Experience from the Anti-Monopoly Law Decision in China – Part I

1. Introduction – Reasons of Estimating Cost of Legal Risks

The general public typically has a positive view of liberty, democracy, and a reliable legal system. For their part, analysts are likely to take the legal system for granted because they have a positive view of the rule of law and are able to construct airtight arguments explaining why a reliable legal environment is important for investors.

However, simply stating that having the rule of law is always better than not having it may not be sufficient. Scholars rarely evaluate the magnitude of the positive effect of the rule of law. Certain studies may consider that legal risk increases costs at the operating level, such as the risk of suffering litigation expenses, but these studies have not analyzed how legal risk may cause investment loss.

Additionally, scholars may attempt to show that the rule of law is not a foundational concern for investors by developing models based on the interaction between governments and investors; however, these studies may miss the mark when investors hesitate to enter the market because of the perception of an unfair legal environment or when the same model is applied to a variety of industries.

In reality, it is not easy to calculate accurate figures of profit or loss resulting from the stability of the legal environment for an entire society, but a test estimating a rough ceiling of loss that might be caused by the improper application of the rule of law in a particular circumstance might be a valuable indicator for investors.

Robert Hahn et al. suggest a cost-and-benefit approach to examine the enactment of regulations; they apply it to the question of whether legislators should prohibit drivers from using cellphones while driving in 2001 and 2007.

Subject to assumptions and adjustments, such an approach might provide investors with a general idea about how much the application of the rule of law affects profitability by applying the analysis to judicial matters.

2. Cost-and-Benefit Analysis for Legislation

Since the late 1990s, several states in the US have prohibited drivers from using their cellphones while driving (or have required the use of a hands-free device). Clearly, if cellphone use while driving was prohibited, the number of accidents (and the amount of loss) would be reduced.

However, Hahn et al. were not satisfied with—and did not dispute—the simple conclusion that such a regulation would cause a net reduction in accidents; instead, they addressed the issue of whether such benefit was valued more than the costs associated with the regulation.

Unlike an income statement from a business entity, there is no profit and loss itemization in an accident. Thus, Hahn et al. undertook a series of assumptions to estimate the economic effects of the regulation coming into force.

They considered the benefits of people using cellphones as the cost of the prohibition. They arrived at a valuation of the cost by multiplying the value of people using cellphones by the percentage of time that cellphones are used when driving; this figure was determined to be approximately USD25 billion.

Next, they estimated the benefits of prohibiting cellphone usage when driving by adding together insurance compensation from accidents for death, personal injury and property damage and multiplied this figure by the percentage of these accidents that were associated with cellphone usage, which totaled approximately USD4.6 billion.

The authors concluded that it was not economically efficient to prohibit cellphone usage during driving because losses from accidents were far outweighed by the value of cellphone usage by drivers.

In 2007, Robert Hahn and James Prieger conducted tests to generate updated data on this same topic. The difference between the costs and benefits in the 2007 article was not as extreme as that of the previous study, but the authors stressed that lawmakers should consider the economic effects of such legislation in addition to considering that such regulations might reduce loss generated by traffic accidents and save human lives.

3. “Legal Risk Discount” Analysis for Judiciary

It may not be accurate for Hahn et al. to use a subjective valuation of consumer benefits as a cost of regulation. It might also anger certain segments in the general public to use economic efficiency as an argument when human life is the counterbalancing cost. However, the authors offer an important contribution by showing that support for (or objection to) a law is much stronger when universal valuations can be made with an economic efficiency analysis; the same applies to an analysis of the rule of law.

The foundational difference between Hahn et al.’s analysis and traditional risk-factor pricing is that it expands use of risk evaluating from investment project decisions to the market environment as a whole. In this circumstance, individual investors may not charge a premium to compensate their uncertainty when entering a high risk project. Nonetheless, this method provides a clear concept for the government to estimate potential economic losses stemming from the laws that it adopts.

Additionally, it should be easier to achieve an accurate conclusion about the effects of judicial matters on investment than the original attempt by Hahn et al. to provide a rationale for legislators to impose (or not impose) a regulation on society.

First, in terms of statistics, greater variance typically indicates less certain results. One test on a single project should involve more certainty than legislative matters that involve a multitude of factors covering an entire country.

Second, even if Hahn et al. correctly estimated that the benefits of cellphone use are much greater than the costs of death, personal injury and property damage suffered as a result cellphone use in accidents, it may be inherently objectionable to value the loss of life (or sustainment of injury) in terms of economic efficiency.

In an investment decision, however, there is only the indicator of profitability to show investors that they should not enter a market if the costs from legal risk exceed the potential profits they may earn. Economic efficiency that is reflected in profit making is already the dominant concern for investors (if not the only concern). It is more reasonable to apply the conclusions of a cost-and-benefit analysis to an investment project analyzing the judicial environment than to apply the same analysis to cell phone usage per Hahn et al.

The most important point is that the results of the cost-and-benefit analysis are a tool for investors to use to make an investment decision and is also strong evidence for the government to understand that investment may be discouraged if the rule of law is not consistently applied.

However, the identical cost-and-benefit analysis of Hahn et al. cannot be strictly applied to the question of the rule of law.

For example, at the state level, the cost to the investment environment when the government shows undue influence to favor domestic companies with lower efficiency is that a higher-efficiency company does not secure a contract or the market. Thus, it does not constitute “benefit” when a local entity is awarded a project for political influence because its lower productivity is engaged in a zero-sum game with the higher-efficiency firm, which means increased cost.

As discussed above, it may be too complicated to estimate efficiency for an entire society when it involves many variables that may cause statistical problems. Therefore, the test below focuses only on firm-level loss when a company is rejected in a market for non-economic reasons, such as protectionism—a legal “discount” on a firm’s profitability.

3.1. The Test Case

The merger and acquisition application from Coca Cola for Huiyuan Juice (2009) is selected as the test case for several reasons. First, this case involves a foreign entity attempting to enter the Chinese market by acquisition and failing for judicial reason. Second, the data about the matter is relatively accessible because the parties involved are listed companies who must publicly release certain financial information. It is an ideal circumstance to estimate the costs of legal uncertainty caused by the government in a new market. Third (and perhaps most importantly), it is a case in which foreign analysts questioned the rule of law in China.

It is impractical to assume that the risks from the legal environment cause the same costs in all industries. The following case may provide a general idea of how investors might estimate the costs attributable to an uncertain legal environment quantitatively instead of looking for a certain figure that is generalizable for all users.

The analysis in tomorrow’s piece is an example of how an investor (in this instance, Coca Cola) estimates the profit loss in a single project if its application for merger and acquisition is rejected. It does not conclude that the decision by the MOFCOM disapproves the application because of political concerns or that Coca Cola would become dominant in the market if the proposal is approved; instead, it merely calculates the maximum possible loss caused by uncertainty in the legal environment.