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Monday, December 21, 2015

The FTC Opens the Hood

Ruggles December 2015

I hadn’t intended to write this as a standalone piece. And I am guilty of using the title to the post, published on the Federal Trade Commission website: The FTC Opens the Hood

I wrote a lengthy piece on their site rebutting some of the assertions made by authors Tara Isa Koslov, Office of Policy Planning, and James Frost, Bureau of Competition. For some reason, as of this writing, the FTC has chosen not to publish my comments in reply to their original post. So here we go, point by point.

The FTC: For many of us, the holiday season involves at least one loooong automobile ride. We travel over the river and through the woods in our beloved cars, our trunks stuffed with presents for family and friends. Today, the way we buy those presents and the way we buy the car that carries them look very different. While the retail landscape has changed dramatically in the last 50 years, the system of automobile sales in the United States has stayed mostly the same. Are consumers benefiting from the current distribution system for automobiles or are changes needed? In an upcoming public workshop, FTC staff will explore this question and related issues, with a focus on the regulatory environment governing automobile distribution.

Frost and Koslov seem to be saying they are puzzled by the fact that a consumer can buy Christmas gifts, toys, jewelry, gadgets, etc. while buying a vehicle involves having to go to a car dealer, a process they seem to think is “antiquated.” One wonders if they realize that buying a vehicle involves trade-ins with negative equity, complex financing issues based on a myriad of credit scores and the associated “tiering,” debt to income ratios, loan to value issues, state inspection and registration issues that impact state sales tax issues, not to mention service after the sale issues. One can’t exactly package up one’s new car and mail it back to the factory to get a window leak repaired.

If people start paying for the new vehicles with credit cards, the cost of using the card will be passed on to them. In many cases, the credit card fees are more than the financing interest and it would be paid up front. Maybe they are unaware of this or think it is a small deal. This morning I ordered a new printer from Amazon. There were no financing issues. I paid for it by credit card. There was no trade in because they don’t accept trade-ins. Besides, the cost to ship my old printer back exceeds its value. No tax was collected. I confess I might be tempted to mail order a new vehicle if I could avoid paying sales tax on it, but I might have a difficult time getting my state to issue me license plates if I haven’t first paid sales tax.

Bottom Line: There are many issues to be considered. One wonders if these two authors have any real understanding of the good reasons things are the way they are and aren’t outmoded at all. But there’s more, so we’ll proceed.

What did the broader retail marketplace look like in 1965? There were no big box stores, the suburban shopping mall was a novelty, and consumers ordered from paper catalogs to purchase goods not available at their local retailer. A time-traveling shopper from 1965 would be shocked at how easily one can now browse an almost unlimited selection of merchandise online, purchase it instantly, and arrange for it to be gift-wrapped and shipped virtually anywhere in the world – all without even getting off the couch.

As a practical matter, it IS technically possible to order a new vehicle without getting off the couch. In fact, it used to be commonplace for auto buyers to be on a year to year, or every two years, trade cycle. All they had to do was pick their colors and equipment. Because the dealer knew how they took care of their car, and because he/she had done the service and warranty work on the car, it was easy to assign a value. So what complicated things over the years? A higher number of consumers today have much more complex financing issues than “back in the day.” The advent of rebates and incentives have further complicated things along with the current lack of consumer loyalty caused by a plethora of reasons, led by the fact that today the options available to consumers is mind boggling. The days of the Big Three are long past; in Boston, a Nissan dealership faced dealerships selling 14 other brand within a 10 mile radius. (Automotive News Dec 21, 2015)

In contrast, purchasing a new automobile today works pretty much the same way it did in 1965. Most consumers still buy new cars through franchised, independent automobile dealers. During an in-person transaction, they haggle over the price of the car, the value of a trade-in, and other terms of sale.

Except for the fact that there are many more vehicles to choose from, financing terms have gone from 12 -36 months then to 60 – 94 months today, there are complex rebates and incentives to digest, the credit system is much more complex, there is much more negative equity, and that’s just the beginning of the list. Then, as now, consumers WANT to haggle. They absolutely want to “play the game.” Then, as now, they want to be guaranteed a “win.” They’d like to be guaranteed a “win” when they negotiate a real estate deal, too. They would like to be guaranteed that after buying a new vehicle, a piece of jewelry, a boat, furniture, or other expensive purchases, they do not find out that someone else got a better or deal, or that the item went on sale the day after they made their own purchase. Perhaps the FTC wants to get involved in that?

Few people entering a new car showroom realize that their state government plays a major role in determining how all this works. In every state in the union, the relationship between the dealer who sells the car and the manufacturer who made it is extensively regulated. State legislators and regulators determine whether a manufacturer can add new dealers or terminate under-performing dealers, and even whether a dealer can move to a new location. In many states, only independent, franchised dealers are legally allowed to sell new vehicles.

Now here is where the FTC authors really go off the rails! Yes, the relationship between the auto OEM and the dealer is extensively regulated. There are very good reasons why this is the case. From the beginning, auto OEMs needed the capital, expertise, and local relationships of business people to create a distribution network. Between real estate, buildings, repair bays, and new and used inventory the capital to accomplish this is daunting, to say the least. That was the beginning of it. It is frankly impossible for an auto OEM to muster the resources to stay ahead of the design and technology curve while directing cash reserves toward buying expensive commercial property and trying to operate retail sales and service points. Tesla seems to want to attempt this and ultimately the market will determine whether or not it works out for them. More on the Tesla situation later.

The FTC authors failed to mention that it was the need on the part of the auto OEMs to establish retail networks that caused them to recruit local business people and set them up as dealers. This was done using a document commonly referred to as the Sales and Service Agreement, or “Franchise Agreement.” After all, what rational business person would make a significant investment without some guarantees from their supplier? For example, they might want a protected sales territory. Imagine an auto OEM coming to you and saying, we want you to build us a really nice facility on a major thoroughfare using your money while we reserve the right to sell direct to consumers in your area, thereby cutting you out or reserving the right to place another dealer in the same area to sell to the same market. Only idiots would invest money under such circumstances.

So the auto OEMs freely offered terms a local business person would require to make such an investment. State government had nothing to do with this. Now the auto OEMs wrote the sales and service agreements in such a way as to reserve as much overage on the dealers as possible. An individual dealer going up against a deep pocketed auto OEM wasn’t workable. Dealer abuses by auto OEMs were ubiquitous, led by Henry Ford, who thought investors and dealers were “parasites.” As a consequence, dealers banded together in trade associations to allow them to effectively fight abuses perpetrated by the auto OEMs. And this was an issue in all franchise systems: overfranchising, threatening non-renewal, imposing new franchise terms ex post, favoritism and even extortion.

A lot of the dealer abuse issues took place at the regional levels where District or Area executives often ran their territories like personal fiefdoms. I recall once being placed on the area “Sh*t List” because I refused to but a $2K brochure rack along with special signs for the restrooms. Well, the dealership I operated housed 4 franchises. Imagine having 4 signs on the door of each toilet to satisfy facility “requirements” by all of my OEMs. When a new district executive for that OEM took over, I was off the “Sh*t List.” Imagine a regional executive has a buddy who wants your store. The executive starves a dealer of product, driving him/her out of business so his buddy can pick up the pieces for a song. The list of abuses is long; older readers may recall that over a dozen Honda sales executives were indicted for soliciting kickbacks in return for allocating hot-selling vehicles to dealers (Automotive News March 21, 1994). Dealers don’t have to be concerned about these things anywhere near as much as they once did.

Of course franchisees weren't angels, either. Other state laws came about to protect good dealers from bad dealers as well as protecting consumers. Back in the day, there were no real dealership requirements. A dealer with no facility might sell cars out of his briefcase. More recently, new car dealerships might be a trailer on a gravel lot. When I was in college, the local Saab dealer was a college student selling Saab Sonnets out of his dorm room. Here today, gone tomorrow new car dealers didn’t make consumers happy. A real dealer with a real facility wasn’t happy to have to compete against someone operating out of the trailer on a gravel lot. Hence, state regulation.

The premise that consumers are prevented from buying new vehicles directly from an auto OEM because of dealer lobbying at the state level is blatantly false. The reason is because auto OEMs needed to create a dealer network because they didn’t have the capital or expertise to do it themselves, so the used the Sales and Service Agreement to make the deals they needed to make to get what they wanted. They still lack the capital to own their own dealer network. But for car companies who think that isn’t a problem, all they have to do is to buy out their current dealers when their current Sales and Service Agreements expire, then refuse to renew them. Once word gets out that an auto OEM is employing such a strategy, their dealers will be looking around for other products to represent.

The next paragraphs from the FTC post at least mention some of the reasons the state regulations exist:

Some of these state regulations have been in place for decades and reflect the long history of the American automobile industry. As far back as the 1930s, dealers were concerned that once they made major investments in buildings, inventory, parts and the like, they would be effectively at the mercy of the manufacturer with which they were affiliated. Historically, manufacturers exploited this bargaining asymmetry in a variety of ways. These abuses led dealers to appeal to their state legislatures to seek protection. For the most part, these protections persist in every state, as does the heavily dealer-oriented automobile distribution system.

Some industry stakeholders maintain that the traditional distribution model benefits not just incumbent dealers, but ultimately the car buying public as well. They note the benefits of placing inventory close to the consuming public and the ability to obtain high-quality warranty service as key benefits of the existing distribution model. Other stakeholders, however, urge greater scrutiny of potentially outdated regulations that may, over time, make it more difficult for car manufacturers to experiment with alternative distribution methods that do not rely entirely on dealers. Many economists argue that it is inefficient and unnecessary for states to tightly regulate private distribution arrangements, rather than allowing market forces to determine the mix of distribution models.

Ford famously attempted to operate its own sales points through its failed “Ford Collection.” In 1998 Ford bought up all of the sales points in Tulsa, Salt Lake City, Indianapolis, and San Diego. They operated these dealerships in accord with consumer survey results on the new vehicle purchasing process, which proved a disaster. More relevant, Ford set fixed prices in these cities, permissible because all sales points in the market were under the same owner. Consumers still felt put upon because the trade-ins still had to be “haggled” as did finance terms. The Internet hasn’t changed that. Now the FTC gave the Ford Collection (and Saturn) a pass on “price fixing.” In contrast, it's a felony if independent auto dealers get together to fix prices – as auto parts suppliers have recently been reminded, with convictions of over 20 executives and $2 billion-plus in fines.

Ask yourself what might happen if an auto OEM bought up all of its sales points in a particular market, then started selling direct to consumers, delivering new vehicles all over the country. In theory, it could be done from a single factory owned store as long as that store could get licensed as a dealer in a particular state. Would that OEM not be violating its own Sales and Service Agreements? This would have nothing to do with state franchise laws. Imagine the auto exec that started such an initiative. Imagine the dealer upheaval. Imagine the lawsuits based on the violation of the Sales and Service Agreements. Imagine the drop off in sales. Imagine that executives head rolling on the floor. Recall Jacque Nasser, the architect of the Ford Collection, who was summarily fired for that mistake (among others).

Now we get to Tesla. It is unimaginable to me that the FTC is suggesting that auto OEMs violate their own Sales and Service Agreements. Perhaps the FTC is suggesting that Tesla be allowed to distribute its cars however it wants to. Actually, except for a few states, it is. And I’m fine with that except if state law mandates a dealership sales point also include a service department. If the state wants to change that law for all dealers, not just for Tesla, I’m also fine with that. If Tesla discovers that the “inventory buffering” and “production smoothing” that other auto OEMS find helpful is also a benefit to them, they will need to convert to the traditional model. In such a case, it is doubtful that Tesla could raise money from business people without assurances to those business people such as those included in a rather standard Sales and Service Agreement.

So far, as a boutique producer, Tesla has managed to balance the equilibrium between supply and demand quite well. That won’t last forever. We’ll know they’re a real car company the first time they have to deal with excess supply; so far demand has exceeded their ability to produce. What will they do when they are faced with shutting down assembly and furloughing employees, while trying to figure out what to do with the incoming stream of parts they contracted for? Or will they continue to build cars and stack them someplace waiting for demand to return, a costly move if there ever was one! Having a dealer body to sell those cars to would come in handy. That’s when Tesla will have to figure out who their real customer is. So far it has been end users. With the traditional auto OEMs, however, their customer is their dealer body. And with their dealer body, they get paid for the newly produced new vehicle immediately after it rolls of the assembly line. Often, the auto OEM gets paid not long after a VIN is generated. Rest assured, Tesla will learn those lessons at some point. I’m happy to see the market sort that out.

On January 19, 2016, the FTC will convene a one-day workshop where a large group of seasoned experts will discuss these issues in greater detail. Workshop participants will explore how state-based laws and regulations governing automobile distribution may affect consumers and competition, whether and to what extent the policy justifications that motivated these laws continue to be of concern, and whether less restrictive alternatives to the current system of extensive state regulation might satisfy legitimate policy goals while promoting greater competition and innovation.

I wouldn’t miss it for the world. If nothing else, I want to ask why my contribution wasn’t posted after it was submitted to FTC for “moderation.” It will be interesting to find out if the authors speak for the FTC or if are only expressing their own opinions. There are more than a few “journalists” who have written pieces, after reading other opinions from these same authors, that believe FTC supports auto OEMs competing with their own dealers against their own Sales and Service Agreements. Perhaps the authors will be present to answer the question directly.