He is a member of numerous professional organizations and boards, and an Honorary Life Member of the American Law and Economics Association, which honored him as one of the four founders of the field of Law and Economics.

Professor Manne has published many books and articles, with emphasis on law and economics, the free market, and securities regulation. His development of the theory of a “market for corporate control” is credited with opening the entire field of corporate law to economic analysis,and his 1966 book, “Insider Trading and the Stock Market,” began, and still heavily influences, the vast literature on that subject. He is a frequent contributor to the Wall Street Journal.

Among his notable educational innovations were the Law and Economics Center (LEC), the first academic center devoted to the development of the field of Law and Economics (presently part of the George Mason University School of Law); the Economics Institutes for Law Professors; the Law Institutes for Economists; the Economics Institutes for Federal Judges; the first specialized law degree program for Ph.D.’s in economics; and the first law school (George Mason) whose curriculum was built around the use of economics in law.

About Us

DATE AND PLACE OR BIRTH : SOUSSE (TUNISIA)
May 2, 1945

CITIZENSHIP : French

MARITAL STATUS : Married, 2 sons

ADDRESS :

Home : La Bastide des Adrechs
3207 Chemin de la Plaine
13590 MEYREUIL
Tel : (33)442 38 78 77
E.mail : jean-pierre.centi@univ.u-3mrs.fr

Office : M. le Doyen J.P. CENTI
Faculté d’Economie Appliquée
3 Avenue Robert Schuman
13628 AIX EN PROVENCE CEDEX 1
Tel. : (33)442 17 29 94
Fax : (33)442 59 38 87
E.mail : cabdoyen@univ.u-3mrs.fr

UNIVERSITY EDUCATION DEGREES

• Université d’Aix-Marseille III (1980) Doctorat de 3ème cycle en
Macroéconomie
(Mention Très Bien avec Eloges à
l’unanimité)

• Université d’Aix-Marseille III (1979 ) Doctorat d’Etat en Sciences
Economiques (Ph. D)
(Mention Très Honorable avec Eloges à l’unanimité)

• Académie d’Aix-Marseille :
Faculté de Droit et des Sciences Economiques (1964-1969)
Diplôme d’Etudes Supérieures
En Sciences Economiques
(Mention Bien)

PREVIOUS AND PRESENT POSITIONS

• Professor of Monetary Theory, Economic Policy and Public Choice
(Université d’Aix-Marseille III), 1986 to date.

• Professor of Monetary Theory and Economic Policy
(Université de Perpignan, France), 1982-1986

• Assistant Professsor of Monetary theory and Macroeconomics
(Université d’Aix-Marseille III), 1979-1981

• Lecturer in Monetary Theory and Macroeconomics
(Université d’Aix-Marseille III), 1969-1979.

ADMINISTRATIVE ACTIVITIES

• Dean of the Faculté d’Economie Appliquée since January 2002.
• Member of the Board of Directors of Paul Cézanne University of Aix-Marseille
• Director of « Centre d’Analyse Economique » de la Faculté d’Economie Appliquée from 1983 to 2002.
• In charge of the D.E.A. Degree « Analyse Economique des Institutions, from 1986 to 2002.
• Director of « Magistère Media et Formation Economique » from 1988 to 2002
• Coordinator for the European Erasmus (next SOCRATES) Programme « Law and Economics »
since1991, afterwards Erasmus Mundus Programme since 2004
• Member of the “Conseil National des Universités” (National Academin Advisory Council), Paris, 1987 –
1991, and 2003 - .
• Consultant to the French Ministry of National Education from 1994 to 1996.

PROFESSIONAL ASSOCIATIONS :

• American Economic Association.
• European Public Choice Society.
• Institute for Economic Studies Europe (Director).
• Mont Pèlerin Society: (Director from 2002).
• International Center for Research and Environmental Issues (Board member).

OTHER ACTIVITIES :

• Editor of « Le Journal des Economistes et des Etudes Humaines », Quarterly bilingual Review (first
number to be published in winter 1989/1990.
• Member of the “Editorial Advisory Board of the Fraser Institute » Vancouver, British Columbia, Canada.
• Member of the Scientific Committee of the International Centre for Economic Research (Turin).
• Member of the Scientific Committee of the Review “Procesos de Mercado, Revista Europea de
Economia Politica”
• Consultant to the French Ministry of Justice (1996).
• Visiting Professor, California State University of Hayward, CAL, USA (April-May-June, 1990)
• Visiting Professor, WSHiP (Warsaw Private University) (1997, 1998)

OTHER OPPORTUNITIES :

• Set up international meetings in Aix-en-Provence : especially an International Conference on Property
Rights and Environmental Resources every 2 years, and publication of the proceedings in French and
English (the first Conference was held in June 1996, the second in July 1998 on “water resources”, the third
in July 2000 on “marine resources”, the fourth in July 2002 on “coastal resources”, the fifth in June 2004 on
“waste”).
• Attending several meetings of “The Mont Pelerin Society”, European Public Choice Meetings, many
“Liberty Fund” Colloquia, and workshops in Law and Economics.
• Fellowship at the International Center of Economic Research, Turin, Italy (June, July, Sept, Oct. 1994).

RESEARCH : MAIN FIELDS :

• Monetary Theory and Policy
• Public Choice Analysis
• Law and Economics
• Austrian Economics.

RECENT PUBLICATIONS AND WORK

. « Intellectual Property Rights and Entrepreneurship : On the Precedence of Trademarks”, ICER,
WP No 2905, presented at the 75th Annual Conference of the Southern Economic Association,
Washington, DC, 2005.

. “Droit des marques et croissance économique : le cas de la Chine est-il généralisable ? », 54ème
Congrès de l’Association Internationale des Economistes de Langue Française, Aix-en-Provence, 2005,
submitted paper.

. “Promoting Entrepreneurship and Growth through Tax Reform”, in Austrian Economics Today
II: Reforms for a Competitive Economy, Conference proceedings under the auspices of the Federal
Minister of Finance, Karl-Heinz Grasser, Friedrich A. v. Hayek Institut (ed.), pp. 21-34, The ILAE (2005).

. “Competitive Strategies and Intellectual Property Rights in the Global Economy”, paper
prepared for the French-Chinese Conference, Shanghai University, December 2004 (Proceedings).

. “Possible Economic Consequences of Electronic Money” (en collaboration avec G.
Bougi), in Austrian Perspectives on the New Economy, Jack Birner and Pierre Garrouste (eds.), pp. 262-
286, Routledge (2003).

• “L’esprit d’entreprise au service du littoral” in Droits de propriété, économie et environnement : le
littoral, M. FALQUE et H. LAMOTTE (eds.), pp.196-204, Bruylant (2003).

• “The Meaning(s) of the Market Process”, paper presented for the Spring NYU Seminar, 2003, en
collaboration avec Neelkant Chamilall.

• “Hayekian Perspectives on the Monetary System: Toward Fiat Private and Competitive Moneys”, in
Austrian Economics Today : Analyses, Ideas and Suggestions, Conference proceedings under the auspices
of the Federal Minister of Finance, Karl-Heinz Grasser, Kurt R. Leube (ed.), pp. 89-104, The IIAE?
Frankfurter Allgemeine Buch, Frankfurt am Main (2003).

• “Property Rights and Marine Resources : Theoretical Foundations and Applications” in Marine
Resources: Property Rights, Economics and Environment, M. FALQUE, M. DE ALESSI, and H. LAMOTTE
(eds.), JAI: Elsevier, 2002, pp.123-36

• “Droit, économie et propriété: la place fondamentale de l’éthique », in Ethique et propriété, J.-Y.
Naudet (éd.), pp. 181-200, Librairie de l’Université d’Aix-en-Provence, (2002).

• “On Extending Currency Convertibility to African Countries and Allowing Spontaneous Monetary
Integration” (48 pp.), Contribution au dossier “On the Prospects and Feasibility of African Integration” ;
coordonnateur : Prof. E. Colombatto, (février 2001).

• “La détermination du prix de l’eau par les droits de propriété”, in Droits de propriété et environnement,
M. FALQUE et M. MASSENET (eds), Dalloz, (Collection Thèmes et Commentaires), mars 2000, pp. 199-163.

• “Equilibrium or Market Order ?”, Paper prepared for the 70th Conference of the Southern Economic
Association, Arlington, Virginia, November 10-12, 2000; en collaboration avec Neelkant Chamilall.

• Essays in Honour of Hayek’s Centenary Birthday (sous la direction de J.P. CENTI) :
Part 1 : Journal des Economistes et des Etudes Humaines, Vol. IX, n° 2/3, juin/sept. 1999, 259 pp
Part. 2 : Journal des Economistes et des Etudes Humaines, Vol. IX, n° 4, déc. 1999, 168 pp.

• “Le prix de l’environnement. Une approche par l’analyse économique du droit”, in Droits de Propriété
et Environnement, M. FALQUE et M. MASSENET (eds), Dalloz, Coll. Thèmes et Commentaires, 1997 (pp
156-172).

About Us

Honorable Ronald A. Cass is President, Cass & Associates, PC, a legal consultancy in Great Falls, VA, specializing in international trade, intellectual property, anti-trust law, administrative law and regulation. He also serves as an international arbitrator in NAFTA, ICSID, UNCITRAL and AAA cases. He served Presidents Reagan and Bush as Vice Chairman and Commissioner of the US International Trade Commission, and is Dean Emeritus of Boston University School of Law, where he served as Dean from 1990-2004 and Melville Madison Bigelow Professor of Law from 1995-2004.

Dean Cass is the author of more than 100 scholarly books and articles, including The Rule of Law in America (Johns Hopkins University Press, 2001), International Trade Law (with Michael Knoll, Ashgate Publishing Co., 2003), and Administrative Law (with Colin S. Diver and Jack M. Beermann, 5th ed., Aspen Law & Business, 2006). His commentaries appear in The Wall Street Journal, LA Times, Boston Globe, Forbes, RealClearPolitics, and many other media outlets. Dean Cass has taught at the University of Virginia, Boston University, Université Lyon III and Université d’Aix-Marseille III in France, and Universidad Francisco Marroquin in Guatemala, and lectures around the world on international trade, anti-trust, property rights, and other Rule of Law issues. He has served as Rapporteur to a US-EU Task Force on Intellectual Property Rights and is a senior fellow at the International Centre for Economic Research in Torino, Italy.

In addition, Dean Cass is Chairman of the Federalist Society Practice Group on International Law and National Security and Chairman-Elect of its Administrative Law group. He serves as Policy and Government Affairs Officer of the American Bar Association’s International Law Section, and is a past Chairman of the Association’s Section on Administrative Law and Regulatory Practice and former Delegate to the ABA House of Delegates. He is a member of many organizations, including the American Law Institute, American Bar Foundation, the Mont Pelerin Society, and the London Court of International Arbitration North America Group. He serves on the boards of several non-profit enterprises as well as academic editorial boards.

Dean Cass received his B.A. with high distinction from the University of Virginia in 1970, and is a graduate of the University of Chicago Law School, where he received his J.D. with honors in 1973.

About Us

She is currently the Editor of the Philanthropy Roundtable Newsletter, produced by the Federalist Society. She is a member of the Federalist Society and a Royce Fellow at Brown University.

Mrs. Cass received her A.B. summa cum laude from Brown University, and was a Dean’s Scholar at Boston University School of Law, where she received her J.D. with honors.

January 12, 2007

COMMENTARY

Forum-Shopper of the Year
By RONALD A. CASS

Anna Nicole Smith makes for good copy. America’s most gaudy litigant has spent the last few months dodging eviction notices in the Bahamas and paternity-test subpoenas in the U.S. A few days after the death of her son, she donned a wedding dress for a “commitment ceremony” with her attorney, then made almost a million dollars selling photos of her late son’s last hours, her new baby and her “wedding” to tabloid magazines. In the midst of all of this, she has kept up her long-running litigation over the estate of her late husband, J. Howard Marshall II. The litigation, which initially was filed more than a dozen years ago against heirs to the estate of her husband, has changed into a suit against the heirs of E. Pierce Marshall, her husband’s son, who died unexpectedly last summer.

Ms. Smith, a Texan who married a Texan, still comes to court in California seeking a sizeable share of J. Howard Marshall’s Texas-based estate. At the same time, she asserts that she is now a resident of the Bahamas, so California courts lack jurisdiction over her in the paternity litigation. Outlandish as this soap opera appears, her manipulation of our legal system could have significance to the law and to the rule of law. That is why devotees of serious news, as well as tabloid aficionados, should give heed.

* * *
Ms. Smith’s litigation begins with her brief marriage to J. Howard Marshall, when she was 26 and he nearly 90. Mr. Marshall formally memorialized their marriage with a $6 million gift to Ms. Smith but chose not to put her in his estate plan. Ms. Smith sued in Texas probate court seeking half his fortune, estimated at $1 billion, alleging that he had promised this to her only to have his son frustrate those wishes. The Texas court rejected her claims after a lengthy trial, but that didn’t end matters because Ms. Smith, after suing in Texas as a Texas resident, had instituted an action in federal bankruptcy court in California as a California resident. She sought asset protection following a default judgment against her (on a sexual harassment claim by her personal assistant). That judgment later was compromised for a smaller sum, but by then she had imported the essence of her Texas claims into the California proceeding.

The federal judge in California drew conclusions directly opposite those reached in Texas, a decision overturned by the Federal Court of Appeals for the Ninth Circuit, primarily on the ground that, under the “probate exception,” federal courts lack jurisdiction to hear matters within the competence of state probate courts. That conclusion was in turn reversed by the Supreme Court, which sent the case back to the appeals court to consider other reasons for overturning the lower court decision.

Proceedings in California between the parties have resumed, and the Ninth Circuit will likely take this matter up again in the spring. When it does, it will look at alternative doctrines that could avoid conflict between state and federal decisions. For example, “claim preclusion” prevents a second court (federal or state) from deciding a legal claim that was asserted in another court and “issue preclusion” prevents decision on a particular issue that was disposed of by another court. These doctrines are broader than the “probate exception” to federal jurisdiction addressed by the Supreme Court but do not have the same tension with federal court supremacy.The legal system generally arrives at predictable outcomes in logical venues based on reasonably foreseeable legal rules. But litigants can frame claims to induce application of less foreseeable rules in less logical venues. However much judges in California federal courts might endeavor to interpret Texas state law the way they believe Texas state judges would, the interpretations inevitably diverge — and the effort to engage a more remote forum often looks intended to take advantage of the divergence. The difference between determinations in two different court systems was the difference between an $88 million award and nothing.The case is likely to come to an end with a decision on one of the preclusion doctrines. The decision of the state probate court, based on the more extensive proceeding in the more logical venue, will then stand as the final word on the claims Ms. Smith has asserted. That does not, however, make this a story of the legal system working well; it is a story of the system working eventually.

If litigation were costless and decision makers consistent, forum shopping would present little problem. But litigation can be costly. A study estimates legal and administrative costs in tort suits (just a portion of the litigation landscape) at $140 billion per year and overall costs at $250 billion. And decisions on some questions, such as punitive damages, vary enough that the process has been compared to a “lawsuit lottery.”The problem is particularly acute for businesses, which fear that threats of costly litigation will be leverage for settlements. Such strategic use of litigation can occur because the litigation costs and risks are not symmetrical — some litigants have more to lose than others. Some law firms specializing in suing businesses, and some state attorneys general, rely on strategies that exploit risk sensitivity to extract settlements, at times very substantial ones. The behavior of former AG Eliot Spitzer and indictments of key partners at the plaintiffs’ law firm Milberg Weiss highlight the problem. Risks associated with ordinary litigation are magnified by opportunities to choose favorable venues for litigation, and even more by the prospect that litigants can engage in a repeat-play game, trying successive venues in search of a sympathetic forum. Forum shopping smacks of manipulation to reduce predictability and to secure biased decision makers.

Of course, some risks associated with conflicting decisions in parallel litigation are unavoidable in a complex system with overlapping competences in different jurisdictions. Attempting to minimize those risks, courts and lawmakers have developed rules that harmonize and prioritize conflicting legal commands and jurisdictions, that allow courts to stay their hand to avoid conflicts, and that provide for recognition of earlier decisions on the same issue or claim. But the degree to which those rules work efficiently — the degree to which they effectively limit the ability of determined litigants to exploit slack in the system and craft claims in creative ways that give them strategic advantage — is open to question.

And problems in the U.S. legal system are only one part of the picture. Once a strictly domestic game, forum-shopping has gone international. Not only can a growing roster of foreign enterprises and authorities enter the game, American businesses keen to restrain more successful competitors have a world of opportunities for doing so. If they cannot succeed with litigation at home, they can seek friendlier venues in many parts of the world. Thus, Microsoft, Intel and other market leaders now face proceedings in Europe, South Korea and elsewhere at the urging of American rivals such as IBM, Adobe and AMD.

Ms. Smith’s story demonstrates that a determined litigant with resources can move litigation among legal forums, tailor legal claims to prolong litigation, tie up assets, and make life difficult enough that most opponents would pay substantial amounts merely to bring the matter to a close. A victory for her would encourage forum-shopping, multiply costs and undermine the predictability of legal rules, doing damage that would last well beyond her 15 minutes of fame. A defeat for her would show that the system can at long last bring such manipulation to an end. And if that is what comes from her extended venture into the American court system, it would be a better legacy than any other she is apt to leave behind.

Mr. Cass is chairman of the Center for the Rule of Law and dean emeritus of Boston University School of Law.

URL for this article:
http://online.wsj.com/article/SB116856836667074708.html

COMMENTARY

The Follies of Regulation
By HENRY G. MANNE
September 27, 2005; Page A18

Christopher Cox, the newly minted chairman of the Securities and Exchange Commission, has offered the first hints of his direction on substantive policy issues. Addressing the question of exorbitant executive compensation — which has become the focal point of the American public’s concern about corporate governance — Mr. Cox last week raised the venerable battle standard of the SEC: full disclosure. That is too bad; the regulatory philosophy of full disclosure has been tried for over 70 years and been found sadly wanting as a way to protect shareholders from corporate and financial abuses.

Of course, Mr. Cox has a large and probably ideologically hostile bureaucracy to contend with, was accused of being too “pro-business” by Democrats before he took office, and faces a public that has rarely been as angry about corporate derelictions as it is right now. But such is the stuff that leadership is made of, and one can hope that Chairman Cox’s initial sally into the regulatory wars is merely a feint to test the enemy’s position.

The problem begins with thinking (as reflected in his statement) that shareholders will use the information they receive as a result of full disclosure laws to make their hired agents toe the (bottom) line. But while information that would not otherwise be available is valuable to those who trade in it or make their livings dealing with it, that is not the position of most shareholders. That includes most institutional investors, to whom some savants look for shareholder protection.

Shareholders who do not also control a corporation and designate the management cannot supervise and monitor managers and their salaries. Despite the apparatus of the derivative suit, courts are rightly reluctant to overturn compensation decisions by independent boards. Even those who do have control but not all the shares, may, for familiar free-rider reasons, spend less on monitoring than they would if they owned all the shares. And, not just incidentally, institutional investors are barred from owning control of portfolio companies by the Investment Company Act of 1940.

The result in many large, publicly held companies is precisely the situation that Berle and Means, in their 1932 classic, “The Modern Corporation and Private Property,” envisioned and condemned as the “separation of ownership and control.” Today the more commonly used term is “agency costs.” Call it what you will, the implications are clear. With no effective means for shareholders to monitor the self-interested or even merely stupid behavior of a corporation’s managers, a lot of peculiar things begin to happen.For example, even independent boards will tend to pay managers higher salaries or other compensation than would be true in non-publicly held companies, since the competitive and oversight pressures for restraint are relaxed. Managers may hoard cash to guarantee their own emoluments or to expand an “empire,” even though a payout would be more in the shareholders’ interest. They may use corporate funds to overpay other employees and avoid the headaches of labor strife. Or they may use corporate funds for nonprofitable ventures or “social” purposes, justified as part of the corporation’s “social responsibility,” but not in the shareholders’ interest. We can, and do, see all of these things happening today and in greater amounts than ever.

Most shareholders do not care whether their investment is tanking because the executives are overpaid or because the same people live like monks and give all the company’s wealth to good causes. Disclosure of the facts, of the sort the SEC has so long and disingenuously promoted — and which Chairman Cox sounds like he is still pushing — will not make a significant difference in what actually occurs. This is especially so on a matter like executive compensation, where real competitive market forces do, in fact, substantiate obscene-sounding compensation figures and the business judgment rule will generally prevent courts from second-guessing the market.

By and large, the media, the government, and many academics have been looking for the explanation for “obscene” executive compensation in the wrong places. Greed, immorality, lack of full disclosure and cronyism have precious little to do with corporate economics. For at least 45 years, legal and finance scholars have had available the explanation of what is going on and, at least in theory, the proper fix for apparent problems. Alas, that fix is now so politically out of the mainstream that other, far less desirable solutions are regularly proposed.

A brief review of the economics may be useful for regulators and businesspeople alike. We start the scenario with managers of a publicly traded company who are providing less than the maximum feasible rate of return on the corporation’s assets. Consequently, share prices, sensitively following the facts, decline relative to those of similar companies that are well managed. When the decline is sufficient that the difference between the purchase price of control shares and a higher share price expected from new management would cover the costs of a displacement action, the incumbents will be ousted and replaced by more competent managers.

This process occurs easily when enough shares are held by one or a few collaborating shareholders (and this includes hedge funds, which, for this reason alone, should not be further regulated) to allow them to vote the board and the overpaid executives out of office and preferably out of town. But when shares are widely owned and no one has a controlling block, incumbents cannot be so easily “fired.” Some other mechanism is required. Since the coordination costs of organizing diffused shareholders into a block are usually insurmountable, direct shareholder democracy in the form of a proxy fight has little chance of solving the problem. Only in the make-believe world of SEC regulation could anything like the proxy fight be seen as a significant solution to the agency-cost problem of exorbitant salaries.

But free markets do not tolerate economic inanities for long, even in the case of large, publicly held companies. Contrary to the popular liberal shibboleth, markets do not often fail on their own. It usually requires help from the government. In the late ’50s and ’60s, we witnessed the early development of the hostile tender offer — the most powerful market tool ever devised for dealing with non-profit-maximizing managers in publicly held companies. It did not appear before this time for the simple reason that there were very few companies that had the wide diffusion of stock ownership prerequisite to hostile tender offers. Tax laws and a growing understanding of the virtues of share diversification changed all that, and hostile takeovers were not slow then in making their appearance.

But their appearance was, for incumbent managers, a terrifying thing: surprise offers for almost all outstanding shares at a huge premium over current market price — and with little time for shareholders or the corporation to shop the offer, or for the incumbents to mount a counterattack or defense. The opportunity for affording such a premium, of course, was created by the low stock market value generated by the policies of the incumbent managers. There were no inefficiencies in the stock market that generated incorrectly low prices for these companies’ shares.

Even today, mention of the surprise hostile tender offer is enough to throw most executives into paroxysms of hysteria. And the politics of the situation were such that Congress, at enormous cost to shareholders, passed the Williams Act in 1968 to put a stop to surprise tender offers. Public disclosure of takeover intentions and plans for management, plus a lot more, were required to be made public when 5% of the target shares were acquired. This, of course, elevated the price of the other 95% of shares immediately and very significantly reduced the profitability of a takeover. State legislatures also got into the act with various anti-takeover rules, and state courts made it a lot easier for companies to adopt defenses or otherwise prevent a hostile takeover.

The number of hostile takeovers plummeted, and negotiated mergers and friendly takeovers increased to fill the gap. In these methods of changing control, however, incumbent managers became integral participants in the process of displacing themselves. Profits from control transactions, which previously were shared only between the shareholders and the raiders, now have to be shared as well by the incumbent managers, perhaps in the form of continuing employment without real responsibility.Further, as the cost of waging a successful displacement of incumbents escalated, managerial compensation was bound to go up. Any addition to the costs of displacement made just that amount of money available, which incumbents could claim for themselves. They did not have to perform better to get the higher figure; it was just there for the taking. Thus, the Williams Act and state takeover laws laid the groundwork for the controversy over executive compensation that we see today.

This is not just airy theory. Markets do work, and to the extent that these costs must enter the calculations of raiders and lower the number of hostile takeovers, the ensuing rents have to go somewhere. The most likely recipient of truly free and unconstrained money is the one who designates the recipient. And as some companies take advantage of this situation, competition forces everyone else to meet the new and higher market price for executives. That is the most obvious explanation of why we are seeing more and more obscene salaries.

Of course, the executives might choose to use some of the money for social purposes or good labor relations. This might make them feel better or keep pesky activists at bay. An increase in such behavior was predictable as management-displacement costs increased. Since the money is available, demands for such expenditures by anyone with an even slightly plausible-sounding claim on corporate funds became louder and shriller. The current frenzy for corporate social responsibility and stakeholder benefits has the same economic genesis as the obscene CEO salaries that Chairman Cox has vowed to curtail.

Until we return to something like the pre-Williams-Act market for corporate control, we shall continue to see egregious salaries, crazy option grants, and golden handshakes and parachutes. Disclosure as a solution to that problem is a bit like a New Orleans levee faced with Katrina. A return to the takeover law of the ’60s would substantially solve the compensation problem without ungainly regulation, and it would also deliver us from vacuous and harmful notions of corporate social responsibility. All that is required is a little guts from Mr. Cox, confidence in free markets from the managers of large corporations, and some humility about economic regulation from the U.S. Congress.

Mr. Manne, a resident of Naples, Fla., is Dean Emeritus of the George Mason University School of Law.

Copyright 2005 Dow Jones & Company, Inc. All Rights Reserved This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit www.djreprints.com.

80 Notre Dame L. Rev. 48
Notre Dame Law Review
January, 2005

Competing and Complementary Rule Systems: Civil Procedure and ADR
Article

*489 ARBITRATION: GOVERNANCE BENEFITS AND ENFORCEMENT COSTS

Keith N. Hylton [FNa1]

Copyright © 2005 University of Notre Dame; Keith N. Hylton

Introduction
It is difficult to talk about arbitration from a theoretical perspective without saying things that are equally applicable to law in general. Much of what I will say in these remarks sketch out a theory of law and law enforcement, or norms and norm enforcement. Arbitration can be viewed as just one special and important application.

We can think of law as creating a web of rules within which social intercourse is supposed to take place. Alternatively, you can think of law as providing a frame, like the frame of a building. Either way, it is a structure, a spine, a basic set of parameters within which people are free to arrange their affairs.Now, once you have spun this web of rules, how do you get people to stay inside it? There will be individuals who will want to stick their fingers outside of the web, and may want to do so on a regular basis, perhaps because they get some private gain by refusing to stay within the structure that everyone else is abiding by.

The usual way of getting people to stay within the web of rules is through enforcement. That typically involves setting a penalty that falls on the person who violates a norm or legal rule. We can think of this as a hammer that someone holds as he stands on the other side of the web of rules. When he sees a finger poke through the web, he hits it hard with his hammer, creating sufficient pain to deter the offender and like-minded others from poking their fingers through the web.

*490 Enforcement is not the only way to guarantee norm or law compliance. We can also rely on repeat dealing, reputation, and reciprocity. Someone who breaches contracts regularly will find that there are few others willing to trade with him. If his potential associates are rational, they will take even the slightest hint that he is unreliable as a strong signal to keep their distance. In the repeat-contracting setting, the norm-violator’s conduct will bring its own punishment. However, outside of the contract setting, we find other settings in which repeat dealing may not be observed. A thief who burgles houses in the middle of the night does not have to worry about repeat dealing because success in his conduct depends on avoiding detection by others.

The law itself plays a role in controlling conduct, separate and apart from the force or penalty applied by any enforcement authority. While introducing the web metaphor, I described enforcement as if it were carried out by someone standing outside of the web wielding a hammer. The law itself sets the rules, or the boundaries of the web. Society might choose to change the boundaries to make it more or less difficult to avoid being found in violation of the law in some cases. For example, if we know that the hammer-wielder will catch only fifty percent of the norm-violators, we may want to change the norm (or law) so that it is difficult for a violator to avoid being found in violation. We might reduce the number of defenses, or the amount of evidence necessary to prove a violation of the law. For example, if we think law enforcement authorities are unlikely to catch most people engaged in price-fixing, we might structure the law so that there are few defenses available to anyone charged with price-fixing. This is, in fact, what we see.

It should be clear from this description how arbitration should be described. The courts, and the common law, provide the normal, or default, set of rules and enforcement conditions. Arbitration provides an alternative set of rules and enforcement procedures. For parties who can choose to submit their disputes to arbitration, they have a choice between two legal regimes: the court regime and the arbitration regime. Arbitration, in effect, provides the parties with the opportunity to set up a different set of rules–that is, to structure a web that is shaped differently from that spun by the courts. Also, arbitration provides them the opportunity to appoint a different hammer-wielder, one who hits harder or perhaps more softly, or more or less frequently, than we see under the court regime.

*491 In the remainder of these remarks, I will sketch a framework for choosing between alternative legal regimes. [FN1] I will start by sketching the basic theory and then move on to see whether the theory is consistent with empirical evidence. The theory emphasizes two key aspects to the choice between legal regimes: governance benefits and enforcement costs.

I. Governance Benefits and Enforcement Costs
Any set of rules governing interaction among private parties is likely to provide a benefit for which the parties are willing to pay. For example, the simplest type of benefit may be coordinating their conduct, like the rules of order (i.e., who moves when) in a game. More complicated and controversial rules will govern the amount of risk that one can impose on others. The parties will be willing to pay an amount that reflects the costs saved by having rules. A rule against breaching contracts, if complied with perfectly, provides an ex ante benefit equal to the expected net cost (i.e., loss to victim less gain to breaching party) of a breached contract. [FN2] I will refer to the ex ante benefits provided by rules as governance benefits.

In order to secure these benefits, the parties will have to bear some costs. One cost is the cost of writing rules. When parties rely on the common law as the source of rules, the cost of writing rules is bundled into the fixed costs of having courts. Those costs are not borne entirely by the parties to a particular dispute because they are part of the general government budget, and shared by all individuals, whether litigants or not. In addition to the cost of writing rules, the most significant cost borne by potential litigants is the enforcement cost. Since we are talking about private litigation, enforcement costs are usually the costs of litigating to enforce the rules governing private interaction.

It follows that any set of rules governing private conduct can be described as having governance benefits and enforcement costs. The courts generate rules that have clear governance benefits, to the extent they describe and proscribe socially undesirable conduct, and enforcement costs, since the rules must be enforced by the very individuals who benefit from them.

In settings where parties are repeat dealers, or involved in long-term contracts, they are in a position to compare the governance benefits*492 and enforcement costs of the rules governing their conduct. They can decide whether a certain rule is too expensive, because the governance benefit associated with that rule is less than its enforcement cost. If they decide that a particular rule is too expensive, they may agree among themselves to waive the rule. If parties are rational and well-informed, they will waive a legal rule whenever the governance benefit from the rule is less than the enforcement cost.

“Now wait a minute,” you might say, “why would someone who is protected by a legal rule waive it, merely because the expected total cost of enforcement is greater than the total governance benefit?” Even if the total governance benefit is less than the total enforcement cost, it may still be the case that for that individual who is protected by the rule, the governance benefit he enjoys is greater than the enforcement cost he would bear. Assuming a setting of repeat dealers, there will be an opportunity, if transaction costs are low, for that individual to be compensated ex ante for waiving the rule. [FN3] Since total welfare would be enhanced by waiving enforcement of the rule, there is a set of transactions that would leave all parties better off under an agreement that waives the rule. This is just an application of the Coase theorem. [FN4]Why might the governance benefits of a legal rule fall short of its enforcement costs? In some cases, the harm that results from a violation is too small to justify the expense of going to court. The claims could be aggregated and brought on a class-wide basis. Alternatively, these matters could be treated as issues that will be dealt with through repeat dealing, reputation, or reciprocal conduct (tit-for-tat). In other cases, the likelihood of a real violation of the norm may be so small that the expected governance benefits of the rule are clearly less than the expected enforcement costs generated by frivolous claims.

Even if the governance benefit of a legal rule is greater than its enforcement cost, there may still be an incentive to waive it if the differential between governance benefits and enforcement costs is not *493 sufficiently large. Again, suppose that parties are involved in repeat dealings. Any party that breaches the rule would be punished by a refusal by the other party to deal with him. Since punishment by tit-for-tat refusals to deal or through group ostracism may be an effective means of enforcing group norms, the parties may decide to waive the legal rule. [FN5] The legal rule, in this scenario, provides insubstantial incremental governance benefits, while at the same time introducing a substantial enforcement cost.The same considerations that go into the decision to waive a legal right go into the decision to arbitrate. Arbitration provides an alternative forum in which parties can structure rules and enforcement methods so that the difference between governance benefits and enforcement costs is larger than in the default regime represented by ordinary courts. Why might the difference between governance benefits and enforcement costs be larger under arbitration than in the court system? There are several possible reasons.

First, one might find that the governance benefits associated with a given rule can be enhanced by moving into the arbitration regime. Suppose, for example, that a court is likely to make mistakes when deciding whether a group norm was violated. If the court is likely to make mistakes, the governance benefits associated with that particular rule could be enhanced by having it enforced in a regime in which adjudication is more accurate. [FN6] Under a more accurate regime, people who were innocent of violating the norm would have less reason to fear that they would be punished by mistake, and people who had violated the norm would have less reason to expect that they would escape punishment. To return to the web analogy that I began with, the arbitration regime may be one in which the norm-enforcer swings his hammer more accurately than under the court regime.

Second, even if the governance benefits from a particular rule are the same within the court regime and within arbitration, a group might find that the enforcement cost is much lower within arbitration. For example, with a more accurate set of decisionmakers, the parties might find that the evidentiary burdens of proving their arguments in court are lower under the arbitration regime. Thus, even if there are no governance benefits associated with enhanced accuracy, there may *494 be substantial enforcement cost savings. In addition, the arbitration regime may be able to develop a special efficiency or productivity in considering disputes of a given nature. This will reduce the cost of enforcement for claims falling within its ambit.Third, one should note there is a close connection between enforcement costs and governance benefits. An increase in enforcement costs can reduce governance benefits. If the cost of enforcing is too high relative to the private benefit a litigant gets from bringing suit, he will drop his claim. But that means rule violators whose victims fall within this group are effectively shielded from the law. They will continue to act in a socially undesirable manner. It follows that an arbitration regime may enhance governance benefits simply by introducing a cheaper method of claim enforcement.

Congestion provides an important reason why arbitration agreements may involve cheaper enforcement costs than the court regime. Congestion in ordinary courts makes it less likely that any court will have the time or resources to match the level of accuracy in adjudication that repeat dealers are likely to desire. Congestion also introduces delay, which increases the cost of enforcement. Given these costs, it is quite plausible that sophisticated parties who are repeat dealers will prefer to set up their own arbitration regime rather than submit all of their disputes to the courts. Of course, this preference may not be put into effect because it is costly to set up an arbitration regime. And to do so involves foregoing some of the governance benefits already provided by courts.

One well-known argument against the contractualist approach taken here points to the importance of external effects. According to the argument, arbitration may be socially undesirable because it reduces the stock of publicly accessible legal rules and stunts the development of law. [FN7] It follows from this argument that individuals, or groups, may be too quick from a social standpoint to commit their disputes to arbitration. The reason is that they fail to take into account the benefits externalized to others when they litigate in the courts.

The externality critique of arbitration raises potentially important issues, but there are reasons to doubt the importance of the issues too. If the argument is understood as opposing any agreements that divert *495 disputes away from a final judgment in court, including settlement agreements, then it must be regarded as an untenable position. Settlements tend to occur when the law is relatively clear and neither party has a desire to seek to change it. Banning settlements will therefore do little to enhance the stock of publicly accessible legal rules. [FN8] If the argument is understood as opposing only arbitration agreements, then its concerns could be met by requiring that the law developed within arbitration be made publicly accessible, rather than banning arbitration altogether. In addition, parties opt for arbitration in some cases to secure enhanced governance benefits. In such cases, the gains to the parties will be substantial while the external costs imposed on others are likely to be trivial and remote. [FN9]

Much of the foregoing argument depends on the ability of parties to make intelligent choices. The most obvious case in which this does not hold is that of mandatory arbitration. I am not using the term “mandatory arbitration” to refer to arbitration contracts in the employment setting, as many writers do. I refer to state-mandated regimes that require litigating parties to go into arbitration before entering the courts. [FN10] There is no guarantee in the case of state-mandated arbitration that arbitration will go into effect when and only when the difference between governance benefits and enforcement costs is greater within arbitration than in the courts. Indeed, mandatory arbitration may have the perverse effect of driving up the overall cost of litigation, [FN11] as litigants realize that in order to pursue their claims, they may have to go through arbitration and then into *496 the courts. This realization may lead potential claimants to drop their claims, which in effect provides an immunity shield to rule violators.

The other case in which real choice might not be observed is that of the so-called adhesion contract. I refer to contracts in which one of the parties is offered a take-it-or-leave-it standard form and may be effectively uninformed about the terms of the deal. He signs the form because he feels in some sense coerced to sign. If one of the parties signs an agreement to arbitrate without being aware of the terms of the deal, he may find that he has entered a regime in which the governance benefits, for him, disappear entirely.

However, the adhesion contract theory must be viewed as a theory or hypothesis and not much more. People sign take-it-or-leave-it contracts all the time without being fully aware of all of the terms of the deal. We often rely on what we see of the experiences of others. We see that a neighbor bought a high-tech refrigerator and it works quite well. We decide on the basis of that neighbor’s experience to buy one ourselves. Or we rely on the reports provided by consumers to a neutral source. The mere fact that someone signs a contract without being aware of all of its terms does not tell us whether the provisions of the contract were, or whether any particular provision of the contract was, a bad or good deal.The mere fact that an arbitration agreement appears as a take-it-or-leave-it provision of a contract does not tell whether or not the offeree signed the contract based on a reasonably informed choice over his alternatives. Nor does it tell us whether or not the offeree gained an ex ante benefit from signing the contract. If he gained a benefit from signing the contract, and had reason to expect that he would, he should be held to his agreement in most cases.

Whether arbitration agreements specified in adhesion contracts are socially undesirable is an empirical question. [FN12] Given this, the argument against arbitration contracts framed in adhesion contracts should be taken as a hypothesis to be tested. The question to test is as follows: if we confine ourselves to contracts of adhesion, is the difference between governance benefits and enforcement costs lower for arbitration than for the courts? Until someone answers this question, the argument for banning arbitration agreements set out in take-it-or-leave-it contracts is based on speculation.

*497 II. Empirical Evidence
Now let’s consider the empirical evidence. As far as I am aware, few studies have attempted to find evidence of governance benefits from arbitration. Most empirical studies in this area examine the results of arbitration–e.g., damage awards and plaintiff win rates. [FN13] Perhaps the most careful of the recent studies is one by Theodore Eisenberg and Elizabeth Hill. [FN14]Eisenberg and Hill present empirical evidence on the results of non-civil rights employment disputes heard by courts and by arbitrators. They find that for high-pay employees (more than $65,000 per year) the outcomes from arbitration and litigation are the same. [FN15] The win rates and mean damage awards are roughly equal in their samples of arbitrated and litigated cases. [FN16] However, they also find a substantial plaintiff win rate (forty percent) for claims brought by low-pay employees in arbitration. [FN17] In addition, in the sample used by Eisenberg and Hill, the total number of claims taken into arbitration by low-pay employees (eighty-eight) exceeds the total number of claims taken into arbitration by high-pay employees (seventy-seven). [FN18]

In interpreting Eisenberg and Hill’s results, one should keep in mind that very few low-pay employees bring employment disputes into court. As they note in their paper, most attorneys say that the damage award must be at least $60,000 in order to cover the costs of litigation. [FN19] Most low-pay employees are unable to find an attorney willing to prosecute their claims.

Keeping this fact in mind, the Eisenberg and Hill results suggest that arbitration may provide substantial governance benefits in the workplace. If high-pay employees are receiving roughly the same treatment in arbitration as they get in court, and low-pay employees are able to pursue claims that would otherwise never gain the attention *498 of a competent lawyer, then the total number of claims against employers must be larger under arbitration. This suggests that the governance benefits are larger under arbitration, at least in the area of non-civil rights employment claims. Moreover, the issues that are of special concern to low-pay employees are more likely to be addressed in arbitration.

The only paper to look directly for evidence of substantial governance benefits in connection to arbitration is one that I coauthored with Chris Drahozal. [FN20] Our study examines franchise contracts, many of which include arbitration provisions. We examined the factors that determine the presence of arbitration provisions in a franchise contract. Our results show that the traditional factors cited in the franchise literature as important aspects of governance have a substantial effect on the likelihood of an arbitration provision being present in the franchise contract.

To understand the results of my study with Chris Drahozal, it is helpful first to consider one of the fundamental results of the literature on the economics of franchise contracts. [FN21] One key result is that the franchisee has an incentive under certain circumstances to “free ride” on the brand capital of the franchisor. For example, consider McDonald’s. If an individual McDonald’s franchisor cuts its costs and at the same time lowers the quality of its product, the franchisor will enjoy the full benefit of the cost reduction while externalizing the reputational harm to other business units in the chain. [FN22] That is because many of the customers view each McDonald’s outlet as interchangeable and associate any negative experience in quality with the whole enterprise. Given this, one of the major governance problems present in any franchise contract is discouraging franchisees from free riding on the franchisor’s brand.

One empirical measure of the incentive to free ride is the percentage of business units owned by the franchisor. As that percentage increases, the incentive to free ride falls. That is because as more business units are owned by the franchisor itself, the less likely it is that *499 any individual business unit will think that it can externalize any reduction in quality to other units in the chain.

Chris Drahozal and I found that the percentage of company-owned units in a franchise is negatively associated with the probability of an arbitration clause being present in the franchise contract. [FN23] If arbitration provides governance benefits, as we hypothesize, this result would make sense. For on the theory that arbitration provides substantial governance benefits, it should be more important to have an arbitration provision as the likelihood of a dispute over free riding increases. And our findings show just such a correlation. As the likelihood of a dispute over free riding increases (which happens as the percentage of company-owned units falls) the likelihood of an arbitration provision in the franchise contract also increases.

The finding of a statistically significant, negative correlation between the percentage of company-owned units in a franchise network and the probability of an arbitration clause appearing in the franchise contract suggests that arbitration enhanced governance benefits in the sample of franchise contracts that Chris Drahozal and I studied. The likely reason for this is that arbitration provides a forum in which industry experts can determine whether a franchisee’s conduct should be considered a valid basis for termination of the franchise contract. The alternative forum for deciding this question, the courts, would ask a jury to answer this question. Given the large number of ways in which a franchisee could appear to be complying with the provisions of a franchise contract while at the same time violating contract norms, it is quite plausible that arbitration provides a more accurate forum for determining whether the franchisor had a valid basis for terminating a contract.

We also found evidence that arbitration provisions are designed to avoid over-deterrence from excessive litigation and to minimize enforcement costs. For example, we found that the likelihood of an arbitration provision jumps substantially if the parties have included a contract provision limiting punitive damage awards. [FN24] That suggests that if the franchisors are concerned that terminated franchisees will go to court to seek large punitive damages, they are especially likely to try to avoid that outcome by seeking to channel their disputes into arbitration. In addition, we found that franchisors whose home offices were located in a litigious jurisdiction were more likely to seek arbitration than other franchisors. [FN25]*500 The empirical evidence reviewed here suggests that governance benefits are an important reason that we see arbitration agreements. This has important implications for the public debate on arbitration.First, the finding that governance benefits provide a major reason for arbitration agreements goes against the oft-repeated view that arbitration contracts operate in effect as waivers. In other words, the oft-repeated view is that potential plaintiffs sign away their legal rights when they enter into arbitration regimes. However, the Eisenberg and Hill, and Drahozal and Hylton studies suggest that arbitration contracts do not operate as waiver agreements. To the extent that they enhance governance benefits, they enhance at least some legal rights.

Second, the empirical results on arbitration and governance benefits suggest that the benefits of arbitration are more widespread than typically thought. If arbitration agreements involved nothing more than the waiver of rights, they would provide few if any social benefits because they would simply redistribute costs. In addition, if arbitration agreements simply reduced litigation costs, they would be beneficial, but in a limited sense connected to litigation. The finding that they enhance governance benefits suggests that they result in organizations working more effectively on a day-to-day basis. For example, if arbitration agreements enhance governance benefits in franchise networks, then they probably reduce the risk of free riding behavior within these networks. Reducing the frequency of free riding leads, in turn, to more reliable, effective franchises.

I do not wish to be understood as providing an unqualified defense of arbitration agreements. Of course it is possible for arbitration agreements to reduce the overall welfare of the contracting parties or of society in general. [FN26] But that is also true of litigation–it may or may not enhance society’s welfare. [FN27] The theory of litigation and arbitration has reached the stage where it is beginning to suggest useful empirical tests of the social value of arbitration. The empirical evidence on arbitration agreements remains sparse, and much more work needs to be done in this area. I am hopeful that policy debates concerning arbitration will soon be informed by solid empirical research rather than speculation.

[FNa1]. Professor of Law and Paul J. Liacos Scholar, Boston University, knhylton@bu.edu. This paper is based on my remarks at the January 2004 AALS Annual Meeting session on “Competing or Complimentary Rule Systems? Adjudication, Arbitration, and the Procedural World of the Future.”

[FN1]. The argument is based largely on Keith N. Hylton, Agreements to Waive or to Arbitrate Legal Claims: An Economic Analysis, 8 Sup. Ct. Econ. Rev. 209 (2000).

[FN2]. For a richer analysis of governance benefits in the contractual context, see Oliver E. Williamson, The Economic Institutions of Capitalism 68- 84 (1985).

[FN3]. Compensation could take the form of an implicit understanding that if you ignore the slight harms I inflict on you, I will ignore the slight harms you inflict on me. Alternatively, one of the parties might agree to some concession to the other party, with an implicit understanding that the other party will not litigate over some issue in the future. On the adoption of norms (sometimes involving the waiver of strict rights) that deviate from the explicit law, see generally Robert Ellickson, Order Without Law: How Neighbors Settle Disputes 123-30 (1991).

[FN4]. A rough statement of the Coase theorem is as follows: if transaction costs are low, parties will find side payments that will lead them to adopt the most efficient allocation of resources. See R. H. Coase, The Problem of Social Cost, 3 J.L. & Econ. 1 (1960).

[FN5]. For such a waiver to occur, it is not necessary for the parties to get together and sign a formal waiver contract. They may decide to conduct their affairs, as Ellickson found in Shasta County, California, without resort to lawsuits. See Ellickson, supra note 3, at 130.

[FN6]. Hylton, supra note 1, at 223-26; see Steven Shavell, Alternative Dispute Resolution: An Economic Analysis, 24 J. Legal Stud. 6 (1995) (using an economic analysis to determine benefits and choices of parties regarding dispute resolution options).

[FN7]. For the most general source for such arguments, see Owen M. Fiss, Against Settlement, 93 Yale L.J. 1073 (1984). For the argument applied to arbitration, see Edward M. Morgan, Contract Theory and the Sources of Rights: An Approach to the Arbitrability Question, 60 S. Cal. L. Rev. 1059, 1081-82 (1987) (arguing that the Supreme Court’s decision in Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth, Inc., 473 U.S. 614 (1985), has permitted party autonomy to govern state-imposed objectives).

[FN8]. Hylton, supra note 1, at 244.

[FN9]. Id. at 245-47. Of course, in the final analysis, the externality critique of arbitration raises issues that should be resolved by examining empirical evidence. The arguments in the text merely show that the externality critique is not persuasive on theoretical grounds. What if the externality critique cannot be evaluated empirically? Then the critique should be viewed as a purely speculative argument that awaits some empirical verification.

[FN10]. Many states have enacted statutes requiring arbitration for certain types of civil disputes before a trial. States requiring arbitration in at least some circumstances include Alaska, Arizona, California, Connecticut, Delaware, Florida, Hawaii, Michigan, Minnesota, Nevada, North Carolina, New York, Oregon, Pennsylvania, Rhode Island, Texas, and Washington. See Lucy Katz, Compulsory Alternative Dispute Resolution and Voluntarism: Two-Headed Monster or Two-Sides of the Coin?, 1993 J. Disp. Resol. 1, 8 n.37. For an empirical analysis of one type of state-mandated arbitration, see Donald Wittman, Lay Juries, Professional Arbitrators, and the Arbitrator Selection Hypothesis, 5 Am. L. & Econ. Rev. 61 (2003).

[FN11]. See Lisa Bernstein, Understanding the Limits of Court Connected ADR: A Critique of Federal Court-Annexed Arbitration Programs, 141 U. Pa. L. Rev. 2169, 2211-12 (1993) (analyzing the impact of mandatory arbitration).

[FN12]. For a detailed examination of the issues, see Stephen J. Ware, Paying the Price of Process: Judicial Regulation of Consumer Arbitration Agreements, 2001 J. Disp. Resol. 89.

[FN13]. See, e.g., Lisa B. Bingham, Employment Arbitration: The Repeat Player Effect, 1 Employee Rts. & Pol’y J. 189, 205-17 (1997) (analyzing how knowledge of multiple arbitration affects employees); William M. Howard, Arbitrating Claims of Employment Discrimination: What Really Does Happen? What Really Should Happen?, Disp. Resol. J., Oct.-Dec. 1995, at 40, 44.

[FN14]. Theodore Eisenberg & Elizabeth T. Hill, Employment Arbitration and Litigation: An Empirical Comparison (Mar. 5, 2003) (unpublished draft), available at http://ssrn.com/abstract=389780. For a closely related paper, see Elizabeth Hill, Due Process at Low Cost: An Empirical Study of Employment Arbitration Under the Auspices of the American Arbitration Association, 18 Ohio St. J. on Disp. Resol. 777 (2003).

[FN15]. Eisenberg & Hill, supra note 14, at 14-19.

[FN16]. Id.

[FN17]. Id.

[FN18]. Id. at 14.

[FN19]. Id. at 10.

[FN20]. Christopher R. Drahozal & Keith N. Hylton, The Economics of Litigation and Arbitration: An Application to Franchise Contracts, 32 J. Legal Stud. 549 (2003).

[FN21]. See Paul H. Rubin, The Theory of the Firm and the Structure of the Franchise Contract, 21 J.L. & Econ. 223 (1978).

[FN22]. For example, McDonald’s has a rule governing the number of minutes that a cooked hamburger can sit waiting for a customer to purchase it before it must be thrown out. An individual franchisor could cut its costs by violating the rule. However, many customers, who are often travelers, will attribute the bad experience to the whole franchise.

[FN23]. Drahozal & Hylton, supra note 20, at 575.

[FN24]. Id. at 574.

[FN25]. Id.

[FN26]. Hylton, supra note 1, at 230.

[FN27]. Steven Shavell, The Social Versus the Private Incentive to Bring Suit in a Costly Legal System, 11 J. Legal Stud. 333, 339 (1982) (using equations and numerical examples to describe the social and private costs of litigation).
END OF DOCUMENT

(C) 2006 Thomson/West. No Claim to Orig. U.S. Govt. Works.

Consider the following developments over the last year. Visa and Mastercard settle antitrust litigation brought by Wal-Mart for $3 billion over the allegation that the card businesses illegally tied use of debit-card and credit-card purchases. The European Union announces a decision to impose a fine of $600 million on Microsoft for, among other things, its incorporation of a Media Player into its Windows computer operating system. “Tying” doctrine, here and overseas, has become the crowbar with which virtually every business now can be threatened. A quick review of the doctrine suggests that although courts have made progress in understanding why businesses combine particular features in the packages they sell to the public, much work remains to be done to bring the law into line with business realities.

Tying doctrine prohibits (under certain circumstances) the connection of two goods for sale as a package. This doctrine began with a simple view of what tying was all about: the firm could use the product that was intensely demanded to generate sales of a less popular product. Courts viewed that tie as inimical to competition and to consumers. And some of the early cases looked, at least on the surface, as though they fit that pattern. Not surprisingly, then, the courts adopted a per se rule making tie-ins illegal when the seller had market power in the intensely-demanded product.

Over time, tying doctrine has come under considerable pressure. Two observations lie at the core of this pressure.

First, commentators observed that the connection of more and less popular (more and less intensely demanded) goods did not, except in the most unusual conditions, confer advantage on the firm. The “one monopoly rent” argument asserts that a firm with market power can extract the benefit of that power only once – by raising the price of the good it has power over – and that the firm can change the form of the rent extraction but not the magnitude. Although that assertion left room for debate about just which conditions allowed a shift of profits to the tying firm, economists generally agreed that the basic argument was correct.

Second, observers recognized that tying is not a rare and suspicious practice. Quite the contrary: it is ubiquitous, commonly done by firms with little or no market power as well as by dominant firms. Hotels bundle rooms with robes and towels, shampoo and chocolates – and no one thinks their hotel should be offering them a choice of competing vendors for the amenities, even if they might prefer another brand or item. Law firms offer the services of their senior lawyers in combination with those of their more junior lawyers – and no one thinks that partners in one firm should be required to offer clients a choice of associates from other firms. [other examples(?): Colleges offer the services of their best teachers along with those of average teachers – and no student thinks that gives him a right to substitute courses from another school. Cars are sold with audio, dvd, and air-conditioning systems. Shoes are sold with laces even though every stores that sells shoes also sells laces independently.] The list of packages – of tie-ins – is endless. Virtually all products and services are sold as combinations of items or features that could be – and often are – also sold separately. Certainly, if everyone ties goods together as packages, even with no market power in either good, the reasons for tying cannot primarily be the extension or leveraging of monopoly power. Instead, efficiencies – lower cost to producers and lower cost or higher value to consumers – provide the general explanation for tying. That point seems lost on the European Union’s antitrust regulators, who seem far more concerned with preventing disadvantage to competing businesses than with promoting efficiencies that benefit consumers.

Over the past two decades, however, U.S. courts responded to the obvious mistake of tying doctrine – of labeling tying as so clearly inimical to consumers to be branded as per se illegal – with various efforts to step back from its more egregious consequences. The Supreme Court’s 1984 Jefferson Parish decision, for instance, attempted to separate instances in which there are obvious, pervasive inefficiencies of separate provision of goods – so pervasive that there was not an independent market for the tied good. The Court retained the per se rule in form, but it moved toward analysis of the markets for the tied and tying goods that functionally moved the doctrine closer to a neutral standard. Four justices would have gone further and adopted a “rule of reason” analysis (an unstructured inquiry into the efficiency benefits and competitive effects of the practice in each specific instance).

The Jefferson Parish decision marks an important step in the development of tying doctrine, but it ultimately does little to reverse the initial mistake. After all, almost all tied goods do have independent markets. There plainly are separate markets for bathrobes and towels and chocolates, even if it is grossly inefficient for hotels to separate those items from the room. Hotels tie the items together when leaving the provision of these items to the traveler reduces the value of the package by more than the cost savings to the hotel. The same is true for joint provision of automobiles and audio systems and for innumerable other bundles. Failure to clearly recognize this point left the law in limbo, with some opportunity to except efficient bundling from tying law but with the onus largely on defendants to carve their conduct out from the presumption that tying was improper.

Another step in the development of tying law came in the U.S. litigation over Microsoft Corporation’s evolving Windows platform for personal computers. The Department of Justice claimed Microsoft violated the antitrust law by bundling its Explorer Web browser with its Windows operating system. The Web browser was one of many features that over time went from options available strictly on a stand-alone basis to integrated parts of the Windows platform. Indeed, Windows was created by bundling the DOS operating system with a (formerly separate) graphical user interface.

The U.S. Court of Appeals for the D.C. Circuit rejected the district judge’s conclusion that the Web browser’s integration into Windows created an illegal tie-in. It rooted this rejection largely in its understanding of the market forces that support bundling. Going beyond Jefferson Parish, the Microsoft III decision (as this one is commonly referred to) recognized that there typically are efficiencies in combining features that could be offered on a stand- alone basis. The court observed that bundling can increase value to consumers and can take advantage of economies of scope that lower costs. It noted that software producers, whether plausibly having market power or not, commonly integrate new features into their software. The court saw that in platform markets especially, integration could help software developers as well as consumers, by reducing the costs of other software that would be added on to the platform.

The court, therefore, adopted a rule of reason approach, under which the government would bear the burden of showing that the harm to competition from integration of features into software outweighs its efficiency benefits. This test, which the Microsoft III court expressly limited to software tying cases, is a far cry from the presumption that tying is per se illegal. It seems far more in keeping than European competition doctrine with an understanding of why all software firms bundle features together rather than selling each one discretely and why software programs grow over time to house more and more features that once were sold separately.

As a step in the general development of tying doctrine, then, Microsoft III should be applauded. But the test also stops well shy of acknowledging that the practice the court was addressing – and the problem with treating the practice as presumptively illicit – was not peculiar to the software business. The court also set forth a test that does not readily distinguish the problematic tie from the ordinary, market-driven integration of features and that leaves a great deal of discretion to the decision maker in the particular case.

Microsoft III’s rejection of the per se illegality approach is clearly the right decision, given the efficiencies of tying. Before software businesses crack open the champagne to celebrate, however, they should think about two things. First, the new rule of reason test for software integration, although more lenient than the hybrid per-se test generally applied to tying, is actually a more restrictive test than the one courts traditionally have applied to the physical integration of existing products. In this sense, Microsoft III will appear to some as a step backward along tying law’s path. Second, software businesses should consider the difficulties that arise under the rule-of-reason test. How will the burden of proof ultimately be allocated by courts? How will anticompetitive harms be determined – by the complaints of rival software firms or by proof of harm to the typical consumer? Will the test accommodate instances in which efficiencies are likely to be realized only after several years have passed? Will allowance be made for “honest mistakes” in business judgment, as when a firm takes a competitive action that harms a rival and the resulting efficiencies are weaker, or further delayed, than anticipated? How much weight should be put on market share in software markets, where consumer herding imparts volatility to market share statistics?

Given the continuing pressures on the per se illegality rule, the future of tying law depends on how courts answer these questions. A rule-of-reason test that makes sense in light of tying’s efficiencies, in software and in other markets, would set a high standard of proof – perhaps requiring “clear and convincing” evidence – and put the burden on the plaintiff. A test that aims for a formal neutrality by imposing significant proof burdens on the defendant would leave many businesses in the position they are in today, uncertain about the liability risks of tying. When the vast majority of ties are efficient, as observation suggests, the proper resting point for tying doctrine is on the other end of the spectrum from its per se illegality starting point: something close in operation to a presumption of legality. We hope that tying doctrine will continue to evolve in this direction, to continue to be guided more by business reality than its original formulation, and to be less dependent on its initial path. But after Wal-Mart and the EU’s Microsoft decision, we fear that the path toward a sensible tying doctrine will be a long one.

She is currently the Editor of the Philanthropy Roundtable Newsletter, produced by the Federalist Society. She is a member of the Federalist Society and a Royce Fellow at Brown University.

Mrs. Cass received her A.B. summa cum laude from Brown University, and was a Dean’s Scholar at Boston University School of Law, where she received her J.D. with honors.