auctions with an incumbent's right of first refusal

Shelley,

My colleague, Clayton Vernon, who has a background in economics, wrote a
short summary of arguments
against the ROFR.

We are working on the second approach to the problem: we try to come up with
a numerical estimate of the
value of this option. The fact that an incumbent shipper has this option has
distributional consequences:
he has something of value he never paid for. Having a numerical estimate of
the value of this option
could help to argue against it. The value of such an option is case specific;
so we shall rather
produce a template you can use for valuation case by case.

Vince Kaminski

---------------------- Forwarded by Vince J Kaminski/HOU/ECT on 01/20/2000
08:34 AM ---------------------------

Clayton Vernon@ENRON
01/20/2000 08:29 AM
To: Vince J Kaminski/HOU/ECT@ECT
cc: Stinson Gibner/HOU/ECT@ECT, zlu/HOU/ECT@ECT
Subject: auctions with an incumbent's right of first refusal

Vince-

Here is an essay on the issue you are discussing:

The Adverse Economic Impact of "Rights of First Refusal"

An option to "first refuse" to match a competitor's offer is a restraint of
free trade and an impediment to efficiency in the marketplace. This economic
conclusion is unambiguous.

If an "incumbent" has the right to match an offer made by a competitor, for
an item or service of value, then few competitors will invest the time and
expense necessary to prepare and submit offers, those offers will be lower
than they would have been otherwise, and the contract will often be awarded
to an inefficient incumbent instead of a more efficient challenger.

In a traditional auction, where all bids are sealed and the item up for
auction is awarded to the highest bidder, we can safely predict the item will
be awarded to the bidder who values it the most, at a price reflecting the
full value of the item up for auction. This is the efficient result in a
market economy, because the financing of the high bid reflects resources
freely allocated to the high bidder. If the auction has open bids, we can
again safely predict the item to be awarded to the correct bidder, albeit at
a slightly lower price to the donor of the item since the bidder with the
highest valuation can simply increment by an infinitesimal amount the
second-highest valuation.

Now, in a modified auction, where an incumbent bidder has the right to match
the highest bid and retain the item for himself, each competing bidder must
justify his own due diligence and bid preparation expenses against the
following, and likely, scenario: the incumbent does not spend himself for due
diligence, but instead uses these savings to help finance his matching the
top bid from a competitor.

Simply put, the incumbent with a "right of first refusal" can be safely
predicted to simply match their competitor's bid by "rule of thumb." But the
incumbent's valuation of the item up for auction can be less than the
valuation of the competitor, by the amount of the due diligence and
administrative expenses. And, the incumbent firm expropriates the expertise
of his competitors, not only in their valuations themselves, a nontrivial
financial exercise, but in any operational details required to be submitted
along with the bid.

Furthermore, in an esoteric concept known as the "Winner's Curse," a bidder
realizes that if his bid actually prevails, if the incumbent fails to match
it, he almost certainly overbid.

Given this, most competitors will not even bother to bid in an auction when
an incumbent has the right of first refusal, and those that submit a bid do
not rationally invest the time, expense and expertise necessary; they may
just "fire off" a "low-ball" bid. After all, in almost every conceivable
"state of the world" arising from the auction the competitors expect to lose
money. So, the incumbent almost always retains the contract at a
below-market price, despite the incumbent not necessarily placing the highest
value on the contract because the incumbent cannot put the contract to its
most efficient use.