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[TOTM: The following is part of a blog series by TOTM guests and authors on the law, economics, and policy of the ongoing COVID-19 pandemic. The entire series of posts is available here.

This post is authored by Geoffrey A. Manne, (President, ICLE; Distinguished Fellow, Northwestern University Center on Law, Business, and Economics); and Dirk Auer, (Senior Fellow of Law & Economics, ICLE)]

Back in 2012, Covidien, a large health care products company and medical device manufacturer, purchased Newport Medical Instruments, a small ventilator developer and manufacturer. (Covidien itself was subsequently purchased by Medtronic in 2015).

Eight years later, in the midst of the coronavirus pandemic, the New York Times has just published an article revisiting the Covidien/Newport transaction, and questioning whether it might have contributed to the current shortage of ventilators.

The article speculates that Covidien’s purchase of Newport, and the subsequent discontinuation of Newport’s “Aura” ventilator — which was then being developed by Newport under a government contract — delayed US government efforts to procure mechanical ventilators until the second half of 2020 — too late to treat the first wave of COVID-19 patients:

And then things suddenly veered off course. A multibillion-dollar maker of medical devices bought the small California company that had been hired to design the new machines. The project ultimately produced zero ventilators.

That failure delayed the development of an affordable ventilator by at least half a decade, depriving hospitals, states and the federal government of the ability to stock up.

* * *

Today, with the coronavirus ravaging America’s health care system, the nation’s emergency-response stockpile is still waiting on its first shipment.

The article has generated considerable interest not so much for what it suggests about government procurement policies or for its relevance to the ventilator shortages associated with the current pandemic, but rather for its purported relevance to ongoing antitrust debates and the arguments put forward by “antitrust populists” and others that merger enforcement in the US is dramatically insufficient. 

Only a single sentence in the article itself points to a possible antitrust story — and it does nothing more than report unsubstantiated speculation from unnamed “government officials” and rival companies: 

Government officials and executives at rival ventilator companies said they suspected that Covidien had acquired Newport to prevent it from building a cheaper product that would undermine Covidien’s profits from its existing ventilator business.

Nevertheless, and right on cue, various antitrust scholars quickly framed the deal as a so-called “killer acquisition” (see also here and here):

Unsurprisingly, politicians were also quick to jump on the bandwagon. David Cicilline, the powerful chairman of the House Antitrust Subcommittee, opined that:

And FTC Commissioner Rebecca Kelly Slaughter quickly called for a retrospective review of the deal:

The public reporting on this acquisition raises important questions about the review of this deal. We should absolutely be looking back to figure out what happened.

These “hot takes” raise a crucial issue. The New York Times story opened the door to a welter of hasty conclusions offered to support the ongoing narrative that antitrust enforcement has failed us — in this case quite literally at the cost of human lives. But are any of these claims actually supportable?

Unfortunately, the competitive realities of the mechanical ventilator industry, as well as a more clear-eyed view of what was likely going on with the failed government contract at the heart of the story, simply do not support the “killer acquisition” story.

What is a “killer acquisition”…?

Let’s take a step back. Because monopoly profits are, by definition, higher than joint duopoly profits (all else equal), economists have long argued that incumbents may find it profitable to acquire smaller rivals in order to reduce competition and increase their profits. More specifically, incumbents may be tempted to acquire would-be entrants in order to prevent them from introducing innovations that might hurt the incumbent’s profits.

For this theory to have any purchase, however, a number of conditions must hold. Most importantly, as Colleen Cunningham, Florian Ederer, and Song Ma put it in an influential paper

“killer acquisitions” can only occur when the entrepreneur’s project overlaps with the acquirer’s existing product…. [W]ithout any product market overlap, the acquirer never has a strictly positive incentive to acquire the entrepreneur… because, without overlap, acquiring the project does not give the acquirer any gains resulting from reduced competition, and the two bargaining entities have exactly the same value for the project.

Moreover, the authors add that:

Successfully developing a new product draws consumer demand and profits away equally from all existing products. An acquiring incumbent is hurt more by such cannibalization when he is a monopolist (i.e., the new product draws demand away only from his own existing product) than when he already faces many other existing competitors (i.e., cannibalization losses are spread over many firms). As a result, as the number of existing competitors increases, the replacement effect decreases and the acquirer’s development decisions become more similar to those of the entrepreneur

Finally, the “killer acquisition” terminology is appropriate only when the incumbent chooses to discontinue its rival’s R&D project:

If incumbents face significant existing competition, acquired projects are not significantly more frequently discontinued than independent projects. Thus, more competition deters incumbents from acquiring and terminating the projects of potential future competitors, which leads to more competition in the future.

…And what isn’t a killer acquisition?

What is left out of this account of killer acquisitions is the age-old possibility that an acquirer purchases a rival precisely because it has superior know-how or a superior governance structure that enables it to realize greater return and more productivity than its target. In the case of a so-called killer acquisition, this means shutting down a negative ROI project and redeploying resources to other projects or other uses — including those that may not have any direct relation to the discontinued project. 

Such “synergistic” mergers are also — like allegedly “killer” mergers — likely to involve acquirers and targets in the same industry and with technological overlap between their R&D projects; it is in precisely these situations that the acquirer is likely to have better knowledge than the target’s shareholders that the target is undervalued because of poor governance rather than exogenous, environmental factors.  

In other words, whether an acquisition is harmful or not — as the epithet “killer” implies it is — depends on whether it is about reducing competition from a rival, on the one hand, or about increasing the acquirer’s competitiveness by putting resources to more productive use, on the other.

As argued below, it is highly unlikely that Covidien’s acquisition of Newport could be classified as a “killer acquisition.” There is thus nothing to suggest that the merger materially impaired competition in the mechanical ventilator market, or that it measurably affected the US’s efforts to fight COVID-19.

The market realities of the ventilator market and its implications for the “killer acquisition” story

1. The mechanical ventilator market is highly competitive

As explained above, “killer acquisitions” are less likely to occur in competitive markets. Yet the mechanical ventilator industry is extremely competitive. 

A number of reports conclude that there is significant competition in the industry. One source cites at least seven large producers. Another report cites eleven large players. And, in the words of another report:

Medical ventilators market competition is intense. 

The conclusion that the mechanical ventilator industry is highly competitive is further supported by the fact that the five largest producers combined reportedly hold only 50% of the market. In other words, available evidence suggests that none of these firms has anything close to a monopoly position. 

This intense competition, along with the small market shares of the merging firms, likely explains why the FTC declined to open an in-depth investigation into Covidien’s acquisition of Newport.

Similarly, following preliminary investigations, neither the FTC nor the European Commission saw the need for an in-depth look at the ventilator market when they reviewed Medtronic’s subsequent acquisition of Covidien (which closed in 2015). Although Medtronic did not produce any mechanical ventilators before the acquisition, authorities (particularly the European Commission) could nevertheless have analyzed that market if Covidien’s presumptive market share was particularly high. The fact that they declined to do so tends to suggest that the ventilator market was relatively unconcentrated.

2. The value of the merger was too small

A second strong reason to believe that Covidien’s purchase of Newport wasn’t a killer acquisition is the acquisition’s value of $103 million

Indeed, if it was clear that Newport was about to revolutionize the ventilator market, then Covidien would likely have been made to pay significantly more than $103 million to acquire it. 

As noted above, the crux of the “killer acquisition” theory is that incumbents can induce welfare-reducing acquisitions by offering to acquire their rivals for significantly more than the present value of their rivals’ expected profits. Because an incumbent undertaking a “killer” takeover expects to earn monopoly profits as a result of the transaction, it can offer a substantial premium and still profit from its investment. It is this basic asymmetry that drives the theory.

Indeed, as a recent article by Kevin Bryan and Erik Hovenkamp notes, an acquisition value out of line with current revenues may be an indicator of the significance of a pending acquisition in which enforcers may not actually know the value of the target’s underlying technology: 

[Where] a court may lack the expertise to [assess the commercial significance of acquired technology]…, the transaction value… may provide a reasonable proxy. Intuitively, if the startup is a relatively small company with relatively few sales to its name, then a very high acquisition price may reasonably suggest that the startup technology has significant promise.

The strategy only works, however, if the target firm’s shareholders agree that share value properly reflects only “normal” expected profits, and not that the target is poised to revolutionize its market with a uniquely low-cost or high-quality product. Relatively low acquisition prices relative to market size, therefore, tend to reflect low (or normal) expected profits, and a low perceived likelihood of radical innovations occurring.

We can apply this reasoning to Covidien’s acquisition of Newport: 

  • Precise and publicly available figures concerning the mechanical ventilator market are hard to come by. Nevertheless, one estimate finds that the global ventilator market was worth $2.715 billion in 2012. Another report suggests that the global market was worth $4.30 billion in 2018; still another that it was worth $4.58 billion in 2019.
  • As noted above, Covidien reported to the SEC that it paid $103 million to purchase Newport (a firm that produced only ventilators and apparently had no plans to branch out). 
  • For context, at the time of the acquisition Covidien had annual sales of $11.8 billion overall, and $743 million in sales of its existing “Airways and Ventilation Products.”

If the ventilator market was indeed worth billions of dollars per year, then the comparatively small $108 million paid by Covidien — small even relative to Covidien’s own share of the market — suggests that, at the time of the acquisition, it was unlikely that Newport was poised to revolutionize the market for mechanical ventilators (for instance, by successfully bringing its Aura ventilator to market). 

The New York Times article claimed that Newport’s ventilators would be sold (at least to the US government) for $3,000 — a substantial discount from the reportedly then-going rate of $10,000. If selling ventilators at this price seemed credible at the time, then Covidien — as well as Newport’s shareholders — knew that Newport was about to achieve tremendous cost savings, enabling it to offer ventilators not only to the the US government, but to purchasers around the world, at an irresistibly attractive — and profitable — price.

Ventilators at the time typically went for about $10,000 each, and getting the price down to $3,000 would be tough. But Newport’s executives bet they would be able to make up for any losses by selling the ventilators around the world.

“It would be very prestigious to be recognized as a supplier to the federal government,” said Richard Crawford, who was Newport’s head of research and development at the time. “We thought the international market would be strong, and there is where Newport would have a good profit on the product.”

If achievable, Newport thus stood to earn a substantial share of the profits in a multi-billion dollar industry. 

Of course, it is necessary to apply a probability to these numbers: Newport’s ventilator was not yet on the market, and had not yet received FDA approval. Nevertheless, if the Times’ numbers seemed credible at the time, then Covidien would surely have had to offer significantly more than $108 million in order to induce Newport’s shareholders to part with their shares.

Given the low valuation, however, as well as the fact that Newport produced other ventilators — and continues to do so to this day, there is no escaping the fact that everyone involved seemed to view Newport’s Aura ventilator as nothing more than a moonshot with, at best, a low likelihood of success. 

Curically, this same reasoning explains why it shouldn’t surprise anyone that the project was ultimately discontinued; recourse to a “killer acquisition” theory is hardly necessary.

3. Lessons from Covidien’s ventilator product decisions  

The killer acquisition claims are further weakened by at least four other important pieces of information: 

  1.  Covidien initially continued to develop Newport’s Aura ventilator, and continued to develop and sell Newport’s other ventilators.
  2. There was little overlap between Covidien and Newport’s ventilators — or, at the very least, they were highly differentiated
  3. Covidien appears to have discontinued production of its own portable ventilator in 2014
  4. The Newport purchase was part of a billion dollar series of acquisitions seemingly aimed at expanding Covidien’s in-hospital (i.e., not-portable) device portfolio

Covidien continued to develop and sell Newport’s ventilators

For a start, while the Aura line was indeed discontinued by Covidien, the timeline is important. The acquisition of Newport by Covidien was announced in March 2012, approved by the FTC in April of the same year, and the deal was closed on May 1, 2012.

However, as the FDA’s 510(k) database makes clear, Newport submitted documents for FDA clearance of the Aura ventilator months after its acquisition by Covidien (June 29, 2012, to be precise). And the Aura received FDA 510(k) clearance on November 9, 2012 — many months after the merger.

It would have made little sense for Covidien to invest significant sums in order to obtain FDA clearance for a project that it planned to discontinue (the FDA routinely requires parties to actively cooperate with it, even after 510(k) applications are submitted). 

Moreover, if Covidien really did plan to discreetly kill off the Aura ventilator, bungling the FDA clearance procedure would have been the perfect cover under which to do so. Yet that is not what it did.

Covidien continued to develop and sell Newport’s other ventilators

Second, and just as importantly, Covidien (and subsequently Medtronic) continued to sell Newport’s other ventilators. The Newport e360 and HT70 are still sold today. Covidien also continued to improve these products: it appears to have introduced an improved version of the Newport HT70 Plus ventilator in 2013.

If eliminating its competitor’s superior ventilators was the only goal of the merger, then why didn’t Covidien also eliminate these two products from its lineup, rather than continue to improve and sell them? 

At least part of the answer, as will be seen below, is that there was almost no overlap between Covidien and Newport’s product lines.

There was little overlap between Covidien’s and Newport’s ventilators

Third — and perhaps the biggest flaw in the killer acquisition story — is that there appears to have been very little overlap between Covidien and Newport’s ventilators. 

This decreases the likelihood that the merger was a killer acquisition. When two products are highly differentiated (or not substitutes at all), sales of the first are less likely to cannibalize sales of the other. As Florian Ederer and his co-authors put it:

Importantly, without any product market overlap, the acquirer never has a strictly positive incentive to acquire the entrepreneur, neither to “Acquire to Kill” nor to “Acquire to Continue.” This is because without overlap, acquiring the project does not give the acquirer any gains resulting from reduced competition, and the two bargaining entities have exactly the same value for the project.

A quick search of the FDA’s 510(k) database reveals that Covidien has three approved lines of ventilators: the Puritan Bennett 980, 840, and 540 (apparently essentially the same as the PB560, the plans to which Medtronic recently made freely available in order to facilitate production during the current crisis). The same database shows that these ventilators differ markedly from Newport’s ventilators (particularly the Aura).

In particular, Covidien manufactured primarily traditional, invasive ICU ventilators (except for the PB540, which is potentially a substitute for the Newport HT70), while Newport made much-more-portable ventilators, suitable for home use (notably the Aura, HT50 and HT70 lines). 

Under normal circumstances, critical care and portable ventilators are not substitutes. As the WHO website explains, portable ventilators are:

[D]esigned to provide support to patients who do not require complex critical care ventilators.

A quick glance at Medtronic’s website neatly illustrates the stark differences between these two types of devices:

This is not to say that these devices do not have similar functionalities, or that they cannot become substitutes in the midst of a coronavirus pandemic. However, in normal times (as was the case when Covidien acquired Newport), hospitals likely did not view these devices as substitutes.

The conclusion that Covidien and Newport’s ventilator were not substitutes finds further support in documents and statements released at the time of the merger. For instance, Covidien’s CEO explained that:

This acquisition is consistent with Covidien’s strategy to expand into adjacencies and invest in product categories where it can develop a global competitive advantage.

And that:

Newport’s products and technology complement our current portfolio of respiratory solutions and will broaden our ventilation platform for patients around the world, particularly in emerging markets.

In short, the fact that almost all of Covidien and Newport’s products were not substitutes further undermines the killer acquisition story. It also tends to vindicate the FTC’s decision to rapidly terminate its investigation of the merger.

Covidien appears to have discontinued production of its own portable ventilator in 2014

Perhaps most tellingly: It appears that Covidien discontinued production of its own competing, portable ventilator, the Puritan Bennett 560, in 2014.

The product is reported on the company’s 2011, 2012 and 2013 annual reports:

Airway and Ventilation Products — airway, ventilator, breathing systems and inhalation therapy products. Key products include: the Puritan Bennett™ 840 line of ventilators; the Puritan Bennett™ 520 and 560 portable ventilator….

(The PB540 was launched in 2009; the updated PB560 in 2010. The PB520 was the EU version of the device, launched in 2011).

But in 2014, the PB560 was no longer listed among the company’s ventilator products:  

Airway & Ventilation, which primarily includes sales of airway, ventilator and inhalation therapy products and breathing systems.

Key airway & ventilation products include: the Puritan Bennett™ 840 and 980 ventilators, the Newport™ e360 and HT70 ventilators….

Nor — despite its March 31 and April 1 “open sourcing” of the specifications and software necessary to enable others to produce the PB560 — did Medtronic appear to have restarted production, and the company did not mention the device in its March 18 press release announcing its own, stepped-up ventilator production plans.

Surely if Covidien had intended to capture the portable ventilator market by killing off its competition it would have continued to actually sell its own, competing device. The fact that the only portable ventilators produced by Covidien by 2014 were those it acquired in the Newport deal strongly suggests that its objective in that deal was the acquisition and deployment of Newport’s viable and profitable technologies — not the abandonment of them. This, in turn, suggests that the Aura was not a viable and profitable technology.

(Admittedly we are unable to determine conclusively that either Covidien or Medtronic stopped producing the PB520/540/560 series of ventilators. But our research seems to indicate strongly that this is indeed the case).

Putting the Newport deal in context

Finally, although not dispositive, it seems important to put the Newport purchase into context. In the same year as it purchased Newport, Covidien paid more than a billion dollars to acquire five other companies, as well — all of them primarily producing in-hospital medical devices. 

That 2012 spending spree came on the heels of a series of previous medical device company acquisitions, apparently totally some four billion dollars. Although not exclusively so, the acquisitions undertaken by Covidien seem to have been primarily targeted at operating room and in-hospital monitoring and treatment — making the putative focus on cornering the portable (home and emergency) ventilator market an extremely unlikely one. 

By the time Covidien was purchased by Medtronic the deal easily cleared antitrust review because of the lack of overlap between the company’s products, with Covidien’s focusing predominantly on in-hospital, “diagnostic, surgical, and critical care” and Medtronic’s on post-acute care.

Newport misjudged the costs associated with its Aura project; Covidien was left to pick up the pieces

So why was the Aura ventilator discontinued?

Although it is almost impossible to know what motivated Covidien’s executives, the Aura ventilator project clearly suffered from many problems. 

The Aura project was intended to meet the requirements of the US government’s BARDA program (under the auspices of the U.S. Department of Health and Human Services’ Biomedical Advanced Research and Development Authority). In short, the program sought to create a stockpile of next generation ventilators for emergency situations — including, notably, pandemics. The ventilator would thus have to be designed for events where

mass casualties may be expected, and when shortages of experienced health care providers with respiratory support training, and shortages of ventilators and accessory components may be expected.

The Aura ventilator would thus sit somewhere between Newport’s two other ventilators: the e360 which could be used in pediatric care (for newborns smaller than 5kg) but was not intended for home care use (or the extreme scenarios envisioned by the US government); and the more portable HT70 which could be used in home care environments, but not for newborns. 

Unfortunately, the Aura failed to achieve this goal. The FDA’s 510(k) clearance decision clearly states that the Aura was not intended for newborns:

The AURA family of ventilators is applicable for infant, pediatric and adult patients greater than or equal to 5 kg (11 lbs.).

A press release issued by Medtronic confirms that

the company was unable to secure FDA approval for use in neonatal populations — a contract requirement.

And the US Government RFP confirms that this was indeed an important requirement:

The device must be able to provide the same standard of performance as current FDA pre-market cleared portable ventilators and shall have the following additional characteristics or features: 

Flexibility to accommodate a wide patient population range from neonate to adult.

Newport also seems to have been unable to deliver the ventilator at the low price it had initially forecasted — a common problem for small companies and/or companies that undertake large R&D programs. It also struggled to complete the project within the agreed-upon deadlines. As the Medtronic press release explains:

Covidien learned that Newport’s work on the ventilator design for the Government had significant gaps between what it had promised the Government and what it could deliverboth in terms of being able to achieve the cost of production specified in the contract and product features and performance. Covidien management questioned whether Newport’s ability to complete the project as agreed to in the contract was realistic.

As Jason Crawford, an engineer and tech industry commentator, put it:

Projects fail all the time. “Supplier risk” should be a standard checkbox on anyone’s contingency planning efforts. This is even more so when you deliberately push the price down to 30% of the market rate. Newport did not even necessarily expect to be profitable on the contract.

The above is mostly Covidien’s “side” of the story, of course. But other pieces of evidence lend some credibility to these claims:

  • Newport agreed to deliver its Aura ventilator at a per unit cost of less than $3000. But, even today, this seems extremely ambitious. For instance, the WHO has estimated that portable ventilators cost between $3,300 and $13,500. If Newport could profitably sell the Aura at such a low price, then there was little reason to discontinue it (readers will recall the development of the ventilator was mostly complete when Covidien put a halt to the project).
  • Covidien/Newport is not the only firm to have struggled to offer suitable ventilators at such a low price. Philips (which took Newport’s place after the government contract fell through) also failed to achieve this low price. Rather than the $2,000 price sought in the initial RFP, Philips ultimately agreed to produce the ventilators for $3,280. But it has not yet been able to produce a single ventilator under the government contract at that price.
  • Covidien has repeatedly been forced to recall some of its other ventilators ( here, here and here) — including the Newport HT70. And rival manufacturers have also faced these types of issues (for example, here and here). 

Accordingly, Covidien may well have preferred to cut its losses on the already problem-prone Aura project, before similar issues rendered it even more costly. 

In short, while it is impossible to prove that these development issues caused Covidien to pull the plug on the Aura project, it is certainly plausible that they did. This further supports the hypothesis that Covidien’s acquisition of Newport was not a killer acquisition. 

Ending the Aura project might have been an efficient outcome

As suggested above, moreover, it is entirely possible that Covidien was better able to realize the poor prospects of Newport’s Aura project and also better organized to enable it to make the requisite decision to abandon the project.

A small company like Newport faces greater difficulties abandoning entrepreneurial projects because doing so can impair a privately held firm’s ability to raise funds for subsequent projects.

Moreover, the relatively large share of revue and reputation that Newport — worth $103 million in 2012, versus Covidien’s $11.8 billion — would have realized from fulfilling a substantial US government project could well have induced it to overestimate the project’s viability and to undertake excessive risk in the (vain) hope of bringing the project to fruition.  

While there is a tendency among antitrust scholars, enforcers, and practitioners to look for (and find…) antitrust-related rationales for mergers and other corporate conduct, it remains the case that most corporate control transactions (such as mergers) are driven by the acquiring firm’s expectation that it can manage more efficiently. As Henry G. Manne put it in his seminal article, Mergers and the Market for Corporate Control (1965): 

Since, in a world of uncertainty, profitable transactions will be entered into more often by those whose information is relatively more reliable, it should not surprise us that mergers within the same industry have been a principal form of changing corporate control. Reliable information is often available to suppliers and customers as well. Thus many vertical mergers may be of the control takeover variety rather than of the “foreclosure of competitors” or scale-economies type.

Of course, the same information that renders an acquiring firm in the same line of business knowledgeable enough to operate a target more efficiently could also enable it to effect a “killer acquisition” strategy. But the important point is that a takeover by a firm with a competing product line, after which the purchased company’s product line is abandoned, is at least as consistent with a “market for corporate control” story as with a “killer acquisition” story.

Indeed, as Florian Ederer himself noted with respect to the Covidien/Newport merger, 

“Killer acquisitions” can have a nefarious image, but killing off a rival’s product was probably not the main purpose of the transaction, Ederer said. He raised the possibility that Covidien decided to kill Newport’s innovation upon realising that the development of the devices would be expensive and unlikely to result in profits.

Concluding remarks

In conclusion, Covidien’s acquisition of Newport offers a cautionary tale about reckless journalism, “blackboard economics,” and government failure.

Reckless journalism because the New York Times clearly failed to do the appropriate due diligence for its story. Its journalists notably missed (or deliberately failed to mention) a number of critical pieces of information — such as the hugely important fact that most of Covidien’s and Newport’s products did not overlap, or the fact that there were numerous competitors in the highly competitive mechanical ventilator industry. 

And yet, that did not stop the authors from publishing their extremely alarming story, effectively suggesting that a small medical device merger materially contributed to the loss of many American lives.

The story also falls prey to what Ronald Coase called “blackboard economics”:

What is studied is a system which lives in the minds of economists but not on earth. 

Numerous commentators rushed to fit the story to their preconceived narratives, failing to undertake even a rudimentary examination of the underlying market conditions before they voiced their recriminations. 

The only thing that Covidien and Newport’s merger ostensibly had in common with the killer acquisition theory was the fact that a large firm purchased a small rival, and that the one of the small firm’s products was discontinued. But this does not even begin to meet the stringent conditions that must be fulfilled for the theory to hold water. Unfortunately, critics appear to have completely ignored all contradicting evidence. 

Finally, what the New York Times piece does offer is a chilling tale of government failure.

The inception of the US government’s BARDA program dates back to 2008 — twelve years before the COVID-19 pandemic hit the US. 

The collapse of the Aura project is no excuse for the fact that, more than six years after the Newport contract fell through, the US government still has not obtained the necessary ventilators. Questions should also be raised about the government’s decision to effectively put all of its eggs in the same basket — twice. If anything, it is thus government failure that was the real culprit. 

And yet the New York Times piece and the critics shouting “killer acquisition!” effectively give the US government’s abject failure here a free pass — all in the service of pursuing their preferred “killer story.”

[TOTM: The following is part of a blog series by TOTM guests and authors on the law, economics, and policy of the ongoing COVID-19 pandemic. The entire series of posts is available here.

This post is authored by Eric Fruits, (Chief Economist, International Center for Law & Economics).]

The Wall Street Journal reports congressional leaders have agreed to impose limits on stock buybacks and dividend payments for companies receiving aid under the COVID-19 disaster relief package. 

Rather than a flat-out ban, the draft legislation forbids any company taking federal emergency loans or loan guarantees from repurchasing its own stock or paying shareholder dividends. The ban lasts for the term of the loans, plus one year after the aid had ended.

In theory, under a strict set of conditions, there is no difference between dividends and buybacks. Both approaches distribute cash from the corporation to shareholders. In practice, there are big differences between dividends and share repurchases.

  • Dividends are publicly visible actions and require authorization by the board of directors. Shareholders have expectations of regular, stable dividends. Buybacks generally lack such transparency. Firms have flexibility in choosing the timing and the amount of repurchases, subject to the details of their repurchase programs.
  • Cash dividends have no effect on the number of shares outstanding. In contrast, share repurchases reduce the number of shares outstanding. By reducing the number of shares outstanding, buybacks increase earnings per share, all other things being equal. 

Over the past 15 years, buybacks have outpaced dividend payouts. The figure above, from Seeking Alpha, shows that while dividends have grown relatively smoothly over time, the aggregate value of buybacks are volatile and vary with the business cycle. In general, firms increase their repurchases relative to dividends when the economy booms and reduce them when the economy slows or shrinks. 

This observation is consistent with a theory that buybacks are associated with periods of greater-than-expected financial performance. On the other hand, dividends are associated with expectations of long-term profitability. Dividends can decrease, but only when profits are expected to be “permanently” lower. 

During the Great Recession, the figure above shows that dividends declined by about 10%, the amount of share repurchases plummeted by approximately 85%. The flexibility afforded by buybacks provided stability in dividends.

There is some logic to dividend and buyback limits imposed by the COVID-19 disaster relief package. If a firm has enough cash on hand to pay dividends or repurchase shares, then it doesn’t need cash assistance from the federal government. Similarly, if a firm is so desperate for cash that it needs a federal loan or loan guarantee, then it doesn’t have enough cash to provide a payout to shareholders. Surely managers understand this and sophisticated shareholders should too.

Because of this understanding, the dividend and buyback limits may be a non-binding constraint. It’s not a “good look” for a corporation to accept millions of dollars in federal aid, only to turn around and hand out those taxpayer dollars to the company’s shareholders. That’s a sure way to get an unflattering profile in the New York Times and an invitation to attend an uncomfortable hearing at the U.S. Capitol. Even if a distressed firm could repurchase its shares, it’s unlikely that it would.

The logic behind the plus-one-year ban on dividends and buybacks is less clear. The relief package is meant to get the U.S. economy back to normal as fast as possible. That means if a firm repays its financial assistance early, the company’s shareholders should be rewarded with a cash payout rather than waiting a year for some arbitrary clock to run out.

The ban on dividends and buybacks may lead to an unintended consequence of increased merger and acquisition activity. Vox reports an email to Goldman Sachs’ investment banking division says Goldman expects to see an increase in hostile takeovers and shareholder activism as the prices of public companies fall. Cash rich firms who are subject to the ban and cannot get that cash to their existing shareholders may be especially susceptible takeover targets.

Desperate times call for desperate measures and these are desperate times. Buyback backlash has been brewing for sometime and the COVID-19 relief package presents a perfect opportunity to ban buybacks. With the pressures businesses are under right now, it’s unlikely there’ll be many buybacks over the next few months. The concern should be over the unintended consequences facing firms once the economy recovers.

I posted this originally on my own blog, but decided to cross-post here since Thom and I have been blogging on this topic.

“The U.S. stock market is having another solid year. You wouldn’t know it by looking at the shares of companies that manage money.”

That’s the lead from Charles Stein on Bloomberg’s Markets’ page today. Stein goes on to offer three possible explanations: 1) a weary bull market, 2) a move toward more active stock-picking by individual investors, and 3) increasing pressure on fees.

So what has any of that to do with the common ownership issue? A few things.

First, it shows that large institutional investors must not be very good at harvesting the benefits of the non-competitive behavior they encourage among the firms the invest in–if you believe they actually do that in the first place. In other words, if you believe common ownership is a problem because CEOs are enriching institutional investors by softening competition, you must admit they’re doing a pretty lousy job of capturing that value.

Second, and more importantly–as well as more relevant–the pressure on fees has led money managers to emphasis low-cost passive index funds. Indeed, among the firms doing well according to the article is BlackRock, “whose iShares exchange-traded fund business tracks indexes, won $20 billion.” In an aggressive move, Fidelity has introduced a total of four zero-fee index funds as a way to draw fee-conscious investors. These index tracking funds are exactly the type of inter-industry diversified funds that negate any incentive for competition softening in any one industry.

Finally, this also illustrates the cost to the investing public of the limits on common ownership proposed by the likes of Einer Elhague, Eric Posner, and Glen Weyl. Were these types of proposals in place, investment managers could not offer diversified index funds that include more than one firm’s stock from any industry with even a moderate level of market concentration. Given competitive forces are pushing investment companies to increase the offerings of such low-cost index funds, any regulatory proposal that precludes those possibilities is sure to harm the investing public.

Just one more piece of real evidence that common ownership is not only not a problem, but that the proposed “fixes” are.

As Thom previously posted, he and I have a new paper explaining The Case for Doing Nothing About Common Ownership of Small Stakes in Competing Firms. Our paper is a response to cries from the likes of Einer Elhauge and of Eric Posner, Fiona Scott Morton, and Glen Weyl, who have called for various types of antitrust action to reign in what they claim is an “economic blockbuster” and “the major new antitrust challenge of our time,” respectively. This is the first in a series of posts that will unpack some of the issues and arguments we raise in our paper.

At issue is the growth in the incidence of common-ownership across firms within various industries. In particular, institutional investors with broad portfolios frequently report owning small stakes in a number of firms within a given industry. Although small, these stakes may still represent large block holdings relative to other investors. This intra-industry diversification, critics claim, changes the managerial objectives of corporate executives from aggressively competing to increase their own firm’s profits to tacitly colluding to increase industry-level profits instead. The reason for this change is that competition by one firm comes at a cost of profits from other firms in the industry. If investors own shares across firms, then any competitive gains in one firm’s stock are offset by competitive losses in the stocks of other firms in the investor’s portfolio. If one assumes corporate executives aim to maximize total value for their largest shareholders, then managers would have incentive to soften competition against firms with which they share common ownership. Or so the story goes (more on that in a later post.)

Elhague and Posner, et al., draw their motivation for new antitrust offenses from a handful of papers that purport to establish an empirical link between the degree of common ownership among competing firms and various measures of softened competitive behavior, including airline prices, banking fees, executive compensation, and even corporate disclosure patterns. The paper of most note, by José Azar, Martin Schmalz, and Isabel Tecu and forthcoming in the Journal of Finance, claims to identify a causal link between the degree of common ownership among airlines competing on a given route and the fares charged for flights on that route.

Measuring common ownership with MHHI

Azar, et al.’s airline paper uses a metric of industry concentration called a Modified Herfindahl–Hirschman Index, or MHHI, to measure the degree of industry concentration taking into account the cross-ownership of investors’ stakes in competing firms. The original Herfindahl–Hirschman Index (HHI) has long been used as a measure of industry concentration, debuting in the Department of Justice’s Horizontal Merger Guidelines in 1982. The HHI is calculated by squaring the market share of each firm in the industry and summing the resulting numbers.

The MHHI is rather more complicated. MHHI is composed of two parts: the HHI measuring product market concentration and the MHHI_Delta measuring the additional concentration due to common ownership. We offer a step-by-step description of the calculations and their economic rationale in an appendix to our paper. For this post, I’ll try to distill that down. The MHHI_Delta essentially has three components, each of which is measured relative to every possible competitive pairing in the market as follows:

  1. A measure of the degree of common ownership between Company A and Company -A (Not A). This is calculated by multiplying the percentage of Company A shares owned by each Investor I with the percentage of shares Investor I owns in Company -A, then summing those values across all investors in Company A. As this value increases, MHHI_Delta goes up.
  2. A measure of the degree of ownership concentration in Company A, calculated by squaring the percentage of shares owned by each Investor I and summing those numbers across investors. As this value increases, MHHI_Delta goes down.
  3. A measure of the degree of product market power exerted by Company A and Company -A, calculated by multiplying the market shares of the two firms. As this value increases, MHHI_Delta goes up.

This process is repeated and aggregated first for every pairing of Company A and each competing Company -A, then repeated again for every other company in the market relative to its competitors (e.g., Companies B and -B, Companies C and -C, etc.). Mathematically, MHHI_Delta takes the form:

where the Ss represent the firm market shares of, and Betas represent ownership shares of Investor I in, the respective companies A and -A.

As the relative concentration of cross-owning investors to all investors in Company A increases (i.e., the ratio on the right increases), managers are assumed to be more likely to soften competition with that competitor. As those two firms control more of the market, managers’ ability to tacitly collude and increase joint profits is assumed to be higher. Consequently, the empirical research assumes that as MHHI_Delta increases, we should observe less competitive behavior.

And indeed that is the “blockbuster” evidence giving rise to Elhauge’s and Posner, et al.,’s arguments  For example, Azar, et. al., calculate HHI and MHHI_Delta for every US airline market–defined either as city-pairs or departure-destination pairs–for each quarter of the 14-year time period in their study. They then regress ticket prices for each route against the HHI and the MHHI_Delta for that route, controlling for a number of other potential factors. They find that airfare prices are 3% to 7% higher due to common ownership. Other papers using the same or similar measures of common ownership concentration have likewise identified positive correlations between MHHI_Delta and their respective measures of anti-competitive behavior.

Problems with the problem and with the measure

We argue that both the theoretical argument underlying the empirical research and the empirical research itself suffer from some serious flaws. On the theoretical side, we have two concerns. First, we argue that there is a tremendous leap of faith (if not logic) in the idea that corporate executives would forgo their own self-interest and the interests of the vast majority of shareholders and soften competition simply because a small number of small stakeholders are intra-industry diversified. Second, we argue that even if managers were so inclined, it clearly is not the case that softening competition would necessarily be desirable for institutional investors that are both intra- and inter-industry diversified, since supra-competitive pricing to increase profits in one industry would decrease profits in related industries that may also be in the investors’ portfolios.

On the empirical side, we have concerns both with the data used to calculate the MHHI_Deltas and with the nature of the MHHI_Delta itself. First, the data on institutional investors’ holdings are taken from Schedule 13 filings, which report aggregate holdings across all the institutional investor’s funds. Using these data masks the actual incentives of the institutional investors with respect to investments in any individual company or industry. Second, the construction of the MHHI_Delta suffers from serious endogeneity concerns, both in investors’ shareholdings and in market shares. Finally, the MHHI_Delta, while seemingly intuitive, is an empirical unknown. While HHI is theoretically bounded in a way that lends to interpretation of its calculated value, the same is not true for MHHI_Delta. This makes any inference or policy based on nominal values of MHHI_Delta completely arbitrary at best.

We’ll expand on each of these concerns in upcoming posts. We will then take on the problems with the policy proposals being offered in response to the common ownership ‘problem.’

 

 

 

 

 

 

One of the hottest antitrust topics of late has been institutional investors’ “common ownership” of minority stakes in competing firms.  Writing in the Harvard Law Review, Einer Elhauge proclaimed that “[a]n economic blockbuster has recently been exposed”—namely, “[a] small group of institutions has acquired large shareholdings in horizontal competitors throughout our economy, causing them to compete less vigorously with each other.”  In the Antitrust Law Journal, Eric Posner, Fiona Scott Morton, and Glen Weyl contended that “the concentration of markets through large institutional investors is the major new antitrust challenge of our time.”  Those same authors took to the pages of the New York Times to argue that “[t]he great, but mostly unknown, antitrust story of our time is the astonishing rise of the institutional investor … and the challenge that it poses to market competition.”

Not surprisingly, these scholars have gone beyond just identifying a potential problem; they have also advocated policy solutions.  Elhauge has called for allowing government enforcers and private parties to use Section 7 of the Clayton Act, the provision primarily used to prevent anticompetitive mergers, to police institutional investors’ ownership of minority positions in competing firms.  Posner et al., concerned “that private litigation or unguided public litigation could cause problems because of the interactive nature of institutional holdings on competition,” have proposed that federal antitrust enforcers adopt an enforcement policy that would encourage institutional investors either to avoid common ownership of firms in concentrated industries or to limit their influence over such firms by refraining from voting their shares.

The position of these scholars is thus (1) that common ownership by institutional investors significantly diminishes competition in concentrated industries, and (2) that additional antitrust intervention—beyond generally applicable rules on, say, hub-and-spoke conspiracies and anticompetitive information exchanges—is appropriate to prevent competitive harm.

Mike Sykuta and I have recently posted a paper taking issue with this two-pronged view.  With respect to the first prong, we contend that there are serious problems with both the theory of competitive harm stemming from institutional investors’ common ownership and the empirical evidence that has been marshalled in support of that theory.  With respect to the second, we argue that even if competition were softened by institutional investors’ common ownership of small minority interests in competing firms, the unintended negative consequences of an antitrust fix would outweigh any benefits from such intervention.

Over the next few days, we plan to unpack some of the key arguments in our paper, The Case for Doing Nothing About Institutional Investors’ Common Ownership of Small Stakes in Competing Firms.  In the meantime, we encourage readers to download the paper and send us any comments.

The paper’s abstract is below the fold. Continue Reading…

In a recent long-form article in the New York Times, reporter Noam Scheiber set out to detail some of the ways Uber (and similar companies, but mainly Uber) are engaged in “an extraordinary experiment in behavioral science to subtly entice an independent work force to maximize its growth.”

That characterization seems innocuous enough, but it is apparent early on that Scheiber’s aim is not only to inform but also, if not primarily, to deride these efforts. The title of the piece, in fact, sets the tone:

How Uber Uses Psychological Tricks to Push Its Drivers’ Buttons

Uber and its relationship with its drivers are variously described by Scheiber in the piece as secretive, coercive, manipulative, dominating, and exploitative, among other things. As Schreiber describes his article, it sets out to reveal how

even as Uber talks up its determination to treat drivers more humanely, it is engaged in an extraordinary behind-the-scenes experiment in behavioral science to manipulate them in the service of its corporate growth — an effort whose dimensions became evident in interviews with several dozen current and former Uber officials, drivers and social scientists, as well as a review of behavioral research.

What’s so galling about the piece is that, if you strip away the biased and frequently misguided framing, it presents a truly engaging picture of some of the ways that Uber sets about solving a massively complex optimization problem, abetted by significant agency costs.

So I did. Strip away the detritus, add essential (but omitted) context, and edit the article to fix the anti-Uber bias, the one-sided presentation, the mischaracterizations, and the fundamentally non-economic presentation of what is, at its core, a fascinating illustration of some basic problems (and solutions) from industrial organization economics. (For what it’s worth, Scheiber should know better. After all, “He holds a master’s degree in economics from the University of Oxford, where he was a Rhodes Scholar, and undergraduate degrees in math and economics from Tulane University.”)

In my retelling, the title becomes:

How Uber Uses Innovative Management Tactics to Incentivize Its Drivers

My transformed version of the piece, with critical commentary in the form of tracked changes to the original, is here (pdf).

It’s a long (and, as I said, fundamentally interesting) piece, with cool interactive graphics, well worth the read (well, at least in my retelling, IMHO). Below is just a taste of the edits and commentary I added.

For example, where Scheiber writes:

Uber exists in a kind of legal and ethical purgatory, however. Because its drivers are independent contractors, they lack most of the protections associated with employment. By mastering their workers’ mental circuitry, Uber and the like may be taking the economy back toward a pre-New Deal era when businesses had enormous power over workers and few checks on their ability to exploit it.

With my commentary (here integrated into final form rather than tracked), that paragraph becomes:

Uber operates under a different set of legal constraints, however, also duly enacted and under which millions of workers have profitably worked for decades. Because its drivers are independent contractors, they receive their compensation largely in dollars rather than government-mandated “benefits” that remove some of the voluntariness from employer/worker relationships. And, in the case of overtime pay, for example, the Uber business model that is built in part on offering flexible incentives to match supply and demand using prices and compensation, would be next to impossible. It is precisely through appealing to drivers’ self-interest that Uber and the like may be moving the economy forward to a new era when businesses and workers have more flexibility, much to the benefit of all.

Elsewhere, Scheiber’s bias is a bit more subtle, but no less real. Thus, he writes:

As he tried to log off at 7:13 a.m. on New Year’s Day last year, Josh Streeter, then an Uber driver in the Tampa, Fla., area, received a message on the company’s driver app with the headline “Make it to $330.” The text then explained: “You’re $10 away from making $330 in net earnings. Are you sure you want to go offline?” Below were two prompts: “Go offline” and “Keep driving.” The latter was already highlighted.

With my edits and commentary, that paragraph becomes:

As he started the process of logging off at 7:13 a.m. on New Year’s Day last year, Josh Streeter, then an Uber driver in the Tampa, Fla., area, received a message on the company’s driver app with the headline “Make it to $330.” The text then explained: “You’re $10 away from making $330 in net earnings. Are you sure you want to go offline?” Below were two prompts: “Go offline” and “Keep driving.” The latter was already highlighted, but the former was listed first. It’s anyone’s guess whether either characteristic — placement or coloring — had any effect on drivers’ likelihood of clicking one button or the other.

And one last example. Scheiber writes:

Consider an algorithm called forward dispatch — Lyft has a similar one — that dispatches a new ride to a driver before the current one ends. Forward dispatch shortens waiting times for passengers, who may no longer have to wait for a driver 10 minutes away when a second driver is dropping off a passenger two minutes away.

Perhaps no less important, forward dispatch causes drivers to stay on the road substantially longer during busy periods — a key goal for both companies.

Uber and Lyft explain this in essentially the same way. “Drivers keep telling us the worst thing is when they’re idle for a long time,” said Kevin Fan, the director of product at Lyft. “If it’s slow, they’re going to go sign off. We want to make sure they’re constantly busy.”

While this is unquestionably true, there is another way to think of the logic of forward dispatch: It overrides self-control.

* * *

Uber officials say the feature initially produced so many rides at times that drivers began to experience a chronic Netflix ailment — the inability to stop for a bathroom break. Amid the uproar, Uber introduced a pause button.

“Drivers were saying: ‘I can never go offline. I’m on just continuous trips. This is a problem.’ So we redesigned it,” said Maya Choksi, a senior Uber official in charge of building products that help drivers. “In the middle of the trip, you can say, ‘Stop giving me requests.’ So you can have more control over when you want to stop driving.”

It is true that drivers can pause the services’ automatic queuing feature if they need to refill their tanks, or empty them, as the case may be. Yet once they log back in and accept their next ride, the feature kicks in again. To disable it, they would have to pause it every time they picked up a new passenger. By contrast, even Netflix allows users to permanently turn off its automatic queuing feature, known as Post-Play.

This pre-emptive hard-wiring can have a huge influence on behavior, said David Laibson, the chairman of the economics department at Harvard and a leading behavioral economist. Perhaps most notably, as Ms. Rosenblat and Luke Stark observed in an influential paper on these practices, Uber’s app does not let drivers see where a passenger is going before accepting the ride, making it hard to judge how profitable a trip will be.

Here’s how I would recast that, and add some much-needed economics:

Consider an algorithm called forward dispatch — Lyft has a similar one — that dispatches a new ride to a driver before the current one ends. Forward dispatch shortens waiting times for passengers, who may no longer have to wait for a driver 10 minutes away when a second driver is dropping off a passenger two minutes away.

Perhaps no less important, forward dispatch causes drivers to stay on the road substantially longer during busy periods — a key goal for both companies — by giving them more income-earning opportunities.

Uber and Lyft explain this in essentially the same way. “Drivers keep telling us the worst thing is when they’re idle for a long time,” said Kevin Fan, the director of product at Lyft. “If it’s slow, they’re going to go sign off. We want to make sure they’re constantly busy.”

While this is unquestionably true, and seems like another win-win, some critics have tried to paint even this means of satisfying both driver and consumer preferences in a negative light by claiming that the forward dispatch algorithm overrides self-control.

* * *

Uber officials say the feature initially produced so many rides at times that drivers began to experience a chronic Netflix ailment — the inability to stop for a bathroom break. Amid the uproar, Uber introduced a pause button.

“Drivers were saying: ‘I can never go offline. I’m on just continuous trips. This is a problem.’ So we redesigned it,” said Maya Choksi, a senior Uber official in charge of building products that help drivers. “In the middle of the trip, you can say, ‘Stop giving me requests.’ So you can have more control over when you want to stop driving.”

Tweaks like these put paid to the arguments that Uber is simply trying to abuse its drivers. And yet, critics continue to make such claims:

It is true that drivers can pause the services’ automatic queuing feature if they need to refill their tanks, or empty them, as the case may be. Yet once they log back in and accept their next ride, the feature kicks in again. To disable it, they would have to pause it every time they picked up a new passenger. By contrast, even Netflix allows users to permanently turn off its automatic queuing feature, known as Post-Play.

It’s difficult to take seriously claims that Uber “abuses” drivers by setting a default that drivers almost certainly prefer; surely drivers seek out another fare following the last fare more often than they seek out another bathroom break. In any case, the difference between one default and the other is a small change in the number of times drivers might have to push a single button; hardly a huge impediment.

But such claims persist, nevertheless. Setting a trivially different default can have a huge influence on behavior, claims David Laibson, the chairman of the economics department at Harvard and a leading behavioral economist. Perhaps most notably — and to change the subject — as Ms. Rosenblat and Luke Stark observed in an influential paper on these practices, Uber’s app does not let drivers see where a passenger is going before accepting the ride, making it hard to judge how profitable a trip will be. But there are any number of defenses of this practice, from both a driver- and consumer-welfare standpoint. Not least, such disclosure could well create isolated scarcity for a huge range of individual ride requests (as opposed to the general scarcity during a “surge”), leading to longer wait times, the need to adjust prices for consumers on the basis of individual rides, and more intense competition among drivers for the most profitable rides. Given these and other explanations, it is extremely unlikely that the practice is actually aimed at “abusing” drivers.

As they say, read the whole thing!

In March 2014, the U.S. Government’s National Telecommunications and Information Administration (NTIA, the Executive Branch’s telecommunications policy agency) abruptly announced that it did not plan to renew its contract with the Internet Corporation for Assigned Names and Numbers (ICANN) to maintain core functions of the Internet. ICANN oversees the Internet domain name system through its subordinate agency, the Internet Assigned Numbers Authority (IANA). In its March statement, NTIA proposed that ICANN consult with “global stakeholders” to agree on an alternative to the “current role played by NTIA in the coordination of the Internet’s [domain name system].”

In recent months Heritage Foundation scholars have discussed concerns stemming from this vaguely-defined NTIA initiative (see, for example, here, here, here, here, here, and here). These concerns include fears that eliminating the U.S. Government’s role in Internet governance could embolden other nations and international organizations (especially the International Telecommunications Union, an arm of the United Nations) to seek to regulate the Internet and limit speech, and create leeway for ICANN to expand beyond its core activities and trench upon Internet freedoms.

Although NTIA has testified that its transition plan would preclude such undesirable outcomes, the reaction to these assurances should be “trust but verify” (especially given the recent Administration endorsement of burdensome Internet common carrier regulation, which appears to be at odds with the spirit if not the letter of NTIA’s assurances).

Reflecting the “trust but verify” spirit, the just-introduced “Defending Internet Freedom Act of 2014” requires that NTIA maintain its existing Internet oversight functions, unless the NTIA Administrator certifies in writing that certain specified assurances have been met regarding Internet governance. Those assurances include findings that the management of the Internet domain name system will not be exercised by foreign governmental or intergovernmental bodies; that ICANN’s bylaws will be amended to uphold First Amendment-type freedoms of speech, assembly, and association; that a four-fifths supermajority will be required for changes in ICANN’s bylaws or fees for services; that an independent process for resolving disputes between ICANN and third parties be established; and that a host of other requirements aimed at protecting Internet freedoms and ensuring ICANN and IANA accountability be instituted.

Legislative initiatives of this sort, while no panacea, play a valuable role in signaling Congress’s intent to hold the Administration accountable for seeing to it that key Internet freedoms (including the avoidance of onerous regulation and deleterious restrictions on speech and content) are maintained. They merit thoughtful consideration.

The Religious Freedom Restoration Act (RFRA) subjects government-imposed burdens on religious exercise to strict scrutiny.  In particular, the Act provides that “[g]overnment shall not substantially burden a person’s exercise of religion even if the burden results from a rule of general applicability” unless the government can establish that doing so is the least restrictive means of furthering a “compelling government interest.”

So suppose a for-profit corporation’s stock is owned entirely by evangelical Christians with deeply held religious objections to abortion.  May our federal government force the company to provide abortifacients to its employees?  That’s the central issue in Sebelius v. Hobby Lobby Stores, which the Supreme Court will soon decide.  As is so often the case, resolution of the issue turns on a seemingly mundane matter:  Is a for-profit corporation a “person” for purposes of RFRA?

In an amicus brief filed in the case, a group of forty-four corporate and criminal law professors argued that treating corporations as RFRA persons would contradict basic principles of corporate law.  Specifically, they asserted that corporations are distinct legal entities from their shareholders, who enjoy limited liability behind a corporate veil and cannot infect the corporation with their own personal religious views.  The very nature of a corporation, the scholars argued, precludes shareholders from exercising their religion in corporate form.  Thus, for-profit corporations can’t be “persons” for purposes of RFRA.

In what amounts to an epic takedown of the law professor amici, William & Mary law professors Alan Meese and Nathan Oman have published an article explaining why for-profit corporations are, in fact, RFRA persons.  Their piece in the Harvard Law Review Forum responds methodically to the key points made by the law professor amici and to a few other arguments against granting corporations free exercise rights.

Among the arguments that Meese and Oman ably rebut are:

  • Religious freedom applies only to natural persons.

Corporations are simply instrumentalities by which people act in the world, Meese and Oman observe.  Indeed, they are nothing more than nexuses of contracts, provided in standard form but highly tailorable by those utilizing them.  “When individuals act religiously using corporations they are engaged in religious exercise.  When we regulate corporations, we in fact burden the individuals who use the corporate form to pursue their goals.”

  • Given the essence of a corporation, which separates ownership and control, for-profit corporations can’t exercise religion in accordance with the views of their stockholders.

This claim is simply false.  First, it is possible — pretty easy, in fact — to unite ownership and control in a corporation.  Business planners regularly do so using shareholder agreements, and many states, including Delaware, explicitly allow for shareholder management of close corporations.  Second, scads of for-profit corporations engage in religiously motivated behavior — i.e., religious exercise.  Meese and Oman provide a nice litany of examples (with citations omitted here):

A kosher supermarket owned by Orthodox Jews challenged Massachusetts’ Sunday closing laws in 1960.  For seventy years, the Ukrops Supermarket chain in Virginia closed on Sundays, declined to sell alcohol, and encouraged employees to worship weekly.  A small grocery store in Minneapolis with a Muslim owner prepares halal meat and avoids taking loans that require payment of interest prohibited by Islamic law.  Chick-fil-A, whose mission statement promises to “glorify God,” is closed on Sundays.  A deli that complied with the kosher standards of its Conservative Jewish owners challenged the Orthodox definition of kosher found in New York’s kosher food law, echoing a previous challenge by a different corporation of a similar New Jersey law.  Tyson Foods employs more than 120 chaplains as part of its effort to maintain a “faith-friendly” culture.  New York City is home to many Kosher supermarkets that close two hours before sundown on Friday and do not reopen until Sunday.  A fast-food chain prints citations of biblical verses on its packaging and cups.  A Jewish entrepreneur in Brooklyn runs a gas station and coffee shop that serves only Kosher food.  Hobby Lobby closes on Sundays and plays Christian music in its stores.  The company provides employees with free access to chaplains, spiritual counseling, and religiously themed financial advice.  Moreover, the company does not sell shot glasses, refuses to allow its trucks to “backhaul” beer, and lost $3.3 million after declining to lease an empty building to a liquor store.

As these examples illustrate, the assertion by lower courts that “for-profit, secular corporations cannot engage in religious exercise” is just empirically false.

  • Allowing for-profit corporations to have religious beliefs would create intracorporate conflicts that would reduce the social value of the corporate form of business.

The corporate and criminal law professor amici described a parade of horribles that would occur if corporations were deemed RFRA persons.  They insisted, for example, that RFRA protection would inject religion into a corporation in a way that “could make the raising of capital more challenging, recruitment of employees more difficult, and entrepreneurial energy less likely to flourish.”  In addition, they said, RFRA protection “would invite contentious shareholder meetings, disruptive proxy contests, and expensive litigation regarding whether the corporations should adopt a religion and, if so, which one.”

But actual experience suggests there’s no reason to worry about such speculative harms.  As Meese and Oman observe, we’ve had lots of experience with this sort of thing:  Federal and state laws already allow for-profit corporations to decline to perform or pay for certain medical procedures if they have religious or moral objections.  From the Supreme Court’s 1963 Sherbert decision to its 1990 Smith decision, strict scrutiny applied to governmental infringements on corporations’ religious exercise.  A number of states have enacted their own versions of RFRA, most of which apply to corporations.   Thus, “[f]or over half a century, … there has been no per se bar to free exercise claims by for-profit corporations, and the parade of horribles envisioned by the [law professor amici] has simply not materialized.”  Indeed, “the scholars do not cite a single example of a corporate governance dispute connected to [corporate] decisions [related to religious exercise].”

  • Permitting for-profit corporations to claim protection under RFRA will lead to all sorts of false claims of religious belief in an attempt to evade government regulation.

The law professor amici suggest that affording RFRA protection to for-profit corporations may allow such companies to evade regulatory requirements by manufacturing a religious identity.  They argue that “[c]ompanies suffering a competitive disadvantage [because of a government regulation] will simply claim a ‘Road to Damascus’ conversion.  A company will adopt a board resolution asserting a religious belief inconsistent with whatever regulation they find obnoxious . . . .”

As Meese and Oman explain, however, this problem is not unique to for-profit corporations.  Natural persons may also assert insincere religious claims, and courts may need to assess sincerity to determine if free exercise rights are being violated.  The law professor amici contend that it would be unprecedented for courts to assess whether religious beliefs are asserted in “good faith.”  But the Supreme Court decision the amici cite in support of that proposition, Meese and Oman note, held only that courts lack competence to evaluate the truth of theological assertions or the accuracy of a particular litigant’s interpretation of his faith.  “This task is entirely separate … from the question of whether a litigant’s asserted religious beliefs are sincerely held.  Courts applying RFRA have not infrequently evaluated such sincerity.”

***

In addition to rebutting the foregoing arguments (and several others) against treating for-profit corporations as RFRA persons, Meese and Oman set forth a convincing affirmative argument based on the plain text of the statute and the Dictionary Act.  I’ll let you read that one on your own.

I’ll also point interested readers to Steve Bainbridge’s fantastic work on this issue.  Here is his critique of the corporate and criminal law professors’  amicus brief.  Here is his proposal for using the corporate law doctrine of reverse veil piercing to assess a for-profit corporation’s religious beliefs.

Read it all before SCOTUS rules!

An interesting looking empirical piece from David Yermack (NYU), Tailspotting: How Disclosure, Stock Prices and Volatility Change When CEOs Fly to Their Vacation Homes.  I haven’t read it closely yet.  Here’s the abstract:

This paper shows close connections between CEOs’ vacation schedules and corporate news disclosures. Identify vacations by merging corporate jet flight histories with real estate records of CEOs’ property owned near leisure destinations. Companies disclose favorable news just before CEOs leave for vacation and delay subsequent announcements until CEOs return, releasing news at an unusually high rate on the CEO’s first day back. When CEOs are away, companies announce less news than usual and stock prices exhibit sharply lower volatility. Volatility increases immediately when CEOs return to work. CEOs spend fewer days out of the office when their ownership is high and when the weather at their vacation homes is cold or rainy.

HT: Salop.

Say on say on pay?

Larry Ribstein —  6 November 2011

“Say on pay” seems like one of those “chicken soup” ideas — at best salutary and at worst unobjectionable.  Who could object to letting the shareholders vote on executive pay?

Minor Myers, for one, in The Perils of Shareholder Voting on Executive Compensation. He suggests that “the more involved shareholders are in a firm’s managerial decisions, the more difficult it is for directors to be held accountable for the outcome of those decisions.” The shareholder vote, he argues, will insulate directors’ compensation decisions from shareholder outrage, which might otherwise have served as an important discipline.  He “proposes amending the [say on pay] legislation to allow firms to opt-out of the say on pay regime by shareholder vote. This preserves the benefits of say on pay for those firms where shareholders wish to retain it and allows other firms to exit the regime at little cost.”

This proposal makes some sense. Myers cites evidence indicating that some firms gain and others lose from say on pay.  In other words, some firms find that they benefit more from holding directors solely responsible for managerial pay than by having the (mostly disengaged) shareholders take responsibility. Indeed, Myers’ theory suggests say on pay may be a boon to greedy managers.

Although Myers would amend say on pay to make it optional, one wonders why the rule would be necessary at all.  State corporation law already provides for something like an opt-in regime by authorizing charter amendments on this issue. Myers argues that opt-out is better than opt-in because the equilibrium under the opt-in alternative would be driven by managerial opportunism.  But given shareholder inertia, I’m not persuaded the equilibrium under opt out would be any better.

In any event, the rationale for federal interference in state corporate law is the need for federal minimum standards.  If say on pay is no longer a minimum standard — if, like other corporate governance provisions it is just another default rule, with costs and benefits that vary from firm to firm — then why should it be a federal rule?

Myers’ analysis suggests that say on pay is, at best, one possible decent default rule, suitable for some firms.  If that’s the best rationale we can come up with, then it’s hard to see why we shouldn’t have federal say on all other corporate governance — in other words, a full-fledged optional federal corporate law.  Such a law could include a say on pay opt-in.  Or we could have an opt-in federal corporate law with opt out say on pay.  We could call such a statute say on say on say on pay.

Or we could just forget the whole thing.

Alison Frankel gripes about a NJ judge’s ruling throwing out a shareholders’ derivative suit seeking to hold the J & J board accountable for problems concerning the company’s Rispardal drug. Frankel thinks the bad faith standard the court applied is not high enough.

Ted Frank responds that the fact that the company had settled criminal allegations doesn’t mean the board was irresponsible given big companies’ exposure to prosecutorial overreaching (here’s my thoughts on the problems with prosecutors).  He notes that given huge potential penalties and legal costs “even a risk-neutral set of executives would refuse to go to trial on criminal charges that they had a 95% chance of winning.”  As Ted says:

The issue is this: first, any corporate law is going to have to balance false negatives (valid suits against directors being thrown out prematurely) and false positives (invalid suits against directors costing tens of millions of dollars in time and money to resolve). Any opening up of the courtroom doors to challenge directors will reduce false negatives at the expense of more false positives; any increase in the burden to bring suit will reduce false positives at the expense of more false negatives.

Anyway, Ted continues, shareholders of NJ corporations can decide to invest in firms incorporated elsewhere if they think NJ law is too lenient on directors, aptly citing my and O’Hara’s The Law Market.

Of course Frankel might argue that the business judgment rule that the court used to decide the case is ubiquitous, leaving plaintiffs with little choice. Indeed, the only significant dissent is Nevada which is, if anything, even easier on directors than NJ.   Frankel might also argue that this indicates state corporation law is rigged for managers and that we would do better under federal law.  Perhaps what we need is a super Dodd-Frank/SOX on steroids that preempts state law and exposes managers to suits like the one NJ dismissed.

I would respond that the universal acceptance of the business judgment rule represents the market’s rejection of Frankel’s position.  If Frankel wants to complain that the market for corporate law is imperfect,  she would need to persuade me that shareholders are better off in the clutches of Congress.

Yaniv Grinstein and and Stefano Rossi have an interesting paper, Good Monitoring, Bad Monitoring, on the effect of corporate law, and specifically of the famous Delaware case Smith v. Van Gorkom and the Delaware legislature’s subsequent “fix” of that result.  Here’s the abstract:

We estimate the value of monitoring in publicly traded corporations by exploiting a natural experiment. A Delaware Supreme Court decision unexpectedly held directors liable for monetary damages for breach of fiduciary duties. The ruling signaled a sharp and exogenous increase in Delaware Courts’ scrutiny over board decisions. We analyze the impact of the ruling on stock returns using matching and differences-in-differences techniques. We find that, compared with appropriately matched non-Delaware firms, Delaware-incorporated firms in high-growth industries lost (CARs of -2.10%) and firms in low-growth industries gained (CARs of 1.40%) in the [0,10] window around the announcement of the Supreme Court decision. A later regulatory reform to the Delaware Code that reversed the effects of the Supreme Court decision had opposite results: firms in high-growth industries gained and firms in low-growth industries lost significantly. Our results shed light on the complex interplay of courts and regulation and on its implications for shareholder value.

In the conclusion the authors state:  “We interpret these results as implying that “one-size-fits-all” models represent inadequate solutions to the corporate governance problem.” In other words, a strict duty of care is good for some companies but not others.

This suggests that firms should be allowed to contract to tailor regulation to their needs. But the Delaware code revision did just that — allow firms to contract.  Yet returns for low-growth firms dropped, despite the fact that the statute allowed these firms to remain subject to the strict care standard.

Does this suggest that corporate contracting is flawed?  Or what?