Author: karlhenriksmith

A Framework for Managing Key-Person Risk

~ karlhenriksmith

In the days leading up to Adam Neumann’s ouster as CEO of WeWork in September, theories around WeWork’s corporate governance were in full swing. Neumann’s move to cash out $700 million of his holdings compounded a series of absurd decisions, including a reorganization earlier in the year where the company paid its own CEO $5.9 million for the “We” trademark, granted Neumann loans to buy properties WeWork would then rent, and hired several of his relatives. While this saga demonstrated a serious lack of accountability and an unsustainable governance structure, it was also reflective of an increasingly common notion in organization theory: key-person risk. 

According to The Economist, key-person risk occurs when “an individual’s presence, absence, or behaviour disproportionately affects a firm’s value.” The loss of a key person could prove to be a firm’s biggest liability, affecting everything from company finances to its image or investor confidence. In WeWork’s case, the company’s S-1 acknowledged that if Neumann were absent, it could have a material adverse effect on the business. It went so far as to state that Neumann was “critical to our operations” and “key to setting our vision, strategic direction, and execution priorities.” In November, WeWork laid off almost 20% of its global workforce.

At WeWork, key-person risk did not originate solely from the founder’s charisma or strategic vision. The governance structure permitted it; from the S-1:

From the day he co-founded WeWork, Adam has set the Company’s vision, strategic direction and execution priorities. Adam is a unique leader who had proven he can simultaneously wear the hats of visionary, operator and innovator, while thriving as a community and culture creator. Given his deep involvement in all aspects of the growth of our company, Adam’s personal dealings have evolved across a number of direct and indirect transactions and relationships with the Company. […]

Adam controls a majority of the Company’s voting power, principally as a result of his beneficiary ownership of our high-vote stock. Since our high-vote stock carries twenty votes per share, Adam will have the ability to control the outcome of matters submitted to the Company’s stockholders for approval, including the election of the Company’s directors. As a founder-led company, we believe that this voting structure aligns our interests in creating shareholder value.

WeWork’s multi-class stock structure, in conjunction with Neumann’s delusions of grandeur and his complex web of personal and professional dealings as CEO, were emblematic of key-person risk. Companies operating with such a practice concentrate outsize power to their founders and early employees under the assumption this ensures prioritization of long-term objectives. But it may also make management less accountable to shareholders. According to the CFA Institute, a dual-class structure may “reduce the oversight of public, unaffiliated shareholders who have the majority of the economic stake but a minority of votes,” but can vary in nature.

Alphabet and Omega

Take Google’s parent company Alphabet, whose co-founders Larry Page and Sergey Brin stepped down on December 3rd. On the news of their departure, Alphabet’s shares rose slightly. And yet, Page and Brin will continue to have effective control over the company, remaining on the board with a majority of voting shares.

The co-founders’ gradual (and well-documented) disappearance from operations at Alphabet has deterred any potential over-reliance on them as key executives. The same cannot be said of Google CEO Sundar Pichai, who is succeeding Page and Brin at the helm. Pichai will be simultaneously the company’s largest asset and liability:

  • Whereas Pichai was previously head of the core search engine operations, he will begin overseeing new and emerging segments of the business, from driverless cars to AI and life extension technology. Since the core business accounts for 85% of the company’s sales, Pichai has over the past few years been more of a “key person” within Alphabet than either of its founders.
  • A fundamental reworking of the culture could be in order following a series of internal protests at Google around claims of harassment, civic and labor rights, executive mismanagement, and a number of contentious hires. Most of the organizers of the Google Walkout have since resigned. Pichai’s handling of the crisis will set the tone.
  • Looming antitrust investigations around Google’s ad business and YouTube’s financials will raise questions around the company’s anti-competitive practices. Pichai, who has already testified in Congress on issues ranging from data privacy to political bias, will undergo even greater scrutiny as CEO of the parent company.

It’s difficult to lump in Pichai with typical examples of key-person risk. He has been called “very cautious” by coworkers, known for his steady management style. But those qualities may also be characteristic of stagnation; from FT:

The new Alphabet chief is not without an idealistic streak. A committed globalist, he is deeply interested in technology’s potential to transform countries such as his native India. But taming the worker upheaval is a priority. Employees may have believed they have “signed up for a movement,” but the company is becoming a far more conventional place to work, one former Googler said. […]

Internally, Mr. Pichai is a known quantity and not expected to make significant changes. That could make him different from Mr. Nadella, who pushed Microsoft in a new direction.

Pichai may nonetheless experience a situational type of key-person risk, being put in a position where he becomes indispensable to Alphabet irrespective of his performance. Manu Cornet, a software engineer at Google, famously illustrated the differing management styles at top tech companies in his 2011 comic “Org Charts” (cited by Satya Nadella in Hit Refresh as one of the drivers for changing the culture at Microsoft).

With Brin and Page exiting stage left, Alphabet’s organizational chart should be updated to reflect a more archaic structure, short of a rigid Amazonian hierarchy. In addition to the core business of search, mobile, hardware, and cloud services, Pichai’s focus will extend to a slew of more obscure and long-term projects, including DeepMind AI, Calico (health and wellness), Sidewalk Labs for urban infrastructure, and more. Control over all these entities will make Pichai an indispensable presence, for better or worse.

Achievement Unlocked

Taking the above into account, I propose the following framework for identifying and managing the variants of key-person risk.

To avoid dependency risk, organizations need to create a governance structure that is simultaneously accountable, fluid, and transparent:

  1. Accountability: Organizations often fall prey to key-person risk by proactively enabling senior leadership and failing to implement a proper mechanism for checks and balances. Carlos Ghosh, the former chairman of the global alliance between Nissan, Renault, and Mitsubishi is one such example. Ghosn, who is currently on trial for financial misconduct and leveraging corporate resources for personal gain, was considered an irreplaceable maestro without whom the empire would crumble. Other structures are also responsible for unaccountable leaders; for instance, dual-class share structure can erode corporate accountability in certain cases by watering down shareholders’ voting power.
  2. Fluidity: The most effectively run organizations are prone to a more detrimental type of key-person risk: executive lock-in. If organizational culture is fluid, it creates a structure where managers are easier to remove when they start making poor decisions. Jack Ma, who stepped down as Chairman of Alibaba in September, understood this; he contends that the right system is one with a robust leadership system “that can create, can make, and can discover, can train a lot of leaders.” Daniel Zhang, Ma’s successor as executive chairman, argues that the best succession plans are those that ensure a leader will fight for the vision, mission, and values of a company.
  3. Transparency: When leaders are not transparent with their board, their employees, or the public at large, they create developmental hurdles. The concentration of knowledge to a single person inhibits organizations from adapting to industry trends. If a business is opaque or financially complex (i.e. SoftBank), a key-person could have tacit knowledge that makes them vital to operations. Jony Ive’s departure from Apple demonstrates the inverse scenario: the loss of institutional knowledge.

Let’s take each one in turn.

Accountability

The first is when an individual with a lot of influence (i.e. control over a majority of voting rights) fails to spread responsibility, lacks accountability, and appoints feckless subordinates. Facebook finds itself in this predicament, with Mark Zuckerberg controlling nearly 60% of voting rights and unwilling to make changes to the firm’s governance structure.

In its Oversight Board Charter released in September, the social media giant set forth some parameters for its board composition, the main purpose of which would be to “protect free expression by making principled, independent decisions about important pieces of content and by issuing policy advisory opinions on Facebook’s content policies.” Ideally, this would raise transparency and clarity around the reasoning for decisions relating to content; from the Charter:

Members must not have actual or perceived conflicts of interest that could compromise their independent judgment and decision-making. Members must have demonstrated experience at deliberating thoughtfully and as an open-minded contributor on a team; be skilled at making and explaining decisions based on a set of policies or standards; and have familiarity with matters relating to digital content and governance, including free expression, civic discourse, safety, privacy and technology.

And yet, none of this oversight is more democratic than before. The charter represents a firewall that shields the company’s executives from scrutiny. The board’s responsibility will instead be to issue recommendations around policy that Facebook can choose to support, but only “to the extent that requests are technically and operationally feasible and consistent with a reasonable allocation of Facebook’s resources.” It’s largely toothless and does not intend to make the firm more accountable.

Fluidity

A second variety of key-person risk occurs when a leader excels in their role. While this type of leadership can improve performance, the dependency risk that results may prove detrimental to both the succession process and long-term sustainability of a business. But this can be avoided if the governance structure is fluid and adaptable. In Microsoft’s Momentum, I argued that Satya Nadella’s tenure represented a shift in both culture and priorities:

Culture is what allowed Microsoft to become a dominant player, cementing Windows as the only clear option for enterprise IT managers. But the same exact assumptions that allowed Microsoft to scale – that it would (with its unmatched resources) inevitably develop a superior solution, or continue leveraging its Windows dominance into the end of days – later constrained its ability to make a directional shift when required. By looking beyond their golden goose and betting instead on a cloud-based future, Nadella precipitated Microsoft’s revival.

The sagas resulting from this dependency risk have made good fodder for screenwriters. One example of this is HBO’s Succession, a dark comedy (with tones of King Lear) that follows an obstinate patriarch, Logan Roy, the CEO and founder of an international media conglomerate, Waystar Royco. Facing declining health, Logan contemplates the future of his business and ultimately decides not to step down, thwarting several family members in the process.

Succession is reminiscent of the winding path to power at real-life media businesses, and the role of managing key-person risk in boosting confidence. Sumner Redstone, the media mogul who was formerly executive chairman of CBS and Viacom, oversaw the break-up of the two companies in 2006, declaring that the age of the diversified media conglomerate had come to an end. Over the past few years, his daughter Shari (now the chairwoman at ViacomCBS) has attempted to remerge the businesses on several occasions, but received significant pushback. The merger was completed on December 4th.

Transparency

The third – and most nuanced – variant of risk affects companies with a governance structure so complex that a singular perspective is required to maintain confidence. While WeWork tried to frame itself in this lens, I believe that their unaccountable executive places them squarely in the first category. Instead, it is WeWork’s main investor, Masayoshi Son of SoftBank (colloquially known as Masa), who fits this description.

Over the past few years, SoftBank has been characterized by a series of poor judgments. The Vision Fund raised $45 billion from Saudi Arabia in spite of global scrutiny around their human rights record, and several of its high-profile bets – WeWork, Uber, Slack – have seen mounting losses. Masa himself has been accused of recklessness on conference calls, alternating from charming one moment to enraged or demanding the next; from FT:

The technological evangelism of Mr Son divides opinion. “He is a visionary,” says Dan Baker, an analyst at Morningstar who rates the company a buy. “He is extremely bullish and rarely mentions negatives. Investors are wary of what is not being talked about.”

These include “complexity, opacity, and leverage,” according to Chris Hoare of New Street Research. Even compiling a sum-of-the-parts valuation – a simple exercise for most conglomerates – is tricky for SoftBank. But the discount between the impressive value of the group’s investments and its lowly Tokyo-listed shares is over 60 per cent, according to FT analysis of S&P Global data.

The chasm is hardly flattering for Mr Son. It implies his investment skills – or a perceived lack of them – have a negative impact equivalent to $148bn. The boss of a quoted private equity company could be fired for a discount as big as this.

Masa also invests in founders who are risk-seeking and erratic (much like himself), which can sometimes be an asset: his first bet of $20 million in Alibaba’s Jack Ma paid off. But this does not necessarily make for a good governance structure. In a recent CNBC interview about the pervasive effect of SoftBank on the technology space, Masa claimed the company is “just a small startup,” albeit one with 100bn at their disposal. 

Concerns have been raised around SoftBank’s lack of transparency. Masa rarely addresses negatives, such as the gap between the value of SoftBank’s investments and the price of its shares – which, alongside years of poor returns, have soured investor confidence around the company’s $100bn Vision Fund (and its successors). In spite of all this, investors would likely panic if Masa were to resign. As with unequal voting rights, financial complexity can entrench leaders in an organization. In the case of SoftBank, it has provided Masa with significant job security.

Tech Absolutism and Political Advertising

~ karlhenriksmith

Last month, Twitter’s CEO Jack Dorsey announced the company would ban political advertising across the entire platform. He listed several reasons for the policy, including how political ads are detrimental to organic reach, can create risks in the voting process, and are purveyors of false or misleading information. The policy, which comes into force today, applies not only to candidate ads, but also issue ads – to a point. Dorsey argued that issue ads could allow ad buyers to circumvent Twitter’s objective: to ensure that reach is earned, not bought.

Although there was initially broad support for Twitter’s decision to ban political ads, concerns remain. The examples of legislative issues provided by Twitter, including taxation, gun control, social security, and trade, will never be fully exhaustive. In Facebook, the EU, and Election Integrity, I argued a similar point in the context of the European Parliamentary elections: that subjectively-defined issues will always vary depending on the country in question, given the vastly different legal and regulatory regimes involved:

This rollout extends beyond campaign ads by including issue ads: relevant, important, or highly-debated topics like get-out-the-vote campaigns, ballot initiatives, or referendums. To prevent foreign interference in the EU Parliamentary elections, Facebook requires that all political advertisers go through a country-specific authorization process wherein they submit documents that run technical checks to confirm identity and location.

One shortcoming of this framework is the seemingly arbitrary process according to which issues of national importance are chosen, and how to determine if the parameters are too restrictive or too broad. Facebook’s current list for the EU’s top issues – which it admits is subject to change – includes six topics: immigration, civil and social rights, political values, security and foreign policy, the economy, and environmental politics. In contrast, the equivalent list for the US contains more than twice as many issues of importance, going to show the opaque nature of how political issue ads are chosen and defined.

In Facebook’s case, the same core problem resurfaced: how to identify which ads are political. If the main issue is paid political reach, Twitter’s approach of restricting political action committees (PACs), Super PACs, and 501(c)(4)s from advertising on its platform seems like a sensible one. But if the objective is to solve broader societal challenges like misinformation and restoring civic discourse (apparently also a motivation for the decision), Twitter’s political ad ban is misguided at best. Corporations, nonprofit organizations, and other ‘apolitical’ actors will continue paying for reach and effecting long-term change over legislative outcomes.

That’s not to say there haven’t been efforts already to address the lack of transparency around political ads. In 2018, Twitter launched the Ads Transparency Center to provide its users with insights into ads, with details like spend, number of impressions, and targeting demographics. But issue ads fell under a separate policy. Vijaya Gadde, Twitter’s global lead for legal, policy, and trust and safety, argued this would allow Twitter to achieve a more “nuanced approach to transparency that is mindful of the inherent difference between political and issue-oriented advertising campaigns.”

It’s important to consider the extent to which Twitter’s political ad ban is a direct result from the company’s inability to deliver that nuanced approach. Before the ban, Twitter’s ad policy read as follows:

Political Content: Twitter permits political advertising, which includes political campaigning and issue advertising, but there may be additional country-level restrictions. In addition to Twitter Ads policies, all political content must comply with applicable laws regarding disclosure and content requirements, eligibility restrictions, and blackout dates for the countries where they advertise.

An advantage of the new policy for Twitter is that it will no longer have to police country-level restrictions. Instead, it can remove any content that “references a candidate, political party, elected or appointed government official, election, referendum, ballot measure, legislation, regulation, directive, or judicial outcome.” This definition is broad, vague, and ultimately bolsters Facebook’s argument: that it should be up to the government, and not social media executives, to set the parameters around content restrictions.

Issue Ad-dendum

One of the grey areas around Twitter’s political ad ban is the extent to which it would apply to issue ads, and what constitutes an issue ad. When prompted on this question, Gadde provided the following definition:

  1. Ads that refer to an election or a candidate, or
  2. Ads that advocate for or against legislative issues of national importance (such as: climate change, healthcare, immigration, national security, taxes)

There are naturally caveats to this. Ads supporting voter registration will be permitted, alongside what Twitter has called “cause-based advertising,” or issue ads by another name. These ads will be restricted and not prohibited, the argument goes, because they can be effective tools in the proliferation of civic discourse and outweigh many of the related challenges (microtargeting, misinformation, etc.). This was outlined on Twitter’s updated content policy page:

Twitter restricts the promotion of and requires advertiser certification for ads that educate, raise awareness, and/or call for people to take action in connection with civic engagement, economic growth, environmental stewardship, or social equity causes. We have made this decision based on the following two beliefs:
• Advertising should not be used to drive political, judicial, legislative, or regulatory outcomes; however, cause-based advertising can facilitate public conversation around important topics.
• Advertising that uses micro-targeting presents entirely new challenges to civic discourse that are not yet fully understood.

This raises some thorny issues. First, if scientific concepts like climate change are defined as legislative issues, it could give weight to arguments denying its existence, creating a framework that moderates ads according to political disagreements in a specific country rather than factual contributions. This could lead to incumbency advantage by favoring representatives or existing legislation over their challengers and alternate proposals. Climate initiatives of a journalistic or multilateral nature could fall by the wayside in the U.S. while being acceptable in many other countries.

A second concern is where to draw the line around corporate ads. Twitter outlines the following restrictions around the advertisements of for-profit organizations: 1) they should not have the primary objective of “driving political, judicial, legislative, or regulatory outcomes” (whether this occurs incidentally is seemingly unimportant), and 2) advertisements must be tied to the publicly stated principles or values of the organization in question. For instance, Juul would be permitted to run ads in line with its mission to “improve the lives of the world’s one billion adult smokers by eliminating cigarettes,” so long as it doesn’t explicitly promote a piece of legislation that would, say, overturn a ban on e-cigarettes.

The third problem is enforcement – particularly in the U.S., where these issues are most salient. Twitter stated the following ways according to which it intends to ensure compliance with its new policy; from its Restricted Content Policies page:

  • The completion of its advertiser certification process, including identification and proof of being located in the U.S. (e.g. Employer Identification Number, mailing address, or government-issued ID) and additional requirements for handles to be consistent with a company or individual’s online presence.
  • Additional restrictions on targeting by geo, keyword, and interest: ZIP code level targeting will be prohibited, as will terms associated with political content, leanings, and affiliations (like liberal, conservative, and more). There is still a lack of clarity on how Twitter will police the context in which these words are used.

The restrictions on micro-targeting drew a sharp contrast with Facebook, where access to vast troves of data ensure that advertisers can be highly effective in targeting a specific segment of the population. According to Ellen Weintraub, the chair of the Federal Election Commission, the ideal policy would be a ban on micro-targeting, which would still allow political ads, “while deterring disinformation campaigns, restoring transparency and protecting the robust marketplace of ideas” (a similar system for restricting data strategies can be found in Germany).

But beyond the oft-repeated argument that political message reach should be earned and not bought, micro-targeting and political ads have simply not been a lucrative strategy for Twitter. Therein lies the actual problem with the company’s political ad ban: it represents a convenient trade-off with a status quo in which paid reach thrives, but does not resolve the core issues at the heart of Twitter’s decision. There are two reasons for this: 1) ads run by corporations and nonprofits can still prevent organic reach from being elevated across the platform; 2) ads from the public, private, and academic sectors, while not expressly political, could still reverberate across voting decisions and the collective consciousness.

Credit Score

Over the past few years, Twitter has been shifting its focus away from candidate campaigns and towards advocacy groups, federal agencies, and NGOs. This shift was the result of a lower “direct-response” rate of the political ads on Twitter’s platform compared to Facebook, where political ads typically lead to a higher conversion rate into campaign donations and email lists. Ned Segal, the CFO of Twitter, retorted that the ban was based on principle and not money, providing the example of ad spend for the 2018 midterm elections, which amounted to less than $3 million.

The connection is not evident. If anything, it illustrates how much less of a sacrifice it is for Twitter to ban political ads than platforms like Facebook. Ben Thompson, author and founder of tech newsletter Stratechery, argues that Twitter’s decision is a strategy credit, which he defines as “an uncomplicated decision that makes a company look good relative to [others] who face much more significant trade-offs.”

The full extent of the trade-offs Twitter faces is not yet clear. Its third quarter ad revenue was reported at $702 million (8% lower than analyst expectations). But with political ads representing a minuscule portion of the company’s ad revenue, and the PR generated by taking a seemingly principled stance, Dorsey’s decision seems like the epitome of a strategy credit. The timing was also convenient, with Twitter announcing the ban right as Facebook was about to report their third-quarter earnings.

Other critics argue that instead of banning political ads outright, platforms like Twitter or Google should instead evaluate the authenticity of claims being made; some lawmakers have, naturally, argued that an ideal solution would be to start fact-checking paid reach:

But norms around large companies fact-checking candidates or political groups tend to raise eyebrows. Axios framed Snapchat’s recent decision to dedicate a team to political fact-checking as putting it “at a middle ground between Twitter’s ban and Facebook’s highly-criticized policy of not fact-checking political ads at all.” That is inaccurate. Both companies’ approaches (a full ban and a hands-off approach) allow them to maintain a respective moral clarity by framing the issue differently: promoting organic reach vs. championing free expression. Anything in between is a lose-lose position, and lends credence to the argument that tech executives should not be the arbiters of content.

Framing the Problem

Alex Stamos, the former chief security officer at Facebook, says that while advertising is the most dangerous part of social media platforms, a full ban on political ads is not the solution to what ails them; from Columbia Journalism Review:

1. Tech platforms should absolutely not fact-check candidates’ organic (unpaid) speech
2. Tech platforms should have an open and transparent standard for facts in advertisements that gives them the least leeway possible to take down candidate speech
3. Tech platforms should enforce those rules as transparently as possible, preferably explaining why they made any given decision and laying out their reasoning (which should be precedent-setting)
4. It might be smart for #2 to be synchronized with the cable channels and other media who are making these decisions

Stamos goes on to recommend a legal floor on the advertising segment size for political ads – for instance, 10,000 people for a presidential election or 1,000 for a Congressional one. I agree with Stamos that the main risk of online ads (political or not) is not misinformation or the breakdown of civic discourse, but instead “the ability to target very small groups of people.” The legal floor on ad segment size would, on the one hand, diminish the effectiveness of false or highly targeted news coming from political ads. But it would also reduce the vast market for voter data across these platforms, which itself has led to several concerns related to privacy or election-meddling. 

Although legislative action on micro-targeting has been minimal, there has been some progress over the past few years. The Honest Ads Act, a bill sponsored by Senators Amy Klobuchar (D-MN) and Mark Warner (D-VA), would enforce disclaimers for digital ads with the objective of increasing transparency. It would require a public archive maintained by the Federal Election Commission (FEC) of election-related ads for candidates and legislative issues, and contain clear disclaimers revealing the individual or organization who paid for the ad. There are some shortcomings, however; from the Stanford Cyber Policy Center:

Currently, the most significant drawback of the Honest Ads Act is that the draft legislation places the critical responsibility of defining a political ad or an “issue of national legislative importance” entirely with the social media platforms themselves. Disclosure of issue advocacy represents a dramatic shift in the law, and it is too significant to trust private companies with defining which issues rise to the level of warranting advertising disclosure. As Facebook has moved in this direction, the firm has run into an array of line-drawing problems, including (1) addressing media organizations that boost news stories; (2) potentially designating charitable activity as political if, for example, its advertisements are related to health; or (3) managing product ads that touch on politics, such as a recent Nike ad featuring Colin Kaepernick, a Budweiser ad mentioning immigration, or an Amazon ad promoting a political book. Strong arguments could be made in favor of disclosure in all or just some of these cases, but such decisions should not depend on an individual company’s definition. […]

The second drawback of the proposed legislation concerns the disclosure of targeting information. While the Honest Ads Act is premised on a conception of targeting in which advertisers specify demographic categories and/or geographic regions, targeted online advertising has moved beyond categories of users to individual lists of users. The most sophisticated political consultants and parties now curate lists of individuals, along with email addresses to identify them, so as to send individualized messages to them. These lists are then turned over to Facebook and Google who promise to deliver the advertisement to a list of people (a “custom audience”) representing a large share of the targets. […]

Data regarding who was exposed to an ad is equally if not more important than targeting information. As targeting increasingly moves away from categories and towards individuals, advertisers or platforms cannot be expected to reveal the names of people who are targeted by the ad. “Exposure disclosure” should instead be required at a smaller level, such as zip code, census block, precinct level, or even at the county or district level. Talented enterprising analysts – and opposing campaigns – may still be able to identify some individuals from this geographical data, but the specific characteristics of these individuals would remain concealed. Although platforms tend to balk at such micro-level disclosure because it reveals the “secret sauce” of advertisers, the innate surgical precision of effective individual-level targeting remains a key problem with digital advertising, and exposure disclosure is the only way to truly understand the dynamics of modern campaigning. At a minimum, policy makers and the platforms should consider calibrating disclosure to the level of ad targeting, in order to ensure that the more micro-targeted an ad, the greater the disclosure obligation on the spender.

This last point is of particular interest, given the efforts at Twitter (and more recently, Google) to limit the use of micro-targeting on their platforms. But there are still differences in how they will do so; for instance, Google is prohibiting targeting users according to their political leanings with data from public voting records, but will allow targeting users by age, gender, and postal/ZIP code. Contextual targeting, the practice of serving ads to users relating to stories they’re reading or watching, will still be permitted. Twitter, on the other hand, would evade “exposure disclosure” entirely.

As tech companies attempt to navigate the absolutist spectrum of political advertising, it’s worth restating their intended aims:

  • Twitter operates according to the principle that “reach should be earned, not bought.” In other words, it wants to promote organic reach (in the political realm, at least) over any ads paid for by PACs, Super PACs, and 501(c)(4)s. Secondary harms, like the weakening of civic discourse or the spread of misinformation, are important but not the main driver of the policy.
  • Google wants to “improve voters’ confidence” in political ads they encounter on the platform by cracking down on micro-targeting. Its stated goal is to restore confidence in digital advertising and electoral processes globally. The policy would make ads less effective and more costly, and start rolling out in the U.K. within a week, ahead of the General Election.
  • Facebook maintains that ad buyers should be able to run any ads (social, political, electoral), provided they comply with applicable laws and the company’s authorization process. But this historically hands-off approach is being tested, as Facebook is reportedly consulting ad buyers on ways it could limit microtargeting to hamper fake news across the platform.

All companies acknowledge these policies will continue to evolve over time. But the debate over digital political ads has already drawn philosophical battle lines on the respective harms of each policy, whether it’s about the spread of misinformation, restoring democratic norms, free expression, or paid political reach. Facebook has long argued that the government, not tech executives, should be setting the parameters around content. But with each company hardening their stance on digital ad regulation, government involvement looks increasingly unlikely to effect change.

Stripe and the Next Wave of Digital Payments

~ karlhenriksmith ~ Leave a comment

The most successful players in the digital payments space are those that design their core products in such a way that recognizes the different functions of money and facilitate their execution. One of these is Stripe, a fintech firm that processes mobile and online payments on behalf of companies like Airbnb, Twilio, and GitHub. Early on, its business consisted of providing an API to e-commerce firms by linking them to card networks and banks. But Stripe has grown, and the company now offers a wider array of services including fraud protection, credit cards, and incorporation services.

Patrick Collison, Stripe’s CEO who co-founded the company with his brother John in 2010, argues that working with card networks has been the aim from the start, saying it was “always clear there was no viable independent strategy.” Last month, Stripe raised a $250m round at a valuation of $35bn, coming on the heels of many new product updates and international expansion. Stripe’s continued diversification, alongside aggressive growth and intelligent branding, are making the payments startup more competitive.

A hackable medium

In finance, the concept of money is frequently defined in terms of the three functions it serves. As a medium of exchange, money can facilitate transactions – and without it, bartering would be the primary method of exchanging goods and services. As a store of value, money can be stored for a given period of time and remain valuable in exchange at a later date. And finally, as a unit of account, money acts as a common measure of value for goods and services, recording debts, or making calculations.

Money and the notion of exchange through payments have both evolved drastically since their inception from barter to metal coins and banknotes, or bank accounts to e-wallets. The digital payments market is forecast to reach 7.64 billion USD by 2024, recording a CAGR of 13.7% in the period from 2019-2024. But in areas like payment security, concerns persist. Although the shift to EMV chip cards in the U.S. has led to a decrease in counterfeit card fraud, criminals are creating synthetic identities to apply for and receive EMV credit cards to defraud merchants and banks.

One answer could be contactless payments, which are set to emerge as a preferred option across the industry. Contactless has a higher rate of adoption in countries like Canada, the UK, Australia, and South Korea – with the latter having the highest rate of contactless cards in force at around 96% in 2016. The US, meanwhile, had less than 3.5% of such cards in force that same year, reflecting cost efficiencies on behalf of banks. With popular mobile tap systems like Apple Pay catching on (it controls 10% of the global smartphone market and half in the US), the mobile contactless user base has grown considerably, from 20 to 144 million in the 2015-17 time period.

Contactless payments operate thanks to short-range wireless technology like radio frequency identification (RFID) or near-field communication (NFC) to secure payments with a compatible point of sale terminal. Although such transactions are appealing due to their ease-of-use and speed (at around 1/10th of the time of a conventional electronic transaction), adoption has also proven slower in some countries due to security concerns. Consumers are worried that cybercriminals could compromise their card data; from Investopedia:

There have been stories in the media about criminals skimming card data using smartphones to read tap cards in consumers’ wallets. The range at which a card can be read is very short and, even if the criminal is close enough to grab data and do a transaction, he cannot create a copy of the card. This is not true of magnetic strip cards. That said, the chip and pin card is still the most secure, as they can’t be duplicated and they require data (your pin) that is not contained anywhere on the card.

Merchants and credit card companies are increasingly being considered liable for fraudulent activity if they lack chip technology. Fintech companies are taking note. In June, Stripe announced its Terminal product, consisting of “a set of SDKs, APIs, and pre-certified card readers,” extending the company’s payment system to allow for in-person payments. According to Devesh Senapati, a Product Manager at Stripe, the Terminal’s pre-certified card readers have built-in protection from counterfeit fraud for in-person transactions, and support both chip cards and contactless payments.

Another factor contributing to the digital payments boom has been an explosion in the Internet penetration rate, from 35% global penetration in 2013 to 57% this year. This is making optical QR codes, on which many e-wallet apps are increasingly reliant, a more appealing option. In China, where WeChat Pay and Alipay are the dominant players, QR codes are omnipresent in retail and convenience stores, restaurants, and even movie theaters. Implementing QR codes is a cheaper alternative to NFC technology, and its inherent security has made it the driving force in digital payments across the country, allowing consumers and sellers to interact without point-of-sale terminals.

Defining monetary value

When discussing money, how to define its function as a store of value? Is it somewhere to put one’s life savings (transferring purchasing power from the present to the future), and if so, what are the parameters? To help crystallize monetary value in the context of Stripe, let’s take a look at two examples and long-term initiatives within the company: digital currencies and access to money.

New money

There has been a longstanding debate around whether cryptocurrency fulfills the core functions of money. Bitcoin, for instance, can be used as a medium of exchange, although the fluctuations in transaction confirmation times and fees could make it less useful as a method of payment. There is less of a consensus that cryptocurrencies are a store of value, given their volatility – while Bitcoin can be saved and exchanged at a later date, there has been disagreement over the immutability of its network. According to William Wu, a Wharton Student Fellow, Bitcoin also fails at being a unit of account since it does not indicate the real value of an item, acting instead as “an intermediary between the item and the fiat currency with which it is being exchanged.”

Although it ended its support of Bitcoin in 2018 (largely for the reasons listed above), Stripe has long been supportive of cryptocurrencies more broadly. John Collison, Stripe’s president and co-founder, expressed excitement for crypto’s potential at Recode’s Code Commerce conference in 2018, saying “if we want to offer easy APIs to pay out to long-tail countries, we think there could be a bunch of interesting ideas there.” For regions lacking well-functioning payment systems, Stripe sees significant potential in digital currencies as a medium of exchange. It also provided seed funding for a crypto network called Stellar early last year.

There have been some bumps along the way. On October 2nd, the Wall Street Journal reported on that Stripe (alongside PayPal, Visa, Mastercard, and many others) would back out of its membership in Libra, the cryptocurrency-based payments network created by Facebook. Critics and regulators alike have argued that Libra could be used for illicit purposes like money laundering, with Treasury Secretary Steven Mnuchin calling the project “a national security issue,” and the head of the Federal Reserve expressing similar reservations.

One of the primary reasons Stripe reconsidered its involvement in the Libra project was the heightened level of regulatory scrutiny, made clear in a letter from Sens. Brian Schatz (D-HI) and Sherrod Brown (D-OH). In it, the lawmakers argued that Facebook has failed to provide a plan for how it will avoid facilitating activities like terrorist financing, monetary policy intervention, or destabilizing the global financial system. They argue this will compound the issues currently faced by the social network; from the letter:

Facebook is currently struggling to tackle massive issues, such as privacy violations, disinformation, election interference, discrimination, and fraud, and it has not demonstrated an ability to bring those failures under control. You should be concerned that any weaknesses in Facebook’s risk management systems will become weaknesses in your systems that you may not be able to effectively mitigate. […] If you take this on, you can expect a high level of scrutiny from regulators not only on Libra-related payment activities, but on all payment activities.

The external pressures on Facebook itself were made clear in a series of tweets by David Marcus, who heads the Libra project:

Although there are regulatory hurdles around the deployment of Libra, it’s unclear whether the project’s members would have been committed with more lax regulation. Given Facebook’s record on user privacy and security, many partners are dubious that the social network could act entirely independently from its cryptocurrency project. In his testimony at the House Financial Services heading on Wednesday, Facebook CEO Mark Zuckerberg said that the company could even be forced to leave the Libra Association if U.S. regulators did not approve.

Stripe will not be waiting on lawmakers. In February, the payments company led a funding round for Rapyd, a “fintech as a service” startup which offers services ranging from funds collection to currency transfers and ID verification. Although Rapyd doesn’t currently offer support for crypto, CEO Arik Shtilman said they are looking into such services down the line – providing Stripe with a hedge against Facebook and potentially circumventing the regulatory pressures of such initiatives.

Financial inclusion and access

Any truly global payments network should also aim to enable financial inclusion. This notion refers to the process whereby vulnerable groups – or regions – are ensured access to financial products and services, according to the RBI, “at an affordable cost in a fair and transparent manner.” As of 2017, around 1.7 billion adults worldwide remain unbanked, according to the World Bank – that is, without an account tied to a financial institution or through a mobile money provider; from Global Findex:

Since many traditional payments systems never reach people in countries with underdeveloped banking systems, fintech firms have penetrated developing markets through a different medium. Although 90% of Bangladeshis do not have bank accounts, around 75% have access to mobile phones, providing most with the capacity to make digital payments. This has led to the rise of firms like bKash, a payments system that processes around 5 million daily transactions across Bangladesh. bKash, through which customers can open accounts that run on a fully encrypted platform, is facilitating digital payments nationwide.

One of Stripe’s main objectives is democratizing access to money. It recently launched Stripe Capital, a service to make instant loan offers to customers on its platform. Through this service, cash advances – which are a staple for competitors like PayPal and Square – are repaid out of future sales through Stripe’s payment platform, with the customer’s transaction activity acting as a basis for loan amounts and repayments. As with credit cards, the aim of Stripe Capital is to provide customers with “quick (next-day) access to funds to help both with daily liquidity as well as to invest in growth,” which could be of particular use in the developing world.

William Gaybrick, Stripe’s CFO, is eyeing Southeast Asia’s digital payments market. According to the South China Morning Post, the lack of dominant digital payment providers and low credit card penetration are key reasons for the push. Stripe’s continually expanding offering make the expansion a no-brainer, and its existing partnerships with WeChat Pay and Alipay have already unlocked a market accounting for half of total worldwide mobile wallet spending.

John Collison has long framed Stripe as a “[provider of] infrastructure for the Internet economy,” going beyond merely processing payments and adapting to the changing dynamics of the retail landscape by making smaller companies more competitive. But whether Stripe succeeds in the next wave of digital payments will depend on how its services leverage the core functions of money as a medium of exchange, store of value, and unit of account.

The OTA, Anti-Intellectualism, and Congressional Lobbying

~ karlhenriksmith ~ Leave a comment

In the 2018 Congressional hearings of Facebook CEO Mark Zuckerberg, Sen. Orrin Hatch (R-UT) illustrated a lack of expertise around digital business models when he asked how Facebook could sustain a business in which users don’t pay for their service. After being told that the social media platform is essentially supported by ads, Hatch was derided by many news outlets for his perceived disconnect with technology. He was nonetheless resolute on social media following the hearing, claiming that his central argument still stood and that his main concern was a very real one: the Cambridge Analytica scandal illustrated that Facebook had not been transparent. From the hearing:

Nothing in life is free. Everything involves trade-offs. If you want something without having to pay money for it, you’re going to have to pay for it in some other way, it seems to me. And that’s what we’re seeing here. And these great websites that don’t charge for access, they extract value in some other way. And there’s nothing wrong with that, as long as they’re being upfront about what they’re doing.

In my mind, the issue here is transparency. It’s consumer choice. Do users understand what they’re doing when they access a website or agree to terms of service? Are websites upfront about how they extract value from users or do they hide the ball? Do consumers have the information they need to make an informed choice regarding whether or not to visit a particular website? To my mind, these are questions that we should ask or be focusing on.

This context is only somewhat helpful to Sen. Hatch’s case. Whereas the questions pertaining to Facebook’s terms of service and transparency more broadly are important ones, Hatch takes some liberties with the fundamental assumptions around digital services trade-offs. If businesses offering a free tier of service always find a way to extract value from end users (whether monetary or data-driven), stricter terms of service and clarity around data-sharing will not instantly reduce users’ suspicion around corporate practices. This also raises the issue of regulation. If lawmakers have trouble articulating their reservations around the impact of new and emerging technologies, it doesn’t inspire widespread trust they can set the parameters for digital activity.

But the inability of lawmakers to ask questions more thoughtfully is only half the problem. Congressional representatives and staffers receive opinions from a wide range of sources including think tanks, lobbyists, and academic institutions. This is not an ideal situation. It’s not sufficient for lawmakers to receive a wide array of industry knowledge according to Zach Graves, the Head of Policy at the Lincoln Network, a tech nonprofit. Members and staff also lack the proper knowledge to choose which experts to consult and receive advice from. Graves argues that the choices are not always neutral: “A lot of these experts have other motives. Think tanks have donors and ideologies, and having worked in that space for a while, the quality of work is very inconsistent.”

As a result, the current debate is just as much about the issue of Congressional independence as providing regulators with a wider array of technical material. With the continued decline in congressional staff pay over the past few decades, the main source of technical or scientific knowledge is increasingly originating from corporate lobbyists. Google disclosed that it spent a record $21.2 million on lobbying the U.S. government in 2018 alone, which comes alongside increasing scrutiny into issues like user privacy, data security, taxation, or anticompetitive practices. When lawmakers start to consider whether and how they should regulate tech companies, they should probably not be reliant on lobbyists for an overview of the relevant technical terminology.

Education and accountability

In his last interview in May 1996, renowned American scientist and educator Carl Sagan made his views on science and government very clear, bemoaning both anti-intellectualism among lawmakers and its potential for taking off across society at large; from Charlie Rose:

CS: There’s two kinds of dangers. One is what I just talked about, that we’ve arranged a society based on science and technology in which nobody understands anything about science and technology – and this combustible mixture of ignorance and power, sooner or later, is going to blow up in our faces. I mean, who is running the science and technology in a democracy if the people don’t know anything about it?And the second reason that I’m worried about this is that science is more than a body of knowledge. It’s a way of thinking; a way of skeptically interrogating the universe with a fine understanding of human fallibility. If we are not able to ask skeptical questions to interrogate those who tell us that something is true, to be skeptical of those in authority, then we’re up for grabs for the next charlatan, political or religious, who comes ambling along. It’s a thing that Jefferson laid great stress on. It wasn’t enough, he said, to enshrine some rights in a constitution or a bill of rights. The people had to be educated and they had to practice their skepticism and their education. Otherwise, we don’t run the government. The government runs us.

Grim view, but not inaccurate. Sagan was lamenting in particular the recent loss of the Office of Technology Assessment (OTA), which from 1972-95 evaluated a range of technology issues and provided Congress with information and policy proposals on the impact of new and emerging technologies. At the time, the OTA had three divisions: energy, materials, and international security; science, information, and natural resources; and health and life sciences. In this time, it produced approximately 750 reports on a wide array of subjects, from the United States banking system and telecommunications to genetic engineering, climate change, and even space-based weaponry.

Although the OTA was created as a bipartisan agency, some Republican lawmakers viewed it as “duplicative, wasteful, and biased against their party,” according to Science magazine. In 1995, the office was defunded (and essentially abolished) by House Speaker Newt Gingrich, who said in a radio interview that he felt the OTA had been “used by liberals to cover up political ideology with a gloss of science,” and he “constantly found scientists who thought what [the reports] were saying was not accurate.” This is largely anecdotal. In all likelihood, the advice being offered on key scientific or technological issues ran counter to the party’s ideology, which would prove inconvenient.

To curb the influence of lobbyists on lawmakers and contend with increasingly nuanced technology issues, presidential candidate Sen. Elizabeth Warren (D-MA) on September 27th proposed its revival. Members of the House have previously called for the OTA to be reinstated, but Warren’s proposal differs in two important ways. First, she argues that lawmakers’ reliance on corporate lobbyists only partially reflects vested interests. It should instead be attributed, per Warren, to a largely successful “decades-long campaign to starve Congress of the resources and expertise needed to independently evaluate complex public policy [issues].” Warren also proposes a modernization of the OTA to deal with increased partisanship and allow for greater focus on interdisciplinary issue areas.

There are several considerations to this proposal. If the OTA were to be reintroduced, it would have to amend its prior structure and priorities in light of the radical transformations in both the digital and scientific space over the past two decades. One clear example of this is environmental; the IPCC has reported that carbon emissions need to be cut approximately in half by 2030 to meet the scale and ambition of mitigating the effects of climate change. But it also applies to lawmakers who struggle to ask questions around more technical concepts, like end-to-end encryption, algorithmic bias, or location tracking.

It’s also not clear what the role of the reinstated OTA would be. Agencies like the Government Accountability Office (GAO) have taken a more prominent role in the past few decades, made clear by the recent creation of the Science, Technology Assessment and Analytics (STAA) group. Its stated role is varied, from providing in-depth reports to policy makers to auditing STEM programs at federal agencies, or even creating an “innovation lab” focusing on exploring and deploying analytic capabilities and emerging technologies. With more programs and groups trying to fill the void left by the OTA, Congress is lacking a singular authoritative source of objective facts.

It should be noted that bringing back the OTA is also not a catchall solution to educating lawmakers; from Grace Gedye in the Washington Monthly:

The other half [of the problem] has to do with the overall congressional workforce. The Gingrich revolution not only wiped out the OTA; it also decimated congressional staff ranks, and their numbers have never fully recovered. That’s a major reason why Congress has become so dysfunctional. Staffers shape what information their bosses get, take meetings with interest groups, and participate in important negotiations. But congressional staff these days tend to be young, low-paid, and thinly spread — And those with technology backgrounds are as uncommon as, well, flip phones. To deal with an ever more technologically complex world, Congress needs a critical mass of staffers who bring science and tech experience to the table.

Any actual fix to the Congressional knowledge deficit must include provisions on improving the conditions of staffers. Having access to an abundance of reports is helpful, but only when staffers can use them to advise policymakers – most of whom have no background in STEM fields. Currently, staffers in Congress are not being paid according to the General Schedule which, coupled with a consistent decrease in their pay over the past two decades, makes the private sector a far more appealing option. This would also contribute to reducing Congressional dependence on the policy teams from Amazon, Google, or Facebook.

Lobbyism’s fair market value

Although Warren has been accused of overstating the market power of companies like Facebook and Google, it is nonetheless clear that a large portion of all Internet traffic goes through sites owned or operated by a small number of tech firms. This raises concerns around the degree of Congressional independence from tech firms given the current federal antitrust investigations being conducted by the Department of Justice (DOJ) and the Federal Trade Commission (FTC) into anti-competitive practices.

If lawmakers are receiving key technical terminology from corporate lobbyists, their ability to critically assess whether antitrust law is being violated diminishes significantly. In my piece on Microsoft, I discussed how many of the decisions made after the antitrust battles from the late 1990s came down to basic definitions, like the distinction between an ‘upgrade’ and a ‘product’. The absence of the OTA was certainly felt in the eventual settlement between Microsoft and the Department of Justice, which a number of states argued failed to curb the company’s anti-competitive practices; from the New York Times:

In a broad reading of the appeals court decision, appropriate remedies might include forcing Microsoft to put its Internet explorer browser in the public domain, require Windows to include Java technology created by a competitor, and to remove other middleware products like Microsoft’s media player and instant messaging software from Windows. In recent weeks, Microsoft rivals urged the Justice Department to include such sanctions in any settlement deal.

Yet the Bush administration adopted a narrower reading of the appeals court decision — more in line with the position of the Microsoft legal team and some legal experts. The appeals court decision did express a reluctance for having the judiciary meddle in software design decisions, though it also found that Microsoft had illegally “commingled” code when it bungled its browser with Windows.

Had the OTA existed during the Microsoft investigation, it’s not immediately clear that the outcome would have been any different. But the ruling, deeming Microsoft an unlawful monopolist that leveraged its dominance in personal computing to the detriment of its competitors, seemed like it might warrant a larger penalty – one potentially amounting to a breakup of the company. The concern is whether lawmakers are becoming more reliant on information from these firms’ legal and policy teams, and if so, how entrenched they are in Congressional proceedings.

Bill Pascrell Jr., a representative of New Jersey’s 9th Congressional District who supports the OTA’s revival, says in the Washington Post that Congress is currently “like an abacus trying to decipher string theory.” While critics to the bill may point to institutional corruption, rooting out regulatory capture isn’t unattainable nor indecipherable – especially when Congress is given both the capital and the staff to make educated policy decisions.

A Framework for Digital Taxation

~ karlhenriksmith ~ 1 Comment

One of the policies in contention at the G7 summit in France last month had little to do with climate change, finance, or disease eradication. In a renewed effort to placate the U.S. (and to avoid potential tariffs), French President Emmanuel Macron announced that a digital tax on revenues put into effect earlier this year could be deducted by companies that pay, but only once a new international deal is ratified.

The Digital Services Tax (DST), passed by the French Senate in July, would approve a 3% levy on revenue coming from digital services earned in France by firms with over €25m in national revenue and over €750m worldwide. With these parameters, the tax would apply to around 30 major companies (mostly U.S.-based). This has earned a sharp rebuke from Internet giants like Amazon, Google, and Facebook, which accuse the French government of targeting foreign technology companies. The U.S. Trade Representative, Robert Lighthizer, added that he would investigate whether the law “is discriminatory or unreasonable and burdens or restricts United States commerce.”

What’s interesting here is the attempt by these firms to frame the bill as a departure from the current global tax regime. Nicholas Bramble, the trade policy counsel for Google, said the law threatens the processes laid out in the OECD, undermining the multilateral momentum around the modernization of tax rules for multinational corporations. Moreover, he claims that “efforts by one country to unilaterally change the rules on how profits are allocated among countries can generate new barriers to trade and hamper economic growth.”

And yet, the multilateral OECD process has not been an effective conduit for international tax reform in some time. Austria, Belgium, Britain, Italy, and Spain are all contemplating a digital services tax in light of the EU’s recent failure to reach an agreement. Amazon, Google, and others are most likely not advocating multilateral action to preserve the integrity of the international tax regime. Instead, perhaps they hope that any proposal which is so widely accepted is bound to be watered down and relatively harmless.

Bramble makes a fair argument with his claim that the bill would tax just a handful of e-commerce or Internet businesses. With economic sectors like healthcare and manufacturing becoming increasingly digitized, it is not clear that the DST is a catchall solution that bridges the divide between where profits are taxed and where the firms’ digital activity is carried out. In an excerpt from EY’s Global Tax Policy and Controversy Briefing, Rob Thomas and Chris Sanger clearly lay out the confines of the digital taxation issue:

The current debate is not about tax avoidance or the existence of stateless income. It is, rather, about the division of tax rights among countries who consider that their citizens contribute to the profits made by some digitally focused companies, even if they do so via unconventional means.

At issue, then, is how to craft a measure that not only addresses this value creation problem but also does not raise concerns over the perceived discrimination of a handful of digital companies. But that did not seem to be the French government’s objective. The DST, which politicians and media outlets in France had dubbed the ‘GAFA Tax’ (an acronym for the targeted firms: Google, Apple, Facebook, and Amazon), would have primarily applied to U.S.-based companies. If anything, this law reflects the view that the global tax regime crafted in the early 20th century has failed to predict the radical transformation of transnational corporations over the past century.

A Discriminatory Measure

In retaliation to the announcement of the bill, the Trump administration threatened a tax on French wine, calling the measure a comprehensive attempt at “[targeting] innovative U.S. technology firms that provide services in distinct sectors of the economy.” In its criticisms, the USTR decried the DST’s retroactive application from the start of 2019, which it deemed unfair, and listed three reasons why the tax is unreasonable:

  1. Extraterritoriality
  2. Taxing revenue not income
  3. It targets a handful of tech companies

Take each one in turn. National laws are often crafted with extraterritoriality in mind, that is, laws that apply to individuals or firms outside of a nation’s borders. While it has in the past been associated with the cross-border activity of digital companies (e.g. the GDPR), extraterritoriality can also apply to issues like crime, sanctions, and diplomatic immunity. But the Internet complicates things. Online activities that are legal in one country can be illegal in another. Governments across the EU may be starting to regret taking a ‘light touch’ in allowing the Internet’s unfettered growth to persist early on, and attempt to create a set of parameters around measuring digital activity in two or more jurisdictions.

Also at the heart of the debate around digital taxation is France’s decision to tax revenue (turnover) rather than income. In the case of the DST, a 3% levy would apply to gross revenue from activities in which users “play a role” in creating value. These could include the following:

  • Placing ads on a digital interface which are aimed at its users
  • Making available a digital interface allowing users to find and interact with each other, and thereby facilitating a transfer of any underlying goods or services between them
  • Transmission of user-generated data on these digital interfaces

Whereas some digital companies would be within the scope of the proposed DST, like online advertisers or platforms aimed at connecting users to trade goods or services, others could be excluded due to their limited scope in contributing to “value-creating” activities. This lack of clarity extends to online marketplaces with little or no user-to-user selling, yet where there may be a lot of user-generated content. SaaS firms which offer data analytics and other cloud services could fit somewhere in between.

Thirdly, the USTR claims that the French tax is unfair since “its purpose is to penalize particular technology companies for their commercial success.” There is some truth to this. The measure is targeted by nature and would hit around 30 tech companies, most of which are U.S.-based. France highlights a ‘dual injustice’ and argues that SMEs pay an average tax rate around 14 points higher than large digital companies, and that French citizens’ personal data are used to create value for these enterprises. The Finance Minister, Bruno Le Maire, has also stated that the DST would affect only a single French company, raising concerns around the benchmarks set around digital taxation.

Digital Value Creation

Whereas some characteristics of digital firms are clear, there are many blurred lines. Traditional sectors are increasingly exhibiting similar attributes as digital firms, a trend visible in areas like academia, healthcare, and agriculture. As the OECD works towards a consensus on the ideal digital services tax by 2020, it will have to consider the distinction between digital and digitized businesses: the former provides digital services, whereas the latter is operationally reliant on digital tools for its survival.

A complete diagnosis of the value creation mismatch would point to a few factors. Companies today can provide a wide array of digital services in areas where they are not physically present, a practice the Commission dubs “scale without mass.” The reproduction of this phenomenon has lowered the number of jurisdictions where the international tax regime can assert taxing rights on the profits of multinational companies. Moreover, digital businesses have typically been characterized by their reliance on intangible assets like IP, indicating a higher level of mobility.

The third feature of digital companies is a data-driven business model that is predicated on user participation, characterized by network effects and user-generated content. But this is difficult to measure, especially in a framework which distinguishes purely digital companies from those (in manufacturing, healthcare, etc.) which are caught up in, and adapting to, an increasingly digital economy. The debate is therefore around whether and how this creates value, according to Freshfields Bruckhaus Deringer, a law firm:

[…] notably, countries are divided as to whether this third limb contributes to value creation. Some countries argue that it does, on the basis that users provide digital companies with data that can be monetized (either by using it to improve services or selling it to third parties) and content that can be used to attract and retain other users. In addition, these countries argue, network effects mean that by participating via a digital platform, users increase the value of the platform to advertisers and potential users alike. The idea of user-generated value underpins the Commission’s proposals. Other countries, however, disagree: user-generated data and content is equivalent to sourcing inputs from independent third parties, and thus under normal taxation principles should not be seen as value-creating.

But are “normal taxation principles” relevant to digital firms? An effective framework for digital taxation would need to overturn these principles and redefine what activities are value-creating. With the increasing digitization of our economic processes, the conventional notions of service providers and cross-border activity are no longer applicable.

The result is a digital value-creation framework that looks like this:

Ultimately, scale without mass is the most impactful feature of a highly digital business model, given that these companies can have significant effects on the economy of multiple jurisdictions without any physical presence whatsoever. But it is also the least complex of the three limbs of digital companies, which explains why France and others have been using it as the benchmark for measuring lost revenue. Moving forward, it will be necessary for unilateral and multilateral solutions alike to consider all value-creating elements of digital businesses.

To address the scale without mass issue, it is imperative that the third limb (user participation) is also included in the framework and deemed a value-creating activity. There are two reasons for this. First, it will allow individual countries and institutions to craft laws that will be more accurate and less discriminatory in targeting a specific kind of digital business. One obvious example of this is social networks, which have a much greater level of involvement from users than cloud computing or data archiving. Second, some businesses would not exist today if it were not for user-generated content and network effects.

Tax Nationalism

The whole debate around the DST is suffused with economic nationalism. In a rush to ensure that large digital companies pay their fair share of taxes, the French government is encouraging other member states to impose similar unilateral measures to the detriment of an OECD-wide solution. But previous institutional attempts to create a digital taxation framework have led to an impasse, and there is decreasing confidence in the OECD to devise a multilateral measure that is unanimously approved. Countries do not want to waste time in capturing the spoils of a digital economy.

On the other hand, American tax nationalism is not just presidential bluster – it is codified in federal laws. According to Section 891 of the Internal Revenue Code (IRC), the U.S. President has the right to double the income tax rates on foreign nationals and firms that are operating domestically when “under the laws of any foreign country, citizens or corporations of the United States are being subjected to discriminatory or extraterritorial taxes.” The USTR has threatened to do just that if the DST provision were to be implemented, under the guise of preventing “significant double taxation.”

Another problem relates to jurisdictions and the risks involved with unilateral measures. Gary Clyde Hufbauer, an economist at the Peterson Institute for International Economics, argues that the DST is misguided largely because of this; from PIIE:

The French digital tax is ill-considered firstly because it contravenes the “permanent establishment” principle for dividing the profits of a multinational company between two or more taxing jurisdictions. Under current tax treaties, the existence of a permanent establishment — some sort of physical presence — is the threshold for including a portion of corporate profits in the domestic tax base. Digital firms, including U.S. tech giants, purvey their websites globally with no physical presence in most countries.

Hufbauer also cites Section 301 of the Trade Act of 1974, allowing the U.S. President to deem certain measures “unreasonable, discriminatory, or unjustifiable,” open an investigation, and if affirmative, subsequently place trade restrictions on exports on, say, French wine. Although the heyday of Section 301 use was in the Reagan era (in which current USTR Robert Lighthizer served), rules around trade in services, IP rights protection, anti-competitiveness practices, or foreign trade policy had not yet been codified. Its contemporary use would not be in line with formal WTO settlement dispute procedures, and indicates a reversion to the nationalism and aggressive unilateralism largely characteristic of the 1980s.

Hufbauer continues:

The claim is often made that the Internet calls for a new threshold for dividing the corporate tax base. But until a new threshold is agreed between countries, national self-help measures, like the proposed French tax, will result in double taxation and discourage the spread of digital commerce, one of the strongest forces now lifting the global economy.

While I agree that a multilateral solution and consensus around the definition of digital benchmarks are essential to divvying up the corporate tax base, resorting to antiquated laws is not the solution. The Trade Act and the IRC were respectively released in 1974 and 1986, both prior to the formation of the WTO and the notion of a digital enterprise. If OECD processes were to stall and nations are left to their own devices (not an unlikely scenario), the tax framework depicted above could, at the very least, represent a starting point in the process of measuring digital value-creation.

Welcome to Besteps

~ karlhenriksmith ~ Leave a comment

Over the past few months, I have been writing articles on Medium with some degree of regularity. The simplicity is appealing. Writers earn money through its Partner Program, and the platform offers exposure to a wide array of topics and publications (shoutouts to The Startup, OneZero, and Elemental). In addition, maintaining a blog can be a chore for writers whose only interest is creating content — the layout and promotion require frequent attention. In contrast, Medium handles the distribution by curating stories or granting authorship permissions to various publications.

There are caveats to this. Medium isn’t a repository for building a brand, nor does it offer certain features like co-authoring articles. Hunter Walk, a partner at Homebrew, referred to Medium as a new type of content farm, rather than one which “churned out low-quality prose in SEO-friendly formats to try and garner traffic from Google and other search engines.” Features of these high-quality content farms include article-based construction, some level of cross-promotion, and easy-to-use tools that remove obstacles to creating content.

Yet, it’s still unclear whether this leads to a higher level of engagement with readers. Having a blog is equivalent to owning a dry piece of land, and makes sense for writers with a consistent style or thematic throughline. Vox is one example, having been founded with the aim of ‘explaining the news’ (read: analysis). But its desire for reach and continued growth of the platform was uncompromising, creating a trade-off with Klein’s initial objective of writing with a singular voice and building loyalty from a particular type of reader.

Introducing a new medium

In this context, I am creating a blog, Besteps, which aims to provide analysis of business practices and evaluate their impact on society. The reason for the name is twofold. First, it is an amalgamation of best steps, since many articles will make proactive and constructive recommendations for the ideal business practices. It also happens to be an acronym for each field of study that will be covered in the articles: Business, Ethics, Strategy, Technology, Economics, Policy, and Society. It’s been done before.

Moving forward, articles like those I have previously shared will be posted exclusively on Besteps. The duplication of Medium content isn’t conducive to building a brand and could lead to a lower-trafficked site. I do still intend on sharing thoughts occasionally on Medium on topics like writing or culture.

You can find my latest posts at besteps.net and follow the blog on Twitter and LinkedIn.