The Financial Times reported yesterday that an embarrassed GE CEO Jeffrey Immelt had to tell GE shareholders that the 10% growth in earnings for 2008 that he had promised analysts in March was not going to be possible.  GE missed its quarterly forecasts and halved its 2008 forecast to 5% growth in earnings (as opposed to the 10% growth promised).  The Financial Times article mentioned a “sense of shock among the investor community” and noted that one analyst, after Immelt’s downward revision, “compared GE’s promise of long-term improvements to the Chicago Cubs, the US baseball club that hasn’t won a championship in 100 years.” 

Upon reading this FT article this morning, I thought “oh, dear God.  Do we remember none of the lessons learned just a few years ago about the perils of over-promising results to analysts?”  Why, exactly, does Immelt feel the need to promise a 5% increase in earnings for 2008 when (a) we are in a credit crunch, (b) GE is likely going to have to do more write-downs this year, (c) the cost of inputs is increasing, if not skyrocketing, (d) inflation is high, and (e) the economy is weak (among other things)?  Why is Immelt promising *growth* in earnings when the reality is that just achieving positive earnings for 2008 is likely to be good thing?  Why is Immelt putting pressure on himself and his officers to produce growth? 

Memo to Immelt:  Earnings do not have to grow each year.  In some markets, in some economies, in some industries, in some “downturns,” simply having earnings – any positive earnings – is a good thing.  Matter of fact, sometimes earnings should NOT be growing each year.   Were I a GE investor, I would not want Immelt promising 5% growth for 2008 because I would figure that the only way he can promise to hit that number in such an uncertain market and gloomy economy is by commiting to fudge year-end 2008 numbers if needed.  And, as we learned several years ago, fudging year-end numbers tends to catch up with companies, and, when it does catch up, the valuation fall-out is worse than if the forthright disclosure (e.g. “2008 earnings might be flat”) had been made initially. Am I the only one who remembers back to the not-so-distant past, when unrealistic promises made to analysts by corporate officers led to companies cooking their books at year end to make the numbers?  As I recall, things did not always work out so well in those cases.  Enron, anyone? 

Surely it is enough for a company in some years to produce returns that are merely equal to the prior year’s, as opposed to “besting” the prior year’s earnings. Didn’t we learn this lesson several years ago?  Investors are supposed to invest for the long term and diversify.According to the FT, one of the reasons why GE missed its quarterly numbers recently is because GE was unable to close “$900m-worth of real estate asset sales,” which the FT referred to as “a traditional way for GE to boost quarterly returns.”  If I were a GE investor, I would be peeved to read this.  I would rather GE just do the real estate deals when they make the most sense, when the market is most favorable for the deals at issue, regardless of when the gain/loss woulbe be booked.  If that means GE misses its numbers sometiemes due to the lack of a crystal ball regarding the best time to sell the assets, and I take a short-term valuation hit (on paper) as a GE investor, so be it.   It doesn’t create long-term value for shareholders if GE rushes through real-estate transactions just to make the numbers if the timing is not sensible for the transactions and waiting a little bit of time would garner value for shareholders.(The FT reports that “GE slashed its 2008 earnings forecast from $2.42 per share to $2.20-$2.30 – still an increase of as much as 5 per cent from last year.”  Slashed?  Slashed?  Are you KIDDING me?  “Slashed” implies something negative.  Earnings of $2.20-$2.30 per share for a year that is not likely to shape up particularly well  would be good.)

On the flight back from my spring break ski trip, I had a chance to read the recent Tenth Circuit opinion reversing the insider trading conviction of former Qwest CEO, Joseph Nacchio. Mr. Nacchio had been convicted of 19 counts of insider trading, sentenced to six years in prison (plus two years’ supervised release), fined $19 million, and ordered to disgorge $52 million more. In a 2-1 decision authored by Judge McConnell, the Tenth Circuit reversed Nacchio’s conviction because of the district court’s exclusion of expert testimony by Dan Fischel (my corporations prof). The court also concluded that retrial will not constitute double jeopardy because a properly instructed jury could have found Nacchio guilty of insider trading. To reach that conclusion, the court had to delve extensively into the law of insider trading and the evidence presented at trial.

Here are a few thoughts on the decision.

Fischel’s Expert Testimony

The court was right to insist that Nacchio be allowed to present Prof. Fischel’s expert testimony. The government’s basic claim against Nacchio was that he sold Qwest stock after he learned that the company’s revenues were largely comprised of non-recurring sources, implying that the company would have a hard time meeting projected earnings. Nacchio maintained that he sold the stock not because he was trying to avail himself of an inflated stock price but because he wanted to diversify after he exercised soon-to-expire stock options. He also contended that the specific information to which he was privy (i.e., that much of Qwest’s revenue was non-recurring) was not “material” non-public information because the market didn’t react when the information was publicly disclosed.

Prof. Fischel was to testify (1) that Nacchio’s trading pattern was more consistent with a diversification strategy than with an attempt to profit from inside information and (2) that the stock price effect of the disclosure concerning Qwest’s non-recurring revenue suggested that the information wasn’t material. The district court ruled that Prof. Fischel wasn’t properly disclosed as an expert witness and that, in any event, his testimony wouldn’t “assist the trier of fact.”

I don’t want to get into the expert disclosure rules (where the district court apparently ignored distinctions between the criminal and civil contexts), but it seems clear to me that the district court was just wrong on the question of whether Fischel’s testimony would help a jury. Having taught Business Organizations a few times, I’ve seen that many smart, educated people are not aware of (1) why diversification is so important (and thus why sophisticated investors always diversify) and (2) how stock prices immediately incorporate material information. Fischel’s testimony would undoubtedly help jurors understand Nacchio’s defense. (More on this aspect of the decision from Jay Brown.)

Two Wrongs Don’t Make a Right (…as I said earlier)

One of Nacchio’s arguments was that his knowledge of pending deals with the government — deals that would have boosted Qwest’s revenue — immunized him from insider trading liability. This undisclosed “good news,” he argued, negated the materiality of the undisclosed fact that much of Qwest’s revenue was non-recurring. Moreover, he contended, the fact that he knew this information shows that he did not act with scienter (an intent to deceive).

I previously expressed skepticism about Nacchio’s defense. In a post titled Nacchio’s Puzzling (Innovative?) Defense, I wrote the following:

Is Nacchio claiming that it was OK for him to sell while in possession of material non-public bad news regarding company prospects because he also possessed material non-public good news? Is this a “two wrongs make a right” theory?…

Nacchio’s defense (or this part of it, at least) is that two “wrongs” do make a right because the second piece of non-public information to which Nacchio was privy when he traded (i.e., the likelihood of the lucrative defense contracts) would make the first piece (i.e., various bits of bad news at the company) immaterial. In other words, the theory seems to be that the totality of non-public information of which Nacchio was aware would not be something a rational investor would consider important in deciding how to invest (and thus would not be material), for Nacchio’s private negative information was counterbalanced by private positive information.

…I’m not optimistic for Nacchio.

It seems my skepticism was warranted. Upholding the district court’s decision to prohibit Nacchio from presenting classified information about the alleged government contracts, the Tenth Circuit quickly disposed of the “two wrongs” theory:

[E]ven if the classified information were presented and established what he said it would, it could not exonerate Mr. Nacchio as he claims. Essentially, Mr. Nacchio argued that undisclosed positive information can be used as a defense to a charge of trading on undisclosed negative information. We disagree. … If an insider trades on the basis of his perception of the net effect of two bits of material undisclosed information, he has violated the law in two respects, not none.

An Opening to Challenge Rule 10b5-1

Nacchio claimed that his sales were not illegal insider trading because he did not make them “on the basis of” material non-public information. Even if he possessed such information when he sold his stock, the information, he insists, did not cause the sales; he would have made them anyway in order to exercise his options and achieve diversification. Thus, the sales were not “on the basis” of material non-public information.

If one were to look only to the securities regulations, Nacchio’s position would seem doomed. The SEC’s Rule 10b5-1 states that any securities trade made while “aware” of material non-public information is made “on the basis” of such information, unless the trade was made pursuant to some securities trading plan executed before the trader became aware of the information. Thus, if you possess material non-public information, and you trade, and your trade wasn’t pursuant to some previously executed contract or instruction or “written plan for trading securities,” you’re in trouble.

But that rule would seem to read the “scienter” element out of an insider trading claim. The law prohibiting insider trading, Section 10(b) of the Securities Exchange Act, prohibits only “manipulative or deceptive device[s] or contrivance[s]” that contravene SEC rules. This language would seem to require some intent to deceive (or at least recklessness), and the Supreme Court has interpreted it accordingly. In a prominent insider trading case, Dirks v. SEC, the Court was careful to emphasize that “[t]here must also be ‘manipulation or deception’ in an insider trading case,” and it said the following about the required scienter element:

Scienter — “a mental state embracing intent to deceive, manipulate, or defraud” — is an independent element of a Rule 10b-5 violation. Contrary to the dissent’s suggestion, motivation is not irrelevant to the issue of scienter. It is not enough that an insider’s conduct results in harm to investors; rather, a violation may be found only where there is “intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities.”

(Note 23, citations omitted.)

Thus, it would seem that proof of “intent to deceive, manipulate, or defraud” is required to establish illegal insider trading. Rule 10b5-1 would impose liability without such proof, but that rule, promulgated by the SEC, can’t go further than the authorizing statute, Section 10(b). The rule, then, may be invalid. (For more on this, check out this from Prof. Bainbridge.)

On remand, Nacchio is almost certain to challenge the validity of Rule 10b5-1. Judge McConnell’s opinion invites him to do so. It notes that “[s]ome commentators maintain that [Rule 10b5-1] (the authority of which has not been resolved by any circuit) is unlawful because it effectively eliminates fraud from the liability standard.” Watch for Nacchio’s lawyers to seize on this argument when fighting over jury instructions on remand.

A Lenient Materiality Standard

Finally, the Tenth Circuit’s decision is notable for adopting a very lenient standard for the “materiality” of non-public information. The non-public information at issue in this case suggested that earnings targets were overstated. Nacchio argued that this information was not material because the degree of overstatement was so slight. He contended that the degree of overstatement was 1.4% of total revenues; the government maintained that it was 4.2%. In either event, Nacchio’s argument would seem to be fairly strong. The Tenth Circuit noted that “[c]ourts regularly look to the magnitude of a potential loss in determining whether knowledge of it is material,” and it cited an unpublished Ninth Circuit decision concluding that “[revenue] projections which are missed by 10% or less are not generally actionable.” (In re Apple Computer, Inc., 127 F. App’x 296, 204 (9th Cir. 2005).) It also quoted from an SEC accounting bulletin in which the accounting staff assessed the “common ‘rule of thumb’ among accountants ‘that the misstatement or omission of an item that falls under a 5% threshold is not material in the absence of particularly egregious circumstances.’” In that bulletin, the accounting staff stated:

The use of a percentage as a numerical threshold, such as 5%, may provide the basis for a preliminary assumption that–without considering all relevant circumstances–a deviation of less than the specified percentage with respect to a particular item on the registrant’s financial statement is unlikely to be material. The staff has no objection to such a “rule of thumb” as an initial step in assessing materiality. But quantifying, in percentage terms, the magnitude of a misstatement is only the beginning of an analysis of materiality; it cannot appropriately be used as a substitute for a full analysis of all relevant considerations.

Given the accounting staff’s unwillingness to create a real safe harbor for revenue deviations of less than 5% of projections, the Tenth Circuit was unwilling to conclude that Nacchio’s non-public information about a likely revenue shortfall (which the court measured at 4.2% of projections) was immaterial. So much for the rule of lenity.

(More on the materiality ruling here.)

***

So what’s going to happen on remand? Jay Brown thinks Nacchio’s prospects are pretty grim. I’d perhaps offer a brighter prognosis. If Nacchio can get the court to reject Rule 10b5-1’s “awareness” standard, so that the government must prove that the material non-public information caused the sales at issue AND if Fischel sets forth a convincing case for why the stock trades must have been accomplished as part of a diversification strategy, not as an attempt to profit from inside information, then he has a shot.

Of course, those are some big ifs. Nacchio’s best approach might be a plea bargain. I, of course, hope he doesn’t do so so that a court can directly confront Rule 10b5-1’s overbreadth.

I’m a bit late to the party on Jeffrey Rosen’s provocative article in the NY Times Magazine claiming that the Supreme Court is biased in favor of businesses. For readers not familiar with Rosen’s claim, the basic assertion is that:

With their pro-business jurisprudence, the justices may be capturing an emerging spirit of agreement among liberal and conservative elites about the value of free markets.

Eric Posner’s insightful response hits the nail on the head in critiquing Rosen’s characterization for lack of evidence and exposing Rosen’s implicit assumption that populist jurisprudence is the “unbiased” baseline. I want to focus in the role of the Roberts Court antitrust cases in Rosen’s claim. Rosen cites to these cases as evidence in favor of his bias claim, noting the significant increase in antitrust activity in the Court in recent years and emphasizing the fact that “the Roberts Court has heard seven [cases] in its first two terms - and all of them were decided in favor of the corporate defendants.”

So what are we to make out of these cases? Are the Roberts Court cases really pro-business? Rosen’s “pro-business bias” claim is analytically identical to Erwin Chemerinsky’s take on the Supreme Court cases that I criticized here awhile back (Chemerinsky concluded that the Supreme Court’s antitrust decisions favored “businesses over consumers”). It is also identically incorrect.

Posner gives one excellent reason in his response when he notes that 6 out of the 7 Roberts Court cases involve businesses as both plaintiffs and defendant. Only Twombly involved consumer plaintiffs (and Credit Suisse involved a mixed class of plaintiffs including corporate investors). As Posner notes, it is a bit of a reach to credibly claim “pro-business bias” on this track record where a corporate plaintiff loses in the majority of the cases.

But there is another reason that this “pro-business bias” argument should be dismissed as incorrect with respect to the antitrust cases despite the superficial and soundbyte style argument that a winning streak for defendants is a sufficient condition for anti-consumer bias. I’ve argued elsewhere at length that the Roberts Court’s antitrust jurisprudence can be characterized as embracing the Chicago School tradition of antitrust analysis with its emphasis on theoretical rigor, empirical evidence, and sensitivity to error costs. To the extent that this is consistent with the view that the Roberts Court’s antitrust cases are increasingly “pro-market,” there is an important difference between that statement and the leap to “biased in favor of businesses over consumers!”

The 5-4 decision in to overrule Dr. Miles’ per se prohibition against minimum resale price maintenance in Leegin provides an illustration of that difference in practice. Is Leegin pro-business? Quite obviously, we would need to know something about whether minimum RPM is good or bad for consumers before we concluded that lifting the per se prohibition was a good or bad thing. A Supreme Court interested in consumer welfare analysis (what antitrust does) would be interested in the competitive effects of minimum RPM in order to address the underlying issue: are consumers better or worse off when we allow the practice? A Supreme Court biased in favor of business would have no need at all for that sort of inquiry. But Justice Kennedy’s opinion on behalf of the majority relies extensively on economic theory and empirical evidence that minimum resale price maintenance made consumers better off! Now, one might think that the Court got it wrong, misunderstands the evidence, and that RPM actually harms consumers. For the record, I disagree and believe Leegin was correctly decided. But to argue that the Court got there by favoring business over consumers is not accurate, and obvious from reading the opinion.

What about Twombly? The one case which involves a consumer plaintiff. Is Twombly biased in favor of businesses? It certainly makes it more difficult for plaintiffs to survive a motion to dismiss in a Section 1 case. But is that anti-consumer? Again, only under a superficial analysis of the reasoning in that case. Specifically, the Court is concerned that abuse of the antitrust laws through discovery and frivolous claims exposes firms to the risk of false positives and may chill pro-competitive conduct — which is bad for consumers. One might disagree with these concerns, or believe that the Court misunderstands their magnitude or impact on consumers. But the Court explicitly motivates its analysis with concern about the social costs of abuses of private antitrust enforcement which are passed on to consumers. Similar concerns motivated the Court’s analysis in Credit Suisse. To argue that this conclusion comes from some sort of pro-business bias is a stretch.

We could do this with the rest of the cases. There is clearly a shift in antitrust analysis in the Supreme Court both in terms of activity level and, to a lesser extent, the analytical framework employed. The adoption of the Chicago School of antitrust analysis principles is not properly viewed as a pro-business bias. In fact, it was contributions from that movement in economics that demonstrated why some business practices previously thought to be inefficient actually improved consumer welfare. Subsequent empirical evidence has been overwhelmingly consistent with this approach. I don’t have enough expertise in the other areas of law that Rosen covers to say something about the general claim, though I suspect Posner’s characterization is correct. With respect to the antitrust cases, the Roberts Court decisions have been thoughtful and mindful of the ultimate goal of antitrust: consumer welfare. The conclusion that these cases are biased must rely on some implicit assumption that there is an “unbiased” baseline approach to these cases that does not involve consumer welfare analysis. At least for the past 30 years, and to the benefit of consumers, modern antitrust analysis has rejected alternative approaches that favor small businesses (”small dealers and worthy men”) or non-economic concerns.

Just as the April 1 trial date was approaching in the lawsuit by seven elite-level poker players against WPT Enterprises, it has been extended four months to August 5.  The case involves antitrust claims of exclusive dealing and price-fixing as well as the non-antitrust issue of contractual interference with respect to the releases players must sign before competing in a WPT tournament.  I have an article in the March issue of Two Plus Two Internet Magazine targeted towards providing everyday individuals who follow the WPT a basic understanding of the antitrust claims and my opinion on what they’re likely all about.

In the “small world” coincidence department, I happened to play at the same table as WPT CEO Steve “Other Guy” Lipscomb back in December (if the name Berman means anything to you, you’ll understand what “Other Guy” means).  When he mentioned he was the CEO of the WPT, no one believed him.  Personally, I refused to believe him for a solid half-hour until I decided to ask him what was going on with the player lawsuit against the WPT.  When he instantaneously dodged the question, I was pretty confident he wasn’t lying…………Oh, and looking up his name and picture on the Internet when I got home also helped.

Anyway, it will be interesting to see if the antitrust elements are settled or go to trial, or if they were really just thrown in the case as some attempt at leverage for what appears to be the players’ main complaint about the alleged overly broad releases.

Motivated by a slate of forthcoming articles, books, and various projects involving unincorporated firms, Professor Ribstein has announced his plans to begin blogging more extensively about partnership, LLCs and agency issues over at Ideoblog. This is good news to anybody interested in issues of business law and finance more generally. Two early installments in this endeavor are already up here and here. With all of Professor Ribstein’s upcoming projects, I was a bit concerned that the cost of these increased efforts might be less time dedicated to exposing the hand waving economic illiteracy of Ben Stein in the NY Times. I guess I don’t have to worry about that.

I’d have to say the answer is yes (duh).  Radiohead’s In Rainbows made a stunning “official”debut, coming out at number 1 on the Billboard chart with 122,000 US sales in the first week.

But Radiohead’s last album, Hail to the Thief, debuted at number 3, selling 300,000 copies in its first week.

The band must be disappointed with those sales numbers.  Number 1 or not (and I’m pleased to see it doesn’t take all that much to bump Mary J. Blige from the top spot), that’s a huge decrease in initial sales, especially for an album so critically lauded and with such a spectacular media following at the end of last year (including this very influential blog).

Of course it didn’t make my top 25, which probably explains the whole thing, come to think of it.

My former co-clerk (now Hofstra Law prof) Ron Colombo asked that I pass along information on an upcoming symposium at Hofstra Law School. The symposium, Regulation of Currency Exchange and Its Impact on International Business, will be held at Hofstra on February 8. The keynote speaker will be Walter Lukken, Acting Chairman of the CFTC. Three panels are planned:

Is the depreciating dollar good for the U.S. economy? Is it good for the World’s economy? Are there policy or intervention initiatives that the governments and central banks are undertaking or coordinating?

FOREX Regulations in the New Millennium: the impact of Zelener and recent OTC retail FOREX regulations, and the protection of customer funds.

Will the pricing and hedging strategies for individual firms be affected by the declining dollar and the legal implications thereof?

More information and a link to register is here.

Ron tells me there may still be a limited number of openings for papers and presentations. Anyone interested in presenting should contact the editor-in-chief of the Journal of International Business and Law, sponsor of the event. The editor is Paul Sudentas — Phone: (516) 463-6188, E-mail: psuden1@pride.hofstra.edu.

A story in today’s WSJ highlights Dell’s rather slow move into retail distribution of its PCs.  The delay has been, at least in part, calculated to control the image of Dell’s products with its customer base.  For example, Dell’s new arrangement with Best Buy is designed to restrict Best Buy’s product line on some margins as part ofan effort to Dell sales from cannibalizing its Web customers.  Like with most distribution restraints, the manufacturer and retailer attempt to align incentives and facilitate performance.  In thise case, Dell was apparently concerned with Best Buy’s incentive to alter its product line up in a way that would harm Dell’s image and so included contractual restraints to reduce this incentive:

Dell’s biggest concern was that its products be positioned among the higher-end PCs in Best Buy stores, say executives from both companies — a must for Dell since Best Buy hosts more affluent electronics shoppers. The discussions became so detailed that executives from both sides even homed in on the colors of the notebooks that should be sold at Best Buy.

I wonder if Dell’s contracts include shelf space provisions.

Much discussion of corporate governance in the last few years has centered on reforms advocated by ISS and CII and indices of good corporate governance practice created and maintained by such groups. A new study by Roberta Romano, Sanjai Baghat, and Brian J. Bolton, however, concludes that there is “no consistent relation between governance indices and measures of corporate performance.” The authors continue,

[T]here is no one “best” measure of corporate governance: the most effective governance institution appears to depend on context, and on firms’ specific circumstances. It would therefore be difficult for an index, or any one variable, to capture critical nuances for making informed decisions. As a consequence, we conclude that governance indices are highly imperfect instruments for determining how to vote corporate proxies, let alone for portfolio investment decisions, and that investors and policymakers should exercise caution in attempting to draw inferences regarding a firm’s quality or future stock market performance from its ranking on any particular corporate governance measure. Most important, the implication of our analysis is that corporate governance is an area where a regulatory regime of ample flexible variation across firms that eschews governance mandates is particularly desirable, because there is considerable variation in the relation between the indices and measures of corporate performance.

The paper is entitled The Promise and Peril of Corporate Governance Indices and the full text is available on SSRN.

In France, it has been ruled that Amazon can no longer offer free shipping on book purchases. Don’t you just love it when competition policy protects certain competitors instead of actual competition? The protected competitors here are “vulnerable small bookshops.” Last I checked, the essence of competition is that “vulnerable” or inefficient competitors are supposed to be likely to go out of business. That’s the whole idea of promoting efficiency, innovation, economic growth, and enhanced welfare. The reason they’re vulnerable in the first place is that consumers in the market reveal that they more highly value the product characteristic bundle of other alternatives.

Personally, I have a love/hate relationship with this policy. I hate the “backwards” economics it promotes, but I love the fact that I get to make fun of it on TOTM. Death to free shipping, free samples, free coffee, loss-leaders, and, while we’re at it, Wal-mart rolled-back prices too!

See here.

I recently came across a keynote speech by Frank Easterbrook (published at 52 Emory L.J. 1297 (2003)) where he discusses Type I errors in antitrust cases.  Easterbrook, of course, produced the fundamental insight for antitrust enforcement that competition itself constrained the costs associated with false negatives while false positives were likely to ripple throughout the economy.  The argument is frequently raised that those concerned with false positives overestimate both their frequency and impact.  Sometimes this argument is coupled with the challenge: if Type I errors are so important, show me one in the cases!   In Easterbrook’s speech, he makes the point that the error rates do not have to be very high to produce serious consequences:

Courts are not supposed to go along with suits by or in the interest of rivals, but error is endemic in the judicial system. Let us suppose that there is a ten percent chance of a Type I error–that is, wrongful condemnation of an efficient practice–in any given antitrust  case. If ten cases can be brought in different jurisdictions, and they are resolved independently, then the risk of wrongful condemnation in at least one case climbs to sixty-five percent (0.910 = 0.349). Because any federal judge can issue a nationwide injunction, a single false positive can obliterate the challenged practice. And if the risk of a Type I error is fifteen percent, then the aggregate error rate in ten suits is eighty-one percent–which is to say that efficient, pro-consumer practices are highly likely to be suppressed. These numbers should cause great discomfort–and some large firms, of which Microsoft is only one example, are facing more than ten independent suits about the same practices. Maybe judges do better than this example gives them credit for: if the rate of Type I errors is five percent, then ten suits produce “only” a forty percent risk of wrongful condemnation. Sorry, but I’m still worried. Not until the error rate gets down to the one percent range in any given area does my concern abate–and I must tell you that the judges I know err more often than that. I do too.

As an aside, the challenge to produce examples of false positives from litigated cases misses the point of the social costs of false positives.  The real social costs associated with false positives are not just the treble damages and all of the follow-on private litigation in the litigated cases — though those certainly count too.  The larger social costs are the pro-competitive conduct that never occurs in the first place for fear of antitrust liability.

A few days ago, I posted a comment about Starbucks’ recent disclosure that its average per store traffic has gone down slightly even though overall profits have gone up. I suggested a number of explanations for these phenomena consistent with a story that consumer taste for the Starbucks product has not diminished. One of these explanations was that Starbucks makes its product available to non-Starbucks retailers and that consumers may be turning increasingly to these other retailers. That is, consumers could be shifting away from Starbucks stores rather than away from the Starbucks product. In passing, I observed that Starbucks’ distribution of its product to non-Starbucks stores is proconsumer and belies the accusations of some opportunistic competitors who claim that Starbucks’ business model is anticompetitive.

Yesterday, Stephen Bainbridge helpfully pointed out that Starbucks owns its stores and does not franchise them (correcting my reference to Starbucks “franchisees”). At the same time, Stephen also notes that Starbucks does license holders of otherwise inaccessible real estate to sell Starbucks products, an arrangement that is economically indistinguishable from franchising. I appreciate this clarification from Stephen. But I also should say that the analysis and conclusions in my original post do not turn on the distinction between Starbucks owning or franchising its stores. The important point is that the Starbucks product is available at other places besides Starbucks stores, such as at Barnes & Noble. Whether these alternatives are created by franchise or license is immaterial. Stephen does not dispute my conclusion that the antitrust allegations against Starbucks are without merit. And though he presents the point as “a problem with [my] analysis,” Stephen’s correction is, as Josh explains, really factual rather than analytical.

Leaving aside the issue of why traffic is down at Starbucks stores, Stephen raises (or rather recycles from a superb earlier posting he wrote back in 2003) the important question of why some firms like Starbucks choose to own their own stores (i.e., to vertically integrate) while other firms such as Subway choose to franchise. Many great minds have weighed in on this question over the years, beginning (at least implicitly) with Ronald Coase’s great 1937 essay “The Nature of the Firm” (which uses variation in transaction costs to explain a firm’s choice between internal and external contracting) and continuing most recently with Josh’s and Larry Ribstein’s excellent postings in response to Stephen.

I wish to add here only one point to the analysis. Whatever its economic benefits, vertical integration has the added virtue that it can reduce a firm’s exposure to certain types of antitrust claims. While a franchisor and franchisee can be sued under Section 1 of the Sherman Act for anticompetitive vertical restraints (such as vertical price fixing or other forms of restricted distribution such as territorial restraints), a single firm or a parent and its wholly owned subsidiaries are immune from such suits under the Supreme Court’s Copperweld decision, which held that a firm cannot conspire with itself for purposes of satisfying the conspiracy element of Section 1. At the same time, even while reducing exposure under Section 1, vertical integration by a firm with an already high market share can increase the firm’s exposure to a monopolization (or attempted monopolization) claim under Section 2.

The antitrust factor may well be one explanatory variable in Starbucks’ decision to own its stores rather than franchise them and Subway’s decision to franchise rather than own. Starbucks has a high and growing market share in the market for retail coffee, particularly if one defines the product market narrowly to include only “high end” coffee. It is plausible that a court could find it to have some degree of “market power” (though not “monopoly power”) in this market, which makes it vulnerable to Section 1 claims with respect to its arms’ length, vertical arrangements. Owning its own stores reduces that exposure, and since the stores have been owned from the start rather than acquired later there isn’t an apparent act of monopolization that would increase the firm’s exposure under Section 2. Subway, by contrast, seems much less dominant in its product space and indeed may not even have “market power” at all. If that is right, then Subway would benefit from vertical integration much less than Starbucks does–at least from an antitrust perspective.

Needless to say, other factors may well be at work besides the antitrust factor, as Josh, Larry, and Stephen ably suggest. My point here is only to add antitrust as another variable that may well explain firm franchising behavior in some range of cases.

The countdown is on for the XM-Sirius merger decision! (I wouldn’t be optimistic that the “end of the year” decision target will stand.)  Former FCC Chairman Reed Hundt and Representative Rich Boucher (D-Va) have recently come out in favor of the merger.  As everyone knows, it’s all about market definition, baby!  I’m not a gambling man, but I’d love to know what the Vegas odds would be for approval.

http://www.broadcastingcable.com/article/CA6500514.html?rssid=193

http://www.businessweek.com/technology/content/nov2007/tc20071115_361525.htm?chan=search

Traffic at Starbucks shops open for 13 months or more is down one percent. Does this mean that the public is finally losing its appetite for Starbucks? Not necessarily.

While traffic is down, profits are up. Thus a more likely explanation for the new data is the firm’s price increase last summer rather than a change in consumer tastes. Another possibility is that even if demand *per store* is down, overall demand could still be constant or even up, given that Starbucks is always opening new stores whose sales to some extent dilute the revenues of existing stores. A third factor that may explain things, and this is the one that I want to focus on because it is of interest to antitrust lawyers, is that Starbucks stores do not enjoy exclusivity in the sale of Starbucks coffee.

You can go into a Barnes & Noble and other non-Starbucks stores and find a cafe selling “Starbucks coffee” even though the seller isn’t a Starbucks. The coffee itself and the surrounding atmosphere at such cafes (complete with their wireless hotspots to go with the lowfat lattes) are in many cases close to perfect substitutes for Starbucks stores. Sales at such places, if they are increasing at an ever faster rate, may well be diluting sales at Starbucks stores and hence may well account for the new data.

Starbucks’ willingness to sell its product widely rather than reserve it exclusively for its full-service franchisees suggests to me that the firm is competing aggressively in an “output enhancing,” pro-consumer way, rather than seeking to find ways to reduce output and raise price, as some opportunistic antitrust plaintiffs have erroneously alleged.

All therefore seems well for the Starbucks franchise–even if, as Jackie Mason has quipped, it is a bit much to ask customers both to clean up after themselves and also to leave a tip!