Regulating the Trial-and-Error Economy
TheFamily Papers #021
By Nicolas Colin (Co-Founder & Partner) | TheFamily
The great tech bubble burst in 2000. Since then, our economy has been going through a slow and progressive change in terms of production and consumption: the digital transition. We’re leaving the old 20th century paradigm of mass production and consumption to enter into a new one driven by digital technology.
We all know the mass production economy: long lines of standardized goods made in giant factories organized following Fordist industrial processes. The digital economy instead concentrates value in the applications used every day by the multitude—billions of individuals connected by powerful networks. The digital economy still manufactures goods, but this manufacturing is relatively marginalized along value chains that have gone through the five-stage process of digital transition.
The digital transition affects all industries, from transport to energy, health to education, agriculture to finance. Each industry is forced to reevaluate the value available in many dimensions: infrastructures, relationships between businesses and individuals, the organizational elements of the business itself, and certainly the legal structures that regulate business activities up and down the value chain — from upstream (which supplies raw materials) to downstream (where we find the end-user). In fact, an industry can’t fully transition to the digital economy until its legal framework evolves to incorporate new ways of producing and consuming. And so the question becomes how to facilitate the emergence and growth of new business models.
Unfortunately, business models and the legal regulations that apply to them do not evolve at the same pace. Rather, there is a gap between the rise of new digital businesses within an industry and the updating of the rules that govern their activity. The industry’s first tech startups are slowed down both by the inadequacy of the standing rules and resistance on the part of those parties interested in maintaining the status quo. The legal battles in several industries that are quite highly regulated, including transportation, law, banking and health, are representative of the inevitable tension that exists between the old paradigm and the new.
Why Do Entrepreneurs Ignore the Rules?
Given the inadequacy of the rules with regards to the new paradigm, many tech Entrepreneurs operate in a world of uncertain legality. The job of an Entrepreneur is to tackle a problem and discover a solution backed by a sustainable business model. But in many cases, the business models made possible through new technologies do not fit inside existing legal frameworks. Consequently, during their initial phases, many businesses in the digital economy operate outside of the applicable rules.
Waiting for these rules to change before launching may seem a wise solution. But an Entrepreneur who launches a product in the digital economy does not necessarily know a priori where the path will lead: they tackle a problem, search for a pathway little by little, meet their first customers, put together a product while conversing with their users. Eventually, when their company is really growing, they discover their business model.
The defiant relationship that Entrepreneurs have with existing rules leads to skeptical reactions from observers who are not familiar with the field. It certainly takes rebellion and breaking the rules to make an entrepreneurial ecosystem. But indeed, simply not being aware of the rules is more often than not the case. Many Entrepreneurs, as they’re growing their company and discovering their business model, do not ask any questions about the state of the law or how their activities fit within the regulations. This is usually more a result of naïveté than of malice: Entrepreneurs easily tells themselves that if technological progress allows for a new approach and if there is demand for a solution, then the legal frameworks are obsolete and therefore must evolve, whether that be sooner or later.
That mission is even more difficult within the current transition. By nature, the paradigm that we’re leaving behind — the mass production economy — prospered thanks to the profusion of rules and the swelling of the bureaucratic organizations put in place to ensure their application. The legal and administrative standards that must evolve to hasten the deployment of the digital economy are thus massive, complex and particularly resilient.
Nonetheless, an effort must be made, certainly in order to better solve the problems that individuals face in their daily lives—but also to better position our businesses in the race to establish those dominant positions that are there for the taking in the global digital economy.
The US Superiority
The legal field is one of the places where the race is accelerating particularly quickly.
The ability to develop and operate innovative business models, ones that do not fit within the frames provided by the law, involves two issues. For Entrepreneurs, who are mobile and can create their businesses wherever they like, those places that give them broader space on the margins to operate are the most attractive. As for venture capitalists, they are investing more and more into businesses operating on regulated markets; but they only want to invest capital in businesses operating in those countries whose laws are evolving at a similar pace alongside innovation.
In this global competition to update the norms, the United States are far ahead: up until now, they’ve been able to better adjust the law to take into account new technologies and new business models. There are several reasons for this.
The first, of course, is the nature of the US legal system. In countries governed by common law, a judge can interpret the application of a law in an individual case; and if this decision is confirmed through the highest jurisdiction (in the United States, the Supreme Court), it becomes precedent: the text of the law itself is submitted to this interpretation. Common law is thus more favorable to innovation: as new technologies render rules obsolete, courts have a wide margin in which to maneuver in reinterpreting the rules, ignoring certain applications, even installing new rules. Innovative companies are thus incentivized to mobilize their (abundant) capital to pay for lawyers and accelerate the evolution of the rules through litigation.
In continental Europe, on the contrary, our judicial tradition is based upon Roman law: texts are applied as they are, giving judges very little room for interpretation. It is up to the legislative and regulatory bodies to take the questions up again in order for the law to evolve in ways that can accommodate new business models. The law thus changes in a less dynamic way, and new business models find it difficult to emerge.
The culture of control also plays a critical role. The continental European administrative culture is one of a priori control. On the other hand, common law countries have a culture based on accountability, giving more liberty to each player but also providing the necessary means to ensure that harm is not inflicted throughout the system. In contrast to our culture of a priori control, a culture of a posteriori control is less restrictive in terms of systematic rules and gives more room for factual proof.
We oftentimes say that US laws are less constraining for businesses. But in doing so, we forget that when there are damages inflicted upon individuals, there is a system to bring together collective, class action lawsuits and to demand extremely large amounts of financial compensation. The deterrent effect is there: without being obliged to follow rules established a priori, companies are discouraged from acting against the interests of all the parties involved.
A third reason for the United States’ advanced legal position is the federal system. The federal government is tasked with developing the economic rules that apply in all fields where commercial activities take place across state lines (the famous “Commerce Clause”). But the states themselves have significant room to maneuver in creating norms that are more or less favorable to innovation. This allows some of them to become pioneers—or “laboratories of democracy” as Supreme Court Associate Justice Louis Brandeis famously labeled them. Thanks to an avant-garde legal framework, they can attract Entrepreneurs who want to experiment with new business models on a small scale, proving their viability while waiting for the laws to become more favorable in the rest of the country. Two recent examples can be seen in Nevada, the first state to authorize driverless cars (with California following soon thereafter), and in Colorado, which in 2012 voted by referendum to authorize businesses centered on recreational cannabis use.
The fourth reason, typically overlooked, is that the system of campaign financing in the United States encourages legal flexibility. After the 2010 Citizens United decision, there are virtually no limits to the campaign financing that can be undertaken by either individuals or businesses. The ability of businesses to finance, directly or indirectly, the careers of politicians in the US has long been seen as a way for retrograde economic interests to defend the status quo in the face of social questions or economic innovations.
Since 2012, however, the dynamic of this financing system has reversed, becoming much more favorable to innovation. The principal sources of Democratic candidate funds in particular are no longer unions, Hollywood or the financial sector; instead they are Silicon Valley businesses, their management and their employees. The result of this trend is that the Democratic Party is today financed by businesses whose political agenda favors innovation rather than the status quo. The decisions made at the federal, state and local levels, being more and more favorable to the digital economy, reflect a growing influence of these businesses on politics, through the means of campaign financing.
Interesting Precedents
So how can the type of flexibility that exists in the US legal system be injected into European countries, where Entrepreneurs are doubly handicapped by the nature of the legal system and larger difficulties in accessing capital (which restricts access to lawyers, PR agencies and lobbyists)?
The goal is to make sectorial rules and regulations more dynamic and accepting of digital business models, and to put in place a system of laws that enables trial-and-error. Every day, startups are proposing commercial and technological innovations that haven’t yet been tested, but which could eventually upend existing equilibriums. Our desire is to avoid impeding the development, even in experimental forms, of models that find a demand on the part of the public and that allow European countries to grow giant tech companies. There are several examples of this type of system that can be considered.
Clinical trials are perhaps the most evident example. The first users of an innovative digital application are like the subjects in clinical trials: they know that the application isn’t perfect and it is expected that the trial will give a better understanding of both its primary and secondary effects. A framework exists for clinical trials. The question is one of transposing that framework into other fields so that it can be tested with innovative digital applications.
Collective bargaining is another, generalized version of a right to experimentation applied to organizations and company management. The collective accords in a company have the goal of adapting social and labor rights to the specificities of a particular activity, if need be by opening spaces for experimentation.
With fair use, we find an exception to copyright law as it applies in the United States. It allows for businesses and individuals to not ask for the authorization of a copyright holder and to not pay for the use of a work covered by copyright so long as they use only a small part of the work and without that part substantially enriching the person who uses it. For example, a book extract available for free on Google Books is an example of fair use; the use of a song in a home video uploaded onto YouTube is another. As noted by Yochai Benkler, law professor at Harvard, we now have economic studies that demonstrate the value of fair use to innovation and growth. This situation suggests that we can create exceptions within sectorial regulations, with the condition that these exceptions are still held to certain restrictive conditions: the small size of a business, a one-time use of the exception, a use that is on the margins of the business model.
Finally, safe harbors are an instrument used in conventions and contract law to establish exemptions from certain obligations. The tradeoff is oftentimes a reporting obligation and regular audits. An example of safe harbor is that which protects online hosting services from the consequences of their users’ actions. In the United States, this is outlined in the Digital Millennium Copyright Act. In Europe, the applicable rules are those found in a directive from 2000: if the business is held to be a host under the directive of 2000 regarding electronic commerce, then it does not have any civil or criminal liability for the uploaded data, being responsible only for removing them upon receiving appropriate notice.
A New Regulation Paradigm
There are numerous similarities in these approaches: the idea of permission, which brings to mind the “régime de déclaration” in French administrative law; a lessening of preexisting obligations, in return for the obligation of reporting and submitting to a posteriori checks; a progressive formalization, following the outcomes of experimentation, if need be through the intervention of a third party; practical engagements on the part of the players involved in experimentation (removing content based on the request of a rights holder, turning data over to regulators).
Independent regulatory agencies are those that can promote trial-and-error in the economy. After all, their job is to serve as an intermediary between the public authorities and the market. In the context of radical innovation, like that coming out of the economy’s digital transition, the normal rhythms of public authorities are not necessarily adapted to a rapid evolution in use and the exponential progress of technology. This rhythm can also slow down for reasons of political economy: public authorities are more familiar with existing models than new ones and, in questions of regulated professions, have a tendency to favor the status quo over innovations coming from the digital economy. Each attempt at innovation is going up against fierce resistance from existing corporations.
Above all, the digital economy itself provides new possibilities for regulating activities, since it allows us to track the affected businesses in a much more thorough manner. How can one guarantee that regulations are respected by economic players within the context of an experiment? Without digital technologies, it’s difficult to control the activities of many economic players up and down the line. For that reason, regulating the pre-digital economy consisted of concentrating regulatory efforts on the market entry point, and thus imposing various preexisting conditions: having a high level of qualifications from day one, tying up assets, being identifiable by regulators who are both too few and too specialized and whose activities are thus sporadic and necessarily marginal.
Concentrating control at market entry, which was justified by the state of technology and the business models, is no longer needed today. Digital technologies, the business models they allow, and the new needs demonstrated by users have changed everything. Nick Grossman, of New York-based Union Square Ventures, recently explored this new frontier in a white paper produced in collaboration with a group of researchers from Harvard University. He shows how the public authorities must utilize digital technologies to transform the manner in which they regulate business: according to him, there must be an elimination of the barriers to market entry (thus less need for qualifications or assets and more room for experimentation), but in return an increase in the regular and systematic monitoring of data coming from businesses — exactly the type of monitoring enabled through digital technologies.
This would have three significant advantages. The first is knowing exactly what we’re talking about: rather than depending on that which various parties claim, public authorities would have real and exhaustive numbers as well as a better view of evolving elements of supply and demand. The second is that of lowering barriers to entry: by lessening these conditions, vestiges of a prior age, we can enable any entrepreneur to play with a new business model and respond to needs that have to this point gone unsatisfied. And the third advantage is that of finally listening to consumers, since part of the monitored data concerns their satisfaction with the services rendered and their appetite for different types of business models.
Why Trial-and-Error Matters
We must remember a few of the arguments favoring experimentation. The first of these are absolute: in a transitioning economy, where Schumpeter’s creative destruction is in full force, the ability to experiment is necessary for discovering new business models, putting in place appropriate regulations and enlarging digital businesses. The arguments favoring this approach should be put in a historical perspective: the right to experiment is not one that frees businesses from all constraints, but it is one that gives them direction while lowering barriers to market entry in ways that recognize the challenges of the frontier.
The second series of arguments concerns the level of competition found in European economies. In today’s digital economy, deployed across all sectors, neither technology (commoditized) nor capital (abundant, even if the means of distribution are distorted) are really differentiating factors. The superiority of some countries over others is, other than a cultural question or the availability of talent, found in the regulatory environment and the infrastructures. Just as we create fiscal incentives to make the environment more attractive in terms of capital, we can create “regulatory exonerations” that make the environment more attractive in terms of facilitating the emergence of new business models.
Finally there are the arguments based in the particular nature of the digital economy. From its beginnings, this economy developed itself on top of decentralized infrastructures governed by simple standards of voluntary adoption (TCP/IP, HTTP) and an economic model that did not impose billing based on volume or time spent. The innovation dynamic of the digital economy comes from its initial characteristics: it is particularly adapted to the appearance of emerging trends, to successive iterations, to observation and real-time adjustments. For the law, this is a Copernican revolution. We must leave behind the norms of mass production, based on the rarity of administrative resources and the need to erect barriers to entry, and embrace the norms of the digital economy, focusing on the abundance of data and privileging open markets that are in the interest of consumers as well as national economic development.
Trial-and-error is not only a theoretical debate, even if legal experts need to have their part in defining its terms and contours. It is also an economic imperative for our European countries. Privileging the status quo through norms coming from an outdated paradigm has the effect of slowing down economic development and job creation. From Europe’s point of view, we’re quick to think that this is a question of resisting the power of American businesses. But from a global perspective, this is simply a refusal to take part in the race to power in a world economy that grows more and more digital every day.
Further Readings
Afew readings to go further into the complicated relationship between rules and innovation:
- Brad Templeton, “On The Invention of The Internet”, Brad Ideas, May 2005.
- Yochai Benkler, “Growth-Oriented Law for the Networked Information Economy: Emphasizing Freedom to Operate Over Power to Appropriate”, Rules for Growth: Promoting Innovation and Growth Through Legal Effort, Ewing Marion Kauffman Foundation, 2011.
- Nathan Cortez, “Regulating Disruptive Innovation”, Berkeley Technology Law Journal, Spring 2014.
- Vivek Wadhwa, “Laws and Ethics Can’t Keep Pace with Technology”, MIT Technology Review, April 2014.
- Venkatesh Rao, Breaking Smart, Season 1, 2015.
- Nick Grossman, “Regulation, The Internet Way: A Data-First Model for Establishing Trust, Safety, and Security”, Regulatory Reform for the 21st Century City, April 2015.
- Ted Ullyot, “When Software Eats the Physical World, Startups Bump Up Against Regulations ”, Andreessen Horowitz, April 2015.
- Tim O'Reilly, “The WTF Economy”, What’s the Future of Work?, July 2015.
- Neal Katyal, “Disruptive Technology and the Law”, Georgetown Law Journal, August 2015.
- Benjamin G. Edelman & Damien Geradin, “How Should We Regulate Companies like Airbnb and Uber?”, Harvard Business School, September 2015.
- Jason Furman, “Barriers to Shared Growth: The Case of Land Use Regulation and Economic Rents”, The Urban Institute, November 2015.
(This is an issue of TheFamily Papers, a series which covers various areas such as entrepreneurship, strategy, finance, and policy. An alternate version of this article is to be published in French in the Nouveaux Cahiers du Conseil constitutionnel. Thanks to Kyle Hall and Laurent Vallée.)
