Message-ID: <18890291.1075856778377.JavaMail.evans@thyme>
Date: Thu, 20 Jan 2000 00:39:00 -0800 (PST)
From: vince.kaminski@enron.com
To: shelley.corman@enron.com
Subject: auctions with an incumbent's right of first refusal
Cc: stinson.gibner@enron.com, zimin.lu@enron.com, vince.kaminski@enron.com, 
	clayton.vernon@enron.com
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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.
