Federal Trade Commission Protecting America's Consumers

DKT/CASE NO.:P951201

TITLE: HEARINGS ON GLOBAL AND INNOVATION-BASED COMPETITION

PLACE: Washington, D.C.

DATE: October 26, 1995

PAGES: 1079 through 1303

Meeting Before the Commission

C O R R E C T E D C O P Y

Date: October 26, 1995

Docket No.:P951201

I N D E X

Presentation by: Page:

Professor Diran Apelian

Sloan Foundation Aluminum Casting Study 1083

Professor Ernest Gellhorn

George Mason University 1164

Bennett Katz

VISA 1117

Samuel R. Miller, Esquire

Folger & Levin 1151

Professor Thomas M. Jorde

University of California, Berkeley 1192

Professor Roger Noll

Stanford University 1220

Professor Janusz Ordover

New York University 1208

Robert A. Skitol, Esquire

Drinker, Biddle & Reach 1239

FEDERAL TRADE COMMISSION

In the Matter of: )

) Docket No.: P951201

HEARINGS ON GLOBAL AND )

INNOVATION-BASED COMPETITION )

Thursday,

October 26, 1995

Federal Trade Commission

Sixth and Pennsylvania Avenue

Room 432

Washington, D.C.

The above-entitled matter came on for hearing,

pursuant to notice, at 9:37 a.m.

PARTICIPANTS:

FEDERAL TRADE COMMISSION:

ROSCOE R. STAREK, III

Commissioner

CHRISTINE A. VARNEY

Commissioner

JANET D. STEIGER

Commissioner

SUSAN B. DE SANTI

Director, Policy Planning

DEBRA A. VALENTINE

Deputy Director, Policy Planning

WILLARD K. TOM

Director for Policy & Evaluation

Bureau of Competition

JONATHAN B. BAKER

Director, Bureau of Economics

SPEAKERS:

PROFESSOR DIRAN APELIAN

Sloan Foundation Aluminum Casting Study

PROFESSOR ERNEST GELLHORN

George Mason University

BENNETT KATZ, VISA

SAMUEL R. MILLER, ESQUIRE

Folger & Levin

PROFESSOR THOMAS M. JORDE

University Of California, Berkeley

PROFESSOR ROGER NOLL

Stanford University

PROFESSOR JANUSZ ORDOVER

New York University

ROBERT A. SKITOL, ESQUIRE

Drinker, Biddle & Reach

P R O C E E D I N G S

COMMISSIONER STAREK: Good morning. I appreciate all you coming today. My name is Roscoe Starek, and I'm one of the five commissioners of the FTC, and I'm joined this morning by my colleague Commissioner Varney.

Unfortunately, Chairman Pitofsky has a speaking engagement this morning, a long-standing commitment, so I don't think he will be able to join us -- maybe later. Probably all day -- anyway, this morning we are going to look at such issues as how can businesses capture innovation or other efficiencies through collaboration in markets that are undergoing change, and try to answer some questions about whether or not antitrust impedes firms or industry efforts to collaborate to achieve innovation-bound efficiencies.

Our first witness this morning is Mr. Diran Apelian, who is Provost and Howmet professor of engineering at Worcester Polytechnic Institute, and before assuming that position in 1990, he has held various positions at Drexel University, including professor, head of the Department of Materials Engineering, Associate Dean of the College of Engineering, and Vice Provost.

Between 1972 and 1975, he worked in Bethlehem Steel's Homer Research Laboratory.

Professor Apelian is accredited with pioneering work in various areas of the solidification processing and including among other things, molten metal processing and filtration of metals, and aluminum foundry engineering.

He has over 200 publications to his credit. He currently serves on several technical advisory boards and corporate boards, and he has served on and chaired several national materials and advisory boards for the National Research Council.

Professor.

PROFESSOR APELIAN: (Showing slides) Good morning. I thank you for that introduction, and thank you for the opportunity to come here and spend some time with you, and hopefully I can contribute to these deliberations throughout these hearings.

My name is Diran Apelian, as has already been stated, and I am at WPI where I serve the institute as the institute's provost.

However, I will only be in that position for another year -- a period of six years -- and thereafter, I will be heading the Center for Metals Processing which I have overseen its foundations at WPI, and its establishment.

As already mentioned in the introduction, for many years, I have had a close alliance with the industrial sector, and prior to joining the academe, I spent several years at advanced product development at Bethlehem Steel Corporation in Bethlehem, Pennsylvania.

My scholarship and area of research, research work is in materials processing, and specifically metals processing.

The Center for Metals Processing at WPI has three distinct laboratories, each of which serves a certain sector of the metal processing industry.

These three laboratories are the aluminum casting lab -- ACRL -- the powder metallurgy laboratory, and the semi-solid processing laboratory.

I will revisit these laboratories of the center a bit later on to illustrate and discuss with you how manufacturing -- and I will spell out here that it's fragmented manufacturing industries -- can and have captured innovation as well as other efficiencies in markets which are undergoing dramatic and significant changes.

My hope is that this presentation will demonstrate some innovative and creative approaches in an effort to enhance U.S. competitiveness.

The metal casting industry is a $29 billion industry. The powder metallurgy industry is a two to three billion dollar industry, and the semi-solid processing is a brand new technology, so the markets for which are not developed yet, so you can see that there is a, three different very different sizes, scales, and technologies.

I would like to conclude with some specific recommendations and look forward to some discussion later on.

In this presentation, what I would like to do is briefly look at these four areas as an outline.

I was initially going to read this paper verbatim, but I have decided in the last five, six minutes it doesn't really make much sense.

I've never really felt comfortable reading it. I've never read a speech, so some of it, I'm going to wing it, so if you're trying to read this, you're not going to know where I am, but that's exactly what I'm trying to do so you can pay attention to what I'm saying.

So societal sea changes is an important, in my mind, an important thing for us to review because so much has happened that has implications and opportunities as to how businesses do, manufacturing industries do business with the universities.

There is some overarching issue for fragmented manufacturing industries, which I would like to touch on, a little bit more on the Center for Metal Processing, the details as to how industry and universities work together.

There may be some concerns out there as to how the research that is being done is not first class, whether this is still applied, and that we're losing the edge on fundamental research.

I would like to touch upon that; some of the operational principles, and lastly, conclusions and recommendations.

So let me start with the first one on societal sea changes.

As you can see in my write-up there, a lot of changes are going on, that one thing that we're seeing and we're experiencing is that the changes in society are all happening at the same time, whether they be political, economics, societal forces, so things are not occurring in series, so the impact is quite dramatic.

I've used a nautical metaphor in this presentation that -- and called it the sea changes, so the focus of the sea change I will be addressing here is more of a transition from defense oriented to commercial sector to the civil research, civil commercial sector.

If you look at the last 40 years, we have been at times criticized that we haven't had a strategy, business strategy, as a nation, and I would submit to you that we have had it.

It has been the military-industrial complex. We have had a three-legged, three-legged structure wherein the Pentagon, whether it's through ARPA or DARPA, now ARPA, ONR, Navy, Air Force, AFSR, Army, Army Research Office and a variety of other agencies have funded much of the research at the universities to carry out fundamental research with 6.1, 6.2, or 6.3, the results of which went to establish the foundation for technologies for products, for the defense industry, the industry, the manufacturing industries where making these components, not for the civilian sector, but rather for the Pentagon, so it was a three-legged structure with the Pentagon, universities, and the manufacturing industries.

And there is a strata of manufacturing industries. You would have the motherships if you will such as the McDonnell Douglases or the Lockheeds or the Boeings under which there would be a variety of smaller corporations and companies, whether they be $20 million companies or $50 million companies, but nevertheless, service manufacturing industries, so there is a very long chain under these motherships.

Today that has changed because the defense industry is doing lengthy research. The research monies are not coming to the universities nor are they going to these corporations.

To cite one example, Rockwell International, once a paragon of defense-oriented industries, now derives only 18 percent of its revenues from military contracts. That's a major, major change in a period of only five years.

Throughout this paragon change, the by-product of the universities was the graduate students, and I hate to call it a by-product, but in a way, it was. It is. It has been. So the graduate students upon graduation was either recruited by industry to continue the research industrial labs, or recruited at the universities to clone other graduate students like themselves later on.

As I have already indicated, that has changed in that the funds are not there anymore, and if you look at some of our research universities, it's obviously clear to you that over the years, when Vanover Bush of MIT, when he really was one of the architects of the foundations of the National Science Foundation, the notion was that the faculties of our universities were a tremendous asset and resource for the country to help the Pentagon to help our defense industries, so research universities were established over the years.

When I say established, they really became major research universities. Examples would be Stanford, would be Cal Tech, would be MIT, Berkeley, and I would characterize these research universities as battleships. That's why the nautical metaphor of sea changes.

The defined skirmish lines are no longer there, and thus these major universities find it difficult to reposition themselves.

As provost, I can tell you it is very hard to make budgets work when you're relying on 30 to 40 percent of all, all of your faculty's salaries to come from self-money, so these research universities cannot steer quickly enough to maneuver to sea change and the change in the tide, and I would certainly suggest that that's the last thing we need to emulate in our nation.

Peter Drucker, a very well-known professor of management and a prolific writer, has submitted that our productivity as a nation and our competitiveness will only improve if, if the productivity of the knowledge workers is enhanced.

That's interesting that he coins those words knowledge worker, so he's putting emphasis on the labor, the people who are working, but he has an adjective there -- knowledge, knowledge worker.

The more informed they are, the more educated they are, and I would also submit to you that there is a big difference between data, information, and knowledge.

I personally believe in Drucker's notion, and similarly I believe that productivity of our universities, though this is not one of your concerns here, will only increase if the learning experience by our students is enhanced.

Let's compare for a second the perspectives of the university and an industry.

Universities in general have a unique situation in that their customer and their product is exactly the same. It's the individual, the student, except that there is added value on graduation. At least we hope there is added value on graduation.

On the other hand, the industrial perspective is one where wealth ought to be created, should be created, and we're trying to add value to the shareholders or the principals of the company. That's if it's a private company.

Technology plays a major role in the creation of wealth, and thus the knowledge base is the foundation to competitive advantage.

I don't think one could argue with that. However, we all know that the knowledge base is not something you pick up off the shelf in a CD ROM or a certain number of books, but that the knowledge base is invested in the knowledge worker, so both industries and universities have a very key common thread, and that is the graduating student or the product of our universities as well as the human resource base in our, in our industries, manufacturing industries.

So it is important for us to acknowledge that it is the human resource base of our nation's industries which is the crucial factor in enhancing our nation's competitiveness, and you might hear this re-emphasized in the next ten minutes in my presentation or so, that it is really a crucial point that it is the knowledge worker, it's the people who are really going to make the difference.

It might be interesting for me to point out in the metals processing industry how the defense-oriented research has fueled developments within metal processing manufacturing industries.

I'll give you some examples. Rapid solidification technologies where you can take a liquid metal and cool it down at a million decrees a second, 10 to the sixth, 10 to the seventh degrees per second.

Very rapid solidification technologies initially came out of Cal Tech -- Paul Duwade's initiative funded by ARPA during the late '70s early '80s; solidification modeling funded by at that time I think DARPA and the Air Force during the late '80s and early '90s; metal matrix composite work funded by all of the agencies, ARPA having the major lead.

These technologies have truly emanated from defense-oriented initiatives for very specific applications for defense purposes, and they are quite numerous and have certainly impacted the commercial sector, but there has been a lag.

I would like to point out that many of these technologies that have come from the Pentagon were not developed based on the needs of the marketplace and were not driven by the manufacturing industries, either, but rather they were hoisted upon them for a defense-oriented perspective rather than the civilian one.

The new paradigm in closing here and moving on to the next section, is that we need to have a focus on the needs of the civilian sector, focus on new product development, the focus on market share or market penetration, all of which translate to successful commercialization creating wealth, creating value, increasing competitiveness and productivity.

Now let me move on to some overarching issues in the second point, in manufacturing industries, and to start off, our competitiveness is influenced very much by the viability of small companies, small businesses, and I would like to talk about the fragmented industries in our, fragmented manufacturing industries in our country because there is a whole bunch of them. It's not just the automotive, the big steel, ship building, the big aerospace, but a host of fragmented manufacturing industries.

Now what is a fragmented manufacturing industry?

This is one in which the market leaders do not have the power -- you may want to call them mom and pop type operations, but nevertheless do not have the power to shape the events of the industry.

These industries usually contain many small or medium-sized firms and are often characterized by low profitability.

They don't have much money for R&D expenditures, and the useful criterion for fragmentation is that 40 percent of its sales generated reside or are generated by four, the four largest producers.

Some examples of these kinds of industries can be seen here -- non-ferrous rolling and drawing. The numbers in the parentheses are the percentages, the percentage of sales concentrated among the top four producers.

For example, in plastic materials and resins, 22 percent of the sales generated in that industry reside, are generated by four companies alone, whereas in non-ferrous, it's a fairly high number -- 38 percent; in powder metallurgy, 33 percent; so in this context, let me try to point out to you what are some of the components that are made by these industries so it's not abstract to you.

If you ever have the occasion to go out underneath your car, take a look at the big transmission box that you have.

There is a casing in which the transmission resides. That transmission casing is made completely by die casting.

Large parts are made through die casting, jet jet engine blades and vanes through investment casting, whether it's Precision Cast Parts or Homid Corporation, now Thiokol.

Aerospace doors and structural components, these are made by Fuhrman and Sand Castle, by Hitchcock Industries in Minneapolis.

Many automotive components such as steering column parts and the multitude of gears that go into the transmission of our car are made through powder metallurgy.

These are the kinds of industries that service the large manufacturing industries, and they make a significant portion of our manufacturing infrastructure in our country.

It is our firm belief that investments must be made to strengthen the knowledge base and to enhance the level of the knowledge worker so that these near-net-shape manufacturing industries can demand a world class position.

I'm not going to go, I'm not going to go in too much detail in the next section except to point out that there is a lot of pessimism out there that the industries are becoming more efficient and that they are becoming, they are creating value at the expense of the workers.

A little bit, over a hundred years ago, Karl Marx and Frederick Engels in their Communist Manifesto, and I quote from them -- they said the modern laborer, instead of rising with the progress of industry, sinks deeper and deeper below the conditions of existence of his own class. He becomes a pauper, and pauperism develops more rapidly than population of wealth.

Obviously it is a very pessimistic view of increased productivity, and there is some liberals and conservatives alike today like Jeremy Rifkin, author of "The End of Work," who are suggesting that these kinds of productivity increases occur at the expense of the workers.

Our experience is totally different in the Center for Metals Processing at WPI. It's much more optimistic.

We're finding that through re-infrastructure, through re-engineering, all of these terrible names, and some downsizing, what's occurring is that the corporations are enabling themselves to redesign themselves, to reinvent themselves, where value is being created, and we're not so concerned about the wage of the worker. It's the value of the worker.

We subscribe to the notion that fatter paychecks follow higher productivity. I think that caps it all in that one sentence.

In the early decades of the 20th Century, when mass production ruled, competitive advantage was realized by fragmenting work, by specializing tasks and using a hierarchical management theory.

We're finding out today that productivity gains are made by increasingly relying on empowerment of the work force.

These are cliches perhaps, but to truly do it, it's a transformation in the manufacturing work force in the workplace -- delegating authority using information and communication technologies.

Chaparral Steel in Midlothian Texas, Gordon Ford, who is the CEO, recently told me only two weeks ago that when he is trying to buy a continuous casting machine, which is a several million dollars investment, he doesn't make that decision, nor does the R&D department make that decision.

He sends the workers around the world to look at all the various suppliers, and they make a decision as a committee as to which machine they ought to buy, and empowerment really means that you delegate the work.

There is no doubt in our minds that education and life-long learning is the key to ensuring the world-class manufacturing, and it is principally for this reason that industry/university collaboration ought to be nurtured.

Now let me move on to the Center for Metals Processing and tell you a little bit about the details of how this consortium works.

As I said earlier, there are two laboratories -- three laboratories, each of which addresses a certain sector of the industry.

I'm not going to have the time to go through all three laboratories.

I would like to spend a few minutes about the, about the aluminum casting and the powder metallurgy.

We're talking here about over 40 corporations, 40 manufacturing industries supporting the center with an annual consortium fee.

Fundamental and applied research is carried out by the center addressing technological needs, technological barriers identified by the industrial sector, so let me first talk about the casting laboratory.

I assume everybody knows what near-net-shape manufacturing is.

That's where you take liquid metal and you pour it into a cavity, different kinds of cavities, whether it's die permanent mold sand casting, and you make a net-shaped component perhaps. With some minor machining, or very little machining, you have a fairly complex component that's, that is used by society, so the objectives of this consortium, of the center are really two-folds -- to perform basic and I mean fundamental research relevant to the aluminum casting industry.

There is a difference between, there is a different way of viewing what applied research means and what fundamental research means.

My own view is that fundamental research within a given context can be viewed as and should be viewed as applied research.

It's not black and white, but rather there's a continuum there. It's how you view it.

The second objective is to provide a network, a structure, where dialogue takes place within the various sectors of the industry.

The aluminum casting is a growth industry. As I indicated earlier, the metal casting industry is about 28 to 29 billion dollars a year business of which about 9 billion or so is for aluminum castings, the remaining being for iron and steel.

The aluminum casting research laboratory of ours addresses the technological needs of the industry and does so by integrating faculty from different disciplines, brings different people together.

It also serves as an educational center, disseminating results, developing courses in continuing education programs, serving the industry, tutorials, et cetera.

Now who are the members of this, of this center?

I think you can read the names of the companies yourselves, but one thing you will note is that these -- that we have here a broad spectrum of the industry.

It spans a very broad spectrum in that we have primary and secondary producers of aluminum, so the people who are listed under the primary, they make aluminum ingots, billets.

Second producers are recyclers like Wabash Alloys in Indiana where a million ton a day is not enough of -- is the scale of recycling we're talking about.

Then you have people like Comalco, Doehler-Jarvis who buy aluminum from either the secondaries or the primaries, melt it, pour it in their dies, in their cavities, in their molds, and make all kinds of components.

Then you have end users. These are the people who buy the castings, and we have Ford, General Motors, Harley Davidson.

The members pay an annual fee of only 15,000 a year. It's probably going to go to 20,000 very shortly. It has been like that for the last four years.

We have a Steering Committee, which is established consisting of six elected members of the consortium.

The membership on the Steering Committee is on a rotational basis so that we can have representation from every member company.

This committee meets at least twice a year. Specific projects are, are decided on, and each specific project has a focus group made up of consortium members.

This might help. We have a Steering Committee, leaders of the industry, six of them.

There is the director of the laboratory. Then you have the research staff, the graduate students, the post-docs, the undergraduate students, and four projects a year, but some of these projects have been going on for three, four years, so they are not necessarily yearly projects. They can go on for several years if they are fundamental research topics.

Each of those projects in turn, though they are not shown there, has a focus group of several industry members participating with the student, with the supervising professor, giving lots of counsel, lots of advice and truly bridging the gap if you will if there is such a gap between industry and university.

It's, it's a high maintenance way of doing research. You know, you've heard of high maintenance body. This is a high maintenance organization to the research, but the output, the outcome of it is just dramatically different than what I have been accustomed to 20 years ago.

The beneficiary of this is the student, who is much more knowledgeable, has been grilled by the industrial sector if you will, and I think the industrial sector as well, who is, who has available to them the graduating engineer, graduating technologist who has been well educated in a contextual sense.

I'm not going to go into any detail the research projects, but just to have a listing for you, to see what their projects are in the casting laboratory, prediction of feeding characteristics, that's a three, four-year project. Very, very detailed modeling work is going on that's real.

The next one is a fundamental project on how can we relate processing parameters to the resultant microstructure?

The last one there, the heat treatment of aluminum magnesium -- at first when I thought about it, I said to myself many years ago it's going to be too applied, not enough fundamentals here.

It has turned out just to be the opposite. The schedules presently used by the industry are archaic and medieval.

I'm being perhaps too dramatic here, but some of these schedules for heat treatment have been established 40, 50 years ago by the industry, military specs.

Since that time, a lot of technology has occurred, and microstructures are different. We have changed the solutionizing, the heat treating cycle from ten hours to two hours for the industry -- much more energy efficient, much better results, and a lot of savings. I mean a lot of savings.

In addition, we have several projects by the Department of Energy, recent one of the size of $2.8 million to look at how can we make metals cleaner so that they are -- so defects are removed before you even make the castings, another one within the die casting industry, about half a million over two years, so you can see that in addition to the monies coming from the industry, we are able to leverage ourselves because many of these government, federal agency projects require cost sharing.

Overnight we're able to do that because of the industrial base and infrastructure we have within our reach.

That has been a major benefit for us to be able to position ourselves.

To summarize and move on here -- you know, I should have asked how much time I have here.

How am I doing?

MS. DE SANTI: How about about five more minutes?

PROFESSOR APELIAN: Okay. I'll try to do it in four. You can hold me to that.

So the summary of ACR activities you can see there -- research programs, annual workshops, technical seminars, ACLR newsletters, technical education programs, industrial interns -- so you can see why I said earlier this is a high maintenance technology.

The powder metallurgy laboratory, the next laboratory, is based on the same model, so I'm not going to go through the template that I just talked about as to how the aluminum casting research laboratory works. It's the same model.

The members of the companies, member companies of the center are a different list of companies except that Ford Motor Company and General Motors shows up again, and by the way, those companies, the GMs and the Fords, they pay membership fees for the P/M laboratory. They pay membership fees for the aluminum casting laboratory, and they are also going to be paying membership fees to the semi-solid processing, which is a brand new technology they have come up.

It's also clear to you here that some of these are transnational corporations. They are not necessarily regional corporations.

I think I said earlier that this industry is a smaller industry, about a two plus billion dollar industry, so it's not in the same scale as the aluminum casting, but you can see that it's comprised of a lot of industries.

As you probably know, the Sloan Foundation is very interested in the competitiveness of the U.S. industries, and they are funding several industry studies.

I saw in the agenda that you've heard from my friend Professor Cooney yesterday on the pharmaceutical industry.

Stanford is looking at the software industry. Berkeley is looking at the semiconductor industry, Carnegie-Mellon the steel industry, et cetera, et cetera, and we're looking at fragmented manufacturing industries, particularly interfirm relationships, cost estimation, interfirm relationships meaning the supply chain relationships, horizontal as well as vertical, and we're finding out a whole bunch of very interesting happenings within the firms as to how they view competition, how they talk to each other, and how they can think of themselves.

Cost estimation is another one. We're appalled as to how prices are set. It's not based on real cost or any activity cost basing, but rather what the other person is selling it for, so my colleague Professor Chick Kasouf is going to give some more details on our results of these works, the interfirm relationships, cost estimation, value creation and globalization, on November the 8th, and if I can do it, I would like to accompany him, but the schedule may not permit me.

Some principles for university-industry alliances in closing here, and some conclusions -- when you look at the powder metallurgy lab and the casting lab, you might ask the questions aren't they competing technologies within your own center?

Isn't casting, which is a near-net-shape manufacturing technology, competing with powder metallurgy technology?

How can you keep all these industries together when they are competing with each other?

The answer to that I like to give you is one that will hopefully illustrate our philosophical bent and our belief in the center is that if you're in the near-net-shape manufacturing business, you better not only know what is happening within your own industry, but other industries that also make near-net-shape manufacturing components, and our view of competition is a bit different.

Competition we view as a partner with whom we have not made an alliance. That's a bit different than how people view competition at times.

Collaboration occurs for the development of generic knowledge base, and we do so by creating a black box.

We laugh about this at times, but we have a parameter or window within which everything is safe. It's fundamental, generic.

The companies who are the beneficiaries of that research use it in their own ways, any way they want to for any market they wish to.

Things outside of the black box are not safe. They are overly-proprietary, and we just don't even get involved in those areas.

Using an industrial lexicon, in closing here, we need to fortify and strengthen the customer/supplier relationships.

We see ourselves as supplying the knowledge base and qualified personnel, and moreover, we believe that the knowledge base should be developed collaboratively.

We're cognizant of these paradigm changes and are establishing bridges between the industrial and academic sector through the workings of the center.

It's important to realize that early on, one needs to establish a delicate balance between competition and teamwork for the participants of a horizontal research collaborative.

I have talked about the box, the black box, and I can tell you it works very well.

We're -- one of the concerns we have is this leaky technology where through collaborations, industry is putting money into collaboration, but the technology gets leaked out to other companies, overseas or nationally, who have not invested in that, so what we have done to alleviate that is that our member companies, the companies who, the 40 plus companies, that the consortium, they get the research results first, so publications and things that go out to the public through our research and publications professional journals, meetings, et cetera, there is a lag time, so it's important that we honor that and there is some, some agreements to that.

Also intellectual property, the, the university owns the intellectual property, but our member companies get first right of refusal and royalty-free use of those intellectual properties.

In closing, I would like to remind you that I'm a professor of engineering, not an attorney or student of antitrust issues.

I even had a hard time reading the article in the New York Times Sunday about what is happening in Justice and and FTC.

However, I firmly believe that policies and regulations, and I hope that's what going to be the outcome of these hearings, should not be, that regulations and policy should not be a barrier for developing generic knowledge base and contributing to the education of the human resource base in our fragmented manufacturing industries.

I would much prefer to have our energies as a nation committed to making our manufacturing industries more productive than to address a host of secondary problems about how you're going to pay for this, for that, for that.

I would rather us focus on how to generate revenues. Taking care of the root cause problems will ensure the long-term prosperity of our people.

In the real estate business, we hear often that the secret is location, location, location. I'm sure you have heard that before.

I submit to you that for us to enhance our nation's productivity, we have got to invest, invest, and invest to ensure that our work force is the very best, the most knowledgeable work force in the world.

The university's business should be driven by its academic mission, and the university-industry collaborations attempting to elevate the level of our knowledge workers certainly fit this mission.

I hope that these comments and the insight that I have provided here will be helpful in your deliberations, and if there is any time -- I don't know how the program is -- if there are any questions, I would be happy to entertain them.

Thank you.

COMMISSIONER STAREK: Thank you very much, Professor. That was fascinating.

I'm unfamiliar with this kind of collaboration that you have described at the center, and I find it extremely interesting.

I do have a couple of questions if I might.

PROFESSOR APELIAN: Absolutely.

COMMISSIONER STAREK: First, is it, is it your thesis that as a result of the, of the drying up of resources that generally has been generated by the Pentagon for universities and industries to do national security-related research and development, that the Center for Metal Processing and its relationships with universities is the wave of the future for collaborative joint ventures to make up for that loss?

PROFESSOR APELIAN: It is certainly my view, and it is not shared by many, but it is also being shared by many as well, so it's, it's, I would not even give some percentage 50/50, but it is certainly shared by many of us that as the defense -- as we as a nation are moving more towards the civilian and commercial sector, that there is some real models out there that we can learn from Germany and other places as to how industry and universities can work together for the benefit of society.

We certainly are doing it. Actually it is very -- the Director of Engineering at the National Science Foundation in the Reagan Administration, Nam Suh, Nam Suh, S-u-h from MIT, he had the very first such collaborative consortium at MIT in the plastic industry, and the engineering research centers, when they were first established, were based on this model -- how can we have specific focused areas of excellence in our nation at various universities as long as the industry was going to support this?

So many of these notions are not totally original. You know, Einstein said I never discovered anything, I just reinvent the same old things that had been discovered by others before, but it's clearly, in my view, it's clearly the paradigm for the future that industries and universities have to work together to develop the knowledge base for the commercial sector.

You know, industry itself is not ready to take this on as well.

You know, they are so -- you know, you have, if you have a small company of 15, 20 million dollars, and I have served on a board of one such company, $25 million company, there are all kinds of daily issues of inventory, cash flow, personnel issues.

R&D is not necessarily thought of as an investment. It's thought of at times unfortunately as a cost, so I think there is a real opportunity, and our universities as viewed by the whole world as one of the best assets of America.

If we can just take that and leverage it and parlay it into the, into the industrial manufacturing base and invest in our work force together, and if we have some regulations and policy that even stimulates that or even create some incentive for that, I think it's going to be great.

Maybe it's too optimistic, but I really believe that.

COMMISSIONER STAREK: We have looked at several industries here, and a couple come to mind, pharmaceuticals and consumer products basically, and it seems to me that in the those two industries, the companies take their research and development very, very seriously because it's their future.

I mean obviously they need to continue to keep developing new products, whether it be for consumer use or in the pharmaceutical area.

It's my sense that they do most of their research and development in-house out of, you know, what must be their profits, and I wondered why in the metals industry that you're familiar with this can't be done.

Is it because there so many companies that you need to collaborate, or why is the industry so fragmented and collaboration is required unlike in the other industries?

PROFESSOR APELIAN: It's an interesting point, and I think it will tie into some of the things I have already talked about here and there, and let me try and integrate that.

There is a very large difference between -- I'm going to cite some companies as examples so it's not abstract, to be specific, very large -- there is a very significant and dramatic difference between a Merck, Sharp and Dome under the leadership of a Ray Vagilis, who was a professor at one time, who knows that the pharmaceutical industries, the products that they have to make has to be at the cutting edge, so it's a very advanced technological R&D intensive business if you will, and dominated by a few companies alone whereas in the manufacturing base industries, whether it's screw machines or rolled aluminum parts or castings or die castings, it is not that intensive an R&D.

The, the large manufacturers, whether it is General Motors or Ford or McDonnell Douglas, dictate to a large extent to the customer what's needed, and it's the business of these companies to make it, so the R&D that is needed usually has been driven by the customer.

The General Electrics tell the Howmets or the Precision Cast Parts, the General Motors tell the Candy Die Castings what their needs are, so in a way, we have crippled to some extent the service manufacturing industries by having very, very large customers, motherships if you will, of manufacturers -- I shouldn't call them manufacturers -- assemblers, the General Motors, they are manufacturers but they assemble a lot of parts together -- by dictating what the needs are, so many of these servicing manufacturing industries have for many, many years not been given the opportunity to control their own destiny, so there is a transition there, and I hope -- I have tried to point out that there is a large difference between the pharmaceutical industry that Charlie talked about. I'm sure like Merck, Sharp and Dome, they know their products have to be at the cutting edge, very next things, and it's hard to do in the die casting where you have got a metal die in which liquid metals coming in stamping hundreds and hundreds of parts every hour, but nevertheless these are industries that provide a lot of jobs, many billions of sales, many, many individuals make a living and raise families and send their children to school.

There is a lot of chain under that, too -- people selling paper and pens and pencils to these companies, so there is a very large chain, and I think we need to pay attention to that.

MS. VALENTINE: Just one quick question -- we have obviously heard before, and I think we'll hear again, that private control of research results is generally what yields greater incentives to innovate.

You have an interesting arrangement here where you have the university owning the research results and members getting royalty free use and then a time lag.

How is that arrived at and how happy are your members with that?

PROFESSOR APELIAN: That was a major dispute or deliberation at the very beginning when it was being created.

As it has turned out in the last five and a half years of this center, we have not applied for a single patent. Okay.

Since the research is so generic, it's so basic that the companies are taking, are taking the fundamental research results and using it for their own use any way they want to, and there is a, there is a time of a year or so before we publish anything, so the corporations are benefiting from that.

MS. VALENTINE: The time lag is a year?

PROFESSOR APELIAN: Yeah.

COMMISSIONER STAREK: Intellectual property belongs to the university.

PROFESSOR APELIAN: It does, but as I was saying, it's really a moot point because we really haven't applied for any patents.

MS. VALENTINE: Thanks.

COMMISSIONER STAREK: Well, thank you very much.

Our next witness is Bennett Katz, who is Group Executive Vice President, General Counsel, and Secretary of VISA International.

He is also Vice Chairman of VISA's Management Executive Committee.

Mr. Katz has been in VISA since 1970, and has been VISA's General Counsel and Secretary since 1973, and prior to that, he served for five years as the Chief Counsel of Avco Financial Services.

Mr. Katz, thank you for coming. We certainly look forward to your remarks.

MR. KATZ: Well, thank you. We're helping the universities -- I want you to know that -- by having a VISA card in the hands of every student.

PROFESSOR APELIAN: That's true.

COMMISSIONER STAREK: You need a VISA card to pay for the books these days!

MR. KATZ: Well, let me just say that that was a very interesting speech, although I didn't know very much about the metals industry before, but I think maybe this topic comes closer to home with a lot of people because as you look around this room, I would suggest that seven out of ten people sitting in this room, maybe more, have a VISA card, and so it's something that affects every one of us in this society, so I think there is a lot of interest.

Let me start off by saying that a document was presented by me here, and I have to admit that it was written by Steve Bomse here. I brought my clocker here, and I don't intend to go over that document whatsoever.

I support that document. Actually I read it, so that's why it's submitted, but I'm here to talk more about legal and business issues with respect to VISA and hope that would be of some interest to you.

Obviously, you know about VISA. It's probably the largest joint venture in the world. It will do this year probably in the range of three quarters of a trillion dollars of business, and I would suggest I hope because my bonus is somewhat dependent on it, that we will go over a trillion dollars in the next two years.

It is worldwide in scope. It covers probably 160 countries. It involves banks throughout the world. It involves consumers throughout the world, and we hope that it has brought innovation to this country and in fact to the world economy, so let me go back to this issue of what we are.

We're a joint venture, no question about it. We're owned by the member banks who issue the cards, and they are located -- we have a joint venture in the U.S. composed of U.S. banks.

That joint venture in part owns VISA International, which is a worldwide joint venture, and the U.S. joint venture owns approximately I would say today in the neighborhood of 45 percent of the worldwide ventures, but I don't want to be quoted on that, but it is a substantial part of the worldwide joint venture.

In 1970 when I had the privilege of joining VISA, and you talk about luck, not skill, I just happened to luck out to join a company that was involved in a reverse merger, and I was arrogant enough to think that I could become general counsel at the Bank of America at a young age, so I applied for the general counselship of BNA when they already had a general counsel, and it turned out they referred my resume to this new upstart company, and that's how I wound up at VISA.

It's just luck, as I say. I wound up there at a time when I was the eighth employee or the tenth employee of VISA. We were all in one little room trying to do business, and as I remember it then, it's almost unbelievable to realize that in those days, everything was paper.

You go into the merchant and you go zap zap, and you would get a sales draft, and that sales draft would be sent to the bank, and the bank would actually mail it to the issuing bank, and an authorization had to be received.

Would you believe the way a bank would get an authorization is using the telex system?

Can you imagine a customer sitting at the store waiting for a telex to go to the issuer, and a telex coming back, and that's how it was in 1970.

Now the world has changed greatly. VISA has changed that today where almost 95 percent of the transactions in the United States are fully electronic data capture, so paper is gone, and transactions take place instantaneously, and obviously everybody has benefitted from that innovation.

What are the drivers of innovation as I see them?

Well, of course the first driver and the most important driver for us in 1970 in the early days is just keeping up with the business.

The business was growing, and we needed to put in the infrastructure just to be able, to be able to support the growth of the VISA system.

The second driver was now that we have an infrastructure of electronics, we have got to reduce the costs.

The costs were going out of sight in terms of losses, and we needed to drive those costs down, so that was the second driver of innovation, and after you get through those two drivers, and that is a lot of time spent just doing those things because we didn't have have lot of money to do it with, the next one driver is let's increase market share.

Believe it or not, that was the third driver in my view, and how were those drivers segregated?

Well, first is you want to increase your existing products in existing markets through innovation.

Secondly, you want to take existing products and you want to move them into new markets. That's your second issue at least at VISA, where you look.

Thirdly, you want to take new products and move them into existing markets, and fourthly, and last, you want to have new products in new markets, and each one of them becomes more and more difficult and more and more expensive.

Needless to say, and I'll take you just quickly through some of the innovations to remind you of them, we talked a little bit about existing products and how we went into existing markets, and we had to change that product for security purposes, with mag strip, with securing the mag strip with all of the electronics to increase the efficiency and to drive that market share up by making it more secure and competing harder against our, our competitors in the existing markets.

We needed to move our existing products into new markets, and so we went into supermarkets, and we went into health care with our existing products, and in order to do that, we had to have innovative products, software systems and pricing.

Thirdly, we needed to develop the new products in existing markets, and so we came out with debit cards, on line, off line.

We are working on pre-paid cards. There are new products being developed right now which we can talk about in a few minutes because I want to spend time with you talking about the future as I see it.

Probably you don't care how I see it, but I thought I would do that anyway.

Fourthly, we wanted new products in new markets, and so we went into Traveler's checks, and we're going into the pre-paid cards and so forth, and we'll talk about that because that's the last phase of the development.

Now what does antitrust have to do with innovation in this way that we have been through?

Well, first of all, let's talk about VISA because it's unique.

VISA is unique in the sense it is a joint venture, and as a joint venture, it is always looked upon as a horizontal group of competitors making decisions, and well, wait a second, we have got these competitors -- the banks -- who compete with each other, working on an innovation on working on a product and dealing with how to do it, and so it is always subject to antitrust scrutiny.

Every decision, every move we make is subject to antitrust scrutiny, so is that good? Is that bad? We will get to that in a moment, but let me go back over the history of my career at VISA, not with Steve Bomse. There were lawyers before him, but he has been in this fight for many years with me, fortunately for me, but we start all the way back with when I started in 1971 with our first antitrust suit, which was the Worthen case, and we went to the Justice Department for guidance, and we didn't get any guidance, and what did we wind up with? We wound up with duality.

Now I was a fighter for duality, anti-duality. We didn't believe -- we believed I should say that we should keep systems separate, that we wanted to maximize intersystem competition, and we did it at a time when we were the smaller system.

This was not an attempt by a larger system to keep their members out of a smaller system.

We were the smaller system in 1970 by far, and yet we got no guidance, and so we were small and we couldn't afford to fight a major antitrust suit, and so what did -- the board after listening to this said throw in the towel, and we threw in the towel, and within a few years, duality was rampant, and we have duality today, which means that every bank in this country, almost every bank that issues, issues both VISA and MasterCard owns both, votes for the directors on both, shares the information between the two, and although we still are vigorous competitors -- you probably read in the Journal how we came out with STT and MasterCard is doing this.

It's more of a management competition, but the banks are not particularly thrilled spending their money seeing us beat up on each other. I have to admit that, so there is a different kind of competition as a result of duality.

The second lawsuit of major consequence was the Nabanco case, so now we finally get rid of that one. The next thing we're hit with was a case dealing with our interchange fee, an issue that was very important to us because I believe that without interchange fees, there could be no float in this system. I still believe it.

And in those days, in 1971 when we adopted an interchange fee, there were many lawyers, and I remember them on our board saying you cannot have an interchange fee. It is a per se violation of the antitrust laws.

Fortunately, our outside counsel said, you know, this doesn't make common sense. How can you have a per se violation of the antitrust laws when it's essential to the viability of this joint venture? You'll -- I think you're going to win that one.

And I said you think I'm going win that one? Well, what's the guarantee?

He said there is no guarantees, so I went to the board and I said there are no guarantees, and they said what do you think we should do?

And I said well, you've two choices. You cannot have an interchange fee and let's wrap this this up and I'll move on to my next job, or we can at least fight this battle, and I think we have logic, we have reason, we should win this battle if it ever came up, and it did come up.

Fortunately we had outstanding counsel. Steve Bomse was with me on that, and we won that case.

I believe it was an important decision. It has been an important decision because so many of the joint ventures in the banking industry and the financial services industry use interchange pricing. It's in the telecommunications industry, and as a result, we have seen the incredible expansion of the VISA system, but let me point out the VISA system took the risk.

Had we not been willing to take that risk, we might not or I might not be sitting here. You would, but I might not.

Let's talk about the third major piece of litigation -- the Dean Witter case, and we have counsel for Dean Witter sitting in the audience here, so I have to be very careful what I'm going to say.

I'm just being facetious. I'm going to say exactly what I want to say.

But in the Dean Witter case, the only thing I want to say about Dean Witter is that we believe that this again was an issue of maximizing intersystem competition and preserving the best of competition between competing organizations.

They would differ with us, and they are entitled to that difference, but that's not the point I would like to make here today.

What the Dean Witter case was about was membership in VISA -- an issue that plagued us from the day we started in terms of who was entitled to come into VISA. Could we draw a line to credit unions? Could we draw a line to savings banks? Could we draw a line to non-banks? Could we draw a line as to special credit card banks? Where could we draw the line?

We drew the line finally because there was too much risk and I personally could not come to a conclusion where to draw the line, and we grew and grew and grew.

We drew the line and said we're not going to take a competitor into the organization. That is the line that needs to be drawn under any circumstance.

Fortunately, we won it. We lost in the lower court.

The risk to VISA in case anybody hadn't read the lawsuit, according to Dean Witter was $1 billion in damages. I will repeat that -- $1 billion.

Now I think most industries would be disincented from doing something if they had that kind of potential liability.

We took that risk, and we won, but I have to, to say once again, if we had lost it, you would have somebody else testifying here today. That's for sure.

It took courage to do it. It was the right decision I believe because following Dean Witter was American Express and every other competitor who had demanded access into VISA.

Now what does that, what is the lesson of that case?

The lesson of that case is it was a rule of reason case, and what guidance did rule of reason give us?

We went to Justice. We came to the FTC for some help. We got very good, very good understandings of the problem, but at the end of the day, I hate to say it -- I'm not saying this in a mean way, or I'm just saying we didn't get the support of the government. It basically was VISA, it's your problem, face it. You're a man. Face it.

That's fine. And we faced it, but had we lost it, we could have been exposed to incredible damages.

What guidance does rule of reason give us? First of all, the judge, a very nice brilliant judge, had very little antitrust experience, and most Federal District Court judges have very little antitrust experience, so the guidance they give the jury is not particularly illuminating.

You go to a jury of people who really -- I know the Constitution protects the plaintiff, and I understand that, but you're going to a jury, how in the world are they to understand the implications, the economic implications of these things? God only knows.

So when you have a rule of reason case, you're in the hands, hands of the gods, if I can put it that way.

And every time we take an act, and we have, I agree that probably per se doesn't apply to VISA. It's a rule of reason case, and I say what's our percentage of winning? It's you have got a sure case. It's what's our percentage of winning? Well, 60/40, 70/30. Go to the next lawyer, it's, I think it's 30/70.

Someone has to make a call, and it's the Board of Directors that makes the call, and they turn to me and say what's your opinion, and I'm saying hm, my job is at stake, what should I say? What's the right thing for VISA? Put all that in the equation, and be truthful, and tell them as it is, and hope that if it's something important to VISA that they will take the challenge, but again, I want to make the point that every act of VISA has that potential challenge, and I will tell you now that we have refused to take decisions which in my opinion would have been consumer welfare.

I can give you one perfect example we have refused to do it because of the risk involved, and it's wrong, but I could not in good conscience push the board into that kind of a decision for the fear of rule of reason case.

That covers the past. What about the future? Well, the future is much more complicated than the past.

How do I see the world five to ten years from now?

I see the world of electronic commerce, a world in which you as a consumer will be able to shop from anywhere you want to be.

You will be able to do your banking from anywhere you want to be, but in order to do this electronic commerce, the electronic infrastructure needs to be put in place at great cost and at great challenge and at great risk, and one of the risks being the antitrust risks.

Now what does it mean to have electronic commerce?

Well, it means being able to use your personal computer from your home.

It means being able to use any personal computer wherever it's located.

It means having a personal digital assistant with you in your pocket.

It means having an electronic wallet to transfer funds between you and other people.

It means being able to bank with your bank without ever having to walk into that branch again, and frankly, I haven't been in a bank branch -- I hate to admit this -- I don't think I have been in a branch in two years. I can't remember.

Who wants to go, when you can go to an ATM, you can use the phone, why would I want to be hassled with lines? I don't know.

It will be a lot better in the future, but we need to do a lot of things to get there, so what do we need?

We need software, lots and lots of software that is going to go into the personal computer.

The client, we need service software. We need telecommunications. We need standards. We need interoperability, and we need an efficient way to create all of that for privacy, security, and authentication.

I will tell you that VISA is going to be, if I have anything to do with it, is going to be on the leading edge of this electronic commerce because you can't have an electronic commerce without a payment engine. It doesn't work.

So who's going to come up with this payment engine? The payment engine I foresee is a chip card which will have all your relationships on it, which will have digital cash on it, which will store information, which will be usable in PCs, in PDAs, in ATMs, which will be used in electronic wallets, which will have encryption, will provide privacy, security, and authentication.

Is there such a chip today? Yes. The power is there. The price is too high. To put such chip out today, it probably would run between, and I can't exactly give you the figure, but I will estimate somewhere between five and ten dollars a chip.

We need to drive that price down. In order to drive it down, we need to have cooperation to be able to get volume orders, and we need to do a lot of research to make sure that there is interoperability of those chips with all of the equipment that will be put in the field, so you need standards, and probably as you have read, VISA and MasterCard have announced standards with respect to chip deployment, both for the chip and for the, for the, for the point of sale device.

We are in the process, and you probably have heard this, we have a joint venture with Microsoft which has caused some consternation among some, but we need to get on with it, and there is a tendency to be afraid of these joint ventures and especially what are the implications of them not only legally, but business-wise, but we need to get on with this, and of course, as I said before, you need software, you need telecommunications. You need hardware, and you're going to need content, so you need to have joint ventures with content providers.

That's part of what the joint venture will be, so now what I'm seeing for our future, for VISA's future, is that we need to make these joint ventures among joint ventures in a sense.

The VISA is a joint venture. It needs to joint venture with the likes of a Microsoft, the likes, and I'm not naming these because it has any meaning, I'm just giving you the likes of an AT&T, the likes of a content provider like Time Warner for entertainment, the likes of banks for content for banking, hardware manufacturers who will bring out the terminals at point of sale who will work with us to have the standards we need to induce it.

We need to figure out a way where it's a chicken/egg -- how do we get people to move into compliance before we have the actual chip cards out there, or do we need to get the chip cards out there before we have the terminals, and why would someone want to invest in chips if there is no place to use them, and why would anybody want to have terminals if there are no chips to be used in them?

It's the the chicken and egg dilemma that VISA faced in 1970.

There are ways to do that, but when we do it, we're taking big antitrust risks again because we need to do incentive pricing.

The minute we talk about pricing, oh, boy, the joint venture setting, a price, is this a price fixing thing? Is it legal, illegal? So we -- Steve and I haven't even talked about it. You're the first to hear about it, but this is, this is in the future.

It's something that has me greatly concerned, but I will say this, that we need to get on with it. We need to get there because if we don't do it, the standards will be set outside this country.

We're behind. I hate to say this. We are behind in chip card development in this country. We are behind in the deployment of chips at point of sale.

We are behind in some of the in-home banking infrastructure. It's already in place in France, in Europe, so we have got to get on with it.

Now what does that mean for us in terms of antitrust and its, whether it will have an effect on us.

We need predictability. You can help us figure out a way to give you predictability that we don't have to risk our neck each and every time we do something that we and you believe is in the best interests of the consumer.

Then you have done a great service for this country. You have also done a great service for VISA, but I don't want to do it because it's going to be something that's anticompetitive. It's something that ought to be encouraged.

Secondly, we have got treble damage liability. We could come to you and you could bless us. The Justice Department could bless us and say fantastic, but you have no control over people or businesses suing us in state courts.

You have no control over them moving into federal courts, and even worse, let me make this point -- if VISA is a joint venture, an international joint venture, the U.S. antitrust laws is just a small piece of it.

We have to comply with the EU competition laws. We have to comply with every country's antitrust laws.

When we do an antitrust compliance for anything that we are coming out with, it could take me months.

I mean you know how long -- it isn't just going to Steve Bomse. I've got a network of antitrust lawyers all over the world, and so U.S. is only a small little example because you have to comply with 50 state antitrust laws, plus the federal antitrust laws. That's only one little part of the dilemma for VISA.

So I'm saying treble damage liability, just escalate that to a point that I think is unreasonable, especially if we have come to the regulators, they know about it and they bless it, why should there be treble damage liability? It makes no sense.

I think that I have probably taken enough of your time.

Recommendations -- I don't, I really honestly haven't thought about that very long.

If someone were to ask me, I could come up with recommendations, but I wouldn't presume to tell you what to do.

I just wanted you to be aware of what's happening and hope that you will use good judgment and make sure that VISA, if it is in other joint ventures, if they are trying to make for a more competitive society, trying to help the U.S. economy move forward in helping consumers have a better way of life, that there is a way to do it and not, not be challenged or be subject to undue risk.

Thank you very much.

COMMISSIONER STAREK: Well, thank very much. It was fascinating testimony. We appreciate your coming today and sharing it with us.

I think Commissioner Varney has a question.

COMMISSIONER VARNEY: Thanks. First of all, I apologize for being up and down. I was not able to clear my calendar. I have to keep going out and taking a couple of calls, but I found both your presentations very interesting.

If only seven out of ten people have VISA's it's not my fault. I have plenty in my household. I want to assure you it's not my fault.

I may have missed this in your remarks, so please forgive me if I did, but as I was talking on the phone, I was also -- these are internally televised, so I was able to try and keep one eye on them.

It seems to me that you were really advocating interoperability of the systems and standard setting as procompetitive, which I tend to agree with, but -- and I may have a further misunderstanding here -- your current relationship with Microsoft, I thought you were engaged in developing proprietary systems, you and Microsoft.

It is not proprietary?

MR. KATZ: No.

COMMISSIONER VARNEY: Didn't MasterCard pull out and the whole thing fell apart?

MR. KATZ: You know, I hates to wash dirty laundry in public.

COMMISSIONER VARNEY: That's okay. It's been in the paper.

MR. KATZ: Well, the true story hasn't been.

COMMISSIONER VARNEY: Oh, good. I want the true story.

MR. KATZ: You're talking to Liz Smith right now!

But the truth is that, and I won't, I'm not going to talk about MasterCard. They can say anything they want. I'm not going to say anything negative about them. I'm just going to tell you factually what the deal is with Microsoft. You can judge for yourself.

Am I under oath? No! But you have my word I'm telling you the truth.

COMMISSIONER VARNEY: Thank you.

MR. KATZ: The truth is that there are two parts of it. That has been confusion.

With Microsoft, we had an agreement to come out with an open standard that there would be nothing proprietary in the standard.

The standard would be made available to anybody that wanted it. As a matter of fact, if you know how to use a browser, and you wanted to go to the VISA site, you can download that standard right here today and bring it on your desk, so if it's proprietary, why would I put it out on a browser?

Now anybody, and I say that anybody can code, decode, to that, to that standard.

What the confusion is is that once you have a standard, you can develop proprietary software to meet that standard. It has to be interoperable. Otherwise it doesn't work, but you can have a smoother working software, you can have a more efficient working software, you can have a cheaper working software.

You can put bells and whistles on your software as long as it meets the minimum standard of interoperability, and what's being confused here is that yes, Microsoft has developed software, and it is proprietary to Microsoft.

I can't ask Microsoft to spend millions of dollars, which they have, and then turn it over to their competitors. I mean Netscape wouldn't do it. Microsoft is not going to do it, but what we have agreed, and without any question, is that the standard that we're advocating and have adopted with Microsoft is totally open to the public so without any issue on that point -- none.

Anything to the contrary that you read is not true.

That's all I can say on that point.

COMMISSIONER VARNEY: Okay.

COMMISSIONER STAREK: I would like to explore your feelings on the duality issue.

Do you think that innovation in your industry would have been different if you and say MasterCard had separate memberships?

MR. KATZ: I'm not, I'm not sure it would have been quite different, but it would have been a lot faster.

One of the things that duality creates is that because the bank is in both, they don't want to have to comply with two different systems at different points because they, if they're going to do a software change to comply, they want to do it one time, so what slows you down is that the bank slows you down to make sure that at the time that they do the change, they do it for both VISA and MasterCard, and if VISA is going to make that change, they have cost saved. Well, shouldn't that change be made available to MasterCard because after all, we issue both cards.

Why do I want to enhance VISA against MasterCard? Do I want to raise my costs to my MasterCard?

So you wind up with the -- it may not change the, what we do, but I think it has a slowdown effect, and I really haven't thought about what differences would have happened as a result.

I'm not sure they would have, but I really don't know the answer to that.

It could. It could have, but my biggest problem right now is the slowdown we see, perfect example is STT. If you want one, there you are, and if you think that is the STT context, MasterCard is trying to slow this process down because they are so far behind, and do you know what's going to happen? I will predict it for you.

I hate to even admit this, but the banks are going to insist there be one standard because they are not going to deploy two different pieces of software in their bank, so even though we're out there in front ready to go, it isn't going to go until MasterCard says we're ready to go. You're forced to the table because of it.

If we didn't have in the bank and we had our group and they had their group, we -- this thing would be out there already.

COMMISSIONER STAREK: Aren't they within it?

MR. KATZ: They're with Netscape and -- they're with Netscape and IBM, but nothing can get done because -- until this convergence because of duality, the banks aren't willing to allow us to go forward with this development because they say it will cost us twice. Why would I want to have two different securities? Let's have a common security.

COMMISSIONER STAREK: One other thing -- in your prepared written remarks, you allude to the fact that we need to be a little bit more forward thinking I guess in determining how to judge joint ventures, and I wondered if you had any specific thoughts, in other words, you know, you made it clear that you think treble damages is, you know, is certainly a deterrent to engaging in certain kinds of joint ventures, but I wondered if you thought there was any way in the way they are they looked at by enforcement agencies and by the courts that needs to be rethought?

In other words, should a market power screen be adopted, or is there some specifics about the rule of reason analysis that, that is causing the heartburn here.

MR. KATZ: Well, if market power is as clean as I would like, maybe that would be good for a screen, but I've tried to understand market power for a lot of years, and certainly when you are in one line of business and you're trying to get into new areas of business, what does the market do? If you look at the traditional -- so no one even can tell you what -- I know that in the Dean Witter case, Dean Witter had one view of market power. We had a different view of market power.

I don't know what was happening at Dean Witter, whether they had a divergence of views of how to even define market power there.

I know that we had divergence of views of trying to figure out market power.

I think we had it right, and the court agreed, but I think you need to give it some guidelines. I think you need to give the court some guidelines.

These are inexperienced people. I mean they are wonderful. The judges are wonderful. My experience has been they have been honest, trying hard to figure this out, but they don't have a clue about what's going on.

They maybe get an antitrust case once every four or five years, some of them, or once every three years, and it isn't exactly this.

They cite cases from 1890. I mean we've got Topco to deal with, and what does that mean? And I could tell you a lot of things how I feel about the antitrust laws, but I don't think you want my personal views here at this time, but I think what I'm asking for is that you have the expertise.

This organization, the Justice Department, if there are any people who are brilliant, know this field, it should be right here, and I believe it is here.

I have talked to people on the staff here, and this is a wonderful staff you have. You're very lucky, but what needs to happen is take that expertise and give the guidance to the courts. Make them clear on what this all means.

Maybe you can't figure it out. That's possible. But if you can, I think clarity breeds predictability, which leads to I shouldn't do this, or I should do this. Once the decision, I should do this, and we ought to all be coming from the same rulebook.

You know, it's like golf. If you've got the rules, you know how to play.

I just, I just would like to know what the rules of the game are.

I can't -- be honest with you, I can't figure it out. I've been doing this -- I'm not an expert in antitrust, but I have been playing that -- I shouldn't say game, but I have been playing in this field for 25 years, of antitrust, and I still can't figure it out, and I try the best I can.

I think I have some people who thank God represent us who are experts in it, but when I listen to them, even they, two of the most brilliant antitrust lawyers I know sit in the room and they debate with themselves as to what it should be, and I'm saying now wait a second. This is not right.

There should be enough clarity among the experts.

That's all I'm saying.

COMMISSIONER STAREK: Thank you. Questions?

MS. VALENTINE: I guess I would just follow up on Commissioner Starek's question, which is thank you very much for attributing us with substantial powers, but you really do have some of the best attorneys helping you, and in terms of thoughts about where one should go and rationalizing joint venture law, if do you have any suggestion about either market power screens, registration under NCRA, NCRPA, if that should change, if you -- I would be interested even if you have issues with the foreign participant aspect of the NCRA since you have indicated you're an international joint venture, so any thoughts would be appreciated.

MR. KATZ: And I might point out that as you know, you can't go retroactively in that statute for some weird reason. I can't figure that out, but that's -- I know, I didn't draft it and I haven't figured out why it isn't retroactive.

For a company that was formed in 1970, you can't even file, so I don't understand that, but leaving aside some of these, and I frankly can't even figure out what the statute means. I've tried to read it. I've asked my counsel, and they can't figure it out, what it means, sometimes, so that even that statute needs some clarity, but I can say that, you know, if I point to, for example, the EU market, I just know one thing about it.

There are bad parts of it, bad parts to the antitrust laws in the EU, but there are some very good parts.

I know one thing, that when I file my documents before the Commission, I have no liability. I mean I'm protected.

Now the bad part is I think the Commission personally has, has too much power. They don't have enough -- there isn't a -- the screen is a little scary, but at least one thing is for sure -- when I file, when I register my bylaws and my articles, I'm free of damage liability.

Now if a -- now they are free to investigate. They are free to tell me you can't do this, but once it's before them, I am free of liability.

I want to disclose everything. As a matter of practice, VISA has been, I'll predict we have been the most open organization with the Justice Department maybe in the history of the Justice Department because of one reason.

I'm fearful by the structure -- we have had more meetings with the Justice Department from 1970 all the way through on. Everything we do, we have talked to the Justice Department, but it doesn't give me any comfort.

They look at it, but they -- there is no comfort level, so maybe there is something we can talk about in terms of a way where if you file something, and it isn't challenged within a certain period of time, that you at least are free of treble damage liability -- something.

MS. DE SANTI: I would like to follow up on this.

A lot of your testimony was resonating. There was a period of time when I was in private practice, and one of the cases I worked on involved a joint venture that had gotten a business review letter from the Justice Department blessing it, and then there was a subsequent private suit with a Federal District Court judge denying summary judgment and citing cases from 1928 and 1930 -- very brilliant judge, and the suit was settled rather than pursue it farther because, precisely because of the types of issues that you're talking about, so I know that certainly your experience is not unique.

If you do pursue this farther, and I would very much like to request if you have real suggestions you would like to put forward for consideration, we would very much like to get that on the record.

When you think about those issues, could you also think about how, how, you know, if you file for, and in the sense that you were just talking about, that there is an exemption that is, is issued in some sense, a certain period of time goes by and the antitrust agency doesn't challenge the proposal, is there any way to take care of changing circumstances down the road?

Is there, you know -- and I don't know actually know how the EU does it. I know that's an issue that has been raised from time to time when there have been discussion about this type of approach, but we would very much like to get --

MR. KATZ: Can I make one slight comment on that?

MS. DE SANTI: Please do.

MR. KATZ: I'm not an expert on antitrust -- period.

I just, I just am subject to it all over the place, but in the EU, the changing circumstances, the burden is on the Commission, and it's also the way it works practically speaking.

If someone is injured, and feels injured, they make the complaint to the Commission, that's where they go, and so that raises the level to the Commission of I better look at this, and you get a comfort letter.

Generally speaking, they have so many registered or file exemptions, they don't have time to get it, so what it does in effect is give us the comfort until they come in and challenge you, you don't have this -- you're open about it. Anybody can see it, you know, on the Commission, and anybody can challenge it, but if it sits there until a complaint is made, or the Commission takes it on their own because they hear about something and they want to challenge it, you're a safe harbor.

MS. DE SANTI: Could I ask you, you said you had an example of when VISA had decided not to go in a particular direction because of the fear of a rule of reason case, and you believed that it would have been pro-consumer welfare.

Could you give us that example?

MR. KATZ: There are many, but the one that popped in my head at that moment was this, this is so simple, you would say oh, come on, this doesn't make any sense.

It doesn't, and that is let's say we have a merchant who is, who is creating fraud, or there are lots of losses. He has very bad shoddy merchandise, and we -- but he has a bank that's willing to sign that, sign that merchant, but that merchant is creating losses for consumers, doing, doing things that we don't think the consumer should be subject to that, and we want to terminate that merchant.

Now we, early on, we wanted to just set up a policy that says that if VISA reviewed it and found losses to be excessive, we should just be able to terminate that, but the fear, of course, was quote, unquote, group boycott.

This is a joint venture. The banks as a group have said we won't let anybody deal with that particular merchant and so we didn't deploy for a long time.

Now we have put in some procedures, new procedures, but for a long time, we just sat because of the fear of this, we sat back and didn't protect the consumer against those merchants that I wanted to terminate, that the board wanted to terminate, but it was fearful of a group boycott concept, per se violation.

Under the rule of reason, do you have the right procedures? How do you do it? What -- you know, it just got to be such a mess that we passed on it at that time.

MS. DE SANTI: Thank you.

COMMISSIONER STAREK: Well, thank you very much.

I think our reporter has been extraordinarily patient, and I think we need to give her a short break so she can change the paper, et cetera.

I would propose that we reconvene in about five or six minutes.

Is that all right with everybody? And hear from the remainder of our panel this morning.

MR. KATZ: Well, thank you very much. I'm sorry I get so excited, but --

COMMISSIONER STAREK: Terrific. I really appreciate it.

(A recess was taken.)

COMMISSIONER STAREK: Okay. I think we're ready to reconvene here.

Our next witness is Samuel Miller. Mr. Miller joined the law firm of Folger & Levin January of 1995, and during 1994, Mr. Miller served as the special trial counsel in the Antitrust Division of the Department of Justice.

He was the lead counsel in the Microsoft investigation and prosecution, which concluded with filing of a consent decree on July 15th, 1994.

He has also served on the Antitrust Division's Intellectual Property Task force.

Mr. Miller has written, lectured extensively on among other things, ethical issues for attorneys, attorney-client privilege, and federal civil procedure.

In addition, he is an active member of the ABA litigation section, currently the Chairman of the Antitrust Litigation Committee, and he previously served as Chair of the Consumer Rights Litigation Committee, so Mr. Miller, thank you for coming, and we look forward to your thoughts.

MR. MILLER: Thank you, and I appreciate the opportunity to be here.

When I was at the Department of Justice, I focused on monopolizing conduct of a single firm, but today what I want to address is collaborative activity in particular in the computer industry.

It's now estimated that 30 percent of American households have personal computers, and in the last several years, the focus has shifted from stand-alone desktop computing to connecting computers. The explosion of the Internet in the last two years reflects this trend.

Because of this, the need and importance of interoperability has become even more essential, and I define interoperability as the ability of hardware or software manufactured by one company to communicate with or work compatibly with products of competing or complementary suppliers.

Interoperability between products enhances consumer choice, lowers prices, and promotes innovation.

Collaboration today you see among all kinds of computer manufacturers to achieve -- Plug and Play is one example of this.

So in today's environment, antitrust policy should promote rather than hinder efforts to achieve interoperability.

Interoperability in the computer industry is not generally achieved through either government standard setting or even industry-wide formal standard setting bodies.

Rather it is most often achieved through ad hoc voluntary coalitions which get together to set compatibility standards or information -- I'm sorry -- interface definitions.

More formal efforts to set standards are just too slow. Where product life cycles are sometimes as little as six months and oftentimes are twelve months to eighteen months, the benefits of compatibility standards in the computer industry have been recognized by commentator and professor David Teece, who you will hear from, and I quote him in my paper.

One paradox of antitrust law is that a dominant firm which can muscle or coerce an industry toward its de facto proprietary standard faces less antitrust risk than a collaborative effort by smaller competitors to agree on a standard, and the particular irony of this situation today is that most often, the alliances and consortia which have been formed in the computer industry have been by those companies with smaller market share in order to compete against a dominant firm that's pushing its own de facto standard.

Now the adoption of compatibility standards is particularly important in the initial stages of a new product introduction, and there are numerous benefits to interoperability.

As I said, price competition is enhanced when competing manufacturers can supply substitutable product.

The compatibility of system components takes sound cards or graphic cards that facilitates the entry of new competitors and reduces the risk of lock-in, and the acceptance of standards also encourages the creation of complementary products and is important in gaining the benefits of network externalities.

Go back ten years and think about the PC industry.

I suggest that it was not so much the introduction of the IBM PC that caused the explosion of the industry that we see today.

Rather I think it was the acceptance of a standard of IBM compatibility in hardware and software that enabled hundreds of companies to get into the market, lots of new entrants that pushed innovation, increased price performance ratios, and lowered prices, and that's what led to benefits to the consumers in terms of the PCs that we have today.

That was done by having standards that could -- that were open so that many manufacturers could meet the standard and compete in the implementation of the standard as opposed to having one company try to impose a proprietary standard.

Now the adoption of a standard increases the installed base with respect to an emerging technology, and that creates greater incentives to produce products which meet or complement the standard, and a collaborative standard for new technology needs actually to achieve a critical mass of companies that support it before, before it's worth supporting, and we have examples that we're watching today, one of which is what Mr. Katz talked about is the protocols for secure transactions over the Internet, and you have two major camps fighting about what standard is going to be the one that is accepted.

Another example is with respect to the emerging desktop videoconferencing technology, and another is the, the issue of what format would be accepted for the new digital CDs.

Another is modem compatibility, which becomes increasingly important for the new generation of modems so that consumer users can send and receive sound pictures and video as well as text, so the only way to achieve those standards quickly is through a collaboration of competitors who can settle on open, an open compatible standard.

Even -- and you read in the trade magazines such as PC Week, you read about industry coalitions which are formed on just about every issue, and I cite again some of those in my paper.

Now I think Commissioner Varney in speeches this year has recognized that actually new product introduction can be slowed when there is a battle of standards, and I will quote her as saying many consumers experienced hesitation and reluctance when Beta video cassette recorders competed with VHS, when eight track battled for market share with cassette tapes, or when vinyl gave way to compact disks, so with respect to the examples I mentioned, we may be in that phase today.

The Commission, commissioners recently recognized the procompetitive benefits of standard setting because it gives consumers a baseline to compare increasingly complex items and allows competitors to produce compatible goods, but there are anticompetitive potentials in standard setting.

For example, when -- and again I'm quoting Commission Varney in a speech this year where she said faced with competition from an emerging technology, the holders of older technology could use the standard setting process to deter entry or raise the cost of entry of new technology.

A review of the case law on standard setting I think reflects situations where existing companies have tried to slow or retard the introduction of new technology, but I would suggest that with respect to collaborative efforts today to get out new technology, that the antitrust laws should be interpreted and defined to promote that effort, and not to deter it.

Given the rapid pace of technological change, the opportunity for a standard setting effort to retard innovation or improperly exclude market participants is probably not substantial where firms are collaborating to establish a common platform or interface through which different suppliers of new products can operate in harmony.

This is because the strongest motivation is to agree on a standard so all the competitors can start selling.

If the standard isn't there, then nobody can sell, and that's different than situations where existing competitors are trying to exclude a new technology.

I think that was the case in cases such as Allied Tube or Hydrolevel or even in the Sessions Tank case.

Now as I said, there is an irony because the dominant firm with market power doesn't need to get together with horizontal competitors to establish a standard.

It can try to hijack, well, it can try to shove the standard down everyone's throat, so I think although some regulators have raised concern about the, the dangers of some company, quote, hijacking the standard setting process, I'm not sure at least in the computer industry with respect to new technologies that that's a significant risk, and the reason is that any firm that's powerful enough to hijack the standard setting process doesn't need to collaborate in the first place, so the firms that need to collaborate are the ones to do so because they don't have the market clout to do it on their own, and that's why I don't think that generally, there is significant antitrust risk in the collaborations and consortia that you read about every day.

Now economists and maybe some lawyers have debated about whether current antitrust policies prohibit collaborative activity in high technology markets, but the fact is that every day when you read the paper, you see that these coalitions are forming, and so I would say based on my unscientific observation, antitrust enforcement policy is probably not a significant deterrent to collaborative activity with respect to compatibility standards or specifications.

However, it probably slows the process by requiring more elaborate procedures and maybe overly-broad participation rights.

No industry participant wants to be embroiled in costly and time-consuming litigation because it participated in a collaborative standard setting process which a disfavored competitor tries to characterize as illegal, a group boycott or a refusal to deal, and I cited the Addamax case as a current example.

Now there the court correctly refused to apply per se rules, but it also denied summary judgment and said this is a rule of reason case which now is going to expose the participants to a very time-consuming and costly battle, so what can the Commission do to promote interoperability, and I do have some specific concrete suggestions.

One, I think it should continue to emphasize in public pronouncements both by individual commissioners and by the Commission as a whole that legitimate collaborative efforts to set compatability standards for new technologies are procompetitive and should be validated under the rule of reason.

Second -- and maybe one way to do this is to look at the 25-year old advisory opinion issued by the Commission in 1971 on the legality of proposed standard certification programs.

I have, I did -- in doing a LEXIS search, that I didn't find that overruled or even cited very much, but when you go back and look at what's in it, at least I respectfully submit that a number of the guidelines are outdated, are inconsistent with current case law and/or economic thinking, and I cite Guideline 4.

It says construction or specification standards should not be used except in exceptional circumstances and never when performance standards could be developed.

That I believe is inconsistent with technical realities today, and certainly computer industry practice, and I would hate to have that cited in a, in a case, so I suggest that the Commission review that old advisory opinion and perhaps change its guidelines.

Guideline 9 requires due process, including timely hearings.

I think that requirement, if it was a requirement, I think it has been overruled by the Northwest Wholesaler Stationers case.

Guideline 11 calls for the validation of any standard by independent bodies, and although Mr. Gellhorn or Professor Gellhorn is going to address that, I don't think that has flexibility to ad hoc coalitions of industry participants who want to get their product out in the market, so that's one specific way the Commission could take action to help this process and help the emergence of new technologies.

On the other hand, I think the Commission should continue to be vigilant to prevent abuse by a dominant firm with market power of a proprietary interface standard, and I note that in the recent proposed Silicon Graphics consent decree, which is still pending before the Commission, there is a requirement in the consent decree that SGI maintain an open architecture and publish its application programming interfaces, and the Commission noted that the purpose of the open architecture requirement was to permit other independent software developers to continue to write for the SGI platform.

In assessing the procompetitive or anticompetitive impact of standards, the Commission might similarly examine whether interface specifications are open and publicly available.

Fourth, in appropriate circumstances, the Commission could encourage Congress and the Executive Branch to promote interoperability in legislation and federal government purchasing decisions.

For example, during the debate on telecommunications reform, there were legislative provisions which required interoperability, so the Commission could continue to, to monitor legislative activity and look for opportunities to, to express its views on the procompetitive benefits of interoperability.

This also might have flexibility in terms of the federal government's own purchasing decisions since as I understand it, the federal government purchases more computers than any other customer in the world.

Finally, the Commission might consider declaring that collaborations to support interface specifications or compatibility standards fall within the protections of the National Cooperative Research and Production Act.

It's questionable whether or not such a collaboration would or would not fall within the literal language of the Act, but it certainly is consistent with the spirit of the act and the Congressional findings which prompted the legislative changes in 1993, and that, of course, would have the benefit of reducing the exposure to the companies involved from treble damages to single damages.

So those are my suggestions. I hope this is helpful.

COMMISSIONER STAREK: Well, I can assure you it is very helpful.

I appreciate your specific suggestions. They are quite interesting.

I might add that until I read your testimony, I had never heard of the advisory opinion on the legality of the proposed standard certification program.

MS. DE SANTI: I think you were not alone in that, Commissioner Starek.

Many of us had never heard of it before.

COMMISSIONER STAREK: I think before we get into questions, we ought to hear from Professor Gellhorn, and then we can cross-examine you together.

Ernest Gellhorn is the George Mason University Foundation Professor of Law.

He has over the years taught at Duke University, University of Virginia, served as the Dean of Arizona State University, Case Western university, and the University of Washington.

On a couple of occasions during his distinguished career, Professor Gellhorn engaged in private practice of law with the firm of Jones, Day, Reavis & Pogue, and while at Jones Day, he was the regional managing partner of the Washington, D.C. and the Los Angeles office.

Professor Gellhorn is the author of approximately 75 articles and four books on antitrust and administrative law.

He is the co-author of the Supreme Court Economic Review, and he is a former Chairman of the American Bar Association Section on Administrative Law and Regulatory Practice.

Thank you for coming, Professor Gellhorn.

PROFESSOR GELLHORN: Thank you very much Commissioner Starek, and I'm very pleased to be here.

I am struck by the focus on innovation in this 1920's ornate building. I think it's a most appropriate setting to consider it.

I also want to congratulate the Commission on these hearings and to look at this issue, and want to express my appreciation to Todd Miller of the firm of Baker & Miller for his assistance in preparing these remarks as well as for conversations I had with Susan De Santi who probed and pressed me to think about some issues more carefully.

I want to look at two questions really together. Both involve shared activities, joint ventures, and standard setting, because I think they share a lot of common points.

They both can be used for very useful beneficial procompetitive events and they can also be covers to price fixing, cartelization, exclusionary practices.

They both are addressed I think very inconsistently and generally very badly in the law.

Joint ventures predominantly have been viewed as an issue of characterization primarily because the Supreme Court started out on a bad path and hasn't been able to deviate from it.

If you look at the Timken, Sealy, Topco cases, they looked at essentially what were partial integrations to serve new customers, and treated them assumably as market allocations or price fixing, and it has been very hard to get away from them, so litigators constantly are trying to push it into the per se category or get it out instead of thinking what are the competitive effects of this particular activity?

Whereas in standard setting, it's really quite different. There in essence we have put a blind eye and haven't looked at it very carefully except to say if they really are egregious, we will put them in the boycott category and perhaps consider them too stringently, but in fact they have been saved by rules of damage, damages or antitrust causation with the Sessions case because in virtually every standard setting case of any significance, government's the major purchaser, and if government is the major purchaser, then it is very difficult to, for any party to show injury as a result of the standard setting arrangement.

The Sessions case broadly read, and Noerr-Pennington are in unity to the point at which it seems to me is a limited potential private damage cases, so that what we have here is sort of an odd mix of on the one hand the antitrust rules discouraging joint venture activity that could be highly beneficial by imposing the wrong standards, and rules in standard setting activity, particularly when it's looking at independent bodies who engage in restrictive standards.

That's quite different if you're not talking about restrictive standards.

It has not given enough attention to an area in which I think the then Professor Bork wrote about it at length in Chapter 18 of his book on the antitrust paradox -- predation by government processes.

Well, let me talk about both of them just briefly by two examples that I think make my point perhaps more clearly.

They both involve situations in which not too recently, I was involved in giving some advice to potential clients, and I will use them really as hypotheticals.

The first involved a situation in which a distributor, let's say in the State of Ohio, was involved in the following market -- distributor of widgets.

The two dominant distributors in the state were located in Columbus, Ohio, had about 90 percent of the market, but there were several other smaller distributors either in Cleveland or in Cincinnati, and two of them came to me and said what we would like to do is offer an alternative to the two major ones.

What we want to do is distribute the product -- agree on the price we will set, distribute it statewide under a marketing program.

It's a regulated industry, so they were limited within the state. Made it a lot simpler.

And my response to them was in the way they described it to me, give me the size of your risk because you're describing a per se violation that's a criminal law violation. You can't do it.

And so we wrestled with it for a while. Well, if you look at the case law, this was either price fixing, or if we moved away from price, this appeared to be something subject to the Maricopa County rules requiring integration and risk sharing, but these two small distributors did not want to integrate at all.

What they wanted to do was offer a supplier statewide distribution with a joint marketing program where one would take the northern half of the state, the one located in Cleveland, and the other would take the southern half of the state.

Under existing legal standards, it really was very hard to figure out how they could do it.

Now we still came up with a proposal that they could accomplish this by building a file that but for their getting together, they couldn't enter the market, that this was a necessary condition in order to enter the market to help deconcentrate it and intensify competition.

The second thing we drafted into their arrangement was that there would be a term limit on the agreement.

This isn't going to work for the VISA-type operation because if they terminated after ten years, you've got a lot of problems in terms of planning and investment, etc.

Distribution arrangement is a little easier than the production arrangement.

The third thing we put into the agreement is prior to the ten years -- I asked the companies how long do you think it would take for you to get the 35 percent of the market?

We figured it would take at least three years and probably five, so we thought in order to encourage their investment, we would put into the agreement that after the first five years, either one of them could terminate upon a showing that in the prior year, they had at least 30 percent of the market, and in other words, an effort to show that we have put together the two entities, though not integrated them, with some sensitivity to antitrust concerns.

Nonetheless, I had to advise them that I thought it was a tremendous risk because under the existing case law and guidelines, we don't meet either the characterization standards of Timko -- Timken -- excuse me -- Topco and Sealy on the one hand, or the integration, risk sharing of Maricopa, and it seems to me that that's an undesirable effect.

The second one I would point to is a sort of an add-on to what occurred in Allied Tubes to talk about standard setting, and I think it is a very common process. Standard setting governs most major purchases by large entities, particularly the government.

Take a look at almost all highway construction, building construction, et cetera, and the illustration would be the use of plastic coated electric wiring, which has been kept out of markets for many years with the famous situation in Chicago between the trade unions and the building codes that are primarily by private entities.

Under consensus standard setting procedures and then adopted by government, they were able to keep out plastic coated electric wiring, and instead what we had was steel conduit wiring.

The other place where this is done is private fire protection associations, National Fire Protection Association or the Western Fire Protection Association.

You will also get this frequently in regions where there are a lot of standard setting organizations, and what happens is competitors participate in the process primarily because they have the information, and codes are written to govern existing technology and to keep out new technology, and what happens then along the way is that the consensus standard becomes the basis by which they are kept out because under most consensus standards, take, for example, the American Society of Testing and Materials -- they provide for balanced committees that review standards before they go through subcommittee to a committee to the main committee to the full assembly.

There is no requirement that anybody who participate be knowledgeable on the subject. They have got to be held, but the committees are balanced so that they include the industry, academics, government, and outsiders.

No one group can have more than 49 percent and industry cannot have more than 49 percent, but under traditional consensus procedures, one third plus one can block it, and what happens, if you look at primarily the plastics industry and highway construction, building construction, it has struggled to get into the market I would argue primarily because of standards.

The State of New York, for example, in 1989, made the decision to allow plastic pipe into highways, and the market penetration went from 1 to 25 percent over a three-year period.

The State of California permits it, but Southern California, which is governed by what is called the Green Book construction standards, which is primarily adopted by industry, not industry, by government members who participate in a private standard setting group, listen to industry guidance, had refused until very recently to adopt, and so in essence the market penetration was 1 or 2 percent.

The difficulty here in the standard setting area is we have not articulated a careful standard as to what constitutes a technical basis, what kind of evidence is necessary.

If there is a dispute in the industry, as inevitably there is in almost every new product, you can find credible grounds for denying the standard, and to the extent to which you permit interested parties to participate, the results are not hard to predict, and I'm not suggesting here that people even have to get together.

They don't have to get together to make these decisions, and what has happened is we don't look at them with any care because particularly as the Allied Tube case has been interpreted by the 9th Circuit in the Sessions case, what happens is if the standard is adopted by a government, governmental body, and that governmental body is either a major purchaser or is followed by others in terms of the decision they make on what to purchase or not to purchase, the result is that the conclusion is drawn or the inference is drawn that the damages are caused by the government's decision not -- to adopt the standard, not because private parties follow it.

I think that's a misreading of Noerr-Pennington, because Noerr-Pennington, if you go back to the facts, involved a situation where the private parties petitioned the government to take particular action to exclude in that case the trucker, the truckers from the benefits of a particular regulatory scheme, and protect the railroads.

That's not true of most standard setting organizations.

What they do is adopt their own standards. Government independently decides whether or not it will act on it, and I would cut off Noerr-Pennington immunity at that point.

Well, enough to tell the story for the next point which I would raise is well, what should be done about it?

And here my outline which I have proposed to submit into a longer essay before these hearings are closed for you, focuses on the following -- first, it seems to me that we know enough about joint ventures that we ought to have some specific guidance.

We have it in the merger area. We have it in the intellectual property licensing. We have it now in health care.

We don't have it in joint ventures, and this is an area where we need it particularly because the case law is so bollixed up and we have a tradition of doing it when the case law isn't very sensible.

The merger area is, of course, the best demonstration.

I likewise think we need guidance from the agencies in terms of standard setting.

Here I think it involves not just liability standards, but also the procedures that they use, and while Mr. Miller is correct, it seems to me that the Northwest Stationers case suggests that the due process was not necessary.

I don't think it immunized standard setting organizations whose procedures are designed so that they can be abused to exclude competitors in the innovation.

The second point I would suggest if you were to go ahead and draw up some guidelines, and that is to move away from the concept of characterization.

It is not a helpful vehicle to say this standard setting organization or this joint venture has gotten together to fix prices or to exclude a particular product that may be a necessary part of an effective standard.

The issue is it seems to me first of all, what is the effect in the marketplace?

Look at competitive effects. Identify the market. Identify whether or not it's likely to restrict output or increase output, lower prices or increase prices. What are the efficiency justifications?

Third, I think it would be very helpful to identify some safe harbors. Give the guidance. Provide some predictability.

And fourth, focus primarily on some of the procedural issues.

I think that's enough. I appreciate very much the opportunity to participate.

COMMISSIONER STAREK: Thank you very much for some very, very helpful suggestions.

What about integration? I would like to ask both of you.

What weight are we supposed to give when we look at a particular joint venture, when we do, about the level of integration that's necessary?

PROFESSOR GELLHORN: Well, I would argue that it is not a relevant consideration.

One could take it, look at the issue of integration, and say yes, that's terribly essential to its operation, and it made sense that they did it.

On the other hand, there may be situations in which integration is not a particularly important vehicle.

I think the illustration I gave of two distributors of a widget in the State of Ohio, there wasn't any need for them to get together.

In fact, you don't want integration in one respect because they are more likely to go their own separate ways.

If you force integration, all you're doing is creating a merger when you didn't need one.

Indeed I taught a class last night and we looked at joint ventures, and the question I posed to the students was should we favor joint ventures or favor mergers? And it was clear after about five minutes of discussion that at least with a joint venture, they might go their independent paths at the appropriate time.

On the other hand, it seems to me that listening to Mr. Katz's description of VISA earlier this morning, if they didn't have some integration of their operations, they would have had increased costs, less competition, and the marketplace wouldn't be benefitted, so it has got to be a fact-specific inquiry.

MR. MILLER: Well, I mean with respect to compatibility standards, you're not going to have integration.

You're going to have competitors get together to make sure that their products talk to each other, and that benefits the consumers and increases the market, so integration in that context really would be irrelevant.

COMMISSIONER STAREK: Well, thank you.

MS. DE SANTI: Yeah. I would like to ask both of you to speak to each other's presentations with respect to standard setting and get a better sense of the areas where you agree and where you disagree on those issues.

MS. VALENTINE: On that, just to make that slightly more precise or to be sure to address this as part of it is, the consensus aspect -- since obviously if regulators and courts are thinking about eventually looking at these things, judging fairness of the process is a very difficult thing, and I would even be interested in Mr. Katz's views as well on whether if he is ever engaged in setting standards, anybody can after the fact assess the fairness of that process.

PROFESSOR GELLHORN: Let me make two comments. One, that in listening to Mr. Miller's presentation and reading his paper, I constantly came up against the point that the real problem here may lie elsewhere, and that is the application of copyright protections open to these designs rather than patent laws, and when you put the copyright overlay on it, you all of a sudden change the antitrust mix enormously.

Copyright laws generally I believe are 50-year protection with a 25-year addition, no disclosure requirement, in contrast to patent law.

If you deconstruct a copyrighted material and then reconstruct it, that's infringement.

Not true in terms of patent laws; and you protect under copyrights derivative works. If you write "Gone with the Wind," I can't write the sequel whereas in patent law, improvements are separately patentable and you can invent around them, and so I think in many respects, the problem that we see in the computerized area -- operating systems, software programs -- are in many respects due to the direction the Supreme Court took in 1976 and led us down the wrong path to suggest you had to copyright these items instead of protecting them by patents, and that's something I would suggest you might want to take a look at at some point.

In terms of the procedures and consensus thing, I think there are several positions I would draw.

One is are we talking about an exclusionary standard, or one that's inclusive? Because I view them quite differently, and therefore I put much of what Mr. Miller says in the, in a -- totally separate from what I'm saying because he's looking at something I would rather encourage than discourage.

Second is to what decree would competitors be in a position to block innovation by others, and that very much is affected by have you got the entire industry in it, or do you have just one third of group?

There may be a requirement that everybody get into it, and I think that's clearly the case if you're talking about something that's going to be used on a wide basis.

I thought Mr. Katz, on the other hand, pointed out that in many respects, what occurs in his industry is affected by this decision much earlier requiring duality, and that if you look, for example, I believe Canada, they didn't require it. They have a very different structure. They have competition, and I would argue you wouldn't have had the block on innovation, so one of the problems here, of course, is despite all the praise that has been given this morning, I think government is a big part of the problem in having made the wrong decision using antitrust in a far too rigid fashion, and we're stuck by it.

We're prisoners of it. That gets me back to guidelines.

With guidelines, you can get around it. You can in essence put, like Nelson and Trafalgar, the telescope to the blind eye and then design your own.

MR. MILLER: Actually I don't hear us saying things that are in real opposition to each other.

PROFESSOR GELLHORN: No.

MR. MILLER: But it's a matter of the context in which standards are set.

In a situation where you have a standard body coming up with a certification and then it is incorporated in a government code, so either you meet it or you don't, it seems like there is more of a possibility for exclusion, and what I'm talking about are voluntary standards by some industry participants so that they can talk to each other and build a market share.

One difference it seems to me in that context is whether a standard is open or whether it's proprietary and closed, and open standards are more procompetitive I think than proprietary standards, so that's, those are things that should be, those should be considered in deciding on competitive effects.

Now what Mr. Katz referred to is a battle of standards.

You have two or three groups that are fighting, and consumers often want one standard, and it is true that, you know, if you are in the camp that goes in the wrong direction, and the market decides against you, you lose, but that's the way the market should work, and I don't know how, I don't know how you could legislate that there ought to be one standard versus a battle of standards, but it is true that in the, in the market, that consumers wait until there's a convergence, and this just happened with the format for the new CDs where Sony and Toshiba agreed, and now you're going to see that, that market rolling out, but I think open, open standards really have to be the key in -- to prevent abuse by a dominant firm or by, or perhaps by a collaboration of firms with market power.

MR. KATZ: I'm hearing I think there is a definitional problem here.

MS. VALENTINE: Right.

MR. KATZ: What people are talking about as standards may be specifications.

When you -- in the VISA context, with Microsoft, we are not -- that is not a standard. That is a specification for a secure technology for VISA cards and VISA cards only.

Now we make it open because we want to say look, we think it's the best specification and we're making it available to the industry if the industry thinks it's the best specification.

Now you can do that through putting it in the public domain and hoping that people say this is a wonderful standard, thank you very much.

This costs a lot of money. This is not a cheap thing to develop. This technical -- this is millions of dollars were expended to develop the specification, and we're making it public, so everybody -- we didn't ask for agreement. We just made it available. That's a specification.

A standard is quite different in the sense of that's where the industry gets together and says let's adopt a common standard even if it's not the best.

It's at least something that we can have and so the consumers will go buy it.

Now I'm not an expert on that, but there is, I would think there might be a danger of the timing of a standard before it's ripe for establishing a standard so that there needs to be some innovation first from the competitors to make sure that what is adopted as the standard is in the best interests of the consumer, so it's a timing issue, but for a company like VISA or for that matter for any company, they need to adopt a specification for their business, and that's all we have done, and so I hope I have made the distinction between a specification and a standard.

I think that's important to keep in mind.

PROFESSOR GELLHORN: The difficulty is I can think of illustrations where they cut against each other soon that I would be a little bit cautious about saying there is a sharp line between the two, and there are many industries in which the specification in fact becomes the standard, and so just I agree with what you're saying.

On the other hand, this issue of timing and who decides, unless government does it, normally we allow private parties to do it.

The real question is is it subject to opening up, or is it closing?

The subject of opening up, I don't think we have much trouble with.

If it's a closure, then we have got some concerns.

MR. KATZ: And in response to that point, I think you have hit it right on the head, and that is that if we were to get together with MasterCard, American Express, Discover, Designers Card, Carte Blanche, to come up with a standard for security transactions, I can assure you I wouldn't be here today.

I probably would be sitting in meetings that would go on ad infinitum to come up with that specification.

We have to agree on it. That could take us six months, that people have different ideas. It could take a year. It could take two years.

We had to make a decision. Frankly, I'm talking as a business person now.

We had to make a decision did we want to slow down the process?

Electronic commerce is happening as we sit here today in a very insecure mode. It is subject to big fraud, big-time fraud.

It's subject to -- well, we read about it, about hackers coming in and ripping off credit card numbers.

It is a very dangerous situation today. The Internet is dangerous to be used, in my opinion, but it's being used. We can't stop people from using it, so what we made a decision unilaterally is that we want to move quickly to get something in the marketplace to protect at least the VISA product and the VISA system, and we weren't willing to sit down with MasterCard and everybody else to try and spend all of that time which could take years to come up with a common standard, so we adopted our specification then made it public because we spent our money doing it. We made it publicly available, answering your point that it's open, and said why don't you adopt it? It's terrific.

There are other considerations -- politics, et cetera, et cetera, but nevertheless, that's how we went, and I think that's a very procompetitive way to go because if it isn't the best, someone will go with something else and bring it back and criticize ours, and it's open for criticism and we will adjust it if it's not the best.

We have no legal obligation to continue that standard with Microsoft -- I should say that specification. We can change it at any time.

That's our -- a unilateral act, so I think it's the best way to move this process ahead, in my opinion, so we are probably a year ahead of where we would have been if we had got the industry together to try and figure out what this would be, because I don't think we even could have understood it without the help of a Microsoft or without the help of an IBM or somebody who understands such things as encryption technology, who understands client, client and server technology, who understands how it has to be integrated into the operating systems and into the software -- should it be on the hard disk?

We don't have that kind of expertise, so we needed to form a joint venture with someone with the expertise to come up with something to protect a VISA brand and VISA product.

PROFESSOR GELLHORN: You can take your very example -- I don't want to extend this -- and say just the opposite could occur.

Take, for example, the situation of electronic data processing, of insurance claims by doctors.

It's a market in which there's relatively modest computer innovation. I mean 80, 85, 90 percent of the claims are filed not electronically.

Well, the question is does one big company go in with the largest insurer out there and set up a process, put it up in all the doctors' offices, and they can thereby it seems to me have enormous effect on other insurance companies.

In many states, there is one or two companies that have much of the insurance business. Do they align themselves with one of the two or three larger electronic companies and set up their own architecture, or does the industry get together to try to work out a standard so that it's compatible for everybody?

I don't have the answer to that. I don't mean to suggest that I have the answer for it, but what I think I'm trying to do is give an illustration of which the individual approach that you're suggesting may not work or might slow down technology, and that's, of course, where standard setting and the Department of Commerce first got involved in the early '30s and late '20s under then Secretary of Commerce Hoover. One of his great contributions was that kind of standard setting, and it is, of course, a very difficult process when private individuals are involved.

MR. KATZ: Can I make one comment? I'm probably talking too much, but in the case of take the, what you're talking about, medical electronic, medical clearings and settlements -- there's lots of competition going on and people looking at it.

We're looking at it. Electronic companies are looking at it. MasterCard is looking at it. We're all competing with different technologies and trying to figure it out.

I can assure you, though, that I don't think what you say will be a problem because I'm a doctor. I am not going to stand for having to deal with just one payment product.

I need to have it all compatible, so while we push ahead, and we are ahead, so we at least get it started, it takes the consumer demand will force the adoption of interoperability, and the interoperability means that the platform has to be interoperable, but there may be lots of bells and whistles which makes my platform superior to their platform, but we have a common interoperable thing, whether it be the terminal, whether it be the software, that we clear between each other, so I'm a little concerned frankly about sitting down for the industry and trying to figure it all out while the doctors are sitting there, the patients are sitting there waiting for us to come to agreement, and there isn't the impetus -- I'm a real believer that you need impetus of competition to get things done quickly, and then work out -- once you've got the problem, work it out, but trying to in front avoid these problems just slows down the economy, slows down consumer welfare in my view.

That's just a personal view.

MS. VALENTINE: Can I just ask one last quick question on the government adoption of the standards?

I should look at Sessions before I ask the question probably, but were there any state action claims made?

Can people, I mean could you try to approach this through a Ticor or Burget process, you know, as part of the active supervision prong of state action doctrine that a state should be taking a look at or being responsible for the state process or the standard that is adopted??

PROFESSOR GELLHORN: As Judge Conti analyzed the situation, and I claim some blame on this because he and I are co-authors many years, 20 years ago of an article somewhat in this area and I let him look at it from a First Amendment standpoint and didn't force him to look at it from an antitrust standpoint.

Nonetheless the way he looked at it did not address the issue of state action because the issue was, instead was the injury to the plaintiffs caused by the defendant's adoption of the standard, or rather by the fact that the government adopted the standard, and once the government adopted the standard, he put it within the Noerr-Pennington framework, and if you go, for example, to the Justice Department or to the Bureau of Competition in the FTC, both of them have at least told me in matters that they follow the Sessions ruling, so they're giving a rather broad immunity in my view to conduct that was not encompassed within the concept of Noerr-Pennington of appeals to government.

This is rather government adoptions, and I think you raise a very interesting point I hadn't thought about -- why can't one use the state action cases and say well, where is the active supervision? Haven't we extended this too far?

The real problem it seems to me comes in part from Justice Scalia's opinion in Omni where he says no, there is no conspiracy exception to Parker versus Brown, and later cases he said that as a matter of first impression, I would not have adopted Parker versus Brown, but it is there. I'm stuck with it, and again, all we're illustrating is antitrust doctrine here.

It's not a straight line. In fact it's not even a wiggly line. It is inconsistent, and as a consequence, it sort of bites us in the tail every now and then and we come up with results that are counterproductive, and you get this enormous uncertainty that those operating in the front lines of the business such as Mr. Katz say that we don't do things that are innovative because of the fear, and that's where I would urge the Commission to play an enormous role.

MS. VALENTINE: Thanks.

COMMISSIONER STAREK: Well, thank you very much.

We could go on for quite a while on this topic. It's fascinating, and I deeply appreciate all of you coming and offering your thoughts and sharing your views with us. It has been most helpful. You have excellent suggestions. We thank you again.

So I guess we stand in recess.

(Whereupon, at 12:15 p.m., the proceedings were recessed, to reconvene at 1:30 p.m. the same day.)

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A F T E R N O O N S E S S I O N

1:37 p.m.

COMMISSIONER STAREK: Well, good afternoon. I think we're set to begin.

COMMISSIONER VARNEY has been just slightly detained, but we expect her shortly. She indicated that she had to be in and out this afternoon.

Chairman Pitofsky is involved in a speaking engagement, a long-time commitment, so unfortunately, I don't think he will be with us, but fortunately, Commissioner Steiger is with us today.

COMMISSIONER STEIGER: That remains to be seen.

COMMISSIONER STAREK: Our first witness this afternoon is Professor Tom Jorde.

He is a member of the University of California at Berkeley School of Law faculty and is a co-founder of the school's Law and Technology/Intellectual Property Program.

He is also the founder and President of Law & Economics Consulting Group, Incorporated.

Now before he joined the law school faculty at Boalt Hall, Professor Jorde served as a law clerk for Justice William J. Brennan, Junior of the United States Supreme Court and for Judge Stanley Weigel, United States District Court, Northern District of California, and he also has served as a Special Assistant to the FTC Bureau of Competition, and has practiced law as a litigator in San Francisco.

Professor Jorde obviously specializes in antitrust, intellectual property, and civil procedure, and he has published extensively and has testified in these areas.

He also is co-editor of "Antitrust Innovation and Competitiveness," and co-author of two new case books on intellectual property and legal protection for computer technology.

Professor Jorde, thank you for coming all this way to be with us.

We certainly appreciate it.

PROFESSOR JORDE: Thank you especially for the opportunity to participate today.

It goes without saying the topic areas that the Commission is focusing on are extremely important, and I think that the breadth of the topics being covered under the general topic areas of global competition and innovation is extremely impressive, and it's our thanks from a speaker's point of view as well for the opportunity to be here and to participate in an event like this.

My own remarks are going to focus on the relationship of antitrust policy and antitrust enforcement efforts with cooperation among competitors particularly, and especially when the cooperation among competitors is focused on the creation of new products and processes, namely, innovation and the commercialization of innovation.

It's clear today and it is certainly clear from the enforcement efforts of this Commission and the Department of Justice that modern antitrust law recognizes that competitor agreements can create efficiencies and new markets, and they can certainly advance other procompetitive benefits, and because of these procompetitive justifications for cooperative arrangements, the agencies and the courts have reached the conclusion quite appropriately that such agreements ought to be looked at under rule of reason analysis, and one of the things I would like to focus on a little bit later is the reason, rule of reason analysis itself and why it ought to be part of that kind of analysis on the part of the agencies and courts, but I especially want to focus on cooperative arrangements among competitors designed to create new innovations or to commercialize innovation because I think these types of agreements require a special consideration and special concern when they are being evaluated by the agencies.

They ought to have that special concern because the economic welfare that flows to society from innovation is clear, and I think there is general agreement that the societal gains from innovation and the commercialization of technology are enormous, and indeed they quite outweigh allocative efficiency gains that are sometimes the focus of more static antitrust analysis.

The focus of traditional antitrust has oftentimes been more short-run oriented, but again, I think we see over the last certainly five years and maybe the last decade a real move on the part of the government agencies to be shifting attention at least in equal scope to dynamic kinds of consideration and a clear appreciation on the part of the agencies that those dynamic efficiencies are critical for the advancement of societal good.

One of the things that I think is important to realize is that often competitors in a modern age today in a technological setting where technologies are changing rapidly may see reasons to get together one with the other to advance innovation and to commercialize technology, and those benefits may flow more in a future timeframe and in a dynamic setting than one might see in the very near term, and it seems to me that in order to avoid hindering the progress that comes from technological innovation and change, antitrust needs to be vigilant that it looks into that forward context to a careful evaluation of those benefits that may come down on stream a little bit later, and although it's easy to say this, I do want to emphasize I think it's right as well as it's easy to say, and that is it seems to me that when we get into the difficult balancing questions of comparing perhaps shortrun inefficiencies or short-run gains and market power against dynamic efficiencies, there is a tradeoff problem that exists, and given that the burden of proof, from a lawyer's perspective, here rests with an agency and stopping an action or rests with a private party in opposing a particular agreement, it seems that when we're not clear, and when evidence isn't clear against the kind of efficiency arguments that might be made, we probably want to err in favor of dynamic efficiency in order to make sure that, that the benefits to society are capable of being sought.

There are a number of reasons that firms might wish to get together to collaborate to advance innovation, and let me just go through a few of those.

The obvious ones that come to mind first are economies of scale and scope.

These are fairly well known. It's also important to minimize risk and avoid duplication, particularly as a good deal of technological advancement today is costly and very fast moving, and in order to stay abreast of it, it might make sense for firms to get together.

In addition, there may be reasons of efficient technology transfer or commercialization for competitors to get together.

It's fairly well understood that much of innovation today is not serial, that is, it doesn't follow lockstep A, B, C, D from R&D through prototype to manufacturing and finally to sales.

Rather a lot of innovation today takes place more in what some economists and engineers have termed a kind of simultaneous nature where it's important to be able to stay in touch with many aspects of the innovation process, including all the way forward to customers, because the pace of change makes it important that you not only come out with the best first generation product, but that you be there right away for the second and third generations because if you aren't, somebody else will be, and it may be that a particular firm has some aspects, some parts of the puzzle for that simultaneous venture of innovation, and that they will be more efficient if they hook up with other firms who have other complementary or co-specialized capabilities, so it's not surprising that we may see competitors linking up in a horizontal fashion to gain maximum efficiency.

Another reason, of course, firms might wish to get together to cooperate is to better appropriate the returns of innovation.

There are well-known free rider problems and public good characteristics of innovation that make it difficult sometimes to capture the full benefits of innovation.

Well, sometimes one might say well, what's the matter with intellectual property for taking care of that?

After all, we have patents, trade secrets, copyrights and the like.

One of the problems is that in many industries, intellectual property on its own is not capable of protecting a vast amount of innovation and innovation-type activities, and in that case, it is easier to have public good or free rider kinds of problems, all of which may drive firms to get together to try to encompass the entire effort of innovation in order to appropriate the returns to themselves.

We want that sort of appropriation to go on, of course, to give proper incentive to the innovating parties and to make sure that we have incentives in place, so private contracting can often fill that gap.

The forms of cooperation that might take place involve mergers, joint ventures, strategic alliances, and contracts.

There has been a tendency sometimes I think in antitrust enforcement and by courts to start to make distinctions in those categories.

We look at mergers one way. We look at joint ventures another, and yet another for contracts, and I would argue that we ought to really try hard to see these as alternative forms of integration where we're not preferring one over the other.

At a minimum, it seems to me that contractual arrangements and the restraints that go by contract ought to be treated no less well than full integration by merger.

After all, after contract, the parties remain still free to, to have more flexibility among themselves than they would with a full merger.

I think treating these forms the same can be done if we pay attention to a structured rule of reason analysis, and I would like to address that at least in brief.

I have certainly tried my best to do that in more lengthy articles, and I have done about, certainly as well as I can.

Others can improve on mine for sure, but I'll just try to summarize here.

The first point, of course, is the rule of reason analysis occurs and not per se rules when cases can be made that what integration is about is to promote innovation or commercialize innovation.

As a first step in a rule of reason analysis, it's very important that markets be defined and that market power be assessed.

In the absence of market power, it's going to be difficult to argue credibly as an enforcement agency that there are likely anticompetitive effects that follow with the arrangement, so we ought to be clear about looking for market power and defining markets.

I know you have already focused in a prior couple of days on the, on the complexities, indeed difficulties of defining markets in the area of innovation.

We're not going to try to repeat that here I'm sure, but I do want to add a voice in that area that to make sure that when we're thinking about market definition, that we pay attention to the dynamic performance based side of that to be sure that we're capturing markets in the way that they really unfold in the area of innovation.

The guidelines sort of 5 percent test focusing on price probably needs to be elaborated. It's a good starting point, but it's probably important to move to performance-based kinds of criteria as well when we're thinking about products in areas of technology.

There are also difficulties in defining know-how markets, and beyond that, innovation markets, and I don't want to tread back to those areas, either, except to say that paying attention is very, very important for getting the market definition correct because I think once we get markets defined properly, we can then feel more comfortable about taking a next important step that I certainly urge the Commission and courts to do, and that is to recognize a safe harbor if you will that would exist for cooperating firms who have less than 20, 25 percent market share.

That could be translated into Herfindahl index figures as well, and I have talked about that in more detail in my writings.

The intellectual property guidelines for intellectual property licensing recognize the value of the safe harbor.

Guidelines concerning health care have recognized safe harbors.

Certain courts have recognized safe harbors. I think we know why, how to go about that process, and I just think it's important to extend it with some clarity any time we're dealing with cooperative arrangements involving innovation and the development of technology.

One other value of having a safe harbor in place is that it makes clearer that the form will not make a difference, that is, we will start to treat cooperative contractual arrangements very much like we treat merging parties under the current merger guidelines.

Now the difficulties, of course, occur once a party continues to want to cooperate in some contractual arrangement and there are horizontal parties involved, and yet they are outside of or above a safe harbor analysis.

Now at this point, it seems to me an agency has done enough when it has shown that real market power concerns exist that are above a safe harbor level.

At that point, I think a burden realistically ought to shift to the cooperating parties to demonstrate the reasons why they have gotten together as horizontal competitors to advance innovation or to help promote commercialization of innovation, and what I would urge on the Commission, and again, there is certainly lots of evidence the Commission already is doing this, so this is nothing new, but to continue the careful attention that's being paid now to efficiency claims and efficiency arguments that are dynamic in nature and are not short run.

I want to be clear in my own presentation that those of us who have been working before the Department of Justice and with the Federal Trade Commission know this is all going on.

A clearer exposition of this, appropriate cases may be helpful to the bar in general, but let me just enumerate some of the dynamic efficiencies that I would expect defendants to speak about, and then it would be up to the Commission and its staff on a case-by-case basis to find out where there is a factual basis.

Obviously just the mere assertion of some kind of dynamic efficiency can't carry the day, but one would expect to hear the following kinds of arguments I think -- that the innovation sought by a cooperative arrangement will, if achieved, help the firms capture value in situations where intellectual property for this particular product or particular technology is somewhat weak, that is, the regime of the intellectual property is not as protective as it might otherwise be, so the parties are getting together to appropriate returns for innovation.

Another justification one might see is that the arrangement is necessary because the character or magnitude of the cooperative arrangement is necessary to achieve economies of scale and scope.

It may also be the case that successful innovation is sought by the arrangement and that it will be, it will allow the parties to bring this together and that the restraints are necessary for capturing value.

The arrangement may also compete in market or markets -- or markets plural, that are characterized by rapid technological change, which may be another reason for sharing resources to get products to market quickly.

Finally, I would expect to hear arguments occasionally that the cooperative arrangement is part of an effort that in some way one might think of as an effective type of intra, interbrand I should say competition, that is, we're getting together almost intrabrand to compete effectively head to head with other ways or other groups who are doing the same thing.

The difficulty, of course, comes when there are strong efficiency claims and there are large market shares, assuming that markets have been correctly defined.

There's no escaping the hard judgment calls and the qualitative judgments that have got to come from staff and the Commission. There is no escaping that at all.

There are two cautions, though, that I would like to toss in to the Commission to think about because now that we're going to have to balance, sometimes there is a reference back to less drastic means analysis, and sometimes, especially more recently, I think there has been a, a kind of feeling that we want to make sure that there are a multiplicity of avenues of innovation, and that either one of those or both in combination may kick the Commission in the direction of opposing the activity.

I want to suggest caution on both those for the following reasons -- we obviously want to avoid with hindsight looking back at what the business arrangement was and kind of saying well, you could have done that in an easier way that wouldn't have had the same restraints or wouldn't have had the same number of participants involved.

It seems to me if we're going to do that kind of analysis, we need to make sure that at the time, that is then when the arrangement is being put together, at the time, the alternative that the Commission is suggesting was obvious and it would have been substantially less restrictive.

In those kinds of cases, then it may be fair for a trier of fact to say that the current arrangement is an unreasonable restraint of trade, but one needs to be careful about the timeframe when the evaluation is being made.

On the other point about the reduction in paths of innovation, again we're assuming the case is above safe harbors. Below safe harbors, we don't have this, this balancing problem.

It's not at all clear and the empirical evidence is not clear that reductions in R&D are necessarily going to lead to less innovation or put differently, that we need somehow to have the maximum number of paths of innovation available in order to create efficiencies and to make sure that the maximum amount of innovation occurs.

Given that the government has the burden of proof in halting an agency or private plaintiff in the same, I think we would want strong evidence on either one of these cases of less drastic means analysis or strong evidence that the chance of alternative pathways here was fairly clearly going to alter the kinds of innovation that we would expect before that would kick in as the means the government would use to halt the particular cooperative arrangement.

Finally, I think there is no escaping that there is a type of sliding scale that's going to go on between market power and the efficiency claims involved, and that again has been rather historic and traditional, too.

Well, this concludes my remarks on rule of reason analysis.

One last point I would like to make, but it really doesn't apply to the Commission so much as to businesses who may be following the remarks and may be looking at the proceedings in general here at the FTC -- I think far too little attention has been paid by business to registering cooperative ventures under the amended now National Cooperative Production Amendments of 1993.

I think there are significant gains that could come from participating in that registration kind of process and letting the FTC and DOJ know about the arrangement.

It guarantees rule of reason analysis. It limits damages to single damages, and all this would seem to me to go a long way toward getting some of the security that business desires in these areas, and yet I'm afraid this is, you know, an area that's rather underutilized today.

Well, thank you very much for the time to make these remarks.

COMMISSIONER STEIGER: For the Q and A session that comes later, I wondered if you could make a note and address your last point in a little more detail?

We have heard that there are serious shortcomings in the joint venture development of legislation front.

We know of one being claimed by our allies abroad who say that they have restriction on their participation, limitation on the placement of it, joint ventures should be simply done away with.

I am not referring to that limitation, but if you have knowledge of something that is missing and might indeed be causing businesses not to utilize this, I would appreciate your mentioning it later.

PROFESSOR JORDE: Okay.

COMMISSIONER STAREK: Well, thank you very much. That was very stimulating, very interesting.

I think the way that it has been suggested that we proceed this afternoon is the way we have been proceeding most of the previous afternoons, which is to hear from our witnesses and then engage in a question and answer session and then an exchange between the participants and the representatives from the Commission, so unless there is some burning question or something, I think we will go on to Professor Ordover.

Janusz is professor of economics at New York University, and he is also advisor to the World Bank on privatization and regulation of infrastructure industries, and is affiliated with Law and Economics Consulting Group in Berkeley, California.

In the past, Professor Ordover has served as Deputy Assistant Attorney General for Economics of the Antitrust Division of the department, and he was also Special Consultant on Trade and Competition Policy to the OECD, and an advisor to the post-communist governments of Poland, Russia and Hungary.

In addition, Professor Ordover was one of the founders of Consultants in Industry Economics, Inc.

He has authored and co-authored numerous articles on many aspects of antitrust and regulation.

Professor Ordover, thank you for coming.

PROFESSOR ORDOVER: Thank you very much. I am greatly honored by this invitation partly because the Omni high tech case that I was ever deeply involved in I lost in front of the Commission, the PPG, so I will try to relitigate this case this afternoon in light of the new learning!

Well, I think obviously the subject matter for today's hearings is more than challenging partly because economics is not really up to snuff to ask all the deep questions that the staff and the commissioners have come up with over these months to pose to the academic community and to others.

If I were to answer very quickly the two questions posed, the first -- how should antitrust treat dynamic/innovation efficiencies in mergers and joint ventures -- my answer could be pretty much the way you are doing right now, but just take it easy on the innovation markets. I'll come back to that a little later on.

The second -- are such efficiencies peculiarly valuable or more subject to imitation by others -- the answer is it all depends, and depends on several factors, and let me quickly rattle them off so that we can move on.

I presume it is reasonably well known that a great deal of R&D is devoted not to development of new technologies or the development of new production processes, but really to modifying the available set of commodities that people choose from.

For example, I found out that Sony on the average tries out somewhere between 500 and a thousand new products every year, most of which do not make it to the shelf, and if you ever have gone to the new food show that is often held in New York which displays all the products that are going to be available to put on supermarket shelves, you will realize that only about one thousandth of 1 percent is ever judged to be edible enough to be sold, so there is a huge amount of issues in front of us, and that is whether or not the R&D that we're so much worried about is all that valuable in the sense that it truly enhances the scope of choices facing the consumers, or is it basically designed to divert whatever low rent that may remain in the existing products from one set of producers to another, and I think there's a great deal of economic literature that I presume Professor Scherer may have already talked about -- if not, he will certainly talk about it -- that focuses on the fact that in monopolistically competitive environments in which various barriers to entry into the provision of new products are relatively low, there is a potential tendency to in fact overfill the product's space with new products in order to still divert or to hang on to the existing rents, whatever they might be, so when one hears the talk about R&D and how valuable it is, I presume the commenters really focus on these types of R&D that at least expose, turn out to substantially expand the choice from which consumers can pick or at least or maybe even more valuably, reduce production costs, speed up production technologies, in fact, enable us to release resources to the economy that can be used elsewhere but which also enable us to produce the next generation of products, and I think that's the one area of R&D which frequently has been perhaps been paid inadequate attention to, so I would suggest that we cannot argue I don't think ex cathedra somehow these efficiencies are or these innovations are more valuable than others or that they are something that is intrinsically inherently valuable that should be protected.

I think the answer that I always give to myself when I think about the R&D is that the valuable parts of it are those that in the aggregate substantially contribute to the enhancement of productive efficiency and substantially enhance the scope of choices facing consumers. As I said, not all of it is what goes on.

Now this is not to say, of course, that many of these projects which turn out to be highly uncollaborative in the end are wasted in that sense.

Obviously people search for answers, and many people come up with wrong answers to often obvious questions, but the point again is that from our standpoint, the Commission and I think the Department of Justice have become increasingly well attuned how to analyze antitrust problems in so-called high technology industries, and I guess from my perspective, the definition of such an entry is the one in which at least the predominant mode of competition over the medium term is, of course, product innovation and cost innovation -- and cost reduction.

Now having said all that, what I would like to suggest to you is a few points that may or may not stimulate us during the discussion period. I prefer to hear others than myself, frankly.

No. 1, I would like to take you back some 30 years or 40 years ago and recall that this was the period of U.S. economic dominance and was a period of spectacular economic growth in the United States, yet surprisingly this was also the period during which the antitrust enforcement was most stringent and least attuned to the issue of research and development and dynamic competition and all of these.

Conceivably, markets and industries during that period 20, 30 years ago were less driven by high technology concerns than they are right now, but it suggests to me that in fact our current set of concerns do not necessarily come because somehow antitrust has become a hamper on what's going on, but because all of a sudden, the United States' economy is facing competition from abroad, and many of the discussions about the need for NCRA, many of the discussions about the need to tighten up our patent enforcement and so on really are not driven by the basic considerations that the American economy has slowed down to a halt, but also, but primarily by the fact that the American economy has been invaded by products from abroad which are taking away market share from the American dinosaurs, and that often happens.

This is the process of competition that everybody talks about, and I will say something about that a little bit later on, but the point No. 1, and No. 2 that stay in my mind is that antitrust, however important it may be, is really not necessarily the primary driver behind or primary inhibitor of the economic forces that are unleashed nowadays in the global economy.

I think what happens is that the application of antitrust to a particular set of companies when inappropriate is very painful, so that the pains are highly concentrated, but whether or not the effect of such a mistake sends shivers through the economic business community I am less certain, although without turning to the left too much, I would suggest that we came close in certain circumstances in trying to influence the thinking over the long term in ways that might have been adverse.

Now the point No. 3, and that is if you're looking at NCRA, which was at least hailed as the first step in more reasonable joint ventures, especially recent joint ventures, there are interesting things about it that I will say in two words very quickly.

One is that participation in recent joint ventures is highly concentrated in a handful of firms.

Even though there are a large number of firms that participate, there are thousands of firms in fact if you go out to, if you aggregate it all up, it turns out that something like 90 percent of all the firms that participate participate in no more than five joint ventures having registered with the NCRA, and in fact somewhere around 200 and 250 firms are the ones that engage in most of the recent joint venture type of technology that NCRA covers.

That raises an interesting, however, question to which I don't have any answers to, but I am slowly working on them, as is Professor Von North from George Washington University, in trying to understand why is it that it is so far a handful of firms find the NCRA to be a valuable vehicle for their -- at least valuable for shielding themselves from potential antitrust litigation?

I have no answer to that. It strikes me, however, that again, there is absolutely no evidence one way or the other that the industries which predominate such as telecommunication are the ones in which appropriation, problems of appropriability, spillover funding, are the ones that are really critical, so we find that 25 percent of NCRA registered joint ventures come from telecommunications -- again, very little explanation as to why. One would like to know.

We know that another 20 percent comes from energy and environment where generic research is very critical and in which appropriability is very difficult, spillovers being extremely high, so this is a bit of a puzzle.

The good news for Tom Jorde and myself to one extent is what we're seeing nowdays on the NCRA registration front is a substantial number of joint ventures which are truly of the vertical sort, and that is of the sort that do put together indeed competencies that are quite complementary along the production channel.

What is surprising indeed is that large participation of joint ventures from the service sector despite the fact that it produces somewhere around 30 percent of the U.S. gross product spends only about 9.4 percent on R&D.

What we're seeing indeed in this case is enhanced participation by service-oriented firms in the R&D effort of people who actually supply them the high technology products that these service industries need.

That is very important because it does support the thesis which is that what's key in antitrust treatment of these joint ventures is the recognition that technological development of the R&D process are not indeed as linear as we initially suspected or suggested, but is a much more complicated, much more complex, multifaceted and multilayered process that requires extensive number of abilities or competencies to be put together in a way that ultimately leads to something that consumers will value.

On the negative side, I would point out that there is, there has been now a downturn in the number of R&D joint ventures registered under NCRA, and there has been also a marked number of firms exiting from the registered joint venture.

Now is it a temporary phenomenon, or is it something indicative of the fact that joint ventures, research and otherwise, to a large extent, to some extent are a product of management gurus who in the '80s sold these ventures to the senior management as being solutions to their many competitive problems.

Obviously many CEOs are beholden to management gurus as is the FTC or the Department of Justice to some friends and economists such as Cornout, Bertrand. Of course we have moved beyond that Frenchman now. We're off to a dead German Schumpeter, and let me say a word about that because it is quite clear Schumpeter seems to be the fountainhead on which much of the current analysis is built, and it is very easy to misunderstand what exactly Schumpeter had in mind, and maybe that will be my final thought because we're going to run out of time.

What really Schumpeter had in mind was the process of competition, and Schumpeter I think is misunderstood when he, when people believe that what he argued for was somehow the presence of monopoly, that market power was something that was driving R&D and economic progress.

I don't believe that to be true for one minute. In fact I looked at some of his writings prior to coming, and it strikes me that what he is saying is that it's the race to be the dominant firm for however a fleeting period of time that is propelling R&D, and indeed what Schumpeter was always advocating, was always of the view in my mind, that it's the freedom of entry into the R&D process, it's the freedom of being a competitor with the reward that it can bring if you are successful.

That is something that a capitalist society should cherish and what capital society is good at promoting, and his revulsion to, to the communist regimentation, he and people like Von Mesis and Hayek argued that it's the freedom of competition that is the driving force, and I believe that if I were to close my remarks with how should antitrust treat dynamic/innovation efficiencies in mergers and joint ventures, I would say it should treat them in the way that (A), does not foreclose possibilities for others to compete in the next generation of R&D, the next generation of products, and the next generation of technologies, and also that (B) it does not destroy the chances for the current firms to earn potentially supercompetitive rewards from successful innovation, so there is a careful and delicate balancing that has to take place.

Thank you very much.

COMMISSIONER STAREK: Well, thank you for that most enlightening and quite interesting testimony. We appreciate it.

COMMISSIONER STEIGER: I must say if you have to deal with Schumpeter, it helps if you read German.

Since I don't, I can't argue with your revitalization of Schumpeterian theory.

PROFESSOR ORDOVER: I consider the translations are quite good.

MR. BAKER: Polish translations particularly!

PROFESSOR ORDOVER: That's especially fantastic, state of the art!

COMMISSIONER STAREK: Well, thank you. Our next witness this afternoon is Roger Noll, and he is the Morris M. Doyle Professor of Public Policy in the Department of Economics at Stanford University.

He is also a director, the Director of the Public Policy Program, and the Director of the Program on Regulatory Policy in the Center for Economic Policy Research.

In the past, he has served as Associate Dean for Social Sciences in the School of Humanities and Sciences.

Prior to joining the Stanford faculty until 1984, Professor Noll was the Chairman of the Division of Humanities and Social Sciences and Institute Professor of Social science at Cal Tech, and he served on the staff of the Brookings Institution and the President's Council on Economic Advisors.

Professor Noll is the author of seventeen books and more than a hundred articles, and his research interests include, among other things, government regulation of business and public policies regarding research and development.

Professor Noll, thank you for joining us. Thank you for making the long trip. We appreciate it very much.

PROFESSOR NOLL: Actually it was a very short trip. I'm on sabbatical at the Brookings Institution.

COMMISSIONER STAREK: Well, I didn't know that.

PROFESSOR NOLL: In any case, the spirit is here. I would have come anyway.

Thank you very much for giving me the opportunity to be here.

It's always disadvantageous to be the second economist because even though off by ourselves, economists fight like cats and dogs, inevitably when it comes to appearing in positions, hearings such as this, we end up all saying the same thing, and of course Janusz has taken away about 75 percent of my notes, but let me, let me proceed. I will try not to duplicate to the best of my ability.

The basic idea I think that we want to, we want to consider here is whether -- is I think best capsulized in the notion as a working principle if not something we can actually implement of thinking of an R&D intensive firm as a vertically integrated firm in two markets, one of which would be R&D production and the other of which would be final product production, and to see if that gets us anywhere for antitrust analysis and for reviewing the wisdom of limited joint ventures or mergers, and the thing that makes this especially interesting is that in most cases, either through history or indeed at a given moment in time, in other kinds of questions pertaining to vertical integration, we have the opportunity to observe both integrated and non-integrated firms, and unfortunately, in the case of the R&D business, that is almost never true, that R&D intensive firms are almost never separated from production, and that is to say, the private sector undertakes more than 98 percent of its research and development in-house.

And the reason for this, of course, has to do with the difficulties of retaining intellectual property rights and ideas with patent and copyright and trade secret protection.

That's sort of the standard explanation for why firms do this, but there is also a contracting reason why firms do this, that is to say, because the nature of research and development by definition is that one really does not know the relationship between input and output.

Indeed one doesn't even know how to measure outputs.

It is extraordinarily difficult to write a contract whereby one organization obtains research and development from another.

And the best evidence of that is the attempt for the federal government to buy weapons system development in the private sector.

The mechanism used by the federal government to solve this contracting problem is an extraordinarily complete and intrusive and very expensive auditing system that not only audits things like costs, but audits things like what people actually do in an extraordinarily intensive way and ends up producing systems in which overhead rates and indirect cost rates between private for profit firms and the government exceed the direct costs of actually undertaking the work, and so there is a -- that we have this peculiar problem then which is, which is, of course, just absolutely perfectly made for economists since there is no danger that somebody will come up with any facts that are going to disprove our theories, which is we're trying to figure out in principle how to think about two separate activities as if they were two separate markets when in fact there is virtually no credible market or useful market for one of them.

Now that's sort of the first major idea that I want to put forth.

My purpose here is to try to gain some purpose and understanding about this.

The second major idea, however, that I want to keep in the background, as I do this analysis, is that antitrust analysis of the R&D component comes across in much more vivid detail, the inherent contradictions of public policy with respect to objectives, with respect to research and development.

That is just an order of magnitude more important than it is in conventional antitrust analysis, and by this I mean the following -- for 30 years, since Ollie Williamson wrote his article on efficiencies in his antitrust defense, we have been aware of the fact that there is, there are two major tensions in any kind of analysis about competition.

The first major tension arises from the fact that in order to give people -- which is the one that we usually attend to, that's the one Tom was talking about -- that in order to give people incentives to undertake innovation, they have to be given at least some form of property right that is not subject at least in the short run to competition, and no matter what we do in this regard, there is always going to be a second best issue here, which is that we don't, unless we want to have a system in which literally all the benefits of innovation accrue to the innovator, which it had -- had it been true all the way back through human history, we would have a very tiny number of people who get all of GNP above what is necessary for subsistence and everybody else was living at subsistence -- if we don't want to have that kind of a world, then there is always this tradeoff between how much shall we sacrifice in innovative activity by having something fall short of a complete intellectual property right?

That's the standard way people think about it, but there is a, there is a second equally intriguing story here which is the difference between the way most economists think about this problem and the way people like the commissioners of the Federal Trade Commission and most importantly, members of Congress think about it, which is they don't think of antitrust as primarily an efficiency issue.

They think of it as a consumer protection issue, and this is a big difference.

Consider the following example -- it may be the case in the Ollie Williamsonian sense that the merger of two firms will in fact reduce costs, but simultaneously if consumers are sufficiently insensitive to price changes, it can also raise price, and an economist might well decide that the cost reducing effects of the merger are sufficiently great that they offset the harm to consumers arising from higher prices, but in fact antitrust law tells us that that isn't good enough, that the -- and this is what Ollie's conclusion in his paper was.

Now turning to the innovation side, what this means, of course, is that it isn't sufficient to identify certain kinds of economies of scale and scope and avoidance of duplication that might arise.

One has to ask the question about the vertical connection, whether in fact some sort of collaboration or cooperation in the innovation market enable the participants in it to be able to engage in more effective either tacit or straightforward collusion in the downstream market.

Now that's the -- this basically starts off what I want to do, and I want to illustrate all these issues first of all, in the fable of SEMATECH, and then to go on with what the principles that we can adduce from that fable and some other ones might be.

The essence of the idea in SEMATECH I think brings forth a whole bunch of issues that come to bear here.

The basic idea behind SEMATECH is one that there are perfectly valid, legitimate reasons why it might make sense for firms engaging in semiconductor manufacturing to engage in general research and development.

In particular, it had come to pass in the semiconductor manufacturing industry that there was not standardization across firms, and consequently, the industry that produces equipment for semiconductor manufacturing was sort of engaging in independent job shopping for everyone, and there was some potentially unclaimed benefit out there from engaging in some standardization particularly in the semiconductor equipment business.

It was also the case that as you can well imagine, that in the semiconductor business, intellectual property rights have a relatively short half life.

It is relatively easy to reverse engineer a semiconductor device, and for all these reasons, we might think for the appropriability reasons, for the standardization reasons, and for avoidance of duplication reasons, it would make sense for indeed such a joint venture to come into existence.

Moreover, because of reverse engineering possibilities and the inappropriability of invention in this industry, it would make sense for government to subsidize it to some degree.

The realities of SEMATECH, when it came into existence, were that the industry -- that SEMATECH immediately began to focus primarily on this upstream problem, semiconductor equipment manufacturing business, and of course the rules of SEMATECH handed down for it were in the first instance, the participants in SEMATECH were to be given an advantage in the R&D that they produced, namely, they were to have a one-year headstart on using any equipment that was developed for them, and in addition, of course, they were, they were essentially by virtue of subsidizing research and development in the upstream industry, and basically exclusively dealing with the firms they were subsidizing, a completely unavoidable collaborator from the point of view of these manufacturers.

Now as time progressed, two things happened, and I don't want to pass judgment on that. That's not my purpose. It's to illustrate the problems that arise, the practical problems of implementing such things.

The first problem was, of course, that the firm, the firms that manufacture semiconductor equipment faced the following dilemma -- on the one hand, the U.S. semiconductor industry was not sufficiently large in the world market that each firm could actually expect to make maximal profits or indeed in some cases even survive by selling only to the members of SEMATECH, so the first domain of controversy arose because these firms were not allowed to sell to the non-SEMATECH members, most of whom were actually foreign producers, so that was the first basic form of controversy.

That led to pressure from the government and eventually the recision of the rule that gave the members the head up -- the leg up.

That, of course, in turn reduced substantially the incentive of member firms to engage in this collaborative venture, and it basically is falling apart.

Now this isn't because it was necessarily a bad idea. I don't want to say that.

It may very well have been a good idea, but the key lesson that comes about from this it seems to me is that going back to our lessons of the past, that some of the people who are in the market, in this case, in the market of selling to the semiconductor firms, regarded themselves as harmed, and in particular, the nature of the joint venture by virtue of not having an instrumentality to take full advantage of the potential for economies of scale in the upstream suppliers, meant that they couldn't behave optimally, and the private for profit, profit maximizing incentives for the participants weren't sufficient to cause them to want to continue to go forward if indeed the rule about exclusive dealing had to be rescinded.

Now I -- that sort of illustrates a lot of the problems of organizing joint ventures, so let me go back now to principles about how we might think about antitrust and joint venture rules in light of experiences such as these.

All right. The basic rationale for why we would allow mergers or joint ventures has to do with two facts.

The first is the possibility of duplicative innovative effort, so that we can reduce total R&D costs to obtain a given cost objective or product improvement objective by combining efforts, and the second has to do with economies of scope, and this has to do with the, essentially the following idea, that firms based on their history have specialized expertise, so they will tend to differ in where they are really good at coming up with innovations.

To sort of think about how these innovations come about, they may come about either in the process line or the product line, as was described, but even more than that, they will come about in components of the product or components of the process line, and different firms can have different talents and different parts, so the economies of scope argument is in part let the firms combine their advantages.

The second part of the economies of scope argument is that somehow it is the case, and there are lots of historical examples, that people who invent or come up with new knowledge are not the ones who figure out how to use it in the most productive fashion.

That is to say, it could often be the case that a discovery in one industry or one firm is the basis for a major product innovation or process innovation in another firm or industry, and the discoverer is not even aware of it, is not even aware of that potential use, and of course the more broadly based the coalition that is undertaking this R&D, the more likely that this is going to come about.

Now what I would like to point out is that neither one of these works by themselves. All right.

That is to say, first of all, duplication of effort is not necessarily bad for the same reason as the economies of scope argument is true, that is to say, different research and development departments doing exactly the same thing will draw different inferences from exactly the same discovery, and the act of reducing the degree of duplication in the industry may in fact reduce innovative effort not because people aren't discovering things, but because they are not drawing as many inferences from them.

And again, one of the features of SEMATECH from some recent research done by Doug Erwin and Pete Cleanough at the University of Chicago is that our hundred million dollars public investment in SEMATECH caused a $350 million reduction in industry effort in research.

Now it may be it just eliminated useless duplication, but it may also be that it will reduce innovation because of the fact that the different companies are no longer drawing different inferences from what was seen to be duplicative.

The second issue that has to do with heterogeneity of research and development as it pertains to economies of scale within this, this various components of products and processes, and here I want to make the distinction that's sort of interesting between how we think about this in product markets and how we might think about it in R&D markets.

The interesting thing about R&D economies of scope is that cooperation among heterogeneous firms is likely to be a good thing if what they're doing is genuinely completely non-overlapping -- if somebody in the automobile business is looking at engines and somebody else is looking at transmissions. All right.

That kind of intersection, it's almost completely unlikely that it's going to be the fact that there will be a reduction in R&D effort because they are already, each firm, engaging in whatever amount is going to be sensible for them, and indeed they might find synergies across that, but the intriguing thing to do is to think about what happens if they are really doing research on transmissions and taking two different approaches?

And there the issue of elimination of, quote, duplication can be seriously inhibiting to the rate of R&D advancement, so if one were going to get into the business of deciding whether product innovation, whether a, the R&D component of the industry, if it merged were in fact procompetitive or anticompetitive, one would have to know something in reasonably great detail about the R&D portfolios of the companies.

In other words, it would have to, you would have to know not only whether they were looking at the same thing or not and whether it was likely or unlikely they were going to draw the same inference from the same project, but you would also have to look even when they were doing things in the same general component of the industry to know whether they were taking different approaches or similar approaches.

Well, I have spoken of this mainly in thinking about it in terms of mergers, and even though my example was joint ventures, let me talk just a bit, and then I will quit, about the, about the notion are mergers and joint ventures pretty much the same thing, or is it in fact the case that joint ventures are safer?

And here I would just like to make two observations that in the case of R&D, we might -- there would be circumstances that would arise where joint ventures are actually less safe than even joint ventures in production. All right.

That is to say, it isn't a clear-cut case, and again, I don't want to say the arguments on the other side are wrong.

I'm just saying they pertain to a special circumstance, and I'm going to identify another special circumstance.

The first is the most obvious one, which is that intellectual property rights that are shared among competitors are a great basis for cartel facilitation, and the most -- this has been true ever since the Bessemer patent pool of the 19th Century.

All that you have to do is set royalty rates on access to the pool of patents equal to the difference between the monopoly price and the competitive price, and you can use a patent pool completely to produce the monopoly price result in a highly competitive industry where each firm is acting in the product market completely independently, so there is -- that is the most, is an important fact to examine -- that the patent pool idea can simply over time mean that essentially all of the benefits of innovation accrue to the innovating firms and none to their customers.

Beyond that, notice that the joint venture issue has the same contracting problem that acquisition of research and development through the private market would have if there were simply a vertically segmented industry.

That is to say, if the joint venture is distinctly separate from the competing firms that are sharing in it, that is to say, it is not integrated into those firms, then indeed the joint venture entity has exactly the same contracting problem that the Department of Defense has when it tries to contract for research and development on a new missile system that it does not know how to measure effort.

It does not know how to measure output. It does not know how to tell when an idea didn't come to fruition because it was a bad idea versus an idea didn't come to fruition because there was insufficient effort.

It does not know how to assess whether the R&D effort inside the joint venture has been captured for the benefit of a subset of members of the joint venture.

The fundamental contracting problem that arises in market-based allocation of research effort also happens with respect to joint ventures.

And finally, there is another feature to it which is a joint venture that was successful in facilitating the spread of information across firms would have the property of eliminating the first-in advantage for firms, that is to say, if we examine industries like the semiconductor industry or a lot of other industries, a large fraction of what we observe is productivity increases in those industries, is in fact learning by doing.

It's not so much organized research in a formal sense in a distinct research entity whose job is to increase the technological base of an industry.

Instead it occurs right at the shop with interaction between people who work on the assembly line and product engineers that are sitting in the same facility.

That learning by doing advantage is a large part of the motivation for innovation, and if something about the joint venture causes the copying of the, of one firm's innovation more quickly by another, it in fact reduces the incentive to innovate to begin with, so one could have the property that one has a much more efficient R&D operation but less innovation because firms in competition with one another to get the first product and to get learning by doing disappear.

Finally, with regard to the heterogeneous product story, when we look at an industry that is product differentiated, notice that in a product differentiated industry as contrasted to a homogeneous product industry, the consequences of a merger, the negative economic consequences of a merger, are less than the same industry structure with a homogeneous product.

Why? Because the firms in the industry already enjoy market power, so the additional market power and the additional profits they can extract by combining are less.

Interestingly enough, sort of the opposite can happen in the case of R&D mergers.

Why? Because in a heterogeneous product industry, it is -- the principal means of competition is very likely to be exactly what we were talking about, what I was talking about before, namely, product competition, and product competition is the means by which firms would engage in, in displacing each other as contrasted to price competition.

It is more likely to be product competition, so again, a research and development joint venture in a heterogeneous product industry has more likelihood of eliminating the, that remaining domain of important competition, and so has more anticompetitive concerns rather than less that you would get from looking at product market.

Well, these are a summary of my ideas. Let me just conclude by saying I do not want anybody to think that I believe as a consequence of what I just said that it is a bad idea to think separately about the R&D aspect of a business when -- and indeed to take into account the possibilities that economies of scale and scope and eliminating duplication are important efficiencies arising from joint ventures or mergers. I do not mean to say that.

What I mean to say is that if one is going to get into the business of taking these into account, one is required to have a very serious set of first of all, rules of thumb that will convey good information to firms, that will tell people what the criteria are for making these decisions, and secondly, one has to have a substantial increase in in-house analytic capability in an antitrust agency to make certain that these things are brought to bear.

That is to say, you would need to know these questions about exactly what is the nature of research and development and that structure within the industry in order to be able to assess whether there were more likely to be good than harm arising from a merger or joint venture.

Thank you.

COMMISSIONER STAREK: Thank very much, Professor. That was most interesting, quite helpful, sincerely appreciated.

Well, our final speaker this afternoon is Bob Skitol.

Bob is a member of the litigation department in the law firm of Drinker, Biddle & Reath, and between 1987 and 1992, he was a partner in Pepper, Hamilton & Scheetz, and before that, a partner at Wald, Harkrader & Ross.

From 1970 to 1971, Mr. Skitol served as an attorney advisor to the Chairman of the Federal Trade Commission, and then served for a year as Special Assistant to the Director of the Bureau of Consumer Protection.

Mr. Skitol specializes in antitrust and trade regulation, and he has written and lectured extensively on this subject, and lately he has been focusing on international competition policy.

In fact, he recently served as a special consultant on competition policy to the Government of Jamaica and participated in drafting the recently enacted Jamaica Competition Act.

Bob, thanks for coming.

MR. SKITOL: Many thanks, Commissioner. I'm really delighted to be here, and I thank the commissioners and the staff, and I'm especially honored to be in the presence of the distinguished speakers before me.

I guess what I will do today is talk about the same subject, but from a working lawyer's perspective, and I would define the topic that we're talking about here again from a working lawyer's and counselor's standpoint as one that I think is, is among the most difficult, but also one of the most critical antitrust tasks of our day, which is the development of practical standards for the evaluation of innovation effects and decision-making about mergers and other kinds of collaborations in the high technology sector.

For those of us struggling to stay on top of all of the latest thinking on this subject, we appreciate the fact that there already is a major body of learning and major body of economics literature, a great deal of it coming from the economists that are with us this afternoon, and also a great deal of learning already in being from the enforcement agencies, from this agency, yet the fact remains that we collectively, the antitrust community, are still at a very early stage in our education in this area, and the central question yet to be answered in plain English is how one determines with some reasonable degree of confidence the difference between those consolidations of rival R&D efforts that are likely to generate efficiencies and thereby enhance innovation output, and those consolidations more likely to be predominantly anticompetitive and thereby reducing innovation output.

I think at that point, I do drop a footnote citation to Roger Noll's remarks. I know that I'm among many in the antitrust bar that applauds this Commission's commitment to addressing that question as thoughtfully and thoroughly as is evidenced by this set of hearings, but let me begin by respectfully submitting that from my perspective, this agency already possesses an impressive degree of sophistication about innovation and about the imperatives of the high technology sector.

My clients often begin the Hart/Scott/Rodino process here at this agency with doubting concern as to whether the reviewing staff is capable of understanding their technologies and their business dynamics.

They more often than not end the process with considerable respect for the competence and the knowledge that the staff brings to bear on their transactions.

Of course, that's especially the case when their transactions get cleared -- exactly.

But still the general point holds for, for many people in Silicon Valley. Howard Morse and his merry gang are the human face of what antitrust is all about, and what it means to their companies, and this Commission can take a great deal of pride in how Howard and his staff perform their role in the computer industry and the allied industries that, for which his group has been responsible.

Let me quickly add, however, that there is a certain black magic quality and lack of transparency about the decision-making, especially about the conclusions reached on high visibility confidential transactions, and to put it another way, there's little doubt in my mind that both the staff and the leadership of this agency possess more insight on these matters than has been disclosed to date, and of course this is understandable.

There are institutional as well as legal confidentiality-related inhibitions upon what can be disclosed about the decision-making on particular transactions.

With due regard to those inhibitions, I believe the Commission can do more to enlighten the public on what lies behind the decisions being made.

I think there are two ways that this can be done, or at least two possible ways that I would like to suggest.

The first relates to the paper that comes out when the Commission announces a complaint and consent order.

The papers include the so-called analysis to aid public comment, which is an adjunct that has been around for about 25 years now, but that analysis typically does almost nothing to inform the public about the thinking involved beyond a bare summary of complaint allegations and proposed order provisions.

Many high technology transactions subject to complaints and settlements in the last few years have involved both fairly provocative liability theories and also creative fixes.

The accompanying analyses shed very little, if any, light on what are surely thoughtful judgments and difficult tradeoffs behind these resolutions.

The published analyses could be more enlightening than they are without improper breaches of confidentiality, particularly since the agency possesses some leverage to extract the parties' consent to more openness in the course of the consent negotiation process.

Let me add that my criticism in this regard and my, my suggestion are equally applicable to the Justice Department's typical Tunney Act filing, their so-called competitive impact statement.

Second, when the Commission clears a transaction without extracting any order, no settlement at all, the clearance will again often be the product of a difficult and extended decision-making process, but the public never learns anything about it.

There is a way to lift this available to some extent anyway suggested by former Assistant Attorney General Jim Rill about four or five years ago.

He began a process in which through speeches at public gatherings, he identified particular transactions that raised novel issues and then proceeded to elucidate the division analysis and reasons for ultimately resolving the issues in favor of clearing the transaction without any relief.

He had apparently elicited the consent of the parties involved to, their advanced consent to his using their transactions as the examples in his speech speeches.

From my perspective as an outside counselor, I found those speeches informative and valuable to my counseling function.

Unfortunately, there were only a couple speeches in that series and then the idea just kind of went away.

Perhaps this would be an appropriate time for FTC commissioners to experiment along these same lines with the focus upon clearance decisions involving resolutions of difficult innovation issues.

Of course the FTC commissioners are already well down the road in utilizing speeches to enlighten the public generally on agency thinking about innovation concerns.

Commissioner Varney particularly has contributed importantly to the dialogue in this area with her series of speeches on innovation and related themes.

I offer my suggestion about clearance decisions when no orders are issued as really just a possible modest addition to efforts already underway and appreciated on this front.

Now I would like to turn to the HSR process itself where my experience has been that the various recent additions and refinements to the procedures have materially enhanced the efficiency of the process generally.

My main thought on this subject today is to urge consideration of a pre-filing process particularly for transactions in the high technology sector.

The reason for special treatment in this area is that these transactions often involve new technologies, complex issues of market definition, and exceptionally difficult issues relating to innovation effects.

It's in the interests of everyone concerned to begin a dialogue about transaction-specific issues of this kind at the earliest possible time with a view to maximizing the prospect of an informed and correct agency judgment about the transaction without the necessity of a messy and prolonged second request.

There are potential inhibitions on a pre-filing process of this sort.

Agency staff may have understandable reservations about devoting scarce time and resources to a transaction not yet filed, especially if there is doubt as to whether the FTC or DOJ would ultimately receive clearance under the liaison process.

These inhibitions can be addressed particularly since for many transactions in the high technology sector, there's little doubt or there should be little doubt that FTC rather than DOJ is the logical agency to receive the responsibility based on its handling of other transactions in the same field or similar field.

I can tell you that among many companies in the high technology sector, there is considerable interest in obtaining this kind of early insight and advice on agency staff reaction and thinking about transactions under negotiation.

All that's really needed to make the process happen is some formal or indeed informal Commission statement that expressly invites pre-filing meetings of this kind.

Now with a view to deepening our knowledge of how different kinds of R&D collaboration actually do affect innovation, let me suggest a research project for the Commission's Bureau of Economics. I don't know if Jonathan will like this idea or not, but I'll try it out.

The Commission now possesses ten years' worth of NCRA and NCRPA notifications, including a wide array of organizational structures from loose consortia to consolidations that are the functional equivalent of asset mergers, R&D asset mergers if you will.

Why not select a half dozen or so of these collaborations, focusing on the ones that are perhaps more like mergers or closer to the merger side than the consortia side, and that involve leading players in consolidated parts of the high technology sector, take a half a dozen or so ventures of that sort from the filings of several years ago, and take a close look at what has evolved -- how precisely and to what extent have those collaborations been efficient and been successful?

What actual impact on innovation generally in the affected markets can be discerned?

Perhaps through in-depth interviews of industry personnel, those involved in the ventures, and also outsider from competing companies, you would discover a range of views as to whether the innovation impact had been good or bad.

These studies could generate new insights into conditions most conducive to efficient R&D, into the impact of these collaborations on industry-wide innovation incentives and related issues.

I think the Commission would want to be extremely careful about generalizing from studies of this sort, but they nonetheless could prove useful to the evolution of merger and joint venture enforcement policy for the high technology sector, I think especially for the evolution of creative remedies for transactions raising innovation concerns.

I want to offer a thought specifically about remedies.

Chairman Pitofsky recently floated the idea of subsequent review or conditional clearance aspect for some transactions where there would be an agency commitment to ongoing monitoring, post-consummation monitoring with regard to competitive effects and whether or not promised efficiencies materialized.

This seems to me to be an idea that should be tried, and I would especially urge application of it in connection with licensing renewals.

The consent orders of this sort have been controversial with lively debate over their efficacy, and an acquisition cleared in reliance on entry into the relevant market by a licensee of the merged firm's technology would seem to be an ideal candidate for close monitoring with the view to ascertain whether the selected licensee really does become over time an effective competitor, particularly one really capable of innovation rivalry against the licensor.

These orders generally rest on the premise that conveyance of rights to intellectual property combined with requirements for technical assistance suffice to create effective competition in innovation as well as the related goods markets involved.

They also rest on judgments that the chosen licensees already possess other essential innovation assets such as human capital, a corp of people with relevant expertise in their heads.

Whether these judgments have been correct is a question deserving close scrutiny a year or two after completion of the compliance implementation process.

Let me skip over parts of my prepared statement to move us along.

I think I'll just -- well, I did want to say a few words that, but without the detail in my prepared statement, about agency resources.

I have made the suggestion that perhaps the time has come for the agency to think about expanding the kinds of professional staff that it has.

It's now an agency exclusively of lawyers and economists, increasingly called upon to, to evaluate cutting edge technologies.

Perhaps the agency ought to have its own computer scientists or two, software engineers, so forth and so on, raise the question of where are the resources going to come from at this time of budget austerity?

And my prepared remarks include a brief editorial about what would be wise or unwise for the United States Congress to do with the budget of this agency, so I'm just going to skip over all that, but I do think that with the kinds of mergers before this agency and the high technology merger wave that is only going to intensify in the coming years, that the high technology community itself should be the leading advocate of increasing rather than decreasing the budget of this agency.

The industry itself is going to be among the victims of anything done that undercuts the ability of this agency to, to deal in an informative and an informed manner with these kinds of transactions.

I'm just going to go to a couple final thoughts.

At some point along the innovation learning curve, the Commission together with the Antitrust Division should undertake to articulate the standards for this analysis in some clear, understandable form, and I would suggest that it should be done within the four corners of the merger guidelines.

The best and most logical place to do so is through an expansion of the guidelines efficiency section.

The fact of the matter is that in contrast to most parts of the guidelines, the section on efficiencies is uninformative.

It's also essentially unrepresentative I would suggest, unrepresentative of the de facto decision-making process that has occurred in the past few years.

It's my belief that both enforcement agencies do in fact now evaluate merger efficiencies to a greater degree and with more sophistication than suggested by the verbiage in this part of the guidelines.

The one exceptionally valuable and practical outcome of the Commission's investment in these hearings could be the formulation of a new efficiency section that captures the essence of how the agencies do and should address this critical dimension of transactions that come before them, and permit me to add that the agency should also as part of the same re-examination fix a related problem in current antitrust law and policy that, that our economists this afternoon have, have also referenced or described in one manner or another, and that the way I put it is a mischievous lack of clarity as to whether and how the conceptual framework and modes of analysis set forth in the merger guidelines apply to other forms of horizontal collaboration, including the many variations one sees throughout the high technology sector these days.

I submit to you that the same general framework and analysis of market power, entry barriers, competitive effects and efficiencies that form the core of the merger review process should be equally applicable to such operating structures as strategic alliances, R&D, or production or other joint ventures and standard setting consortia efforts.

Of course different degrees of collaboration entail different decrees of resource integration.

These differences should be considered in evaluating likely ramifications, but again, the framework and overall mode of analysis should be the same for all forms of collaboration with the same objectives in mind.

There's a good deal of confusion as well as difference of views on this front, particularly among the federal courts, but also within the actions and pronouncements also of the Federal Trade Commission itself.

By way of example, it's clear enough in today's enforcement environment that market power is a threshold screen in merger policy.

It's anything but clear as to whether or how market power analysis serves the same role in either this agency's or the judiciary's application of rule of reason standards to other less permanent or less complete forms of resource integration.

Again, for example, the description of the rule of reason standard in the recently issued antitrust guidelines for intellectual property licensing is exceptionally vague in this respect, and the reference in it to the Commission's Mass-Board standard compounds the confusion on this subject.

The role of efficiencies, while needing considerable further elaboration as applied to merger policy, as we have already discussed, is even more in need of attention as applied to other collaborative structures.

Many of us see confusion and divergence in the treatment of this subject among federal courts, particularly in private litigation over what might be called hybrid collaborations, those that entail some aspects of joint R&D, but also entail some elements of industry standard setting or technology standardization.

There are collaborations of that sort that incidentally, have been NCRA registered and nonetheless have gotten rather bogged down in private litigation which, and I suppose in the discussion session or session later, we will have opportunity to talk this over a bit.

I'm certainly on the side of those who believe that the NCRA has failed in the mission to clarify and reduce litigation exposure, which to my mind makes it all the more desirable that the FTC undertake the job of helping to clarify what should be the standards in this area.

The Commission is the logical forum for thoughtful development of antitrust law and policy in this area generally.

I have co-authored a modest proposal on this front with apologies for its not so modest title. It's called, "A Proposal for Guidelines Deproliferation and their Consolidation into One Simple, Rule-of-Reason Framework."

It doesn't capture the general point to be made, but it's still -- I think this is a good place to begin on the process, and it's a good place for me to conclude my comments today by just reiteration of the need for a clear set of standards for the role of efficiencies generally, and for innovation efficiencies in particular in decision-making on high technology collaborations of all sorts.

So my thanks again for the opportunity to appear before you, and special hats off to Susan and Debra for their outstanding work in organizing these hearings.

COMMISSIONER STAREK: Well, thank you very much. That was a very interesting suggestion there.

At this point, I think it behooves us to take a little break, maybe about ten minutes, to give the reporter an opportunity to change the tape and all of you to ponder questions and responses to our suggested questions.

I guess when we return we will begin with Commissioner Steiger's initial inquiry to Tom Jorde, so about ten minutes.

(A recess was taken.)

COMMISSIONER STAREK: Welcome back. I guess we're all assembled.

I thought before we would turn to the question that Commissioner Steiger raised of Tom Jorde that we might give Sam Miller an opportunity to, to chime in.

Sam participated in our morning session and sat through all afternoon now, and I thought maybe you might have a comment or some thoughts about some of the remarks that you heard this afternoon.

MR. MILLER: All right. Well, this morning I did talk about the importance of interoperability in the computer industry, and urged the Commission to take several actions to promote and support interoperability, one of which is responsive to Commissioner Steiger's question, which is could anything be done to the National Cooperative Research and Production Act, and I suggested that perhaps the Commission could either declare that the Act now covers or seek to gain coverage for collaborations among competitors to support an interface specification or a compatibility standard, because this is the kind of collaboration that I think that the Act was intended to promote, especially through the 1993 amendments.

And with respect to the comments I heard this afternoon, I do have a -- I would like to ask Professor Ordover and Tom Jorde to, maybe to comment further on whether they believe that the antitrust enforcement regimes as understood now and as implemented by the agencies does get in the way of efforts to achieve interoperability?

PROFESSOR JORDE: Oh, that's a question? It seems to me that that's one we can pass around that should go to the agency.

I'm not aware of agency difficulties, and we have had cases of private litigation popping up for access.

You probably are talking about Addamax from this morning, and I could imagine situations where agency guidance or participation in some way or statements, including just talks, could be of help, but that's not going to stop private plaintiffs, and one of the problems we have in a lot of these areas is we, we see agencies both here and at the Department of Justice evolving effectively in the sense of really caring about innovation issues, looking hard at the facts involved, looking hard in many of the same ways, Roger, that you were asking agencies to look at in terms of evaluation, and it doesn't necessarily carry over into private litigation brought outside the context of the agencies, and there is nothing we can do about that short of District Courts themselves being clear on rule of reason standards that they are applying.

MR. MILLER: Well, the agency, the agency can help clarify things either through guidelines or actually through intervention in cases such as filing amicus briefs in appropriate cases.

When I was at the Department of Justice, the Department was asked often to intervene in that way, and that is a role that the Commission could undertake in appropriate cases, especially in helping clarify how the rule of reason should be interpreted with respect to procompetitive collaborative activity.

PROFESSOR ORDOVER: Let me just say one word, and that is that the problem is the agency stepping in, unlike the courts that have to consider such problems because they are brought by private plaintiffs -- I think it is very difficult to draft even a semi-general set of guidelines that would govern the issue of how standards do affect competition one way or the other, and one of the major factors that one should look at other than simply listing what, about 15 or 20 articles which Commerce so far have generated, and all of them are totally inconclusive because they are specific to the details of the situation that is being, that is being considered, so I would be at this stage, be somewhat less inclined than Sam Miller to suggest to the Commission that it actually does say something or that Ann Bingaman says something.

Maybe Carl Shapiro will say something because he wrote half of those articles, because the problem is that I just don't know what the best economics is on the subject matter at this stage of the game, and I think that unlike even in horizontal merger cases, we have varied some the playing field.

I think the same thing is beginning to emerge perhaps in the straightforward vertical merger settings.

COMMISSIONER STAREK: You do?

PROFESSOR ORDOVER: Yeah, I think so. I have all the answers!

But when it comes to so-called network industries, when it comes to standards, when it comes to the issues of competitive forces working one way or the other, there's too much uncertainty for a profound statement that would, that would actually guide these things in a way that, that I would find appropriate.

Maybe there is a benefit in fact of having competitive rules developed through competing jurisdictions.

It's a free market -- in trying to figure out exactly what's going on through competitive lawsuits, and I think that may be a way to actually ensure some kind of consensus down the road, but I don't think we are there yet.

COMMISSIONER STEIGER: I would like to ask anyone who cares to comment about the quote, unquote standard setting in general and see if they would agree with the distinction I'm going to draw at least hypothetically.

I think the Commission has experience in what I would call the goods standardization market, and by that I mean the typical voluntary grouping of competitors through association from which they may determine for safety, for efficacy, for performance standards for let us say such things as copper piping, durable goods, or inputs to a manufactured product, including, of course, household or insulation.

We are familiar I think with the rather fulsome literature on the potential anticompetitive result; I will limit my example only to an exclusionary practice against a new product or alternative product.

Would you agree that hypothetically there is a difference between that kind of standard and a standard such as a computer interface which may have perhaps a higher degree of patentability or protection or conversely less, depending upon whether it's a built-on, add-on idea product or not, and that traditionally the marketplace has settled those issues?

I'm thinking of the Beta, what is it -- Beta/VCR?

PROFESSOR ORDOVER: VHS.

COMMISSIONER STEIGER: VHS history in which as I understand it, a market preference was established, at least as I understand it.

Would you apply a different role for this Commission in the area of invasive standards or not?

MR. MILLER: Actually I spoke about that in some depth this morning, but just to briefly reiterate what I, what I said, I think there is a difference between, there's a difference, No. 1, between mandatory standards like government approved codes and voluntary standards.

There is also a difference between open standards and proprietary standards.

And by open, I mean those that are publicly available and can be implemented by anybody in the industry, and either are free or are licensed at a nominal cost by the developer. That would be an open standard.

A proprietary standard is one that either is exclusive to the developer, or you have to pay a lot of money to utilize, and there is a difference between competitors getting together with the purpose and effect of excluding new technologies.

A lot of the cases that are on the books relate to that like the Allied Tube case and the Hydrolevel case and the Radiant Burner case, and even the Sessions case.

That's different from I believe necessary collaborations today to get products out into the market because in some situations, a critical mass of companies has to support a certain new technology in order to get it going and get it out there, and in the computer industry, that it is often the firms with the smaller market shares actually that get together and try to agree on an interface specification, not the same way to do something, but at least so that the different technologies can talk to each other, and they get together in the face of trying to compete against one dominant firm which by the sheer muscle of its market share is trying to impose a standard on everybody else, and there is a, there is more antitrust risk for the smaller firms that collaborate than to the giant firm that can do it on its own unilaterally, so I think there is a difference and should be a difference between those collaborative efforts intended to suppress and -- suppress a new technology -- versus collaborative efforts to help a new technology emerge. And many times, the interface, the collaboration between competitors on how are our machines going to talk to each other I think is procompetitive because it is helping establish that critical mass so that the technology can get out there, and I gave some examples in the morning.

There is one interesting facet of the VHS/Beta fight which I think deserves a little bit more emphasis.

Beta was a proprietary standard of one company, and it decided to try to do it alone, and it lost.

What is -- and it lost to the VHS standard, which as I understand it, was licensed very cheaply to a whole bunch of companies, so there we had a specification which then could be implemented by lots of different companies and then companies that were manufacturing the VHS machines could compete against each other in how well they implemented the standard, and the benefit of that is that VHS machines have gone down dramatically in price from, you know, $2,000 when I bought a Beta machine, by the way --

COMMISSIONER STEIGER: You guessed wrong.

MR. MILLER: I guessed wrong because they said it was better technology, so I'm one of those stranded consumers that they talk about.

PROFESSOR NOLL: You're supposed to buy one more than once every fifteen years!

MR. MILLER: But the price, when you look at the price --

COMMISSIONER STEIGER: Practically anti-American, isn't he?!

MR. MILLER: You know, the price has gone down from over $2,000 to $200 -- on the VHS machine because there has been competition in the implementation of the, basically an open standard, and you see the same thing in the computer industry with respect to how the prices of PCs have come down when there are lots of different companies competing to implement compatible standards.

There is risk when you have one company trying to dominate a market by setting its own proprietary standard, and Janusz knows all about that.

MR. SKITOL: Let me just add a comment about this whole technology standard setting area, and particularly standard setting activities acknowledged as promoting interoperability of the sort Sam was talking about.

COMMISSIONER STEIGER: Do share with us because you had some thoughts on how the National Cooperative Research joint venture legislation might or could be in your opinion improved, and we have had one suggestion.

I would be most interested in any others that you have.

MR. SKITOL: Right. Okay. Well, I think that the NCRA is not, not, it is in fact not helpful to standard setting.

You know, there's a difficulty with pigeon holes that we have been into for ten years since the original NCRA which was aimed at R&D, and so I know some standard setting efforts that got going in the 1980s, and they actually went through NCRA filings, and then a disaffected competitor decided to bring an antitrust suit, and in response to the defense that well, this is an NCRA protected organization, the counter-response was oh, no, it isn't. This isn't bona fide R&D. This is standard setting, and that's something different.

The whole, the whole technology standard setting thing is highly sensitive to, to antitrust bullying by the private bar.

What happens is if you have ten companies in an industry that need to get together to commonalize and do a standard that will promote interoperability, you're going to end up with ten different antitrust lawyers in a room arguing about, you know, what is and is not, and is not permissible as their clients argue about whose proprietary technology should or should not be adopted to become key parts of the standard, and this is an area where a lot of very, very desirable standard setting is not, is not proceeding very well and is being bogged down because some, somebody out there has hired an antitrust lawyer to send a threatening letter trying to make an antitrust violation out of what really shouldn't be, be considered an antitrust violation.

The NCRA doesn't help. I think the FTC could help. I think there's, there is serious guidance about good versus not so good ways to do standard setting in this area from an antitrust standpoint that the FTC could provide.

The big problem today is that antitrust lawyers out there involved with these groups are having a lot of fun arguing about how the essential facilities doctrine should or should not apply to these kinds of collaborations, and it's an area where flaky threats of antitrust litigation are having mischievous impact, and it's an area where I think the FTC could perform a very desirable role in, in taking the lead in providing thoughtful guidance.

COMMISSIONER STEIGER: Thank you.

PROFESSOR JORDE: I'm going to respond a little bit and follow up.

One of the -- I think we're, Bob, we're back to the problem of what the FTC is capable of doing in its arena and how that affects the arena where the lawyers are having trouble and sending threatening letters.

They are different arenas, and you can get guidance about rule of reason analysis and the importance of standard setting and how do you it and how it would vary depending on what markets were being covered, whether you had -- very different setting whether you're trying to capture an entire market and say that's the standard for it versus, you know, here is a group that's pulled together one third of the smallest of competitors who are going after the dominant firm.

Those are very different analytical circumstances it seems to me, but worse than that, I mean you can sort of state the general principles.

What I have a hard time understanding, what it is the FTC would say about this that will stop the plaintiff's lawyer from writing the threatening letter where the lawsuit will be treble damages oriented in a Federal District Court.

My own sense there is I don't see a, short of Congressional legislation, and that isn't in the cards at all, I don't see anything short of a number of cases decided one at a time, unfortunately, while judges finally come to terms with safe harbors within rule of reason analysis, and here the agencies are farther ahead unfortunately I would say than the courts are.

PROFESSOR ORDOVER: A couple of thoughts -- you characterize these as threatening and frivolous and so on, but that obviously depends on where you sit, and I presume if you and Sam were to talk about, you know, what is or is not frivolous as opposed to just plain threatening, the extortionary use of the antitrust process, but as a serious concern, I think that even amongst lawyers, there would be genuine disagreement in the same way there exists among economists or even in business practice, if you take standards, there is a serious thought being expressed that standards which are open which nobody owns never get anywhere.

For example, let's look at failure of Unix in many applications to develop.

In fact, there was a non-starter for so many years because it was not sponsored adequately by anybody.

At the same time, whatever you may say about the MS DOS standard, it certainly succeeded beyond anybody's expectation because it was sponsored, and powerfully so, by Microsoft.

Now are we better off with having a standard that nobody owns or licenses for a penny without taking the risk to develop it, or are we better off with a standard that somebody is trying to control and set like Microsoft has done or Intel?

I presume there are many other examples from the software and other industries, in which the firm is taking substantial risks potentially to develop the next generation, which is why my initial reaction was that you don't just know enough to even contemplate the guidelines.

At least I wouldn't know how to do it, speaking for myself, and I don't know, you know, I can't speak for others, but I believe that these tradeoffs are so genuinely tough that anything but some reasonably structured rule of reason and some development of litigation of cases that would give us some way of working through particulars as opposed to general statements I think strikes me as a more fruitful way to proceed than a statement from the FTC that standard setting should not be used for antitrust purposes, and you know, if it's unduly exclusionary or unduly inclusive, we will, we will, you know, extend an amicus in private litigation.

What else can be said other than those three sentences? Maybe they are helping, but I'm worried about more than three sentences.

COMMISSIONER STEIGER: If you're worried about more than three sentences, I'm worried. It's not your normal worry.

PROFESSOR ORDOVER: It depends.

COMMISSIONER STEIGER: The same can be said of all commissioners at the Commission.

MS. DE SANTI: I have a question for Tom initially, but I would like to get the opinions of others as well.

In your remarks, you have talked about one of the possible justifications for these joint ventures being that there is weak appropriability of the innovation that comes about through the joint venture, and I understand and I think it's very interesting your analogy to the free rider rationale that's developed in antitrust case law. It's pretty securely there at the moment.

My question is how, how do we understand when we're just furthering a right, what has at least over the past couple of decades become a fairly usual antitrust argument and when are we trespassing on what Congress has had to say about the extent of intellectual property rights, and when are we going beyond that to get into an area that Congress has resolved in a particular way, whether it's the extent of copyright or patent production, and take on a role that's not appropriate for antitrust?

PROFESSOR JORDE: That is an absolutely first-class terrific question.

It really goes to the core of worrying about this intersection of antitrust and intellectual property and for which I will say real quickly I don't have an answer.

The answer is in all cases I think, and it's not, I'm not ducking when I say that because I think there's no other way than to look seriously at what the claims are about the intellectual property and the reasons that, for example, trade secrets and the possession of them in this particular industry setting don't lend themselves at all to patenting, and therefore there is not a public knowledge tradeoff available for keeping the intellectual property in-house, and therefore in that case, the public goods characteristics and free rider possibilities are quite real if things are not contractually bounded in.

It seems to me you have got to pay attention carefully to the technology involved, the intellectual property involved to see if the claims are legitimate because they might not be, but that, that itself is not a complete answer at all because it doesn't address in a way a more fundamental question that I think you stated perhaps like this, that is, are we to read Congressional statements through legislative enactments in the area of intellectual property as the final line and anything else that doesn't fall within an already legislated area is open for imitation?

And that's the tradeoff that Congress struck, and any private contracting arrangement to stop or otherwise thwart that imitation possibility is fair game for, for imitators and shouldn't be used as a justification for collaboration that otherwise might raise market power problems.

I mean my own view, and it is just a view, is that the tradeoff that Congress has drawn with respect to patenting and copyright is not the limit of intellectual property.

Nothing is inhibiting state law protecting trade secrets and the like even though Congress might not have stepped in the same areas.

Lots and lots of innovation and intellectual property falls outside of patents and copyright, and studies have demonstrated in a lot of industries patenting is not sufficient, so it seems to me that there is no reason to think that when intellectual property or a trade secret or tacit knowledge type is significant, and parties collaborate to gain the rent on it, it doesn't seem to me that Congress has eliminated that as a good thing as long as the end product of that is further innovation.

That doesn't make the balance less difficult, but I would certainly argue against the idea that well, we have taken care of that from a federal intellectual property point of view and if it's not already in, then there shouldn't be any further prospect of collaboration to capture additional value.

PROFESSOR ORDOVER: So it's not clear exactly what the Congressional view of anything was on that subject, but if you just look at the patent protection, prior to the setting up the special tribunal for the patent enforcement, it was the case that outside of the court plaintiffs, the infringers prevailed with huge certitude.

Something like 60 percent or more percent of the cases, the court would find a patent invalid or no infringement or limited infringement.

Nowdays it's completely flipped. Indeed it is almost impossible to prevail as an infringer against the holder of the patent, or I don't know about copyright, but certainly on the patent side, so the mandate is, you know, as a patent, you have the right to exclude, but that doesn't mean that you have no right to get as much profit as you can from that grant of the property right. That would not conflict with some basic precepts of competition, so I don't see the conflict as stark as you perhaps posed it.

Maybe there is some, but certainly not as stark as that question would deem.

MR. MILLER: I'm going to ask what may be a simple-minded question, but I think that it does raise the potential tension between intellectual property protection on the one hand and consumer benefit on the other, and that is was the cloning of the IBM PC a good thing?

Now it certainly wasn't good for IBM, but was it good for all the users in the world?

And I would submit as we talked about before, there has been tremendous innovation and variety and the price has gone down, and that's because there was, there were companies that were able to, by cloning, create compatible products.

There is a tension sometimes between intellectual property protection and the ability to create consumer choices and promote innovation, and that is going to be before the Supreme Court in the Lotus versus Borland case.

If you focus in particular on the concurring opinion of one of the judges, he focused on the potential anticompetitive aspects of upholding Lotus' copyright claims, and there could, or the ability to reverse engineer an interface is something that in the Sega versus Accolade case, for example, was held to be procompetitive, and in some circumstances, where you have a dominant firm with the proprietary interface, that may be a good thing.

I mean I'll pose a hypothetical to Professor --

PROFESSOR JORDE: Before you propose a hypothetical, I want to comment on what you just said because I don't think it answers the question about the tension.

Reverse engineering is just reverse engineering. There is patents out there, and it protects certain things, and they don't -- you have got reverse engineering.

I think the better analogue would have been to have asked what if three or four horizontal competitors possessing about 25 percent of the market get together who do not have patent protection for a particular area of innovative activity, but what they have is the black magic of how to do the thing right. They understand what the process is.

Take resin production, for example. Most of it's art. A little of it is science.

If you take the people involved and move them from one firm to another, you transfer that technology all right, but the question what happens if you get there as a group, four or five firms together, and decide to restrain others that might get that technology or might get that type of process or that information.

You say look, if you come into the group, you can't give it away. You can't sell it. We're going to benefit collectively from that.

Well, you've stopped reverse engineering of a type. You have stopped imitation of a type for sure, but you have probably also advanced innovation and advanced commercialization, and it seems to me a lot would revolve around market power questions and are not answered by whether or not there was intellectual property protection by patent versus by contract.

PROFESSOR ORDOVER: It seems clear to me, though, that if you tied it up, intellectual property protection as has happened over the years, and it may be expanding into the copyright area software, which is especially very sensitive, at least my understanding, the usual arguments for joint ventures as being necessary to recapture the spillovers to undertake these risk-sharing agreements, sponsor and others, I think it's somewhat diminished.

I think that you cannot have a dynamic which is totally unbalanced, and that is you cannot have a circumstance in which both the patent and the copyright law are conferring stronger and stronger exclusionary power against those who are by law excluded, so that copying a single line of code, for example, may be viewed as a major infringement, and at the same time, the antitrust regime is liberal enough which says well, you know, spillovers are out there and you're going to be recapturing them one way or the other so you better -- you have to be allowed to joint venture or to do all kinds of things by contract and so on, so forth.

I think there has to be a balance of some sort. I think there has to be sufficient amount of openness in the economy for people to be able to engage in constructive competition, and if you are not, there is no room for doing that, then the next phase of competition will come to a grinding halt, and that's what I was saying initially, that the balancing ought to be looking forward.

Obviously that's a very hard balancing to undertake, but it's my view that the more you're allowed to exclude through the IP law, the less you need, the less argument there is for the usual arguments for joint ventures.

If you look at the NCRA data base, there's very little of it, for example, in chemical industries or medical instruments industries.

Why? Because these industries -- sorry -- these people have very potent patent protection. They really don't need to mess around with too much of these kinds of arrangements.

There is very little fear that anybody is going to encroach and succeed.

Most people encroach and fail, and therefore, you see the data confirming what we are saying here, which is when exclusionary problems may be real, maybe we're talking about development of generic technology, you will observe not only two player joint ventures but five or ten or fifteen player joint ventures.

COMMISSIONER STAREK: Did you want to pose your hypothetical now?

MR. MILLER: Okay. Well, let's take, let's take Windows, which up to now Microsoft has said what they would claim is an open interface. They give out the application program with interfaces, and they say lots of people, thousands of programs have been built on it, which are complementary to, complementary to the operating system, but in the meantime, Microsoft now has gone into not only the operating system business, but also the application business.

In fact, it gets more revenue today from applications than it does from operating systems, so it might say well, we have an intellectual property right to the software. We own the interface. We don't have to give it to anyone. We're not obligated to license it.

Let's suppose that next week Microsoft changes its business model and says we're, we're not going to license the interface to anybody who is in competition with any program that we make.

We're not going to give it to any word processing company or data base company or anybody that makes presentation graphics or anything else that we make.

We're just going to do it ourselves, and we have an absolute right under the intellectual property laws to do that.

Does that create anticompetitive problems?

PROFESSOR ORDOVER: Roger will talk about that. I -- actually, the hypothetical to me -- I decline the offer.

I think that it's a very tough hypothetical, but you would want to consider how long Microsoft would survive as a standard for the operating system if it conducted its business in such a way, so there are forces -- I think people have very differing opinions on indeed what should be done in a circumstance like that.

I think that some years ago, 15 years ago I wrote a paper which was uniformly derided for suggesting that there may be something untoward about changing interface specifications.

It was actually partly sponsored by the FTC, the paper was -- not the conclusions, but the, the point being I think that first of all, it seems to be true that arbitrary changes in the licensing of such things as software would provoke much more outcry than if, than if Microsoft followed the Apple route and said I'm going to write everything myself. I won't license it to anybody.

You can see where the success of Apple versus Microsoft has been partly for that very reason perhaps, so changing your business plan would expose Microsoft to substantial risks, and potentially appropriate substantial risks partly because to the extent that one believes in this theory of installed base opportunism, there would be a significant base of MS DOS or WINDOWS 95 owners who actually purchased the systems on the presumption that it's going to be reasonably open so that other people can write applications for it, and until Netscape or somebody else or OS 2 would supersede the dominant system, there will be room for a fair amount of exploitation, and that creates a danger especially if in your hypothetical you would not posit any particular reason for a change of business strategy.

There may be a circumstance in which there may be a reason, and others there may not be, but the way you structure it, I think that that would be a dangerous proposition for Microsoft, one leading to extinction, but not immediately obviously.

COMMISSIONER STAREK: Interesting hypothetical. John, did you have a question? Or sorry -- Professor Noll?

MR. BAKER: Let Roger take it.

COMMISSIONER STAREK: Please.

PROFESSOR NOLL: It seems to me you asked a very specific question which has gone so far off track I'm not sure I should still try to answer it.

MS. DE SANTI: I'm still interested.

PROFESSOR NOLL: I will resist the temptation to respond to Janusz and go to the question about can joint ventures solve the appropriability problem?

And you know, whereas I will say that we have to admit the intellectual possibility that they can in certain circumstances, I will simply make a broad claim in the vast majority of cases, that is complete and utter window dressing and has nothing to do with reality.

And the reason for it essentially is the following, that if you ask the question under what circumstances can a non-appropriable innovation become appropriable, only by virtue of a joint venture, it has to be by reduction of competition among the people in the industry, which means they have to somehow not compete in the application of that innovation, and they have to be able to protect against entry, and that the, the reason things become non-appropriable is because in fact of copying and innovation, copying and innovation by others, and product market competition, and the solution to that again is a royalty system whereas the royalty rate is unrelated to the, the quality of innovation. It simply becomes a cartel facilitation device.

The second reason for it is I know of no way to write down a rule that would be something like a merger guideline which would say R&D joint venture, you are required to specialize only in non-appropriable innovation. All right.

That is to say, what -- the natural inclination of any R&D joint venture is going to be to maximize profits of the joint venturers, and the way you maximize profits of the joint venturers is to focus on appropriable innovation.

The third point I would make about it is that you cannot discuss this outside the context of all federal policies towards R&D, and the traditional way we have thought about how to deal with non-appropriable innovation is produce it in the public sector and make it publicly available, or at least subsidize a joint venture and make it publicly available, and that's exactly the, the issue here.

It seems to me that if you genuinely identify an area where there is enormous amounts of social value to be obtained, the alternative is to pay for it and make it publicly available and to allow free participation by the industry, but not exclusive orientation towards it.

And you know, the argument here is so similar to the argument, the battle we fought for 25 years about process utilization and economic regulation, which is the argument that, you know, it's really important that people who live in rural areas be able to pay the same price for utilities as people who live in urban areas despite the fact that it's ten times as expensive to serve them, and rather than pay the money for it, Congress is somehow unwilling to see the intelligence of this brilliant policy, so therefore let's prohibit competition in the industry in order to engage in internal cross-subsidization with all of the horrendous inefficiencies that arise from that both in terms of production efficiencies of the regulated firm and in terms of the dead weight losses created by the cross-subsidization.

I think that trying to do non-appropriable innovation through R&D joint ventures is exactly the kind of avoidance of the true public good feature of those things that ought to be publicly subsidized

MS. DE SANTI: Bob, do you want to talk about this question?

MR. SKITOL: Well, I guess, I guess this is responsive.

The interplay between intellectual property right to exclude versus competition concerns under the antitrust laws is yet to be played out.

I don't think we're even close to working out the, the right balance between those two regimes, and it's right smack in the middle of the Kodak case.

Kodak today filed their JNOV, and their big argument against the verdict is that these replacement parts were patented, and Kodak has the right to refuse to sell patented parts to competing independent service organizations.

That's going to go all the way to the Supreme Court I guess, and in standard setting, there is a tremendous tension yet to be resolved about just, you know, when and under what circumstances do you make somebody, do you have a rule of law that says that even though that's your patent or copyright, even though that's technology you developed, that's your innovation, and it's protected by the patent code or the copyright code, nonetheless because of the way you wish to have that technology used, the antitrust laws require you to license it out.

We haven't yet figured out how to and under what circumstances the antitrust laws should say something like that to intellectual property.

PROFESSOR NOLL: Bob, let me disagree with you. Suppose the rule was that, that Bell Communications Research or AT&T Bell Labs has a patent on all the necessary things to use a telephone, which isn't true now but would have been true 20 years ago.

Do they have the right to say that we'll not sell our telephone to anybody who doesn't let us own their house?

In other words, I think we have fairly clear guidelines that the, that at least point out the domains of which it would be ludicrous to allow patent extension into other markets, and the real question has to do with close calls obviously, but I think we know what the principles are, and the principles are that there are reasons why, in closely related markets, a firm might very well want to leverage an intellectual property right into the other market even if it were an inefficient provider in that other market for a whole host of reasons, the most obvious of which is to engage in better price discrimination.

To take the case of Windows versus applications, if you're just selling Windows, you don't know whether you're selling it to someone who is going to use it primarily for word processing, primarily for using financial management programs, primarily for using its statistical packages, primarily for using it for any host of other applications, and you can engage in far better price discrimination against the users of Windows 95 if you discriminate among them in terms of the applications they are going to use, and so it makes great sense if you're Microsoft to try to foreclose entry into applications programs for engaging in that kind of price discrimination, so once again, it's sort of a fact-based question.

Is the plausibility of the economies of scope and greater integration greater or less than the plausibility of the terms of this as pure market extension for a host of reasons we can list, and it seems to me that in the great majority of these cases, the market extension argument is, the notion that there is an efficiency to be captured there is extraordinarily weak, but in any case, you can probably figure it out if you just investigate it.

MS. VALENTINE: If we could bring this back maybe to where we started, does this suggest that for those of you who suggested that regardless of the form of collaboration, the standard should be the same, and I think that's both Jorde and Skitol, that you're looking more at a rule of reasonsafe harbor and a similar, or an extension of the guidelines, the current guidelines framework to joint ventures, and you're not going to next tell us, which I actually thought you were doing, Tom, well, in fact innovation efficiencies are so special that we should go to yet a different way of measuring those efficiencies, and instead of having these least restrictive alternatives, look at whether it would have been substantially fewer participants Is this an effort now to ratchet down guidelines or --

PROFESSOR JORDE: No. I think it stays the same, and I really think you ought to be applying remarkably similar standards in order not to cause businesses to choose forms of organization that don't match what they are trying to accomplish just to get a different substantive result.

I would apply the safe harbor in collaborative contracting and alliance areas equal to what is being done for mergers so that we don't have an odd pressure in one direction or another.

With respect to sort of my version of drastic means analysis, that's how I think it ought to be done -- period.

I think there is loose language in a number of judicial decisions suggesting probably a stronger standard than is actually applied by any of the agencies anyway, and I suspect that what I stated in my remarks and have written in more detail is much closer to what agencies in fact do when they are thinking about looking at alternatives, so I don't think there's a change there.

There is a change with respect to innovation and technology-related questions.

If by that you mean are there special considerations that come into play because the nature of what's being looked at involves innovation and technology and rapidly changing industrial settings, then I think the answer is yeah, there is a separate set of concerns that you would at least want to pay attention to that wouldn't come up or be as familiar to us if we were looking at a transaction involving a mature industry with several players that had been around facing each other over a long period of time, without much change.

MS. VALENTINE: That would be factored into the analysis?

PROFESSOR JORDE: Oh, yeah. Sure.

MS. VALENTINE: Bob, where are you?

MR. SKITOL: I think Tom and I are of a similar view.

I agree with everything Tom just said. At least I think I do.

MS. VALENTINE: Including his version of less restrictive alternative?

MR. SKITOL: Well, I think he's suggesting that it would be for, for somebody to, for a prosecutor or a plaintiff to overcome a defender's efficiency showing on least restrictive grounds, it would be a high standard.

You would have to show that there was an obviously less restrictive way to do it, and one that was, would have been substantially less restrictive if that's -- I think that's what I heard Tom say, and that sounds pretty sensible to me.

MR. TOM: I was struck by the fact the very next point that Tom Jorde made after the least restrictive alternative standard was that a lot of these problems could be ameliorated, if not solved, by the elimination of treble damages, the application of NCRA or the like, and that led me to wonder whether the same kind of latitude in the least restrictive alternative test ought to be given in cases where you are not dealing with retrospective remedies, but you're only dealing with prospective changes in the competitive landscape which of course would be the case under Section 5 of the FTC Act as opposed to the Sherman Act itself.

PROFESSOR JORDE: That's an interesting point with respect to the Section 5.

I didn't mean -- if I did, I erred -- I didn't mean to suggest that the rule of reason standards that I was advocating here ought to change or something different ought to happen if the National Cooperative Research Act or Production Act came into play.

At the end, I thought that, you know, there ought to be more attention paid to that, but I don't think the rule of reason changes there, either.

All that Act does is say the rule of reason applies, and everything that we have been talking about I think would fold into that.

I understand the point about looking at things, at the time that the FTC might be looking at them that you really don't have this hindsight kind of less drastic means problem coming up unless one were looking at an agreement that was already in effect and you were coming in to see whether it ought to be taken apart or altered or something of that sort. Then I think you would run into that.

MR. BAKER: Sorry if I croak through the microphone.

One of the -- this whole session has got me so concerned about appropriability -- by the way, I was talking about this during the break, that from now on, I'm keeping all of my academic research captive -- I have a question for Bob about your proposed research program for my economic staff.

I'm actually delighted -- usually when people are proposing that we undertake an ambitious research program in the Bureau of Economics, it's people who want to keep us out of the case work, find something else to do. It's like when you ask the fellow who stops you for speeding don't you have a robber you can go after?

You, of course, have a better reason, which is that -- and I agree that research would be very helpful for us to learn about how collaboration affects innovation and competition just as you were proposing -- but what I'm wondering about is whether, and you can probably speak to this from your knowledge of your clients, whether the firms we would be asking these questions to will cooperate with us and tell us what they have been doing and all the details, and what they learn and what they figure out and how it was commercialized and who they talked to and what they charged for the products and how related technologies were folded into it, whether they would take the time to do that with us on their own and whether outsiders would take the time to talk to us or whether we should be using our subpoena power to ask your clients these questions and whether they would be comfortable with that and whether they would raise, waive their -- whether all of these attorneys would waive their confidentiality were we to publish the results?

I mean-

MR. SKITOL: That's a very interesting question.

On the one hand, I suspect that, that you would find a lot of people with very strong opinions as to whether the particular effort did or did not work and what was right and what was wrong. You would find a great range of opinions.

Would people be willing to talk to you? I think the confidentiality thing would be an issue for many, and you would have to, you would have to come to grips with that, but I think as a matter of cooperation, I think lots of people, I'm thinking about some particular clients of mine, I think they would want to be supportive of an in-depth Commission look at this sort of thing.

I have my own sort of hypothesis as to one of the things you would find out.

If you compared the relative success of loose consortia versus arrangements that were more, that were closer to the merger model, you would find those that are closer to the merger model more likely to have been successful and efficient, and that's because what I have seen as a working lawyer and advisor to loose consortia is an awful lot of industry politics that get in the way of serious work.

When you try to do serious R&D, with loose consortia, with a whole bunch of companies, each of which has its own separate agenda and each of which doesn't totally trust the other, the other members, you are likely to end up with a lot of inefficiency and less effectiveness than the other model which raises kind of an interesting question when we talk about least restrictive and so forth, there's a lot of traditional thinking about joint venture law that's -- and merger law -- that says that, you know, it's like what the guidelines now say about efficiencies.

They say well, we'll consider efficiencies as a defense to a merger, but only if there's no less restrictive way to accomplish the efficiencies, and often at least in the past, the enforcement thinking has been in the direction of well, a joint venture is less restrictive than a merger because it's less permanent, and that's, I'm not sure that's, that's a valid bias, and I think the kinds of studies of past collaborations that we have been talking about might shed some interesting light on that.

MR. BAKER: If you're right, it would seem that safe harbor should be set higher for mergers than for joint ventures?

PROFESSOR JORDE: I like that. Any sort of efforts at studying this area run into some complications that we really want to be careful about.

One is the different settings that you would expect people to merge into versus loose consortia.

I would be real surprised if people were trying to accomplish the same things as you went through and looked at what was behind the particular joint activity, so it might be, be comparing apples and oranges and keeping the apples and apples straight.

The other thing that's difficult, though it's really interesting to do from a study point of view, it is very difficult to understand -- two things.

One is what would have happened but for what you have seen over the last three or four years? I mean it's sort of compared to what?

It's a very difficult thing to come to terms with. So what if something fails?

Now I would assume we're going to understand that a whole lot of these joint ventures and consortia and mergers for that matter fail, and they don't achieve what people tried to achieve, but that doesn't make them anticompetitive or make there any greater reason for an enforcement agency to have taken a second harder look at the next group of those coming down the line, so it's a difficult proposition for agency expenditures.

PROFESSOR NOLL: Knowing that it's OMB budget review period, I hate to detract from the possibility of your actually getting a budget increase to undertake a study, but I actually have done the first half of this proposed study in the sense that I have, I actually went through the first four years' worth of registrations and classified them as I see them.

Now admittedly about 5 percent of them are not classifiable from just reading the title and the names of the firms. All right.

But I wish I could remember off the top of my head. I didn't think of it as being a major issue, but something on the order of 88 percent of the registrations are in three industries.

They are either telecommunications involving Bell Corp or AT&T, or in the computer industry or in the automobile industry involving the big three automobile manufacturers on issues pertaining to either batteries or emissions technology, so that now those three also happen to be areas of enormous historical antitrust activity. All right.

So that if you were going to evaluate the effect of the Act, you could really very quickly conclude that the effect is probably virtually nothing except in those three industries and focus just there and see if, if, you know, if those sets of projects -- it's also the case when you read the actual project description, that part of them which is public information -- you have access to more information than I do, but just reading what I did, they typically get defined in relatively broad and opaque ways, and one of the things that is public is the stated justification, and I found frankly personally distressing that in almost half the cases, the stated justification was elimination of duplicative effort.

MR. BAKER: If we were to go forward with this, perhaps we would want to collaborate with you so we can appropriate.

PROFESSOR NOLL: Well, I would like to join your cartel for doing the research, too, unless somebody pays us!

PROFESSOR ORDOVER: I just want to not add, actually extract something that Roger said a while ago. It's a long day for me not to pick a fight with Roger. I feel like I have not accomplished enough, but a couple of things that I thought were interesting but misguided.

One is on the issue that just because there are spillovers, that somehow there ought to be government intervention.

I believe that there is no more harm to be accomplished than to have the government somehow get involved in underwriting the alleged spillover projects because that would require humongous apparatus of determining which amount of spillover qualifies and what the actual degree of appropriability, how much money would be required to cure the spillover, and on and on, and I think that even thinking of such a proposal suggests how inappropriate it is to solving what's truly not often a huge market failure, but some market failure, and I agree that when it comes to basic or fundamental research, there is a fair amount of government support already, and if you, as you have looked at NCRA filings, there are a number of them although substantially smaller than I thought, that involved actually universities and nonprofit organizations and things of that sort.

Secondly, I disagree that spillovers cannot be, that the internalization of spillovers is tantamount to reduction of competition.

I think that's just not plain so because there is plenty of work showing, theoretical and empirical demonstrating the fact that such collaborations do indeed enable firms to at least enhance the amount of research partly because they fear less spillover, so the equilibrium may be without internalization, almost very little output or no output whereas with internalization, some output, not as much as we would have if somehow ideally philosopher Queen philosopher King could determine how much should be done, but I do agree with you, Roger, that if you're looking at the NCRA filings, you'll find that these spillover justifications just don't make it as a paramount explanation other than in energy and in, and in environmental research.

I think most of those NCRA filings my guess currently are designed to put together firms with complementary assets, people that are good at doing one thing with people who are doing something else, and enjoy scope economies at the level of R&D, which doesn't have anything to do with in fact spillover, capturing of spillovers, but it has to do with putting together assets that are held in separate hands but which could function very well together, and I believe that's a tremendously legitimate reason for joint venture as it is for any other conglomeration of complementary assets which is why we do take a somewhat more lenient view of vertical mergers, which to a large extent are indeed such in fact putting together of complementary assets as opposed to putting together of competing assets.

MR. TOM: Listening to the economists today, I'm struck by the degree to which efficiencies really can't be identified, quantified in this area with a great deal of specificity and, you know, there's a lot of vagueness perhaps just inherent in the enterprise itself.

In light of that, I wonder a bit about the practicality of Bob Skitol's suggestion that we write guidelines about efficiencies.

I mean I don't know if it can be done in the current state of knowledge.

I don't know if we would end up with a better product than essentially the approach that we have now, which I take it to be that mergers in general are generally efficient, and we allow a lot of latitude toward mergers, and we don't find them anticompetitive in the first place very often, and in light of that, we don't often need to balance a highly quantified measurement of efficiencies against anticompetitive finding when we do find those clear anticompetitive situations.

Is there any reasonable prospect that we can do better than that at this time with our current state of knowledge?

MR. NOLL: I don't think that's the right interpretation to put on what economists have said. All right.

I think that the right interpretation to put on it is that it's a case-by-case kind of system, that there is a number of, there is a number of issues out there about the likely effect of a merger or a joint venture on R&D by the participants, and then there is a spillover effect or a connectiveness of that to what is likely to happen in the product market, and that goes beyond what you would normally get just by looking at product market shares.

I don't think you can conclude from that that it's, that it's sort of non-quantifiable.

It seems to me that it's multi -- just take, for example, the -- forget Janusz's desire to differentiate his product and just take what he said in response to what I said.

What we have, if we merge those two statements, we have the following story, which is Janusz emphasized the economies of scope rationale. All right. So you hear it said. You take a merger. You have got all the normal merger analysis.

In addition, each company reports to you, in detail, what its research projects are, what it perceives to be research strengths, and you simply match them up, and the more they overlap, the less likely it is the economies of scope is a justification that could cause you to say well, maybe I will give them a few points on the Herf in the product market because of the strong possibility of complementary in research, but so likewise, if you were to -- if it looks like they had good Herf numbers but it turns out they were the two leading research firms in the industry, and their research projects were virtually identical, then you would have much less of a reason.

Then you would say gee, maybe I should subtract a few points on the Herf in order to let this thing go through, so I don't think that it's not implementable.

I think that what -- that the story is research and development is complicated. It has many motivations and many attributes.

It's motivated in part for the purpose of this positive incentive to gain appropriable returns.

It's also motivated by the negative incentive to avoid being the one that goes bankrupt in the industry because you didn't keep up, and those phenomena can be conceptualized in a case-by-case basis.

I just think at this point it takes more sophistication, there is complexities to analyzing the R&D aspects of a merger and joint venture that are just not the same as analyzing the product market aspect.

PROFESSOR JORDE: We're getting toward the 4:30 mark, Mr. Commissioner.

I want to just take 30 seconds to say how wonderful the paper was that was written by Bill Cohen in preparing background materials for not just today's session, but for, as I understand --

PROFESSOR NOLL: You're just saying that because he knows how to spell your name!

MR. JORDE: It was just a superb piece of work, and I have now learned it was done under quite pressed time periods, so it's nice to have that kind of help available.

MR. SKITOL: Here here.

COMMISSIONER STAREK: I agree. It was remarkable, and in fact we have got several other papers prepared by Susan and Debra's staff, and I must say all of them have been extraordinary, very helpful and quite well done.

Okay. Thank you all. My sincere thanks to all of the panelists today who took the time to prepare extensive statements and stayed around for a very lively and enjoyable debate. It has been very helpful to the work that we have here, to the mission that we're undertaking, and I appreciate it and appreciate all of your time and effort. Thank you.

(Whereupon, at 4:33 p.m., the proceedings were recessed, to reconvene at a future date.)

C E R T I F I C A T E

DOCKET/CASE NUMBER: P951201

CASE TITLE: HEARINGS ON GLOBAL AND INNOVATION-BASED COMPETITION

HEARING DATE: October 26, 1995

I HEREBY CERTIFY that the transcript contained herein is a full and accurate transcript of the notes taken by me at the hearing on the above cause before the FEDERAL TRADE COMMISSION to the best of my knowledge and belief.

DATED: October 26, 1995

SIGNATURE OF REPORTER

Catherine S. Boyd

(NAME OF REPORTER - TYPED)