The Legal Infrastructure of Business

Response to: Chronicle of a Death Foretold – Who Monitors the Monitors?

 

When MF Global filed for bankruptcy protection in August 2011, voices in the media wondered aloud why regulators could not successfully monitor the excessive risk undertaken or why a bailout from the U.S. government wasn’t forthcoming.

A year after MF Global’s bankruptcy, another financial firm, Knight Capital, was near collapse. Though Knight was a broker-dealer much smaller than MF Global and in a different business from MF Global, Knight was the largest handler of stock orders for U.S. retail brokerages. Its case serves as an interesting counterpoint to the bankruptcy of MF Global, as well as the events of the fall of 2008.

What happened to Knight may sound like a scene from a bad movie. Due to a computer glitch, the firm bought $5 billion of stock in a trade that was intended to take place over five weeks but was executed in just 20 minutes. The firm subsequently disclosed a $440 million pretax loss due to this malfunction, while its market value at its low-point after the erroneous trade disclosed was just $250 million. Knight share price plummeted from around $12 in late July 2011 to around $2.50 in mid August of that year.

 

Thus, in a matter of a few minutes, a firm that had been reasonably healthy came close to collapse.

 

To avert bankruptcy, the firm desperately attempted to sell itself to other broker-dealers. These deals fell through, as other firms were reluctant to take on the suddenly-troubled broker-dealer.

Ultimately, Knight secured about $400 million over a weekend from a few investors led by Jefferies. In turn, Knight issued convertible securities, which are bonds that will turn into equity in the firm in the future.

 

The part of the story that is worth highlighting is the tenor of the response within the financial community to Knight’s predicament. While other firms, competitors and clients alike, expectedly based their business decisions in part on the familiar rationale of cost-benefit analysis of the competitive landscape, they also reached out to Knight in attempt to help save the firm.  CEO Thomas Joyce said, in a live interview, "The wildly flattering thing was how our clients responded to us...when we were under stress last week."

It appears that there was willingness on the part of Knight’s counterparties to step in to Knight’s rescue, partly because of the trust that Knight engendered with its business partners over their years of doing business together. While the firm remains a shadow of its former self, its good business relations stood in its good stead and allowed it to stay afloat. Recently, competitors Getco and Viru have offered to buy the company, albeit at $3.50 a share, a fraction of its value in July 2011.

Shareholder lawsuits have come and will be coming in the future against Knight. It should be noted, however, that Knight shares could easily have been wiped out had Knight not been able to secure bridge funding, leaving shareholders without even the fraction of the value of the firm.

 

The point of this episode as it relates to our class discussions of bailouts, bankruptcy, and regulators and accounting firms whose job it is to monitor the business practices of other companies, is that trust built over years of doing business can go a long way into solving unexpected and sometimes difficult problems. Knight CEO Thomas Joyce said that the company received some 90 inquires from clients offering to participate in its bridge funding to avert the firm’s collapse. With 90 market participants offering to chip in, there was little need for the U.S. government to contemplate a bailout even if the government was interested in doing so.

There are of course important caveats to generalizing this episode to the bailouts of 2008 and to MF Global. The most obvious one is the small size of Knight Capital compared to the firms involved in those events. But if professionals and laypeople alike had been told about a trading firm experiencing a bankruptcy-threatening computer malfunction, not many would have predicted an outpouring of goodwill towards Knight from its clients. This goodwill would not have been possible had the U.S. government publicly pondered a bailout.

 

Links:

http://www.forbes.com/sites/halahtouryalai/2012/08/06/knight-avoids-bankruptcy-what-now/

http://www.foxbusiness.com/investing/2012/08/02/investor-psyche-takes-another-blow-with-knight-capital-glitch/

http://online.wsj.com/article/SB10000872396390443866404577566890251463940.html

http://www.foxbusiness.com/industries/2012/08/02/knight-capital-plummets-55-after-disclosing-huge-440m-pretax-loss/

http://www.cnbc.com/id/48516238

http://www.law360.com/articles/370958 

http://www.bloomberg.com/news/2012-11-30/knight-board-said-meeting-next-week-to-study-getco-virtu-offers.html?cmpid=yhoo

 

Really, 40 mpg?

Hyundai and Kia have not had an easy year. In July 2012, Hyundai faced a class-action lawsuit filed by Consumer Watchdog for misleading gas price-sensitive customers about the realities of fuel economy of its 2011 and 2012 Elantra models. Drivers of Hyundai’s Elantra model claimed that its advertising failed to make consumers adequately aware of variations in mpg by only citing highway mpg and not city mpg. They also alleged that the automaker did not include mandatory disclaimers in its advertising. Hyundai however, believed it was acting in accordance all rules, adding that a consumer’s particular average mpg varies with driving style, temperature, elevation, road surfaces, and traffic conditions. The Federal Trade Commission specifies that the mileage numbers on car stickers and in advertising must be the ones generated by the Environmental Protection Agency’s approved testing process, but they not longer require disclosure of both the city and highway numbers. The recent changes have allowed auto makers to promote only one number usually the higher producing highway mileage number, whereas in the past, both had to be given equal weight in advertising. Hyundai got by on this one, but more issues were to come further dampening the year.

In early November 2012 Hyundai and Kia, both controlled by the same Korean automaker, admitted internal process flaws resulting in overstated fuel economy figures on the stickers of the majority of their 2012 and 2013 models. The confession arose after an investigation by the Environmental Protection Agency revealed discrepancies between their testing and what was printed on the window stickers. The reinstated mpg figures, 1-6mpg less depending on the model, affect over 1 million recently sold vehicles in North America: nearly 900,000 in the United States and 170,000 in Canada. Hyundai has also withdrawn claims of 40 mpg for three of its four models in the 2013 lineup.

Hyundai and Kia have been preemptive in their efforts to fix the issue allowing customers to receive debit cards reimbursing them for the difference in stated and accurate fuel economy, and an extra 15% added to that amount for inconvenience. “Our priority is to make this right for our owners, and that’s precisely what this program does,” says Chris Hosford, Hyundai spokesman. Shortly after the confession, a string of class-action status lawsuits have popped up in California and Ohio (so far) claiming that this is not enough. Car owners are asserting that the compensation plan does not reimburse them for the now reduced value of their vehicles. In the case of the internal process flaws, it will be interesting to follow how the damages pan out. It is notable that the companies are attempting to not just fix the situation but also offer consumers a premium on top of strictly financial losses. The compensation plan is estimated by Moody’s Investor Service to cost the two firms about $100 million per year, while economic harm could reach $775 million.

In the case of advertising fuel economy, what’s really interesting is consideration of what to do moving forward. Should there be an industry-wide practice of how to advertise fuel economy figures? Perhaps we should return to equal attention on both city and highway numbers or instead go with a combined number. Or is it up to the consumer to do enough due diligence on a vehicle’s mpg range before purchasing or leasing it? What do you think?

http://news.consumerreports.org/cars/2012/07/hyundai-lawsuit-points-out-why-consumers-need-to-beware-of-40-mpg-claims.html

http://www.thecarconnection.com/news/1077610_hyundai-sued-over-elantra-40-mpg-ad-claims

http://www.nytimes.com/2012/07/15/automobiles/hyundai-is-sued-over-mileage.html?_r=0

http://www.reuters.com/article/2012/11/08/us-hyundai-mileage-idUSBRE8A705I20121108

http://www.detroitnews.com/article/20121105/AUTO0104/211050447

http://www.edmunds.com/car-news/hyundai-and-kia-face-lawsuits-losses-over-exaggerated-fuel-economy-claims.html

http://www.businessweek.com/news/2012-11-04/hyundai-kia-shares-tumble-on-overstated-mileage-claims

 

Watch the Borders – a Supreme Court Split

The Story

Everyone goes to Costco to load up on bulk toilet paper, non-perishables, and find great deals on unexpected items. This is exactly what consumers were doing when they found Omega watches selling for $700 below what they expected. The deal seemed almost too good to be true, and several watches were sold.

Here’s what was happening behind the scenes. Costco was purchasing legitimate watches that were manufactured in Switzerland from an authorized distributor abroad, because they selling for much cheaper than in the U.S., and then importing them back into the States.  Once here, they would be put on the shelves for purchase at Costco stores. Costco was selling the watch for $1,299 as opposed to the suggested retail price of $1,995. In this particular case, Costco was participating in the gray market, also referred to as parallel imports and secondary markets. The gray market frustrates brand owners as they try to control discounting practices. Products in the gray market are genuine goods sold by U.S. retailers using unofficial distribution channels, enabling middlemen to exploit global price differences and disregard the familiar suggested retail price figure. Omega knew it was doing this for years, but didn’t care to take action until other retailers started complaining. Once Costco’s competition started to complain, Omega threw a globe emblem on the back of the watch, which then became the basis for the copyright claim.

The Suit

In 2010, Omega SA sued Costco Wholesale Corp for copyright infringement, noting that the sales of its Seamaster watches in California Costco stores were unauthorized and infringed on Omega’s exclusive rights to distribute its work by sale, rental, lease or lending under Section 106(3) of the Copyright Act of 1976.

The difficulty in this case is interpreting the “first –sale doctrine” which allows resellers to sell products at whatever price they wish, or even lend them for free.  When Congress wrote this into the Copyright Act, it intended it apply to any “particular copy or phonorecord made lawfully under this title.” However, what does “lawfully under this title” mean the in the context of international sales? The complexity arose when both the manufacturing and the “first sale” occurred outside of the U.S.

The District court sided with Costco, allowing it to use the first sale doctrine as defense and continue selling the watches. Unsatisfied, Omega appealed – and the 9^th Circuit sided with Omega citing that the first-sale doctrine did not apply to foreign manufactured copies purchased abroad. Costco appealed, but since Justice Elena Kagan was sitting out due to her involvement with the case while she was serving as US Solicitor General, the Supreme Court ended in a 4-4 split. A split meant that the 9^th Circuit’s decision stood. However, because of the split the case did not determine a nationwide precedent and was only valid within the bounds of the 9^th circuit. Businesses would have to wait for the next copyright case to settle things for good.

Extra thoughts from Google, eBay

Google and eBay sided with Costo in the case, noting that letting Omega control the sale of products manufactured and first sold abroad, but not the sale of products manufactured in the U.S. and first sold abroad would lead to manufacturing jobs being moved from the U.S. to overseas. This came at a time when the domestic manufacturing industry was already at a low.

 

http://www.lexology.com/library/detail.aspx?g=5e0ee34e-4e96-4e39-a917-91d65e21efea

http://www.watchtime.com/wristwatch-industry-news/industry/u-s-supreme-court-will-examine-costco-sale-of-omega-watches/

http://thelicensinglawblog.com/2010/12/costco-v-omega-supreme-court-punts-on-another-big-ip-case/

http://www.forbes.com/sites/danielfisher/2010/11/05/costco-v-omega-is-about-much-more-than-cheap-watches/

http://www.washingtontimes.com/news/2010/dec/13/costco-case-ends-in-tie-with-kagan-not-hearing-it/

http://www.patentlyo.com/patent/2010/12/supreme-court-does-not-decide-costco-v-omega-intl-exhaustion-case.html

http://en.wikipedia.org/wiki/Omega_S.A._v._Costco_Wholesale_Corp.

 

The First Sale Doctrine (and why I sold my Netflix stock)

This post is in response to the Kirtsaeng post regarding the first sale doctrine vs. importing copyrighted goods.  It seemed to me, from reading that story, that the first sale doctrine is under attack from lawmakers, who most likely are being lobbied aggressively by copyright owners - heavyweight firms from the music, movie and book industries.  As I describe below, the death of the first sale doctrine is turning into a major victory for content owners, allowing them to freely extract the maximum value from the value chain for copyrighted content, at a loss to consumers.

The First Sale Doctrine

Historically, the first sale doctrine has powered some well-known business plans to great success.  Blockbuster, RedBox, Netflix, and even the venerable public library have depended on this doctrine.  For those not familiar, this doctrine states that the copyright holder loses control over how the consumer uses the goods after the first sale.  The only thing that is forbidden is copying.  So, in effect, you can rent or re-sell a movie or book, but you can’t make copies and do the same.

Blockbuster and Netflix used this doctrine to their advantage, purchasing DVDs at retail prices and renting them many times over.  Because of the content owner’s inability to enforce price discrimination, and charge re-sellers more than end consumers, the owners’ rights - and profits - were limited.  The protection offered by the first sale doctrine effectively gave resellers and re-renters a low fixed cost and unlimited rights to rent copyrighted content for profit.

The Digital Age

Well, along came the digital age, and rampant illegal copying of copyrighted materials.  The music and movie industries took a big hit in sales, and worked hard to counteract the effects.  They invested in Digital Rights Management (DRM) software and hardware, and successfully got the Digital Millennium Copyright Act (DMCA) passed that makes it illegal to circumvent the DRM facilities.  Using these tools to limit the damage done by pirating, content owners began to raise prices to law-abiding consumers in order to make up for losses due to theft.

Back to Netflix.  They originally built their business model on a low, fixed monthly subscription price to view as many DVDs as people could watch and mail back and forth.  Their costs were held in check by a combination of the first sale doctrine and the speed of the U.S. mail.  Once they tried to switch to streaming digital content over the internet, however, these cost caps were no longer effective.  At first, because Netflix was a fledgling company with small market share, content owners allowed them to get reasonable prices for unlimited use of digital content, typically under short-term contracts of 1-3 years.  Once those contracts were up and needed to be renewed, however, the content owners were aware of the potential profits that Netflix could make, and upped the costs of licensing content.  Due to the lack of any legal protection, such as the first sale doctrine, Netflix lost all bargaining power.  Essentially, the content owners appear to have decided to squeeze all the value out of the value chain, and leave Netflix next to nothing.  The image below depicts the change in situation from DVDs by mail to Internet streaming:

A Loophole Closed

One company, named Zediva, tried to use a potential loophole in Copyright law to get around this stranglehold by the content owners, and rescue the effectiveness of the first sale doctrine.  They basically avoided copying content onto their own disk drives, but rather installed computer servers with physical DVDs in them, and streamed the DVD content over the internet.  Their lawyers reasoned that it was akin to a consumer renting a DVD and using the Internet as the playback device and remote control.   The DVD could only be viewed by one person at a time, and no copies were made of the content.  It seemed like a way to regain the power of the first sale doctrine, except they lost in court when the Motion Picture Association of America (MPAA) sued them, stating:

“Unlike Netflix and other licensed online services, [Zediva's] business is based on infringing Plaintiffs’ rights. Defendants transmit performances of Plaintiffs’ copyrighted works to members of the public without Plaintiffs’ authorization. Defendants thereby infringe Plaintiffs’ exclusive rights to perform their works publicly.”

Public Libraries

Sadly, it’s not only profit-oriented firms such as Netflix suffering from this situation; the public library has also taken a tremendous hit as they attempt to keep up with modern times and lend digital books.  Basically, the only way that libraries can lend digital books is through a combination of DRM software from Adobe called Digital Editions (which prevents illegal copying), and the “kindness” of content owners.  Libraries actually have no legal right to lend the digital books; they sign contracts with content owners that give them this ability.  However, in a now familiar-sounding situation, these contracts are not as low-cost as they used to be, when the first sale doctrine protected their rights to lend the books freely.  Libraries pay up to 300% more for digital rights than physical books, and must renew the contracts periodically or lose their ability to lend the books.

The New World we live in

There are more examples of how the first-sale doctrine is losing its effectiveness due to the digital age: for example, you can’t re-sell software that you have purchased.  What it boils down to is that, with digital content, you no longer “own” your copy of the content, you are only licensing it.  And licenses have (sometime onerous) terms.  It’s unclear whether there is any rescue of consumer rights in sight, but I doubt it.  Content owners have been lobbying lawmakers aggressively for quite some time, with no sizable counterbalancing force.  What will be interesting to monitor going forward is if law enforcement authorities are successful in reducing illegal pirating of content, and if so, whether that will result in price decreases in legally obtained content.  Such a development would be good for consumers overall, as well as for firms like Netflix, but it remains to be seen of those savings would be passed on to consumers.  It might only serve to fuel bigger profits for content owners, who have suffered in the digital age, and would likely be looking to regain what they have lost.

Opinion

In my opinion, lawmakers need to pass some sort of digital consumer’s rights law to balance out this situation, something that would restore some of the power lost by no longer truly owning copies of copyrighted content.  I believe it’s possible to use the same DRM tools, in concert with digital content laws, to allow consumers to re-sell and re-rent digital media after the first sale.  “Digital First-Sale Doctrine” anyone?

References

http://en.wikipedia.org/wiki/First-sale_doctrine

http://en.wikipedia.org/wiki/Digital_rights_management

http://en.wikipedia.org/wiki/Digital_Millennium_Copyright_Act

http://abovethecrowd.com/2011/09/18/understanding-why-netflix-changed-pricing/

http://www.wired.com/business/2011/03/zediva/

http://gigaom.com/video/zediva-shut-down/

http://www.thedigitalshift.com/2012/03/ebooks/librarians-feel-sticker-shock-as-price-for-random-house-ebooks-rise-as-much-as-300-percent/

http://www.cnn.com/2012/06/26/tech/web/ebook-lending-pew/index.html

http://freading.com/questions/index

http://www.llrx.com/features/deathcopyrightfirstsale.htm