As these examples suggest, clients—much to their disappointment and, at times, surprise—occasionally find that setting a deal’s basic terms does not resolve all the thorniest distributive issues connected with the deal. Suppose, for example, that the parties agreed that the $2.9 million purchase price would be paid with stock in David’s publicly traded corporation.8 The parties may never have considered when the value of David’s stock should be assessed, even though this might significantly affect the number of shares that Textile Corporation receives. Should the stock price be set on the day of the purchase and sale agreement or on the day of the closing? If the latter, what if David behaves in a way that artificially raises the stock price between the P&S and the closing, so that Textile Corporation will receive fewer shares for the land?
Such valuation issues can be very nettlesome and risk serious conflict later. Consider Questrom v. Federated.9 Allen Questrom was lured away from Nieman Marcus in 1990 to become CEO of Federated Corporation, a retail clothing giant then on the brink of bankruptcy. In addition to a $2 million signing bonus and a salary of $1.2 million for a guaranteed five years, his employment agreement also provided for a bonus that was to be based on any increase in Federated’s “equity value” during the specified five-year period. When it came time to determine the bonus in 1995, the relationship collapsed and the parties ended up in litigation. Questrom’s expert claimed that Federated’s value in 1995 was $6 billion, thus entitling him to a $63 million bonus, while the investment bank hired by the company (and initially accepted by Questrom) valued Federated at $4 billion, entitling him to $16 million. Questrom lost his case on summary judgment on February 4, 2000. One lesson is clear: after a contract is signed, if it later becomes clear that the stakes are high, one or both parties to an agreement may have an incentive to search for ambiguity and construe in his own favor a valuation method specified in the contract.10 One of a lawyer’s central roles in deal-making is to help her client understand these types of risks.
Allocating Risks and Dampening Strategic Opportunism
After identifying the risks inherent in a deal, a lawyer must consider what might be done to protect his client. There are several contractual and noncontractual ways to constrain risk.
CONTRACTUAL MEANS: THE LAWYER’S TOOLBOX
Lawyers use a variety of contractual tools for dealing with risks, uncertainties, and strategic opportunism.11 The toolbox includes:
• Representations and warranties
• Covenants
• Conditions
• Remedies
Box 8
A representation is a detailed statement of fact about the subject of a transaction. A warranty is a promise that a fact is true. A representation might describe the merchandise to be shipped, and a warranty would state that it is in good condition. In deals involving the transfer of goods, a representation helps the buyer acquire knowledge about the seller’s product. For this reason, most warranties and representations are made by the seller.12 In our example, David would want Textile Corporation to make as many representations as possible—on evidence of title, on lack of encumbrances, on the existence of tenancies, on relevant zoning ordinances, and on the corporation’s standing to complete the transaction.
Covenants are promises to perform or refrain from performing certain actions. An affirmative covenant might require a board of directors to submit a plan for shareholder approval. A negative covenant might contain a promise not to pay dividends prior to closing.13 Both parties are likely to include covenants in their agreement. Because of moral hazard, David might worry that Textile Corporation will take some action prior to the closing that diminishes the value of the property. To deal with this, he will seek a covenant by which Textile Corporation promises not to destroy or reduce the value of its land prior to the closing date. Similarly, if consummation of the deal is conditioned on obtaining financing, Textile Corporation might require David to undertake certain commitments to obtain financing within a specified time.
Box 9
Conditions are exit options. They are statements which, if not satisfied, “relieve a party of its obligation to complete the transaction.”14 For example, Textile Corporation may place a condition in the contract that David must receive his mortgage financing by August 1. Parties seeking exit options will want to expand the number of terms that operate as conditions.
Finally, contracts can provide for customized remedies in the event of nonsatisfaction. This tailors the remedies the parties receive should some term or condition not be met and ensures that the deal can then go forward rather than derailing into litigation over damages. For example, the parties may specify a sliding scale to adjust the purchase price should the property be different than anticipated. Similarly, they may build in liquidated damages clauses, triggered if certain promises are broken.
Box 10
THE PROBLEM OF INCOMPLETE CONTRACTS
Regardless of how well a lawyer employs the provisions in her toolbox, no contract can specify the full range of risks in a deal or the host of future contingencies for which it might be important to have done some planning. Contracts are inevitably incomplete.
Consider a simple example. Lee Strickland was planning for a six-month sabbatical in London. He faced a quandary. On the one hand, he couldn’t justify the sabbatical if he didn’t rent out his house. On the other hand, how could he be sure that his tenant wouldn’t damage his beautifully furnished home, which he cherished?
One way to address Lee’s problem would be to write a very detailed contract specifying the level of care any prospective tenant would need to maintain. For example, Lee might insist that the tenant wax the floors every two weeks, dust every week, and keep her feet off his sofa. Lee might set out a long list of requirements, such as no eating in the library or no playing the stereo system above level 5 to save the speakers. But this list could be endless. Leaving to one side how Lee could ever monitor compliance, there’s no way that he could detail all of the rules that would be required to ensure a level of care to his satisfaction.
Contracts may be incomplete in two ways. They may be obligationally incomplete in that they do not fully specify the parties’ obligations to one another, or they may be contingently incomplete in that they fail to realize the potential gains from trade under a range of economically relevant contingencies. A complete contract, in contrast, would specify the parties’ obligations in a manner that rendered compliance more attractive than breach over the range of economically-relevant contingencies.15
Just because a contract is silent with respect to a particular contingency does not mean it is incomplete in this economic sense.16 Even without an explicit contract term, an agreement may still allocate a relevant risk because the default rules—that is, the background provisions created by contract law—clearly protect one side or the other. When drafting an agreement to implement a deal, a lawyer must always decide how much detail to include and which contingencies to cover explicitly with a contractual provision. Indeed, for tactical reasons, a lawyer might choose not to raise a particular risk because the background rule is favorable to his client.
But most contracts are incomplete by the economist’s definition, for one of several reasons. First, deal-makers by nature are not perfectly rational. No one can predict the future; even sophisticated parties may not be able to foresee all the relevant contingencies in a deal.17 Second, even if a risk is identified that is not clearly allocated under the default rules, parties might rationally decide not to address the risk in their contract. The transaction costs of negotiating a provision for some contingencies may outweigh the expected benefits.18 The parties might view the risk as very remote. They might decide that rather than deal with it now, they can wait, see if it materializes, and negotiate about it later if necessary.
In short, it is impossible to provide for all contingencies, and it may be inefficient to try. Lawyers may ill serve their clients by trying to plan for every eventuality. In Lee’s case, t
he absurdity of doing so is obvious. On the other hand, sometimes lawyers and clients throw up their hands in despair and prefer to create only bare-bones contracts in the belief that cooperative business partners will resolve all future disputes amicably. This solution can be equally unwise. Deals can and should channel the incentives of deal-makers in a direction that gives the deal the best chance of working out in the long run. While there are limits to what contracts can accomplish, through sensible planning many risks can be constrained by contract.19 The mark of a good business lawyer is knowing when to press for certainty and when to leave terms for ad hoc resolution down the road.
Other Means of Dampening Strategic Opportunism
Lee was clearly unhappy with a contractual solution to his problem. He couldn’t detail the tenant’s rules of conduct completely, and even if he could, such a contract would not offer him much reassurance. After all, a contract only provides for relief after the damage is already done. Lee didn’t want any damage to his home—he wanted to prevent, deter, and preempt a loss, not remedy it through compensation. Suing his tenant for breach of contract after he returned from sabbatical was not what Lee had in mind. It would be a hassle, and it was unlikely to restore his home to its original state. So how could Lee best protect his home?
Legal promises are often a second-best solution, given the transaction costs and delay involved in enforcing those promises in court.20 Thus, business lawyers must structure the business incentives of the contracting parties so that each partner will want to comply for reasons that are independent of the legal enforceability of the contractual promises they have made. Several mechanisms, besides the threat of going to court after the damage is done, can increase the parties’ incentive to comply with the terms of the deal. These include:
• Hostage-taking
• Reciprocal exchange
• Early warning mechanisms
• The prospect of future deals
• Compensation mechanisms
HOSTAGE-TAKING
This is a common means of aligning incentives. A hostage is an asset that is forfeited by a party who doesn’t honor his contract or agreement. A hostage raises the cost of noncompliance and may therefore motivate that party to honor his obligations.21 In a lease, the most common hostage is a security deposit from the tenant.
A hostage was not a perfect solution to Lee’s problem, however. A normal security deposit wouldn’t be sufficient to assure Lee that the tenant would take care of his home. He was planning to rent the house for $3,000 a month for six months, for a total of $18,000. One month’s rent as security deposit would not do much to protect Lee’s antiques and valuable photograph collection. He could, of course, ask for a very large security deposit—say $50,000. This would increase the likelihood that the tenant would be careful with Lee’s belongings. But this approach raises two problems. First, in Lee’s home state, security deposits cannot, by law, be greater than one month’s rent. Second, even if a tenant could agree to such a large deposit, this hostage might create its own incentive problems.
The most effective hostage is one that is valuable to the giver but not very valuable to the receiver. To see why, consider the potential incentive problems if the tenant gave Lee a large cash deposit. Because the hostage would be inherently valuable, an unscrupulous landlord would have an incentive to behave opportunistically at the end of the lease—to keep more of the money than is justified. He could claim that modest wear on the carpet or marks on the walls required him to spend the security deposit to recarpet or repaint the entire house. To reduce the risk of opportunism on either side, a better deal would involve a hostage that is valuable to the tenant—such as a piece of treasured memorabilia or an object of sentimental value—but not to Lee. Of course, the tenant would need to show credibly that losing the nonpecuniary hostage would be sufficiently undesirable to create the deterrence Lee hopes to achieve. In Oliver Williamson’s classic (if sexist) analogy, a king who wants to guarantee his promise to another sovereign is better off offering his ugly daughter as a hostage than his beautiful daughter—not because the king loves the ugly princess any less (which he doesn’t) but because the other sovereign will be less tempted to keep her after the promise is fulfilled.22
What sort of hostage might Lee take—perhaps in addition to a one-month security deposit—that could help reassure him? Reputation is a common nonpecuniary hostage. Imagine that Lee and a prospective tenant know many people in common. In addition to being able to get more information about the tenant’s character by contacting these references, the tenant’s reputation may be held as a hostage, provided Lee could damage it if the tenant was irresponsible. Better yet, suppose Lee finds a tenant who is about to start work in a major law firm in Lee’s town and that Lee knows well several partners for whom the tenant will be working. Assuming the tenant is concerned about her reputation, this may be a more effective hostage than a large cash security deposit.
RECIPROCAL EXCHANGE
The reciprocal nature of some transactions automatically provides both parties with a means to guarantee the other’s behavior. This occurs in situations where the parties buy and sell reciprocally “some specialized product, or product requiring a specialized input,” from each other.23 As Paul Rubin has explained, “If a manager of Firm B is in a position of buying some specialized input from Firm S and is afraid that S will behave opportunistically, he should look for something for B to sell to S which will make it possible for Firm B to also behave opportunistically.”24 In other words, the parties mutually create a situation akin to a bilateral monopoly, in which each side can exploit the other.
To take advantage of reciprocal exchange, Lee might look for a tenant who has a home in the city where Lee intends to take his sabbatical. They might swap houses, as in some time-share arrangements. So long as their homes are of roughly similar value, this might reassure Lee that his house will be safe—after all, each side can exploit the other, and thus each side will have an incentive not to do so.
EARLY WARNING MECHANISMS
A third means of dampening strategic opportunism without contemplating court enforcement is to build in monitoring and early warning mechanisms. Thus, Lee might require as a condition of the lease that his tenant employ his housekeeper during the six-month sabbatical. This would serve two functions. First, it would guarantee to Lee that someone was doing basic cleaning and maintenance in a way that he approved of. More important, however, this would provide Lee with an inside source of information on the condition of his house. Each week his housekeeper would be able to inspect the premises and report to Lee if there were any problems. And knowing this, his tenant might be less likely to cause problems in the first place.
THE PROSPECT OF FUTURE DEALS
In commercial relationships, both parties to a deal may want to do business with each other again. Neither party wants to lose the profit it would earn from future transactions.25 Suppose that apart from his sabbatical, Lee went away for two months every summer and typically left his house vacant. If Lee found a tenant who came to his city every summer, both parties might have a substantial interest in future dealings.
At some point, however, there may be no prospect of further dealings. There is no shadow of the future in what game theorists call the “last round” of a series of transactions. Moreover, if it is known in advance when the relationship ends, there is a risk of unraveling. If a supplier knows that its December shipment will be the last shipment it will ever deliver to a particular manufacturer, and if the manufacturer must always pay in advance, the supplier may take advantage of this opportunity to ship inferior goods in December, since no future profits will be forfeited.26 But the manufacturer, anticipating this problem in December, can also behave opportunistically: he can cancel the December shipment as soon as the November shipment arrives. Why pay for the December goods and then get an inferior product? Knowing that the manufacturer is likely to think this way, the supplier will in turn be tempted to ship inferior produc
ts in November. But the manufacturer, anticipating such opportunism, will be tempted to terminate the relationship in October. And so on.
As L. G. Telser observes, “If there is a last period known to both parties, then no self-enforcing agreement will be feasible.”27 Given appropriate assumptions, it is possible to demonstrate mathematically that unraveling should occur.28 The unraveling effect is undoubtedly less extreme in practice than in theory, but it does seem clear that as the shadow of the future shortens, the incentive to behave opportunistically increases.
COMPENSATION MECHANISMS
Deal-making often involves arrangements where one party is providing services over time that benefit the other. As we suggested in the principal-agent context, while perfection may not be possible, some compensation mechanisms can better constrain opportunism, and better align incentives, than others. The examples that follow illustrate the effective use of incentive terms. Lawyers should be sensitive to these issues when they help to structure deals.
Incentive terms can address a host of problems. For example, they can be used when parties have different time horizons. Consider the possible contractual relations between a movie distributor (like Paramount, Universal, or Fox) and a local theater that will exhibit a movie.29 At the extreme, the exhibitor could pay a fixed rental fee for the right to screen the movie for a given period and keep all the revenue itself. Or, at the other extreme, the exhibitor could charge the distributor a flat rental fee to screen the movie, with the distributor receiving all the revenue from ticket sales. As Victor Goldberg has shown, parties typically avoid these extremes. Instead, they divide the revenues in a manner that takes account of the fact that both parties can influence how successful the movie’s run is, although the period in which each makes its effort differs.
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