Category: Contract Law & Beyond


Tipping Points and Viral Law

475px-The_Sick_Doctor.jpgWhich channels for legal authority are most efficient? This enforcement-efficacy question is a tough one, understudied by traditional L&E and even BL&E. Most instrumentalist theories of law spend relatively little time thinking about the costs of distributing legal rules, and the likelihood that their recipients (citizens) will internalize them. Indeed, the basic L&E approach to criminal law (Becker’s) is frankly dismissive of law’s signaling function, and equates criminal and civil wrongs as taxable infractions.

The problem is not confined to criminal law, of course. Imagine that we want to promote good behavior by a corporate officer. Traditional corporate law doctrine says that we should do so by tinkering with legal rules (“the duty to auction should attach at a Revlon moment”; “Revlon doesn’t happen unless control transfers apart from a distributed market transaction”; “officers must seek Board approval for corporate opportunity taking”; etc.) These doctrinal choices are framed against an incentive problem (principal agent). Richer motivational accounts complicate the story: maybe officers won’t be incented to avoid negligence by imposing a care rule; maybe monitoring rules will increase distrust). But even behavioral law and economics assumes that the way that law is pushed out to its targets is basically immaterial to whether it is effective.

This is the standard, hierarchical, model of distributing law. Different approaches, born out of network theory, are of course possible. Malcolm Gladwell’s The Tipping Point illustrates the point. Gladwell popularized the idea of the “law of the few”: “The success of any kind of social epidemic is heavily dependent on the involvement of people with a particular and rare set of social skills.” He further identified connectors (people who “link us up with the world … people with a special gift for bringing the world together”; mavens (“people we rely upon to connect us with new information.”); and salesmen (“persuaders”). Finally, he suggested that some messages are more sticky than others. (Source for the quotes: Wikipedia) .

How would these insights apply to law? Well, obviously, we might imagine Judge Hercules thinking about a change in the law. She has some criterion to evaluate the goodness of that change. [Be it Kaldor-Hicks efficiency, or something as subtle as de-biasing a pernicious cognitive error, or maybe a fMRI readout of a few brain scans, or maybe she just flipped a coin. Don’t be distracted by the mechanism, stick with the story!] Once she’s made the decision, however, she wants the greatest number of people in society to follow her new rule, so as to maximize the benefits she thinks flows from the change. L&E and BL&E have, to date, said almost nothing about this distribution and enforcement problem. (Indeed, as I learned from Alex Rasholnikov’s workshop at Temple this week, tax folks haven’t done much on enforcement either.) So, she follows the conventional wisdom, issuing her decision in an opinion, or an order if she thinks it likely to be unappealled, and assumes that individuals will learn about the new legal rule in the traditional ways – the media, by word-of-mouth, and by personal experience with the policeman’s stick.

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Borat Gets His Forum

It’s been widely reported that Sacha Baron Cohen and his production company won a forum selection clause motion in Alabama yesterday. As a result, etiquette teacher Kathie Martin, who was embarrassed in Borat, will have to sue in New York. I’d imagine that the case suddenly has significantly less settlement value, even assuming that she pursues it up North.

I wish I could tell you more about the lawsuit, but I can’t find the opinion online. The Alabama Supreme Court website charges a ridiculous, Bar-protecting, $200 a year for access to its opinions. But for first-year contracts students who are now taking civil procedure, the case is a good example of why the former class is much, much more important than the latter.


The New Hall Monitors

The front page of today’s Washington Post reports on a recent explosion in the number of corporate “monitorships,” noting a sevenfold increase since 2001. In these cases, the article reports, federal prosecutors direct contracts to private parties, who are given responsibility to oversee sometimes radical reconstructions of companies charged with fraud or other wrongdoing. The often hefty bill, of course, goes to the relevant company.

Much of the analysis in the article speaks to potential corruption/favoritism in the appointment of individuals to fill these lucrative positions. The article notes the appointment of “various former prosecutors and SEC officials with ties to President Bush, his father and other Republican luminaries,” before focusing on a particular case out of New Jersey. (Which choice I saw, as a perhaps overly defensive temporary resident, to play on pernicious stereotypes of this fair state…)

I was more interested, however, to think about the nature of the institution of “monitors” more generally. What, I wondered, were potential analogies in our schemes of law and governance? Court-appointed special masters immediately came to mind. Naturally, there’s some whiff of our sorely missed independent counsels. Perhaps given my international interests, I somehow thought of the U.N. trusteeship system as well, which in turn brought to mind the various uses of private trustees in the U.S. bankruptcy system.

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What’s Wrong With A Company Paying for a CEO’s Family to Fly?

120px-Bombardier.learjet60.vp-crb.arp.jpgMichelle Leder, of Footnoted, was on NPR’s Marketplace yesterday. The story: the worst examples of agency-costs in footnotes in SEC filings in 2007. (She doesn’t sell it that way, but that’s what it is.)

Bloggers have highlighted a few of Michelle’s “best” finds, including Edward Mueller’s agreement, as CEO of Quest, to permit his family members to use the company plane to travel back and forth to California (where his family was based) to Denver (where Qwest is headquartered.) Although the story was hyped as permitting Mueller’s daughter to commute daily to school — something of a modern-day Leonard v. Pepsico, there is no evidence that the family plans to fly back and forth in this way.

But who cares anyway? Increasing numbers of high-level executives work far away from home, commuting to headquarters for parts of the week. (The consultants’ four day week, but permanently.) Encouraging them to do so maximizes shareholder wealth because it (presumably) allows recruitment of talent that wants to live elsewhere. Now the problem with these schemes is that it is taxing for the executive and her/his home life to be separated from the family. As Professor Joan Heminway explains here, personal turmoil in a CEO’s life can have materially adverse consequences for shareholder value, and well-run companies probably ought to do everything they can to make executives personally happy.

So why not pay for a family to commute back to California, to enable a family member to finish her last year of high school surrounded by friends, while coming “home” to Denver when possible? If that makes Mueller happy, and reduces the chance that he would live in California and commute to Denver, Qwest’s shareholders win. If the argument is simply that the CEO should pay for this travel out of his own pocket, the flight costs will be imputed as income to him under the agreement, so the economics are basically the same. Given disclosure, these kinds of perks should be seen simply as salary-substitutes, at worst, and as ways to reduce the chance of disruption by increasing the CEO’s chance of having a normal family life.

Dailykos (which originally brought the story to my attention) had this to say:

And as this president likes to remind us, this is the ownership society, so don’t be surprised to learn that some of your retirement funds are going to fuel up that jet so an execu-kid can zip off to the prom.

But this is plainly silly. Would we prefer that Qwest simply paid Mueller more money? Or not disclosed the behavior?


More Davidoff-Ribstein-Lipshaw on the Cerberus-URI Case

Steve Davidoff over at M&A Law Profs Blog has more on this opinion, about which I posted several days ago, and with Larry Ribstein’s first and second posts, we may have now beaten the three-headed dog of hell to death. But not quite.

I want to address Larry’s suggestion that Chancellor Chandler has issued a warning to lawyers using “notwithstanding” and “subject to” clauses in complex agreements not to do so because they create ambiguities that effectively require the court to go beyond the document to things like the “forthright negotiator” doctrine. That argument depends on the following thought process actually occurring in the mind of a lawyer about to propose a change to an agreement: “Chancellor Chandler in Delaware has suggested that it is inartful drafting to have a syntactical and grammatical correct overriding of a provision where the content of the two provisions is contradictory. Rather than handle the deal-making problem in this way, which is NOT ambiguous, but merely Rube Goldberg-esque (linguistically speaking), I should confront the other side head-on with the issue, recognizing that we may have a purer document. In doing so, I have decided that the risk of this issue being screwed up by a court in the event of litigation weighs more than the risk of doing something to cause the deal not to close (e.g., triggering further discussion of the provision, losing a face-saving way of resolving a disagreement, causing another round of revisions in a time-sensitive environment, etc.)”

It’s an interesting situation where theory, I think, has to give way to practice. My casual empiricism says lawyers make that calculation doing deals all the time, in one form or another, but that the conclusion is almost always to let either difficult construction or even ambiguity stand for fear of wrecking the deal. (That’s the gist of John Coates’ expert report.) If I were to resort to behavioral psychology and economics, I’d suggest that risk aversion accounts for the ex ante choice – between taking the present deal and the risk of either losing the deal or having an adverse outcome in litigation, we select the certainty of doing the deal – and hindsight bias accounts for the ex post analysis.

In my day, I negotiated some of the most arcane and difficult risk splitting provisions possibly in the history of contract drafting – for example, multiple overlapping indemnification buckets for different kinds of risks like environment, patent, product liability, and so on – all on the thesis that getting cash for the business now outweighed the risk that we somehow had either royally screwed up the contract, or that some unknown liability would come crashing down on us in the future. Most deal lawyers never want to look at an agreement once the deal is closed, because as I’ve said, you pays your money and you takes your chances, and just hope to hell that it all works out.

Or as one of the finest deal lawyers I ever knew, my former boss and later colleague at AlliedSignal, Martin Cohen, used to say, when you are selling a business, the best insurance against lawsuits is that the buyer succeeds wildly with it.


The Cerberus Case and Lessons in Law, Society, and Language

Over in the M&A world (that’s mergers and acquisitions for all you non-corporate types), there’s a recent decision from the Delaware Chancery Court, written by Chancellor William Chandler, that is getting a fair bit of play in the blogosphere, including from my friends Larry Ribstein and Steve Davidoff.

One of the reasons I love complex acquisition agreements as the subject of contract theory is that, like life, they are incredibly complex. No mere agreement to buy 100 bushels of wheat in thirty days at X dollars per bushel here! No, the agreements attempt to map a highly contingent future, one in which the environment or the businesses can change, financing may not be available, bet the company lawsuits can be filed, shareholder actions begun, and so on. I’ve argued before that language is often a blunt instrument used to capture the fine lines of an understanding.

I’ve not fully studied the opinion, but it is a fine piece of analysis, even where in very subtle ways I disagree with it. And with all due respect to Larry Ribstein and Steve Davidoff, I think Chancellor Chandler has a better feel for the limitations of law and language. Yes, this could be “sloppy drafting,” but as I alluded in an earlier post, lawyers, for all their pretensions of being at the center of a deal are often flies swarming around the galloping steed that is the deal itself, and the focus on the contract as the source of the problem is merely a fly’s-eye view.

In simple terms, what is the issue? Section 9.10 of the agreement says that the merger target (i.e. the company whose shareholders are going to walk away with cash – let’s call it the seller for ease of reference) has the right to enforce the agreement by injunctive relief for specific performance for a whole bunch of things, including forcing the deal to close. But Section 9.10 says it is “subject to” Section 8.2, which says “notwithstanding” any other provsion in the agreement, the seller’s sole remedy if the buyer walks away is a $100 million termination fee. The buyer walks away, and the issue is simply whether it must close under 9.10 or can walk away for a price of $100 million under 8.2. Got it?

Chancellor Chandler’s opinion says (i) the language is ambiguous on the walk-away right, but (ii) the circumstances of the negotiation make it clear that the seller understood its rights were limited to the $100 million walk-away fee. The crux of the ambiguity (and the source of the “sloppy drafting” criticism) is the fact that one provision (the “left hand”) appears to be taking away what another provision (the “right hand”) is giving. Why would that happen? And, indeed, there was testimony to the effect that it would have been clearer if one of the provisions had been deleted rather than having this “subject to/notwithstanding” trumpery.

I have read the two provisions, and I don’t think they are ambiguous. From the standpoint of the logical construction, the contract is doubly clear that the walk-away right dominates over the injunctive right. This, it seems to me, is as close as we come in the law to a semantical paradox, like the Liar’s Paradox (“this sentence is false”). The problem is that the grammar and syntax are absolute clear, but we rebel against the contradictory content. In short, why is it there? Try this: “Underlying the semantical paradoxes is our naive intuition that ‘paradoxical sentences because they are not ungrammatical, vague, or sortally suspect and encompass no false presuppositions, must yield statements when used.'” (Oren Perez, “Law in the Air: A Prologue to the World of Legal Paradoxes,” in Perez & Teubner, Paradoxes and Inconsistencies in the Law, quoting L. Goldstein, “A Unified Solution to Some Paradoxes,” in Proceedings of the Aristotelian Society.)

Perhaps it is because I have actually been in the shoes of an M&A lawyer trying to craft a linguistic solution, or have been the client of M&A lawyers trying to craft linguistic solutions for me, that I chuckle at the charges of “sloppy drafting” as though lawyers have the absolute power (a reductive, rational, scientific, but unrealistic assumption) to control all outcomes through language. One of my rules of thumb in negotiating language was to change as little as possible to achieve the desired outcome. That’s an art not a science, and Cerberus’ lawyer’s judgment ultimately bore out in this case. Who knows what would have happened if he tried to make the change by deleting rather than trumping?

Moreover, we don’t know what the lawyers were saying to their clients. We do know from the testimony that the seller’s lawyers understood that the walk-away right essentially created a $100 million option. How do we know that the following conversation did not occur in the seller’s executive suite or boardroom – “look, we aren’t going to do much better than this – we will be able to make an argument there’s an ambiguity on the walk-away right, but Cerberus is probably going to win it in the end. On the other hand, the worst thing that happens if we lose is that we get $100 million, and that should be a sufficient litigation war chest if we want to pursue an injunction.”

My point is that the contract, as important as it is, is only a piece of the entire social system that is a complex business acquisition. There can be sloppy drafting, but that’s an easy default.

For those interested, I’ve addressed this previously in two respects: (a) the illusion that there was an original mutual intention of the parties when a contract is later capable of colorable conflicting interpretations (The Bewitchment of Intelligence: Language and Ex Post Illusions of Intention, 78 Temple L. Rev. 99 (2005), and (b) the lawyers’ illusion that a contract is the deal (i.e. the game), when in fact it is just a model of the deal.

UPDATE: Larry Ribstein has an insightful follow-up to my comment here, and Steve Davidoff offers a detailed analysis here.


ECCO Shoes, Transaction Costs, Reputational Norms, the Limits of the Legal System, and Internet Disintermediation

On October 15, 2007, at the recommendation of my wife, I bought a pair of ECCO shoes at what, for me, was an ungodly amount to pay for a pair of shoes. The reason for the investment is that we live in a city now, and I do a lot more walking. (For comparative purposes, I buy all of my shirts from Lands’ End, and my pants are whatever Dockers – pants for the bigger butted man, as my daughter Arielle and Dave Barry say – are on the table at Costco. So buying shoes at a chi-chi store on Newbury Street was an unnatural act.)

About six weeks later, I happened to notice that the heel had worn through. I wear these shoes a fair amount, but it didn’t seem to me that a pair of shoes at this ungodly price should wear through in six weeks. You can’t just take shoes back to the ECCO store, however. You have to order a prepaid bag from customer service, and send the shoes away to an outsourced “warranty service,” which makes a unilateral judgment whether ECCO will do something about the problem. I duly packed them up and send them away.

The warranty service received them yesterday, and the following is now posted online under my repair ticket: “WEAR IS NOT A DEFECT NORMAL WEAR NO DEFECT.”

From time to time, I teach contracts! I think there’s at least a fact issue whether a sole wearing through in six weeks of relatively normal wear on a pair of $190 shoes constitutes a breach of the implied warranty of merchantability under Section 2-314 of the U.C.C. I channeled Ronald Coase a few minutes ago, and he told me that in the absence of transaction costs, clear default rules, and freedom of contract, the initial allocation of legal rights as between ECCO and me would be irrelevant to an efficient outcome. And when I channeled Frank Easterbrook, he referred me to Hill v. Gateway 2000, and told me I was bound by a warranty disclaimer that was available on the ECCO website if I had read the sales slip and clicked my way through to find it before I wore the shoes.

I am not finding either of those results particularly satisfying at this minute. But wait! I also channeled Lisa Bernstein who has studied diamond brokers in New York City, and they don’t rely on formal law. Do a deal, say “mazel v’broche” (luck and blessing), and reputational norms will do the rest. Hmm. I wonder what that means, if anything, in a world of internet information disintermediation. I’m kind of a “you pays your money and you takes your chances” on this kind of stuff anyway. Personally, that’s the last pair of ECCO shoes for me. But you can make your own decision.


Law Talk: George R. R. Martin

gm-lochness-t.jpgIn today’s episode of Law Talk, we hear from George R. R. Martin, the prolific author of the “high fantasy” series The Song of Ice and Fire. George has also been a screenwriter and Hollywood producer, an editor, a chess tournament director, a union leader, and a volunteer media director for the Cook County Legal Assistance Foundation. As I’ve previously written, George is a leader in the movement to bring a degree of realism to fantasy, and he has been dubbed (by Time Magazine) “The American Tolkien.”

George and I talked for almost an hour, on topics ranging from the role of law in fantasy books (starting 3.5 minutes in); the limits of magic as a plot device (20 minutes in); law professor Robert Cover (22 minutes in, brought up by me, to my shame); why most fantasy novels seem to be set in merry olde england (28 minutes in); fan fiction and copyright infringement (31minutes in); how writing sci-fi is like selling music, and whether he likes Radiohead’s distribution model (35 minutes in); how to keep control over your work when it is transformed into another medium (39 minutes in); and inheritance law (toward the end).

George is a fantastically interesting, well-read, thoughtful guy, and I think you will enjoy this interview quite a bit. (If you aren’t a fan of the books, ignore my constant, irritating, references to characters you have never heard of.) Finally, if you want to learn more about George, visit his blog (which he says isn’t one) and join the hordes of folks waiting for the next installment of the series, A Dance With Dragons, to ship.

Missed the link? Here’s the interview again. Warning: it’s a big file!

You can subscribe to “Law Talk” using iTunes or Feedburner. You can also visit the “Law Talk” page at the iTunes store. For previous episodes of Law Talk at Co-Op click here.

For other posts in the “Law and Hard Fantasy” Interview Series, see:

Confronting Contractors

brokedown.jpgThere’s a nice review of Barry B. Lepatner’s Broken Buildings, Busted Budgets in the WSJ today. Lepatner offers an interesting economic model of traditional business methods here:

Firms aren’t really competing to deliver quality for the lowest possible price. Instead, according to Mr. LePatner, “they compete for the future right to increase the initial cost of their agreement.”. . . “We end up with many firms,” Mr. LePatner writes, “but little head-to-head competition on the big economic variables of time, quality and price.”

Construction firms often make unrealistically low bids to get jobs, Mr. LePatner notes, but they can count on finding plenty of reasons later to jack the price up enough to allow for a profit. When the building is under way, it becomes prohibitively expensive to fire the contractor and start anew. The owner has become a hostage.

Yet another reason to suspect “lock-in” as a business model. On the bright side, LePatner suggests that cyberspace’s enhancement of “reputation nation” should make experiences like our guest Jeff Lipshaw’s less likely in the future:

[LePatner suggests] hiring experts who can monitor builders and who have financial incentives to prevent needless overruns. Tougher contracts should enforce fixed costs or, at least, severely limit the scope for escalation. And thorough background checks — looking for lawsuits, public complaints and financial troubles — may lower the chance of hiring dodgy engineers and construction teams.

Photo Credit: night86mare.