Today is the last day for public comment on the Federal Communications Commission’s latest net neutrality proposal. Here are two excellent op-eds on the matter, one by former FCC Commissioner Robert McDowell and the other by Tom Hazlett and TOTM’s own Josh Wright. Hopefully, the Commission will take to heart the pithy observation of one of my law school friends, Commissioner Ajit Pai: “The Internet was free and open before the FCC adopted net neutrality rules. It remains free and open today. Net neutrality has always been a solution in search of a problem.”
Last Monday, a group of nineteen scholars of antitrust law and economics, including yours truly, urged the U.S. Court of Appeals for the Eleventh Circuit to reverse the Federal Trade Commission’s recent McWane ruling.
McWane, the largest seller of domestically produced iron pipe fittings (DIPF), would sell its products only to distributors that “fully supported” its fittings by carrying them exclusively. There were two exceptions: where McWane products were not readily available, and where the distributor purchased a McWane rival’s pipe along with its fittings. A majority of the FTC ruled that McWane’s policy constituted illegal exclusive dealing.
Commissioner Josh Wright agreed that the policy amounted to exclusive dealing, but he concluded that complaint counsel had failed to prove that the exclusive dealing constituted unreasonably exclusionary conduct in violation of Sherman Act Section 2. Commissioner Wright emphasized that complaint counsel had produced no direct evidence of anticompetitive harm (i.e., an actual increase in prices or decrease in output), even though McWane’s conduct had already run its course. Indeed, the direct evidence suggested an absence of anticompetitive effect, as McWane’s chief rival, Star, grew in market share at exactly the same rate during and after the time of McWane’s exclusive dealing.
Instead of focusing on direct evidence of competitive effect, complaint counsel pointed to a theoretical anticompetitive harm: that McWane’s exclusive dealing may have usurped so many sales from Star that Star could not achieve minimum efficient scale. The only evidence as to what constitutes minimum efficient scale in the industry, though, was Star’s self-serving statement that it would have had lower average costs had it operated at a scale sufficient to warrant ownership of its own foundry. As Commissioner Wright observed, evidence in the record showed that other pipe fitting producers had successfully entered the market and grown market share substantially without owning their own foundry. Thus, actual market experience seemed to undermine Star’s self-serving testimony.
Commissioner Wright also observed that complaint counsel produced no evidence showing what percentage of McWane’s sales of DIPF might have gone to other sellers absent McWane’s exclusive dealing policy. Only those “contestable” sales – not all of McWane’s sales to distributors subject to the full support policy – should be deemed foreclosed by McWane’s exclusive dealing. Complaint counsel also failed to quantify sales made to McWane’s rivals under the generous exceptions to its policy. These deficiencies prevented complaint counsel from adequately establishing the degree of market foreclosure caused by McWane’s policy – the first (but not last!) step in establishing the alleged anticompetitive harm.
In our amicus brief, we antitrust scholars take Commissioner Wright’s side on these matters. We also observe that the Commission failed to account for an important procompetitive benefit of McWane’s policy: it prevented rival DIPF sellers from “cherry-picking” the most popular, highest margin fittings and selling only those at prices that could be lower than McWane’s because the cherry-pickers didn’t bear the costs of producing the full line of fittings. Such cherry-picking is a form of free-riding because every producer’s fittings are more highly valued if a full line is available. McWane’s policy prevented the sort of free-riding that would have made its production of a full line uneconomical.
In short, the FTC’s decision made it far too easy to successfully challenge exclusive dealing arrangements, which are usually procompetitive, and calls into question all sorts of procompetitive full-line forcing arrangements. Hopefully, the Eleventh Circuit will correct the Commission’s mistake.
Other professors signing the brief include:
- Tom Arthur, Emory Law
- Roger Blair, Florida Business
- Don Boudreaux, George Mason Economics (and Café Hayek)
- Henry Butler, George Mason Law
- Dan Crane, Michigan Law (and occasional TOTM contributor)
- Richard Epstein, NYU and Chicago Law
- Ken Elzinga, Virginia Economics
- Damien Geradin, George Mason Law
- Gus Hurwitz, Nebraska Law (and TOTM)
- Keith Hylton, Boston University Law
- Geoff Manne, International Center for Law and Economics (and TOTM)
- Fred McChesney, Miami Law
- Tom Morgan, George Washington Law
- Barack Orbach, Arizona Law
- Bill Page, Florida Law
- Paul Rubin, Emory Economics (and TOTM)
- Mike Sykuta, Missouri Economics (and TOTM)
- Todd Zywicki, George Mason Law (and Volokh Conspiracy)
The brief’s “Summary of Argument” follows the jump. Continue Reading…
I share Alden’s disappointment that the Supreme Court did not overrule Basic v. Levinson in Monday’s Halliburton decision. I’m also surprised by the Court’s ruling. As I explained in this lengthy post, I expected the Court to alter Basic to require Rule 10b-5 plaintiffs to prove that the complained of misrepresentation occasioned a price effect. Instead, the Court maintained Basic’s rule that price impact is presumed if the plaintiff proves that the misinformation was public and material and that “the stock traded in an efficient market.”
An upshot of Monday’s decision is that courts adjudicating Rule 10b-5 class actions will continue to face at the outset not the fairly simple question of whether the misstatement at issue moved the relevant stock’s price but instead whether that stock was traded in an “efficient market.” Focusing on market efficiency—rather than on price impact, ultimately the key question—raises practical difficulties and creates a bit of a paradox.
First, the practical difficulties. How is a court to know whether the market in which a security is traded is “efficient” (or, given that market efficiency is not a binary matter, “efficient enough”)? Chief Justice Roberts’ majority opinion suggested this is a simple inquiry, but it’s not. Courts typically consider a number of factors to assess market efficiency. According to one famous district court decision (Cammer), the relevant factors are: “(1) the stock’s average weekly trading volume; (2) the number of securities analysts that followed and reported on the stock; (3) the presence of market makers and arbitrageurs; (4) the company’s eligibility to file a Form S-3 Registration Statement; and (5) a cause-and-effect relationship, over time, between unexpected corporate events or financial releases and an immediate response in stock price.” In re Xcelera.com Securities Litig., 430 F.3d 503 (2005). Other courts have supplemented these Cammer factors with a few others: market capitalization, the bid/ask spread, float, and analyses of autocorrelation. No one can say, though, how each factor should be assessed (e.g., How many securities analysts must follow the stock? How much autocorrelation is permissible? How large may the bid-ask spread be?). Nor is there guidance on how to balance factors when some weigh in favor of efficiency and others don’t. It’s a crapshoot.
In addition, focusing at the outset on whether the market at issue is efficient creates a market definition paradox in Rule 10b-5 actions. When courts assess whether the market for a company’s stock is efficient, they assume that “the market” consists of trades in that company’s stock. This is apparent from the Cammer (and supplementary) factors, all of which are company-specific. It’s also implicit in portions of the Halliburton majority opinion, such as the observation that the plaintiff “submitted an event study of various episodes that might have been expected to affect the price of Halliburton’s stock, in order to demonstrate that the market for that stock takes account of material, public information about the company.” (Emphasis added.)
But the semi-strong version of the Efficient Capital Markets Hypothesis (ECMH), the economic theorem upon which Basic rests, rejects the notion that there is a “market” for a single company’s stock. Both the semi-strong ECMH and Basic reason that public misinformation is quickly incorporated into the price of securities traded on public exchanges. Private misinformation, by contrast, usually is not – even when such misinformation results in large trades that significantly alter the quantity demanded or quantity supplied of the relevant stock. The reason private misinformation is not taken to affect a security’s price, even when it results in substantial changes in quantities demanded or supplied, is because the relevant market is not the stock of that particular company but is instead the universe of stocks offering a similar package of risk and reward. Because a private misinformation-induced increase in demand for a single company’s stock – even if large relative to the number of shares outstanding – is likely to be tiny compared to the number of available shares of close substitutes for that company’s stock, private misinformation about a company is unlikely to be reflected in the price of the company’s stock. Public misinformation, by contrast, affects a stock’s price because it not only changes quantities demanded and supplied but also causes investors to adjust their willingness-to-pay or willingness-to-accept. Accordingly, both the semi-strong ECMH and Basic assume that only public misinformation can be assured to affect stock prices. That’s why, as the Halliburton majority observes, there is a presumption of price effect only if the plaintiff proves public misinformation, materiality, and an efficient market. (For a nice explanation of this idea in the context of a real case, see Judge Easterbrook’s opinion in West v. Prudential Securities.)
The paradox, then, is that Basic and the semi-strong ECMH, in requiring public misinformation, assume that the relevant market is not company specific. But for purposes of determining whether the “market” is efficient, the market is assumed to consist of trades of a single company’s stock.
The Supreme Court could have avoided both the practical difficulties in assessing market efficiency and the theoretical paradox identified herein had it altered Basic to require plaintiffs to establish not an efficient market but an actual price impact. Alas.
The Religious Freedom Restoration Act (RFRA) subjects government-imposed burdens on religious exercise to strict scrutiny. In particular, the Act provides that “[g]overnment shall not substantially burden a person’s exercise of religion even if the burden results from a rule of general applicability” unless the government can establish that doing so is the least restrictive means of furthering a “compelling government interest.”
So suppose a for-profit corporation’s stock is owned entirely by evangelical Christians with deeply held religious objections to abortion. May our federal government force the company to provide abortifacients to its employees? That’s the central issue in Sebelius v. Hobby Lobby Stores, which the Supreme Court will soon decide. As is so often the case, resolution of the issue turns on a seemingly mundane matter: Is a for-profit corporation a “person” for purposes of RFRA?
In an amicus brief filed in the case, a group of forty-four corporate and criminal law professors argued that treating corporations as RFRA persons would contradict basic principles of corporate law. Specifically, they asserted that corporations are distinct legal entities from their shareholders, who enjoy limited liability behind a corporate veil and cannot infect the corporation with their own personal religious views. The very nature of a corporation, the scholars argued, precludes shareholders from exercising their religion in corporate form. Thus, for-profit corporations can’t be “persons” for purposes of RFRA.
In what amounts to an epic takedown of the law professor amici, William & Mary law professors Alan Meese and Nathan Oman have published an article explaining why for-profit corporations are, in fact, RFRA persons. Their piece in the Harvard Law Review Forum responds methodically to the key points made by the law professor amici and to a few other arguments against granting corporations free exercise rights.
Among the arguments that Meese and Oman ably rebut are:
- Religious freedom applies only to natural persons.
Corporations are simply instrumentalities by which people act in the world, Meese and Oman observe. Indeed, they are nothing more than nexuses of contracts, provided in standard form but highly tailorable by those utilizing them. “When individuals act religiously using corporations they are engaged in religious exercise. When we regulate corporations, we in fact burden the individuals who use the corporate form to pursue their goals.”
- Given the essence of a corporation, which separates ownership and control, for-profit corporations can’t exercise religion in accordance with the views of their stockholders.
This claim is simply false. First, it is possible — pretty easy, in fact — to unite ownership and control in a corporation. Business planners regularly do so using shareholder agreements, and many states, including Delaware, explicitly allow for shareholder management of close corporations. Second, scads of for-profit corporations engage in religiously motivated behavior — i.e., religious exercise. Meese and Oman provide a nice litany of examples (with citations omitted here):
A kosher supermarket owned by Orthodox Jews challenged Massachusetts’ Sunday closing laws in 1960. For seventy years, the Ukrops Supermarket chain in Virginia closed on Sundays, declined to sell alcohol, and encouraged employees to worship weekly. A small grocery store in Minneapolis with a Muslim owner prepares halal meat and avoids taking loans that require payment of interest prohibited by Islamic law. Chick-fil-A, whose mission statement promises to “glorify God,” is closed on Sundays. A deli that complied with the kosher standards of its Conservative Jewish owners challenged the Orthodox definition of kosher found in New York’s kosher food law, echoing a previous challenge by a different corporation of a similar New Jersey law. Tyson Foods employs more than 120 chaplains as part of its effort to maintain a “faith-friendly” culture. New York City is home to many Kosher supermarkets that close two hours before sundown on Friday and do not reopen until Sunday. A fast-food chain prints citations of biblical verses on its packaging and cups. A Jewish entrepreneur in Brooklyn runs a gas station and coffee shop that serves only Kosher food. Hobby Lobby closes on Sundays and plays Christian music in its stores. The company provides employees with free access to chaplains, spiritual counseling, and religiously themed financial advice. Moreover, the company does not sell shot glasses, refuses to allow its trucks to “backhaul” beer, and lost $3.3 million after declining to lease an empty building to a liquor store.
As these examples illustrate, the assertion by lower courts that “for-profit, secular corporations cannot engage in religious exercise” is just empirically false.
- Allowing for-profit corporations to have religious beliefs would create intracorporate conflicts that would reduce the social value of the corporate form of business.
The corporate and criminal law professor amici described a parade of horribles that would occur if corporations were deemed RFRA persons. They insisted, for example, that RFRA protection would inject religion into a corporation in a way that “could make the raising of capital more challenging, recruitment of employees more difficult, and entrepreneurial energy less likely to flourish.” In addition, they said, RFRA protection “would invite contentious shareholder meetings, disruptive proxy contests, and expensive litigation regarding whether the corporations should adopt a religion and, if so, which one.”
But actual experience suggests there’s no reason to worry about such speculative harms. As Meese and Oman observe, we’ve had lots of experience with this sort of thing: Federal and state laws already allow for-profit corporations to decline to perform or pay for certain medical procedures if they have religious or moral objections. From the Supreme Court’s 1963 Sherbert decision to its 1990 Smith decision, strict scrutiny applied to governmental infringements on corporations’ religious exercise. A number of states have enacted their own versions of RFRA, most of which apply to corporations. Thus, “[f]or over half a century, … there has been no per se bar to free exercise claims by for-profit corporations, and the parade of horribles envisioned by the [law professor amici] has simply not materialized.” Indeed, “the scholars do not cite a single example of a corporate governance dispute connected to [corporate] decisions [related to religious exercise].”
- Permitting for-profit corporations to claim protection under RFRA will lead to all sorts of false claims of religious belief in an attempt to evade government regulation.
The law professor amici suggest that affording RFRA protection to for-profit corporations may allow such companies to evade regulatory requirements by manufacturing a religious identity. They argue that “[c]ompanies suffering a competitive disadvantage [because of a government regulation] will simply claim a ‘Road to Damascus’ conversion. A company will adopt a board resolution asserting a religious belief inconsistent with whatever regulation they find obnoxious . . . .”
As Meese and Oman explain, however, this problem is not unique to for-profit corporations. Natural persons may also assert insincere religious claims, and courts may need to assess sincerity to determine if free exercise rights are being violated. The law professor amici contend that it would be unprecedented for courts to assess whether religious beliefs are asserted in “good faith.” But the Supreme Court decision the amici cite in support of that proposition, Meese and Oman note, held only that courts lack competence to evaluate the truth of theological assertions or the accuracy of a particular litigant’s interpretation of his faith. “This task is entirely separate … from the question of whether a litigant’s asserted religious beliefs are sincerely held. Courts applying RFRA have not infrequently evaluated such sincerity.”
In addition to rebutting the foregoing arguments (and several others) against treating for-profit corporations as RFRA persons, Meese and Oman set forth a convincing affirmative argument based on the plain text of the statute and the Dictionary Act. I’ll let you read that one on your own.
I’ll also point interested readers to Steve Bainbridge’s fantastic work on this issue. Here is his critique of the corporate and criminal law professors’ amicus brief. Here is his proposal for using the corporate law doctrine of reverse veil piercing to assess a for-profit corporation’s religious beliefs.
Read it all before SCOTUS rules!
Mike Sykuta and I, both proud Missourians, recently took to the opinion section of the Kansas City Star to discuss pending state legislation that would bar automobile manufacturers from operating their own retail outlets in the Show Me state. The immediate target of the bill is Tesla, but the bigger concern of the auto dealers, who drafted the statutory language we criticize, is that the big carmakers will bypass independent dealers and start running their own retail outlets.
The arguments in our op-ed will be familiar to TOTM readers. We begin with three fundamental points: (1) Distribution is an “input” for carmakers. (2) Producers, if left to their own devices, will choose the more efficient option when deciding whether to “buy” the distribution input (i.e., to sell through independent dealers, who pay a discounted wholesale price) or “make” it (i.e., to operate their own retail outlets and charge the higher retail price). (3) Consumers — who ultimately pay all input costs, including the cost of distribution — will benefit if the most efficient option is selected. In short, the interests of carmakers and consumers are aligned here: both benefit from implementation of the most efficient distribution scheme.
We then rebut the arguments that a direct distribution ban is needed to break up monopoly power, to assure adequate aftermarket servicing of vehicles, or to encourage appropriate safety recalls. (On these points, we draw heavily from International Center for Law & Economics’ letter to Gov. Chris Christie regarding New Jersey’s proposed anti-Tesla legislation.)
Go read the whole thing.
FTC Commissioner Josh Wright is on a roll. A couple of days before his excellent Ardagh/Saint Gobain dissent addressing merger efficiencies, Wright delivered a terrific speech on minimum resale price maintenance (RPM). The speech, delivered in London to the British Institute of International and Comparative Law, signaled that Wright will seek to correct the FTC’s early post-Leegin mistakes on RPM and will push for the sort of structured rule of reason that is most likely to benefit consumers.
Wright began by acknowledging that minimum RPM is, from a competitive standpoint, a mixed bag. Under certain (rarely existent) circumstances, RPM may occasion anticompetitive harm by facilitating dealer or manufacturer collusion or by acting as an exclusionary device for a dominant manufacturer or retailer. Under more commonly existing sets of circumstances, however, RPM may enhance interbrand competition by reducing dealer free-riding, facilitating the entry of new brands, or encouraging optimal production of output-enhancing dealer services that are not susceptible to free-riding.
Because instances of minimum RPM may be good or bad, liability rules may err in two directions. Overly lenient rules may fail to condemn output-reducing instances of RPM, but overly strict rules will prevent uses of RPM that would benefit consumers by enhancing distributional efficiency. Efforts to tailor a liability rule so that it makes fewer errors (i.e., produces fewer false acquittals or false convictions) will create complexity that makes the rule more difficult for business planners and courts to apply. An optimal liability rule, then, should minimize the sum of “error costs” (social losses from expected false acquittals and false convictions) and “decision costs” (costs of applying the rule).
Crafting such a rule requires judgments about (1) whether RPM is more likely to occasion harmful or beneficial effects, and (2) the magnitude of expected harms or benefits. If most instances of RPM are likely to be harmful, the harm resulting from an instance of RPM is likely to be great, and the foregone efficiencies from false convictions are likely to be minor, then the liability rule should tend toward condemnation – i.e., should be “plaintiff-friendly.” On the other hand, if most instances of RPM are likely to be beneficial, the magnitude of expected benefit is significant, and the social losses from false acquittals are likely small, then a “defendant-friendly” rule is more likely to minimize error costs.
As Commissioner Wright observed, economic theory and empirical evidence about minimum RPM’s competitive effects, as well as intuitions about the magnitude of those various effects, suggest that minimum RPM ought to be subject to a defendant-friendly liability rule that puts the burden on plaintiffs to establish actual or likely competitive harm. With respect to economic theory, procompetitive benefit from RPM is more likely because the necessary conditions for RPM’s anticompetitive effects are rarely satisfied, while the prerequisites to procompetitive benefit often exist. Not surprisingly, then, most studies of minimum RPM have concluded that it is more frequently used to enhance rather than reduce market output. (As I have elsewhere observed and Commissioner Wright acknowledged, the one recent outlier study is methodologically flawed.) In terms of the magnitude of harms from wrongly condemning or wrongly approving instances of RPM, there are good reasons to believe greater harm will result from the former sort of error. The social harm from a false acquittal – enhanced market power – is self-correcting; market power invites entry. A false condemnation, by contrast, can be corrected only by a subsequent judicial, regulatory, or legislative overruling. Moreover, an improper conviction thwarts not just the challenged instance of RPM but also instances contemplated by business planners who would seek to avoid antitrust liability. Taken together, these considerations about the probability and magnitude of various competitive effects argue in favor of a fairly lenient liability rule for minimum RPM – certainly not per se illegality or a “quick look” approach that deems RPM to be inherently suspect and places the burden on the defendant to rebut a presumption of anticompetitive harm.
Commissioner Wright’s call for a more probing rule of reason for minimum RPM represents a substantial improvement on the approach the FTC took in the wake of the U.S. Supreme Court’s 2007 Leegin decision. Shortly after Leegin abrogated the rule of per se illegality for minimum RPM, women’s shoe manufacturer Nine West petitioned the Commission to modify a pre-Leegin consent decree constraining Nine West’s use of RPM arrangements. In agreeing to modify (but not eliminate) the restrictions, the Commission endorsed a liability rule that would deem RPM to be inherently suspect (and thus presumptively illegal) unless the defendant could establish an absence of the so-called “Leegin factors” – i.e., that there was no dealer or manufacturer market power, that RPM was not widely used in the relevant market, and that the RPM at issue was not dealer-initiated.
The FTC’s fairly pro-plaintiff approach was deficient in that it simply lifted a few words from Leegin without paying close attention to the economics of RPM. As Commissioner Wright explained,
[C]ritical to any decision to structure the rule of reason for minimum RPM is that the relevant analytical factors correctly match the economic evidence. For instance, some of the factors identified by the Leegin Court as relevant for identifying whether a particular minimum RPM agreement might be anticompetitive actually shed little light on competitive effects. For example, the Leegin Court noted that “the source of the constraint might also be an important consideration” and observed that retailer-initiated restraints are more likely to be anticompetitive than manufacturer-initiated restraints. But economic evidence recognizes that because retailers in effect sell promotional services to manufacturers and benefit from such contracts, it is equally as possible that retailers will initiate minimum RPM agreements as manufacturers. Imposing a structured rule of reason standard that treats retailer-initiated minimum RPM more restrictively would thus undermine the benefits of the rule of reason.
Commissioner Wright’s remarks give me hope that the FTC will eventually embrace an economically sensible liability rule for RPM. Now, if we could only get those pesky state policy makers to modernize their outdated RPM thinking. As Commissioner Wright recently observed, policy advocacy “is a weapon the FTC has wielded effectively and consistently over time.” Perhaps the Commission, spurred by Wright, will exercise its policy advocacy prowess on the backward states that continue to demonize minimum RPM arrangements.
The world of economics and public policy has lost yet another giant. Joining Ronald Coase, James Buchanan, Armen Alchian, and Robert Bork is a man whose name may be less familiar to TOTM readers but whose ideas have been hugely influential, particularly on me.
As the first chairman of President Reagan’s Council of Economic Advisers, Murray Weidenbaum lay much of the blame for the anemic economy President Reagan “inherited” (my, how I’ve come to hate that word!) on the then-existing regulatory state. Command and control dominated in those days, and there was virtually no consideration of such mundane matters as the costs and benefits of regulatory interventions and the degree to which regulations were tailored to fit the market failures they purported to correct. Murray understood that such an unmoored regulatory state strangled innovation and would inevitably become co-opted by regulatees, who would use the machinery of the state to squelch competition and gain other advantages. He counseled the President to do something about it.
The result was Executive Order 12291, which subjected major federal regulations to cost-benefit analysis and stated that “[r]egulatory action shall not be undertaken unless the potential benefits to society from the regulation outweigh the potential costs to society.” Such basic cost-benefit balancing seems like nothing more than common sense these days, but when Murray was pushing the idea at Washington University back in the late 1970s, it was considered pretty radical. Many of the Nixon era environmental statutes, for example, proudly eschewed consideration of costs. Murray helped us see how silly that was.
I distinctly remember a conversation we had in 1993. I had just been hired as a research fellow at Wash U’s Center for the Study of American Business, and Murray, the Center director, was taking me and the other research fellow to lunch. The faculty dining club at Wash U is across a busy-ish street from the main campus. There’s a tunnel a block or so west of the dining club, but hardly anybody would use it when walking to lunch. As we waited for an opening in traffic and crossed the street, Murray remarked, “See fellows, this is what I’m talking about. Crossing this busy street is risky. All these lunch-goers could eliminate the risk of an accident by walking two blocks out of their way. But nobody ever does that. The risk reduction just isn’t worth the cost.”
That was classic Murray. He was a plain-talking purveyor of common sense. He was firm in his beliefs but always kind and never doctrinaire. By presenting his ideas calmly and rationally, he earned the respect of differently minded folks, like Democratic Senator Thomas Eagleton, with whom he co-taught a popular course at Wash U. Our country is a better place because of Murray’s service, and I am where I am because he took me under his wing.
Rest in peace, Murray.
On Wednesday, the U.S. Supreme Court heard oral argument in Halliburton v. Erica P. John Fund, a case that could drastically alter the securities fraud landscape. Here are a few thoughts on the issues at stake in the case and a cautious prediction about how the Court will rule.
First, some quick background for the uninitiated. The broadest anti-fraud provision of the securities laws, Section 10(b) of the 1934 Securities Exchange Act, forbids the use of “any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [Securities and Exchange] Commission may prescribe….” The Commission’s Rule 10b-5, then, makes it illegal “to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.”
Although Section 10(b) doesn’t expressly entitle victims of securities fraud to sue for damages, the Supreme Court long ago inferred a private right of action to enforce the provision. The elements of that judicially created private right of action are: (1) a material misrepresentation or omission by the defendant, (2) scienter (i.e., mental culpability worse than mere negligence) on the part of the defendant, (3) a connection between the misrepresentation or omission and the purchase or sale of a security, (4) the plaintiff’s reliance upon the misrepresentation or omission, (5) economic loss by the plaintiff, and (6) loss causation (i.e., the fraud, followed by revelation of the truth, was the proximate cause of the plaintiff’s investment loss).
For most individual investors, the economic loss resulting from any instance of securities fraud (and, thus, the potential recovery) is not enough to justify the costs of bringing a lawsuit. Accordingly, 10b-5 suits seem like an appropriate context for class actions. The elements of the judicially created cause of action, however, make class certification difficult. That is because most securities fraud class actions would proceed under Federal Rule of Civil Procedure 23(b)(3), which requires that common issues of law or fact in all the plaintiffs’ cases predominate over plaintiff-specific issues. Because the degree to which any individual investor relied upon a misrepresentation (element 4) requires proof of lots of investor-specific facts (How did you learn of the misrepresentation?, How did it influence your investment decision?, etc.), the reliance element would seem to preclude Rule 10b-5 class actions.
In Basic v. Levinson, a 1988 Supreme Court decision from which three justices were recused, a four-justice majority endorsed a doctrine that has permitted Rule 10b-5 class actions to proceed, despite the reliance element. The so-called “fraud on the market” doctrine creates a rebuttable presumption that an investor who traded in an efficient stock market following a fraudulent disclosure (but before the truth was revealed) “relied” on that disclosure, even if she didn’t see or hear about it. The theoretical basis for the fraud on the market doctrine is the semi-strong version of the Efficient Capital Markets Hypothesis (ECMH), which posits that securities prices almost instantly incorporate all publicly available information about the underlying company, making it impossible to earn above-normal returns by engaging in “fundamental analysis” (i.e., study of publicly available information about a listed company). The logic of the fraud on the market doctrine is that publicly available misinformation affects a security’s price, upon which an investor normally relies when she makes her investment decision. Thus, any investor who makes her investment decision on the basis of the stock’s price “relies” on the “ingredients” of that price, including the misinformation at issue.
In light of this logic, the Basic Court reasoned that a defendant could rebut the presumption of reliance by severing either the link between the misinformation and the stock’s price or the link between the stock’s price and the investor’s decision. To sever the former link, the defendant would need to show that key market makers were privy to the truth, so that the complained of lie could not have affected the market price of the stock (in other words, there was “truth on the market”…great name for a blog, no?). To sever the latter link, the defendant would need to show that the plaintiff investor made her investment decision for some reason unrelated to the stock’s price—say, because she needed to divest herself of the stock for political reasons.
Basic thus set up a scheme in which the class plaintiff bears the burden of establishing that the stock at issue traded in an efficient market. If she does so, her (and similarly situated class members’) reliance on the misinformation at issue is presumed. The defendant then bears the burden of rebutting the presumption by showing either that the misrepresentation did not give rise to a price distortion (probably because the truth was on the market) or that the individual investor would have traded even if she knew the statement was false (i.e., her decision was not based on the stock’s price).
The Halliburton appeal presents two questions. First, should the Court overrule Basic and jettison the rebuttable presumption of reliance when the stock at issue is traded in an efficient market. Second, at the class certification stage, should the defendant be permitted to prevent the reliance presumption from arising by presenting evidence that the alleged misrepresentation failed to distort the market price of the stock at issue.
With respect to the first question, the Court could go three ways. First, it could maintain the status quo rule that 10b-5 plaintiffs, in order to obtain the reliance presumption, must establish only that the stock at issue was traded in an efficient market. Second, it could overrule Basic wholesale and hold that a 10b-5 plaintiff must establish actual, individualized reliance (i.e., show that she knew of the misrepresentation and that it influenced her investment decision). Third, the Court could tweak Basic by holding that plaintiffs may avail themselves of the presumption of reliance only if they establish, at the class certification stage, that the complained of
misrepresentation actually distorted the market price of the stock at issue.
My guess, which I held before oral argument and seems consistent with the justices’ questioning on Wednesday, is that the Court will take the third route. There are serious problems with the status quo. First, it rests squarely upon the semi-strong version of the ECMH, which has come under fire in recent years. While no one doubts that securities prices generally incorporate publicly available information, and very quickly, a number of studies purporting to document the existence of arbitrage opportunities have challenged the empirical claim that every bit of publicly available information is immediately incorporated into the price of every security traded in an efficient market. Indeed, the winners of this year’s Nobel Prize in Economics split on this very question. I doubt this Supreme Court will want to be perceived as endorsing a controversial economic theory, especially when doing so isn’t necessary to maintain some sort of reliance presumption (given the third possible holding discussed above).
A second problem with the status quo is that it places an unreasonable burden on courts deciding whether to certify a class. The threshold question for the fraud on the market presumption—is the security traded in an efficient market?—is just too difficult for non-specialist courts. How does one identify an “efficient market”? One court said the relevant factors are: “(1) the stock’s average weekly trading volume; (2) the number of securities analysts that followed and reported on the stock; (3) the presence of market makers and arbitrageurs; (4) the company’s eligibility to file a Form S-3 Registration Statement; and (5) a cause-and-effect relationship, over time, between unexpected corporate events or financial releases and an immediate response in stock price.” Others have supplemented these so-called “Cammer factors” with a few others: market capitalization, the bid/ask spread, float, and analyses of autocorrelation. No one can say, though, how each factor should be assessed (e.g., How many securities analysts must follow the stock? How much autocorrelation is permissible? How large may the bid-ask spread be?). Nor is there guidance on how to balance factors when some weigh in favor of efficiency and others don’t. It’s a crapshoot.
The status quo approach of presuming investor reliance if the plaintiff establishes an efficient market for the company’s stock is also troubling because the notion of a “market” for any single company’s stock is theoretically unsound. An economic market consist of all products that are, from a buyer’s perspective, reasonably interchangeable. For example, Evian bottled water (spring water from the Alps) is a very close substitute for Fiji water (spring water from the Fiji Islands) and is probably in the same product market. From an investor’s perspective, there are scores of close substitutes for the stock of any particular company. Such substitutes would include all other stocks that offer the same package of financial attributes (risk, expected return, etc.). It makes little sense, then, to speak of a “market” consisting of a single company’s stock, and basing the presumption of reliance on establishment of an “efficient market” in one company’s stock is somewhat nonsensical.
With respect to the second possible route for the Halliburton Court—overturning Basic in its entirety and requiring individualized proof of actual reliance—proponents emphasize that the private right of action to enforce Section 10(b) and Rule 10b-5 is judicially created. The Supreme Court now disfavors implied rights of action and, to avoid stepping on Congress’s turf, requires that they stick close to the statute at issue. In particular, the Court has said that determining the elements of a private right of action requires “historical reconstruction.” With respect to the Rule 10b-5 action, the Court tries “to infer how the 1934 Congress would have addressed the issue had the 10b-5 action been included as an express provision of the 1934 Act,” and to do that, it consults “the express causes of action” in the Act and borrows from the “most analogous” one. In this case, that provision is Section 18(a), which is the only provision in the Exchange Act authorizing damages actions for misrepresentations affecting secondary, aftermarket trading (i.e., trading after a public offering of the stock at issue). Section 18(a) requires a plaintiff to establish actual “eyeball” reliance—i.e., that she bought the security with knowledge of the false statement and relied upon it in making her investment decision. There is thus a powerful legal argument in favor of a full-scale overturning of Basic.
As much as I’d like for the Court to take that route (because I believe Rule 10b-5 class actions create far greater social cost than benefit), I don’t think the Court will go there. Overruling Basic to require eyeball reliance in Rule 10b-5 actions would be perceived as an activist, “pro-business” decision: activist because Congress has enacted significant legislation addressing Rule 10b-5 actions and has left the fraud on the market doctrine untouched, and pro-business because it would insulate corporate managers from 10b-5 class actions.
Now, both of those characterizations are wrong. The chief post-Basic legislation involving Rule 10b-5, the 1995 Private Securities Litigation Reform Act, specifically stated (in Section 203) that “[n]othing in this Act shall be deemed to … ratify any implied private right of action.” As Justices Alito and Scalia emphasized at oral argument, the PSLRA expressly declined to put a congressional imprimatur on the judicially created Rule 10b-5 cause of action, so a Court decision modifying Rule 10b-5’s elements would hardly be “activist.” Nor would the decision be “pro-business” and “anti-investor.” The fact is, the vast majority of Rule 10b-5 class actions are settled on terms where the corporation pays the bulk of the settlement, which largely goes to class counsel. The corporation, of course, is spending investors’ money. All told, then, investors as a class pay a lot for, and get very little from, Rule 10b-5 class actions. A ruling eviscerating such actions would better be characterized as pro-investor.
Sadly, our financially illiterate news media cannot be expected to understand all this and would, if Basic were overturned, fill the newsstands and airwaves with familiar stories of how the Roberts Court continues on its activist, pro-business rampage. And even more sadly, at least one key justice whose vote would be needed for a Basic overruling, has proven himself to be exceedingly concerned with avoiding the appearance of “activism.” A wholesale overruling of Basic, then, is unlikely.
That leaves the third route, modifying Basic to require that class plaintiffs first establish a price distortion resulting from the complained of misrepresentation. I have long suspected that this is where the Court will go, and the justices’ questioning on Wednesday suggests this is how many (especially Chief Justice Roberts and Justice Kennedy) are leaning. From the Court’s perspective, there are several benefits to this approach.
First, it would allow the Court to avoid passing judgment on the semi-strong ECMH. The status quo approach—prove an efficient market and we’ll presume reliance because of an inevitable price effect—really seems to endorse the semi-strong ECMH. An approach requiring proof of price distortion, by contrast, doesn’t. It may implicitly assume that most pieces of public information are instantly incorporated into securities prices, but no one really doubts that.
Second, the third route would substitute a fairly manageable inquiry (Did the misrepresentation occasion a price effect?) for one that is both difficult and theoretically problematic (Is the market for the company’s stock efficient?).
Third, the approach would allow the Court to eliminate a number of the most meritless securities fraud class actions without appearing overly “activist” and “pro-business.” If class plaintiffs can’t show a price effect from a complained of misrepresentation or omission, then their claim is really frivolous and ought to go away immediately. The status quo would permit certification of the class, despite the absence of a price effect, as long as class counsel could demonstrate an efficient market using the amorphous and unreliable factors set forth above. And once the class is certified, the plaintiffs have tons of settlement leverage, even when they don’t have much of a claim. In short, the price distortion criterion is a far better screen than the market efficiency screen courts currently utilize. For all these reasons, I suspect the Court will decide not to overrule Basic but to tweak it to require a threshold showing of price distortion.
If it does so, then the second question at issue in Halliburton—may the defendant, at the class certification stage, present evidence of an absence of price distortion?—goes away. If the plaintiff must establish price distortion to attain class certification, then due process would require that the defendant be allowed to poke holes in the plaintiff’s certification case.
So that’s my prediction on Halliburton. We shall see. Whatever the outcome, we’ll have lots to discuss in June.
Commissioner Josh Wright’s dissenting statement in the Federal Trade Commission’s recent McWane proceeding is a must-read for anyone interested in the law and economics of exclusive dealing. Wright dissented from the Commission’s holding that McWane Inc.’s “full support” policy constituted unlawful monopolization of the market for domestic pipe fittings.
Under the challenged policy, McWane, the dominant producer with a 45-50% share of the market for domestic pipe fittings, would sell its products only to distributors that “fully supported” its fittings by carrying them exclusively. There were two exceptions: where McWane products were not readily available, and where the distributor purchased a McWane rival’s pipe along with its fittings. A majority of the Commission ruled that McWane’s policy constituted illegal exclusive dealing. Commissioner Wright agreed that the policy amounted to exclusive dealing, but he concluded that the complainant had failed to prove that the exclusive dealing constituted unreasonably exclusionary conduct in violation of Sherman Act Section 2.
The first half of Wright’s 52-page dissent is an explanatory tour de force. Wright first explains how and why the Supreme Court rethought its originally inhospitable rules on “vertical restraints” (i.e., trade-limiting agreements between sellers at different levels of the distribution system, such as manufacturers and distributors). Recognizing that most such restraints enhance overall market output even if they incidentally injure some market participants, courts now condition liability on harm to competition—that is, to overall market output. Mere harm to an individual competitor is not enough.
Wright then explains how this “harm to competition” requirement manifests itself in actions challenging exclusive dealing. Several of the antitrust laws—Sections 1 and 2 of the Sherman Act and Section 3 of the Clayton Act—could condemn arrangements in which a seller will deal only with those who purchase its brand exclusively. Regardless of the particular statute invoked, though, there can be no antitrust liability absent either direct or indirect evidence of anticompetitive (not just anti-competitor) effect. Direct evidence entails some showing that the exclusive dealing at issue led to lower market output and/or higher prices than would otherwise have prevailed. Indirect evidence usually involves showings that (1) the exclusive dealing at issue foreclosed the defendant’s rivals from a substantial share of available marketing opportunities; (2) those rivals were therefore driven (or held) below minimum efficient scale (MES), so that their per-unit production costs were held artificially high; and (3) the defendant thereby obtained the ability to price higher than it would have absent the exclusive dealing.
The McWane complainant, Star Pipe Products, Ltd., sought to discharge its proof burden using indirect evidence. It asserted that its per-unit costs would have been lower if it owned a domestic foundry, but it maintained that its 20% market share did not entail sales sufficient to justify foundry construction. Thus, Star concluded, McWane’s usurping of rivals’ potential sales opportunities through its exclusive dealing policy held Star below MES, raised Star’s per-unit costs, and enhanced McWane’s ability to raise prices. Voila! Anticompetitive harm.
Commissioner Wright was not convinced that Star had properly equated MES with sales sufficient to justify foundry construction. The only record evidence to that effect—evidence the Commission deemed sufficient—was Star’s self-serving testimony that it couldn’t justify building a foundry at its low level of sales and would be a more formidable competitor if it could do so. Countering that testimony were a couple of critical bits of actual market evidence.
First, the second-largest domestic seller of pipe fittings, Sigma Corp., somehow managed to enter the domestic fittings market and capture a 30% market share (as opposed to Star’s 20%), without owning any of its own production facilities. Sigma’s entire business model was built on outsourcing, yet it managed to grow sales more than Star. This suggests that foundry ownership – and, thus, a level of sales sufficient to support foundry construction – may not be necessary for efficient scale in this industry.
Moreover, Star’s own success in the domestic pipe fittings market undermined its suggestion that MES can be achieved only upon reaching a sales level sufficient to support a domestic foundry. Star entered the domestic pipe fittings market in 2009, quickly grew to a 20% market share, and was on pace to continue growth when the McWane action commenced. As Commissioner Wright observed, “for Complaint Counsel’s view of MES to make sense on the facts that exist in the record, Star would have to be operating below MES, becoming less efficient over time as McWane’s Full Support Program further raised the costs of distribution, and yet remaining in the market and growing its business. Such a position strains credulity.”
Besides failing to establish what constitutes MES in the domestic pipe fittings industry, Commissioner Wright asserted, complainant Star also failed to prove the degree of foreclosure occasioned by McWane’s full support program.
First, both Star and the Commission reasoned that all McWane sales to distributors subject to its full support program had been “foreclosed,” via exclusive dealing, to McWane’s competitors. That is incorrect. The sales opportunities foreclosed by McWane’s full support policy were those that would have been made to other sellers but for the policy. In other words, if a distributor, absent the full support policy, would have purchased 70 units from McWane and five from Star but, because of the full support program, purchased all 75 from McWane, the full support program effectively foreclosed Star from five sales opportunities, not 75. By failing to focus on “contestable” sales—i.e., sales other than those that would have been made to McWane even absent the full support program—Star and the Commission exaggerated the degree of foreclosure resulting from McWane’s exclusive dealing.
Second, neither Star nor the Commission made any effort to quantify the sales made to McWane’s rivals under the two exceptions to McWane’s full support policy. Such sales were obviously not foreclosed to McWane’s rivals, but both Star and the Commission essentially ignored them. So, for example, if a distributor that carried McWane’s products (and was thus subject to the full support policy) purchased 70 domestic fittings from McWane and 30 from other producers pursuant to one of the full support program’s exceptions, Star and the Commission counted 100 foreclosed sales opportunities. Absent information about the number of distributor purchases under exceptions to the full support program, it is simply impossible to assess the degree of foreclosure occasioned by the policy.
In sum, complainant Star – who bore the burden of establishing an anticompetitive (i.e., market output-reducing) effect of the exclusive dealing at issue – failed to show how much foreclosure McWane’s full support program actually created and to produce credible evidence (other than its own self-serving testimony) that the program raised its costs by holding it below MES. The most Star showed was harm to a competitor – not harm to competition, a prerequisite to liability based on exclusive dealing.
In addition, several other pieces of evidence suggested that McWane’s exclusive dealing was not anticompetitive. First, the full support program did not require a commitment of exclusivity for any period of time. Distributors purchasing from McWane could begin carrying rival brands at any point (though doing so might cause McWane to refuse to sell to them in the future). Courts have often held that short-duration exclusive dealing arrangements are less troubling than longer-term agreements; indeed, a number of courts presume the legality of exclusive dealing contracts of a year or less. McWane’s policy was of no, not just short, duration.
Second, entry considerations suggested an absence of anticompetitive harm here. If entry into a market is easy, there is little need to worry that exclusionary conduct will produce market power. Once the monopolist begins to exercise its power by reducing output and raising price, new entrants will appear on the scene, driving price and output back to competitive levels. The recent and successful entry of both Star and Sigma, who collectively gained about half the total market share within a short period of time, suggested that entry into the domestic pipe fittings market is easy.
Finally, evidence of actual market performance indicated that McWane’s exclusive dealing policies did not generate anticompetitive effect. McWane enforced its full support program for the first year of Star’s participation in the domestic fittings market, but not thereafter. Star’s growth rate, however, was identical before and after McWane stopped enforcing the program. According to Commissioner Wright, “Neither Complaint Counsel nor the Commission attempt[ed] to explain how growth that is equal with and without the Full Support Program is consistent with Complaint Counsel’s theory of harm that the Program raised Star’s costs of distribution and impaired competition. The most plausible inference to draw from these particular facts is that the Full Support Program had almost no impact on Star’s ability to enter and grow its business, which, under the case law, strongly counsels against holding that McWane’s conduct was exclusionary.”
Because antitrust exists to protect competition, not competitors, an antitrust complainant cannot base a claim of monopolization on the mere fact that its business was injured by the defendant’s conduct. By the same token, a party complaining of unreasonably exclusionary conduct also ought not to prevail simply because it made self-serving assertions that it would have had more business but for the defendant’s action and would have had lower per-unit costs if it had more business. If the antitrust is to remain a consumer-focused body of law, claims like Star’s should fail. Hopefully, Commissioner Wright’s FTC colleagues will eventually see that point.