Antitrust’s sole goal is maximizing consumer welfare.  While that generally means antitrust regulators should focus on lower prices, the situation is more complicated when we’re talking about markets for new products, where technologies for distribution and consumption are evolving rapidly along with business models.  In short, the so-called Agency pricing model Apple and publishers adopted may mean (and may not mean) higher e-book prices in the short run, but it also means more variability in pricing, and it might well have facilitated Apple’s entry into the market, increasing e-book retail competition and promoting innovation among e-book readers, while increasing funding for e-book content creators.

The procompetitive story goes something like the following.  (As always with antitrust, the question isn’t so much which model is better, but that no one really knows what the right model is—least of all antitrust regulators—and that, the more unclear the consumer welfare effects of a practice are, as in rapidly evolving markets, the more we should err on the side of restraint).

Apple versus Amazon

Apple–decidedly a hardware company–entered the e-book market as a device maker eager to attract consumers to its expensive iPad tablets by offering appealing media content.  In this it is the very opposite of Amazon, a general retailer that naturally moved into retailing digital content, and began selling hardware (Kindle readers) only as a way of getting consumers to embrace e-books.

The Kindle is essentially a one-trick pony (the latest Kindle notwithstanding), and its focus is on e-books.  By contrast, Apple’s platform (the iPad and, to a lesser degree, the iPhone) is a multi-use platform, offering Internet browsing, word processing, music, apps, and other products, of which books probably accounted–and still account–for a relatively small percentage of revenue.  Importantly, unlike Amazon, Apple has many options for promoting adoption of its platform—not least, the “sex appeal” of its famously glam products.  Without denigrating Amazon’s offerings, Amazon, by contrast, competes largely on the basis of its content, and its devices sell only as long as the content is attractive and attractively priced.

In essence, Apple’s iPad is a platform; Amazon’s Kindle is a book merchant wrapped up in a cool device.

What this means is that Apple, unlike Amazon, is far less interested in controlling content prices for books and other content; it hardly needs to control that lever to effectively market its platform, and it can easily rely on content providers’ self interest to ensure that enough content flows through its devices.

In other words, Apple is content to act as a typical platform would, acting as a conduit for others’ content, which the content owner controls.  Amazon surely has “platform” status in its sights, but reliant as it is on e-books, and nascent as that market is, it is not quite ready to act like a “pure” platform.  (For more on this, see my blog post from 2010).

The Agency Model

As it happens, publishers seem to prefer the Agency Model, as well, preferring to keep control over their content in this medium rather than selling it (as in the brick-and-mortar model) to a retailer like Amazon to price, market, promote and re-sell at will.  For the publishers, the Agency Model is essentially a form of resale price maintenance — ensuring that retailers who sell their products do not inefficiently discount prices.  (For a clear exposition of the procompetitive merits of RPM, see this article by Benjamin Klein).

(As a side note, I suspect that they may well be wrong to feel this way.  The inclination seems to stem from a fear of e-books’ threat to their traditional business model — a fear of technological evolution that can have catastrophic consequences (cf. Kodak, about which I wrote a few weeks ago).  But then content providers moving into digital media have been consistently woeful at understanding digital markets).

So the publishers strike a deal with Apple that gives the publishers control over pricing and Apple a cut (30%) of the profits.  Contrary to the DOJ’s claim in its complaint, this model happens to look exactly like Apple’s arrangement for apps and music, as well, right down to the same percentage Apple takes from sales.  This makes things easier for Apple, gives publishers more control over pricing, and offers Apple content and a good return sufficient to induce it to market and sell its platform.

It is worth noting here that there is no reason to think that the wholesale model wouldn’t also have generated enough content and enough return for Apple, so I don’t think the ultimate motivation here for Apple was higher prices (which could well have actually led to lower total return given fewer sales), but rather that it wasn’t interested in paying for control.  So in exchange for a (possibly) larger slice of the pie, as well as consistency with its existing content provider back-end and the avoidance of having to monitor and make pricing decisions,  Apple happily relinquished decision-making over pricing and other aspects of sales.

The Most Favored Nation Clauses

Having given up this price control, Apple has one remaining problem: no guarantee of being able to offer attractive content at an attractive price if it is forced to try to sell e-books at a high price while its competitors can undercut it.  And so, as is common in this sort of distribution agreement, Apple obtains “Most Favored Nation” (MFN) clauses from publishers to ensure that if they are permitting other platforms to sell their books at a lower price, Apple will at least be able to do so, as well.  The contracts at issue in the case specify maximum resale prices for content and ensure Apple that if a publisher permits, say, Amazon to sell the same content at a lower price, it will likewise offer the content via Apple’s iBooks store for the same price.

The DOJ is fighting a war against MFNs, which is a story for another day, and it seems clear from the terms of the settlement with the three setting publishers that indeed MFNs are a big part of the target here.  But there is nothing inherently problematic about MFNs, and there is plenty of scholarship explaining why they are beneficial.  Here, and important among these, they facilitate entry by offering some protection for an entrant’s up-front investment in challenging an incumbent, and prevent subsequent entrants from undercutting this price.  In this sense MFNs are essentially an important way of inducing retailers like Apple to sign on to an RPM (no control) model by offering some protection against publishers striking a deal with a competitor that leaves Apple forced to price its e-books out of the market.

There is nothing, that I know of, in the MFNs or elsewhere in the agreements that requires the publishers to impose higher resale prices elsewhere, or prevents the publishers from selling throughApple at a lower price, if necessary.  That said, it may well have been everyone’s hope that, as the DOJ alleges, the MFNs would operate like price floors instead of price ceilings, ensuring higher prices for publishers.  But hoping for higher prices is not an antitrust offense, and, as I’ve discussed, it’s not even clear that, viewed more broadly in terms of the evolution of the e-book and e-reader markets, higher prices in the short run would be bad for consumers.

The Legal Standard

To the extent that book publishers don’t necessarily know what’s really in their best interest, the DOJ is even more constrained in judging the benefits (or costs) for consumers at large from this scheme.  As I’ve suggested, there is a pretty clear procompetitive story here, and a court may indeed agree that this should not be judged under a per se liability standard (as would apply in the case of naked price-fixing).

Most important, here there is no allegation that the publishers and Apple (or the publishers among themselves) agreed on price.  Rather, the allegation is that they agreed to adopt a particular business model (one that, I would point out, probably resulted in greater variation in price, rather than less, compared to Amazon’s traditional $9.99-for-all pricing scheme).  If the DOJ can convince a court that this nevertheless amounts to a naked price-fixing agreement among publishers, with Apple operating as the hub, then they are probably sunk.  But while antitrust law is suspicious of collective action among rivals in coordinating on prices, this change in business model does not alone coordinate on prices.  Each individual publisher can set its own price, and it’s not clear that the DOJ’s evidence points to any agreement with respect to actual pricing level.

It does seem pretty clear that there is coordination here on the shift in business models.  But sometimes antitrust law condones such collective action to take account of various efficiencies (think standard setting or joint ventures or collective rights groups like BMI).  Here, there is a more than plausible case that coordinated action to move to a plausibly-more-efficient business model was necessary and pro-competitive.  If Apple can convince a court of that, then the DOJ has a rule of reason case on its hands and is facing a very uphill battle.

For those of us who have been following the telecom patent battles, something remarkable happened a couple of weeks ago.  On February 7, the Wall St. Journal reported that, back in November, Apple sent a letter[1] to the European Telecommunications Standards Institute (ETSI) setting forth Apple’s position regarding its commitment to license patents essential to ETSI standards.  In particular, Apple’s letter clarified its interpretation of the so-called “FRAND” (fair, reasonable and non-discriminatory) licensing terms that ETSI participants are required to use when licensing standards-essential patents.  As one might imagine, the actual scope and contours of FRAND licenses have puzzled lawyers, regulators and courts for years, and past efforts at clarification have never been very successful.  The next day, on February 8, Google released a letter[2] that it sent to the Institute for Electrical and Electronics Engineers (IEEE), ETSI and several other standards organizations.  Like Apple, Google sought to clarify its position on FRAND licensing.  And just hours after Google’s announcement, Microsoft posted a statement of “Support for Industry Standards”[3] on its web site, laying out its own gloss on FRAND licensing.  For those who were left wondering what instigated this flurry of corporate “clarification”, the answer arrived a few days later when, on February 13, the Antitrust Division of the U.S. Department of Justice (DOJ) released its decision[4] to close the investigation of three significant patent-based transactions:  the acquisition of Motorola Mobility by Google, the acquisition of a large patent portfolio formerly held by Nortel Networks by “Rockstar Bidco” (a group including Microsoft, Apple, RIM and others), and the acquisition by Apple of certain Linux-related patents formerly held by Novell.  In its decision, the DOJ noted with approval the public statements by Apple and Microsoft, while expressing some concern with Google’s FRAND approach.  The European Commission approved Google’s acquisition of Motorola Mobility on the same day.

To understand the significance of the Apple, Microsoft and Google FRAND statements, some background is in order.  The technical standards that enable our computers, mobile phones and home entertainment gear to communicate and interoperate are developed by corps of “volunteers” who get together in person and virtually under the auspices of standards-development organizations (SDOs).  These SDOs include large, international bodies such as ETSI and IEEE, as well as smaller consortia and interest groups.  The engineers who do the bulk of the work, however, are not employees of the SDOs (which are usually thinly-staffed non-profits), but of the companies who plan to sell products that implement the standards: the Apples, Googles, Motorolas and Microsofts of the world.  Should such a company obtain a patent covering the implementation of a standard, it would be able to exert significant leverage over the market for products that implemented the standard.  In particular, if a patent holder were to obtain, or even threaten to obtain, an injunction against manufacturers of competing standards-compliant products, either the standard would become far less useful, or the market would experience significant unanticipated costs.  This phenomenon is what commentators have come to call “patent hold-up”.  Due to the possibility of hold-up, most SDOs today require that participants in the standards-development process disclose their patents that are necessary to implement the standard and/or commit to license those patents on FRAND terms.

As Contreras notes, an important part of these FRAND commitments offered by Google, Motorola, and Apple related to the availability of injunctive relief (do go see the handy chart in Contreras’ post laying out the key differences in the commitments).  Contreras usefully summarizes the three statements’ positions on injunctive relief:

In their February FRAND statements, Apple and Microsoft each commit not to seek injunctions on the basis of their standards-essential patents.  Google makes a similar commitment, but qualifies it in typically lawyerly fashion (Google’s letter is more than 3 single-spaced pages in length, while Microsoft’s simple statement occupies about a quarter of a page).  In this case, Google’s careful qualifications (injunctive relief might be possible if the potential licensee does not itself agree to refrain from seeking an injunction, if licensing negotiations extended beyond a reasonable period, and the like) worked against it.  While the DOJ applauds Apple’s and Microsoft’s statements “that they will not seek to prevent or exclude rivals’ products form the market”, it views Google’s commitments as “less clear”.  The DOJ thus “continues to have concerns about the potential inappropriate use of [standards-essential patents] to disrupt competition”.

Its worth reading the DOJ’s press release on this point — specifically, that while the DOJ found that none of the three transactions itself raised competitive concerns or was substantially likely to lessen the competition, the DOJ expressed general concerns about the relationship between these firms’ market positions and ability to use the threat of injunctive relief to hold up rivals:

Apple’s and Google’s substantial share of mobile platforms makes it more likely that as the owners of additional SEPs they could hold up rivals, thus harming competition and innovation.  For example, Apple would likely benefit significantly through increased sales of its devices if it could exclude Android-based phones from the market or raise the costs of such phones through IP-licenses or patent litigation.  Google could similarly benefit by raising the costs of, or excluding, Apple devices because of the revenues it derives from Android-based devices.

The specific transactions at issue, however, are not likely to substantially lessen competition.  The evidence shows that Motorola Mobility has had a long and aggressive history of seeking to capitalize on its intellectual property and has been engaged in extended disputes with Apple, Microsoft and others.  As Google’s acquisition of Motorola Mobility is unlikely to materially alter that policy, the division concluded that transferring ownership of the patents would not substantially alter current market dynamics.  This conclusion is limited to the transfer of ownership rights and not the exercise of those transferred rights.

With respect to Apple/Novell, the division concluded that the acquisition of the patents from CPTN, formerly owned by Novell, is unlikely to harm competition.  While the patents Apple would acquire are important to the open source community and to Linux-based software in particular, the OIN, to which Novell belonged, requires its participating patent holders to offer a perpetual, royalty-free license for use in the “Linux-system.”  The division investigated whether the change in ownership would permit Apple to avoid OIN commitments and seek royalties from Linux users.  The division concluded it would not, a conclusion made easier by Apple’s commitment to honor Novell’s OIN licensing commitments.

In its analysis of the transactions, the division took into account the fact that during the pendency of these investigations, Apple, Google and Microsoft each made public statements explaining their respective SEP licensing practices.  Both Apple and Microsoft made clear that they will not seek to prevent or exclude rivals’ products from the market in exercising their SEP rights.

What’s problematic about a competition enforcement agency extracting promises not to enforce lawfully obtained property rights during merger review, outside the formal consent process, and in transactions that do not raise competitive concerns themselves?  For starters, the DOJ’s expression about competitive concerns about “hold up” obfuscate an important issue.  In Rambus the D.C. Circuit clearly held that not all forms of what the DOJ describes here as patent holdup violate the antitrust laws in the first instance.  Both appellate courts discussion patent holdup as an antitrust violation have held the patent holder must deceptively induce the SSO to adopt the patented technology.  Rambus makes clear – as I’ve discussed — that a firm with lawfully acquired monopoly power who merely raises prices does not violate the antitrust laws.  The proposition that all forms of patent holdup are antitrust violations is dubious.  For an agency to extract concessions that go beyond the scope of the antitrust laws at all, much less through merger review of transactions that do not raise competitive concerns themselves, raises serious concerns.

Here is what the DOJ says about Google’s commitment:

If adhered to in practice, these positions could significantly reduce the possibility of a hold up or use of an injunction as a threat to inhibit or preclude innovation and competition.

Google’s commitments have been less clear.  In particular, Google has stated to the IEEE and others on Feb. 8, 2012, that its policy is to refrain from seeking injunctive relief for the infringement of SEPs against a counter-party, but apparently only for disputes involving future license revenues, and only if the counterparty:  forgoes certain defenses such as challenging the validity of the patent; pays the full disputed amount into escrow; and agrees to a reciprocal process regarding injunctions.  Google’s statement therefore does not directly provide the same assurance as the other companies’ statements concerning the exercise of its newly acquired patent rights.  Nonetheless, the division determined that the acquisition of the patents by Google did not substantially lessen competition, but how Google may exercise its patents in the future remains a significant concern.

No doubt the DOJ statement is accurate and the DOJ’s concerns about patent holdup are genuine.  But that’s not the point.

The question of the appropriate role for injunctions and damages in patent infringement litigation is a complex one.  While many scholars certainly argue that the use of injunctions facilitates patent hold up and threatens innovation.  There are serious debates to be had about whether more vigorous antitrust enforcement of the contractual relationships between patent holders and standard setting organization (SSOs) would spur greater innovation.   The empirical evidence suggesting patent holdup is a pervasive problem is however, at best, quite mixed.  Further, others argue that the availability of injunctions is not only a fundamental aspect of our system of property rights, but also from an economic perspective, that the power of the injunctions facilitates efficient transacting by the parties.  For example, some contend that the power to obtain injunctive relief for infringement within the patent thicket results in a “cold war” of sorts in which the threat is sufficient to induce cross-licensing by all parties.  Surely, this is not first best.  But that isn’t the relevant question.

There are other more fundamental problems with the notion of patent holdup as an antitrust concern.  Kobayashi & Wright also raise concerns with the theoretical case for antitrust enforcement of patent holdup on several grounds.  One is that high probability of detection of patent holdup coupled with antitrust’s treble damages makes overdeterrence highly likely.  Another is that alternative remedies such as contract and the patent doctrine of equitable estoppel render the marginal benefits of antitrust enforcement trivial or negative in this context.  Froeb, Ganglmair & Werden raise similar points.   Suffice it to say that the debate on the appropriate scope of antitrust enforcement in patent holdup is ongoing as a general matter; there is certainly no consensus with regard to economic theory or empirical evidence that stripping the availability of injunctive relief from patent holders entering into contractual relationships with SSOs will enhance competition or improve consumer welfare.  It is quite possible that such an intervention would chill competition, participation in SSOs, and the efficient contracting process potentially facilitated by the availability of injunctive relief.

The policy debate I describe above is an important one.  Many of the questions at the center of that complex debate are not settled as a matter of economic theory, empirics, or law.  This post certainly has no ambitions to resolve them here; my goal is a much more modest one.  The DOJs policymaking efforts through the merger review process raise serious issues.  I would hope that all would agree — regardless of where they stand on the patent holdup debate — that the idea that these complex debates be hammered out in merger review at the DOJ because the DOJ happens to have a number of cases involving patent portfolios is a foolish one for several reasons.

First, it is unclear the DOJ could have extracted these FRAND concessions through proper merger review.  The DOJ apparently agreed that the transactions did not raise serious competitive concerns.   The pressure imposed by the DOJ upon the parties to make the commitments to the SSOs not to pursue injunctive relief as part of a FRAND commitment outside of the normal consent process raises serious concerns.  The imposition of settlement conditions far afield from the competitive consequences of the merger itself is something we do see from antitrust enforcement agencies in other countries quite frequently, but this sort of behavior burns significant reputational capital with the rest of the world when our agencies go abroad to lecture on the importance of keeping antitrust analysis consistent, predictable, and based upon the economic fundamentals of the transaction at hand.

Second, the DOJ Antitrust Division does not alone have comparative advantage in determining the optimal use of injunctions versus damages in the patent system.

Third, appearances here are quite problematic.  Given that the DOJ did not appear to have significant competitive concerns with the transactions, one can create the following narrative of events without too much creative effort: (1) the DOJ team has theoretical priors that injunctive relief is a significant competitive problem, (2) the DOJ happens to have these mergers in front of it pending review from a couple of firms likely to be repeat players in the antitrust enforcement game, (3) the DOJ asks the firms to make these concessions despite the fact that they have little to do with the conventional antitrust analysis of the transactions, under which they would have been approved without condition.

The more I think about the use of the merger review process to extract concessions from patent holders in the form of promises not to enforce property rights which they would otherwise be legally entitled to, the more the DOJ’s actions appear inappropriate.  The stakes are high here both in terms of identifying patent and competition rules that will foster rather than hamper innovation, but also with respect to compromising the integrity of merger review through the imposition of non-merger related conditions we are more akin to seeing from the FCC, states, or less well-developed antitrust regimes.

Now comes another example of the holdup problem at work.  In fact, it is difficult to imagine a better example.  Apparently, half way through a flight from India to Birmingham, England, an airline took advantage of the asset specific investments made by its passengers to alter the terms of the deal:

Passengers aboard two chartered jetliners from India to Britain were hit up for about $200 each, in cash, to continue their trip this week in what one flier compared to a hostage situation.  The charter company, Austria-based Comtel Air, and the Spanish company that owns the planes pointed fingers at each other over the situation Thursday. But Lal Dadrah, a passenger on one of the flights who recorded the crew passing the hat, called the situation “a complete, utter sham.”

Comtel Air passengers on a Tuesday flight to Birmingham, England, from the Indian city of Amritsar were hit up for 130 pounds — about $200 each — during a layover in Vienna. They were allowed off the aircraft to take the money from teller machines, a process that took about seven hours. There were varying accounts of what the money was to pay for, ranging from fuel to fees.

The NY Times story provides a few more details:

Britain’s Channel 4 news broadcast video showing a Comtel cabin crew member telling passengers: “We need some money to pay the fuel, to pay the airport, to pay everything we need. If you want to go to Birmingham, you have to pay.”

Some passengers said they were sent off the plane to cash machines in Vienna to raise the money.

“We all got together, took our money out of purses — 130 pounds ($205),” said Reena Rindi, who was aboard with her daughter. “Children under two went free, my little one went free because she’s under two. If we didn’t have the money, they were making us go one by one outside, in Vienna, to get the cash out.”

The economics don’t stop there.  There is potential for an agency problem as well:

Bhupinder Kandra, the airline’s majority shareholder, told the Associated Press from Vienna that travel agents had taken the passengers’ money before the planes left but had not passed it on to the airline.  “This is not my problem,” he said. “The problem is with the agents.”

A great example for the classroom.

I’ve been in my colleague’s unfortunate position three times: once when I was trying to become a professor, once during my first semester of teaching, and once in the semester before I went up for tenure.  Each time, breaching my initial publication contract and accepting the later-received offer from the more prestigious journal would have benefited me by an amount far greater than the harm caused to the jilted journal.  Accordingly, the welfare-maximizing outcome would have been for me to breach my initial publication agreement and to pay the put-upon journal an amount equal to the damage caused by my breach.  Such a move would have been Pareto-improving:  I would have been better off, and the original publisher, the breach “victim,” would have been as well off as before I breached.  

As all first-year law students learn (or should learn!), the law of contracts is loaded with doctrines designed to encourage efficient breach and discourage inefficient performance.  Most notable among these is the rule precluding punitive damages for breach of contract:  If a breaching party were required to pay such damages, in addition to the so-called “expectancy” damages necessary to compensate the breach victim for her loss, then promisors contemplating breach might perform even though doing so would cost more than the value of the performance to the promisee.  Such performance would be wasteful.

So why didn’t I — a contracts professor who knows that a promisor’s contract duty is always disjunctive: “perform or pay” — breach my initial publication agreements and offer the jilted journal editors some amount of settlement (say, $1,000 for an epic staff party — an amount far less than the incremental value to me of going with the higher-ranked journal)?  Because of a silly social norm frowning upon such conduct as indicative of a flawed character.  When I was looking for a teaching job, I was informed that breaching a publication agreement is a definite no-no and might impair my job prospects.  After I became a professor, I learned that members of my faculty had threatened to vote against the tenure of professors who breached publication agreements.  To be fair, I’m not sure those faculty members would do so if the breaching professor compensated the jilted journal, effectively “buying himself out” of his contract.  But who would run that risk?

So I empathize with my colleague who now feels stuck publishing in the less prestigious journal.  And, while I recognize the difference between a legal and moral obligation, I would commend the following wise words to those law professors who would imbue law review publishing contracts with “mystic significance”:

Nowhere is the confusion between legal and moral ideas more manifest than in the law of contract.  Among other things, here again the so-called primary rights and duties are invested with a mystic significance beyond what can be assigned and explained.  The duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it — and nothing else.  If you commit a tort, you are liable to pay a compensatory sum.  If you commit a contract, you are liable to pay a compensatory sum unless the promised event comes to pass, and that is all the difference.  But such a mode of looking at the matter stinks in the nostrils of those who think it advantageous to get as much ethics into the law as they can.

Oliver Wendell Holmes, Jr., The Path of the Law, 10 Harv. L. Rev. 457 (1897).  

Blogging may be light for the next week (but eating and drinking may be heavy). Tips on what I must see and do in Munich would be appreciated.

In any event, one important testable implication for the economic theories of payday lending relied upon by critics of such restrictions (including myself) is that restrictions on their use will have a negative impact on access to credit for payday lending customers (i.e. they will not be able to simply turn to better sources of credit).  While most critics of government restrictions on access to consumer credit appear to recognize the potential for abuse and favor disclosure regimes and significant efforts to police and punish fraud, the idea that payday loans might generate serious economic benefits for society often appears repugnant to supporters.  All of this takes me to an excellent paper that lies at the intersection of these two issues: natural disasters and the economic effects of restrictions on payday lending.  The paper is Adair Morse’s Payday Lenders: Heroes or Villians.    From the abstract:

I ask whether access to high-interest credit (payday loans) exacerbates or mitigates individual financial distress. Using natural disasters as an exogenous shock, I apply a propensity score matched, triple difference specification to identify a causal relationship between access-to-credit and welfare. I find that California foreclosures increase by 4.5 units per 1,000 homes in the year after a natural disaster, but the existence of payday lenders mitigates 1.0-1.3 of these foreclosures. In a placebo test for natural disasters covered by homeowner insurance, I find no payday lending mitigation effect. Lenders also mitigate larcenies, but have no effect on burglaries or vehicle thefts. My methodology demonstrates that my results apply to ordinary personal emergencies, with the caveat that not all payday loan customers borrow for emergencies.

To be sure, there are other papers with different designs that identify economic benefits from payday lending and other otherwise “disfavored” credit products.  Similarly, there papers out there that use different data and a variety of research designs and identify social harms from payday lending (see here for links to a handful, and here for a recent attempt).  A literature survey is available here.  Nonetheless, Morse’s results remind me that consumer credit institutions — even non-traditional ones — can generate serious economic benefits in times of need and policy analysts must be careful in evaluating and weighing those benefits against potential costs when thinking about and designing restrictions that will change incentives in consumer credit markets.

This Article explains why and how traditional contract law’s theory of unconscionability should be used to create a modicum of judicial scrutiny to strike obnoxious pay contracts and preserve legitimate ones. Under this proposal, pay contracts that are the product of managerial domination of the process and formed on terms massively favoring the executive will be stricken. This will follow direct shareholder lawsuits in state courts where the contract is made or performed and applying that state’s contract law. This new legal theory circumvents today’s dead-end route, where pay contracts are always upheld in derivative shareholder lawsuits applying corporate law that sets no meaningful limits on executive pay. This proposal creates new but modest pressure from sister states on Delaware to take greater responsibility for the effects its production of corporate law has nationally.

For those outraged by lopsided corporate executive compensation, this Article offers an appealing new legal theory of contractual unconscionability to police them. Those who see no or few problems with contemporary pay arrangements, or who are outraged by federal regulatory schemes like the Dodd-Frank Act, will welcome how this proposal is narrowly tailored using common law to address the most obnoxious cases.

The article, among other things, would take the executive pay issue out of the internal affairs doctrine and put it into the morass of general choice of law rules for contracts (footnotes omitted):

[B]ecause they are not matters of internal affairs, they would be governed by the law of the state having the greatest interest.  Managers could name Delaware as the choice of law by contract and maintain Delaware’s quasi-monopoly that insulates the devices from judicial scrutiny. Yet contractual choice-of-law clauses are but one factor relevant to determining what law governs a contract.

To be sure, says Cunningham,

investors may recoil at the prospect of gadfly fellow shareholders challenging corporate pay contracts.

But he sees this as

a way to restore a modicum of external pressure on the State of Delaware, the leading promulgator of corporate law for national use. * * * [T]he practical reality is that the competition has ended, and Delaware faces no such pressure today.

There is, of course, a substantial literature questioning the Bebchuk-Fried-Walker conclusion on which this proposal is based that executive pay is out of whack.  And another substantial literature on whether or not the market for corporate law is out of whack.  But let’s put those questions aside and play along with the premises of the proposal.  Consider the consequences: 

• Under this proposal, an executive, having negotiated her pay with a corporate board, would have no way of knowing whether, at some point, the pay might be challenged under standards to be named later in some state (her residence state, the corporation’s main place of doing business, somewhere else?) at the instigation of a lawyer seeking to extort a payment from the company. 
• Executives would retain whatever power they supposedly had over the corporation in negotiating their contract to negotiate protection from or payment for this litigation risk.  Shareholders, of course, would pay.
• Firms would surely find some way to deal with this new rule.  Would the result be better than the system we have now of entrusting the decision to directors?

I guess you could say I’m not convinced. I prefer to take this article as an interesting thought-experiment on why regulation of corporate pay is misguided.

Many of ITA’s customers believe that access to ITA’s technology is critical to competition in online air travel search because it cannot be matched by other players in the travel search industry.  They claim that ITA’s superior access to information and superior technology enables it to provide faster and better results to consumers.  As a result, some of these industry participants and independent experts fear that the current high level of competition among online travel agents and metasearch providers could be undermined if Google were to acquire ITA and start its own OTA or metasearch service.  If this were to happen, they argue, consumers would lose the benefits of a robustly competitive online air travel market.

For several reasons, these complaints are without merit and a challenge to the Google/ITA merger would be premature at best—and a costly mistake at worst.

The high-tech market is innovative and dynamic. Goods and services that were once inconceivable are now indispensable, and competition has improved the quality of technology while driving down its costs. But as the market continues to change, antitrust interventions are stuck using a static regulatory framework. As the government develops a strategy for regulating competition in the digital marketplace, it must tread carefully—excessive intervention will stifle innovation, harm consumers, and prevent growth.  And given the link between innovation and economic growth, the stakes of “getting it right” are high. The individual nature of every decision, however, makes errors in antitrust enforcement inevitable. Some conduct that is bad for competition will be allowed to go on while some conduct that is good for competition will be blocked by intervention.

But prosecuting pro-competitive conduct is almost certainly more costly than mistakenly allowing anticompetitive conduct because mechanisms are in place to mitigate the latter but not the former. The cost of erroneous intervention is the loss to consumers directly and a deterrent effect on innovation—for fear of intervention, companies may not take large risks. Meanwhile, allowing conduct to persist amidst uncertainty allows the potential benefits of conduct to materialize while maintaining checks against practices that are bad for consumers: both the competitive marketplace and future enforcers have the power to mitigate specific anticompetitive outcomes that may arise. Unfortunately, current antitrust enforcement—abetted by influential congressmen like Senator Kohl—is more, rather than less, aggressive against innovative companies in high-tech industries. This aggression threatens to stifle growth and deter future innovation in a market with incredible potential.

Google has become a primary target of this scrutiny, and the company’s proposed acquisition of ITA, a software company that compiles and processes travel data, is a good example of aggressive scrutiny threatening to stifle growth.

Google’s acquisition of ITA is a straightforward merger where one company has decided to purchase another outright (instead of merely purchasing its services through contract). There are good reasons for integration. Most notably, Google gets to exercise direct control over ITA’s talented engineers if it owns ITA—influence that it would not have if the company simply signed a contract with ITA. If Google is correct that it can manage ITA’s resources better than ITA’s current management, then integration makes sense and is valuable for consumers.

The primary concern raised over Google’s proposed acquisition of ITA is that acquisition would “leverage” Google’s alleged dominance into another market—the online travel search market—and permit Google to prevent its competitors from accessing ITA’s high-quality analysis of flights and fares.

There are a few problems with this.

• First, ITA does not provide or own the underlying data (this comes from the airlines themselves); rather it works only to analyze and process it—processing that other companies can and do undertake.  It may have developed superior technology to engage in this processing, but that is precisely why it (and consumers) should not be penalized by its competitors’ efforts to hamstring it.  Remember—although most of the hand-wringing surrounding this deal concerns Google, it is first and foremost the innovative entrepreneurs at ITA who would be prevented from capitalizing on their success if the deal is stopped.
• Second, it is hard to see why, under the facts as alleged by the deal’s naysayers, consumers would be worse off if Google owns ITA than if ITA stands on its own.  The claims seem to turn on ITA’s indispensability to the online travel industry.  But if ITA is so indispensable—if it possesses such market power, in other words—it’s hard to see how its incentives to capitalize on that market power would change simply by virtue of a change in its management.  Either ITA possesses market power and is already taking advantage of it (or else its managers are leaving money on the table and it most certainly should be taken over by another set of managers) or else it does not actually possess this market power and its combination with Google, even if Google were to keep all of ITA’s technology for itself, will do little to harm the rest of the industry as its competitors step up and step in to take its place.
• Third and related to these is the simple repugnance of hamstringing successful entrepreneurs because of the exhortations of their competitors, and the implication that a successful company’s work product (like ITA’s “superior technology”) must be rendered widely-available, by government force if necessary.
• Meanwhile, Google does not seem to have any interest in selling airline tickets or making airline reservations (just as it doesn’t sell the retail goods one can search for using its site). Instead, its interest is in providing its users easy access to airline flight and pricing data and giving online travel agencies the ability to bid on the sale of tickets to Google users looking to buy. The availability of this information via Google search will lower search costs for consumers and the expected bidding should increase competition and drive down travel costs for consumers.  It is easy to see why companies like Kayak and Bing Travel and Expedia and Travelocity might be unhappy about this, but far more difficult to see how their woes should be a problem for the antitrust enforcers (or Congress, for that matter).

The point is not that we know that Google—or any other high-tech company’s—conduct is pro-competitive, but rather that the very uncertainty surrounding it counsels caution, not aggression. As the technology, usage and market structure change, so do the strategies of the various businesses that build up around them. These new strategies present unknown and unprecedented challenges to regulators, and these new challenges call for a deferential approach. New conduct is not necessarily anticompetitive conduct, and if our antitrust regulation does not accept this, we all lose.

The new consumer bureau is based on a pretty simple idea:  people ought to be able to read their credit card and mortgage contracts and know the deal.  They shouldn’t learn about an unfair rule or practice only when it bites them—way too late for them to do anything about it.  The new law creates a chance to put a tough cop on the beat and provide real accountability and oversight of the consumer credit market.  The time for hiding tricks and traps in the fine print is over.  This new bureau is based on the simple idea that if the playing field is level and families can see what’s going on, they will have better tools to make better choices.

Like Todd, I find this articulation of the mission relatively innocuous.  Of course, that is different from believing that even this narrowly defined mission will be successful in generating new consumer benefits.  And as Todd notes in his post, there are reasons to be skeptical about whether or not even this narrow mission will succeed.

Todd writes that he doesn’t doubt Professor Warren’s sincerity about this mission.  Nor do I.  But I do believe that the “real” mission of the CFPB isn’t simply disclosure of terms and hidden fees.  I suspect so do its supporters — of which I am not one.

Why do I think the mission is broader than disclosure?  First, I doubt there would quite the fuss that we’ve seen over who runs the Bureau if all that were at stake was who would oversee the imposition of a set of mandatory disclosures on credit cards and other loans.  More importantly, I predict a more ambitious CFPB because both Professor Warren and others have themselves advocated for a much broader vision.  As I’ve observed (and written about elsewhere with economist David Evans):

[T]he blueprint for what was then the Consumer Financial Protection Agency was based in large part on using the insights of behavioral economics to design regulation in consumer credit markets.  Advocates of behavioral law and economics have generally taken a dim view of consumer borrowing, arguing that consumers over-value current consumption and do not adequately account for the costs of repayment in the future.  Policy proposals from this literature include a variety of prohibitions of consumer lending, including restrictions on subprime lending, payday lending, banning credit cards, unbundling the transacting and financing services offered by credit card companies, and usury laws.

An evaluation of the proposals emerging out of the behavioral law and economics literature concerning consumer credit go far beyond mandatory disclosure.  The much-discussed “plain vanilla” requirement, for example, reaches into the realm of product design.  But even a cursory read of this literature, including proposals from Elizabeth Warren and Michael Barr, reveals much more ambitious proposals that run much greater risks for consumers.   Moreover, many of these proposals are grounded in the behavioral economics tradition, and embrace the view that consumers are systematically irrational when it comes to financial products and that the government would make better decisions for consumers for their own protection.

As I’ve pointed out with Evans (and again with Todd Zywicki), the behavioral advocates have not adequately made their case as a matter of economic theory or empirical evidence, nor have they sufficiently overcome concerns that the behavioral approach satisfies a careful cost-benefit analysis that accounts for the dynamic costs of dampening individual incentives to improve decision-making and regulator error.  Unfortunately, it is not difficult to find examples of exactly this type of error.  The potential for false positives with this approach is incredibly high.  And the costs of false positives, and the total costs imposed on consumers, exacerbated by the opportunity for even stricter state law measures.

The CFPB in Elizabeth Warren’s “mission statement” is a different, and less ambitious CFPB than described in Professor Warren’s academic work, and in the work of those advocating a behavioral approach to consumer credit.  Which one will we get?  Theory and data suggest that when confronted with a choice between narrow and less powerful regulator and one with more power and a broader mandate, the smart money is that we’ll observe the latter.  If that prediction holds true, and we get the CFPB promised by its advocates when they contemplated its design, access to consumer credit will fall and there is a significant risk that consumers will be made worse off on the whole.

Here’s to hoping we get the less ambitious CFPB promised in Professor Warren’s press release.

Antitrust observers and football fans alike awaited the Supreme Court’s decision in American Needle for months – inspiring over a dozen articles, and even one from the quarterback of the defending champion New Orleans Saints. Yet the implications of the Court’s decision, effectively narrowing the scope of the “intra-enterprise immunity” doctrine to firms with a complete “unity of interests,” are unclear. While some depict the decision as a schism from the last several decades of antitrust law, we explain why this interpretation is meritless and discuss the practical impact of the Court’s holding. The Court’s antitrust jurisprudence over the past several decades, including that of the Roberts Court and American Needle, has broadly embraced rules that are both relatively easy to administer as well as conscious of the error costs of deterring pro-competitive conduct. Intra-enterprise immunity potentially provided such a “filter” that enabled judges to dismiss a non-trivial subset of meritless claims prior to costly discovery. The doctrine, however, proved notoriously difficult to consistently apply in situations involving common organizational structures. Consistent with error-cost principles that have been the lodestar of the Court’s recent antitrust output, American Needle gave the Court an opportunity to effectively abandon intra-enterprise immunity in favor of the Twombly “plausibility” standard. Rather than marking a drastic change in antitrust jurisprudence, therefore, American Needle should be viewed as the Supreme Court substituting an unreliable screening mechanism in favor of a more cost-effective alternative.

It was a fun project to work on, and a challenging one since so much had been written in anticipation of the opinion.  We appreciate the invitation from Cato.  As the abstract suggests, we focus on the role of the single entity defense as an early stage filter in the antitrust system designed to minimize error costs, how American Needle (perhaps with good reason) rejects that filter, the relationship between American Needle and Twombly, and how the case fits into the existing and ever-growing Roberts Court antitrust jurisprudence.  Enjoy.