In April 2000, the FTC issued a Complaint against women’s shoe distributor Nine West, claiming that Nine West had engaged in minimum resale price maintenance (RPM) (i.e., the setting of minimum prices that retailers could charge for its shoes). Apparently, Nine West was providing retailers with lists of “off limits” or “non-promote” shoes that weren’t to be promoted except during defined periods. Because Nine West sought acquiescence in those policies by threatening to terminate offending dealers, the FTC maintained that it had engaged in a minimum RPM agreement. At that time, such agreements were deemed to be per se unreasonable–and thus automatically illegal–restraints of trade. Nine West ultimately agreed to a broadly worded Consent Order requiring it to refrain from (among other things) fixing prices at which its retailers may sell, advertise, or promote its products; “otherwise pressuring” its dealers to adhere to resale prices; and “[s]ecuring or attempting to secure any commitment or assurance from any dealer concerning the resale price at which the dealer may advertise, promote, offer for sale or sell any Nine West Products.”

In last summer’s Leegin decision, the Supreme Court overruled Dr. Miles, the 1911 decision that had declared RPM agreements per se illegal. The Court reasoned that such agreements are frequently procompetitive and should not be condemned unless they are shown to violate the Rule of Reason (a fairly fact-intensive balancing test that considers the likely competitive effects of a restraint of trade in light of market structure so as to determine whether the restraint is, on balance, pro- or anti-competitive). In light of Leegin, which clearly undermined both the FTC’s Complaint against Nine West and its Consent Order, Nine West petitioned for modification of the Order to eliminate the prohibitions discussed above. Nine West reasoned that the Order unfairly placed it at a competitive disadvantage since its rivals now may engage in RPM and their RPM agreements cannot be successfully challenged absent a showing of actual competitive harm.

This all makes sense. The FTC’s Complaint and Order were based on an old (and much maligned) precedent holding that all minimum RPM agreements are automatically unreasonable and illegal. That precedent has been squarely overruled. Ergo, the Order should be revised to permit Nine West to engage in a business practice the Supreme Court has (correctly) concluded is usually pro-competitive. Seems pretty open and shut, right?

Think again. In an eighteen-page opinion released Tuesday (May 6), the FTC only partially granted Nine West’s request for modification and required Nine West to justify its use of RPM to the Commissioners by filing regular reports showing that its use of the practice is, in fact, pro-competitive.

Now one might wonder how a Supreme Court decision holding that minimum RPM is not presumptively unreasonable could support an order requiring Nine West to continually justify (i.e., to prove the reasonableness of) its use of the practice. Indeed, wasn’t the point of Leegin to put the burden of establishing the unreasonableness of any instance of RPM on the party complaining about the practice? The FTC says no. It maintains that the Rule of Reason applicable to RPM should presume that any instance of the practice is anti-competitive unless the defendant makes some showing otherwise.

To reach this rather odd conclusion, the FTC latches on to the Leegin Court’s observation that:

[a]s courts gain experience considering the effects of these restraints by applying the rule of reason over the course of decisions, they can establish the litigation structure to ensure that the rule operates to eliminate anticompetitive restraints from the market and to provide more guidance to businesses. Courts can, for example, devise rules over time for offering proof, or even presumptions where justified, to make the rule of reason a fair and efficient way to prohibit anticompetitive restraints and to promote competitive ones.

By this remark, the FTC contends, the Supreme Court directed the lower courts and regulatory agencies to adopt “the analytical approach that the D.C. Circuit endorsed in Polygram Holdings” [a.k.a. the “Three Tenors” case]. Under that approach, which builds on the “quick look” or truncated Rule of Reason the Supreme Court began to apply in 1978 in the Professional Engineers case, an antitrust tribunal considering a practice that is “inherently suspect,” though not per se illegal, may presume the practice unreasonable unless the defendant “either identif[ies] some reason the restraint is unlikely to harm consumers, or identif[ies] some competitive benefit that plausibly offsets the apparent or anticipated harm.” Minimum RPM, the FTC argues, is “inherently suspect” because it bears a “close family resemblance” to “‘another practice that already stands convicted in the court of consumer welfare’ – horizontal price-fixing.” Thus, the FTC concludes, Leegin, properly interpreted, presumes the unreasonableness of minimum RPM unless the defendant establishes that anticompetitive harm is unlikely by showing, for example, that the manufacturer engaging in RPM lacks market power, that the impetus for the RPM arrangement is the manufacturer rather than its retailers, and that there is no dominant retailer that might be responsible for the RPM agreement. While Nine West made such a showing (which is why the FTC begrudgingly agreed to modify the order so as to permit RPM), “the circumstances in the market could change” (which is why the Commission required Nine West to continually justify its use of the practice).

This is hogwash.

As an initial matter, the quoted remark from Leegin contemplates a structured Rule of Reason, not the sort of truncated inquiry approved in Professional Engineers and its progeny. The Court was simply saying that as courts accumulate experience evaluating minimum RPM, they will be able to articulate the precise factors that should be considered in determining the legality of any particular instance. Courts have done this sort of thing with other practices that are subject to the Rule of Reason. Horizontal data exchanges, for example, are evaluated by considering specific aspects of the structure of the market in which the participants compete and the nature of the information exchange (see Todd v. Exxon). The Rule of Reason applicable to exclusive dealing practices involves a structured “qualitative foreclosure” inquiry (see Tampa Electric). As courts gain experience with minimum RPM, they will similarly set forth a structured inquiry that is both easier to apply and more predictable than the “kitchen sink” Rule of Reason first set forth by Justice Brandeis in the Chicago Board of Trade decision.

In addition, the FTC erred in concluding that minimum RPM is “inherently suspect” and thus presumptively unreasonable. The Polygram Holdings (Three Tenors) decision itself sets forth the standard for inherently suspect, but not per se illegal, restraints:

If, based upon economic learning and the experience of the market, it is obvious that a restraint of trade likely impairs competition, then the restraint of trade is presumed unlawful and, in order to avoid liability, the defendant must either identify some reason the restraint is unlikely to harm consumers or identify some competitive benefit that plausibly offsets the apparent or anticipated harm.

It is simply not the case that “economic learning” and “the experience of the market” have made it “obvious” that minimum RPM “likely impairs competition.” The Leegin Court was crystal clear on that point.

Presumably realizing as much, the FTC latches onto another statement from Polygram Holdings – the observation that a restraint may be inherently suspicious because of “the close family resemblance between the suspect practice and another practice that already stands convicted in the court of consumer welfare.” The Commission maintains that vertical RPM bears that sort of resemblance to horizontal price-fixing.

But that’s just crazy. While horizontal and vertical price-fixing (minimum RPM) both involve the fixing of prices, there are hugely important differences between the two practices. Most notably, minimum RPM usually cannot benefit the price-fixer (the manufacturer) unless it increases sales at the retail level, generally by motivating point-of-sale services that make the product at issue more desirable to consumers. By contrast, horizontal price-fixing benefits the price-fixers by decreasing output to consumers. Thus, saying that the two practices bear a close family resemblance because they both involve price-fixing is like saying that Gary Coleman and Heidi Klum resemble each other because they both have legs.

As we’ve previously explained (and as the FTC well knows), it’s really hard to use RPM to accomplish anti-competitive ends. Pro-competitive rationales undoubtedly explain most instances of minimum RPM, and for that reason, the burden should be on the party challenging an RPM practice to prove his less plausible story.

The FTC’s May 6 opinion seems to be coated with the fingerprints of Commissioner Pamela Jones Harbour, who has made no secret of her affection for Dr. Miles. At this point, though, it’s getting a little embarrassing. While we all know how hard it can be to say goodbye, it’s time to let the Good Doctor go.

I’ve been waiting for my old con law prof to take a political stand I could really get behind, and he finally has. Barack Obama is the only one of the presidential candidates to take a firm stand against this shamefully populist gas tax holiday. Good for you, Prof!

Now, I’m not normally a big tax guy. Taxes generally expand the government’s coffers, enabling the state to do more of the stuff I don’t think it should be doing, and lots of taxes (e.g., capital gains taxes, Sen. Obama) create terrible, wealth-destructive incentives. But not all taxes are created equal. Activities that impose costs that are not borne by the people engaging in the activities – negative externalities, to use economic jargon – may be appropriately taxed. Gasoline consumption, which creates all sorts of negative spillovers, is one of those activities.

A friend of mine whom I hadn’t seen for a while came over the other night. I laughed when I realized he’d traded his ridiculous monster truck (he’s a city boy who definitely doesn’t need that much vehicle) for a sensible Honda Civic. “What’s up with the ride?” I asked. “Gas prices,” he replied.

What good greenie (as Hillary is trying to portray herself) or economically astute policymaker (as McCain is trying to portray himself) could think this is a bad thing?

Speaking of Nudge, Cato is holding a  book forum on Cass Sunstein and Richard Thaler’s new book on May 1 which will feature Sunstein, and comments from Will Wilkinson and my colleague Terrence Chorvat.  Registration is free and you can also watch the event live at the link above.

Sunstein and Thaler have a series of posts over at Volokh Consipiracy on their new book Nudge, which expands on their notion of libertarian paternalism (see here, here , here and here).  Something in the most recent post caught my eye.  In preparing to respond to various objections to libertarian paternalism, Sunstein argues that this sort of paternalism offers the “best of both worlds”:

In short, we hope that libertarian paternalism might provide a real third way, one that recognizes the best in Hayek and Friedman while also noticing the work of Simon, Kahneman, and Tversky (and Thaler), which shows that human beings often choose poorly. Thus, for example, libertarian paternalism offers fresh ways of thinking about the mortgage crisis, credit card reform, savings for retirement, prescription drugs, health care, environmental law, and even marriage. In all these contexts, a few nudges could help a lot.

One of the problems that I have with libertarian paternalism marketed in this manner is that it sells traditional economic theory short by describing it as missing the point that individuals make errors.  Perfection is costly, and so the optimal rate of errors is not zero.  The argument against paternalism, libertarian or otherwise, is not that individuals  have perfect foresight and do not make errors (even systematic ones).  It is that individuals will tend to make better self-interested decisions than the government would do on their behalf. 

A second problem, and one I’ve noted before, is that:

In accounting for the long run costs of paternalism, we must also be mindful of dynamic effects that are likely to follow from paternalistic decision-making before intervening (on this last point, see Klick and Mitchell in the Minnesota L. Rev., or more recently Ed Glaeser’s essay on Paternalism and Psychology).

These long term dynamic costs of paternalistic intervention surely must be part of the cost-benefit analysis with respect to any such regulatory proposal.   In other words, there is a danger that my mitigating the costs of errors through regulation, we increase the rate of errors.  This point goes directly to the appropriateness of the “libertarian” modifier for this type of paternalism.  Sunstein & Thaler argue that liberty is maintained because these proposals encourage choice rather than coercive mandates.  But the libertarian case also rests on the presumption that allowing individuals to bear the costs of their errors leads to better and more competent choices in the future.  Many, but not all, of the proposed “nudges” do not appear to take this concern to seriously.

Northwestern University School of Law’s Searle Center on Law, Regulation and Economic Growth will be holding a conference on Antitrust Economics and Competition Policy on September 26-27th.  From the Call for Papers:

The goal of this Research Symposium is to provide a forum where leading scholars from across the country can gather together with Northwestern’s own distinguished faculty to present and discuss high quality research relevant to antitrust economics and competition policy. Both theoretical and empirical submissions are welcome. Papers in industrial organization or applied microeconomic theory that address issues relevant to antitrust policy are welcome even if they do not directly focus on particular antitrust policy issues or institutions. We hope to involve leading thinkers from the government, non-profit, and private sector, as well as leading academics from economics departments, business schools, law schools and public policy schools. While most of the conference will be devoted to presentation and discussion of original academic research, we also expect to schedule a small number of panels on important current topics or policy issues. If you have questions about the appropriateness of your paper for the symposium, or suggestions for panel subjects, please contact Professor William Rogerson, Research Director, Searle Center Research Project on Competition, Antitrust and Regulation (wrogerson@northwestern.edu)

NOTE: The deadline for abstracts is April 15, 2008!

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.

With all of the recent talk of the “optimal regulatory structure” and proposals about regulatory consolidation and reorganization (here is Glom Blogger David Zaring on the Big Reorg), I wonder if the discussion might carry over into antitrust and the recurring “dual enforcement” question. 

As some of our readers may know, both the DOJ and FTC share the responsibility of enforcing the federal antitrust laws.  This dual agency structure comes under attack from time to time.  As one might expect, the primary critique is that the dual structure creates inconsistent enforcement and other inefficiencies.  However, the consensus view appears to be that the institutions have evolved in ways that mitigate those inefficiencies.  At least, the agencies have reduced these inefficiencies to the point that there is apparently no constituency harmed by them sufficiently to create a large demand for reform.  Judge Posner describes the structure as “peculiar, to say the least … yet pretty harmless.”  The Antitrust Modernization Committee recently took on the issue of dual enforcement (Chapter II.A) and concluded that while “although concentrating enforcement authority in a single agency generally would be a superior institutional structure, the significant costs and disruptions of moving to a single-agency system at this point in time would likely exceed the benefits.”  In other words, if it ain’t broke (or is only broke a little bit) … It should be noted that three AMC Commissioners did recommend consolidation of all antitrust enforcement powers with the DOJ.

The discussion of benefits and costs of regulatory competition and consolidation in antitrust has been largely anecdotal.  For example, Judge Posner draws on his own experiences with state AGs (read: bad ones), though he does marshal some other evidence, in arguing that states should be stripped of their antitrust enforcement powers except for under narrow circumstances.  I think it is a fairly open empirical question whether and to what extent regulatory competition between federal agencies (or federal agencies and the state AGs)  has been a net good or bad for consumer welfare.   If any rigorous empirical work has been done on this question in antitrust, I haven’t seen it or have forgotten it.  My instinct is that the evidence is likely to differ in those two cases with state v. federal overlapping enforcement generating larger and more robust negative effects (and little or no effect as between the federal agencies).

Today, Treasury Secretary Henry Paulson is set to present some comments about the Treasury’s Blueprint for Financial Regulatory Reform, released on Saturday.  (A summary of the proposal is here.) 

The summary of the proposal report provides:  “In this report, Treasury presents a series of “short-term” and “intermediate-term” recommendations that could immediately improve and reform the U.S. regulatory structure. The short-term recommendations focus on taking action now to improve regulatory coordination and oversight in the wake of recent events in the credit and mortgage markets. The intermediate recommendations focus on eliminating some of the duplication of the U.S. regulatory system, but more importantly try to modernize the regulatory structure applicable to certain sectors in the financial services industry (banking, insurance, securities, and futures) within the current framework.” 

I have a few comments on the proposals:

1.  The report contemplates consolidation of market regulators for the securities markets and the commodities markets.  This is a difficult issue.  Intuitively, I like the notion of consolidating regulation, as the regulatory authority dealing with commodities (the CFTC) and regulators of the general securities markets (SEC) both regulate the markets for securities.  That said, commodities regulation is (a) incrementally more sophisticated than the regulation of the generic securities markets due to the increased complexity in products, their evolution, and their likely economic/market impact and (b) different in sort than the regulation of plain vanilla securities.  Moreover, my impression – based on my experience working at the SEC and my experience as a corporate/securities/business scholar – is that the CFTC does a bit of a better job than the SEC in avoiding political pressure.  (Think about it – while we can easily recall a series of SEC Chairmen resigning under pressure, can we easily recall a series of CFTC Chairmen resigning under pressure?)  Is it sensible to combine agencies and lose that market niche insulation?

2.  The motivation for Treasury’s proposals strikes me as questionable.  The report summary says:  “Market conditions today provide a pertinent backdrop for this report’s release, reinforcing the direct relationship between strong consumer protection and market stability on the one hand and capital markets competitiveness on the other and highlighting the need for examining the U.S. regulatory structure.”  Indeed, the argument was made in connection with last spring’s Paulson report that the US capital markets are becoming less competitive, in part due to mis-regulation (and overregulation).

 But the argument that the US capital markets are becoming less competitive continues to be the subject of robust academic debate.  (For example, Howell Jackson, Jack Coffe, Kate Litvak, and Don Langevoort, all very credible scholars, expressed differing views on the issue at the AALS annual meeting this past year.)  I, for one, do not believe that the US capital markets are becoming less competitive.  Instead, I believe that the overseas markets are becoming *more* competitive.  That is not a bad thing, nor is it reason to overhaul US market regulation.  In reality, maybe the increasing competitiveness of overseas capital markets counsels in favor of our holding the status quo, to see how things shake out with the fundamentals that make the overseas markets increasingly competitive in the short term.

To that end, the report summary says “[g]lobalization of the capital markets is a significant development. Foreign economies are maturing into market-based economies, contributing to global economic growth and stability and providing a deep and liquid source of capital outside the United States. Unlike the United States, these markets often benefit from recently created or newly developing regulatory structures, more adaptive to the complexity and increasing pace of innovation.”  Until we know how these more newly developed regulatory structures fare in the long term, is seems unwise to jump to action to keep up with them.    Moreover, the summary of Saturday’s report indicates that its authors looked closely at the UK, Australia, and Netherlands financial markets regulatory regimes in designing the proposals in the report.  Basing reform of the US capital markets on regulation in the UK, Australia, and the Netherlands, however, does not strike me as sound.  If we are entertaining notions of wholesale reform, why not instead pin down what the conceptual optimal model would look like, as opposed to mining for inspiration from other regulators?  That said, the report purports to so do, to a degree, as discussed below in point three. 

3.  The report touts a new “objectives based regulatory approach.”  This approach, however, while radically different from the current US capital markets regulatory structure in terms of how it is implemented, is nothing new in terms of goals.  (Indeed, the summary says the new structure is motivated in part by “the convergence of financial services providers and financial products has increased over the past decade.  Financial intermediaries and trading platforms are converging.   Financial products may have insurance, banking, securities, and futures components.”  But wasn’t this dealt with in the Gramm- Leach-Bliley Act?  Why now do we need to revisit what appears to have been sensible reform less than a decade ago?)

The report summary says “[l]argely incompatible with these market developments is the current system of functional regulation, which maintains separate regulatory agencies across segregated functional lines of financial services, such as banking, insurance, securities, and futures,” and the report instead argues for an objectives based regulatory scheme, based on the objectives of “[m]arket stability regulation…, [p] rudential financial regulation…, and [b]usiness conduct regulation.”  But our current functional regulatory scheme operates with a focus on these exact objectives.  A consolidation of power into one regulatory authority for each objective seems to do nothing other than allow for (a) tunnel vision by a given objective’s regulator and (b) decreased input in terms of how to regulate to the goal of meeting these objectives.  With respect to point “b,” I believe that it is useful to have the leaders at the SEC, the CFTC, and the Federal Reserve all making calls to each other, giving input to the President and Congress, and agitating for ways to secure better regulation.  Yes, there is tension and a bit of repetitive regulation, but it seems to me that that is healthy when dealing with a matter as important as the United States capital markets.

4.  I have not worked through exactly how Saturday’s report proposes, if at all, to restructure the actual Board of Governors of the Federal Reserve System.  I will note, however, that I am generally leery of restructuring the Federal Reserve, both in terms of authority and operation.  Part of what makes the Federal Rserve work is the fact that the Governors serve for 14 year terms, allowing for insulation from political pressure (to a degree) and a link between immediate decision-making and longer-term implications.  (Contrariwise, the SEC Commissioners are usually long gone before the fall-out from their decisions becomes manifest.)  The Federal Reserve System has worked well for almost 100 years.  Does it really make sense to tamper with it?   

5.  To paraphrase, “regulate in haste and repent in leisure.”  I am never thrilled to see a massive proposal for overhaul and reform on the heels some major business or economic event.  Did the aftermath of the Sarbanes-Oxley Act (which is an act that I support, by the way) teach us nothing?

David Zaring and Gordon Smith have some interesting comments over on the ‘Glom, as does Larry Ribstein on his blog.

Todd Zywicki and Maxwell Stearns have a draft of their new textbook, “Public Choice Concepts and Applications in the Law,” available for review for profs that are interested in teaching with the manuscript this Fall 2008 or Spring 2009 term (the book is due to be published in 2009).  The book is designed for law profs along with “teachers of economics, political science, and public policy courses as well … and to be taught as either a follow-on to a traditional law and economics course or as a substitute for a traditional law and economics course.”  Zywicki & Stearns description of the project and invitation for those interested in early adoption to view the current manuscript is below the fold.

(more…)

Josh had a characteristically thoughtful post last week on safe harbors for loyalty and bundled discounts. I didn’t comment on the post, with which I generally agree, because I was busy writing an amicus brief (also signed by Dan Crane, Richard Epstein, Tom Morgan, and Danny Sokol) in an attempt to preserve a different safe harbor for bundled discounts. That’s the safe harbor created by the Ninth Circuit’s recent PeaceHealth decision (discussed here). PeaceHealth held that

To prove a bundled discount was exclusionary or predatory for the purposes of a monopolization or attempted monopolization claim under Section 2 of the Sherman Act, the plaintiff must establish that, after allocating the discount given by the defendant on the entire bundle of products to the competitive product or products, the defendant sold the competitive product or products below its average variable cost of producing them.

That is an eminently sensible holding. Bundled discounts — discounts conditioned upon purchasing a group of different products from the discounter (think meal deals, Internet/phone/cable bundles) — are pervasive, involve an immediate consumer benefit (lower prices), and are usually procompetitive. Like other price cuts, they should be condemned only when they have the potential to drive equally efficient rivals from the discounter’s market. With single-product discounts, we identify price-cuts that have such anticompetitive potential by asking whether they result in prices below the discounter’s cost of production; if not, they could be matched by any equally efficient rival willing to engage in aggressive price competition.

With bundled (or package) discounts, we may need to look a little harder. In theory at least, a bundled discount that results in above-cost pricing (for the whole bundle) may exclude equally efficient rivals that sell a narrower line of products. Consider, for example, a manufacturer (”MultiCo”) that sells both shampoo and conditioner and competes against another manufacturer (”SingleCo”) that sells only shampoo. SingleCo, the more efficient shampoo manufacturer, can produce a bottle of shampoo for $1.25. It costs MultiCo $1.50 to produce a bottle of shampoo and $2.50 to produce a bottle of conditioner. If purchased separately, MultiCo charges $2.00 for shampoo and $4.00 for conditioner ($6.00 total), but if the consumer purchases both products at once, MultiCo will sell the combination for $5.00. That $1.00 bundled discount results in a price that is $1.00 greater than MultiCo’s cost for the two products ($4.00). Nonetheless, the above-cost bundled discount could exclude SingleCo. SingleCo could stay in the market only if it charged no more than $1.00 for shampoo (so that a consumer’s total price of SingleCo’s shampoo and MultiCo’s conditioner would not exceed $5.00, MultiCo’s package price), but SingleCo’s marginal cost of producing shampoo is $1.25. Accordingly, MultiCo’s bundled discount could eliminate SingleCo as a competitor even though (1) SingleCo is the more efficient producer and (2) MultiCo’s discounted price is above its cost of producing the bundle. The upshot is that we may underdeter if we immunize all bundled discounts that result in an above-cost price for the entire bundle.

But there’s no way the more conservative safe harbor announced in PeaceHealth could immunize anticompetitive discounts. If a challenged bundled discount doesn’t result in below-cost pricing after the entire amount of the bundled discount is attributed to the product or products the defendant discounter sells in competition with the plaintiff, then the plaintiff — if it’s as efficient as the defendant — could meet the defendant’s discount by lowering its price to some above-cost level (or to cost). For example, if MultiCo were to sell its shampoo/conditioner package for $5.50 (50 cents less than the aggregate price of the products sold separately), any equally efficient shampoo producer (producing at $1.50 per bottle) could compete by lowering its price to its cost: A customer could buy that company’s shampoo ($1.50) and MultiCo’s conditioner ($4.00) for the same total price as MultiCo’s bundle.

In short, any plaintiff driven out of business by a discount that passes muster under PeaceHealth’s “discount attribution” test would have to be either (1) less efficient than the discounter, or (2) unwilling to engage in vigorous price competition. Antitrust shouldn’t thwart consumer-friendly discounts in order to create price umbrellas for inefficient competitors or to indulge rivals that won’t lower price to the level of cost. Accordingly, no plaintiff should prevail on a bundled discount challenge unless it can make the discount attribution showing required by PeaceHealth.

In its appeal, Masimo is arguing that the court should permit it to attack Tyco’s bundled discounts on a de facto exclusive dealing theory even though it can’t prove that Tyco engaged in below-cost pricing under PeaceHealth’s discount attribution test. Masimo (along with supporting amici the Consumer Federation of America and the Medical Device Manufacturers Association) contends that PeaceHealth’s safe harbor applies only in “price competition” cases, not in cases involving de facto exclusive dealing.

That makes no sense. Masimo’s de facto exclusive dealing theory is that Tyco’s bundled discounts — though involving no express promises of exclusivity (otherwise the exclusive dealing wouldn’t be “de facto”) — were so successful that they had the effect of inducing purchasers to buy exclusively from Tyco, thereby foreclosing Masimo from the market. But this just means that Tyco succeeded in attracting customers (usurping them from Masimo, among others) via low prices. Because low pricing is the very mechanism by which any “exclusivity” (and, hence, any market foreclosure) is achieved in a de facto exclusive dealing claim based on bundled discounts, every such claim is ultimately a “price competition” claim, falling squarely within PeaceHealth’s ambit.

The Ninth Circuit did the right thing in PeaceHealth. It provided businesses with much-needed guidance by recognizing a conservative safe harbor from which anticompetitive harm cannot flow. Masimo’s position threatens that safe harbor. It would allow plaintiffs to evade the procompetitive protections of PeaceHealth by attaching a new legal label (de facto exclusive dealing, de facto tying, unspecified “exclusionary conduct”) to challenge otherwise indistinguishable conduct. Potential defendants, knowing that plaintiffs may be able to avoid summary disposition of bundled discount claims by creative labeling, would likely respond by avoiding otherwise procompetitive bundled discounts (and the prospects of an adverse treble damages verdict) altogether. Consumers, who generally benefit from bundled discounts, would suffer.

If antitrust is to be a sensible enterprise, the question should not be “What label has plaintiff affixed to its claim?”, but rather “Is the behavior of which plaintiff complains likely to impair competition?” When it comes to bundled discounts — which generally reflect (or promote) cost-savings and which provide an immediate benefit to consumers — there can be no anticompetitive harm if there are no express exclusionary covenants and the competitive product is priced above the defendant’s cost once the entire discount is attributed to that product. Accordingly, the Ninth Circuit should decline Masimo’s invitation to turn the law of bundled discounting into the antitrust version of Greek mythology’s many-headed Hydra. Doing so would simply chill bundled discounts, to the detriment of consumers.

From the WSJ Online:

The transaction had faced stiff opposition in Brussels from Google rivals including Microsoft Corp. and Yahoo Inc., as well as privacy advocates who fretted that a combined company would control a vast storehouse of data on Web users and their surfing habits. But European Commission antitrust officials early on ruled out examining the privacy implications of the deal, resulting in a conventional merger analysis that left fewer ways for the deal to be blocked. In the end, the EU concluded that the still-nascent online-advertising market is changing quickly enough and has enough competitors that a combined Google-DoubleClick wouldn’t be able to shut out rivals. The purchase “would be unlikely to have harmful effects on consumers,” the EU said in a statement. The EU’s approval had been expected. The U.S. Federal Trade Commission gave its blessing, in a 4-1 vote, in December.

UPDATE: Here is more from Google’s Eric Schmidt and a few excerpts from the EC’s Press Release:

The Commission’s in-depth market investigation found that Google and DoubleClick were not exerting major competitive constraints on each other’s activities and could, therefore, not be considered as competitors at the moment. Even if DoubleClick could become an effective competitor in online intermediation services, it is likely that other competitors would continue to exert sufficient competitive pressure after the merger. The Commission therefore concluded that the elimination of DoubleClick as a potential competitor would not have an adverse impact on competition in the online intermediation advertising services market.

And with respect to non-horizontal issues the Commission:

found that the merged entity would not have the ability to engage in strategies aimed at marginalising Google’s competitors, mainly because of the presence of credible ad serving alternatives to which customers (publishers/advertisers/ad networks) can switch, in particular vertically integrated companies such as Microsoft, Yahoo! and AOL. The market investigation also found that the merged entity would not have the incentive to close off access for competitors in the ad serving market, mainly because such strategies would be unlikely to be profitable.

Dennis Carlton and Michael Waldman have posted an insightful DOJ working paper on antitrust safe harbors for unilateral conduct involving quantity discounts and bundling. The discussion is very timely in light of the Microsoft CFI decision, AMC Report, Section 2 Hearings, and various monopolization cases in the United States, EU, and other antitrust jurisdictions. The Carlton & Waldman paper is short, very accessible, and makes several very important points about the benefits of safe harbors to guide antitrust policy in this area generally and some weaknesses in the proposed AMC approach to bundling. Anybody interested in single firm conduct issues in antitrust should read this paper.

The issue they raise — safe harbors for single firm conduct — is one I’ve written about quite a bit. And I want to test out some thoughts on it here that I’ve sketched out partially in some academic writing and blog posts with respect to safe harbors for quantity discounts, loyalty rebates, exclusive dealing and competition for distribution more generally. I am on record defending two very specific safe harbors (one for short-term contracts and another for contracts that foreclose < 40% of the distribution market). I’ll return to the issue of a foreclosure safe harbor in a moment, and that will be the focus of the post, but for now, let me start with Carlton & Waldman’s framing of the antitrust problem of exclusion:

An antitrust claim involving exclusion requires that there be harm to a rival, harm to consumers and a linkage between the harm to the rival and the harm to consumers … This reasoning suggests that all mechanisms of exclusionary pricing conduct that do not alter a rival’s costs of operating or impair his ability to exist should not trigger an antitrust violation. In particular, this means that if there are no such effects, as for example occurs when the production technology is constant returns to scale, then there can be no anticompetitive harm. This does not mean that the rival’s business is unaffected nor that consumers are unaffected by a new pricing policy, but simply that the mechanism of harm, if there is one, has nothing to do with excluding a rival.

Carlton & Waldman focus in on the key issue for antitrust policy related to competition for distribution in the form of discounting conduct: the question of whether the defendant’s conduct has deprived a rival of scale to a degree that it is foreclosed from profitable access to the market altogether, or to a sufficient degree that its competitive constraint on the exercise of the defendant’s monopoly power is reduced, and competition is harmed.

So far so good. This economic insight is at the heart of the “foreclosure” requirement that appears in exclusive dealing cases that involve analytically identical claims concerning exclusion. Carlton & Waldman address claims of exclusion involving single product pricing in a predatory pricing framework and make the following statement about the “recoupment” requirement of the standard two pronged Brooke Group analysis:

[The recoupment prong] is a reflection of the principle that with constant returns to scale rivals will always constrain price and there can be no recoupement. The reason is that with no fixed costs, entry is always possible and guarantees that there is a competitive constraint on price. [The recoupment requirement] is phrased more practically to cover deviations from constant returns to scale that are not so large as to allow recoupment. With no possibility of recoupment, there is no reason to incur the initial loses associated with pricing below cost.

This is very interesting, and perhaps optimistic, understanding of courts are doing when the apply the recoupment requirement. My preliminary reaction is that most single product predatory pricing cases involve an analysis of barriers to entry at the recoupment stage as if the court was answering the question: “can the monopolist increase prices for a sustained period of time without attracting entry and therefore, recoup the losses associated with its period 1 prices?” I don’t think the courts explicitly conceptualize the recoupment prong in the way Carlton & Waldman describe here as it relates to scale. Rather, my tentative view is that analysis concerning the potential to deprive rivals of scale, the presence of substantial economies of scale, and even foreclosure are generally missing from these single product predatory pricing cases.

To be clear, thats not to say that courts are not analyzing in the recoupment prong the issue of whether the pricing scheme is likely to exclude rivals in some sense. But I think this sort of scale and foreclosure analysis that is typically present in exclusive dealing cases is generally absent in single product pricing cases. Now, I do believe that the recoupment requirement in these cases should be applied in the manner Carlton & Waldman suggest it already is. In fact, that is basically where I am going with this post. Keep reading and I’ll explain why I think this would be a good idea.

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Tom Barnett (DOJ Antitrust AG) gave a speech February 29th to the Federalist Society where he touched upon a number of interesting issues we’ve discussed from time to time here at TOTM.  Some highlights:

• Barnett on recent Supreme Court activity.  “I submit that the principal reason for the abundance of supermajority decisions is an analytical consensus that has emerged. The Court has accepted the focus on economic efficiency and the use of economic analysis. Many of the recent decisions reflect no more than an application of these principles to outdated antitrust doctrines. As Judge Douglas Ginsburg concluded in a recent article, the “Court, far from indulging in a pro-defendant or anti-antitrust bias, is [instead] methodically re-working antitrust doctrine to bring it into alignment with modern economic understanding.”

I’ve noted elsewhere that the Roberts Court’s antitrust decision can be characterized as an attempt to square outdated antitrust law with modern economic theory, empirical evidence, and a sensitivity to error-cost analysis (which Barnett seems to agree with in noting the “practical considerations” that guide the SCOTUS decisions in Twombly and Weyerhaueser).   Barnett also goes on to discuss the prominent role of stare decisis considerations in Leegin as compared to the Court’s markedly different position in State Oil v. Khan (1997) and hints that the newfound interest may “involve more than merely antitrust issues.”

• Barnett on Convergence.  “There remain significant differences between U.S. antitrust law and some aspects of other jurisdictions’ competition regimes. The EC, for example, is tasked with promoting a single European market, and therefore prohibits certain territorial contract restrictions that would not violate U.S. antitrust laws if they involved restrictions between U.S. states. More generally, it remains to be seen whether we can forge a consensus on the antitrust rules for judging the activity of individual firms — governed in U.S. law by section 2 of the Sherman Act. Such challenges and differences are important to note but they should not be exaggerated. In general, U.S. and foreign enforcers have made great progress in promoting principled convergence.”

Finally, Barnett chimed in on claims that the level of enforcement activity can be used to infer something about the quality of antitrust enforcement — a topic we’ve devoted some discussion to here at TOTM (see, e.g., here , here and here).  In addition to pointing to the DOJ’s impressive record of increased criminal antitrust enforcement, here’s what Barnett had to say:

• “Much of the scholarly and legal development in recent decades has focused on ways in which our older antitrust enforcement was overly aggressive. Scholars have opined and agencies and courts have accepted that mergers of grocery stores with no more than 15 percent of the market are unlikely to harm competition. Presumptions of market power were misplaced when based merely on the existence of patents. Vertical restrictions, such as territorial limitations or resale price maintenance, can benefit competition and consumers. Vague rules for single firm conduct can chill beneficial, procompetitive activity. More generally, the limitations of institutions such as courts, and the administrative costs of implementing rules, need to be taken into account in developing antitrust standards.”

Not as an economist of course! There is no doubt that Goolsbee is one of the world’s premier economists. But another brilliant economist, Jagdish Bhagwati, argues that voters should (HT: Mankiw) favor Barack Obama’s free trade credentials over Hillary Clinton’s based, at least partially, on Austan Goolsbee’s credentials as an advocate of free trade and as an economist. This argument begs a number of interesting questions: how important are economic advisers anyway? More specifically, is Bhagwati right that free traders should feel more comfortable with Obama than Clinton because of the formers choice of advisers? And how much weight should we assign this choice relative to say, voting patterns?

As a general matter, I think it is perfectly appropriate to give credit to the principal for the quality of the agents he or she is able to attract. And I’m tempted by the notion that an economist could actually constrain some of the protectionist rhetoric coming from a few of the candidates these days from amounting to policy. In fact, I was more optimistic about Goolsbee’s potential free trade influence on Obama several months ago. But I’m starting to doubt that there is any reason to be optimistic with statements like this out of the Obama camp (or this one) which suggest to me that Goolsbee has not had significant influence (though I may be wrong about that):

It’s a game where trade deals like NAFTA ship jobs overseas and force parents to compete with their teenagers to work for minimum wage at Wal-Mart.

Of course, one I suppose one can interpret the evidence in a more negative light. Perhaps without Goolsbee, Obama’s anti-trade rhetoric would be much worse. Perhaps the primary value of a prominent free trade advisor for a candidate with an anti-trade record and platform is to provide some assurance against extreme protectionism. But I don’t think that is Bhagwati’s argument. As an aside, I also believe most of the buzz about the link between behavioral economics and Obama’s economic policies is largely a mischaracterization.

I’m certain that economic advisers like Goolsbee, Mankiw, and other economists in simimlar roles provide significant and valuable services to their candidates. There is also little doubt that economic advisers can play a valuable role in helping to form sound economic policy once a candidate is in office. I don’t want to be misunderstood as saying that economic advisers in general, or Goolsbee in particular, are not valuable. What I am saying is that I don’t think Bhagwati’s argument that we should consider high quality economic advisers as a free trade credential is persuasive. In the case of Goolsbee-Obama, I find the link particularly weak given the strong protectionist talk from Obama in recent weeks. Though I hope I’m wrong, I’m significantly discounting the possibility that Goolsbee is exhibiting much of a constraining effect on Obama or that his presence should be relevant to the free trade credentials of the candidates.

Voting records, as opposed to speeches and selection of advisers, are a bit more informative. Luke Froeb, who is another excellent economist supporting a candidate (Luke is an Economic Policy Adviser for the McCain campaign), reports that McCain voted against trade barriers 88% of the time as opposed to Obama’s 36% and Clinton’s 31%.