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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.

As Geoff posted yesterday, a group of 72 distinguished economists and law professors from across the political spectrum released a letter to Chris Christie pointing out the absurdities of New Jersey’s direct distribution ban. I’m heartened that both Governor Christie and his potential rival for the 2016 Republican nomination, Texas Governor Rick Perry, have made statements, here and here, in recent days suggesting that they would support legislation to allow direct distribution. Another potential 2016 Republican contender, has also joined the anti-protectionist fray. This should not be a partisan political issue. Hopefully, thinking people from both parties will realize that these laws help no one but the car dealers.

In the midst of these encouraging developments, I came across a March 5, 2014 letter from General Motors to Ohio Governor John Kasich complaining about proposed legislation that would carve out a special direct-dealing exemption for Tesla in Ohio. I’ve gotta say that I’m sympathetic to GM’s plight. It isn’t fair that Tesla would get a special exemption from regulations applicable to other car dealers. I’m not blaming Tesla, since I assume and hope that Tesla’s legislative strategy is to ask that these laws be repealed or that Tesla be exempted, not that the laws should continue to apply to other manufacturers. But the point of our letter is that no manufacturer should be subject to these restrictions. Tesla may have special reasons to prefer direct distribution, but the laws should be general—and generally permissive of direct distribution. The last thing we need is for a continuation of the dealers’ crony capitalism through a system of selective exemptions from protectionist statutes.

What was most telling about GM’s letter was its straightforward admission that allowing Tesla to engage in direct distribution would give Tesla a “distinct competitive advantage” and would create a “significant disparate impact” on competition in the auto industry. That’s just another way of saying that direct distribution is more efficient. If Tesla will gain a competitive advantage by bypassing dealers, shouldn’t we want all car companies to have that same advantage?

To be clear, there are circumstances were exempting just select companies from a regulatory scheme would give them a competitive advantage not based on superior efficiency in a social-welfare enhancing sense. For example, if the general pollution control regulations are optimally set, then exempting some firms will allow them to externalize costs and thereby obtain a competitive advantage, reducing net social welfare. But that would only be the case if the regulated activity is socially harmful, which direct distribution is not, as our open letter explained. The take-away from GM’s letter should be even more impetus for repealing the direct distribution bans across the board so that consumers can enjoy the benefit of competition among rival manufacturers who all have the right to choose the most efficient means of distribution for them.

Earlier this month New Jersey became the most recent (but likely not the last) state to ban direct sales of automobiles. Although the rule nominally applies more broadly, it is directly aimed at keeping Tesla Motors (or at least its business model) out of New Jersey. Automobile dealers have offered several arguments why the rule is in the public interest, but a little basic economics reveals that these arguments are meritless.

Today the International Center for Law & Economics sent an open letter to New Jersey Governor Chris Christie, urging reconsideration of the regulation and explaining why the rule is unjustified — except as rent-seeking protectionism by independent auto dealers.

The letter, which was principally written by University of Michigan law professor, Dan Crane, and based in large part on his blog posts here at Truth on the Market (see here and here), was signed by more than 70 economists and law professors.

As the letter notes:

The Motor Vehicle Commission’s regulation was aimed specifically at stopping one company, Tesla Motors, from directly distributing its electric cars. But the regulation would apply equally to any other innovative manufacturer trying to bring a new automobile to market, as well. There is no justification on any rational economic or public policy grounds for such a restraint of commerce. Rather, the upshot of the regulation is to reduce competition in New Jersey’s automobile market for the benefit of its auto dealers and to the detriment of its consumers. It is protectionism for auto dealers, pure and simple.

The letter explains at length the economics of retail distribution and the misguided, anti-consumer logic of the regulation.

The letter concludes:

In sum, we have not heard a single argument for a direct distribution ban that makes any sense. To the contrary, these arguments simply bolster our belief that the regulations in question are motivated by economic protectionism that favors dealers at the expense of consumers and innovative technologies. It is discouraging to see this ban being used to block a company that is bringing dynamic and environmentally friendly products to market. We strongly encourage you to repeal it, by new legislation if necessary.

Among the letter’s signatories are some of the country’s most prominent legal scholars and economists from across the political spectrum.

Read the letter here:

Open Letter to New Jersey Governor Chris Christie on the Direct Automobile Distribution Ban

Last summer I blogged here at TOTM about the protectionist statutes designed to preempt direct distribution of Tesla cars that are proliferating around the country. This week, New Jersey’s Motor Vehicle Commission voted to add New Jersey to the list of states bowing to the politically powerful car dealers’ lobby.

Yesterday, I was on Bloomberg’s Market Makers show with Jim Appleton, the president of the New Jersey Coalition of Automotive Retailers. (The clip is here). Mr. Appleton advanced several “very interesting” arguments against direct distribution of cars, including that we already regulate everything else from securities sales to dogs and cats, so why not regulate car sales as well. The more we regulate, the more we should regulate. Good point. I’m stumped. But moving on, Mr. Appleton also argued that this particular regulation is necessary for actual reasons, and he gave two.

First, he argued that Tesla has a monopoly and that the direct distribution prohibition would create price competition. But, of course, Tesla does not have anything like a monopoly. A point that Mr. Appleton repeated three times over the course of our five minutes yesterday was that Tesla’s market share in New Jersey is 0.1%. Sorry, not a monopoly.

Mr. Appleton then insisted that the relevant “monopoly” is over the Tesla brand. This argument misunderstands basic economics. Every seller has a “monopoly” in its own brand to the same extent as Mr. Appleton has a “monopoly” in the tie he wore yesterday. No one but Tesla controls the Tesla brand, and no one but Mr. Appleton controls his tie. But, as economists have understood for a very long time, it would be absurd to equate monopoly power in an economic sense with the exclusive legal right to control something. Otherwise, every man, woman, child, dog, and cat is a monopolist over a whole bunch of things. The word monopoly can only make sense as capturing the absence of rivalry between sellers of different brands. A seller can have monopoly power in its brand, but only if there are not other brands that are reasonable substitutes. And, of course, there are many reasonable substitutes for Teslas.

Nor will forcing Tesla to sell through dealers create “price competition” for Teslas to the benefit of consumers. As I explained in my post last summer, Tesla maximizes its profits by minimizing its cost of distribution. If dealers can perform that function more efficiently than Tesla, Tesla has every incentive to distribute through dealers. The one thing Tesla cannot do is increase its profits by charging more for the retail distribution function than dealers would charge. Whatever the explanation for Tesla’s decision to distribute directly may be, it has nothing to do with charging consumers a monopoly price for the distribution of Teslas.

Mr. Appleton’s second argument was that the dealer protection laws are necessary for consumer safety. He then pointed to the news that GM might have prevented accidents taking 12 lives if it had recalled some of its vehicles earlier than it eventually did. But of course all of this occurred while GM was distributing through franchised dealers. To take Mr. Appleton’s logic, I should have been arguing that distribution through franchised dealers kills people.

Mr. Appleton then offered a concrete argument on car safety. He said that, to manufacturers, product recalls are a cost whereas, to dealers, they are an opportunity to earn income. But that argument is also facially absurd. Dealers don’t make the decision to issue safety recalls. Those decisions come from the manufacturer and the National Highway Traffic Safety Administration. Dealers benefit only incidentally.

The direct distribution laws have nothing to do with enhancing price competition or car safety. They are protectionism for dealers, pure and simple. At a time when Chris Christie is trying to regain credibility with New Jersey voters in general, and New Jersey motorists in particular, this development is a real shame.

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.

Today the D.C. Circuit struck down most of the FCC’s 2010 Open Internet Order, rejecting rules that required broadband providers to carry all traffic for edge providers (“anti-blocking”) and prevented providers from negotiating deals for prioritized carriage. However, the appeals court did conclude that the FCC has statutory authority to issue “Net Neutrality” rules under Section 706(a) and let stand the FCC’s requirement that broadband providers clearly disclose their network management practices.

The following statement may be attributed to Geoffrey Manne and Berin Szoka:

The FCC may have lost today’s battle, but it just won the war over regulating the Internet. By recognizing Section 706 as an independent grant of statutory authority, the court has given the FCC near limitless power to regulate not just broadband, but the Internet itself, as Judge Silberman recognized in his dissent.

The court left the door open for the FCC to write new Net Neutrality rules, provided the Commission doesn’t treat broadband providers as common carriers. This means that, even without reclassifying broadband as a Title II service, the FCC could require that any deals between broadband and content providers be reasonable and non-discriminatory, just as it has required wireless carriers to provide data roaming services to their competitors’ customers on that basis. In principle, this might be a sound approach, if the rule resembles antitrust standards. But even that limitation could easily be evaded if the FCC regulates through case-by-case enforcement actions, as it tried to do before issuing the Open Internet Order. Either way, the FCC need only make a colorable argument under Section 706 that its actions are designed to “encourage the deployment… of advanced telecommunications services.” If the FCC’s tenuous “triple cushion shot” argument could satisfy that test, there is little limit to the deference the FCC will receive.

But that’s just for Net Neutrality. Section 706 covers “advanced telecommunications,” which seems to include any information service, from broadband to the interconnectivity of smart appliances like washing machines and home thermostats. If the court’s ruling on Section 706 is really as broad as it sounds, and as the dissent fears, the FCC just acquired wide authority over these, as well — in short, the entire Internet, including the “Internet of Things.” While the court’s “no common carrier rules” limitation is a real one, the FCC clearly just gained enormous power that it didn’t have before today’s ruling.

Today’s decision essentially rewrites the Communications Act in a way that will, ironically, do the opposite of what the FCC claims: hurt, not help, deployment of new Internet services. Whatever the FCC’s role ought to be, such decisions should be up to our elected representatives, not three unelected FCC Commissioners. So if there’s a silver lining in any of this, it may be that the true implications of today’s decision are so radical that Congress finally writes a new Communications Act — a long-overdue process Congressmen Fred Upton and Greg Walden have recently begun.

Szoka and Manne are available for comment at media@techfreedom.org. Find/share this release on Facebook or Twitter.

For those in the DC area interested in telecom regulation, there is another great event opportunity coming up next week.

Join TechFreedom on Thursday, December 19, the 100th anniversary of the Kingsbury Commitment, AT&T’s negotiated settlement of antitrust charges brought by the Department of Justice that gave AT&T a legal monopoly in most of the U.S. in exchange for a commitment to provide universal service.

The Commitment is hailed by many not just as a milestone in the public interest but as the bedrock of U.S. communications policy. Others see the settlement as the cynical exploitation of lofty rhetoric to establish a tightly regulated monopoly — and the beginning of decades of cozy regulatory capture that stifled competition and strangled innovation.

So which was it? More importantly, what can we learn from the seventy year period before the 1984 break-up of AT&T, and the last three decades of efforts to unleash competition? With fewer than a third of Americans relying on traditional telephony and Internet-based competitors increasingly driving competition, what does universal service mean in the digital era? As Congress contemplates overhauling the Communications Act, how can policymakers promote universal service through competition, by promoting innovation and investment? What should a new Kingsbury Commitment look like?

Following a luncheon keynote address by FCC Commissioner Ajit Pai, a diverse panel of experts moderated by TechFreedom President Berin Szoka will explore these issues and more. The panel includes:

  • Harold Feld, Public Knowledge
  • Rob Atkinson, Information Technology & Innovation Foundation
  • Hance Haney, Discovery Institute
  • Jeff Eisenach, American Enterprise Institute
  • Fred Campbell, Former FCC Commissioner

Space is limited so RSVP now if you plan to attend in person. A live stream of the event will be available on this page. You can follow the conversation on Twitter on the #Kingsbury100 hashtag.

When:
Thursday, December 19, 2013
11:30 – 12:00 Registration & lunch
12:00 – 1:45 Event & live stream

The live stream will begin on this page at noon Eastern.

Where:
The Methodist Building
100 Maryland Ave NE
Washington D.C. 20002

Questions?
Email contact@techfreedom.org.

Mike Sykuta and I recently co-authored a short article discussing the latest evidence on, and proper legal treatment of, minimum resale price maintenance (RPM). Following is a bit about the article (which is available here).

Despite the U.S. Supreme Court’s Leegin decision holding that minimum RPM must be evaluated under antitrust’s Rule of Reason, the battle over the proper legal treatment of the practice continues to rage at both the federal and state levels.

At the federal level, courts, commentators, and regulators have split over what sort of Rule of Reason should apply.  Some, like yours truly, have argued that because RPM is usually pro- rather than anticompetitive, challengers should bear the burden of proving likely anticompetitive effect (at a minimum, the structural prerequisites to such an effect) under a full-blown Rule of Reason.  Others contend that RPM should be assessed using some version of “quick look” Rule of Reason, under which a challenged instance of RPM is presumed anticompetitive if the plaintiff makes some fairly narrow showing (e.g., that consumer prices have risen, or that the RPM was dealer-initiated, or that the RPM is imposed on homogeneous products that are not sold with dealer services that are susceptible to free-riding).

At the state level, a number of states have simply decided not to follow Leegin and to retain, under state antitrust law, the per se rule of Dr. Miles (the 1911 decision overruled by Leegin).  At least nine states have taken this tack.

We advocates of a full-blown Rule of Reason for minimum RPM have generally emphasized two things.  First, we have observed that while the structural prerequisites to RPM’s potentially anticompetitive harms (facilitation of dealer-level or manufacturer-level cartels, or exclusion by a dominant dealer or manufacturer) are rarely satisfied, the necessary conditions for RPM’s procompetitive benefits (avoidance of free-riding, facilitating entry, encouraging non-free-rideable dealer services) are frequently met.  Second, we have shown that the pre-Leegin empirical evidence on RPM’s effects generally confirmed what theory would predict: Most instances of RPM that have been examined closely have proven output-enhancing.

In recent months, advocates of stricter RPM rules have pointed to an ambitious new study that they say supports their position.  The study authors, University of Chicago economics PhD candidates Alexander MacKay and David Aron Smith, purported to conduct “a natural experiment to estimate the effects of Leegin on product prices and quantity.”  In particular, MacKay & Smith compared post-Leegin changes in price and output levels in states retaining a rule of per se illegality with those in states likely to assess RPM under the Rule of Reason.  Utilizing Nielsen consumer product data for 1,083 “product modules” (i.e., narrowly defined product categories such as “vegetables-broccoli-frozen”), the authors assessed price and output changes between the six month period immediately preceding Leegin (January-June 2007) and the last six months of 2009.

With respect to price changes, MacKay & Smith found that 15% of the product modules exhibited price increases that were higher, by a statistically significant margin, in Rule of Reason states than in per se states.  In only 6.9% of modules were price increases higher, to a statistically significant degree, in per se states than in Rule of Reason states.  With respect to quantity changes, 14.7% of modules saw a statistically significant decrease in quantity in Rule of Reason states versus per se states, whereas only 3% of modules exhibited a statistically significant quantity increase in Rule of Reason states over per se states.  MacKay & Smith thus conclude that greater leniency on minimum RPM is associated with higher prices and lower output levels, a conclusion that, they say, supports the view that RPM is more frequently anticompetitive than procompetitive.

Mike and I contend that the MacKay & Smith study is flawed and does not justify restrictive RPM policies.  First, the study provides very little support for the view that RPM has caused anticompetitive harm within the group of product markets examined.  As an initial matter (and as the authors admit), the study does not demonstrate that actual RPM agreements have caused anticompetitive harm in the post-Leegin era.  To make such a showing, one would have to demonstrate that (1) minimum RPM was actually imposed on a product after the Leegin decision, (2) the RPM policy raised the price of that product from what it otherwise would have been, and (3) the quantity of the product sold fell from what it otherwise would have been.  The authors present no evidence that RPM policies were actually implemented on any of the product categories for which they identified statistically significant price increases and quantity decreases.  As they concede, their study could show only that legal environments treating RPM leniently (not RPM agreements themselves) are conducive to anticompetitive outcomes.

But the authors’ data provide little support for even that claim.  To prove anticompetitive harm stemming from an “RPM-permissive” legal environment, one would have to show that the transition from per se illegality to rule of reason treatment occasioned, for a substantial number of products, both a statistically significant price increase and a statistically significant output reduction on the same product.  An output reduction not accompanied by an increase in price suggests that something besides minimum RPM (or even a “permissive attitude” toward RPM) caused output to fall.  A price increase without a reduction in output is consistent with the view that RPM induced demand-enhancing dealer activities that mitigated the effect of the price increase, albeit by not as much as the producer may have hoped.  (A price increase without an output decrease could also indicate that demand for the product at issue was inelastic, but MacKay & Smith presented no evidence suggesting that demand for any of the product categories exhibiting price increases but not quantity decreases was particularly inelastic.)

According to the authors’ list of “modules with significant price or quantity changes” (Appendix A of their study), only 17 of the 1,083 product categories examined—a mere 1.6%—exhibited both a price increase and a quantity decrease.  And those effects were for categories of products (e.g., barbecue sauces as a whole), not necessarily particular brands of a product (e.g., KC Masterpiece or Sweet Baby Ray’s).  It could well be that within the 1.6% of categories exhibiting both an average price increase and an average output decrease, there were no individual brands exhibiting both effects at once.  Indeed, most of the seventeen product categories involve dealer and manufacturer markets that are neither cartelizable (so neither the dealer nor manufacturer collusion theory of anticompetitive harm could apply) nor dominated by a powerful manufacturer or dealer (so neither the dominant manufacturer nor dominant dealer theory could apply).  To the extent MacKay & Smith’s findings provide any evidence that RPM-permissiveness occasions anticompetitive harm in household consumer products markets, that evidence is awfully thin.

Moreover, in limiting their examination to the product categories included in the Nielsen Consumer Panel Data, MacKay & Smith excluded most products for which one of the procompetitive rationales for minimum RPM—the “avoidance of free-riding” rationale—would apply.  As the authors observe, only about “30% of household consumption is accounted for by the categories in the data.”  That 30% is comprised mainly of groceries, other consumable household products, and small appliances.  The study thus excludes data related to purchases of large appliances, complicated electronics projects, and other relatively expensive products that are frequently sold along with “free-rideable” amenities such as product demonstrations, consumer education, and set-up or repair services.  Because the MacKay & Smith study systematically disregards information on transactions likely to reflect a procompetitive use of minimum RPM, it fails to establish the authors’ conclusion that “the harm to consumers resulting from rule-of-reason treatment of minimum RPM seems to outweigh its benefits.”

In the end, then, Mike and I conclude that the new RPM evidence provides no reason to reject the persuasive theory- and evidence-based arguments in favor of lenient, full-blown Rule of Reason treatment of minimum RPM.  Of course, we welcome comments on our article.

Once again, my constitutional law professor has embarrassed me with his gross misunderstanding of the U.S. Constitution.  First, he insisted that it would be “unprecedented” for the U.S. Supreme Court to overturn a statute enacted by a “democratically elected Congress.”  Seventh-grade Civics students know that’s not right, but Mr. Obama’s misstatement did have its intended effect:  It sent a clear signal that the President and his lackeys would call into question the legitimacy of the Supreme Court should it invalidate the Affordable Care Act (ACA).  Duly warned, Chief Justice Roberts changed his vote in NFIB v. Sebelius to save the Court from whatever institutional damage Mr. Obama would have inflicted.

Now President Obama – who chastised his predecessor for offending the constitutional order and insisted that he, a former constitutional law professor, would never stoop so low – has both violated his oath of office and flouted a key constitutional feature, the separation of powers.  I’m speaking of the President’s “administrative fix” to the ACA.  That “fix” consists of a presidential order not to enforce the Act’s minimum coverage provisions, a move that President Obama says will allow insurance companies to continue offering ACA non-compliant policies to those previously enrolled in them if the companies wish to do so and are able to obtain permission at the state level.

This is, of course, nothing more than a transparent attempt to shift blame for the millions of recently canceled policies.  Having priced their more generous ACA-compliant policies on the assumption that there would be an influx of healthy customers now covered by high-deductible, non-compliant policies, insurance companies would shoot themselves in the foot by accepting Mr. Obama’s generous “offer.”  Moreover, state insurance commissioners, aware of the adverse selection likely to result from this last-minute rule change, are unlikely to give their blessing.  (Indeed, several have balked – including the D.C. insurance commissioner, who was promptly fired.)

But putting aside the fact that the administrative fix won’t work, the main problem with it is that it is blatantly unconstitutional.  The Constitution divides power between the three branches of government.  Article I grants to the Congress “all legislative Powers,” including “Power to lay and collect Taxes.”  Article II then directs the President to “take Care that the laws be faithfully executed.” With his administrative fix, President Obama has essentially said, “I promise not to execute the law Congress passed.”

Moreover, the President went further to say, “I promise not to collect a tax the Congress imposed.”  Remember that the penalty for failure to carry ACA-compliant insurance is, for constitutional purposes, a tax.  That was the central holding of last summer’s Obamacare decision, NFIB v. Sebelius.  When the President assured victims of insurance cancellations that he would turn a blind eye to the law and allow their insurers to continue to offer canceled policies, he also implied that he would order his administration not to collect the taxes owed by those in ACA-noncompliant policies.  Indeed, this matter was clarified in the letter the Department of Health and Human Services sent to state insurance commissioners notifying them of the Obama Administration’s decision not to enforce the law as written.  That letter stated that the Department of the Treasury, which is charged (through the IRS) with collecting the ACA’s penalties/taxes, “concur[red] with the transitional relief afforded in this document.”  That means the IRS, pursuant to the President’s order, is promising not to collect a tax the Congress has imposed.

This, my friends, is a major disruption of the constitutional order.  If the President of the United States may simply decide not to collect taxes imposed by the branch of government that has been given exclusive “Power to lay and collect Taxes,” the whole Constitution is thrown off-kilter.  Any time a president wanted to favor some individuals, firms, or industries, he wouldn’t need to go to Congress for approval.  No, he could just order his IRS not to collect taxes from those folks.  Can’t get Congress to approve subsidies for green technologies?  No worries.  Just order your IRS not to collect taxes from firms in that sector.  Or maybe even order a refundable tax credit.  You think Congress has enacted job-killing regulations on an industry?  Just invoke your enforcement discretion and ignore those rules.  Whew!  This sure makes things easier.

President Obama twice promised, under oath, to “take Care that the Laws be faithfully executed.”  Unfortunately, he also rammed through a terrible law.  Our Constitution now gives him the option to enforce the enacted law and pay the political price, or seek Congress’s assistance to change the law.  On the particular matter at issue here, Congress is willing to help the President out.  On Friday, the House of Representatives voted to amend the law to allow insurance companies to continue to offer ACA non-compliant policies.  Mr. Obama doesn’t like some details of the legislative fix he’s been offered.  Unfortunately for him, though, he’s not a king.  He has to work within the constitutional order.

At least, that’s what I thought I learned in constitutional law.