Regulatory Capture: Navigating the Third Rail of Innovation

Trailing through the darkened corridors of political power are the insidious tendrils of corporate and elite influence. A particularly pervasive and pernicious form of political influence is regulatory capture where corporations control institutions designed to oversee them. Extending this logic, Coase’s Theorem asserts that regulations will not improve economic outcomes that market actors could overwise resolve among themselves. Bill Gurley’s rant on regulatory capture watched by over a half million YouTube viewers alerted Silicon Valley to corporate rent-seeking behavior in Washington where he noted, "If you take away anything, it's that regulation helps incumbents."

Regulatory capture has emerged as the third rail of innovation since Nobel laureate George Stigler first identified the issue in 1971. Industry disruptors must now regularly resist regulatory roadblocks raised by rivals reckoning both with corporate incumbents and their political emissaries. As discussed further below, cities have repeatedly threatened to ban Uber, Lyft and AirBnB following intense lobbying from industry incumbents. Though many startups have flourished, incumbents have nonetheless consolidated market share in over 75% of industries in the past half century.

Innovators and investors are remiss to ignore government. Were the Five Forces Model reconstructed today, Michael Porter would likely include government as a key influencer. Across much of Europe, government funds promising startups as a catalyst for innovation in their countries. In China, government visits take priority over investor or customer meetings as startups understand that local authorities can make or break their businesses. As China has vowed to win in AI by 2030, data is the new oil and governments worldwide are inserting themselves into the artificial intelligence race. During the Cold War, government provided over 90% of Silicon Valley funding into the 1970s and helped secure U.S. leadership in semiconductors, the Internet, biotech and smartphones. The government still contributes half of U.S. funding for basic research, ?and the CHIPS and Science Act of 2022 authorizes $280 billion of new funding to boost semiconductor production and redomicile manufacturing. ??

Dealing effectively in with government is essential for startup success in many industries such as biotech, healthcare, transportation, and increasingly artificial intelligence. At NGP Capital, government has significantly impacted about a quarter of our portfolio companies. Most of these engagements have been positive, but a few have been life threatening for our companies, especially those that encroach on incumbent interests. This article explains how regulatory capture works and offers strategies to engage effectively with the third rail of innovation.

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Regulatory Capture: How it Works

Government has two economic functions: to promote efficiency and equity. Efficiency optimizes economic growth, while equity ensures opportunity is distributed fairly, while includes a level playing field for startups and corporate interests. Regulatory capture is both inefficient and inequitable: it increases costs to consumers and tips scales in favor of incumbents. While entrepreneurship may be productive, unproductive or destructive, regulatory capture is at best unproductive and more often destructive.

Regulatory capture is rife but rarely readily visible. Corporations wield political influence in three ways: (1) influence peddling funding; (2) shuttle diplomacy between corporate boardrooms and political positions of power; and (3) privatizing government oversight. I will first explain each of these three strategies then discuss how technology startups and investors can mitigate risk of regulatory capture and convert government into an ally.

1.?????? Financialization of Government - Influence Peddling:

Initially touted as a healthy pain reliever, opioids morphed into a potent, addictive drug that has killed over a half million people. Yet the U.S. Food and Drug Administration (FDA) responded slowly as drug makers such as Purdue Pharma, manufacturer of Oxycontin, wielded influence through heavy funding to? politicians, advocacy groups, and medical schools. The evolution of opioids should not have surprised the FDA as cigarettes followed a similar path then resisted regulation for decades as described in Smoke Screens: The Truth About Tobacco. Smoking has abated in the west but remains a scourge in developing countries; in 2022, lung cancer killed 1.8 million people worldwide. Drug makers are replaying the opioid and tobacco playbook with marijuana, which was initially approved for medical use and has morphed into a $30 billion industry with ever more potent, addictive versions coming to market annually.???

Patton Boggs, a lobby firm, once marketed “Wins over Sins” and advised clients, “Why litigate, when you can legislate?” Pharmaceutical firms spent $739 million of a record $4.2 billion lobbying federal lawmakers in 2023, more than any other industry. Major tech firms such as Facebook, Amazon, Apple, Verizon and Google are among the largest corporate contributors. More than 13,000 lobbyists ply the halls of Washington serving both as advocates and advisors. After the Lobby Disclosure Act passed in 2012, the American League of Lobbyists tellingly changed their name to Association of Government Relations Professionals in 2013 as did many of their clients to avoid disclosure requirements. ?

Data is the new oil in the artificial intelligence era. The Saudi Arabia of data, China enacted the National Intelligence Law in 2017 enabling government to hoover all data from its citizens and companies. Tech firms are doing the same. Facebook’s default ‘everyone’ setting prioritizes profits over privacy by making all personal posts public. Under its new policy in 2023, Google gathers all publicly and privately available personal data to fuel Google Bard. Facebook and Google together earn $500 billion annually from personal data. While Europe has taken the lead enacting tough privacy policy with its General Data Protection Regulation (GDPR), Internet incumbents have successfully lobbied to thwart similar legislation in the United States.

U.S. Democracy has turned into a Dollarocracy: instead of one person one vote, elections and legislation now may be measured in dollars per vote. Candidates spent over $15 billion on election campaigns in 2020, over $100 per vote and more than double funding in 2012. Acknowledging the increased sway of financial markets, Alan Greenspan, former Chairman of the US Federal Reserve, declared in 2007 that “policy decisions in the US have been largely replaced by global market forces. National security aside, it hardly makes any difference who will be the next president.”??

Yet financial interests ultimately erode democracies. Oligarchies, which consolidate political power by the wealthy to further expand wealth, have increased six-fold in the past four decades; over twenty heads of state worldwide now are oligarchs. Supreme Court Justice Brandeis warned a century ago, “We may have democracy, or we may have wealth concentrated in the hands of a few, but we can’t have both.” In our fraught current political environment, this stark choice seems ever more threatening. ??

2.?????? Shuttle Diplomacy – A Revolving Door from Corporate Boardrooms to Halls of Political Power:

Public service is a hallmark of democracy. We honor accomplished private citizens with relevant industry expertise who accept small wages for political appointments in the twilight of their careers. Over a half century from 1972 to 2021, each of the sixteen U.S. Treasury Secretaries had successful careers in investment banking, private equity or corporations before and/or after their appointments. Having been privileged to work with two of these Treasury Secretaries, I can attest they deserve our respect for their sincere and able leadership.

Yet rising financial rewards for favorable legislation have altered the political calculus and eroded the spirit of public service. The temptation to lobby from within government is potentially lucrative for those who shuttle between corporate boardrooms and the halls of political power.

Corporate influence is potentially pernicious with revolving doors at senior positions. Under Chairman Ajit Pai, a former Verizon executive, the Federal Communications Commission (FCC) repealed net neutrality regulations in 2017 enabling telecom firms to exert control over Internet traffic at the expense of smaller tech firms. The FCC reinstated net neutrality in 2024. In 1999 Congress repealed the Glass Steagall Act, which separated commercial and investment banking during the Great Depression, based on guidance from Treasury and the Securities and Exchange Commission (SEC). Shortly thereafter Treasury Secretary Robert Rubin and SEC Chairman Arthur Levitt accepted lucrative honorary posts at Citibank and American Express, respectively. While they were enriched for their support, nearly 500 banks failed following the 2008 mortgage crisis costing $73 billion to the Deposit Insurance Fund (DIF). Nobel laureate Joseph Stiglitz?blamed the mortgage crisis on lax standards that emerged following repeal of Glass Steagall as an investment banking culture infiltrated commercial banking.

Patents were designed to encourage innovation offering inventors exclusive rights to their invention for up to 20 years. But incumbents have captured the patent system. As the revolving door between the U.S. Patent Office and corporations swings faster, studies observe that patent examiners are more lenient with firms where they previously or later worked. Corporate patents can be highly lucrative. Qualcomm, Nokia, IBM and Ericsson together earned over $10 billion in patent royalties in 2022. Elsewhere, patent trolls acquire patents to extract royalties or litigate those who refuse to pay. Targeted companies spend $29 billion annually to defend claims from patent trolls, and companies reduce R&D spending by over $160 million annually within two years after patent settlements. As a result, patent filings have been falling across Europe for the past forty years as illustrated in Figure 1. Patent filings in the United States have fallen on a per capita basis since the early 1900s.

Figure 1: Patent Awards Across Selected Countries – a Two Century Perspective

?Government officials who leave office yet exert ongoing influence to enrich themselves in the private sector is a troubling trend. As of 2021, 672 former government officials worked for the top 20 defense contractors, which receive over $400 billion in annual defense department contracts. As Wedel observed in Unaccountable, former senior government officials often assume multiple private sector positions and wield ongoing political influence, usually without disclosing conflicts of interest.? ?

3.?????? Outsourcing – Privatizing Government Oversight:

In both the private and public sector, outsourcing works well when interests are aligned and non-core activities are delegated to specialists. Privatization has spurred economic growth and innovation in telecommunications, healthcare and other industries worldwide. The breakup of AT&T in 1984, for example, reduced communication costs and accelerated development of the Internet, broadband, smartphones and related technologies.

Yet governments are increasingly delegating core oversight functions involving inherent conflicts of interest. The Federal Aviation Administration (FAA) delegated much of its safety certification process to Boeing, which rushed the 737 Max to market with a critical flaw in its flight control system resulting in two crashes killing 346 people within six months.

Many outsourced services involve exclusive contracts, which increase costs effectively acting as a regressive tax on the poor. Rather than using local telecom services, the FCC has awarded exclusive contracts for a national Inmate Calling Service (ICS) in federal prisons. ICS is now a $1.2 billion industry controlled by two private equity owned firms that charge up to $17 for 15-minute calls. Competitive market would resolve these inefficiencies, but institutional inertia permits such problems to persistent in the public sector.

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Strategies to Overcome Regulatory Capture

In 2015, thousands of taxi drivers in Paris rioted blocking thoroughfares, damaging cars, and threatening Uber drivers while seeking a ban of Uber in France. In response to lobbying from taxi firms, city councils in Paris, San Francisco, Washington DC and New York threatened bans and imposing fines of up to $5000 fine per ride for each day Uber remained in operation.?But Uber appealed directly to its customers. Within one day, DC city councilmembers received 50,000 emails and 37,000 Tweets with hashtag #UberDCLove. More than 200,000 customers in New York City signed a petition to drop proposed restrictions. Both cities backed down allowing Uber to continue its ride hailing service.

Innovators have long faced threats from incumbents. In the fifteenth century, Machiavelli observed, “There is nothing more difficult to plan, more doubtful of success, nor more dangerous to manage than the creation of a new order of things … Whenever his enemies have the ability to attack the innovator they do so with the passion of partisans, while others defend him sluggishly, so that the innovator and his party alike are vulnerable.”

As technology infiltrates and increasingly disrupts established industries, the threat of regulatory capture is higher but innovators have more tools available to overcome these threats. Following are six strategies that startups may consider to better prepare from the outset. ?

1.?????? Stealth Mode: Generals go to great lengths to secure surprise attacks on battlefields. Decoys and subterfuge are key assets in the art of war. Entrepreneurs may be tempted by marketing campaigns to lure customers, but they also attract attention from potential competitors and incumbents. Secrecy is better until your technology is proven and, ideally, after securing Product Market Fit.?

2.?????? Margin of Safety: Industry disruption is more capital intensive than incremental innovation. Incumbent competitive threats, including regulatory capture, increase capital requirements to achieve Critical Mass and ensure a Margin of Safety unforeseen events. The growth of the venture industry enables startups to disrupt industries and pursue more capital intensive strategies that were previously out of reach.?? ?

3.?????? Advisors: Former industry executives can advise on how best to prepare for competitive responses based on incumbent practices. Several leading venture firms have government practices and can help ascertain the threat of regulatory capture. Advisors can help develop strategies to mitigate risk and navigate relationships at the relevant local, state or federal levels. The National Venture Capital Association and Small Business Association represent venture and startup interests in Washington.

4.?????? Social Capital: Startups can shift incumbent home field advantage by altering the playing field. As I discussed in Social Capital, startups may redefine the network architecture of an industry. Disruptive innovators often identify holes in a market or operate on the fringes of two existing markets. By bridging these gaps, disruptive startups create a superset of customers that converts a potential threat into a competitive advantage much as Uber did in the above example.

5.?????? Strategic Partners: Aligning with powerful allies who have a shared interest in dethroning incumbents helps level competitive dynamics. IBM lost a majority market share in computers when Microsoft and Intel formed the “WinTel Alliance” allowing clones to compete. Lime won leadership in micromobility by partnering with cities to offer green, inexpensive and healthy ways to reduce congestion and commute times.

6.?????? Open Innovation: Incumbents prefer closed networks to reinforce discipline and lock in proprietary advantage. But digital platforms and open innovation are more scalable, lucrative and defensible. When deployed at scale, they can neutralize incumbent advantage and broaden support helping to mitigate risk of regulatory capture. When iPhone launched in 2007, Apple redefined the market and won software developer support with its Appstore leaving incumbents flat footed. Digital platforms enjoy significant network effects, as Salesforce has shown with its Dreamforce annual conference, which attracts over 180,000 attendees.

Entrepreneurs rarely consider government when starting a business and are often dismissive when policy considerations are raised. Yet I have observed across thirty years of investing globally that entrepreneurs who are savvy on policy matters can accelerate growth and mitigate risk by leveraging government channels. For many startups, government should be part of the Five Forces Model vital for success but need not be the third rail of innovation.

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Regulatory Capture: Related Concepts? ??

Regulatory Capture is of greatest concern for disruptive or paradigm shifting innovation that threatens incumbents. Michael Porter is silent on government in the Five Forces Model, yet he highlights the role of government in his Diamond Model in his subsequent book The Competitive Advantage of Nations. Regulatory Capture is most prevalent in Winner Take Most Markets where corporations have incentives and leverage to secure government support, especially in industries deemed strategic to national interests. ??

Regulatory Capture is a form of Social Capital in which incumbents engage government to increase Barriers to Entry. The threat of Regulatory Capture is economically inefficient as it increases capital intensity, critical mass and margin of safety requirements for companies. Engaging government as a customer requires stamina to survive the Valley of Death in contracting. ?Regulatory Capture could also alter the calculus of Competitive Advantage. A swift, compelling market entry strategy securing a strong beachhead position creates a more defensible position in anticipation of a competitive response.

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Resources for Further Reading

This article offers a briefing for innovators and venture investors on regulatory capture. Much has been written on corporate and elite influence on public policy. In addition to the links to many resources referenced in the article, I owe much to several books that explore various aspects of regulatory capture deeply. For those interested in further reading on this topic, I highly recommend the following books.

·?????? Nexus (Harari 2024)

·?????? Everything for Sale (Kuttner 1999): Includes an extended discussion on deregulation of the telecommunications industry on pages 239-255.

·?????? The Oligarchs’ Grip (Lingelbach & Guerra 2023)

·?????? The Wolves of K Street (Mullins 2024)

·?????? Unaccountable (Wedel 2014)

·?????? Shadow Elite (Wedel 2009)

·?????? Political Technology (Wilson 2024)

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