Beyond Winning

by Robert H Mnookin

  A distributor’s effort is concentrated shortly before the movie is released, and after release the exhibitor takes over advertising. The exhibitor has an incentive later to market the movie locally. The sharing formula reflects this difference in timing. As Goldberg observes, “Since the selling effort of the distributor is more heavily front-loaded, a constant profit-sharing formula would give the Exhibitor a poor return on its marketing efforts in the later stages of a film’s run. It would be inclined to terminate a run early, since it would bear nearly all incremental marketing costs [of a longer run while reaping] only a portion of the gains.”30 Distribution contracts respond to this asymmetry by reducing the distributor’s share of profits over time.

  Incentive terms can also address situations in which the parties have different risk preferences. Consider the problem of incentive alignment with respect to executive compensation. Shareholders want executives to behave in a way that maximizes the value of the enterprise—for a publicly traded company this would be reflected in the share price. To the extent that a substantial part of an executive’s total compensation depends on an increase in the stock price, his incentives will be better aligned with those of the shareholders. Providing a lower base salary and more stock options would obviously be better in this regard than a fixed salary arrangement. On the other hand, tying compensation too closely to short-term profits may lead an executive to focus too much on short-term gains at the expense of investments that could provide long-term profits.31

  Finally, incentive terms can be used to constrain opportunistic behavior by one of the parties to an ongoing venture. Consider a negotiation in which a new long-distance telephone service provider is contracting with a broker that will solicit customers to switch from their current long-distance provider to the new company. The broker is to receive a commission based on the telephone bills incurred by the customers whom he induces to switch. But the service provider is worried that under this arrangement the broker has an incentive simply to copy names out of the phone book and to submit them to the provider as customers who authorized a change in service. Of course, the broker will protest that it would never engage in such behavior and may even promise not to do so in the contract. But that might not be enough. The parties might also need a mechanism that enables them to determine relatively cheaply whether a customer has authorized service changes, perhaps by obtaining from each customer a signed letter of authorization or some other kind of proof. But even this might not be enough. After all, these forms of proof can be faked. What should the lawyers do?

  The service provider wants to give the broker the greatest possible incentive to submit only the names of customers who actually authorized a switch in service. This can be achieved by using a sliding commission rate. Because customers who did not authorize a switch in service will likely terminate their service after incurring one or two months of charges, the service provider can offer commissions that increase incrementally with each month that the customer remains with the company. Thus, the broker may collect nothing in the first month, 2 percent in the second month, 5 percent in the third month, and 15 percent for every month thereafter. By structuring compensation in this way, the broker has an incentive to sign over customers who will stay on the service—that is, legitimate customers.

  Managing the Commitment Process

  In addition to allocating risks and dampening strategic opportunism, a lawyer performs another critical function in deal-making: managing the commitment process. Consider the real estate deal between David and Victoria. Suppose that four days after meeting with his lawyer, David found an alternative site that was an even more attractive investment opportunity than Victoria’s mill. Imagine that he wanted to get out of his agreement with Textile Corporation, if he has one. If he were to call his lawyer and ask whether his handshake created a legal contract, his lawyer would reply that nearly every state requires that contracts for the sale of land be in writing. Therefore, neither David nor Textile Corporation would be bound by their preliminary agreement.

  Lawyers are expert in managing and crafting enforceable legal obligations and in specifying when obligations are not meant to be enforceable. Typically, most deals progress from an initial stage of exploratory negotiations—when the parties prefer not to be bound—to later stages in which the parties, having made financial and emotional investments in the deal, prefer to be committed. Between these poles lie intermediate stages of legal commitment that may create uncertainty for clients. Clients may not understand the legal obligations that attach to agreements-in-principle, memoranda of understanding, or purchase-and-sale agreements.32 More important, they may only vaguely understand what degree of legal commitment—at any moment in time—best meets their interests.

  Lawyers have a range of mechanisms to meet clients’ differing preferences toward commitment. Buyers, for example, often want a free option to buy at a specified price for a period of time, during which they can investigate the subject of the purchase. Because such buyers prefer to delay binding commitments until the very last moment in the process, their lawyers may seek to provide them with a condition that gives them an easy exit prior to closing. In our example, David’s lawyer might draft an inspection clause so broad that David could find the property unacceptable for almost any reason. Sellers, on the other hand, will usually seek to nail down the buyer’s escape hatch as early as possible, because they may forgo opportunities to sell elsewhere if their property is kept out of the market for too long. They will want conditions to be narrowly drawn and have short deadlines.

  Lawyers often work hard to clarify whether a commitment is meant to be binding. For example, they will often insert explicit language into agreements-in-principle or term sheets indicating that no one is bound by that document and that only a formal signed contract, yet to be written, will create legal obligations. Sometimes, however, lawyers will intentionally create ambiguity about whether an agreement-in-principle is meant to be enforceable. Parties, of course, often honor commitments even if they are not legally enforceable, and there may be reputational costs to breaking one’s word.33 In addition, fear that a court might enforce such a preliminary agreement may augment the sense of psychological commitment or moral obligation to complete the deal. For the lawyer, the point is to be purposeful.

  Deal-making is like a dance in which the parties begin across the room from each other and end in a tight embrace. Lawyers choreograph this dance by creating small steps, or micro-commitments, that move the parties closer together. These small commitments—such as initial deposits (sometimes called “earnest money”) or agreements-in-principle—pave the way for ultimate commitments by allowing both parties to learn more about each other (thus correcting any information asymmetries) and by signaling that both parties are serious enough about the deal to invest resources. The lawyer’s role as a risk manager facilitates this process. By identifying and allocating risks, lawyers essentially provide insurance to their clients. Clients may find it easier to agree to a deal after the lawyer has approved how the risks are allocated.

  There is substantial interplay, therefore, between the lawyer’s two roles—as risk allocator and as commitment manager. On the one hand, lawyers may withhold or forestall commitment until they understand how the allocation of certain risks will affect the value of a deal for their clients. Similarly, their ability to plan for the most relevant contingencies enables them to shepherd reluctant or hesitant clients through the commitment-making process.

  CLOSING THE DEAL

  So far we have explored how lawyers help their clients structure deal terms to reduce opportunism over the life of a deal. But opportunism persists, including opportunism at the bargaining table. Like dispute resolution, deal-making has both value-creating opportunities and distributive elements. And often deal-making ends up being wasteful or inefficient because the parties engage in hard bargaining to secure distributive advantage, spend more time than is necessary, over-lawyer the deal terms, or blow up a deal un
necessarily. Here we explore some of these opportunities and pitfalls in making deals.

  Value-Creating Opportunities at the Bargaining Table

  Lawyers often say that whereas dispute resolution and litigation are primarily distributive, deal-making is a value-creating enterprise. Parties to a deal are looking for trades that make one or both better off; otherwise they wouldn’t do the deal. When lawyers get involved in deal-making, they can help their clients discover those differences in resources, relative valuations, forecasts about the future, risk preferences, and time preferences that create the potential for gains from trade.

  TRADING BETWEEN TERMS

  The possibility of trades between terms unravels a puzzle inherent in the structure of all deals. In looking at any one provision—be it a price term or a representation—we can confidently predict how each party would prefer to have that term adjusted. With respect to any one term, bargaining is distributive. For example, if David and Victoria—or their lawyers—focused exclusively on the term regarding the date by which David had to secure financing, David would undoubtedly want it to be later and Victoria would want it to be earlier. But because deals involve bundles of terms, each of which can affect the balance of risk and return, negotiators can trade among terms, swapping relatively inexpensive terms for more valuable provisions. Thus, David might agree to secure financing by August 1 in return for a more favorable promise from Victoria on some other term.

  If a lawyer understands his client’s interests, resources, and capabilities, he can structure a deal to maximize its value for his client by securing advantageous provisions on the terms that matter most to his client while yielding a bit on those terms that are relatively more important to the other side. This is not as easy as it sounds. It requires effective communication between the lawyer and the client, and a great deal of trust. It may be very difficult for the client to ever have a nuanced sense of how the wording of different provisions may affect the degree of legal risk. Likewise, a lawyer may not be able to fully explain the opportunities and risks of making trades between various legal terms.

  CREATIVE FINANCING

  Financing arrangements—that is, the terms that govern the allocation of the cash flows generated from a particular venture—can create value by drawing on the different interests of the two parties.

  Consider David’s options for raising money to complete the sale. Assume that David can seek a mortgage from a bank (debt financing), pay the purchase price in net cash reserves, or turn to a business associate or colleague to form a partnership in return for equity share. This is a simple choice between debt and two forms of equity financing. If David can earn 11 percent return on the property and borrow money at 9 percent, he will reap a 2 percent surplus on every dollar he borrows. This will free up David’s cash reserves to make other investments that also might yield more return than the interest payable on the mortgage. In addition, debt financing is attractive because interest payments are usually tax-deductible. But if interest rates are too high, David might well be advised to invite equity participation—minimizing the cost of funds now in exchange for spinning off future cash flows to a partner.

  This is the stuff of real estate finance, and it involves complex decisions about what type of investment will maximize the cash flows generated from the project.34 Of course, financing arrangements are not limited to a simple choice between debt and equity but can be devised in a variety of ways. In every case, however, each of the parties—lender, borrower, equity investor—wants more return for less risk. All have a mutual interest in maximizing the cash flows from the project, but—as our first tension suggests—each is in competition with the other for a larger slice of the pie. Throughout the financing process, lawyers can help their clients understand the advantages and disadvantages of different options and the various risks each poses.

  Common Pitfalls

  Deal-making is not all about value creation, of course. Although two clients may have reached an agreement in principle, inevitably there will still be distributive issues to address at the bargaining table. In haggling over legal terms, the lawyers on each side may try to capture more of the as-yet unallocated gains from trade and push the other side as close as possible to its reservation point. Neither side may know how far it can push the other before the deal risks falling apart.

  HARD-BARGAINING TACTICS

  Each side may start with an initial draft agreement that is highly partisan in its favor. The prototype is the landlord’s lease—a standard form that is extremely skewed in favor of the landlord. Then each lawyer may try to wear the other side down so that the other side will grant valuable concessions on various terms.35 This is not entirely irrational, of course. As in any negotiation, each side faces great strategic uncertainty and neither party wants to be overly generous initially for fear of giving away more than is necessary to do the deal. Each side may thus dig in to an initial position that claims most of the value of the deal and fight hard to concede little while demanding concessions from the other side. If one party seems to be in the more dominant or powerful position—perhaps because it has greater resources or has a better alternative in the marketplace—it may demand that the deal be structured on its terms and refuse to negotiate over those terms with the weaker party.

  When a lawyer says “There can be no deal unless you provide a warranty in the form I’ve suggested,” this creates a basic problem. Is it really true? Or is the lawyer trying to create the perception that the provision is indispensable when it isn’t? The lawyer may be playing a game of chicken just to see how important this provision is to you and whether you’re willing to risk having the deal blow up over it.

  The result may be deadlock. If the lawyers on both sides stake out extreme positions on legal terms, they may argue back and forth without moving the deal forward. Eventually, one or both clients may intervene to get the deal done—particularly if they get impatient with their lawyers for delaying the negotiations.

  OVER-LAWYERING

  Over-lawyering is a second problem. It can occur in two basic ways. First, lawyers can waste the client’s time and money by focusing on small or unlikely risks that do not justify contractual planning. For example, during a merger negotiation, James Freund—then-partner in the New York law firm of Skadden, Arps—was asked by the other side to negotiate a set of clauses that would take effect in the unlikely event that the 1933 Securities Act was repealed.36 Fortunately or not, there is no limit to the process of identifying risks when creative and smart lawyers are involved. The critical consideration to keep in mind is whether the net expected impact of the risk justifies the cost (in both money and relationships) required to allocate it before the fact.

  Another type of over-lawyering is more subtle. It occurs when lawyers insist on creating legally enforceable promises even though the long-term cost of enforcing the promise outweighs the value added. To understand this second type of over-lawyering, consider the factors that bear on the value of a legal promise. In addition to the delay and costs of litigation, there is also the possibility that a reviewing court might come to the wrong conclusion.37 In other words, any estimation of the value of a legal promise must factor in the possibility that when you try to enforce it, the other side might defend the enforcement action vigorously—and win.

  For example, in the case of an indemnification provision given by the seller of a business to the buyer, as Ed Bernstein explains, the value of such a promise is not the full dollar amount of the indemnity. “Rather, it is the dollar amount of the indemnity discounted to take into account the time it will take to obtain a judgment, litigation costs, and the risk that the buyer may not prevail if the court errs and denies him a full recovery on a valid claim.”38 Conversely, a seller’s representation or warranty may be more “expensive” than it appears because of the risk of having to defend against an opportunistic enforcement action and the possibility of losing that defense.

  An estimate of the value of a legal promise must
also consider whether the parties’ relationship will suffer—and more specifically, whether their expectations of each other’s behavior will change—if a variety of state-contingent clauses are proposed. Consider the potential effect on a romantic relationship of asking for a pre-marital agreement. The mere suggestion of a pre-nup implies that at least one party is anticipating breach rather than perfect love.39 The relational costs of negotiating such an agreement often deter couples from even talking about it.

  By analogy, a commercial deal-maker may feel as if he is getting married to his new business partner, and may reassess the relationship if the other side wants to plan systematically for a split-up down the road. The difficulty, of course, is that feigning insult at having to negotiate over contingencies is easy—especially when the other party will truly be at risk if the contingency arises. Moreover, parties who choose not to plan for certain risks may be in denial: they may underestimate the risks to their detriment. To make things more complicated, a client may believe that her attorney is over-lawyering but be wrong. Clients often complain that lawyers don’t understand business and the sorts of risks that businesspeople take every day. They may sometimes be right. On the other hand, lawyers often complain that their clients don’t understand the extent of a legal risk.