I’ve spent the last few days in DC at the ABA Antitrust Section’s Spring Meeting. The Spring Meeting is the extravaganza of the year for antitrust lawyers, bringing together leading antitrust practitioners, enforcers, and academics for in-depth discussions about developments in the law. It’s really a terrific event. I was honored this year to have been invited (by my old law school classmate, Adam Biegel) to present the “antitrust economics” and “monopolization” sections of the Antitrust Fundamentals session. Former TOTM blogger (now FTC Commissioner) Josh Wright has taught those sections in the past, so I had some pretty big shoes to fill. It was great fun.

Two sessions yesterday really got my blood pumping, albeit for different reasons. The first was a session on counseling clients on RPM after Leegin. Leegin, of course, was the 2007 Supreme Court decision overruling the 1911 Dr. Miles precedent that declared minimum resale price maintenance (RPM) to be per se illegal. Post-Leegin, a manufacturer’s setting of the resale price its downstream dealers may charge is evaluated under the Rule of Reason, at least for purposes of federal antitrust law.

While it was a 5-4 decision, the holding of Leegin is hardly controversial among antitrust scholars. Chicago School and neo-Chicago scholars like myself, Harvard School scholars like Herb Hovenkamp, and even post-Chicago scholars like Einer Elhauge are in agreement that RPM is not always or almost always anticompetitive and thus ought to be analyzed under the Rule of Reason. (Indeed, Elhauge queried: “The puzzle is what provoked a vigorous dissent from Justice Breyer, one of the world’s most sophisticated antitrust justices…”). There’s simply no doubt about Leegin among those who have studied RPM most closely: it was correctly decided.

It was most disheartening, then, to hear a group of esteemed panelist opine that Leegin hasn’t really changed the advice one should give clients considering RPM policies. It’s still wise, the panelists stated, to advise manufacturing clients to avoid RPM and instead to implement either (1) so-called Colgate policies where the manufacturer simply announces and follows a unilateral policy of not selling to dealers who discount, or (2) consignment arrangements where the manufacturer doesn’t sell its product to dealers but instead enlists them as its sales agents and retains title to its product until the product is sold to the end-user consumer. The former approach avoids RPM liability because there is no “agreement” concerning resale prices; the latter, because there is technically no “resale.” Both approaches, though, involve costly and cumbersome methods by which manufacturers may exert control over the resale prices of their products. (See, e.g., golf club manufacturer Ping’s now-classic discussion of the difficulties involved in implementing a Colgate policy.)  So why counsel clients to adopt Colgate policies and consignment/agency arrangements when RPM is now adjudged under the Rule of Reason?

Because of the states — a number of them, at least. Maryland has adopted an explicit Leegin-repealer; California’s Cartwright Act uses language that appears to declare RPM to be per se illegal; and the Supreme Court of Kansas recently held that RPM is per se illegal under that state’s predictably unenlightened antitrust laws.  (Sorry Kansas folk. Proud Mizzou Tiger here.) In addition, a number of states lack statutes or court decisions harmonizing state antitrust law with federal precendents, and at least six have rejected certain federal precedents –chiefly, Illinois Brick — even without statutory repealers. How those states will treat RPM post-Leegin is anybody’s guess. (For an exhaustive and regularly updated list of state law treatment of RPM, see this helpful article and chart by Michael Lindsay.)

So what’s behind states’ hostility toward RPM?  At yesterday’s RPM session, California Senior Assistant Attorney General Kathleen Foote suggested that state attorneys general tend to oppose RPM because they are particularly concerned about consumer protection and because states have had actual experience with RPM under the so-called “Fair Trade” laws that for several decades allowed states to create antitrust immunity for RPM arrangements.  The empirical evidence of conditions under Fair Trade, Ms. Foote says, establishes that RPM leads to higher consumer prices and therefore tends to be anticompetitive.

But these arguments, each of which was considered and rejected in Leegin, have been soundly refuted.  A heightened concern for consumer protection in no way supports adherence to Dr. Miles, for manufacturers generally have an incentive to impose RPM only when doing so benefits consumers.  The retail mark-up — the difference between the price the retailer pays and that which it charges to consumers — is the “price” manufacturers effectively pay for product distribution.  Like consumers, they have no incentive to raise that price (i.e., to increase the mark-up through imposition of RPM) unless doing so generates retailer services that are worth more to consumers than the incremental retail mark-up.  Only then would RPM enhance a manufacturer’s profits, but in that case, it also enhances overall consumer surplus.  In short, manufacturer and consumer interests are generally aligned when it comes to RPM.

With respect to Fair Trade, Ms. Foote was playing a little fast and loose.  The Fair Trade laws did not, like Leegin, simply declare RPM arrangements not to be per se illegal; rather, they said that such arrangements were per se legal.  Hardly anyone doubts that RPM arrangements may sometimes be harmful and should be scrutinized.  But under Leegin — unlike under Fair Trade — anticompetitive instances of RPM (those that facilitate manufacturer or retailer collusion or serve as exclusionary devices for dominant manufacturers or retailers) may be condemned.  Thus, the fact that states witnessed consumer harm under Fair Trade’s regime of per se legality says nothing about how consumers will fare under Leegin’s Rule of Reason.

Finally, Ms. Foote’s reasoning that RPM is anticompetitive because the evidence shows it tends to raise prices is fallacious.  Of course RPM raises prices.  It is, after all, the imposition of a price floor.  But that price effect is beside the point.  Each one of the procompetitive, output-enhancing justifications for RPM assumes an increase in consumer prices.  The key is that the increase in retail mark-up will induce dealer services that consumers value more than the amount of the mark-up and will thereby enhance overall sales.  The fact that RPM raises prices, then, is a red herring.

If legislators, courts, and enforcement officials in states like California, Maryland, and Kansas can’t understand these fairly simple points (yes, I realize I’m asking a lot of the Kansans), then the promise of Leegin may go unfulfilled.  It was pretty clear from yesterday’s session that legal advice — and, accordingly, manufacturer practice — will look much as it did pre-Leegin unless the states get their act together.  That’s pretty depressing.

Fortunately, the session following the RPM session was a good bit more promising.  The highlight was a speech by FTC Commissioner Wright, in which he laid out his intentions to promote a more principled understanding of Section 5 of the FTC Act and to pursue the “low-hanging fruit” (his words) of public restraints.  Both developments would be warmly welcomed.

Commissioner Wright maintains that the promise of Section 5 (which enables the FTC, but not private parties, to enjoin unfair methods of competition that do not necessarily constitute antitrust violations) will remain unfulfilled until the FTC lays out the guiding and limiting principles that will govern its use of the provision.  He’s right.  Absent such articulated principles, use of Section 5 could well end up the way Robert Bork once described mid-20th Century antitrust, which he likened to a frontier sheriff who “did not sift the evidence, distinguish between suspects, and solve crimes, but merely walked the main street and every so often pistol-whipped a few people.” The evidence-based principles Commissioner Wright proposes to develop would avoid the frontier sheriff problem by bringing predictability and fairness to the Commission’s implementation of its Section 5 authority.

Even more exciting were Commissioner Wright’s remarks on public restraints.  Without doubt, competition-reducing laws and regulations are responsible for the destruction of vast amounts of consumer welfare.  State action immunity and other legal hurdles, though, make it difficult to police welfare-reducing public restraints.

But litigation isn’t the only weapon in the FTC’s arsenal.  As Commissioner Wright observed, the FTC is uniquely positioned to advocate for the removal of competition-destructive public restraints.  I was heartened to learn that the Commission recently helped persuade Colorado officials not to impose regulations that would have squelched Uber, a smart phone application that is creating much-needed competition in the taxi and private car service market.  It also took the side of the angels in St. Joseph Abbey case, helping to persuade the Fifth Circuit to strike protectionist regulations that reduced competition among casket sellers in Louisiana.  Commissioner Wright also noted that the FTC’s recent victory in the Phoebe Putney case, which narrowed somewhat the scope of state action immunity, will allow it to pursue more public restraints by state and sub-state governmental entities.  This all bodes well for consumers.

So here’s an idea for the FTC: How about using some of that advocacy prowess to convince the anti-Leegin states to bring their RPM doctrine into conformity with federal law?  It might be tough — and Kansas may be beyond help — but I’m confident that Commissioner Wright and his colleagues could help the anti-Leegin states see that they’re not helping consumers by clinging to moth-eaten Dr. Miles.  Instead, they’re just guaranteeing more jobs for lawyers charged with crafting and implementing Colgate policies, consignment relationships, etc.

Filed under: antitrust, consumer protection, markets, regulation, resale price maintenance

Today, a group of eighteen scholars, of which I am one, filed an amicus brief encouraging the Supreme Court to review a Court of Appeals decision involving loyalty rebates.  The U.S. Court of Appeals for the Third Circuit recently upheld an antitrust judgment based on a defendant’s loyalty rebates even though the rebates resulted in above-cost prices for the defendant’s products and could have been matched by an equally efficient rival.  The court did so because it decided that the defendant’s overall selling practices, which involved no exclusivity commitments by buyers, had resulted in “partial de facto exclusive dealing” and thus were not subject to the price-cost test set forth in Brooke Group.  (For the uniniated, Brooke Group immunizes price cuts that result in above-cost prices for the discounter’s goods.)  We amici, who were assembled by Michigan Law’s Dan Crane, believe the Third Circuit’s decision threatens to chill proconsumer discounting practices and should be overruled.

The defendant in the case, Eaton, manufactures transmissions for big trucks (semis, cement trucks, etc.).  So did plaintiff Meritor.  Eaton and Meritor sold their products to the four manufacturers of big trucks.  Those “OEMs” installed the transmissions into the trucks they sold to end-user buyers, who typically customized their trucks and thus could select whatever transmissions they wanted.  Meritor claimed that Eaton drove it from the market by entering into purportedly exclusionary “long-term agreements” (LTAs) with the four OEMs.  The agreements did not require the OEMs to purchase any particular amount of Eaton’s products, but they did provide the OEMs with rebates (resulting in above-cost prices) if they bought high percentages of their requirements from Eaton.  The agreements also provided that Eaton could terminate the agreements if the market share targets were not met. Each LTA contained a “competitiveness clause” that allowed the OEM to purchase transmissions from another supplier without counting the purchases against the share target, or to terminate the LTA altogether, if another supplier offered a lower price or better product and Eaton could not match that offering.  Following adoption of the LTAs, Eaton’s market share grew, and Meritor’s shrank.  Before withdrawing from the U.S. market altogether, Meritor filed an antitrust action against Eaton.

Eaton insisted, not surprisingly, that it had simply engaged in hard competition.  It grew its market share by offering a lower price that an equally efficient rival could have matched.  Meritor’s failure, then, resulted from either its relative inefficiency or its unwillingness to lower its price to the level of its cost.  By immunizing above-cost discounted prices from liability, the Brooke Group rule permits and encourages the sort of competition in which Eaton engaged, and it should, the company argued, control here.

The Third Circuit disagreed.  This was not, the court said, a simple case of price discounting.  Instead, Eaton had engaged in what the court called “partial de facto exclusive dealing.”  The exclusive dealing was “partial”  because OEMs could purchase some transmissions from other suppliers and still obtain Eaton’s loyalty rebates (i.e., complete exclusivity was not required).  It was “de facto” because purchasing exclusively (or nearly exclusively) from Eaton was not contractually required but was instead simply the precondition for earning a rebate.  Nonetheless, reasoned the court, the gravamen of Meritor’s complaint was some sort of exclusive dealing, which is evaluated not under Brooke Group but instead under a rule of reason that focuses on the degree to which the seller’s practices foreclose its rivals from available sales opportunities.  Under that test, the court concluded, the judgment against Eaton could be upheld.  After all, Eaton’s sales practices won lots of business from Meritor, whose sales eventually shrunk so much that the company exited the market.

As we amici point out in our brief to the Supreme Court, the Third Circuit ignored the fact that it was Eaton’s discounts that led OEMs to buy so much from the company (and forego its rival’s offerings).  Absent an actual promise to buy a high level of one’s requirements from a seller, any “exclusive dealing” resulting from a loyalty rebate scheme results from the fact that buyers voluntarily choose to patronize the seller over its competitors because the discounter’s products are cheaper.  In other words, low pricing is the very means by which any “exclusivity” — and, hence, any market foreclosure — is achieved.  Any claim alleging that an agreement not mandating a certain level of purchases but instead providing for loyalty rebates results in “partial de facto exclusive dealing” is therefore, at its heart, a complaint about price competition.  Accordingly, it should be subject to the Brooke Group screening test for discounts resulting in above-cost pricing.

The Third Circuit wrongly insisted that Eaton had done something more sinister than win business by offering above-cost loyalty rebates.  It concluded that Eaton “essentially forced” the four OEMs (who likely had a good bit of buyer market power themselves) to accept its terms by threatening “financial penalties or supply shortages.”  But these purported “penalties” and threats of “supply shortages” appear nowhere in the record.

The only “penalty” an OEM would have incurred by failing to meet a purchase target is the denial of a rebate from Eaton.  If that’s enough to make Brooke Group inapplicable, then any conditional price cut resulting in an above-cost price falls outside the decision’s safe harbor, for failure to meet the discount condition would subject buyers to a “penalty.”  Proconsumer price competition would surely be chilled by such an evisceration of Brooke Group.  As for threats of supply shortages, the only thing Meritor and the Third Circuit could point to was Eaton’s contractual right to cancel its LTAs if OEMs failed to meet purchase targets.  But if that were enough to make Brooke Group inapplicable, then the decision’s price-cost test could never apply when a dominant seller offers a conditional rebate or discount.  Because the seller could refuse in the future to supply buyers who fail to qualify for the discount, there would be, under the Third Circuit’s reasoning, not just a loyalty rebate but also an implicit threat of “supply shortages” for buyers that fail to meet the seller’s purchase targets.

This is not the first case in which a plaintiff has sought to evade a price-cost test, and thereby impose liability on a discounting scheme that would otherwise pass muster, by seeking to recharacterize the defendant’s conduct.  A few years back, a plaintiff (Masimo) sought to evade the Ninth Circuit’s PeaceHealth decision, which creates a Brooke Group-like safe harbor for certain bundled discounts that could not exclude equally efficient rivals, by construing the defendant’s conduct as “de facto exclusive dealing.”  Dan Crane and I participated as amici in that case as well.

I won’t speak for Dan, but I for one am getting tired of working on these briefs!  It’s time for the Supreme Court to clarify that prevailing price-cost safe harbors cannot be evaded simply through the use of creative labels like “partial de facto exclusive dealing.”  Hopefully, the Court will heed our recommendation that it review — and overrule — the Third Circuit’s Meritor decision.

[In case you’re interested, the other scholars signing the brief urging cert in Meritor are Ken Elzinga (Virginia Econ), Richard Epstein (NYU and Chicago Law), Jerry Hausman (MIT Econ), Rebecca Haw (Vanderbilt Law), Herb Hovenkamp (Iowa Law), Glenn Hubbard (Columbia Business), Keith Hylton (Boston U Law), Bill Kovacic (GWU Law), Alan Meese (Wm & Mary Law), Tom Morgan (GWU Law), Barak Orbach (Arizona Law), Bill Page (Florida Law), Robert Pindyck (MIT Econ), Edward Snyder (Yale Mgt), Danny Sokol (Florida Law), and Robert Topel (Chicago Business).]

Filed under: antitrust, economics, exclusionary conduct, exclusive dealing, law and economics, monopolization, regulation, Supreme Court

William & Mary’s Alan Meese has posted a terrific tribute to Robert Bork, who passed away this week.  Most of the major obituaries, Alan observes, have largely ignored the key role
Bork played in rationalizing antitrust, a body of law that veered sharply off course in the middle of the last century.  Indeed, Bork began his 1978 book, The Antitrust Paradox, by comparing the then-prevailing antitrust regime to the sheriff of a frontier town:  “He did not sift the evidence, distinguish between suspects, and solve crimes, but merely walked the main street and every so often pistol-whipped a few people.”  Bork went on to explain how antitrust, if focused on consumer welfare (which equated with allocative efficiency), could be reconceived in a coherent fashion.

It is difficult to overstate the significance of Bork’s book and his earlier writings on which it was based.  Chastened by Bork’s observations, the Supreme Court began correcting its antitrust mistakes in the mid-1970s.  The trend began with the 1977 Sylvania decision, which overruled a precedent making it per se illegal for manufacturers to restrict the territories in which their dealers could operate.  (Manufacturers seeking to enhance sales of their brand may wish to give dealers exclusive sales territories to protect them against “free-riding” on their demand-enhancing customer services; pre-Sylvania precedent made it hard for manufacturers to do this.)  Sylvania was followed by:

• Professional Engineers (1978), which helpfully clarified that antitrust’s theretofore unwieldy “Rule of Reason” must be focused exclusively on competition;
• Broadcast Music, Inc. (1979), which held that competitors’ price-tampering arrangements that reduce costs and enhance output may be legal;
• NCAA (1984), which recognized that trade restraints among competitors may be necessary to create new products and services and thereby made it easier for competitors to enter into output-enhancing joint ventures;
• Khan (1997), which abolished the ludicrous per se rule against maximum resale price maintenance;
• Trinko (2004), which recognized that some monopoly pricing may aid consumers in the long run (by enhancing the incentive to innovate) and narrowly circumscribed the situations in which a firm has a duty to assist its rivals; and
• Leegin (2007), which overruled a 96 year-old precedent declaring minimum resale price maintenance–a practice with numerous potential procompetitive benefits–to be per se illegal.

Bork’s fingerprints are all over these decisions.  Alan’s terrific post discusses several of them and provides further detail on Bork’s influence.

And while you’re checking out Alan’s Bork tribute, take a look at his recent post discussing my musings on the AALS hiring cartel.  Alan observes that AALS’s collusive tendencies reach beyond the lateral hiring context.  Who’d have guessed?

Filed under: antitrust, cartels, law and economics, legal scholarship, markets, monopolization, regulation, resale price maintenance, Supreme Court

The U.S. Department of Justice sued eBay last week for agreeing not to poach employees from rival Intuit. According to the Department’s press release, “eBay’s agreement with Intuit hurt employees by lowering the salaries and benefits they might have received and deprived them of better job opportunities at the other company.” DOJ maintains that agreements among rivals not to compete for workers have long been deemed per se illegal. (Indeed, Google, Apple, Adobe, and Pixar quickly settled antitrust claims based on similar non-poaching arrangements in 2010.)

Read the full piece here.

This coming Friday (Oct. 12), the Center for Business Law and Regulation at Case Western Law School will host what promises to be a terrific symposium on executive compensation.  Presenters include TOTM alumnus Todd Henderson (Chicago Law), Jill Fisch (Penn Law), Jesse Fried (Harvard Law), David Walker (Boston U Law), David Larcker (Stanford Business), Stephen L. Brown (TIAA-CREF), Paul Hodgson (GMI Ratings), William Mulligan (Primus Venture Partners).

Here’s a description of the symposium:

Executive compensation has become the most contentious issue in corporate governance. Many claim that poorly designed executive compensation helped cause the recent financial collapse, but critics disagree widely about what was wrong with those designs. Management and investors are wrestling over their roles in structuring executive compensation through say-on-pay and over the role of proxy advisory services. The symposium brings together prominent practicing attorneys, institutional investors, proxy advisors, and academics to discuss the current issues and where we are, or should be, headed.

If you’re in Cleveland and able to make it to the symposium (for which 4.5 hours of CLE is available), do it.  Otherwise, check out the webcast.

Filed under: announcements, executive compensation

Einer Elhauge and Abraham Wickelgren, of Harvard and the University of Texas, respectively, have recently posted to SSRN a pair of provocative papers on loyalty discounts (price cuts conditioned on the buyer’s purchasing some amount, usually a percentage of its requirements, from the seller).  Elhauge and Wickelgren take aim at the assertion by myself and others (e.g., Herb Hovenkamp) that loyalty discounts should be per se legal if they result in a discounted per-unit price that is above the seller’s incremental per-unit cost.  E&W would cast the liability net further.

We advocates of per se legality for above-cost loyalty discounts base our position on the fact that such discounts generally cannot exclude aggressive rivals that are as efficient as the discounter.  Suppose, for example, that widgets are normally sold for a dollar each but that a seller whose marginal cost is $.88/widget offers a 10% loyalty rebate to any buyer who purchases 80% of its widget requirements from the seller.  Because the $.90 discounted price exceeds the discounter’s marginal cost, any equally efficient widget producer could compete with the discount by lowering its own price to a level above its cost.

But what if the loyalty rebate actually causes a rival to be less efficient than the discounter? Some have argued that this may occur, even with above-cost loyalty discounts, when scale economies are significant.  Suppose that the market for tennis balls consists of two brands, Pinn and Willson, that current market shares, reflective of consumer demand, are 60% for the Pinn and 40% for Willson,  and that retailers typically stock the two brands in those proportions. Assume also that it costs each manufacturer $.90 to produce a can of tennis balls, that each sells to retailers for $1 per can, and that minimum efficient scale in this market (the lowest production level at which all available scale economies are exploited) occurs at a level of production equal to 35% of market demand. Suppose that Pinn, the dominant manufacturer, offers retailers a 10% loyalty rebate on all purchases made within a year if they buy 70% of their requirements for the year from Pinn.

While the $.90 per unit discounted price is not below Pinn’s cost, it might have the effect of driving Willson, an equally efficient rival, from the market. Willson could avoid losing market share and thus falling below minimum efficient scale only if it matched the full dollar amount of Pinn’s discount on its smaller base of sales. It wouldn’t be able to do so, though, without pricing below its cost.

Consider, for example, a typical retailer that initially (before the rebate announcement) satisfied its requirements by purchasing sixty cans of Pinn for $60 and forty cans of Willson for $40. After implementation of the rebate plan, the retailer could save $7 on its 100-can tennis ball requirements by spending $63 to obtain seventy Pinn cans and $30 to obtain thirty Willson cans. The retailer and others like it would thus have a strong incentive to shift purchases from Willson to Pinn.  To prevent a loss of market share that would drive it below minimum efficient scale, Willson would need to lower its price to provide retailers with the same total dollar discount, but on a smaller base of sales (40% of a typical retailer’s requirements rather than 60%). This would cause it to lower its price below its cost.  For example, Willson could match Pinn’s $7 discount to the retailer described above only by reducing its $1 per-unit price by 17.5 cents ($7.00/40 = $.175), which would require it to price below its cost of $.90 per unit.

When one considers dynamic effects, examples like this don’t really undermine the case for a rule of per se legality for above-cost loyalty discounts. Had the nondominant rival (Willson) charged a price equal to its marginal cost prior to implementation of Pinn’s loyalty rebate, it would have enjoyed a price advantage and likely would have grown its market share to a point at which Pinn’s loyalty rebate strategy could not drive it below minimum efficient scale. Moreover, a strategy that would prevent a nondominant but equally efficient firm from being harmed by a dominant rival’s above-cost loyalty rebate would be for the non-dominant firm to give its own volume discounts from the outset, securing up-front commitments from enough buyers (in exchange for discounted prices) to ensure that its production stayed above minimum efficient scale. Such a strategy, which would obviously benefit consumers, would be encouraged by a rule that evaluated loyalty discounts under straightforward Brooke Group principles and thereby signaled to manufacturers that they must take steps to protect themselves from above-cost loyalty discounts. In the end, then, any equally efficient rival that is committed to engaging in vigorous price competition ought not to be excluded by a dominant seller’s above-cost loyalty rebate.

Moreover, even if a loyalty rebate could occasionally drive an aggressive, equally efficient rival from the market, a rule of per se legality for above-cost loyalty discounts would still be desirable on error cost grounds.  An alternative rule subjecting above-cost loyalty discounts to potential treble damages liability would chill all sorts of non-exclusionary discounting practices, so that the social losses from reduced price competition would exceed any social gains from the elimination of those rare discounts that could exclude aggressive, efficient rivals. In short, the social costs resulting from potential false convinctions under a broader liability rule would overwhelm the social costs from false acquittals under the per se legality rule I have advocated.

The two new papers by Elhauge and Wickelgren contend that I and other per se legality advocates are missing a key anticompetitive threat posed by loyalty discounts even in the absence of scale economies: their potential to chill price competition.

The first E&W paper addresses loyalty discounts involving “buyer commitment”—i.e., a promise by buyers receiving the discount that they will purchase some percentage of their requirements from the discounter (not its rivals) in the future.  According to E&W, the discounter who agrees to this sort of arrangement will be less likely to give discounts to uncommitted (“free”) buyers in the future.  This is because, E&W say, the discounter knows that if it cuts prices to such buyers, it will have to reduce its prices to committed buyers by the agreed-upon discount percentage.  The discounter’s rivals, knowing that the discounter won’t cut prices to attract free buyers, will similarly abstain from aggressive price competition.  “The result,” E&W maintain, “is inflated prices to free buyers, which also means inflated prices to committed buyers because they are priced at a loyalty discount from those free buyer prices.”  Despite these adverse consequences, E&W contend, buyers will agree to competition-reducing loyalty discounts because much of their cost is externalized:  “[W]hen one buyer agrees to a loyalty discount, all buyers suffer from the higher prices that result from less aggressive competition,” so “an incumbent supplier need not compensate an individual buyer who agrees to a loyalty discount for the losses that all other buyers suffer.”

The second E&W paper contends that loyalty discounts may soften price competition and injure consumers even when they do not involve buyer commitment to purchase from the discounter in the future.  According to E&W, “[b]ecause the loyalty discount requires the seller to charge loyal buyers less than buyer who are not covered by the loyalty discount, the seller cannot lower prices to uncovered buyers without also lowering prices to loyal buyers.”  Given the increased cost of competing for uncovered buyers  (i.e., any price concession will require further concessions to covered buyers), the seller is likely to cede uncovered buyers to its rival, which will reduce the rival’s incentive to compete aggressively for buyers covered by the loyalty discount.  In short, E&W contend, the loyalty discount will facilitate a market division scheme between the discounter and its rival.

As is typical for an Elhauge paper, there’s some elaborate modeling and math in both of these papers.  The analysis appears to be rigorous.  It seems to me, though, that there’s a significant problem with both papers: Each assumes that loyalty discounts are structured so that the discounter promises to reduce the price from the amount collected in sales to others.  While I’m reluctant to make sweeping claims about how loyalty discounts are typically structured, I don’t think loyalty discounts usually work this way.

Loyalty discounts could be structured many ways.  The seller could offer a discount from a pre-determined price—e.g., “The price is $1 per widget, but if you purchase at least 80% of your widgets from me, I’ll charge you only $.90/widget.”  Such a discount doesn’t create the incentive effect that underlies E&W’s theories of anticompetitive effect, for there’s no reason for the seller not to reduce others’ widget prices in the future.  Alternatively, the seller could offer a discount off a list price that is subject to change—e.g., “If you purchase 80% of your requirements from me, I’ll charge you 10% less than the posted list price.”  This sort of discount might discourage sellers from lowering list prices, but it shouldn’t dissuade them from also giving others a break from list prices.  Indeed, in many industries hardly anyone pays list price.  The only loyalty discounts that threaten the effects E&W fear are those where the discount is explicitly tied to the price charged to others—e.g., “If you purchase 80% of your requirements from me, I’ll charge you 10% less than the lowest price I’m charging others.”

This last sort of loyalty discount might have the effects E&W predict, but I’ve never seen such a discount.  The loyalty discounts and rebates I encountered as an antitrust lawyer resembled the first two types discussed above: discounts off pre-determined prices or discounts off official list prices (from which price concessions were regularly granted to others).  The loyalty discounts that E&W model really just look like souped-up “Most Favored Nations” clauses, where the seller promises not just to meet, but to beat, the price it offers to other favored buyers.  It may make sense to police such clauses, but wouldn’t we do so using the standards governing MFN clauses rather than the rules and standards governing loyalty discounts?  After all, it’s the seller’s promise to beat its other price concessions, not the buyer’s loyalty, that causes the purported anticompetitive harm.

UPDATE:

I just recalled that this is not the first time we at TOTM have addressed Prof. Elhauge’s models of loyalty discounts containing a Most Favored Nations-like provision. FTC Commissioner-Appointee Josh Wright made a similar point about a paper Elhauge produced before these two.  If you found this post at all interesting, please read Josh’s earlier (and more rigorous) post. Sorry about that, Mr. Commish-to-be.

Filed under: antitrust, economics, error costs, law and economics, regulation

TOTM friend Stephen Bainbridge is editing a new book on insider trading.  He kindly invited me to contribute a chapter, which I’ve now posted to SSRN (download here).  In the chapter, I consider whether a disclosure-based approach might be the best way to regulate insider trading.

As law and economics scholars have long recognized, informed stock trading may create both harms and benefits to society.  With respect to harms, defenders of insider trading restrictions have maintained that informed stock trading is “unfair” to uninformed traders and causes social welfare losses by (1) encouraging deliberate mismanagement or disclosure delays aimed at generating trading profits; (2) infringing corporations’ informational property rights, thereby discouraging the production of valuable information; and (3) reducing trading efficiency by increasing the “bid-ask” spread demanded by stock specialists, who systematically lose on trades with insiders.

Proponents of insider trading liberalization have downplayed these harms.  With respect to the fairness argument, they contend that insider trading cannot be “unfair” to investors who know in advance that it might occur and nonetheless choose to trade.  And the purported efficiency losses occasioned by insider trading, liberalization proponents say, are overblown.  There is little actual evidence that insider trading reduces liquidity by discouraging individuals from investing in the stock market, and it might actually increase such liquidity by providing benefits to investors in equities.  With respect to the claim that insider trading creates incentives for delayed disclosures and value-reducing management decisions, advocates of deregulation claim that such mismanagement is unlikely for several reasons.  First, managers face reputational constraints that will discourage such misbehavior.  In addition, managers, who generally work in teams, cannot engage in value-destroying mismanagement without persuading their colleagues to go along with the strategy, which implies that any particular employee’s ability to engage in mismanagement will be constrained by her colleagues’ attempts to maximize firm value or to gain personally by exposing proposed mismanagement.  With respect to the property rights concern, deregulation proponents contend that, even if material nonpublic information is worthy of property protection, the property right need not be a non-transferable interest granted to the corporation; efficiency considerations may call for the right to be transferable and/or initially allocated to a different party (e.g., to insiders).  Finally, legalization proponents observe that there is little empirical evidence to support the concern that insider trading increases bid-ask spreads.

Turning to their affirmative case, proponents of insider trading legalization (beginning with Geoff’s dad, Henry Manne) have primarily emphasized two potential benefits of the practice.  First, they observe that insider trading increases stock market efficiency (i.e., the degree to which stock prices reflect true value), which in turn facilitates efficient resource allocation among capital providers and enhances managerial decision-making by reducing agency costs resulting from overvalued equity.  In addition, the right to engage in insider trading may constitute an efficient form of managerial compensation.

Not surprisingly, proponents of insider trading restrictions have taken issue with both of these purported benefits. With respect to the argument that insider trading leads to more efficient securities prices, ban proponents retort that trading by insiders conveys information only to the extent it is revealed, and even then the message it conveys is “noisy” or ambiguous, given that insiders may trade for a variety of reasons, many of which are unrelated to their possession of inside information.  Defenders of restrictions further maintain that insider trading is an inefficient, clumsy, and possibly perverse compensation mechanism.

The one thing that is clear in all this is that insider trading is a “mixed bag”  Sometimes such trading threatens to harm social welfare, as in SEC v. Texas Gulf Sulphur, where informed trading threatened to prevent a corporation from usurping a valuable opportunity.  But sometimes such trading creates net social benefits, as in Dirks v. SEC, where the trading revealed massive corporate fraud.

As regular TOTM readers will know, optimal regulation of “mixed bag” business practices (which are all over the place in the antitrust world) requires consideration of the costs of underdeterring “bad” conduct and of overdeterring “good” conduct.  Collectively, these constitute a rule’s “error costs.”  Policy makers should also consider the cost of administering the rule at issue; as they increase the complexity of the rule to reduce error costs, they may unwittingly drive up “decision costs” for adjudicators and business planners.  The goal of the policy maker addressing a mixed bag practice, then, should be to craft a rule that minimizes the sum of error and decision costs.

Adjudged under that criterion, the currently prevailing “fraud-based” rules on insider trading fail.  They are difficult to administer, and they occasion significant error cost by deterring many instances of socially desirable insider trading.  The more restrictive “equality of information-based” approach apparently favored by regulators fares even worse.  A contractarian, laissez-faire approach favored by many law and economics scholars would represent an improvement over the status quo, but that approach, too, may be suboptimal, for it does nothing to bolster the benefits or reduce the harms associated with insider trading.

My new book chapter proposes a disclosure-based approach that would help reduce the sum of error and decision costs resulting from insider trading and its regulation.  Under the proposed approach, authorized informed trading would be permitted as long as the trader first disclosed to a centralized, searchable database her insider status, the fact that she was trading on the basis of material, nonpublic in­formation, and the nature of her trade.  Such an approach would (1) enhance the market efficiency benefits of insider trading by facilitating “trade decod­ing,” while (2) reducing potential costs stemming from deliberate misman­agement, disclosure delays, and infringement of informational property rights.  By “accentuating the positive” and “eliminating the negative” conse­quences of informed trading, the proposed approach would perform better than the legal status quo and the leading proposed regulatory alternatives at minimizing the sum of error and decision costs resulting from insider trading restrictions.

Please download the paper and send me any thoughts.

Filed under: 10b-5, corporate law, disclosure regulation, error costs, financial regulation, insider trading, markets, regulation, securities regulation, SSRN

In light of yesterday’s abysmal jobs report, yesterday’s Wall Street Journal op-ed by Stanford economist John B. Taylor (Rules for America’s Road to Recovery) is a must-read.  Taylor begins by identifying what he believes is the key hindrance to economic recovery in the U.S.:

In my view, unpredictable economic policy—massive fiscal “stimulus” and ballooning debt, the Federal Reserve’s quantitative easing with multiyear near-zero interest rates, and regulatory uncertainty due to Obamacare and the Dodd-Frank financial reforms—is the main cause of persistent high unemployment and our feeble recovery from the recession.

A reform strategy built on more predictable, rules-based fiscal, monetary and regulatory policies will help restore economic prosperity.

Taylor goes on (as have I) to exhort policy makers to study F.A. Hayek, who emphasized the importance of clear rules in a free society.  Hayek explained:

Stripped of all technicalities, [the Rule of Law] means that government in all its actions is bound by rules fixed and announced beforehand—rules which make it possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances and to plan one’s individual affairs on the basis of this knowledge.

Taylor observes that “[r]ules-based policies make the economy work better by providing a predictable policy framework within which consumers and businesses make decisions.”  But that’s not all: “they also protect freedom.”  Thus, “Hayek understood that a rules-based system has a dual purpose—freedom and prosperity.”

We are in a period of unprecedented regulatory uncertainty.  Consider Dodd-Frank.  That statute calls for 398 rulemakings by federal agencies.  Law firm Davis Polk reports that as of June 1, 2012, 221 rulemaking deadlines have expired.  Of those 221 passed deadlines, 73 (33%) have been met with finalized rules, and 148 (67%) have been missed.  The uncertainty, it seems, is far from over.

Taylor’s Hayek-inspired counsel mirrors that offered by President Reagan’s economic team at the beginning of his presidency, a time of economic malaise similar to that we’re currently experiencing.  In a 1980 memo reprinted in last weekend’s Wall Street Journal, Reagan’s advisers offered the following advice:

…The need for a long-term point of view is essential to allow for the time, the coherence, and the predictability so necessary for success. This long-term view is as important for day-to-day problem solving as for the making of large policy decisions. Most decisions in government are made in the process of responding to problems of the moment. The danger is that this daily fire fighting can lead the policy-maker farther and farther from his goals. A clear sense of guiding strategy makes it possible to move in the desired direction in the unending process of contending with issues of the day. Many failures of government can be traced to an attempt to solve problems piecemeal. The resulting patchwork of ad hoc solutions often makes such fundamental goals as military strength, price stability, and economic growth more difficult to achieve. …

Consistency in policy is critical to effectiveness. Individuals and business enterprises plan on a long-range basis. They need to have an environment in which they can conduct their affairs with confidence. …

With these fundamentals in place, the American people will respond. As the conviction grows that the policies will be sustained in a consistent manner over an extended period, the response will quicken.

If you haven’t done so, read both pieces (Taylor’s op-ed and the Reagan memo) in their entirety.

Filed under: economics, financial regulation, Hayek, politics, regulation

New York Times columnist Gretchen Morgenson is arguing for a “pre-clearance”  approach to regulating new financial products:

The Food and Drug Administration vets new drugs before they reach the market. But imagine if there were a Wall Street version of the F.D.A. — an agency that examined new financial instruments and ensured that they were safe and benefited society, not just bankers.  How different our economy might look today, given the damage done by complex instruments during the financial crisis.

The idea Morgenson is advocating was set forth by law professor Eric Posner (one of my former profs) and economist E. Glen Weyl in this paper.  According to Morgenson,

[Posner and Weyl] contend that new instruments should be approved by a “financial products agency” that would test them for social utility. Ideally, products deemed too costly to society over all — those that serve only to increase speculation, for example — would be rejected, the two professors say.

While I have not yet read the paper, I have some concerns about the proposal, at least as described by Morgenson.

First, there’s the knowledge problem.  Even if we assume that agents of a new “Financial Products Administration” (FPA) would be completely “other-regarding” (altruistic) in performing their duties, how are they to know whether a proposed financial instrument is, on balance, beneficial or detrimental to society?  Morgenson suggests that “financial instruments could be judged by whether they help people hedge risks — which is generally beneficial — or whether they simply allow gambling, which can be costly.”  But it’s certainly not the case that speculative (“gambling”) investments produce no social value.  They generate a tremendous amount of information because they reflect the expectations of hundreds, thousands, or millions of investors who are placing bets with their own money.  Even the much-maligned credit default swaps, instruments Morgenson and the paper authors suggest “have added little to society,” provide a great deal of information about the creditworthiness of insureds.  How is a regulator in the FPA to know whether the benefits a particular financial instrument creates justify its risks? 

When regulators have engaged in merits review of investment instruments — something the federal securities laws generally eschew — they’ve often screwed up.  State securities regulators in Massachusetts, for example, once banned sales of Apple’s IPO shares, claiming that the stock was priced too high.  Oops.

In addition to the knowledge problem, the proposed FPA would be subject to the same institutional maladies as its model, the FDA.  The fact is, individuals do not cease to be rational, self-interest maximizers when they step into the public arena.  Like their counterparts in the FDA, FPA officials will take into account the personal consequences of their decisions to grant or withhold approvals of new products.  They will know that if they approve a financial product that injures some investors, they’ll likely be blamed in the press, hauled before Congress, etc.  By contrast, if they withhold approval of a financial product that would be, on balance, socially beneficial, their improvident decision will attract little attention.  In short, they will share with their counterparts in the FDA a bias toward disapproval of novel products.

In highlighting these two concerns, I’m emphasizing a point I’ve made repeatedly on TOTM:  A defect in private ordering is not a sufficient condition for a regulatory fix.  One must always ask whether the proposed regulatory regime will actually leave the world a better place.  As the Austrians taught us, we can’t assume the regulators will have the information (and information-processing abilities) required to improve upon private ordering.  As Public Choice theorists taught us, we can’t assume that even perfectly informed (but still self-interested) regulators will make socially optimal decisions.  In light of Austrian and Public Choice insights, the Posner & Weyl proposal — at least as described by Morgenson — strikes me as problematic.  [An additional concern is that the proposed pre-clearance regime might just send financial activity offshore.  To their credit, the authors acknowledge and address that concern.]

Filed under: economics, financial regulation, Hayek, Knowledge Problem, law and economics, regulation