Pareto in Practice

It’s not everyday that textbook law and economics concepts have a practical application. But a nice little object lesson came up recently in my practice. It’s a classic case of Pareto inefficiency, or suboptimality – arising entirely from the way lawyers chose to draft a contract. The true life case study is after the fold.

Green Co., a Delaware corporation, had been spun out as a dividend from an older privately-held company based in New York City. So it began life with a couple of dozen shareholders on three continents. I represented one based in Japan, who held 200 shares, well under 0.5% of the outstanding; some people held even less. The new entity set up its offices in Toronto, Canada, and a law firm there acted as main counsel. (The vast majority of the shareholders were not Canadian.) Recently Green had a round of venture financing. In addition to buying newly-issued shares, the investors offered to purchase up to US$10 million of shares from existing stockholders, who were invited to tender either at least 250 shares or, if they held fewer than that number, 100% of their holdings. If the offer was oversubscribed, all sellers would be reduced pro rata. In this case, the total tendered came out to roughly $15 million at the deal’s price per share, so each seller was cut back to roughly 2/3 of the number of shares tendered.

The timetable worked this way:

Friday, ___ 1st, 17:00 EST: Deadline to deliver notice of tender by email or fax, stating number of shares tendered;
Monday, ___ 4th, 17:00 EST: Email distribution of Stock Purchase Agreement (SPA) to selling stockholders, indicating the number of shares being sold by each Seller, reflecting oversubscription reduction;
Friday, ___ 8th, 17:00 EST: Deadline to submit signature page and “duly endorsed” share certificate (or affidavit of loss) by emailed scan/.pdf or by fax;
Friday, ____ 15th, 17:00 EST: Deadline for originals of sig page and endorsed certificate to be received by Escrow Agent (Green Co.’s outside law firm).

The SPA included this provision about the closing:

“2.6 At the Closing:
“(i) the funds received by the Escrow Agent from the Purchasers will thereupon be held in trust for the Sellers, each of whom instruct the Escrow Agent, subject to subsection 2.6 (iii), to remit such Seller’s portion of the purchase price solely upon receipt by the Escrow Agent of the original of the stock certificate duly endorsed by such Seller representing the Securities sold by such Seller or an affidavit of loss in respect thereof;
(“ii) subject to the terms and conditions hereof, the Escrow Agent shall hold in trust for each of the Purchasers duly executed stock certificates representing the Securities purchased by such Purchaser, registered in the name of such Purchaser, and, subject to subsection 2.6 (iii), shall expedite same by no later than [Monday, Week 4]; and
“(iii) In the event that, for any reason whatsoever, the Escrow Agent has not received, before 5:00 p.m. EST on [Friday, ___ 15th], any original stock certificates duly endorsed by Sellers in whose name such certificate is registered or original affidavit of loss in respect thereof, the purchase and sale of the Securities represented by such certificates shall thereupon be deemed to be null and void, and (a) the number of Securities purchased by the Purchasers as set forth on Schedule B hereto shall be reduced accordingly and proportionally between all Purchasers, and (b) the Sellers having failed to so deliver such originals irrevocably instruct the Escrow Agent to return to the Purchasers such Sellers’ portion of the purchase price held in trust.” (Emphasis added.)

So far, so good. The first hiccup came when tried to figure out what “duly endorsed” meant. We realized on the 7th Japan time (Thurs.) that the SPA was silent on that point. Clearly, it wouldn’t do for the stockholder to just sign and fill in the number of shares, and then send it in: not only does that mean that the next person who handles it could cause shares to be transferred to himself or herself, but most common carriers, including Fed Ex, won’t carry such “endorsed stock certificates” – and this puppy had to get to Canada. I emailed the lawyers, and got an apologetic reply and instructions on how to fill in the blanks for the recipients’ name and the name of an attorney-in-fact for transfer. We met the Friday deadline for electronic delivery. But it was too late to send the original certificate and sig page out by carrier until after the weekend (Japan being 14 hours ahead of EST).

A bigger hiccup came when my client went to Japan Post on Monday. Delivery of “documents” to Toronto took only three days, so there was an extra day’s margin. But he had to fill out a customs declaration – which agitated first him and then the JP staff he was talking to. I had to go there myself and explain in my broken Japanese why the certificate was less negotiable than a money order. But we could only pray that the way we described the contents on the airbill (“Stock certificate – NON-NEGOTIABLE”) would reassure Canadian customs officials. Needless to say, the Canadian lawyers hadn’t provided any guidance on how to finesse this description. And lots of selling stockholders would be in the same boat.

What would happen if the package were in Canada, but stuck in customs when the 5:00 PM Friday deadline passed? A look at the SPA wasn’t reassuring. Section 2.6(iii) said that if there was a delay “for any reason whatsoever,” the sale would be rescinded. There wasn’t any force majeure clause (while customs delay might not count as force majeure, we were lucky that there wasn’t another huge earthquake). And as for waiver, the SPA said this, in relevant part:

“6.4 Amendment and Waiver. Any provision of this Agreement may be amended and the observance thereof may be waived (either generally or in a particular instance and either retroactively or prospectively), only by the written consent of the Sellers, the Purchasers and the Company.”

In other words, just to cut my client, or some other unlucky stockholder, a break, all the sellers and all the purchasers, plus the Company, would have to sign something in writing. Fat chance. If a seller’s certificate was stuck in customs, then by the terms of the SPA the deal would almost certainly unravel as to his or her shares.

How did my client find himself in this predicament? My client steamed that it was all the lawyers’ fault. If they had included an adequate definition of “duly endorsed,” we wouldn’t have lost a day or more. And if they had given non-Canadian sellers a head’s-up about clearing Canadian customs, we wouldn’t be biting our nails. Maybe some readers will look at things differently: after all, it was incumbent on the stockholder to read the SPA immediately and identify any problems — then he could have gotten endorsal instructions a couple of days sooner. And he could have chosen a more expensive, but faster, method of shipment. (Though each of these measures might only have improved his odds as to timely customs clearance – for all anyone knew, that might take a week or more).

To see where Pareto comes in, let’s review some economic terminology. Given a couple of situations, X and Y, you can call X “Pareto superior” if at least one person is better off in X than in Y, and if no one is better off in Y than in X. If there isn’t any other available situation that’s Pareto superior to X, we can say X is “Pareto optimal” or “efficient.” And of course Y would be “suboptimal,” or “inefficient.”

Now consider this case: Each Seller wants to sell his or her shares — and the Purchasers want to buy them. Rescission of the sale means not only that the individual Seller doesn’t get to sell, but the remaining Sellers don’t pick up the slack – the amount each of them sells remains fixed at the amount specified in the SPA (and indicated in the endorsement on their respective stock certificates). So the rescission means the Purchasers can’t buy as many shares as they were hoping to do. That is, it’s a lose-lose. No one is better off, and some people on both sides of the deal are worse off. On the other hand, allowing some grace period so that the sale can go forward doesn’t make anybody worse off, and makes people on both sides of the deal better off. (I’m not saying the same would be necessarily true if the deadline for the closing were extended forever — I’m just talking about some wiggle room.) So giving the sale a chance to go forward is “Pareto superior” to the way things play out under the SPA, which is “inefficient” by comparison.

And the source of this inefficiency? The gratuitously hardball language in the contract — courtesy of the lawyers on the deal.

Gratuitous, because the drafters could have chosen language to make rescission less automatic, or easier to waive. For example, there could have been a provision that if a Seller sent in the certificate by traceable means and the package were determined to be in customs at the deadline, there would be a grace period of __ days. Or that the deadline provision in 2.6(iii) could be waived in a writing signed by the Purchasers only (much less difficult, since they weren’t so numerous).

Were the lawyers in this case incompetent? I don’t think so – more like very typical, in my experience. In the name of a different sort of “efficiency,” they simply redacted some earlier agreement, probably from an entirely domestic U.S. deal. The problems we encountered were subtle ones, and unlikely to have been very obvious to the lead sellers and purchasers who did negotiate the deal (assuming this SPA was even negotiated at all).

A real pitfall is that phrases like “for any reason whatsoever” have a certain grandiloquence that lawyers tolerate without hesitation. Most lawyers are proud that they have the patience to read, and the muscular fingers to write, pompous stuff that makes lesser mortals’ eyes glaze over. And such language shows that the contract “means business” (with the connotations of ‘tough’ and ‘serious’) or, to use a more contemporary idiom, that it “creates incentives for compliance.” The irony is that such provisions can be entirely contrary to the business of the parties. The usefulness – albeit very narrow, I suggest – of doing a Paretian reality check from time to time while drafting a contract is that it can help you to distinguish language that merely strikes you as pleasingly orotund or appropriately incentivizing from language that actually helps the parties to do the deal they want to do.

You may also like...

4 Responses

  1. dave hoffman says:

    Fantastic post!

  2. Frank Pasquale says:

    Agreed–thanks so much for injecting a very illuminating practical example into what can be an aridly theoretical discussion.

  3. Dan Cole says:

    Actually, I think the post goes to show just how useless the Pareto criterion is for determining the social-welfare implications of most real-world transactions, which do not meet the strict condition of complete unanimity of all affected parties (requiring full compensation of any losers at their subjective valuations of their losses).

    The only practical example of a Pareto improvement in the real world is a discrete contract, based on complete information, with no significant negative externalities. To the extent such contracts actually exist, they hold little interest from a legal policy perspective.

  4. Thanks for the comments. I agree with Dan, actually. Moreover, even in the discrete contract situation, a Paretian POV doesn’t give some unique benefit that you can’t get from judgment based on practical experience. But for lawyers who don’t yet have so much experience drafting and negotiating — and even for some who are experienced, such as the Canadian lawyers in this example — it can be a good heuristic that helps them to write better contracts sooner.