WASHINGTON — In what appears to be the first shot in a potentially groundbreaking change to defense mergers and acquisitions, Frank Kendall, the Pentagon’s top acquisition official, said the Department of Defense plans to ask Congress to create rules that could hinder mergers between prime contractors.
The drive behind the move, Kendall told reporters, is concern that such mergers limit the number of defense firms and give too much power to individual companies — power that will end up hurting both the department and the American taxpayer.
“If the trend to smaller and smaller numbers of weapon system prime contractors continues, one can foresee a future in which the department has at most two or three very large suppliers for all the major weapon systems that we acquire,” Kendall said. “The department would not consider this to be a positive development and the American public should not either.”
“With size comes power, and the department's experience with large defense contractors is that they are not hesitant to use this power for corporate advantage.”
Kendall’s announcement comes against the backdrop of the Department of Justice clearing the purchase by Lockheed Martin, the world’s largest defense company, of Sikorsky, the largest producer of military helicopters in the US. That deal was obviously very much on his mind, as it was held up as an example of how the number of major defense firms are shrinking.
“Mergers such as this, combined with significant financial resources of the largest defense companies, strategically position the acquiring companies to dominate large parts of the defense industry,” Kendall said of the Lockheed-Sikorsky deal.
In order to address the situation, Kendall said, the department plans to work with Congress to “explore additional legal tools and policy to preserve the diversity and spirit of innovation that have been central to the health and strength of our unique, strategic defense industrial base, particularly at the prime contractor level.”
Asked specifically what those options are, Kendall said the Pentagon hasn’t had much chance to talk with Congress yet and expects to do that over “the next few months.”
“One obvious [option] would be a provision that took national security considerations into account, but it's very early,” he said. “We need to explore the possibilities with the Congress.”
Asked about Kendall's plan shortly after the conference call ended, Sen. Jack Reed, D-R.I., the ranking Democrat on the Senate Armed Services Committee, said this was his "first opportunity" to hear about Kendall's recommendation. However, he indicated a willingness to listen to Kendall's concerns.
"I have known the secretary for many, many, many years, and I have great respect for his abilities, so anything he would suggest, I would take very seriously," Reed said. "But I would have to look carefully and I have not had the change to look at it in detail."
"Again, having known Secretary Kendall, respecting his opinion, if he is suggesting there is a problem, it has to be taken seriously," Reed added.
The statement is an unusually strong one from the Pentagon, an indicator of how seriously Kendall’s office is taking the question of mergers at the highest level of the defense industry.
However, Kendall was quick to say this message was not aimed at any specific pending merger.
“It’s not pointed at any specific expectation of any other deals. It’s more about the general situation,” he said. “I think we have to look at each case on its merits, but in general I think the trend toward smaller numbers of larger defense primes is not a positive one.”
Earlier this month, Lockheed indicated in a filing with the Securities and Exchange Commission that it received approval from US regulators for its $9 billion acquisition of Sikorsky Aircraft Corp. Without a second request for information from US regulators, the deal appears to be on track to close in the fourth quarter of 2015 or the first quarter of 2016, as Lockheed had hoped when the defense giant announced the deal July 20.
“While the Lockheed Sikorsky transaction does not trigger anti-trust concerns of having a negative impact on competition and we understand and agree with the basis upon which the Department of Justice (DOJ) decided not to issue a request for additional information about the transaction, we believe that these types of acquisitions still give rise to significant policy concerns,” Kendall said in his statement.
The deal does not violate the Pentagon’s ban on mergers between prime contractors, but it does make Lockheed, the world’s biggest defense contract, even bigger.
“The trend toward fewer and larger prime contractors has the potential to affect innovation, limit the supply base, pose entry barriers to small, medium and large businesses, and ultimately reduce competition — resulting in higher prices to be paid by the American taxpayer in order to support our war fighters,” Kendall said in the statement.
Although Kendall’s tone on the conference call indicated a certain level of frustration that the Lockheed-Sikorsky deal was not given another round of review by the Department of Justice, Kendall also made it clear that he was not seeking to block the agreement.
“The Lockheed-Sikorsky deal was not taken into another round of inquiry by DoJ,” he said. “So as far as the Department of Justice is concerned, there is nothing further to investigate. I’m really looking forward. I’m not looking backward to Lockheed-Sikorsky.”
Speaking before Kendall’s remarks, Secretary of Defense Ash Carter declined to comment on the Sikorsky-Lockheed deal, but acknowledged a past statement he had made about the dangers of too much consolidation.
“What I said then, and still believe, is that it was important to avoid excessive consolidation in the defense industry,” Carter said, “to the point where we did not have multiple vendors which could compete with one another on many programs, and to the point where we had so-called vertical integration in companies to the extent that made competition among subcontractors for work on prime less competitive.”
“I think that now and at the time I indicated that I, in that time, but I feel the same way now, didn’t welcome further consolidation among the very large prime contractors,” he said. “I didn’t think it was good for our defense marketplace and therefore for the taxpayer and our warfighter in the long run.”
Jeff Bialos, a partner at Sutherland Asbill & Brennan who specializes in aerospace and defense M&A and previously served as the Pentagon’s deputy undersecretary of defense for industrial policy, said Kendall is concerned that the current law doesn’t give the Pentagon ample discretion to address certain implications of mergers for competition in defense markets
Size alone is not anti-competitive under anti-trust laws, Bialos said. But it’s not hard to envision a scenario in which a company becomes so big, and involved in so many sectors of the defense business, that smaller firms are afraid to team with one of the large firm’s rivals for fear of angering the giant and being frozen out of future business.
“That’s the issue that I think that one might argue that current law doesn’t sufficiently address,” he said.
Current anti-trust law is not a hugely detailed statute, but largely governed by common law, said Bialos.
“There have been periods when the laws were interpreted differently than they are now,” he said, “and perhaps the Pentagon could work with the Justice Department to address these concerns under current law. Or Congress could give the DoD legal standing to weigh in on M&A in the defense sector.”
“If there was a law that gave them a national security direct seat at the table, it would be an easier discussion,” he said.
However, he said, it is hard to anticipate how Congress will respond to the issues raised by Kendall, given the general anti-regulation environment on Capitol Hill right now.
Joe Gould in Washington contributed to this report.