When a company reorganizes successfully through a sale, it is a win-win situation for the debtor, which has guaranteed its continued existence, and creditors, which achieve at least a partial recovery. The one party the bankruptcy court does not have a duty to protect is the consumer, who may end up paying a higher price for the debtor's products.

The latter charge falls to the Federal Trade Commission, which works to block mergers that violate antitrust laws, but thanks to a rarely used clause in the U.S. Horizontal Merger Guidelines, the agency does allow some deals that reduce competition.

Bankrupt companies can invoke the "failing firm defense," which permits such transactions if the absence of the merger would eliminate a certain product from the market.

The defense is rarely raised and even more rarely successful, according to a U.S. paper submitted to the international Organisation for Economic Co-operation and Development. It has only been successful a handful of times since a 1930 decision by the U.S. Supreme Court introduced the concept.

Most recently, the clause came up in Laboratory Corp. of America Holdings' $57.5 million bid for bankrupt rival Westcliff Medical Laboratories Inc.

Both the target and the purchaser provide testing services to physician groups in Southern California, along with a third competitor, Quest Diagnostics Inc. The transaction -- which closed June 16, a week after it won approval from Judge Theodor Albert of the U.S. Bankruptcy Court for the Central District of California in Santa Ana -- left LabCorp and Quest in control of nearly 90% of the market, according to the FTC's Dec. 1 complaint.

The FTC alleged the target could not meet the stringent guidelines necessary to use the filing firm defense, saying other companies were willing to purchase Westcliff for more than its liquidation value, if not the $60 million necessary to trump LabCorp's stalking-horse bid.

"Secured creditors realized that they would not receive any return on their investments if Westcliff had been liquidated," the FTC said, "and therefore believed that even if LabCorp did not purchase the company, Westcliff would have been sold to an alternative purchaser, albeit at a lower price."

Michael Moiseyev, a spokesman in the FTC's bureau of competition, says the bankruptcy court does not consider consumers or trade issues, thus it is not unusual to approve such a seemingly attractive deal for the constituents in the case. Westcliff's secured creditors, owed $56 million, look set to get a full or almost full recovery, for example.

The court approval did, however, make it difficult for the FTC to fight the merger months after the deal had closed. (The agency began to investigate the deal before that, and the parties agreed not to close it until the review was complete. They changed tack, however, and did close the transaction, but LabCorp agreed to keep Westcliff's assets separate pending the FTC review.)

In the end, LabCorp was ultimately successful in its purchase, but not because it succeeded in proving Westcliff was a failing firm, as LabCorp in part argued.

Judge Andrew Guilford of the U.S. District Court for the Central District of California in Santa Ana on Feb. 22 denied the preliminary injunction the FTC had sought, ruling that the companies were actually not as competitive as the FTC alleged. The FTC's complaint, Guilford said, limited the affected market to labs that used a particular payment method in their contracts with physicians. He also found the geographic market for Westcliff's product was larger than Southern California and the FTC was pessimistic about the ability of competitors to enter the market and too easily dismissed the threat of Westcliff's financial losses.

After the district court denied a stay pending appeal on Feb. 25 and the U.S. Court of Appeals for the 9th Circuit on March 14 denied an injunction pending an appeal, the FTC on March 24 withdrew the matter from adjudication and withdrew its appeal of Guilford's order. The FTC dismissed its complaint on April 22.

"While we continue to have reason to believe that LabCorp's acquisition of Westcliff will result in anticompetitive effects, we are convinced that further adjudication of this case will not serve the public interest," FTC commissioners Jon Leibowitz, William Kovacic and Edith Ramirez said in a statement.

As the fight over LabCorp's purchase of Westcliff illustrates, proving a deal does not reduce competition is actually easier than to prove a firm is failing, Moiseyev says.

For a company to qualify as a failing firm, it must be unable to meet its financial obligations in the future, be unable to reorganize through bankruptcy, have made an unsuccessful good-faith effort to elicit reasonable alternative offers to purchase the company, and its assets would exit the relevant market in the absence of the deal.

Furthermore, the target must prove that its financial distress is not part of a cyclical market downturn. Rather, its hardships must stem from an underlying inability to compete effectively in the current and future economy.

"Recessions are temporary, but mergers are forever," warned deputy assistant attorney general for economics Carl Shapiro in a May 13, 2009, speech during an antitrust symposium.

The question of whether a firm is failing, or merely "flailing," has been an issue of contention in the current economic climate. Moiseyev says the defense is brought up more often during times of economic distress. Recessions, however, do not make the defense more likely to be successful.

Take, for example, the 1969 Supreme Court ruling in Citizen Publishing Co. v. United States. Citizen, which published an evening paper in Tucson, Ariz., had negotiated a joint operating agreement in 1940 with the Star, a Tucson daily and Sunday paper. Before the agreement took effect, the newspapers were "vigorous competitors" according to the Supreme Court decision, which struck down Citizen's 1965 purchase of the Star and forced changes to the JOA. Despite Citizen's losses in the years before the JOA took effect -- during the tail end of the Great Depression -- the court said the deal "caused a substantial lessening of competition in daily newspaper publishing" and violated antitrust law. The court also ruled Citizen was not in danger of disappearing, could find other purchasers or could reorganize in the predecessors to today's Chapter 11 if needed.

The FTC also shot down Meade Instruments Corp.'s bid to acquire competing telescope maker Celestron International in 2002. The agency ruled that because the two companies were the only ones making a specific telescope, the Schmidt-Cassegrain, they could not combine even though Celestron's business was faltering. (An affiliate of Synta Technology Corp. acquired Celestron in 2005.)

During both the above cases, the U.S. was experiencing a slight recession, but the downturn did not affect the outcome in the cases. "Keeping markets competitive is no less important during times of economic hardship than during normal times," Shapiro said in his 2009 speech.

Despite the high threshold necessary to justify the failing firm defense, it has been used successfully. The Supreme Court first recognized it in 1930, when International Shoe Co. sought to acquire rival shoe company W.H. McElwain Co. The FTC alleged the merger would restrain commerce because of lessened competition.

The Supreme Court, however, sanctioned the deal, saying because McElwain had large debts and was "faced with financial ruin," the deal was the only chance for the target company's rehabilitation. (Incidentally, International Shoe's eventual parent, Interco Inc., went bankrupt in 1991, but a remainder lives on as Furniture Brands International Inc.)

A company, however, does not always have to be facing "financial ruin" for a seemingly anticompetitive deal to succeed. Sometimes the FTC permits certain deals when a target is merely "flailing" and future competition in the industry is unlikely either with or without the merger. For example, in 1997 the FTC allowed Boeing Co.'s acquisition of commercial aircraft supplier McDonnell Douglas Corp., saying the target had deteriorated to the point that it was no longer a competitor of Boeing, even though McDonnell Douglas was not a failing firm.

Anticompetitive mergers are more likely to appear in industries that have seen a "significant demand shift," according to Bob Schlossberg, a partner specializing in antitrust and competition in the Washington office of Freshfields Bruckhaus Deringer LLP. With ever-advancing technology, some companies may be left "flailing" and thus the market may not need lots of competition in certain sectors. Schlossberg cited the "buggy whip industry" as an example of a market in which a monopoly may suffice.

Nevertheless, the FTC is usually the victor when a company invokes the failing firm defense.

"The confluence of factors that have to come together for it to work are pretty rare," Moiseyev says.