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[This post is the seventh in an ongoing symposium on “Should We Break Up Big Tech?” that features analysis and opinion from various perspectives.]

[This post is authored by Alec Stapp, Research Fellow at the International Center for Law & Economics]

Should we break up Microsoft? 

In all the talk of breaking up “Big Tech,” no one seems to mention the biggest tech company of them all. Microsoft’s market cap is currently higher than those of Apple, Google, Amazon, and Facebook. If big is bad, then, at the moment, Microsoft is the worst.

Apart from size, antitrust activists also claim that the structure and behavior of the Big Four — Facebook, Google, Apple, and Amazon — is why they deserve to be broken up. But they never include Microsoft, which is curious given that most of their critiques also apply to the largest tech giant:

  1. Microsoft is big (current market cap exceeds $1 trillion)
  2. Microsoft is dominant in narrowly-defined markets (e.g., desktop operating systems)
  3. Microsoft is simultaneously operating and competing on a platform (i.e., the Microsoft Store)
  4. Microsoft is a conglomerate capable of leveraging dominance from one market into another (e.g., Windows, Office 365, Azure)
  5. Microsoft has its own “kill zone” for startups (196 acquisitions since 1994)
  6. Microsoft operates a search engine that preferences its own content over third-party content (i.e., Bing)
  7. Microsoft operates a platform that moderates user-generated content (i.e., LinkedIn)

To be clear, this is not to say that an antitrust case against Microsoft is as strong as the case against the others. Rather, it is to say that the cases against the Big Four on these dimensions are as weak as the case against Microsoft, as I will show below.

Big is bad

Tim Wu published a book last year arguing for more vigorous antitrust enforcement — including against Big Tech — called “The Curse of Bigness.” As you can tell by the title, he argues, in essence, for a return to the bygone era of “big is bad” presumptions. In his book, Wu mentions “Microsoft” 29 times, but only in the context of its 1990s antitrust case. On the other hand, Wu has explicitly called for antitrust investigations of Amazon, Facebook, and Google. It’s unclear why big should be considered bad when it comes to the latter group but not when it comes to Microsoft. Maybe bigness isn’t actually a curse, after all.

As the saying goes in antitrust, “Big is not bad; big behaving badly is bad.” This aphorism arose to counter erroneous reasoning during the era of structure-conduct-performance when big was presumed to mean bad. Thanks to an improved theoretical and empirical understanding of the nature of the competitive process, there is now a consensus that firms can grow large either via superior efficiency or by engaging in anticompetitive behavior. Size alone does not tell us how a firm grew big — so it is not a relevant metric.

Dominance in narrowly-defined markets

Critics of Google say it has a monopoly on search and critics of Facebook say it has a monopoly on social networking. Microsoft is similarly dominant in at least a few narrowly-defined markets, including desktop operating systems (Windows has a 78% market share globally): 

Source: StatCounter

Microsoft is also dominant in the “professional networking platform” market after its acquisition of LinkedIn in 2016. And the legacy tech giant is still the clear leader in the “paid productivity software” market. (Microsoft’s Office 365 revenue is roughly 10x Google’s G Suite revenue).

The problem here is obvious. These are overly-narrow market definitions for conducting an antitrust analysis. Is it true that Facebook’s platforms are the only service that can connect you with your friends? Should we really restrict the productivity market to “paid”-only options (as the EU similarly did in its Android decision) when there are so many free options available? These questions are laughable. Proper market definition requires considering whether a hypothetical monopolist could profitably impose a small but significant and non-transitory increase in price (SSNIP). If not (which is likely the case in the narrow markets above), then we should employ a broader market definition in each case.

Simultaneously operating and competing on a platform

Elizabeth Warren likes to say that if you own a platform, then you shouldn’t both be an umpire and have a team in the game. Let’s put aside the problems with that flawed analogy for now. What she means is that you shouldn’t both run the platform and sell products, services, or apps on that platform (because it’s inherently unfair to the other sellers). 

Warren’s solution to this “problem” would be to create a regulated class of businesses called “platform utilities” which are “companies with an annual global revenue of $25 billion or more and that offer to the public an online marketplace, an exchange, or a platform for connecting third parties.” Microsoft’s revenue last quarter was $32.5 billion, so it easily meets the first threshold. And Windows obviously qualifies as “a platform for connecting third parties.”

Just as in mobile operating systems, desktop operating systems are compatible with third-party applications. These third-party apps can be free (e.g., iTunes) or paid (e.g., Adobe Photoshop). Of course, Microsoft also makes apps for Windows (e.g., Word, PowerPoint, Excel, etc.). But the more you think about the technical details, the blurrier the line between the operating system and applications becomes. Is the browser an add-on to the OS or a part of it (as Microsoft Edge appears to be)? The most deeply-embedded applications in an OS are simply called “features.”

Even though Warren hasn’t explicitly mentioned that her plan would cover Microsoft, it almost certainly would. Previously, she left Apple out of the Medium post announcing her policy, only to later tell a journalist that the iPhone maker would also be prohibited from producing its own apps. But what Warren fails to include in her announcement that she would break up Apple is that trying to police the line between a first-party platform and third-party applications would be a nightmare for companies and regulators, likely leading to less innovation and higher prices for consumers (as they attempt to rebuild their previous bundles).

Leveraging dominance from one market into another

The core critique in Lina Khan’s “Amazon’s Antitrust Paradox” is that the very structure of Amazon itself is what leads to its anticompetitive behavior. Khan argues (in spite of the data) that Amazon uses profits in some lines of business to subsidize predatory pricing in other lines of businesses. Furthermore, she claims that Amazon uses data from its Amazon Web Services unit to spy on competitors and snuff them out before they become a threat.

Of course, this is similar to the theory of harm in Microsoft’s 1990s antitrust case, that the desktop giant was leveraging its monopoly from the operating system market into the browser market. Why don’t we hear the same concern today about Microsoft? Like both Amazon and Google, you could uncharitably describe Microsoft as extending its tentacles into as many sectors of the economy as possible. Here are some of the markets in which Microsoft competes (and note how the Big Four also compete in many of these same markets):

What these potential antitrust harms leave out are the clear consumer benefits from bundling and vertical integration. Microsoft’s relationships with customers in one market might make it the most efficient vendor in related — but separate — markets. It is unsurprising, for example, that Windows customers would also frequently be Office customers. Furthermore, the zero marginal cost nature of software makes it an ideal product for bundling, which redounds to the benefit of consumers.

The “kill zone” for startups

In a recent article for The New York Times, Tim Wu and Stuart A. Thompson criticize Facebook and Google for the number of acquisitions they have made. They point out that “Google has acquired at least 270 companies over nearly two decades” and “Facebook has acquired at least 92 companies since 2007”, arguing that allowing such a large number of acquisitions to occur is conclusive evidence of regulatory failure.

Microsoft has made 196 acquisitions since 1994, but they receive no mention in the NYT article (or in most of the discussion around supposed “kill zones”). But the acquisitions by Microsoft or Facebook or Google are, in general, not problematic. They provide a crucial channel for liquidity in the venture capital and startup communities (the other channel being IPOs). According to the latest data from Orrick and Crunchbase, between 2010 and 2018, there were 21,844 acquisitions of tech startups for a total deal value of $1.193 trillion

By comparison, according to data compiled by Jay R. Ritter, a professor at the University of Florida, there were 331 tech IPOs for a total market capitalization of $649.6 billion over the same period. Making it harder for a startup to be acquired would not result in more venture capital investment (and therefore not in more IPOs), according to recent research by Gordon M. Phillips and Alexei Zhdanov. The researchers show that “the passage of a pro-takeover law in a country is associated with more subsequent VC deals in that country, while the enactment of a business combination antitakeover law in the U.S. has a negative effect on subsequent VC investment.”

As investor and serial entrepreneur Leonard Speiser said recently, “If the DOJ starts going after tech companies for making acquisitions, venture investors will be much less likely to invest in new startups, thereby reducing competition in a far more harmful way.” 

Search engine bias

Google is often accused of biasing its search results to favor its own products and services. The argument goes that if we broke them up, a thousand search engines would bloom and competition among them would lead to less-biased search results. While it is a very difficult — if not impossible — empirical question to determine what a “neutral” search engine would return, one attempt by Josh Wright found that “own-content bias is actually an infrequent phenomenon, and Google references its own content more favorably than other search engines far less frequently than does Bing.” 

The report goes on to note that “Google references own content in its first results position when no other engine does in just 6.7% of queries; Bing does so over twice as often (14.3%).” Arguably, users of a particular search engine might be more interested in seeing content from that company because they have a preexisting relationship. But regardless of how we interpret these results, it’s clear this not a frequent phenomenon.

So why is Microsoft being left out of the antitrust debate now?

One potential reason why Google, Facebook, and Amazon have been singled out for criticism of practices that seem common in the tech industry (and are often pro-consumer) may be due to the prevailing business model in the journalism industry. Google and Facebook are by far the largest competitors in the digital advertising market, and Amazon is expected to be the third-largest player by next year, according to eMarketer. As Ramsi Woodcock pointed out, news publications are also competing for advertising dollars, the type of conflict of interest that usually would warrant disclosure if, say, a journalist held stock in a company they were covering.

Or perhaps Microsoft has successfully avoided receiving the same level of antitrust scrutiny as the Big Four because it is neither primarily consumer-facing like Apple or Amazon nor does it operate a platform with a significant amount of political speech via user-generated content (UGC) like Facebook or Google (YouTube). Yes, Microsoft moderates content on LinkedIn, but the public does not get outraged when deplatforming merely prevents someone from spamming their colleagues with requests “to add you to my professional network.”

Microsoft’s core areas are in the enterprise market, which allows it to sidestep the current debates about the supposed censorship of conservatives or unfair platform competition. To be clear, consumer-facing companies or platforms with user-generated content do not uniquely merit antitrust scrutiny. On the contrary, the benefits to consumers from these platforms are manifest. If this theory about why Microsoft has escaped scrutiny is correct, it means the public discussion thus far about Big Tech and antitrust has been driven by perception, not substance.

We’re delighted to welcome Eric Fruits as our newest blogger at Truth on the Market.

Eric Fruits, Ph.D. is the Oregon Association of Realtors Faculty Fellow at Portland State University and the recently minted Chief Economist at the International Center for Law & Economics.

Eric Fruits

Among other things, Dr. Fruits is an antitrust expert, with particular expertise in price fixing and cartels (see, e.g., his article, Market Power and Cartel Formation: Theory and an Empirical Test, in the Journal of Law and Economics). He has assisted in the review of several mergers including Sysco-US Foods, Exxon-Mobil, BP-Arco, and Nestle-Ralston. He has worked on numerous antitrust lawsuits, including Weyerhaeuser v. Ross-Simmons, a predatory bidding case that was ultimately decided by the US Supreme Court (and discussed at some length by Thom here on TOTM: See here and here).

As an expert in statistics, he has provided expert opinions and testimony regarding market manipulation, real estate transactions, profit projections, agricultural commodities, and war crimes allegations. His expert testimony has been submitted to state courts, federal courts, and an international court.

Eric has also written peer-reviewed articles on insider trading, initial public offerings (IPOs), and the municipal bond market, among many other topics. His economic analysis has been widely cited and has been published in The Economist and the Wall Street Journal. His testimony regarding the economics of public employee pension reforms was heard by a special session of the Oregon Supreme Court.

You can also find him on Twitter at @ericfruits

Welcome, Eric!



Six months may not seem a great deal of time in the general business world, but in the Internet space it’s a lifetime as new websites, tools and features are introduced every day that change where and how users get and share information. The rise of Facebook is a great example: the social networking platform that didn’t exist in early 2004 filed paperwork last month to launch what is expected to be one of the largest IPOs in history. To put it in perspective, Ford Motor went public nearly forty years after it was founded.

This incredible pace of innovation is seen throughout the Internet, and since Google’s public disclosure of its Federal Trade Commission antitrust investigation just this past June, there have been many dynamic changes to the landscape of the Internet Search market. And as the needs and expectations of consumers continue to evolve, Internet search must adapt – and quickly – to shifting demand.

One noteworthy development was the release of Siri by Apple, which was introduced to the world in late 2011 on the most recent iPhone. Today, many consider it the best voice recognition application in history, but its potential really lies in its ability revolutionize the way we search the Internet, answer questions and consume information. As Eric Jackson of Forbes noted, in the future it may even be a “Google killer.”

Of this we can be certain: Siri is the latest (though certainly not the last) game changer in Internet search, and it has certainly begun to change people’s expectations about both the process and the results of search. The search box, once needed to connect us with information on the web, is dead or dying. In its place is an application that feels intuitive and personal. Siri has become a near-indispensible entry point, and search engines are merely the back-end. And while a new feature, Siri’s expansion is inevitable. In fact, it is rumored that Apple is diligently working on Siri-enabled televisions – an entirely new market for the company.

The past six months have also brought the convergence of social media and search engines, as first Bing and more recently Google have incorporated information from a social network into their search results. Again we see technology adapting and responding to the once-unimagined way individuals find, analyze and accept information. Instead of relying on traditional, mechanical search results and the opinions of strangers, this new convergence allows users to find data and receive input directly from people in their social world, offering results curated by friends and associates.

As Social networks become more integrated with the Internet at large, reviews from trusted contacts will continue to change the way that users search for information. As David Worlock put it in a post titled, “Decline and Fall of the Google Empire,” “Facebook and its successors become the consumer research environment. Search by asking someone you know, or at least have a connection with, and get recommendations and references which take you right to the place where you buy.” The addition of social data to search results lends a layer of novel, trusted data to users’ results. Search Engine Land’s Danny Sullivan agreed writing, “The new system will perhaps make life much easier for some people, allowing them to find both privately shared content from friends and family plus material from across the web through a single search, rather than having to search twice using two different systems.”It only makes sense, from a competition perspective, that Google followed suit and recently merged its social and search data in an effort to make search more relevant and personal.

Inevitably, a host of Google’s critics and competitors has cried foul. In fact, as Google has adapted and evolved from its original template to offer users not only links to URLs but also maps, flight information, product pages, videos and now social media inputs, it has met with a curious resistance at every turn. And, indeed, judged against a world in which Internet search is limited to “ten blue links,” with actual content – answers to questions – residing outside of Google’s purview, it has significantly expanded its reach and brought itself (and its large user base) into direct competition with a host of new entities.

But the worldview that judges these adaptations as unwarranted extensions of Google’s platform from its initial baseline, itself merely a function of the relatively limited technology and nascent consumer demand present at the firm’s inception, is dangerously crabbed. By challenging Google’s evolution as “leveraging its dominance” into new and distinct markets, rather than celebrating its efforts (and those of Apple, Bing and Facebook, for that matter) to offer richer, more-responsive and varied forms of information, this view denies the essential reality of technological evolution and exalts outdated technology and outmoded business practices.

And while Google’s forays into the protected realms of others’ business models grab the headlines, it is also feverishly working to adapt its core technology, as well, most recently (and ambitiously) with its “Google Knowledge Graph” project, aimed squarely at transforming the algorithmic guts of its core search function into something more intelligent and refined than its current word-based index permits. In concept, this is, in fact, no different than its efforts to bootstrap social network data into its current structure: Both are efforts to improve on the mechanical process built on Google’s PageRank technology to offer more relevant search results informed by a better understanding of the mercurial way people actually think.

Expanding consumer welfare requires that Google, like its ever-shifting roster of competitors, must be able to keep up with the pace and the unanticipated twists and turns of innovation. As The Economist recently said, “Kodak was the Google of its day,” and the analogy is decidedly apt. Without the drive or ability to evolve and reinvent itself, its products and its business model, Kodak has fallen to its competitors in the marketplace. Once revered as a powerhouse of technological innovation for most of its history, Kodak now faces bankruptcy because it failed to adapt to its own success. Having invented the digital camera, Kodak radically altered the very definition of its market. But by hewing to its own metaphorical ten blue links – traditional film – instead of understanding that consumer photography had come to mean something dramatically different, Kodak consigned itself to failure.

Like Kodak and every other technology company before it, Google must be willing and able to adapt and evolve; just as for Lewis Carol’s Red Queen, “here it takes all the running you can do, to keep in the same place.” Neither consumers nor firms are well served by regulatory policy informed by nostalgia. Even more so than Kodak, Google confronts a near-constantly evolving marketplace and fierce competition from unanticipated quarters. If regulators force it to stop running, the market will simply pass it by.

[Cross posted at Forbes]

Ritter, Gao and Zhu ask, Where have all the IPOs Gone?  Well, not to young men everywhere, but to the older men and women who run the big companies that have replaced public markets as the key venture capital exit. Here’s the abstract:

During 1980-2000, an average of 311 companies per year went public in the U.S. Since the technology bubble burst in 2000, the average has been only 102 initial public offerings (IPOs) per year, with the drop especially precipitous among small firms. Many have blamed the Sarbanes-Oxley Act of 2002 and the 2003 Global Settlement’s effects on analyst coverage for the decline in U.S. IPO activity. We offer an alternative explanation. We posit that the advantages of selling out to a larger organization, which can speed a product to market and realize economies of scope, have increased relative to the benefits of remaining as an independent firm. Consistent with this hypothesis, we document that there has been a decline in the profitability of small company IPOs, and that small company IPOs have provided public market investors with low returns throughout the last three decades. Venture capitalists have been increasingly exiting their investments with trade sales rather than IPOs, and an increasing fraction of firms that have gone public have been involved in acquisitions. Our analysis suggests that IPO volume will not return to the levels of the 1980s and 1990s even with regulatory changes.

Why has this happened?  The authors suggest that “there has been a structural change over time that has increased the profitability of large firms that can realize economies of scope, speed products to market, and realize economies of scale in information technology.” For example, Apple could “assign a veritable army of engineers to rapidly implement new technologies into its consumer electronics products, such as the iPad, iPod, and iPhone. * * *No small independent company could implement new technology so rapidly and sell tens of millions of units to consumers in a matter of months.”

On the demand side, “the internet has made comparison shopping easier for consumers * * * Increased speed of communication thus leads to both a greater advantage from implementing new technology quickly, and a greater opportunity cost of waiting.”

If the authors are right, the future of innovation is mainly in large firms. (Not entirely:  the data doesn’t exclude the possibility of more Facebooks, Zyngas and Groupons.) Small firms might come up with the initial ideas, but big firms will become more influential in determining which ideas succeed. 

The question then becomes whether the structure of big firms will adapt to their new role by staying entrepreneurial and receptive to innovation. Big firms tend to get bureaucratized and complacent.  We have needed new blood to shake up the incumbents.  Big firms will have to offer decentralized decision-making and innovative compensation policies (insider trading?). 

Here is where deregulation could be useful:  not in determining the number of IPOs, but in letting today’s big firms offer the incentive structures and flexibility that enabled them to grow up to be what they are today.

The semester is off to a bang.  I arrived at Stanford Monday to start teaching in the Law School and begin a research fellowship at the Hoover Institution.  Yesterday I hiked in the mountains overlooking the SF Bay.  Today I am flying back to DC (and blogging in flight, how cool is that) to testify Thursday before the House Committee on Financial Services alongside SEC Chairman Schapiro, former Chairman Pitt, and former Commissioner Paul Atkins on proposed legislation from Congressman Scott Garrett and Chairman Spencer Bachus to reform and reshape the SEC.

Part of the hearing, titled “Fixing the Watchdog: Legislative Proposals to Improve and Enhance the Securities and Exchange Commission” will deal with the study on SEC organizational reform mandated by the Dodd-Frank Act and conducted by the Boston Consulting Group.  Frankly, I found it full of quotes from the consultant’s desk manual, with references to “no-regrets implementation,” “business process optimization” and “multi-faceted transformation.”  I believe the technical term is gobbledy-gook.

The remainder of the hearing will involve a discussion of the SEC Organizational Reform Act (or “Bachus Bill”) and the SEC Regulatory Accountability Act (or “Garrett Bill”).  The Bachus Bill proposes a number of organizational reforms, like breaking up the new Division of Risk, Strategy, and Financial Innovation to embed the economists there back in to the various functional divisions.  The Garrett Bill seeks to strengthen the guiding principles originally formulated in the NSMIA amendments by elaborating on how the agency can meet its economic analysis burden in rule-making.

I thought I would give TOTM readers a sneak peak at my testimony.  I aim to make two key points.  First, sincere economic analysis is important.  SEC rules have consistently done a poor job of meeting the mandate of the NSMIA to consider the effect of new rules on efficiency, competition, and capital formation, and they will continue to do a poor job until they hire more economists and give them increased authority in the enforcement and the rule-making process.  Second, the SEC’s mission should include an explicit requirement that it consider the effect of new rules on the state based system of business entity formation.

Here’s a sneak peak at my testimony for TOTM readers:

Chairman Bachus, Ranking Member Frank, and distinguished members of the Committee, it is a privilege to testify today.  My name is J.W. Verret.  I am an Assistant Professor of Law at Stanford Law School where I teach corporate and securities law.  I also serve as a Fellow at the Hoover Institution and as a Senior Scholar at the Mercatus
Center at George Mason University.  I am currently on leave from the George Mason Law School.

My testimony today will focus on two important and necessary reforms.

First, I will argue that clarifying the SEC’s legislative mandate to conduct economic analysis and a commitment of authority to economists on staff at the SEC are both vital to ensure that new rules work for investors rather than against them.  Second, I will urge that the SEC be required to consider the impact of new rules on the state-based system of business incorporation.

Every President since Ronald Reagan has requested that independent agencies like the SEC commit to sincere economic cost-benefit analysis of new rules.  Further, unlike many other independent agencies the SEC is subject to a legislative mandate that it consider the effect of most new rules on investor protection, efficiency, competition and capital formation.

The latter three principles have been interpreted as requiring a form of cost-benefit economic analysis using empirical evidence, economic theory, and compliance cost data.  These tools help to determine rule impact on stock prices and stock exchange competitiveness and measure compliance costs that are passed on to investors.

Three times in the last ten years private parties have successfully challenged SEC rules for failure to meet these requirements.  Over the three cases, no less than five distinguished jurists on the DC Circuit, appointed during administrations of both Republican and Democratic Presidents, found the SEC’s economic analysis wanting. One
failure might have been an aberation, three failures out of three total challenges is a dangerous pattern.

Many SEC rules have treated the economic analysis requirements as an afterthought. This is in part a consequence of the low priority the Commission places on economic analysis, evidenced by the fact that economists have no significant authority in the rule-making process or the enforcement process.

As an example of the level of analysis typically given to significant rule-making, consider the SEC’s final release of its implementation of Section 404(b) of the Sarbanes-Oxley Act.  The SEC estimated that the rule would impose an annual cost of $91,000 per publicly traded company.  In fact a subsequent SEC study five years later found average implementation costs for 404(b) of $2.87 million per company.

That error in judgment only applies to estimates of direct costs.  The SEC gave no consideration whatsoever to the more important category of indirect costs, like the impact of the rule on the volume of new offerings or IPOs on US exchanges.

In Business Roundtable v. SEC alone the SEC estimates it dedicated over $2.5 million in staff hours to a rule that was struck down.  An honest commitment by the SEC to empower economists in the rule-making process will be a vital first step to ensure the mistakes of the proxy access rule are not replicated in future rules.

I also support the goal in H.R. 2308 to further elaborate on the economic analysis requirements.  I would suggest, in light of the importance and pervasiveness of the state-based system of corporate governance, that the bill include a provision requiring the SEC to consider the impact of new rules on the states when rule-making touches on issues of corporate governance.

The U.S. Supreme Court has noted that “No principle of corporation law and practice is more firmly established than a state’s authority to regulate domestic corporations.”

Delaware is one prominent example, serving as the state of incorporation for half of all publicly traded companies.  Its corporate code is so highly valued among shareholders that the mere fact of Delaware incorporation typically earns a publicly traded company a 2-8% increase in value.  Many other states also compete for incorporations, particularly New York, Massachusetts, California and Texas.

In order to fully appreciate this fundamental characteristic of our system, I would urge adding the following language to H.R. 2308:

“The Commission shall consider the impact of new rules on the traditional role of states in governing the internal affairs of business entities and whether it can achieve its stated objective without preempting state law.”

The SEC can comply by taking into account commentary from state governors and state secretaries of state during the open comment period.  It can minimize the preemptive effect of new rules by including references to state law where appropriate similar to one
already found in Section 14a-8.  It can also commit to a process for seeking guidance on state corporate law by creating a mandatory state court certification procedure similar to that used by the SEC in the AFSCME v. AIG case in 2008.

I thank you again for the opportunity to testify and I look forward to answering your questions.

Groupon’s tmi

Larry Ribstein —  28 July 2011

The WSJ reports that the SEC is on Groupon’s case for reporting “adjusted consolidated segment operating income” of $81.6 million while noting that subtracting marketing costs would produce a loss of $98 million.  Groupon recently added that adjusted CSOI “should not be considered as a measure of discretionary cash available to us to invest in the growth of our business or as a valuation metric” and that, according to the WSJ’s paraphrase, “investors should look at standard financial metrics such as cash flow, net loss and others when evaluating its performance.”

Apparently the SEC thinks Groupon shouldn’t disclose CSOI at all because it’s gross revenues rather than “profits.”  But does the SEC really know what investors should rely on?  Might not CSOI be a more realistic measure of future earnings than focusing on the investment the company made to produce that income?  Maybe not, but as long as it’s accurate, why not just give investors all the information with the appropriate qualifiers?

Then, too, Groupon co-founder Eric Lefkofsky committed the sin of “gun-jumping” by saying that “Groupon is going to be wildly profitable.” Sort of reminds me of Google’s famous Playboy interview.  As I asked back then:

[S]houldn’t the First Amendment have something to say about this broad regulation of truthful speech? See my article (with Butler), Corporate Governance Speech and the First Amendment, 43 U. Kans. L. Rev. 163 (1994), a chapter in our Corporation and the Constitution.

I recognize that there’s a point to this regulation:  to protect investors from rushing into horrendous investments like Google in 2004.

It’s been over four years since the heyday of the last boom when I first discussed what I called “privlic equity” in an article about Blackstone’s proposed IPO.

So here we are post-bust, and according to the WSJ, they’re baack:

Apollo Global Management LLC became a public company in late March. Last year, KKR & Co. began trading on the New York Stock Exchange. * * * There is more to come. Oaktree Capital Group LLC is planning to sell $100 million of shares, while private-equity powerhouse Carlyle Group LLC is expected to come public in the next six months or so. Meanwhile, hedge-fund investor William Ackman is expected to sell public shares of a new hedge fund.

For those who were skeptical about this business form back in 2007, it’s worth noting that “skeptics acknowledge there is little evidence that being public crimps returns. Blackstone recently raised a $15 billion new fund despite the rough economic period.”

Some may wonder why “private equity” wants to go public.  The WSJ story points to the “irony. . . that many private-equity firms tell potential acquisition targets that becoming private through a sale to these firms will allow their businesses to prosper.” The article ineptly responds by parroting the privlic equity hype that “operating privately works best for companies undergoing change, but their investment businesses already are strong and can thrive as public companies.” Yeah, whatever.

I have a more cogent explanation, which I’ve discussed in several places, including the University of Chicago Law Review and my book, Rise of the Uncorporation.  I argue that the important feature of what I call “uncorporations,” including private equity firms like the ones noted in the WSJ article, is not whether they’re public or private but their form of governance. In a nutshell, uncorporations substitute partnership-type incentives for corporate-type monitoring.  The elements of partnership-type governance include making managers true owners and giving the owners greater access to the cash.  This can make sense for both publicly and privately held firms.

Here, for example, is my description of Blackstone in the Chicago article (304-05, footnotes omitted):

[T]he owners of the managing general partner of the publicly traded Blackstone Group own equity shares in the funds and will continue to receive directly a share of the carry. The Group, in turn, owns controlling general partnership interests in the funds. As in other publicly traded partnerships, taxing earnings, whether or not distributed, to the owners should make them more averse than corporate shareholders to earnings retention. Managers who retain earnings on which the unitholders are taxed are likely to be judged harshly in the capital markets and thus face constraints on future capital-raising.

As a tradeoff for partnership discipline and incentives, “privlic” equity firms eliminate the monitoring mechanisms that characterize the corporate form. The Blackstone Group prospectus thus correctly calls itself “a different kind of public company.” Blackstone Group unitholders get almost no formal control rights. The LLC that manages the Group is controlled by a board elected by the LLC members, not by the Group or its unitholders. The prospectus makes clear that the unitholders “will have only limited voting rights on matters affecting our business and . . . will have little ability to remove our general partner.”

Privlic equity firms also sharply restrict managers’ fiduciary duties. For example, The Blackstone Group limited partnership agreement provides that the general partner may make decisions in its “sole discretion” considering any interests it desires, including its own. The general partner may resolve any conflict of interest between the Group and the general partner as long as its decision is “fair and reasonable.” A unitholder challenging the decision has the burden of proof on this issue, and a decision approved by independent directors is conclusively deemed to be fair and reasonable and not a breach of duty. In addition, since the Group is a Delaware limited partnership, courts are likely to enforce these limitations on fiduciary duties.

This uncorporate structure is not for all firms.  As discussed in Rise of the Uncorporation, the form makes a lot of sense for the standard publicly traded partnership, which manages “natural resources, real estate, and other properties as these firms can commit to making distributions without compromising long-term business plans.” It may make less sense for more entrepreneurial firms that have a lot of business opportunities and need to give their managers control of the cash.  Private equity is somewhere in between.

My discussion of privlic equity in this early-2010 book ended on a bleak note appropriate to the times, noting that “privlic equity shares have melted down with the rest of the market” and “the  possibility that the firms will repurchase their newly cheap shares and become private again. It is not clear whether the privlic model ultimately will be seen as a short-lived fad of the financial boom, will make a comeback when the market does, or be seen as a transitional structure that will give rise to the publicly held uncorporation of the future.”

I also suggested that privlic equity might be the harbinger of a “convergence of corporate and uncorporate forms or some sort of reconfiguration of the divisions among large firms.”

It’s not clear from the WSJ article exactly what is happening in this resurgence of privlic equity. Among other things, I don’t know whether the new IPOs will use Blackstone-type techniques to avoid restrictions on partnership taxation of publicly traded partnerships, or will be tax corporations.  If the former, it would seem the firms will face pressures to make distributions, since the owners will be taxed on the income whether distributed or not.  Yet the WSJ article suggest the firms will have corporate-type “capital lock-in” (to use Margaret Blair’s term): “Mr. Ackman’s IPO would give him capital for investments that can’t be yanked by investors if they sour on him or the market.” 

The WSJ article indicates there’s still confusion about what’s going on with these firms.  But since going privlic may be here to stay, it’s time to try to understand their financial significance.  I suggested in the conclusion of Rise of the Uncorporation that this could be the harbinger of a new type of hybrid firm:

For example, regulators may insist that firms adopt uncorporate discipline before they can waive such important corporate features as shareholder voting and fiduciary duties. Also, publicly traded uncorporations arguably have the same need for inflexible rules as publicly held corporations. Regulators therefore might mandate features such as limited terms or regular distributions for firms that seek to opt out of standard corporate features. In short, the publicly traded partnership could become a distinct type of firm that straddles the corporate-uncorporate boundary.

In other words, we might finally have to face the failure of standard corporate-type governance and the need to replace it with something that works better than shareholder democracy and the business judgment rule.

I’m just catching up with this Board Member article about Delaware’s new competitor, Nevada. It notes that Nevada’s share of the out-of-state incorporation market rose from 4.6% in 2000 to 6% in 2007.  Part of this may be due to lower fees than Delaware. But that can’t be the full explanation because all states are cheaper than Delaware.  More interestingly, the article suggests Nevada may be succeeding by offering a haven for shady operators with low fiduciary standards and high barriers to takeovers. 

The article features a discussion of Michal Barzuza’s article with David Smith, What Happens in Nevada? Self-Selecting into a Lax Law, which as the title indicates supports the competition-for-laxity position.  This paper, as the Board Member article notes, shows that “Nevada corporations posted accounting restatements twice as often as the national average from 2000-2008.”  Barzuza tells Board Member:  “It should be a cause for concern if the companies that need regulation most are allowed to choose a lax legal regime.”

I get a chance to respond in the Board Member article.  Here’s my quote:  “The data show that riskier firms are going to Nevada, but risky firms need capital, too. What Delaware has to offer is its legal infrastructure. But it’s reasonable to ask what that is worth to me as a business.” This is along the lines of my comment on Barzuza-Smith at last year’s Conference on Empirical Legal Studies. 

Barzuza also has a sole-authored paper that focuses on the normative aspects of the Barzuza-Smith empirical study.  That paper doesn’t yet have a public link, but I’ve read it and saw it presented at ALEA last week. 

Barzuza and I agree that Delaware and Nevada appeal to different segments of the incorporation market.  We disagree on whether this is a problem.  In a nutshell:

  • Barzuza thinks the relatively high level of accounting restatements by Nevada corporations indicates Nevada offers an escape from regulation for firms that most need to be regulated.  As Barzuza-Smith say in their abstract:  “Our findings indicate that firms may self-select a legal system that matches their desirable level of private-benefit consumption, and that Nevada competes to attract firms with higher agency costs.”
  • But I see an efficient contracting story, with Nevada offering smaller firms an opportunity to economize on monitoring and litigation costs. (Note: the more recent unposted Barzuza paper also discusses the efficient contracting story.)

The implications of this debate are important because it carries the threat of more federal regulation of corporate governance.

Here’s some support for my efficient contracting hypothesis:

  • Nevada isn’t, in fact, a haven for defrauders.  Its law provides for liability for fraud as well as intentional misconduct or a knowing violation of law. It couldn’t if it wanted to offer escape from federal securities law liability. Although B-S (Table 4) show a higher fraud percentage in Nevada restatements, the total percentage is tiny in Nevada as elsewhere.  More importantly, B-S found no evidence that increased restatements followed incorporation under Nevada’s lax (post-2000) provisions.  In other words, although Nevada may attract dishonest managers, there’s no indication these firms were reincorporating in Nevada in order to commit fraud.
  • The value of Nevada corporations doesn’t suffer from any evident “fraud discount” as measured by Tobin’s q (B-S Table 5) (although it’s not clear how these values might be affected by pre- or post-restatement accounting). 
  • There are benign explanations for the larger number of Nevada accounting restatements.  Nevada public firms are smaller than those in Delaware, increasing the per capitalization cost of setting up controls that could catch accounting errors.  Small size is one of the factors associated with weaker controls (see Doyle, Ge and McVay).  B-S show that Nevada has a relatively high percentage of mining firms, and Barzuza’s ALEA paper shows that Nevada has a relatively high percentage of family firms.  Both of these characteristics relate to the amount and type of monitoring required, and therefore to the efficient contracting story.

In short, the article’s data is consistent with the hypothesis that firms choose Nevada for its better balance of costs and benefits of monitoring than they could get in Delaware. Its strict default standards for suing managers may tolerate some managerial misconduct, but they also reduce firms’ exposure to opportunistic strike litigation.  Nevada removes from its statute the sources of legal indeterminacy that Delaware has been criticized for.  This enables Nevada to offer a legal package that is attractive to some firms without the costly legal infrastructure required to apply Delaware’s open-ended good-faith and loyalty standards.

In other words, in contrast to the B-S claim that Nevada “competes to attract firms with higher agency costs,” in fact Nevada may be attracting firms seeking lower agency costs defined by Jensen & Meckling to include monitoring and bonding costs as well as agent misconduct (Jensen & Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305 (1976).  This recognizes that the costs of hiring an agent, and thereby separating ownership and control, are never zero.  Attempting to reduce agent misconduct to zero could actually increase total agency costs as compared with cheaper monitoring that tolerates a reasonable level of agent misconduct.

None of this is to say that Nevada law offers an optimal set of terms.  We could probably benefit from additional standard forms to match firms’ diverse governance needs.  (Watch for my forthcoming paper with Kobayashi on the production of private law.)   But Nevada law doesn’t have to be optimal to be welfare-increasing. The question is whether the Nevada package of terms offers a better match for some firms than a Nevada-less market for corporations in which only Delaware competes for out-of-state incorporations.

Aside from substantively evaluating Nevada law, it is worth asking whether the Nevada story suggests market failure in the corporate law market.  B-S show that Nevada is not pretending to be something it isn’t.  It clearly advertises its “laxity,” so both shareholders and managers know what they’re getting.  Moreover, the Board Member article indicates there’s inherent resistance to any state that departs from the Delaware standard.  Investors may over-discount Nevada corporate shares out of distrust or fear of the unknown so Nevada laxity is, if anything, over-reflected, in the price of Nevada IPOs.  If Nevada shareholders don’t get an adequate voice on Nevada reincorporations (as where an existing firm merges with a Nevada shell) this is a problem with the law of the non-Nevada states where the firms originate.

So more work needs to be done to flesh out the Nevada story.  This might include

  • More specific comparisons of the firms that are and aren’t choosing Nevada to get a clearer picture of the effect of Nevada incorporation. 
  • As somebody suggested at ALEA, perhaps California-based firms incorporating in Nevada may not really be choosing Nevada governance law because of California’s “quasi-foreign” provisions. 
  • Is there an “out of Nevada” effect analogous to the “out of Delaware” effect documented by Armour, Black and Cheffins, in which Nevada corporate cases, particularly those involving fraud, are being litigated in, say, California or federal court?  This would negate any effort by Nevada to attract managers seeking to escape fraud liability.
  • Is Nevada using a similar strategy to compete in the market for LLCs?  Kobayashi and my data on the market for LLCs suggest not, and that the overall market for LLCs differs from that for corporations.  So why don’t firms opt out of Delaware corporate law by opting into uncorporate law?  I show that this strategy could produce a Nevada-like reduction of indeterminacy.

In short, Barzuza & Smith are right and clever to focus on this evidence of segmentation in the incorporation market.  This contradicts those who contend that the so-called market for out-of-state incorporations is really a Delaware monopoly. 

But it’s a mistake without much more data to jump to the conclusion that this is a “cause for concern.” This sort of argument could feed building pressures to federalize corporate law.  So far the Nevada story shows that there’s a significant demand for rules that reduce governance costs even in the face of strong pressures toward Delaware standardization. This cuts against rather than for increasing federalization, particularly as we are learning that even federal law competes in a global market for corporate law.

Today’s WSJ reports on the US’s slide in stock listings, which explains the NYSE/Deutsche Borse move.  It notes that

  • U.S. stock listings are down by 43%, or by 3800, since 1997.
  • Listings outside the U.S. have doubled.  
  • U.S. IPOs since 2000 are down 71% from the 1990s. 
  • IPOs by VC-backed startups are down from 90% in the 1980s to 15%.

Some reasons:  firms have lower compliance costs, fewer shareholder suits, lower d & o insurance costs, and lower listing fees, no SOX (or Dodd-Frank).

Nasdaq is seeking to compete with London’s AIM by opening an exchange for small companies that don’t meet its general listing requirements.

But this won’t solve the problem.  In the long run, the US securities laws compete in a global market.  Although other factors, including the growth of foreign markets, help explain the above shifts, these other factors increase the competitive pressure on US law.  Congress and the SEC are going to have to stop acting like they’re alone in the world.

Last week I argued that the SEC’s considering relaxing the rule requiring 1934 act registration of stock classes with more than 499 shareholders was not what it seemed.  I noted that while this might look like a move toward liberalization by permitting more Facebook-style markets, it actually furthered a trend toward closing US securities markets by effectively excluding ordinary investors.

John Carney cited my post and argued that

The SEC wants to preserve its authority in public markets and refuses to reduce the regulatory burden of companies with public stock. The investment banks want to increase their fees, and find that they can do this in private markets more easily than they can public market, where they are forced to compete with low cost brokers. So Wall Street and the SEC are cutting a deal that keeps both sides happy.

He added that in making this move the SEC ironically would be encouraging “some of the very practices the SEC and other regulators fought so hard to eliminate not so long ago” — specifically, using hot stocks as leverage to get high brokerage fees from clients. 

More recently we got news of a 17-page March 22 letter from Congressman Darrell Issa, chair of the House Oversight and Government Reform Committee, to SEC Chair Schapiro asking a lot of questions about what the SEC is and is not doing.  Issa wanted to know, among other things, what the SEC thought about why the US IPO market had declined and what the SEC was doing about it, and the costs and benefits and constitutionality of rules shutting off issuer communications during the “quiet period.”

Interestingly, Issa seemed particularly interested in the costs of the 499 shareholder rule in terms of inhibiting liquid markets in non-publicly traded shares, and whether this rule really serves to protect investors.  This letter would seem to explain the SEC’s latest deregulatory wobble and why the SEC is not as concerned about these private markets as Carney and others expected it to be.

But this leaves unanswered the question of what is the best overall policy:  encouraging more private markets or freeing public markets from their regulatory shroud.

Perhaps the SEC should pay more attention Issa’s whole letter, including the part about what happened to IPOs, and another part requesting information about who, if anybody, was analyzing regulatory costs and benefits at the SEC. The minority Republican SEC members have been urging this sort of cost-benefit analysis.

But as Carney noted, the politicians currently in charge of regulating the securities markets are not exactly taking the long and deep view.  Congress jerked their leash, and they seem to be sniffing down the path of least resistance.

Larry makes a strong argument below for why the proposed SEC rules changes reported today in the WSJ should not be heralded as some great opening up of US securities markets, but that the changes are little more than political posturing to prevent addressing the real problem of the costs imposed by securities regulation more generally. I don’t disagree that the proposed rules changes Larry targets are, at best, window dressing to release some (well-justified) pressure created by innovative market-based solutions to circumvent the rules that lie more at the root of the securities market problem.  So long as the costs associated with “public” placements are so high, investors and issuers will continue to look for ways to expand their access to capital within the “private” placement market, which by definition excludes many (especially smaller) investors.

That said, I will point out that one of the quotes in the article bemoaning this proposal comes from an institutional investor–one of the groups that is more likely to benefit from the current 500 entity cap. If raising the cap would not open up the market meaningfully to new potential investors, I wouldn’t expect to see such negative comments from one of the groups who will face this greater competition in the supply of private equity. So while the proposed changes certainly don’t address the real problem, it seems they may make the market a bit more open (and less subject to contrived and costly work-arounds like special purpose vehicles) than it currently is.

However, among the rules changes being proposed is one that should open up the market to greater access even to smaller investors (up to whatever new cap might replace the current 500 entity rule). And it’s a rule  change that appears a direct response to something Larry blogged about here just earlier this year.

According to the WSJ report, the SEC “is considering relaxing a strict ban on private companies publicizing share issues, known as the ‘general solicitation’ ban.” The current regulations are currently under Constitutional scrutiny as a potential violation of 1st Amendment speech rights, as a result of a case by Bulldog Investors that Larry discussed in his earlier post.  Again, how far will the ‘relaxing’ go and will it be a substantive change in the underlying problem, or just another hanging of curtains? But there should be no doubt that more open communication about private equity investment opportunities should further open the market to smaller investors.

All this to say, I believe Larry is on point for the big picture, but the proposed regulation changes don’t seem to be all bad. Of course, the devil is in the details–so we’ll have to reserve judgment until the specifics are revealed before having more confidence in that conclusion.

The WSJ reports that the SEC is considering raising the 500-shareholder limit on the number of holders of a class of securities a company can have before having to register that security with the Commission under Section 12(g) of the 1934 Act. The SEC reportedly is also considering relaxing the “general solicitation” restriction on private offerings.

At first blush this seems like a pro-market liberalization.  The story notes that “the agency has a responsibility to encourage companies to raise capital as well as to protect investors.”

But look again.  The SEC move clearly results from market arbitrage moves by hot firms like Facebook, Twitter and Zynga to open an end-run around the 500 shareholder rule.  I noted last January that Facebook got around the limit by selling all the stock to one person, a special purpose vehicle, which only wealthy investors can trade privately under an exemption to the 1933 Act.  (And maybe only non-US rich people.  Shortly after the story reported above, I noted that Goldman had moved its Facebook market exclusively offshore.) The SEC was also worried about insider trading in this new private market.

In other words, the market created this exemption, not the SEC.  Faced with inexorable market demand and arbitrage the SEC is considering making the escape route official. This resembles the “check the box” tax rule a decade ago which opened the door for LLCs after numerous unincorporated vehicles had challenged the government’s ability to put a lid on exempting unincorporated firms from the partnership tax. 

The SEC’s other option was reducing the various regulatory taxes on IPOs and public companies under the 1933 Act, SOX and Dodd-Frank which created the pressure on the 500 share limit.   In my earlier post I noted that VC partner Ben Horowitz had told the WSJ that

the incentive for going public has lowered and the penalty for going public has increased. . . [T]he regulatory environment and the rise of hedge funds has made it “dangerous” for start-ups go to public without a large cushion of cash. In general, we recommend that our companies be very careful about going public.

By expanding the private market for new firms, the SEC would release some of the political and market pressure building against over-regulation of going public.  Rather than liberalizing regulation, it would help protect existing regulation. 

The costs of this choice are significant.  Consider that in 2004, Google went public when it ran up against the 500 shareholder requirement.  Now, instead of IPOs, we have a market reserved for rich people. As I said last January:

[T]he increased costs of being public have helped exclude ordinary people from the ability to own the stars of the future.  Back in the 1980s, you could just call your broker and get rich off of the Microsoft IPO.  Now you have to be a wealthy Goldman client to do it.  Of course you also got to get poor off of a company that turned out to be a dog.  Now both options are reserved for wealthy people in the name of increasingly onerous disclosure regulation and federal governance requirements such as board structure, proxy access, and whistleblowing rules.

Each of these rules was thought to have some benefit at the time they were enacted.  Nobody really considered how private markets would react (e.g., by establishing alternatives to public markets) or the long-run effects of substituting quasi-private for public markets.  So rules designed to make the markets safe for ordinary investors have ended by excluding them.

Maybe it’s time to start considering whether we got what we wanted

The emerging market for rich people is especially ironic in view of the SEC’s increased push against insider trading. While the SEC is going all out in its Quixotic task to “level the playing field,” it is emptying that playing field of the people for whom it’s supposedly unlevel.

This move from public to private has broad ramifications.  The US traditionally has the broadest and deepest public securities markets in the world.  Indeed, the securities laws were enacted in the 30s to encourage participation by ordinary investors, and the securities laws have been interpreted consistent with that goal.  The problem is that Congress and the SEC have taken this goal too far, overburdening the US markets with regulation.  Coupling the shrinkage of the public market with an expanded option for rich people hastens this evolution away from strong US capital markets. 

At the same time, the US faces increased global competition.  As I discussed last week, evidence on IPOs suggests that public markets elsewhere in the world are catching up with the US.

The privatization of US markets could have important indirect effects.  Broad public participation helps democratize capitalism.  A move in the opposite direction could deepen Americans’ suspicion of capitalism as the playground of the wealthy.  Also, the securities markets are the primary source of data about large companies.  Closing these markets reduces transparency for everybody and not just investors.

The better move is to reverse the regulation that prompted this trend toward closing the public markets. The SEC is opting instead for short-term political expediency.