸

After concluding that Judge Jones had incorrectly applied the hypothetical monopolist test, the Third Circuit found that the government had met its burden of properly defining the geographic market. In particular, the Third Circuit cited to the "extensive evidence" the government had presented showing that "insurers would have no choice but to accept a price increase" from the combined hospitals "in lieu of excluding the hospitals from their networks."¹⁹ Because there was no dispute that within the Harrisburg Area geographic market the proposed merger would increase market concentration levels well above those deemed presumptively anticompetitive, the court found that the government had met its prima facie burden.²⁰

The Third Circuit also concluded that Judge Jones had erred in his consideration of the "equities" of the proposed merger. The Third Circuit found the evidence "ambiguous at best" as to whether Penn State Hershey needed to build a 100-bed patient tower to alleviate its capacity constraints.²¹ More significantly, the Third Circuit endorsed the FTC's argument that the ability to forgo building additional capacity is not a cognizable merger efficiency, but rather the exact opposite—a "reduction in output" that resulted in competitive harm and therefore is not sufficient to offset any anticompetitive effects of a proposed merger.²²

Perhaps more significant than its rejection of this particular efficiencies defense, the Third Circuit expressed skepticism as to whether a so-called "efficiencies defense" is even a cognizable defense. While noting that the FTC and Department of Justice's Horizontal Merger Guidelines acknowledge such a defense, the court made the point that neither the Third Circuit nor the Supreme Court had formally adopted the defense.²³ The Third Circuit concluded that because the hospital defendants could not show that their claimed efficiencies would offset any anticompetitive effects of the merger, it did not need to resolve the issue of whether any efficiencies defense would be cognizable as a matter of law.²⁴

The Third Circuit also addressed Judge Jones' statement about the federal regulatory climate and the possibility that legislative changes had created conditions incentivizing hospital mergers. The Third Circuit noted that "certain extrinsic factors" have made these mergers "beneficial—perhaps even necessary—to the continued success of some hospital systems," but concluded that "opining on the soundness of any legislative policy that may have compelled the Hospitals to undertake this merger is not within our purview."²⁵

Conclusion

The Third Circuit's opinion is a significant victory for the FTC, and provides substantial support for the FTC's approach to analyzing geographic markets in hospital mergers. While the Third Circuit emphasized that its "holding is narrow" and that the hypothetical monopolist test is not the only test that could be used to determine the relevant geographic market,²⁶ the language of the opinion makes clear that an analytic structure focusing on bargaining with insurers rather than patient flow data is the presumptive approach, and hospital administrators considering potential transactions will need to assume that approach will be applied in the future.