“Transaction Costs”: A Nobel-Prize Worthy Analysis for Global Business

The death last week of Nobel-prize winning economist and retired University of Chicago Professor of Economics, Ronald Coase, at 102 years of age, reminds us all of the conflict between the real world and the economist’s theoretical world. His eight decades of work helped found the field now known as “law and economics” and continues to impact our understanding of today’s economy and the law. While an undergrad in college, I read Coase’s writings eons ago. His papers helped me understand the logic behind how business organizations work, and was a factor in my decision to become a transactional business attorney.

In law and pure economics, the fair market value of anything is the price that a willing buyer and a willing seller would agree upon, assuming each has equal knowledge of relevant facts, neither is under any compulsion and the transactions costs are nil. This economy would be comprised of self employed individuals continually contracting work with each other. However, in the real world, there is a price to pay for these constant negotiations or what Coase called “transaction costs”. In his 1937 paper, “The Nature of the Firm”, he posited the idea that people could more readily grow their business by organizing themselves into a firm and gain operational efficiencies by reducing these transaction costs. He further noted there may be a point of diminishing returns in this growth, some say foreshadowing the advent of outsourcing.

In 1960, his paper, “The Problem with Social Cost” dealt with the actions of business firms which have harmful effects on others. In a theoretical world, all affected parties would come together and arrive at a voluntary agreement and solution at nil cost as long as property rights were clearly defined and everyone was willing and able to bargain. In the real world, he advocated that cost benefit analyses should be done to determine the appropriate remedy and that each case should be evaluated individually. Where transactions costs are high, either no deal will occur or government regulation of protection of rights from externalities like factory pollution will be adopted to protect those who cannot protect their interests, or small claimants will sue under class action tort principles.

Today, we recognize that transaction costs are the norm in corporate, commercial, technology and service transactions. Business attorneys like me make a living as a transaction cost when clients buy and sell companies, intellectual property or other assets and when they enter into strategic relationships over an agreed time span, like financing, licensing, leasing, investing in depreciable business equipment and technologies. But I am just one mouth in an ecosystem of commission salesmen (“business developers”), consultants, intermediaries, brokers, investment bankers, accountants, appraisers, engineers, logistics providers, outsourced service providers and others whose transaction costs are embedded in the purchase price of an asset, a new venture or a strategic alliance of small companies fighting in a Big Company world.

For that, I am glad to express my appreciation for his insights.  Thanks, Ron.

Strategic Forum Shopping

Ever since your childhood realization that you can get Daddy to permit what Mommy prohibits (or vice-versa), you have learned the skill of forum shopping.  Getting what you want in business is no different. Artful “forum shopping” is a key business strategy for gaining competitive advantage and avoiding domination, as evidenced by some recent deals and litigation.

What do you want to optimize?  While we can look at governmental incentives and regulations, let’s consider optimizing for low tax rates.  That means a search for a “tax haven” from the storm of normal high tax rates. We’re not talking about tax fraud (hiding income), but simply about tax avoidance (navigating and complying with rules to minimize taxes owed).

What kind of income do you want to optimize?  By identifying the type of operations, you identify the type of income, and thus can have a shopping list according to local tax treatment of that kind of income.  You might want a different home forum for different purposes, such as R&D in one forum, manufacturing in another, distribution and sales in a third.  A typical tech company will generate intellectual property from R&D, resulting in licensing royalties or income from selling products.  Manufacturing is a tool of R&D.  Distribution means local sales in each country.

How to you limit each class of income to a specific jurisdiction?   You can set up your operations yet limit your exposure to a hostile legal environment by setting up an avatar (oops, a new company) to do business only there.   And then you just need to have all the avatars charge reasonable intercompany transfer pricing.

In lawful international tax avoidance or tax deferral, forum shopping is alive but under challenge.  In May 2013, a Senate Panel’s investigation revealed Apple Inc.’s set-up of a research and development center in Ireland in the 1980’s to get access to its low 12.5% corporate tax rate and its even lower dividend withholding rates.  U.S. anti-abuse rules (“Subpart F”) currently don’t require immediate repatriation.  So Apple Inc. is sitting on about $1.0 billion in undistributed untaxed offshore profits from licensing of software and sales of computers and telecom devices.  Like the US, other European Union countries are envious and hostile to Ireland’s competitive tax regime.

Did you forget to do your tax forum shopping plan before you grew into a big company?  No worries.  Like U.S. pharmaceutical, company like Perrigo Co., you can just buy an Irish biotech company like Elan Corp. for $8.6 billion.  That tax-favored strategic acquisition was announced last week.  Perrigo will lower its effective tax rate from roughly 30% to roughly 16-18%, saving about $150 million per year in taxes and operating costs, by creating a holding company in (yep!) Ireland.

What would kill forum shopping?  Think of equality in competitive tax and regulatory regimes and harmonization of laws across borders.  This is a stated objective in the Transatlantic Trade and Investment Partnership (TTIP) talks between the USA and the European Union), begun in July 2013, and the G-20 industrial nations 15-point action plan presented by the OECD, also this past July.  That’s optimism.  

Businesses hire professionals as “concierge forum shoppers.”   Maybe there will be a “forum shopper’s club” in the future.  The world’s a virtual mall for forum shopping.  When will there be an app for that?

SMB’s after ObamaCare: The New Sub-economy of 49’ers, Outsourcing, Automation, and Part-Timers

What should small and mid-sized businesses do to survive the Patient Protection and Affordable Care Act?   What lessons have we learned from the delayed Employer Mandate?

Thanks.  SMB’s can thank someone in the Obama Administration for raising the white flag and acknowledging the need to delay the “Employer Mandate” by a year until January 1, 2015.  (Of course, the statute does not permit any deferral of any mandates, so the delayed Employer Mandate raises constitutional issues.) 

Workforce Containment.   SMB’s can redefine their mission in a new microeconomy driven by enterprises having 49 or fewer “full-time” employees (the New 49’s).  These 49’s enterprises can avoid the complexity, costs and distractions by forcing more part-time employment (i.e., under 30 hours per week).   That means SMB’s will likely be training and keeping only those employees who will drive sustainable growth, and marginalize all the rest into part-time status, forcing part-timers to buy their health insurance on an exchange (yet to be established) or pay the penalty tax.

Boosting Outsourcing.  SMB’s should look for niches where a company of 49’ers could provide outsourced “back office” or “technical” support to other companies of 49’ers.   Any small business function can  be outsourced, such as payroll service providers, collection companies, technology suppliers, lease administration, insurance administration, HR administration, anything that a small business needs.   This will boost the “business services” economy.   Outsourcers might hire the involuntary part-timers, if needed, or just use more SaaS “web-enabled” tools for administration.  

Management of Projects and the Services Supply Chain.   SMB’s need to develop skills in partnering with others.  Such skills will allow strategic alliances to form.  The integration of a microeconomy of “49’er enterprises “ will involve project management training and tools so that unrelated companies can work as a team competing with larger enterprises.

Globalizing the SMB Workforce.    Under ObamaCare, SMB’s have been invited to globalize their workforces.  If the cost of “unnecessary” health insurance coverage is excessive, SMB’s can set up offshore offices, which can help both increase revenues and reduce costs.  Too bad this could come at the expense of local employment in the US.

Automation.   Automation can reduce labor.  The Affordable Care Act just made robots and software more affordable, comparatively. 

Web-Based Teams.   To cover greater territory, teams can be split into modules and assembled across the country.  Big services firms use webinars and videoconferencing.  SMB’s can survive with more geographical dispersion of staff (particularly in sales) while retaining core skills that can be deployed instantly without transportation.

Optimization by Shifting Societal Costs.  The resulting outsourcing, offshoring, part-timing, de-scaling and horizontal integration will have a societal cost.   But, until the law is changed, this is what the law encourages.  Nimble entrepreneurs will fill new niches, and savvy family businesses and new ventures will avoid hiring unless it drives core business revenue.  Everyone will be more specialized to remain small, nimble and niched.  

Pigeon Power!

Why establish your startup in France?  Why invest there?  

On April 12, 2013, the French government reportedly rejected Yahoo’s bid to acquire 75% of a leading video sharing website Dailymotion, owned by Orange, a subsidiary of France Telecom, S.A.  The ostensible reason was that control of a crown jewel of French Internet startups should remain in France.  No great French Internet company should lose its French identity.  The French government owns a 27% stake in France Telecom, S.A.

This result will only harm the French economy by encouraging French entrepreneurs and SMB’s to seek venture capital, growth opportunities and technologies outside of France.   This comes after a year of hostile words by Arnaud Montebourg, France’s Minister of Industrial Renewal  (“productive renewal”) against foreign steelmakers and others who might bring in foreign investment and foreign business methods for French industry.  It will deprive Dailymotion of capital investment needed for sustainability and growth.

Having studied, lived and worked in France, and as a tech business lawyer in New York, I offer my own lament to French entrepreneurs and SMB’s in their own tongue.  (If you only studied French in high school, try www.translate.google.com for a breezy translation.)

Où bâtir votre startup français?   Evidemment, la France ne vous accueille pas. 

C’est ça le message du gouvernement de François Hollande, dont le Ministre du Redressement Productif Arnaud Montebourg a refusé le 12 avril 2013 de permettre à la startup Dailymotion de se vendre le contrôle à Yahoo, Inc.  Le Ministre aurait permis la vente de 50% mais pas le 75% convenu entre la « startup » vedette française Dailymotion (fondée en 2005) et Yahoo. 

Quelles seront les conséquences de la « fin du capitalisme libre» que M. Montebourg a annoncée en 2012 ?  

D’abord, les entrepreneurs français (et leurs investisseurs, comme les « anges d’affaires » (Business Angels) et les fonds de capital risque) vont croire que les subventions et certaines baisses prioritaires de taux d’impôts, récemment annoncées en France, sont illusoires.  On va conclure qu’il vaut mieux établir les moteurs de croissances dans les pays étrangers des « Pigeons ».   L’Ireland, le Canada et, bien sur, les Etats-Unis vont les accueillir avec des visas d’entrepreneur, de startup, d’investisseur et de commerçant.  Sous Hollande, la fuite des cerveaux, des jeunes et des PME va s’accélérer.  Même s’ils ne se délocalisent pas personnellement pour des raisons de famille, les PME pourront établir des sociétés affiliées étrangères dans de tels pays d’accueil, où il trouveront du capital risque (venture capital), des marchés, des taux d’impôts raisonnables et le droit du travail plus équilibré que devant les tribunaux de Prud’hommes. 

Ensuite, déprimés par un dirigisme protectionniste en France, les prix de vente pour les PME français vont rester en dessous des niveaux atteints normalement dans d’autres pays.  

Enfin, au lieu de préserver la façon de vivre, et de protéger les mœurs et coutumes français, ce gouvernement de François Hollande va vider la France des personnes qui auraient soutenu autrement sa place de leader dans les économies européennes et mondiales. 

Et je ne parle as des obligations de la France d’ouvrir des portes à l’investissement étranger sous la convention de l’OMG (WTO) sur les investissements portant sur le commerce international.   Non, je me tais.  Je ne veux pas condamner la France du non-respect de la lettre des lois.   Montesquieu m’a enseigné quand même « l’esprit des lois. »

In short, look around.  Chercher le business là où vous êtes bien accueilli. 

Could an International Trade War on Privacy Rights for Online Businesses be Heating Up?

Privacy and data protection are synonymous with the “good life” of e-commerce, when online businesses are free to use consumer data with little restrictions.  But with technological advances and the explosive growth of e-commerce, this area invites extraterritorial regulation by foreign governments across borders.  I’m concerned that this web of web regulations will be totally inconsistent, unmanageable and lead to significant costs and lost opportunities for e-businesses.  Consumer protection should not become a mandate for imposing bureaucracy and “free” content management services.

EU Harmony.  In January 2012, the EU announced proposed reforms to its 1995 data protection rules in order to further strengthen online privacy rights and regulate the enormous growth of data collection and processing over the internet in this age of mobile and social computing, the Internet of Things, Big Data and related analytics.  In short, these reforms proposed:

• a single set of rules to apply across the EU and its administration by a single national data authority within the home EU country with the power to impose fines for non-compliance. 
• In addition, EU people will have greater privacy rights, including the “right to be forgotten” and the “right to port their data” across service providers. 
• EU rules would apply in cross-border transactions for companies in non-EU countries handling services to EU citizens.  Any serious data breaches would have to be reported to authorities as soon as feasible within 24 hours.  Additional costs would be incurred by businesses.

Since then, some EU member nations, major tech companies and other countries have criticized the proposal as being too restrictive and a burdensome expense for (especially small) companies..  Nevertheless, the EU continues to move forward with an amended draft likely to happen later this year with the objective of implementing a Regulation governing its member nations in 2014.

American Federalism:  A Hodge Podge.   In contrast, American federal laws (see https://www.cdt.org/privacy/guide/protect/laws.php) are generally weaker than European and other countries’ laws in the field of consumer protection for data privacy and the “private life.”  A year after the Obama administration called for a draft of a consumer privacy bill of rights, none has been completed or made public.  There are no baseline privacy laws protecting consumers. Instead there are sector specific privacy laws and self regulated company privacy policies; consumer privacy laws vary by state (see http://www.ncsl.org/issues-research/telecom/state-laws-related-to-internet-privacy.aspx).  Those who support this hodge podge of laws insist that these methods encourage free commerce and growth of online businesses.

New Balance: International Agreement or International Chaos?   There is no free lunch.  My concern is that privacy laws will be so onerous, complex and confusing that it will balkanize the Internet, preventing cross-border transactions and increasing the hurdles for Internet entrepreneurship of small and mid-sized businesses.  Consumer protection and data privacy laws will conflict with business, adding costs that will have to be passed along to the consumer in the form of higher prices, more advertising per view, and less innovation.  Should the EU adopt its proposed reforms independently, American companies could find themselves subject to EU regulations when conducting cross-border transactions with EU citizens even if there is no conflict with American laws. 

I believe that every nation should have “baseline” privacy rules, including the US, but I wouldn’t go as far as the proposed EU reforms.   Businesses and/or consumers alike have a:

• Right to know what data is being collected and aggregated about them

• “right to be forgotten” but only where the user pays the cost of undoing what the user posted “for free”
• copyright in posted content and a right to transfer one’s post to other providers, for a reasonable porting fee
• right to know what data is known by a service provider and the right to correct it.

The US and EU are set to begin negotiations for a free trade agreement June 2013.  Hopefully common agreement on data protection and privacy rules will be a part of it.  More on this subject later.