(Adds trade group, state and union reactions)
By David Ingram and Karen Jacobs
WASHINGTON Aug 13 The U.S. government on Tuesday sued to block American Airlines and US Airways' proposed merger to create the world's biggest airline, saying consumers would end up paying higher fares and fees.
The surprise move likely would delay, or even derail, a merger set to close next month and could stall a broad industry restructuring that investors were counting on to support airline profits, triggering a 5.4 percent decline in U.S. airline shares. It also could hinder American parent AMR Corp's efforts to emerge from its nearly 2-year-old bankruptcy.
The Department of Justice, which has in recent years allowed two major airline mergers - United-Continental and Delta-Northwest - to go ahead, made it clear that it is out to block the $11 billion deal entirely rather than seeking concessions from AMR and US Airways.
"We think the right solution here is a full-stop injunction," Bill Baer, head of the Justice Department Antitrust Division, told reporters on a conference call.
The lawsuit, filed in U.S. District Court for the District of Columbia and joined by six states including Arizona and Texas, drew support from consumer advocates, but surprised the industry and raised questions about its budding recovery.
Investors had been counting on large U.S. airlines to carefully notch up fares, fees and profits, ending years of price wars, overcapacity and setbacks such as the 9-11 attacks, the financial crisis and rising fuel costs.
The Thomson Reuters airlines index had climbed more than 35 percent this year as investors grew more confident that airlines would be solidly profitable.
On Tuesday, US Airways closed 13 percent lower at $16.36 on the New York Stock Exchange. American shares fell 45 percent to $3.17 in over-the-counter trading.
AMR and US Airways said they would launch a "vigorous and strong defense" against the effort to block their merger, which they said would enhance competition.
The two airlines had been widely expected to win approval for the deal, which was announced in February. They secured European Union approval on Aug. 5 after promising to surrender some slots at London's Heathrow and Philadelphia.
Now some experts said the airlines face a tough task convincing regulators that the creation of a new dominant airline would not harm consumers.
"US Airways and AMR have an extreme uphill battle to save the merger," said David Balto, a former trial lawyer in Department of Justice's antitrust division who is now in private practice in Washington, D.C.
"The (DOJ) complaint tells a compelling story of how the airlines acted together to increase fees and reduce service, and how US Airways and American had a blueprint to increase prices through the merger."
He said rising fees for ticket changes and checked baggage suggested a pattern of collusion. "I don't see a conceivable remedy to allow this deal to go forward."
The Justice Department said it was concerned that if the merger went through, four airlines would control more than 80 percent of the U.S. commercial air travel market.
At Reagan National Airport in Arlington, Virginia, the one closest to Washington, D.C., the combined US Airways-American would control 69 percent of take-off and landing slots, the department said.
Other industry experts said the lawsuit's aggressive demands were out of step with past cases and would potentially leave US Air and American, which is emerging from bankruptcy, at a competitive disadvantage.
When beer giant Anheuser-Busch InBev's sought to increase its stake in Mexico's Grupo Modelo, for example, the Justice Department objected. But the sides settled on a compromise that was widely viewed among antitrust lawyers as evidence of pragmatism.
"Airfare remains an unmatched bargain," said Airlines for America, the industry's major trade group, noting that fares have lagged inflation, making flying cheaper.
The group said the merger would help consumers by ensuring that airlines are financially healthy and can "reinvest in their business with new planes, products and destinations, including expanded service to small communities and internationally, which in turn creates jobs."
Some of the airlines' unions also voiced strong disagreement with the DOJ's case, saying a stronger airline made through the merger would ensure stable wages and jobs. Airline workers have had jobs, wages and pensions cut by past airline bankruptcies.
Arizona, where US Airways is based, said the merger probably would prompt the airline to charge American's higher bag and ticket change fees. Texas, home of American Airlines, said it joined because of concerns that it will lose service to smaller airports.
Baer said that while he wouldn't rule out a proposed settlement, he thought the evidence pointed to the DOJ blocking the deal.
But several experts said the deal could ultimately go through with American and US Airways surrendering some overlapping routes at Reagan National Airport and elsewhere, and perhaps giving up a some planes or a hub.
"That has been the key to solving these puzzles in the past," said Stephen Axinn, a partner and antitrust specialist at law firm Axinn, Veltrop and Harkrider. "But it doesn't address the question of potential oligopoly where there are only three legacy carriers - AMR, Delta and United."
"I think this is another governmental mistake," former American Airlines Chief Executive Robert Crandall told Reuters in an email, noting he expected the airlines to sue.
By allowing mergers between United Airlines and Continental, and Delta Air Lines and Northwest, the government "made a third large merger inevitable," he said.
In the long run, he added, blocking the merger will "reduce effective competition in the airline industry, as neither US Air nor American Airlines is large enough to compete effectively in their present form."
The lawsuit "borders on shocking" and is "marvelously inconsistent" in light of the two prior mega-mergers, said George Hamlin, an aviation consultant in Fairfax, Virginia.
"Assuming it prevents US Air and American from merging, does that condemn them to perpetual second-class existence?"
Others said the move was necessary to protect travelers who have paid higher fees and fares in recent years.
Consumer advocate Charlie Leocha, director of the Consumer Travel Alliance, said he was elated at the lawsuit.
"This is a stake in the heart of the merger. I don't see this moving forward," Leocha said. "This is the best possible and the only good consumer outcome that we could have gotten."
While U.S. discussions had centered on remedies such as slot divestitures at Reagan National, Leocha said, "in my meetings with DOJ and in my testimony before Congress, I have constantly said that that won't take care of the overriding nationwide loss of competition that we're going to face. It sounds like the Department of Justice has agreed with me."
A hearing on Thursday to confirm AMR's bankruptcy exit plan, which is based on the proposed merger, was still slated to go forward, according to a clerk in Judge Sean Lane's chambers.
(Reporting by Jonathan Stempel, David Ingram, Alwyn Scott, Karen Jacobs and Nicholas Brown; Editing by Alwyn Scott, John Wallace, Jeffrey Benkoe and Richard Chang)