The WSJ describes how Chairman Bernanke is going on the offensive in advance of his confirmation hearings, using them as an opportunity to oppose those elements of the Dodd Bill that would strip the Fed of some of its powers.  However you feel about the policy debate, you’ve got to give him some credit for using his confirmation hearings to defend his agency, the safer course would be to secure his helmet, dive into a foxhole, and wait until post-confirmation to enter the fray.

One of Bernanke’s concerns is that Ron Paul’s new bill to audit the Fed might compromise its ability to manage monetary policy.  I am one of those people conditioned to worry about the Federal Reserve’s independence, but Ron Paul’s Bill to require the Comptroller to audit the Fed’s books doesn’t seem to me to be all that big a deal.  The GAO is one of the most non-partisan, capable organizations in the beltway, and the Fed’s deliberations would stay confidential despite Ron Paul’s Bill.  The GAO would, however, get a chance to examine transactions taking place at the discount window that have nothing to do with monetary policy.

The Fed is in part to blame for this controversy, during the crisis it used the discount window to lend to non-bank companies in an unprecedented manner that has since put its balance sheet under severe stress.  The discount window is supposed to be a vehicle for monetary policy, but the Fed was the one who chose to confuse that distinction by using the discount window as a vehicle for bailouts.  Bernanke is concerned in part that if institutions thought their loans from the Fed became public knowledge, the institutions would think twice about taking them.  That doesn’t sound like a problem to me, I want firms to think long and hard before they seek handouts from the discount window when they are in trouble.

Some also want to give the Fed resolution authority over systematically risky institutions, an equally bad idea.  As long as the Fed maintains supervisory authority over banks or other institutions, and the power to lend to them, it should not have the power to decide when to liquidate them.  Otherwise, the decision facing the Fed will be to admit it failed as a regulator, and place the institution into receivership, or lend more to the institution and hope to vindicate its record.  Call it a regulatory reverse-moral hazard.

The Dodd Bill also seeks to strip the Fed of its supervisory powers over banks.  I am predisposed to favor regulatory competition, both horizontally among federal agencies and vertically between states and the feds.  But it is not clear to me why the Fed has a competitive advantage as supervisory regulator.  Activities not related to monetary policy, like banking supervision or-even worse- consumer protection regulation, threaten to distract the Fed from its primary mission.  Managing interest rates to tame inflation by buying and selling Treasury bonds is a herculean task, and giving the Fed too many extracirricular activities threatens the very things we like about the Fed.

When I was growing up my father told me that a man only needs three things in life: a good bartender, a good priest, and a good tailor.  I think Dad intended that different people wear those three hats, otherwise it just doesn’t work.  But wearing conflicting hats is the unfortunate mission we have given to the Fed at this point.  Some regulatory re-gearing, and an enhanced audit capability for non-monetary policy activities at the discount window, could be what we need to get the Fed on the right track.

Truth on the Market is pleased to announce its fourth blog symposium:

The Law and Economics of Interchange Fees and Credit Card Markets

For the uninitiated, the interchange fee is the fee charged (usually) by the credit card issuing bank (the cardholder’s bank) to the credit card acquiring bank (the merchant’s bank) to settle a credit card transaction between the cardholder and the merchant.  Interchange fees, as well as various rules set by credit card networks governing credit card transactions and the structure of the industry more generally have long been the subject of debate, litigation and regulation.  Credit cards have been among the most successful financial innovations ever, and credit card markets are fascinatingly complex–two features leading inexorably not only to commercial disputes but also to academic dispute and scholarly attention.

As regular readers may recall, we have had a few posts on the topic, including a spirited exchange when Steve Salop was visiting a few weeks ago.  I noted at the time that the topic of the regulation of interchange was interesting and timely–in fact, since then, while the then-pending bills are still pending in Congress, the GAO has issued its report on the effects of interchange fees on consumers and merchants.  The GAO report notes that interchange fees have been increasing, but questions whether this leads to any viable policy responses.  As the GAO notes:

Proposals for reducing interchange fees in the United States or other countries have included (1) setting or limiting interchange fees, (2) requiring their disclosure to consumers, (3) prohibiting card networks from imposing rules on merchants that limit their ability to steer customers away from higher-cost cards, and (4) granting antitrust waivers to allow merchants and issuers to voluntarily negotiate rates. If these measures were adopted here, merchants would benefit from lower interchange fees. Consumers would also benefit if merchants reduced prices for goods and services, but identifying such savings would be difficult. Consumers also might face higher card use costs if issuers raised other fees or interest rates to compensate for lost interchange fee income. Each of these options also presents challenges for implementation, such as determining at which rate to set, providing more information to consumers, or addressing the interests of both large and small issuers and merchants in bargaining efforts.

Our symposium will bring together several of the world’s leading experts on interchange fees and the law and economics of credit card markets.  Our participants will discuss a range of issues surrounding the regulation of interchange and credit card markets.

The symposium will take place on Tuesday and Wednesday, December 8 and 9.  We have not yet set the precise agenda for the symposium, but our participants include:

• Omri Ben-Shahar (University of Chicago Law School)
• Tom Brown (O’Melveney & Myers)
• Bob Chakravorti (Federal Reserve Bank of Chicago)
• Richard Epstein (University of Chicago and NYU Law Schools)
• Joshua Gans (University of Melbourne Business School)
• Ron Mann (Columbia University Law School)
• Geoffrey Manne (International Center for Law & Economics and Lewis & Clark Law School)
• Tim Muris (George Mason University School of Law and O’Melveney & Myers)
• Allan Shampine (Compass/Lexecon)
• Bob Stillman (CRA International)
• Joshua Wright (George Mason University School of Law)
• Todd Zywicki (George Mason University School of Law)

We look forward to an engaged discussion in the comments to the symposium posts, and we hope all of our readers will check in frequently during the symposium and will contribute to the debate.

We’ll announce the agenda and schedule no later than Monday, December 7.

Joaquin Almunia, described by the WSJ story as a Spanish socialist.  Almunia’s current charge has been to help craft the EU’s response to the financial crisis:

In his current job, Mr. Almunia, 61 years old, has been in the thick of the EU’s response to the financial crisis, though the economic-affairs post has little regulatory power and he has kept a low profile through much of the upheaval. After the collapse of Lehman Brothers last year, he blamed weak regulation in the U.S. for triggering global panic that hurt the EU economy, but he was less vocal than other EU officials.  Still, he appears comfortable with Europe’s traditionally tough antitrust tack: Several Spanish companies have come under fire from Mrs. Kroes in recent years, and one person familiar with the commission says Mr. Almunia has never intervened on their behalf.

I suspect little difference on substantive policy, but maybe less red-meat for supporters and critics in press releases (which is not a very adventurous prediction).

Here.  And Haiku as a teaching tool.

Happy Thanksgiving.

Some interesting thoughts from David Zaring and Larry Ribstein on the future of the empirical legal studies movement and its flagship conference, CELS.   Zaring asks whether there is enough glue holding the various constituencies within the ELS movement together.  Ribstein warns of an empirical bubble and argues that the real need for an umbrella organization and conference is methodological standard setting:

Legal scholars once decried too much untested theorizing. That time is long gone. Legal academics’ discovery of empirical research has given rise to the greatest explosion of intellectual entrepreneurship since Al Gore created the Internet. Now instead of untested hypotheses we get unhypothesized tests. We also get some tests that could be characterized as the intellectual equivalent of pets.com (although thankfully little of this bad stuff at CELS itself). …

I think the greater need is self-discipline in a community of scholars that is becoming rapidly more diverse as folks trained in all kinds of disciplines mingle with legal scholars like me. That, I think, is CELS’s “common cause.” It is furthered by bringing scholars together once a year to focus on methodology and to weed out the bad methods from the good ones.

This is the opposite of the Stigler critique of the modern IO literature in economics — the ratio of empirics to theory is near zero.  Here, Ribstein argues it is too high.  Its true.   The reduced cost of accessing data and running canned statistical packages combined with the lack of peer review in legal scholarship has generated, as Ribstein notes, a whole lot of empirical work in the left tail of the distribution.  Ribstein suggests that CELS might tame the bubble with an emphasis on empirical rigor.  I certainly seems to be doing so and that is an incredibly valuable function in its own right.

I only want to add one modest point to the conversation that focuses less on ELS or CELS per se and a bit more on the broader trends in law and economics scholarship.  Ribstein notes that the high empirics to theory ratio is a problem that might be solved by CELS playing matchmaker with empiricists and theoreticians.   This would certainly be a better outcome than either specialist theorists substituting toward empirical work or driving theorists out altogether.  But I’m not sure there is any reason to be optimistic about the empirics/theory ratio falling.  All theory is not created equal.  And part of the specialization problem that Ribstein notes is to do with trends in the economics discipline (which I’ve discussed before) that have created a premium for more mathematically formalized theory that is, while elegant, often detached from policy relevance.  Sometimes intentionally so.  From a law and economics perspective, this is more of a bug than a feature and a reason to be concerned about the future of law and economics.  Now, obviously, Ribstein has in mind that a conference like CELS would attract the theorists who are interested in testable hypotheses and policy relevance and match them up with empiricists or legal scholars and produce fruitful collaborations.  This is no doubt a benefit of conferences like this.

But on a broader scale, and not so much directly related to CELS or ELS, I wonder if the “next big thing” will be exchanging our empirical bubble for a theory bubble?  I’ve written before that for a number of reasons I suspect that the economic theorist will increasingly be shifted out of law schools toward other departments.   It is not difficult to imagine a scenario where the gap in the production of theory is filled by non-specialists with a similar dynamic to what has generated what Ribstein calls the “empirical bubble.”   Perhaps not though.  One important difference is that there has been a huge reduction in the cost of producing empirical work but rigorous theory, at least as it stands in the modern economics literature, remains really hard to produce without training.  Of course, its much less costly to produce the variety without rigor so that is an option.  In any event, I suspect that the short to medium term future of law and economics will be less theoretical, more empirical, and involve much more collaboration between legal scholars and empiricists (a la Kobayashi and Ribstein) and not a lot of theorist + empiricist combinations.  Whether that leads to trading in our empirical bubble for a theory bubble will be interesting to see.

• The latest on the insurance industry antitrust exemption (still there, so far)
• The EU targets Standard & Poor’s
• The Bowl Championship Series hires Ari Fleischer
• Documenting the uptick in antitrust enforcement in the high-tech sector
• An interesting IP/antitrust case to watch

If you cannot attend this year’s excellent looking (program here) Conference on Empirical Legal Studies, which is at USC Friday and Saturday, you can watch the webcast of the panels here.  This is a pretty nifty addition to the conference and one that I appreciate as I’ll be missing it this year.  Unfortunately, not much in the way of antitrust and competition policy this year but more generally CELS is quickly becoming one of the best conferences around for law and economics scholars interested in empirical work.

My latest working paper, which bears the same title as this post, is now available on SSRN. In the paper, I address the challenge created by the Supreme Court’s 2007 Leegin decision, which abrogated the 96 year-old rule declaring resale price maintenance (RPM) to be per se illegal. The Leegin Court held that instances of RPM must instead be evaluated under antitrust’s more lenient rule of reason. It also directed lower courts to craft a structured liability analysis for separating pro- from anticompetitive instances of the practice.

Since Leegin was decided, courts, commentators, and regulators have proposed at least four types of approaches for evaluating instances of RPM. Some of the approaches, like that advocated by the American Antitrust Institute, focus on whether an instance of RPM has raised consumer prices. Others, like that set forth in the pending Toys-R-Us case, focus on the identity of the party initiating the RPM (manufacturer or retailer(s)?). Some, like that proposed by Professor Marina Lao, focus on whether the product subject to RPM is sold with retailer services that are susceptible to free-riding. One approach, that endorsed by the FTC, mechanically applies factors the Leegin Court mentioned as relevant, but with little consideration of the potential for proof failures.

My paper critiques these four approaches from the perspective of decision theory (or what Josh and Geoff might call error cost analysis). Recognizing that antitrust liability rules always involve a risk of imposing social costs — either losses from under-deterrence if the rule wrongly acquits anticompetitive acts or losses from over-deterrence if it wrongly convicts procompetitive practices — decision theory says liability rules should be tailored to minimize the expected total cost of a liability decision. Specifically, the optimal rule will minimize the sum of decision costs (the costs of reaching a decision) and expected error costs (the costs of getting the decision wrong).

To evaluate how the proposed RPM rules fare from a decision-theoretic perspective, I begin by considering the theoretical harms and benefits associated with RPM and the empirical evidence on the incidence of those various effects. This analysis leads me to conclude that most instances of RPM are pro- rather than anticompetitive. I then consider whether wrongful convictions or wrongful acquittals are likely to cause greater social losses, and I conclude that wrongful convictions threaten greater harm. Taken together, these two conclusions call for a liability rule that tends to acquit more instances of RPM than it convicts. The proposed liability approaches, by contrast, are tilted toward conviction. Moreover, several of the proposed approaches would condemn instances of RPM even when the preconditions for anticompetitive harm are not satisfied.

Finding each of the proposed liability analyses to be deficient, I set forth an alternative approach that (1) reflects the economic learning on RPM (with respect to both the theories of competitive effects and the empirical evidence of those various effects), (2) is aimed at minimizing the costs of incorrect judgments, and (3) would be fairly easy for courts and business planners to administer. The proposed approach, in short, aims to minimize the sum of decision and error costs in regulating RPM.

Please download the piece. Comments are most welcome.

The President has announced his intention to nominate two new Federal Trade Commissioners: Julie Brill and Edith Ramirez.  Brill comes from a State AG background (Vermont and most recently North Carolina).  Ramirez was a partner at Quinn Emanuel whose bio suggests significant experience in litigating intellectual property and other commercial contract disputes.

So, AMD and Intel settled.  Its a case we’ve covered here in significant detail.  Terms haven’t been announced publicly.  AAI has predictably argued that the settlement shouldn’t preclude further enforcement action from NY and the FTC.   The NY Times suggests the same.  They may be right, although Herb Hovenkamp, among others, has suggested that the settlement “has taken a lot of the wind out of the sails” of the FTC case.  Here’s the joint press release:

Under terms of the agreement, AMD and Intel obtain patent rights from a new 5-year cross license agreement, Intel and AMD will give up any claims of breach from the previous license agreement, and Intel will pay AMD $1.25 billion. Intel has also agreed to abide by a set of business practice provisions. As a result, AMD will drop all pending litigation including the case in U.S. District Court in Delaware and two cases pending in Japan. AMD will also withdraw all of its regulatory complaints worldwide. The agreement will be made public in filings with the Securities and Exchange Commission.

What I find most interesting about the settlement are the reported conduct terms.  The settlement reportedly includes provisions whereupon AMD and Intel agree that Intel will not engage in the business practices that gave rise to the Section 2 complaint, i.e. loyalty or all units discounts.  Here is a reported summary of the business practice provisions:

• Offering inducements to customers in exchange for their agreement to buy all of their microprocessor needs from Intel, whether on a geographic, market segment, or any other basis (Section 2.1.1.a)
• Offering inducements to customers in exchange for their agreement to limit or delay their purchase of microprocessors from AMD, whether on a geographic, market segment, or any other basis (Section 2.1.1.b)
• Offering inducements to customers in exchange for their agreement to limit their engagement with AMD or their promotion or distribution of products containing AMD microprocessors, whether on a geographic, channel, market segment, or any other basis (Section 2.1.2a-b)
• Offering inducements to customers in exchange for their agreement to abstain from or delay their participation in AMD product launches, announcements, advertising, or other promotional activities (Section 2.1.2.b)
• Offering inducements to customers or others to delay or forebear in the development or release of computer systems or platforms containing AMD microprocessors, whether on a geographic, market segment, or any other basis (Section 2.2.2 and 2.1.2)
• Offering inducements to retailers or distributors to limit or delay their purchase or distribution of computer systems or platforms containing AMD microprocessors, whether on a geographic, market segment, or any other basis (Section 2.2.1)
• Withholding any benefit or threatening retaliation against anyone for their refusal to enter into a prohibited arrangement such as the ones listed above.

As I read the summary of Sections 2.1.1.a and 2.1.1.b, assuming this summary is accurate and complete, they would prevent loyalty discounts or other inducements paired with exclusivity or market share commitments.  Exclusive dealing arrangements would also seem to be prohibited so long as Intel had to give something up to get the exclusivity.  For example, if Intel offers a rebate conditioned on Dell purchasing 80 percent of its microprocessor purchases from Intel, this necessarily “limits” purchases from AMD.  It’s unclear if the language would apply to discounting practices such as pure volume discounts that clearly provide incentives for purchasers to buy more of their requirements from Intel and less from AMD, but apparently Intel maintains that the agreement will not preclude discounts per se.  And arguably these practices would not be prohibited since, as summarized, the provisions would be triggered only if there was an agreement with a retailer to limit AMD commitments.   Nonetheless, doesn’t it seem fairly straightforward that the settlement would amount to an agreement between competitors for one of them not to engage in some forms of legitimate competition for distribution that have been broadly recognized as such under the antitrust laws?

So does the Intel/AMD settlement raise issues under Section 1?  We know that the FTC’s position on private settlements that reduce competition between rivals, such as those observed in the branded/generic pharmaceutical context, is that such settlements not only can but are likely to violate Section 1 of the Sherman Act despite any of the pro-competitive efficiencies associated with settling underlying legal disputes.   The potential distinction that settling antitrust cases somehow counts “more” than the settlement of patent infringement cases seems weak (and anyway this agreement also settles a patent infringement case).

Settlements only violate Section 1 of the Sherman Act if they satisfy its prerequisites.  So, does a horizontal agreement reached between two rivals that includes a provision aimed at preventing loyalty discounts violate Section 1 as a per se violation?  At a minimum, isn’t such a settlement at least “inherently suspect” or presumptively unlawful under Sherman Act jurisprudence?  Judge Ginsburg described the standard as follows in Polygram:

Although the Commission uses the term “inherently suspect” to describe those restraints that judicial experience and economic learning have shown to be likely to harm consumers, see FTC Op. at 29, we note that, under the Commission’s own framework, the rebuttable presumption of illegality arises not necessarily from anything “inherent” in a business practice but from the close family resemblance between the suspect practice and another practice that already stands convicted in the court of consumer welfare.

Are agreements to prohibit loyalty discounts close in “family resemblance” to other agreements that have been convicted in the court of consumer welfare and “almost or always almost” reduce output?  The tentative answer has to be “yes” doesn’t it?  These practices are, at their core, discounts, even if they are conditioned on market share commitments from buyers.  The counter-argument is that the underlying theory of the AMD and NY and EU cases is that there is something special about loyalty discounts of this particular form, at least as applied in these markets, that suggests that they are anticompetitive and so the per se logic is inapplicable in this context.  While the Section 2 analysis turns on whether Intel’s inducements to customers were likely to harm competition and consumers, the Section 1 question is whether an agreement to stop such inducements is likely, from judicial and economic learning, to always or almost always reduce output.  The questions are obviously related, but they are different inquiries.  The fact that one has a strong belief on the Section 2 question, for example, that the inducements will harm competition and consumers and violate Section 2 does not mean that an agreement between competitors to prohibit the conduct is necessarily immune (although it does complicate the argument as a rhetorical matter for those making it).

Yes, there are theoretical arguments in the literature for why loyalty discounts might be anticompetitive.  But best I can tell from the literature, there is no strong empirical evidence supporting these theories.  Nor is there consensus in the theoretical literature on the relative likelihood that loyalty discounts will have anticompetitive effects (remember that the theoretical models assume away potential efficiencies–a large assumption in the context of a discounting practice).  Further, consider a loyalty discount with a volume threshold that requires the retailer to grant 100% of its purchases to a particular manufacturer.  That would be an exclusive dealing contract, and we know that courts have accepted a plethora of competitive justifications for exclusive dealing arrangements.  The empirical literature also contains evidence that such agreements are generally pro-competitive.

In short, the argument that the discounts are alleged to violate Section 2 doesn’t seem to save the settlement from a Section 1 analysis.  Of course, if the enforcement agencies’ prior is that the contracts are anticompetitive (which is why it will bring the Section 2 case), it is unlikely to believe that the settlement violates Section 1 because it will believe that the settlement is good for consumers.  But that belief is not the law.  The law is that an agreement to stop a practice that generally results in consumer benefits is subject to antitrust scrutiny under Section 1 and might even be per se illegal. For example, the FTC challenges reverse payment settlements despite the fact that there are arguments that they do not “always or almost always” harm competition because they argue that those agreements amount to agreements between competitors to divide the market or reduce output.

I’m not making an argument by analogy to reverse payment settlements.  What I am saying is that a settlement between two competitors that prohibits discounting conduct could raise important issues about the legality of the settlement under Section 1.  (And, for what it’s worth, this WSJ story notes that both stocks had a favorable reaction to the announcement of the settlement (see also here)).   I don’t believe that the fact that the underlying conduct has been challenged under Section 2 changes the analysis.  Nor does the fact that other courts in Europe, Japan and elsewhere have condemned the conduct–especially since those jurisdictions have done so applying a very different welfare standard than that embedded in the U.S. antitrust law.  Nor does the fact that there are economic theories that would predict that loyalty discounts can under some conditions produce consumer harm.  None of these bears upon the appropriate legal standard.  In Polygram, for example, the existence of pro-competitive  theories certainly did not stop the Commission or the D.C. Circuit from concluding that the conduct was inherently suspect.

If the settlement goes beyond prohibiting these particular loyalty discounts and includes other forms of conventional volume discounts, I think the argument that such a settlement violates Section 1 would be even stronger.  But even if the agreement only applies to loyalty discounts, and not other forms of discounting, there may still be problems.  Isn’t there a legitimate reading of the Section 2 case law as sufficiently demonstrating the proposition in antitrust law that single firm discounting conduct is highly likely to be pro-competitive to support an argument that an agreement not to engage in such conduct would be presumptively unlawful whether in the context of a settlement or otherwise?

Obviously, this is hypothetical thus far because we haven’t actually seen the settlement, and what we have seen reported doesn’t seem to cover conventional volume discounts.  And even if I’m right, there are other things that could be in the settlement that might prevent it from violating Section 1 or at least influence the analysis.  It seems highly unlikely that the FTC, who is investigating the underlying conduct, would challenge the settlement since it would then be forced to simultaneously take the position that the discounts were likely to benefit and harm consumers (and one can also imagine the FTC looking for a broader settlement, applying he same conduct provisions with respect to all competitors and not just AMD, for example, or finding some of the precise language too loose).

But there are, presumably, other parties with standing.  And presumably court authority to review the settlement.  This could get interesting.

Any thoughts from others on this?  I confess to being uncomfortable with this analysis, in that I am delighted for Intel and for consumers if the AMD litigation goes away and the wind is taken out of the FTC’s sails as these are cases that I think are fundamentally misguided.  But that same logic compels some concern over the legality of this agreement.  So what’s the best defense of the settlement? Where is the flaw in this argument?

Josh’s thoughtful response (Bitchslap? Nah.) to my post criticizing the Ninth Circuit’s recent Masimo decision raises a number of important matters. I started to just submit a comment to Josh’s post, but then I figured a reply was post-worthy. (I don’t want the antitrust nerds who read these technical posts — and here’s to you, dweeby friends! — to miss the discussion.)

Here’s a run-down of the discussion so far:

I criticized the Masimo court for reasoning that a plaintiff complaining of a rival’s bundled discounting may proceed on a de facto exclusive dealing theory when (1) there’s no express covenant of exclusivity (so it is merely the defendant’s low prices that are leading buyers to forego rivals) and (2) the defendant’s bundled discount would pass muster under the Ninth Circuit’s PeaceHealth standard. Under that so-called “discount attribution” standard, a bundled discount is immune from liability if each product in the bundle is priced above cost after the entire amount of the bundled discount is attributed to that product alone.

The basis for the PeaceHealth court’s safe harbor was a desire to immunize bundled discounts that cannot exclude any single-product rival that can produce its own product as efficiently as the defendant. After all, any bundled discount that results in above-cost pricing on each bundled product, even after the entire discount amount is attributed to that product, could be matched by, and thus cannot exclude, any equally efficient single-product rival. Because such discounts do not make it impossible for equally efficient rivals to stay in the market, the PeaceHealth court reasoned, they are not unreasonably exclusionary.

In my initial post, I argued that this same analysis should apply even when the bundled discount is so successful that it induces customers to drop rivals’ brands and to purchase only from the discounter. If a discounter doesn’t procure a contractual covenant of exclusivity and instead just offers a really attractive discount, that discount, which provides immediate consumer benefit, should be immune from liability as long as it doesn’t threaten to exclude an equally efficient rival. The discount can’t pose such a threat unless it’s so extreme that an equally efficient single-product rival (who must match the entire dollar amount of the bundled discount on its single product) could not match it, and that will be the case only if the discount results in a below-cost price on some item in the bundle after the entire amount of the discount is attributed to that item. Thus, I argued, an allegation (or even proof) that a bundled discount resulted in de facto exclusive dealing should not alter the PeaceHealth safe harbor.

Now, there are two ways one might interpret my position. I could be saying simply that the optimal liability rule would not condemn de facto exclusive dealing induced solely by bundled discounts that pass muster under PeaceHealth. I could appropriately stake that claim, even if I acknowledged potential anticompetitive harm from such discounts, if I concluded that the likelihood and magnitude of such harm was low and the likelihood and magnitude of harm from “false positives” (i.e., improperly condemned discounts) was high. Alternatively, I could be making a more aggressive economic claim, asserting that de facto exclusive dealing accomplished via bundled discounts that satisfy PeaceHealth cannot be anticompetitive.

In his thoughtful and nuanced post, Josh suggests he might, given more empirical analysis, agree with the former position (about what liability rule is optimal, given error costs). But he rejects the more aggressive economic claim. That claim, he maintains, is deficient because it fails to account for the fact that bundled discounts resulting in de facto exclusive dealing may “raise rivals’ costs” even if the discounts would pass muster under PeaceHealth.

Here’s the intuition (my understanding of it, at least): A bundled discount that’s big enough to usurp lots of business from the discounter’s rivals, but not big enough to run afoul of PeaceHealth, may still preclude those rivals from attaining minimum efficient scale (i.e., the output level at which all scale economies are exhausted). The discount may thus prevent rivals from achieving equivalent efficiency with the discounter. That would be anticompetitive. Thus, it is not true, as I said, that “[w]hen it comes to bundled discounts, … there can be no anticompetitive harm in the form of predation, unreasonable exclusion, or foreclosure if the competitive product is priced above the defendant’s cost once the entire discount is attributed to that product.” Rather, Josh suggests, a bundled discount that results in substantial foreclosure of the discounter’s rivals may raise those rivals’ costs and thus be anticompetitive, even if the discount would pass muster under PeaceHealth and therefore not amount to predation.

So what to make of all this? (more…)

Thanks so much to my new colleagues at Truth on the Market for inviting me to join an impressive group of scholars on a blog I have followed for many years now. Chairman Frank of House Financial Services has an interesting thought on how to prevent the next financial crisis.  Let’s require hedge funds, along with other private pools of capital, to register with the SEC as investment advisers.  But wait, wasn’t Bernie Madoff a registered investment adviser?  Yes he was.  And did the SEC’s random compliance inspections detect his fraudulent scheme?  No, unfortunately they didn’t.  Ribstein offers more detail on the OIG report on the Madoff scandal here.  But surely, the SEC’s Division of Enforcement responded to multiple tips about Madoff?  Well, actually, they investigated Madoff multiple times.

Here are a couple of useful clips from the SEC Inspector General’s Report on Madoff: “The OIG investigation found the SEC conducted two investigations and three examinations related to Madoff’s investment advisory business based upon the detailed and credible complaints that raised the possibility that Madoff was misrepresenting his trading and could have been operating a Ponzi scheme. Yet, at no time did the SEC ever verify Madoff’s trading through an independent third-party, and in fact, never actually conducted a Ponzi scheme examination or investigation of Madoff. The first examination and first Enforcement investigation were conducted in 1992 after the SEC received information that led it to suspect that a Madoff associate had been conducting a Ponzi scheme…. In the examination of Madoff, the SEC did seek records from the Depository Trust Company (DTC) (an independent third-party), but sought copies of such records from Madoff himself. Had they sought records from DTC, there is an excellent chance that they would have uncovered Madoffs Ponzi scheme in 1992.”

Interesting.  We imagine the SEC is familiar with the most basic principle of auditing, that obtaining third party verification for randomly selected transactions from sources unlikely to have participated in a possible fraud is the best way to verify reported results.  The SEC should be familiar with the principle, as it has always played an important role in oversight of auditing principles used by accounting firms.   This principle is important for auditing, but it becomes even more important for an investigation triggered by allegations of fraud.

In fact, the SEC’s compliance staff is so backed up that many hedge funds who voluntarily registered with the SEC (despite the SEC’s mandatory registration requirement being overturned by the DC Court of Appeals in 2006) have complained that despite their high compliance costs for registration they haven’t been given compliance reviews for three years.  As such, they can’t obtain the benefit of telling potential clients they’ve been inspected despite having invested in registration and compliance.

I have an alternative plan for hedge fund oversight, not that the Hill is listening, in Dr. Jones and the Raiders of Lost Capital: Hedge Fund Regulation Part II, an SRO Proposal.  My suggestion is to take the same approach that we do for broker-dealer regulation, and create a Self-Regulatory Organization for hedge funds.  The SEC could facilitate this by, for instance, responding to a mandatory requirement for hedge fund registration by offering exemptive relief for funds registered with the Hedge Fund SRO.  To keep the SRO from becoming a vehicle for industry capture, the SEC would play a role in:

i) vetting candidates to the Board to make sure a diversity of fund size and strategy is represented;

ii) approving amendments to the charter of the SRO; and

iii) overturning SRO rules only if they failed a high standard of deference.

The Madoff scandal also puts the Financial Industry National Regulatory Authority (FINRA) in a bad light for failing to respond to Madoff tips as well.  And there is something to be said for the idea that doing nothing at all could be the best option.  But compared to the Frank proposal, we could expect a Hedge Fund SRO to internalize more of the costs of compliance and result in a more efficient outcome than direct regulation by the SEC.  I also developed this idea before the PCAOB constitutionality challenge lit up, so perhaps my idea isn’t quite legal.  But that doesn’t mean it might not be a good idea.

Larry Ribstein points to the new paper from Gelbach, Helland and Klick on Valid Inference in Single Firm, Single Event Studies.  This is an important paper with implications for finance, securities litigation and antitrust where event studies are frequently used as economic expert evidence.  Ribstein gives a good, non-technical explanation of its contribution:

Essentially what’s happening is that single-firm event studies are determining the existence of abnormal returns against an assumption that the firm’s returns are “normally” distributed under a bell-shaped curve. “Abnormal” refers to returns located around the “bell’s” right and left sides. The problem is that returns are often not normally distributed, and you can’t determine if the observed returns are abnormal if you don’t know the shape of the curve. The paper proposes “a very simple but statistically sound alternative,” the “SQ” test, which does not present the problem of assuming a normal distribution.

The slightly more technical version is as follows.  The standard approach to the event study is comparing t-ratios to critical values drawn from the normal distribution.  So if we are interested in abnormal returns, and those returns come from a normal distribution, the standard approach will perform pretty well.  But the evidence is that abnormal returns are non-normal, and GHK present a lot of evidence on that score.  One might also justify the standard approach in a context with a lot of events. But in the law and economics literature, event studies with small numbers of firms and a small number of events (often 1) are common — and of policy importance.  The primary contribution of GHK is to offer an alternative approach with better statistical properties for these types of studies.

The SQ test that they propose works is related to a Chow test.  Recall that a Chow test is aimed at detecting a structural break in the relationship between Y and X between two sets of observations given the normality of regression residuals.  A Chow test focuses on testing whether the slopes are the same across both periods of observations.  The logic of the GHK test is to apply a sort of structural break test which aims at testing whether the abnormal returns before and after the break come from the same distribution.   GHK come up with the SQ test which provides a test statistic and uses critical values which are estimated from the empirical distribution of predicted residuals from earlier in the sample.

GHK have a great example in the text of the paper discussing how the SQ test would apply in practice:

To illustrate using the example on which we focus below, suppose that a firm discloses that its past quarterly earnings were substantially below the level claimed in an earlier earnings statement. A class of plaintiffs file an action under SEC rule 10b-5, citing standard fraud-on-the-market arguments. In light of Dura’s requirement that plaintiffs establish loss causation pursuant to the firm’s corrective disclosure, an expert witness wants to test the null hypothesis that the corrective disclosure had no effect on a firm’s stock price; the alternative hypothesis is that the event has reduced the value of the firm’s stock.

To use our method, the witness would obtain data on the security’s daily return and the market return for both the event date and a set of, say, n = 99 pre-event observations. She would then use OLS estimation to estimate the firm’s beta and the coefficient on an event dummy, with the latter coefficient being the estimated event effect. All of these steps are taken in both the standard approach and in ours. To implement our test, the analyst would then calculate the fitted residuals from the estimated model, sort them, and find the 5th most negative value among the
non-event dates. She would reject the null hypothesis if the coefficient on the event dummy were less than or equal to this value. Remarkably, the Type I error rate of this test converges to 0.05, regardless of the shape of the true distribution of abnormal returns.

The intuition for this result is simple. In a sample of 99 randomly drawn variables, the fifth most negative element is the sample 0.05-quantile. It has long been known that sample quantiles are consistent estimators of population quantiles, so that the sample 0.05-quantile of a large collection of abnormal returns is an excellent estimate of the 0.05-quantile of the true underlying probability distribution for the abnormal returns. As we discuss below, this quantile is the key estimand in assessing whether a single event on a known date significantly reduced a firm’s value.  While the details below involve some technical points, this simple example illustrates how easy our sample quantile (SQ) test is to use in practice.

What interested me in this paper the most was thinking about its application to antitrust event studies.  There is now a substantial literature on event studies in antitrust — which frequently focus either on antitrust litigation or mergers.  For example, McAfee and Williams (1988) suggest that the standard event study methodology cannot detect anticompetitive mergers using data from a horizontal merger “known” to be anticompetitive.   Bittlingmayer and Hazlett (2000) use the event study methodology to test the reaction of financial markets to the antitrust litigation against Microsoft.  Eckbo (1983), Garbade, Silber and White (1982), Werden and Williams (1989) and Eckbo and Wier (1985) are all examples in this literature.  There is of course now also the debate on the value and appropriate use of merger retrospectives to evaluate merger policy (see, e.g. Carlton 2008).  Weinberg offers an excellent and up to date literature review.  There are also examples of litigated merger decisions that rely on event study evidence.

All of this raises important issues about anticompetitive policy generally, but also expert evidence.  Ribstein raises the possibility of judges using their own experts to overcome the bias of hired experts tied to their own standard theories.  Oddly enough, the rate of judges appointing their own experts in antitrust cases is infinitesimal despite the growth in econometric and economic sophisticated of evidence over the last couple of decades so I’m a bit skeptical of  this solution in that context.   But maybe I shouldn’t be.  In the meantime, I think the GHK paper raises all sorts of interesting issues for event study analysis in antitrust and more generally.

Enjoy the paper.

Hilarious video from reason.tv.

(HT: Luke Froeb)