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The Antitrust Prohibition of Favoritism, or the Imposition of Corporate Selflessness

Aurelien Portuese — 16 December 2020

[TOTM: The following is part of a digital symposium by TOTM guests and authors on the law, economics, and policy of the antitrust lawsuits against Google. The entire series of posts is available here.]

It is my endeavor to scrutinize the questionable assessment articulated against default settings in the U.S. Justice Department’s lawsuit against Google. Default, I will argue, is no antitrust fault. Default in the Google case drastically differs from default referred to in the Microsoft case. In Part I, I argue the comparison is odious. Furthermore, in Part II, it will be argued that the implicit prohibition of default settings echoes, as per listings, the explicit prohibition of self-preferencing in search results. Both aspects – default’s implicit prohibition and self-preferencing’s explicit prohibition – are the two legs of a novel and integrated theory of sanctioning corporate favoritism. The coming to the fore of such theory goes against the very essence of the capitalist grain. In Part III, I note the attempt to instill some corporate selflessness is at odds with competition on the merits and the spirit of fundamental economic freedoms.

When Default is No-Fault

The recent complaint filed by the DOJ and 11 state attorneys general claims that Google has abused its dominant position on the search-engine market through several ways, notably making Google the default search engine both in Google Chrome web browser for Android OS and in Apple’s Safari web browser for iOS. Undoubtedly, default setting confers a noticeable advantage for users’ attraction – it is sought and enforced on purpose. Nevertheless, the default setting confers an unassailable position unless the product remains competitive. Furthermore, the default setting can hardly be proven to be anticompetitive in the Google case. Indeed, the DOJ puts considerable effort in the complaint to make the Google case resemble the 20-year-old Microsoft case. Former Federal Trade Commission Chairman William Kovacic commented: “I suppose the Justice Department is telling the court, ‘You do not have to be scared of this case. You’ve done it before […] This is Microsoft part 2.”^[1]

However, irrespective of the merits of the Microsoft case two decades ago, the Google default setting case bears minimal resemblance to the Microsoft default setting of Internet Explorer. First, as opposed to the Microsoft case, where default by Microsoft meant pre-installed software (i.e., Internet Explorer)[2], the Google case does not relate to the pre-installment of the Google search engine (since it is just a webpage) but a simple setting. This technical difference is significant: although “sticky”[3], the default setting, can be outwitted with just one click[4]. It is dissimilar to the default setting, which can only be circumvented by uninstalling software[5], searching and installing a new one[6]. Moreover, with no certainty that consumers will effectively use Google search engine, default settings come with advertising revenue sharing agreements between Google and device manufacturers, mobile phone carriers, competing browsers and Apple[7]. These mutually beneficial deals represent a significant cost with no technical exclusivity [8]. In other words, the antitrust treatment of a tie-in between software and hardware in the Microsoft case cannot be convincingly extrapolated to the default setting of a “webware”[9] as relevant in the Google case.

Second, the Google case cannot legitimately resort to extrapolating the Microsoft case for another technical (and commercial) aspect: the Microsoft case was a classic tie-in case where the tied product (Internet Explorer) was tied into the main product (Windows). As a traditional tie-in scenario, the tied product (Internet Explorer) was “consistently offered, promoted, and distributed […] as a stand-alone product separate from, and not as a component of, Windows […]”[10]. In contrast, Google has never sold Google Chrome or Android OS. It offered both Google Chrome and Android OS for free, necessarily conditional to Google search engine as default setting. The very fact that Google Chrome or Android OS have never been “stand-alone” products, to use the Microsoft case’s language, together with the absence of software installation, dramatically differentiates the features pertaining to the Google case from those of the Microsoft case. The Google case is not a traditional tie-in case: it is a case against default setting when both products (the primary and related products) are given for free, are not saleable, are neither tangible nor intangible goods but only popular digital services due to significant innovativeness and ease of usage. The Microsoft “complaint challenge[d] only Microsoft’s concerted attempts to maintain its monopoly in operating systems and to achieve dominance in other markets, not by innovation and other competition on the merits, but by tie-ins.” Quite noticeably, the Google case does not mention tie-in ,as per Google Chrome or Android OS.

The complaint only refers to tie-ins concerning Google’s app being pre-installed on Android OS. Therefore, concerning Google’s dominance on the search engine market, it cannot be said that the default setting of Google search in Android OS entails tie-in. Google search engine has no distribution channel (since it is only a website) other than through downstream partnerships (i.e., vertical deals with Android device manufacturers). To sanction default setting on downstream trading partners is tantamount to refusing legitimate means to secure distribution channels of proprietary and zero-priced services. To further this detrimental logic, it would mean that Apple may no longer offer its own apps in its own iPhones or, in offline markets, that a retailer may no longer offer its own (default) bags at the till since it excludes rivals’ sale bags. Products and services naked of any adjacent products and markets (i.e., an iPhone or Android OS with no app or a shopkeeper with no bundled services) would dramatically increase consumers’ search costs while destroying innovators’ essential distribution channels for innovative business models and providing few departures from the status quo as long as consumers will continue to value default products[11].

Default should not be an antitrust fault: the Google case makes default settings a new line of antitrust injury absent tie-ins. In conclusion, as a free webware, Google search’s default setting cannot be compared to default installation in the Microsoft case since minimal consumer stickiness entails (almost) no switching costs. As free software, Google’s default apps cannot be compared to Microsoft case either since pre-installation is the sine qua non condition of the highly valued services (Android OS) voluntarily chosen by device manufacturers. Default settings on downstream products can only be reasonably considered as antitrust injury when the dominant company is erroneously treated as a de facto essential facility – something evidenced by the similar prohibition of self-preferencing.

When Self-Preference is No Defense

Self-preferencing is to listings what the default setting is to operating systems. They both are ways to market one’s own products (i.e., alternative to marketing toward end-consumers). While default setting may come with both free products and financial payments (Android OS and advertising revenue sharing), self-preferencing may come with foregone advertising revenues in order to promote one’s own products. Both sides can be apprehended as the two sides of the same coin:[12] generating the ad-funded main product’s distribution channels – Google’s search engine. Both are complex advertising channels since both venues favor one’s own products regarding consumers’ attention. Absent both channels, the payments made for default agreements and the foregone advertising revenues in self-preferencing one’s own products would morph into marketing and advertising expenses of Google search engine toward end-consumers.

The DOJ complaint lambasts that “Google’s monopoly in general search services also has given the company extraordinary power as the gateway to the internet, which uses to promote its own web content and increase its profits.” This blame was at the core of the European Commission’s Google Shopping decision in 2017[13]: it essentially holds Google accountable for having, because of its ad-funded business model, promoted its own advertising products and demoted organic links in search results. According to which Google’s search results are no longer relevant and listed on the sole motivation of advertising revenue

But this argument is circular: should these search results become irrelevant, Google’s core business would become less attractive, thereby generating less advertising revenue. This self-inflicted inefficiency would deprive Google of valuable advertising streams and incentivize end-consumers to switch to search engine rivals such as Bing, DuckDuckGo, Amazon (product search), etc. Therefore, an ad-funded company such as Google needs to reasonably arbitrage between advertising objectives and the efficiency of its core activities (here, zero-priced organic search services). To downplay (the ad-funded) self-referencing in order to foster (the zero-priced) organic search quality would disregard the two-sidedness of the Google platform: it would harm advertisers and the viability of the ad-funded business model without providing consumers and innovation protection it aims at providing. The problematic and undesirable concept of “search neutrality” would mean algorithmic micro-management for the sake of an “objective” listing considered acceptable only to the eyes of the regulator.

Furthermore, self-preferencing entails a sort of positive discrimination toward one’s own products[14]. If discrimination has traditionally been antitrust lines of injuries, self-preferencing is an “epithet”[15] outside antitrust remits for good reasons[16]. Indeed, should self-interested (i.e., rationally minded) companies and individuals are legally complied to self-demote their own products and services? If only big (how big?) companies are legally complied to self-demote their products and services, to what extent will exempted companies involved in self-preferencing become liable to do so?

Indeed, many uncertainties, legal and economic ones, may spawn from the emerging prohibition of self-preferencing. More fundamentally, antitrust liability may clash with basic corporate governance principles where self-interestedness allows self-preferencing and command such self-promotion. The limits of antitrust have been reached when two sets of legal regimes, both applicable to companies, suggest contradictory commercial conducts. To what extent may Amazon no longer promote its own series on Amazon Video in a similar manner Netflix does? To what extent can Microsoft no longer promote Bing’s search engine to compete with Google’s search engine effectively? To what extent Uber may no longer promote UberEATS in order to compete with delivery services effectively? Not only the business of business is doing business[17], but also it is its duty for which shareholders may hold managers to account.

The self is moral; there is a corporate morality of business self-interest. In other words, corporate selflessness runs counter to business ethics since corporate self-interest yields the self’s rivalrous positioning within a competitive order. Absent a corporate self-interest, self-sacrifice may generate value destruction for the sake of some unjustified and ungrounded claims. The emerging prohibition of self-preferencing, similar to the established ban on the default setting on one’s own products into other proprietary products, materializes the corporate self’s losing. Both directions coalesce to instill the legally embedded duty of self-sacrifice for the competitor’s welfare instead of the traditional consumer welfare and the dynamics of innovation, which never unleash absent appropriabilities. In conclusion, to expect firms, however big or small, to act irrespective of their identities (i.e., corporate selflessness) would constitute an antitrust error and would be at odds with capitalism.

Toward an Integrated Theory of Disintegrating Favoritism

The Google lawsuit primarily blames Google for default settings enforced via several deals. The lawsuit also makes self-preferencing anticompetitive conduct under antitrust rules. These two charges are novel and dubious in their remits. They nevertheless represent a fundamental catalyst for the development of a new and problematic unified antitrust theory prohibiting favoritism: companies may no longer favor their products and services, both vertically and horizontally, irrespective of consumer benefits, irrespective of superior efficiency arguments, and irrespective of dynamic capabilities enhancement. Indeed, via an unreasonably expanded vision of leveraging, antitrust enforcement is furtively banning a company to favor its own products and services based on greater consumer choice as a substitute to consumer welfare, based on the protection of the opportunities of rivals to innovate and compete as a substitute to the essence of competition and innovation, and based on limiting the outreach and size of companies as a substitute to the capabilities and efficiencies of these companies. Leveraging becomes suspicious and corporate self-favoritism under accusation. The Google lawsuit materializes this impractical trend, which further enshrines the precautionary approach to antitrust enforcement[18].

[1] Jessica Guynn, Google Justice Department antitrust lawsuit explained: this is what it means for you. USA Today, October 20, 2020.

[2] The software (Internet Explorer) was tied in the hardware (Windows PC).

[3] U.S. v Google LLC, Case A:20, October 20, 2020, 3 (referring to default settings as “especially sticky” with respect to consumers’ willingness to change).

[4] While the DOJ affirms that “being the preset default general search engine is particularly valuable because consumers rarely change the preset default”, it nevertheless provides no evidence of the breadth of such consumer stickiness. To be sure, search engine’s default status does not necessarily lead to usage as evidenced by the case of South Korea. In this country, despite Google’s preset default settings, the search engine Naver remains dominant in the national search market with over 70% of market shares. The rivalry exerted by Naver on Google demonstrates that limits of consumer stickiness to default settings. See Alesia Krush, Google vs. Naver: Why Can’t Google Dominate Search in Korea? Link-Assistant.Com, available at: https://www.link-assistant.com/blog/google-vs-naver-why-cant-google-dominate-search-in-korea/ . As dominant search engine in Korea, Naver is subject to antitrust investigations with similar leveraging practices as Google in other countries, see Shin Ji-hye, FTC sets up special to probe Naver, Google, The Korea Herald, November 19, 2019, available at : http://www.koreaherald.com/view.php?ud=20191119000798 ; Kim Byung-wook, Complaint against Google to be filed with FTC, The Investor, December 14, 2020, available at : https://www.theinvestor.co.kr/view.php?ud=20201123000984 (reporting a complaint by Naver and other Korean IT companies against Google’s 30% commission policy on Google Play Store’s apps).

[5] For instance, the then complaint acknowledged that “Microsoft designed Windows 98 so that removal of Internet Explorer by OEMs or end users is operationally more difficult than it was in Windows 95”, in U.S. v Microsoft Corp., Civil Action No 98-1232, May 18, 1998, para.20.

[6] The DOJ complaint itself quotes “one search competitor” who is reported to have noted consumer stickiness “despite the simplicity of changing a default setting to enable customer choice […]” (para.47). Therefore, default setting for search engine is remarkably simple to bypass but consumers do not often do so, either due to satisfaction with Google search engine and/or due to search and opportunity costs.

[7] See para.56 of the DOJ complaint.

[8] Competing browsers can always welcome rival search engines and competing search engine apps can always be downloaded despite revenue sharing agreements. See paras.78-87 of the DOJ complaint.

[9] Google search engine is nothing but a “webware” – a complex set of algorithms that work via online access of a webpage with no prior download. For a discussion on the definition of webware, see https://www.techopedia.com/definition/4933/webware .

[10] Id. para.21.

[11] Such outcome would frustrate traditional ways of offering computers and mobile devices as acknowledged by the DOJ itself in the Google complaint: “new computers and new mobile devices generally come with a number of preinstalled apps and out-of-the-box setting. […] Each of these search access points can and almost always does have a preset default general search engine”, at para. 41. Also, it appears that present default general search engine is common commercial practices since, as the DOJ complaint itself notes when discussing Google’s rivals (Microsoft’s Bing and Amazon’s Fire OS), “Amazon preinstalled its own proprietary apps and agreed to make Microsoft’s Bing the preset default general search engine”, in para.130. The complaint fails to identify alternative search engines which are not preset defaults, thus implicitly recognizing this practice as a widespread practice.

[12] To use Vesterdof’s language, see Bo Vesterdorf, Theories of Self-Preferencing and Duty to Deal – Two Sides of the Same Coin, Competition Law & Policy Debate 1(1) 4, (2015). See also Nicolas Petit, Theories of Self-Preferencing under Article 102 TFEU: A Reply to Bo Vesterdorf, 5-7 (2015).

[13] Case 39740 Google Search (Shopping). Here the foreclosure effects of self-preferencing are only speculated: « the Commission is not required to prove that the Conduct has the actual effect of decreasing traffic to competing comparison shopping services and increasing traffic to Google’s comparison-shopping service. Rather, it is sufficient for the Commission to demonstrate that the Conduct is capable of having, or likely to have, such effects.” (para.601 of the Decision). See P. Ibáñez Colomo, Indispensability and Abuse of Dominance: From Commercial Solvents to Slovak Telekom and Google Shopping, 10 Journal of European Competition Law & Practice 532 (2019); Aurelien Portuese, When Demotion is Competition: Algorithmic Antitrust Illustrated, Concurrences, no 2, May 2018, 25-37; Aurelien Portuese, Fine is Only One Click Away, Symposium on the Google Shopping Decision, Case Note, 3 Competition and Regulatory Law Review, (2017).

[14] For a general discussion on law and economics of self-preferencing, see Michael A. Salinger, Self-Preferencing, Global Antitrust Institute Report, 329-368 (2020).

[15]Pablo Ibanez Colomo, Self-Preferencing: Yet Another Epithet in Need of Limiting Principles, 43 World Competition (2020) (concluding that self-preferencing is « misleading as a legal category »).

[16] See, for instances, Pedro Caro de Sousa, What Shall We Do About Self-Preferencing? Competition Policy International, June 2020.

[17] Milton Friedman, The Social Responsibility of Business is to Increase Its Profits, New York Times, September 13, 1970. This echoes Adam Smith’s famous statement that « It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard for their own self-interest » from the 1776 Wealth of Nations. In Ayn Rand’s philosophy, the only alternative to rational self-interest is to sacrifice one’s own interests either for fellowmen (altruism) or for supernatural forces (mysticism). See Ayn Rand, The Objectivist Ethics, in The Virtue of Selfishness, Signet, (1964).

[18] Aurelien Portuese, European Competition Enforcement and the Digital Economy : The Birthplace of Precautionary Antitrust, Global Antitrust Institute’s Report on the Digital Economy, 597-651.

Preventing Pandemic Profiteering

Daniel Takash — 2 April 2020

[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 Daniel Takash,(Regulatory policy fellow at the Niskanen Center. He is the manager of Niskanen’s Captured Economy Project, https://capturedeconomy.com, and you can follow him @danieltakash or @capturedecon).]

The pharmaceutical industry should be one of the most well-regarded industries in America. It helps bring drugs to market that improve, and often save, people’s lives. Yet last year a Gallup poll found that of 25 major industries, the pharmaceutical industry was the most unpopular– trailing behind fossil fuels, lawyers, and even the federal government. The opioid crisis dominated the headlines for the past few years, but the high price of drugs is a top-of-mind issue that generates significant animosity toward the pharmaceutical industry. The effects of high drug prices are felt not just at every trip to the pharmacy, but also by those who are priced out of life-saving treatments. Many Americans simply can’t afford what their doctors prescribe. The pharmaceutical industry helps save lives, but it’s also been credibly accused of anticompetitive behavior–not just from generics, but even other brand manufacturers.

These extraordinary times are an opportunity to right the ship. AbbVie, roundly criticized for building a patent thicket around Humira, has donated its patent rights to a promising COVID-19 treatment. This is to be celebrated– yet pharma’s bad reputation is defined by its worst behaviors and the frequent apologetics for overusing the patent system. Hopefully corporate social responsibility will prevail, and such abuses will cease in the future.

The most effective long-term treatment for COVID-19 will be a vaccine. We also need drugs to treat those afflicted with COVID-19 to improve recovery and lower mortality rates for those that get sick before a vaccine is developed and widely available. This requires rapid drug development through effective public-private partnerships to bring these treatments to market.

Without a doubt, these solutions will come from the pharmaceutical industry. Increased funding for the National Institutes for Health, nonprofit research institutions, and private pharmaceutical researchers are likely needed to help accelerate the development of these treatments. But we must be careful to ensure whatever necessary upfront public support is given to these entities results in a fair trade-off for Americans. The U.S. taxpayer is one of the largest investors in early to mid-stage drug research, and we need to make sure that we are a good investor.

Basic research into the costs of drug development, especially when taxpayer subsidies are involved, is a necessary start. This is a feature of the We PAID Act, introduced by Senators Rick Scott (R-FL) and Chris Van Hollen (D-MD), which requires the Department of Health and Human Services to enter into a contract with the National Academy of Medicine to figure the reasonable price of drugs developed with taxpayer support. This reasonable price would include a suitable reward to the private companies that did the important work of finishing drug development and gaining FDA approval. This is important, as setting a price too low would reduce investments in indispensable research and development. But this must be balanced with the risk of using patents to charge prices above and beyond those necessary to finance research, development, and commercialization.

A little sunshine can go a long way. We should trust that pharmaceutical companies will develop a vaccine and treatments or coronavirus, but we must also verify these are affordable and accessible through public scrutiny. Take the drug manufacturer Gilead Science’s about-face on its application for orphan drug status on the possible COVID-19 treatment remdesivir. Remedesivir, developed in part with public funds and already covered by three Gilead patents, technically satisfied the definition of “orphan drug,” as COVID-19 (at the time of the application) afflicted fewer than 200,000 patents. In a pandemic that could infect tens of millions of Americans, this designation is obviously absurd, and public outcry led to Gilead to ask the FDA to rescind the application. Gilead claimed it sought the designation to speed up FDA review, and that might be true. Regardless, public attention meant that the FDA will give Gilead’s drug Remdesivir expedited review without Gilead needing a designation that looks unfair to the American people.

The success of this isolated effort is absolutely worth celebrating. But we need more research to better comprehend the pharmaceutical industry’s needs, and this is just what the study provisions of We PAID would provide.

There is indeed some existing research on this front. For example,the Pharmaceutical Researchers and Manufacturers of America (PhRMA) estimates it costs an average of $2.6 billion to bring a new drug to market, and research from the Journal of the American Medical Association finds this average to be closer to $1.3 billion, with the median cost of development to be $985 million.

But a thorough analysis provided under We PAID is the best way for us to fully understand just how much support the pharmaceutical industry needs, and just how successful it has been thus far. The NIH, one of the major sources of publicly funded research, invests about $41.7 billion annually in medical research. We need to better understand how these efforts link up, and how the torch is passed from public to private efforts.

Patents are essential to the functioning of the pharmaceutical industry by incentivizing drug development through temporary periods of exclusivity. But it is equally essential, in light of the considerable investment already made by taxpayers in drug research and development, to make sure we understand the effects of these incentives and calibrate them to balance the interests of patients and pharmaceutical companies. Most drugs require research funding from both public and private sources as well as patent protection. And the U.S. is one of the biggest investors of drug research worldwide (even compared to drug companies), yet Americans pay the highest prices in the world. Are these prices justified, and can we improve patent policy to bring these costs down without harming innovation?

Beyond a thorough analysis of drug pricing, what makes We PAID one of the most promising solutions to the problem of excessively high drug prices are the accountability mechanisms included. The bill, if made law, would establish a Drug Access and Affordability Committee. The Committee would use the methodology from the joint HHS and NAM study to determine a reasonable price for affected drugs (around 20 percent of drugs currently on the market, if the bill were law today). Any companies that price drugs granted exclusivity by a patent above the reasonable price would lose their exclusivity.

This may seem like a price control at first blush, but it isn’t–for two reasons. First, this only applies to drugs developed with taxpayer dollars, which any COVID-19 treatments or cures almost certainly would be considering the $785 million spent by the NIH since 2002 researching coronaviruses. It’s an accountability mechanism that would ensure the government is getting its money’s worth. This tool is akin to ensuring that a government contractor is not charging more than would be reasonable, lest it loses its contract.

Second, it is even less stringent than pulling a contract with a private firm overcharging the government for the services provided. Why? Losing a patent does not mean losing the ability to make a drug, or any other patented invention for that matter.This basic fact is often lost in the patent debate, but it cannot be stressed enough.

If patents functioned as licenses, then every patent expiration would mean another product going off the market. In reality, that means that any other firm can compete and use the patented design. Even if a firm violated the price regulations included in the bill and lost its patent, it could continue manufacturing the drug. And so could any other firm, bringing down prices for all consumers by opening up market competition.

The We PAID Act could be a dramatic change for the drug industry, and because of that many in Congress may want to first debate the particulars of the bill. This is fine, assuming this promising legislation isn’t watered down beyond recognition. But any objections to the Drug Affordability and Access Committee and reasonable pricing regulations aren’t an excuse to not, at a bare minimum, pass the study included in the bill as part of future coronavirus packages, if not sooner. It is an inexpensive way to get good information in a single, reputable source that would allow us to shape good policy.

Good information is needed for good policy. When the government lays the groundwork for future innovations by financing research and development, it can be compared to a venture capitalist providing the financing necessary for an innovative product or service. But just like in the private sector, the government should know what it’s getting for its (read: taxpayers’) money and make recipients of such funding accountable to investors.

The COVID-19 outbreak will be the most pressing issue for the foreseeable future, but determining how pharmaceuticals developed with public research are priced is necessary in good times and bad. The final prices for these important drugs might be fair, but the public will never know without a trusted source examining this information. Trust, but verify. The pharmaceutical industry’s efforts in fighting the COVID-19 pandemic might be the first step to improving Americans’ relationship with the industry. But we need good information to make that happen. Americans need to know when they are being treated fairly, and that policymakers are able to protect them when they are treated unfairly. The government needs to become a better-informed investor, and that won’t happen without something like the We PAID Act.

Buyback Backlash: Is the Ban Non-binding?

Eric Fruits — 27 March 2020

[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.

In Banking, Corporate & Securities Law, COVID-19, Financial Regulation, Google, International Center for Law & Economics, Platforms, Regulation, The Law, Economics, and Policy of the COVID-19 Pandemic, Truth on the Market corporate buybacks, corporate governance, corporate law, corporate social responsibility, COVID, New York Times, stimulus, takeovers

The European Commission’s Google Android decision takes a mistaken, ahistorical view of the smartphone market

Julian Morris — 23 July 2018

What to make of Wednesday’s decision by the European Commission alleging that Google has engaged in anticompetitive behavior? In this post, I contrast the European Commission’s (EC) approach to competition policy with US antitrust, briefly explore the history of smartphones and then discuss the ruling.

Asked about the EC’s decision the day it was announced, FTC Chairman Joseph Simons noted that, while the market is concentrated, Apple and Google “compete pretty heavily against each other” with their mobile operating systems, in stark contrast to the way the EC defined the market. Simons also stressed that for the FTC what matters is not the structure of the market per se but whether or not there is harm to the consumer. This again contrasts with the European Commission’s approach, which does not require harm to consumers. As Simons put it:

Once they [the European Commission] find that a company is dominant… that imposes upon the company kind of like a fairness obligation irrespective of what the effect is on the consumer. Our regulatory… our antitrust regime requires that there be a harm to consumer welfare — so the consumer has to be injured — so the two tests are a little bit different.

Indeed, and as the history below shows, the popularity of Apple’s iOS and Google’s Android operating systems arose because they were superior products — not because of anticompetitive conduct on the part of either Apple or Google. On the face of it, the conduct of both Apple and Google has led to consumer benefits, not harms. So, from the perspective of U.S. antitrust authorities, there is no reason to take action.

Moreover, there is a danger that by taking action as the EU has done, competition and innovation will be undermined — which would be a perverse outcome indeed. These concerns were reflected in a statement by Senator Mike Lee (R-UT):

Today’s decision by the European Commission to fine Google over $5 billion and require significant changes to its business model to satisfy EC bureaucrats has the potential to undermine competition and innovation in the United States,” Sen. Lee said. “Moreover, the decision further demonstrates the different approaches to competition policy between U.S. and EC antitrust enforcers. As discussed at the hearing held last December before the Senate’s Subcommittee on Antitrust, Competition Policy & Consumer Rights, U.S. antitrust agencies analyze business practices based on the consumer welfare standard. This analytical framework seeks to protect consumers rather than competitors. A competitive marketplace requires strong antitrust enforcement. However, appropriate competition policy should serve the interests of consumers and not be used as a vehicle by competitors to punish their successful rivals.

Ironically, the fundamental basis for the Commission’s decision is an analytical framework developed by economists at Harvard in the 1950s, which presumes that the structure of a market determines the conduct of the participants, which in turn presumptively affects outcomes for consumers. This “structure-conduct-performance” paradigm has been challenged both theoretically and empirically (and by “challenged,” I mean “demolished”).

Maintaining, as EC Commissioner Vestager has, that “What would serve competition is to have more players,” is to adopt a presumption regarding competition rooted in the structure of the market, without sufficient attention to the facts on the ground. As French economist Jean Tirole noted in his Nobel Prize lecture:

Economists accordingly have advocated a case-by-case or “rule of reason” approach to antitrust, away from rigid “per se” rules (which mechanically either allow or prohibit certain behaviors, ranging from price-fixing agreements to resale price maintenance). The economists’ pragmatic message however comes with a double social responsibility. First, economists must offer a rigorous analysis of how markets work, taking into account both the specificities of particular industries and what regulators do and do not know….

Second, economists must participate in the policy debate…. But of course, the responsibility here goes both ways. Policymakers and the media must also be willing to listen to economists.

In good Tirolean fashion, we begin with an analysis of how the market for smartphones developed. What quickly emerges is that the structure of the market is a function of intense competition, not its absence. And, by extension, mandating a different structure will likely impede competition, or, at the very least, will not likely contribute to it.

A brief history of smartphone competition

In 2006, Nokia’s N70 became the first smartphone to sell more than a million units. It was a beautiful device, with a simple touch screen interface and real push buttons for numbers. The following year, Apple released its first iPhone. It sold 7 million units — about the same as Nokia’s N95 and slightly less than LG’s Shine. Not bad, but paltry compared to the sales of Nokia’s 1200 series phones, which had combined sales of over 250 million that year — about twice the total of all smartphone sales in 2007.

By 2017, smartphones had come to dominate the market, with total sales of over 1.5 billion. At the same time, the structure of the market has changed dramatically. In the first quarter of 2018, Apple’s iPhone X and iPhone 8 were the two best-selling smartphones in the world. In total, Apple shipped just over 52 million phones, accounting for 14.5% of the global market. Samsung, which has a wider range of devices, sold even more: 78 million phones, or 21.7% of the market. At third and fourth place were Huawei (11%) and Xiaomi (7.5%). Nokia and LG didn’t even make it into the top 10, with market shares of only 3% and 1% respectively.

Several factors have driven this highly dynamic market. Dramatic improvements in cellular data networks have played a role. But arguably of greater importance has been the development of software that offers consumers an intuitive and rewarding experience.

Apple’s iOS and Google’s Android operating systems have proven to be enormously popular among both users and app developers. This has generated synergies — or what economists call network externalities — as more apps have been developed, so more people are attracted to the ecosystem and vice versa, leading to a virtuous circle that benefits both users and app developers.

By contrast, Nokia’s early smartphones, including the N70 and N95, ran Symbian, the operating system developed for Psion’s handheld devices, which had a clunkier user interface and was more difficult to code — so it was less attractive to both users and developers. In addition, Symbian lacked an effective means of solving the problem of fragmentation of the operating system across different devices, which made it difficult for developers to create apps that ran across the ecosystem — something both Apple (through its closed system) and Google (through agreements with carriers) were able to address. Meanwhile, Java’s MIDP used in LG’s Shine, and its successor J2ME imposed restrictions on developers (such as prohibiting access to files, hardware, and network connections) that seem to have made it less attractive than Android.

The relative superiority of their operating systems enabled Apple and the manufacturers of Android-based phones to steal a march on the early leaders in the smartphone revolution.

The fact that Google allows smartphone manufacturers to install Android for free, distributes Google Play and other apps in a free bundle, and pays such manufacturers for preferential treatment for Google Search, has also kept the cost of Android-based smartphones down. As a result, Android phones are the cheapest on the market, providing a powerful experience for as little as $50. It is reasonable to conclude from this that innovation, driven by fierce competition, has led to devices, operating systems, and apps that provide enormous benefits to consumers.

The Commission decision would harm device manufacturers, app developers and consumers

The EC’s decision seems to disregard the history of smartphone innovation and competition and their ongoing consequences. As Dirk Auer explains, the Open Handset Alliance (OHA) was created specifically to offer an effective alternative to Apple’s iPhone — and it worked. Indeed, it worked so spectacularly that Android is installed on about 80% of all new phones. This success was the result of several factors that the Commission now seeks to undermine:

First, in order to maintain order within the Android universe, and thereby ensure that apps developed for Android would function on the vast majority of Android devices, Google and the OHA sought to limit the extent to which Android “forks” could be created. (Apple didn’t face this problem because its source code is proprietary, so cannot be modified by third-party developers.) One way Google does this is by imposing restrictions on the licensing of its proprietary apps, such as the Google Play store (a repository of apps, similar to Apple’s App Store).

Device manufacturers that don’t conform to these restrictions may still build devices with their forked version of Android — but without those Google apps. Indeed, Amazon chooses to develop a non-conforming version of Android and built its own app repository for its Fire devices (though it is still possible to add the Google Play Store). That strategy seems to be working for Amazon in the tablet market; in 2017 it rose past Samsung to become the second biggest manufacturer of tablets worldwide, after Apple.

Second, in order to be able to offer Android for free to smartphone manufacturers, Google sought to develop unique revenue streams (because, although the software is offered for free, it turns out that software developers generally don’t work for free). The main way Google did this was by requiring manufacturers that choose to install Google Play also to install its browser (Chrome) and search tools, which generate revenue from advertising. At the same time, Google kept its platform open by permitting preloads of rivals’ apps and creating a marketplace where rivals can also reach scale. Mozilla’s Firefox browser, for example, has been downloaded over 100 million times on Android.

The importance of these factors to the success of Android is acknowledged by the EC. But instead of treating them as legitimate business practices that enabled the development of high-quality, low-cost smartphones and a universe of apps that benefits billions of people, the Commission simply asserts that they are harmful, anticompetitive practices.

For example, the Commission asserts that

In order to be able to pre-install on their devices Google’s proprietary apps, including the Play Store and Google Search, manufacturers had to commit not to develop or sell even a single device running on an Android fork. The Commission found that this conduct was abusive as of 2011, which is the date Google became dominant in the market for app stores for the Android mobile operating system.

This is simply absurd, to say nothing of ahistorical. As noted, the restrictions on Android forks plays an important role in maintaining the coherency of the Android ecosystem. If device manufacturers were able to freely install Google apps (and other apps via the Play Store) on devices running problematic Android forks that were unable to run the apps properly, consumers — and app developers — would be frustrated, Google’s brand would suffer, and the value of the ecosystem would be diminished. Extending this restriction to all devices produced by a specific manufacturer, regardless of whether they come with Google apps preinstalled, reinforces the importance of the prohibition to maintaining the coherency of the ecosystem.

It is ridiculous to say that something (efforts to rein in Android forking) that made perfect sense until 2011 and that was central to the eventual success of Android suddenly becomes “abusive” precisely because of that success — particularly when the pre-2011 efforts were often viewed as insufficient and unsuccessful (a January 2012 Guardian Technology Blog post, “How Google has lost control of Android,” sums it up nicely).

Meanwhile, if Google is unable to tie pre-installation of its search and browser apps to the installation of its app store, then it will have less financial incentive to continue to maintain the Android ecosystem. Or, more likely, it will have to find other ways to generate revenue from the sale of devices in the EU — such as charging device manufacturers for Android or Google Play. The result is that consumers will be harmed, either because the ecosystem will be degraded, or because smartphones will become more expensive.

The troubling absence of Apple from the Commission’s decision

In addition, the EC’s decision is troublesome in other ways. First, for its definition of the market. The ruling asserts that “Through its control over Android, Google is dominant in the worldwide market (excluding China) for licensable smart mobile operating systems, with a market share of more than 95%.” But “licensable smart mobile operating systems” is a very narrow definition, as it necessarily precludes operating systems that are not licensable — such as Apple’s iOS and RIM’s Blackberry OS. Since Apple has nearly 25% of the market share of smartphones in Europe, the European Commission has — through its definition of the market — presumed away the primary source of effective competition. As Pinar Akman has noted:

How can Apple compete with Google in the market as defined by the Commission when Apple allows only itself to use its operating system only on devices that Apple itself manufactures?

The EU then invents a series of claims regarding the lack of competition with Apple:

end user purchasing decisions are influenced by a variety of factors (such as hardware features or device brand), which are independent from the mobile operating system;

It is not obvious that this is evidence of a lack of competition. A better explanation is that the EU’s narrow definition of the market is defective. In fact, one could easily draw the opposite conclusion of that drawn by the Commission: the fact that purchasing decisions are driven by various factors suggests that there is substantial competition, with phone manufacturers seeking to design phones that offer a range of features, on a number of dimensions, to best capture diverse consumer preferences. They are able to do this in large part precisely because consumers are able to rely upon a generally similar operating system and continued access to the apps that they have downloaded. As Tim Cook likes to remind his investors, Apple is quite successful at targeting “Android switchers” to switch to iOS.

Apple devices are typically priced higher than Android devices and may therefore not be accessible to a large part of the Android device user base;

And yet, in the first quarter of 2018, Apple phones accounted for five of the top ten selling smartphones worldwide. Meanwhile, several competing phones, including the fifth and sixth best-sellers, Samsung’s Galaxy S9 and S9+, sell for similar prices to the most expensive iPhones. And a refurbished iPhone 6 can be had for less than $150.

Android device users face switching costs when switching to Apple devices, such as losing their apps, data and contacts, and having to learn how to use a new operating system;

This is, of course, true for any system switch. And yet the growing market share of Apple phones suggests that some users are willing to part with those sunk costs. Moreover, the increasing predominance of cloud-based and cross-platform apps, as well as Apple’s own “Move to iOS” Android app (which facilitates the transfer of users’ data from Android to iOS), means that the costs of switching border on trivial. As mentioned above, Tim Cook certainly believes in “Android switchers.”

even if end users were to switch from Android to Apple devices, this would have limited impact on Google’s core business. That’s because Google Search is set as the default search engine on Apple devices and Apple users are therefore likely to continue using Google Search for their queries.

This is perhaps the most bizarre objection of them all. The fact that Apple chooses to install Google search as the default demonstrates that consumers prefer that system over others. Indeed, this highlights a fundamental problem with the Commission’s own rationale, As Akman notes:

It is interesting that the case appears to concern a dominant undertaking leveraging its dominance from a market in which it is dominant (Google Play Store) into another market in which it is also dominant (internet search). As far as this author is aware, most (if not all?) cases of tying in the EU to date concerned tying where the dominant undertaking leveraged its dominance in one market to distort or eliminate competition in an otherwise competitive market.

Conclusion

As the foregoing demonstrates, the EC’s decision is based on a fundamental misunderstanding of the nature and evolution of the market for smartphones and associated applications. The statement by Commissioner Vestager quoted above — that “What would serve competition is to have more players” — belies this misunderstanding and highlights the erroneous assumptions underpinning the Commission’s analysis, which is wedded to a theory of market competition that was long ago thrown out by economists.

And, thankfully, it appears that the FTC Chairman is aware of at least some of the flaws in the EC’s conclusions.

Google will undoubtedly appeal the Commission’s decision. For the sakes of the millions of European consumers who rely on Android-based phones and the millions of software developers who provide Android apps, let’s hope that they succeed.

The Internet Association’s vision for the future looks a lot like the past

Neil Turkewitz — 23 November 2016

Last week, the Internet Association (“IA”) — a trade group representing some of America’s most dynamic and fastest growing tech companies, including the likes of Google, Facebook, Amazon, and eBay — presented the incoming Trump Administration with a ten page policy paper entitled “Policy Roadmap for New Administration, Congress.”

The document’s content is not surprising, given its source: It is, in essence, a summary of the trade association’s members’ preferred policy positions, none of which is new or newly relevant. Which is fine, in principle; lobbying on behalf of members is what trade associations do — although we should be somewhat skeptical of a policy document that purports to represent the broader social welfare while it advocates for members’ preferred policies.

Indeed, despite being labeled a “roadmap,” the paper is backward-looking in certain key respects — a fact that leads to some strange syntax: “[the document is a] roadmap of key policy areas that have allowed the internet to grow, thrive, and ensure its continued success and ability to create jobs throughout our economy” (emphasis added). Since when is a “roadmap” needed to identify past policies? Indeed, as Bloomberg News reporter, Joshua Brustein, wrote:

The document released Monday is notable in that the same list of priorities could have been sent to a President-elect Hillary Clinton, or written two years ago.

As a wishlist of industry preferences, this would also be fine, in principle. But as an ostensibly forward-looking document, aimed at guiding policy transition, the IA paper is disappointingly un-self-aware. Rather than delineating an agenda aimed at improving policies to promote productivity, economic development and social cohesion throughout the economy, the document is overly focused on preserving certain regulations adopted at the dawn of the Internet age (when the internet was capitalized). Even more disappointing given the IA member companies’ central role in our contemporary lives, the document evinces no consideration of how Internet platforms themselves should strive to balance rights and responsibilities in new ways that promote meaningful internet freedom.

In short, the IA’s Roadmap constitutes a policy framework dutifully constructed to enable its members to maintain the status quo. While that might also serve to further some broader social aims, it’s difficult to see in the approach anything other than a defense of what got us here — not where we go from here.

To take one important example, the document reiterates the IA’s longstanding advocacy for the preservation of the online-intermediary safe harbors of the 20 year-old Digital Millennium Copyright Act (“DMCA”) — which were adopted during the era of dial-up, and before any of the principal members of the Internet Association even existed. At the same time, however, it proposes to reform one piece of legislation — the Electronic Communications Privacy Act (“ECPA”) — precisely because, at 30 years old, it has long since become hopelessly out of date. But surely if outdatedness is a justification for asserting the inappropriateness of existing privacy/surveillance legislation — as seems proper, given the massive technological and social changes surrounding privacy — the same concern should apply to copyright legislation with equal force, given the arguably even-more-substantial upheavals in the economic and social role of creative content in society today.

Of course there “is more certainty in reselling the past, than inventing the future,” but a truly valuable roadmap for the future from some of the most powerful and visionary companies in America should begin to tackle some of the most complicated and nuanced questions facing our country. It would be nice to see a Roadmap premised upon a well-articulated theory of accountability across all of the Internet ecosystem in ways that protect property, integrity, choice and other essential aspects of modern civil society.

Each of IA’s companies was principally founded on a vision of improving some aspect of the human condition; in many respects they have succeeded. But as society changes, even past successes may later become inconsistent with evolving social mores and economic conditions, necessitating thoughtful introspection and, often, policy revision. The IA can do better than pick and choose from among existing policies based on unilateral advantage and a convenient repudiation of responsibility.

In Amazon, Copyright, Facebook, Google, Intellectual Property, Platforms, Regulation, Regulatory Reform copyright, corporate social responsibility, DMCA, ECPA, IA, internet, Internet Association, political economy, politics, safe harbors

Appropriate humility from Verizon over corporations’ role in stopping NSA surveillance

Geoffrey Manne — 24 September 2013

Like most libertarians I’m concerned about government abuse of power. Certainly the secrecy and seeming reach of the NSA’s information gathering programs is worrying. But we can’t and shouldn’t pretend like there are no countervailing concerns (as Gordon Crovitz points out). And we certainly shouldn’t allow the fervent ire of the most radical voices — those who view the issue solely from one side — to impel technology companies to take matters into their own hands. At least not yet.

Rather, the issue is inherently political. And while the political process is far from perfect, I’m almost as uncomfortable with the radical voices calling for corporations to “do something,” without evincing any nuanced understanding of the issues involved.

Frankly, I see this as of a piece with much of the privacy debate that points the finger at corporations for collecting data (and ignores the value of their collection of data) while identifying government use of the data they collect as the actual problem. Typically most of my cyber-libertarian friends are with me on this: If the problem is the government’s use of data, then attack that problem; don’t hamstring corporations and the benefits they confer on consumers for the sake of a problem that is not of their making and without regard to the enormous costs such a solution imposes.

Verizon, unlike just about every other technology company, seems to get this. In a recent speech, John Stratton, head of Verizon’s Enterprise Solutions unit, had this to say:

“This is not a question that will be answered by a telecom executive, this is not a question that will be answered by an IT executive. This is a question that must be answered by societies themselves.”

“I believe this is a bigger issue, and press releases and fizzy statements don’t get at the issue; it needs to be solved by society.”

Stratton said that as a company, Verizon follows the law, and those laws are set by governments.

“The laws are not set by Verizon, they are set by the governments in which we operate. I think its important for us to recognise that we participate in debate, as citizens, but as a company I have obligations that I am going to follow.“

I completely agree. There may be a problem, but before we deputize corporations in the service of even well-meaning activism, shouldn’t we address this as the political issue it is first?

I’ve been making a version of this point for a long time. As I said back in 2006:

I find it interesting that the “blame” for privacy incursions by the government is being laid at Google’s feet. Google isn’t doing the . . . incursioning, and we wouldn’t have to saddle Google with any costs of protection (perhaps even lessening functionality) if we just nipped the problem in the bud. Importantly, the implication here is that government should not have access to the information in question–a decision that sounds inherently political to me. I’m just a little surprised to hear anyone (other than me) saying that corporations should take it upon themselves to “fix” government policy by, in effect, destroying records.

But at the same time, it makes some sense to look to Google to ameliorate these costs. Google is, after all, responsive to market forces, and (once in a while) I’m sure markets respond to consumer preferences more quickly and effectively than politicians do. And if Google perceives that offering more protection for its customers can be more cheaply done by restraining the government than by curtailing its own practices, then Dan [Solove]’s suggestion that Google take the lead in lobbying for greater legislative protections of personal information may come to pass. Of course we’re still left with the problem of Google and not the politicians bearing the cost of their folly (if it is folly).

As I said then, there may be a role for tech companies to take the lead in lobbying for changes. And perhaps that’s what’s happening. But the impetus behind it — the implicit threats from civil liberties groups, the position that there can be no countervailing benefits from the government’s use of this data, the consistent view that corporations should be forced to deal with these political problems, and the predictable capitulation (and subsequent grandstanding, as Stratton calls it) by these companies is not the right way to go.

I applaud Verizon’s stance here. Perhaps as a society we should come out against some or all of the NSA’s programs. But ideological moralizing and corporate bludgeoning aren’t the way to get there.

In Data Privacy & Security, Google, Platforms, Telecommunications corporate social responsibility, cost-benefit analysis, John Stratton, national security, National Security Agency, NSA, politics, privacy, Surveilance, Verizon, Verizon Communications

Hating Capitalism

Paul H. Rubin — 13 May 2012

One topic that has long interested me is the source of dislike or hatred of capitalism; my Southern Economics Journal article “Folk Economics” (ungated version) dealt in part with this topic. Today’s New York Times has an op-ed, “Capitalists and Other Psychopaths” by William Deresiewicz, who has taught English at Yale and Columbia, that both illustrates and explains this hatred. What is interesting about this column is that it is entirely about the character and behavior of “the rich” including entrepreneurs. The job creating function of business is briefly mentioned but most of the article focuses on “fraud, tax evasion, toxic dumping, product safety violations, bid rigging, overbilling, perjury.”

What is nowhere mentioned is anything to do with the goods and services produced by business. This is a common attitude of critics of capitalism. In many cases, capitalists may suffer the same personality defects as the rest of us. And, as Mr. Deresiewicz points out, scientists, artists and scholars may also be hard working and smart. But capitalism does not reward moral worth or hard work. Capitalism rewards providing stuff that other people are willing to pay for. While is is easy to point out the stupidity of the critique (Mr. Deresiewicz has written and seems proud of his book, published by a capitalist publisher and available from various capitalist booksellers) that is not my point. Rather, this column is interesting in that it is a pristine example of a totally irrelevant critique of capitalism, written by what is a smart person. He does cite Adam Smith, but seems to misunderstand the basic functioning of markets. Markets reward what one does, not what one is.

In Truth on the Market corporate social responsibility, entrepreneurship, New York Times

Incentive pay for bank regulators

Larry Ribstein — 9 September 2011

Now that regulating banker pay has been studied exhaustively, here’s something else worth studying: bank regulator pay. Fred Tung and Todd Henderson are on the case, in Pay for Regulator Performance. Here’s the abstract:

Few doubt that executive compensation arrangements encouraged the excessive risk taking by banks that led to the recent Financial Crisis. Accordingly, academics and lawmakers have called for the reform of banker pay practices. In this Article, we argue that regulator pay is to blame as well, and that fixing it may be easier and more effective than reforming banker pay. Regulatory failures during the Financial Crisis resulted at least in part from a lack of sufficient incentives for examiners to act aggressively to prevent excessive risk. Bank regulators are rarely paid for performance, and in atypical cases involving performance bonus programs, the bonuses have been allocated in highly inefficient ways. We propose that regulators, specifically bank examiners, be compensated with a debt-heavy mix of phantom bank equity and debt, as well as a separate bonus linked to the timing of the decision to shut down a bank. Our pay-for-performance approach for regulators would help reduce the incidence of future regulatory failures

This is an interesting and well-executed idea which inspired a few thoughts.

First, if private-sector-type compensation for regulators is worthwhile, why not just rely on private sector rather than government regulators? It would seem that the difference between government and private industry is really all about incentives. Indeed, if we only semi-privatize by injecting market incentives into government actors, this could create tension in incentives analogous to imposing “corporate social responsibility” on corporate agents.

Second, might this proposal work for other types of gatekeepers, such as auditors? Of course accounting regulation has moved in the opposite direction, toward making them more “independent.” The Tung-Henderson analysis suggests that carefully structured performance pay may be a better way to go.

Third, if bank regulators, what about other public servants, including prosecutors? As I’ve written in my recently published Agents Prosecuting Agents (SSRN draft), they are agents too. Would incentive compensation better align their interests with those of the public? My article discusses some problems with this (footnotes omitted):

Designing incentive compensation for prosecutors presents significant challenges. Even in private law firms in which lawyers produce a clear financial output in the form of fees, there is controversy over whether billable hours or lockstep seniority-based compensation provides the best overall incentives. The compensation design challenge is greater for prosecutors because there is no measure of the value of prosecutorial efforts. Obviously a simple metric such as number of prosecutions would skew incentives, in that it may induce prosecutors to ignore the social costs of misguided prosecutions. One author has proposed compensation based on convictions of charged crimes with deductions for findings of prosecutorial misconduct. However, this could skew incentives toward, for example, undercharging defendants and over-caution. On the other hand, tests that try to take more factors into account would be very costly to apply.

Tung and Henderson show how to overcome these metrics problems with bank regulators. I’m skeptical analogous devices would work for prosecutors, even regarding purely corporate crime. You’d have to, among other things, measure the deterrence effects of particular prosecutions. Not sure event studies could manage this.

There’s a lot more in this thought-provoking piece. Read the whole thing.

In Corporate & Securities Law, Financial Regulation corporate social responsibility, executive compensation

When markets let corporations be good

Larry Ribstein — 31 March 2011

In my article, Accountability and Responsibility in Corporate Governance, I explored the complex relationship between social responsibility and markets. I noted among other things that social responsibility is a way to sell products, so it’s hard to untangle whether success let’s firms be “good,” or whether “goodness” causes firms to be successful.

A new article by Kubik, Schenkman and Hong, Financial Constraints on Corporate Goodness suggests that the latter is at least part of the story. Here’s the abstract:

We model the firm’s optimal choice of capital and goodness subject to financial constraints. Managers and shareholders derive benefits over profits and social responsibility. Goodness is costly and its marginal benefit is finite; as a result, less-constrained firms spend more on goodness. We verify that less-constrained firms do indeed have higher social responsibility scores. Our empirical analysis addresses identification issues that have long plagued the corporate social responsibility literature, establishing the causality of this relationship using a natural experiment. During the technology bubble, previously constrained firms experienced a temporary relaxation of their constraints and their goodness scores also temporarily increased relative to their previously unconstrained peers. This temporary convergence applies to all components of the goodness scores such as community and employee relations and environmental responsibility but not governance.

The tech bubble provided a kind of natural experiment that helped untangle causation. Firms could indulge their urge to be “good” because markets let them. When the bubble popped, they had to get back to business. This supports my general story that, although the law lets managers be good, they are ultimately constrained by markets.

In Truth on the Market corporate social responsibility

Illinois Corporate Colloquium: Krawiec on Narratives of Corporate Board Diversity

Larry Ribstein — 24 September 2010

Each fall I invite leading corporate scholars to present and discuss their recent work to faculty and students in the Illinois Corporate Colloquium. I plan to discuss these papers here on TOTM.

This semester we started with Kim Krawiec (Duke) and her paper (with Lissa Broome and John Conley), Dangerous Categories: Narratives of Corporate Board Diversity, forthcoming in the North Carolina Law Review. Here’s the abstract:

In this article, we report the results of a series of interviews with corporate directors about racial, ethnic, and gender diversity on corporate boards. On the one hand, our respondents were clear and nearly uniform in their statements that board diversity was an important goal worth pursuing. Yet when asked to provide examples or anecdotes illustrating why board diversity matters, many subjects acknowledged difficulty in illustrating theory with reference to practice. This expressed reluctance to come to specific terms with general claims about the value of director diversity inspired our title phrase: dangerous categories. That is, while “diversity” evokes universal acclaim in the abstract, our respondents’ narratives demonstrate that it is an elusive and even dangerous subject to talk about concretely.

The paper is an interesting take on what board members think about diversity in their midst.

It’s also timely, as we just got a plea from SEC Commissioner Aguilar that board diversity isn’t being taken seriously enough. The Commissioner says (footnotes omitted):

There are many who believe that a diverse board improves outcomes, particularly financial performance and that it improves decision-making processes, which may in turn improve firm performance. Many studies indicate that such diversity in the boardroom results in real value for both companies and shareholders. In fact, a report commissioned by the California Public Employees’ Retirement System (CalPERS) found that companies that have diverse boards perform better than boards without diversity. The report — Board Diversification Strategy: Realizing Competitive Advantage and Shareowner Value — stated that companies without ethnic minorities and women on their boards eventually may be at a competitive disadvantage and have an under-performing share value. The report also found that a selected group of companies with a high ratio of diverse board seats exceeded the average returns of the Dow Jones and NASDAQ indices over a five-year period. Notwithstanding these studies, there is a persistent lack of diversity in corporate boardrooms across this country — women and minorities remain woefully underrepresented.

Commissioner Aguilar notes that when the SEC requested input in 2009 on the need for more information regarding board diversity “we were deluged with letters. These letters were overwhelmingly supportive, with approximately 90% expressing support for disclosure of information related to race and gender diversity on the board.” This led to provisions in a recent SEC rule that require firms to disclose whether diversity is a factor in considering candidates for nomination to the board of directors, how firms consider diversity and how they assess the effectiveness their diversity policies.

The Commissioner thinks still more disclosure is required as to “the concrete steps taken to develop a slate of diverse candidates for a position.” He hopes this will lead to substantive governance changes in the form of more minorities and women as directors. And he also hopes that the SEC itself will become more diverse, consistent with the provision for a new SEC Office of Minority and Women Inclusion in Section 342 of Dodd-Frank.

Recent calls for diversity extend beyond the boardroom and the SEC. Judge Harold Baer recently issued an order (see American Lawyer and ATL) that two firms serving as lead counsel in a securities class action “make every effort” to staff the case with at least one minority and one woman. He reasoned that “[t]his proposed class includes thousands of participants, both male and female, arguably from diverse backgrounds, and it is therefore important to all concerned that there is evidence of diversity, in terms of race and gender, in the class counsel I appoint.”

So this brings us back to Broome, Conley & Krawiec’s paper. If we want to know whether diversity is important and why, let’s ask boards themselves. What we learn, as discussed in the abstract, is that they either don’t know or won’t say.

These interviews also suggest that the board actually doesn’t do much of importance. Their reasoning about diversity seems to indicate that they’re opining on operational matters already handled by executives, such as product design, rather than engaging in the policymaking we generally associate with the board.

Maybe the interviews don’t deal with what the board really does, which is to occasionally intervene in crisis situations. But this just raises another question: Does diversity help the board in situations like this? Possibly having women helps firms deal with sexual harassment allegations (HP). But does it help with financial unraveling (Lehman) or environmental disaster (BP)? Wouldn’t it be better in these situations to select purely for managerial competence?

Or is the board purely symbolic? Maybe it helps a consumer products company sell products by showing that it really is like the consumers it’s selling to. In other words, the board is the corporation’s face.

But, then, why do we need a board for this? We could hire diverse employees and executive officers. The board is important in this regard only if it’s running the company, which gets back to whether it actually is doing this.

With respect to the article’s “dangerous categories” point, there is a problem that the paper mentions but doesn’t emphasize concerning corporate social responsibility: if the board admits that diversity relates to something other than quality of management, is it admitting uncomfortable deviation from profit-maximization? I’m not sure this is a problem since, even if diversity is nothing more than putting a comforting face on the corporation, this arguably helps it sell products. But are the questioned board members unsure even about that?

In the end, the paper left me wondering how far we have come since Myles Mace’s interviews with directors reflected in Directors: Myth and Reality, 90 (1971):

You’ve got to have the names of outside directors who look impressive in the annual report. They are, after all, nothing more or less than ornaments on the corporate Christmas tree. You want good names, you want attractive ornaments. You want to communicate to the various publics that if any company is good enough to attract the president of a large New York bank as a director, for example, it just has to be a great company.

Forty years later Broome, Krawiec and Conley, like Mace, interviewed directors. What they found is at least consistent with the notion that directors are still “ornaments” after all these years.

In Corporate & Securities Law corporate governance, corporate social responsibility

Capitalism as a solution for poverty

Larry Ribstein — 29 July 2010

SKS Microfinance, India’s largest microfinance lender, did a $354 million IPO Wednesday. This may encourage others to do likewise. The result would be much more money for very small loans. Sounds good, but it’s meeting objections:

A publicly traded company’s traditional obligation is to make money for its shareholders, while the mission of microfinance — loans typically under $200 for starting businesses that banks won’t make — is to lift people out of poverty. Some say those are irreconcilable objectives.

* * *

“This is pushing microfinance in the loansharking direction,” Muhammad Yunus, who was awarded the Nobel Peace Prize for his work at established microfinance lender Grameen Bank, told The Associated Press. “It’s not mission drift. It’s endangering the whole mission. “By offering an I.P.O., you are sending a message to the people buying the IPO there is an exciting chance of making money out of poor people. This is an idea that is repulsive to me,” he said. “Microfinance is in the direction of helping the poor retain their money rather than redirecting it in the direction of rich people.”

The for-profit and non-profit models would compete for business. The question is whether poor people should be able to decide whether to borrow money on the terms that capitalists want to loan it (assuming consumer credit regulation allows this) or on the terms that non-profits want to loan it. Chances are there will be more money available to poorer borrowers but on more onerous terms, reflecting the greater risk of the new borrowers that are brought into the market.

Who should get to decide whether poorer borrowers get their opportunities to become entrepreneurs: charitable donors, government regulators or markets? I have contributed to Grameen because I think it’s a worthy cause, but I would also buy SKS stock if it looks like it could succeed in the market. Where is the conflict?

In Truth on the Market corporate social responsibility

The shareholder maximization canard

Larry Ribstein — 28 July 2010

Al Franken buys the old idea that corporate managers have a duty to maximize shareholder value. Todd Henderson appropriately sets Franken (and others ignorant of corporate law) straight. Todd reminds them that the business judgment rule gives managers the flexibility to do pretty much what they want, including help society, as long as they don’t self-deal. Steve Bainbridge adds some detail and wonders whether good faith might qualify this conclusion.

The Franken misconception is widely espoused by those in the radical anti-corporate camp, such as the author of the widely read screed The Corporation. That book and its adherents characterize corporations as psychotic amoral monsters driven to a “pathological pursuit of profit” (the subtitle of the book). This bolsters their argument that corporations, being monsters, shouldn’t have First Amendment rights.

Todd notes that corporations are free to do pretty much what we, the owners, managers and other parties to corporate contracts, want them to do, subject to regulation. As I have argued extensively in my article, Accountability and Responsibility in Corporate Governance, the major constraint on corporations is not law but markets.

This is why the corporate social responsibility debate is largely empty. While many corporate social responsibility proponents argue for giving managers more legal freedom to serve society’s needs, managers already have that freedom.

What the proponents really want but don’t always say is to give managers freedom from market discipline. But as I show in the above article markets already discipline managers to act in society’s interests. Giving managers more freedom would give them more freedom to act in their own interests. Do we really need that?

In Amazon, Constitutional Law, Corporate & Securities Law, First Amendment, Platforms corporate governance, corporate social responsibility, Steve Bainbridge

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When Default is No-Fault

When Self-Preference is No Defense

Toward an Integrated Theory of Disintegrating Favoritism

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A brief history of smartphone competition

The Commission decision would harm device manufacturers, app developers and consumers

The troubling absence of Apple from the Commission’s decision

Conclusion

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