In legal deal-making, the best decisions require a combination of legal knowledge and knowledge about the client’s business and preferences. Ideally, a well-informed client should decide the extent to which her lawyer seeks protection through contractual provisions. Alternatively, if a lawyer knew enough, it might be appropriate for a client to delegate decision-making authority to her counsel. But either ideal may be very difficult to achieve in practice. It can be very expensive (and sometimes impractical) for the client to become sufficiently informed about the lawyer’s area of expertise or for the attorney to learn enough about her client’s business to make informed decisions.
We do not wish to overstate the problem of over-lawyering. Because clients often complain that lawyers don’t understand the business side of a deal, lawyers must walk a fine line with their clients, identifying and allocating those risks that are important for the client but not spending unnecessary time on risks that are relatively trivial. Moreover, lawyer and client may not see eye to eye on which risks are which; the lawyer may find some risks important that the client does not, and vice versa.
Our Example Continued
Let’s return to the real estate deal between David and Victoria. To complete our example, consider how lawyers could help David and Victoria negotiate about the possibility that hazardous wastes have contaminated Textile Corporation’s site.
Assume that David’s attorney drafts a contract to send to Victoria. David’s lawyer, experienced in real estate transactions, calls to David’s attention the possibility that the factory may have contaminated the surrounding water or soil with hazardous wastes. David’s attorney advises him that under the Superfund law (CERCLA) he may be held liable for pollution created by previous owners.40 Moreover, because Super-fund liability is strict, joint and several, and retroactive, there is a possibility that David would be stuck with all the clean-up costs, should there be any. David, of course, does not know whether the site is contaminated with toxic waste. This was a risk that he and Victoria did not discuss. David thus faces a lemons problem. He is purchasing an asset of unknown quality (in this case, a property burdened by an uncertain amount of liability). What should he do?
Assume that Textile Corporation, having held the land as a passive investment for the past thirty years, is certain that it has done nothing to contaminate the site. But Textile Corporation has never tested the soil and groundwater around the factory. It does not know if, and to what extent, there is on-site contamination. The basic dilemma for David and Victoria, then, is how to manage these uncertainties.
David, of course, wants Victoria to represent that the land is uncontaminated, that Textile Corporation has not deposited waste while it owned the land, and that it has no knowledge of hazardous substances being on the property. David wants these representations to survive the closing, and he may even seek indemnification from Textile Corporation for any Superfund liability connected to the site. He may also seek inspection rights, with an option to rescind and terminate the contract if tests reveal toxic waste contamination. In drafting the agreement, therefore, David’s attorney might include language like this:
Seller’s Warranty that Soil Is Free of Toxic Waste Contamination
Purchaser, at Purchaser’s sole expense, shall have 90 days from the date of this contract within which to secure soil and groundwater tests of the property. Purchaser and any firm or person designated by Purchaser shall have the right to enter on the property to secure samples of soil and groundwater and otherwise test the soil and groundwater within the stated period. Buyer shall indemnify and hold Seller harmless from all liability, claims, losses, damages, costs, and expenses, including attorney fees, arising out of or resulting from the performance of any such inspection and testing.
Seller expressly warrants that the soil and groundwater of the property are free of toxic waste contamination as of the date of the passage of the legal title to the property from Seller to Purchaser.
In the event Purchaser’s experts determine within the stated period that the soil and/or the groundwater of the property is or are not free of toxic waste contamination, and a written analytical report by the experts demonstrates conclusively that such is the case, Purchaser may at Purchaser’s option rescind and terminate this contract, provided written notice of termination and rescission is given to Seller on or before 120 days from the date of this agreement.
From David’s viewpoint, this term obtains the maximum degree of disclosure about the land prior to the actual exchange. If Victoria refused to deliver such a warranty, it might suggest that something is wrong with the property. In addition, this term, as do all representations, “lays the groundwork for indemnification, should it develop after the transaction has been closed that the representation was untrue.”41
Victoria is likely to think that David’s lawyer is asking for too much. She might respond by requiring that David take title to the land on an as-is basis.42 She might allow David to inspect the land to his satisfaction but insist that no warranties or representations be made about environmental conditions. Before returning the draft to David’s lawyer, she might cross out his language and insert the following:
Purchaser’s Agreement to Take Property “As Is”
All previous understandings and agreements between the parties are merged in this agreement, which alone fully and completely expresses their agreement, and the same is entered into after full investigation, neither party relying upon any statement, representation, express or implied warranties, guarantees, promises, statements, “setups,” representations, or information, not embodied in this agreement, made by the other, or by any real estate broker, agent, employee, servant, or other person representing or purporting to represent Seller. Purchaser has inspected the property and is thoroughly acquainted with its condition and takes same “as is,” as of the date of this contract, ordinary wear and tear and damage by the elements or casualty excepted. Seller has not made and does not make any representations as to the physical condition, expenses, operation, or any other matter or thing affecting or related to the property, except as specifically set forth in this contract. Purchaser acknowledges that all representations which Seller has made, and upon which Purchaser relied in making this contract, have been included in this contract.
Victoria might claim that the purchase price of $2.9 million contemplated an as-is purchase and that if David wants representations as to quality, the purchase price must be increased. Or Victoria might react with anger (feigned or real) that David is reneging on previously agreed-to terms. The bargainers might reach an impasse on this point.
How can David and Victoria create value when dealing with this risk? Textile Corporation knows more about the past use of the land than David does. Presumably, it is easy—and cheap—for Textile Corporation to indemnify David for any clean-up costs traceable to its own ownership of the land, because it knows it dumped no waste. In exchange for reducing this uncertainty, Textile Corporation can seek a higher price from David or concessions on other deal terms of importance to it. In effect, Textile Corporation can trade what is relatively inexpensive to it for something more valuable.
Victoria’s lawyer will likely point out a further wrinkle. In indemnifying David for clean-up costs, Textile Corporation will worry about moral hazard.43 Because Textile Corporation’s warranty will fully insure David, the buyer may not have the strongest incentive to minimize clean-up costs should any arise. In fact, David may even exacerbate the problem—by digging new wells or otherwise disturbing any contaminated area—knowing that any increased harm will be attributed to Textile Corporation. The seller, therefore, might want to cap its total liability to the buyer. The cap will provide incentives for the buyer to minimize clean-up costs should contamination turn up. Similarly, Textile Corporation will seek indemnification from the buyer for any clean-up costs associated with hazards during the buyer’s ownership.
A similar problem would arise if David and Victoria tried to create contractua
l promises based on what Victoria does or doesn’t know about the condition of the land. For example, rather than promise that there are no toxic wastes, Victoria might promise that she knows of none. Or she might claim to have no knowledge either way. The parties, of course, would face a distributive issue as to the stringency of the term—David would push for a term that held Victoria responsible more often, Victoria for the opposite. Throughout this negotiation, Victoria’s lawyer would be concerned about the ways in which David could abuse the term later. For example, suppose Victoria stated that she knew of no waste. If there is waste, it’s almost certain that David will allege that Victoria knew of it—even if she didn’t. And how will Victoria prove that she didn’t know? If the burden of proof is on her to do so, she may find it very difficult.
As a result, perhaps Victoria will suggest a different approach. Rather than promise that she knows of no waste, she might turn over all of her records, books, and files to David before the sale. “Here,” she might say. “I promise that this is all the information I have about the property. Look for yourself. But once you’ve inspected, the risk is yours.” In that situation, if David later found waste, the burden would be on him to prove that Victoria hadn’t shown him all the documents and information—a much more difficult task for David.
Carving up these risks and tailoring the contract to them will create value for David and Victoria. Of course, clever trades cannot entirely eliminate distributive conflict. Much of the bargaining about terms in a deal involves attempts—however subtle—to do better for your side. Perhaps the best example occurs when a party fails to comply with an obligation that is a condition for closing, or when new, unanticipated information surfaces. While technically granting one party an out, these developments are often used as the basis for price renegotiation.
Suppose that on inspection David discovers trace lead levels in the groundwater. Assume such levels are not in themselves hazardous and that the law does not require their clean-up. Nevertheless, the possibility that such deposits will increase over time creates a risk that someday David may have a significant environmental clean-up on his hands. David might try to reduce the purchase price by the amount of the cost to clean up the trace amounts of lead. Presumably, Victoria will resist. She may not know whether David is using the trace amounts of lead as a strategic ploy to reduce the purchase price or whether he is genuinely concerned about future environmental risks. It may, in fact, be some of both.
If Victoria thinks that David is simply bluffing, she may require a term in the contract that the clean-up actually occur. If David does not want to clean up the waste and is just trying to decrease the purchase price, he will resist this term—and his real interest will be discovered in the process. By changing the terms of the contract, Victoria can smoke out David’s ploy.
CONCLUSION
Our colleague Ronald Gilson has advanced a theory to explain how lawyers create value in business transactions.44 Gilson asserts that in a world of perfect markets, four ideal conditions would exist:
• The parties to a transaction would have a common time horizon
• They would share future expectations about an asset’s risk and return
• Transaction costs would not exist
• All information would be available without cost
According to Gilson, lawyers would play little role in this world. They certainly could not increase the value of a transaction, because investors would do just fine on their own. Prices would accurately reflect value, and bargainers could make deals at no cost.
But this utopia does not exist. The real world is beset with various forms of market failure which increase the cost and difficulty of contracting. Gilson writes that it is precisely these forms of market failure that provide the basis for the lawyer’s value-creating role: the lawyers step in to correct these failures at an acceptable cost. Lawyers act as “transaction-cost engineers,” devising efficient mechanisms—or deals—to bridge the gap between this hypothetical world of perfect markets and the real world. “Value is created when the transactional structure designed by the business lawyer allows the parties to act, for that transaction, as if” the four ideal conditions existed.45
As we have seen, business lawyers may create value by designing a transactional structure that reduces the parties’ mutual fear of strategic exploitation. Reducing this uncertainty helps the deal go through and adds value to the process. We have also seen, however, how hard-bargaining over representations, warranties, or indemnities may cause a deal to flounder even though both parties would be better off if it were completed. And even if a deal goes through, hard bargaining may impose unnecessary costs.
This dilemma, of course, is present in both deal-making and dispute resolution. In Chapter 6 we turn to several additional reasons that lawyers and clients often end up in adversarial rather than collaborative legal negotiations.
6
Psychological and Cultural Barriers
Dispute resolution and deal-making present somewhat different substantive and strategic challenges for lawyers and clients, but in each domain the tension between creating value and distributing value is a powerful undercurrent. As clients try to navigate in either context, a lawyer can make things better or worse. In this chapter, we consider psychological and cultural challenges that can complicate the lawyer’s task. Psychologists have demonstrated that a variety of cognitive, social, and emotional forces can distort rational decision-making. In order to be an effective problem-solver, a lawyer must understand these psychological effects and the role they can play within the system of a legal negotiation. Similarly, an attorney must be aware of the impact of legal culture—how the often implicit assumptions about what it means to be a client or a lawyer (and what legal negotiation is all about) can undermine problem-solving.
IRRATIONALITY AND EMOTION
Under standard assumptions about rational decision-making in the face of uncertainty, individuals are presumed to be able to weigh different possible outcomes by the probability each will occur and to evaluate each outcome objectively, without regard to whether it is presented as a gain or loss compared to some arbitrary reference point.1 Cognitive and social psychologists have demonstrated, however, that negotiators often think and interact in ways that violate these basic axioms of rationality.2 As a consequence, a negotiator may fail to recognize or accept an agreement that rationally serves his self-interest. Here we describe some of these biases and speculate about how the introduction of lawyers may exacerbate or moderate their impact in legal bargaining.
Partisan Perceptions
What you see depends in part on where you stand, who you are, and what you’ve seen before. Each of us constructs a reality based on our attitudes, values, and past experiences. This creates the problem of partisan perceptions.3 Although we often assume that we perceive and remember our experiences neutrally and objectively, people are disposed to “see” what they expect and wish to see, and what is in their self-interest to see.
In a dispute, for example, each party will typically have a radically different story about what has happened, who is to blame, and what a fair outcome would be; and each party may selectively remember facts and seek new information that confirms, rather than challenges, their initial narrative. The effect on dispute resolution can be profound. Not only will recollections differ, but interpretations and construals relating to who was at fault, who began the conflict, and who betrayed whom will also differ. Partisan perceptions may lead each disputant to believe that his own demands are reasonable, but that the other side’s are outrageous.
In the slip-and-fall example from Chapter 4, Tom Mazetta remembers the trash on the loading dock and is sure that the hotel’s employees left it there. He blames the hotel for his injury. The hotel manager, however, is sure that there was no trash that day but recalls seeing Tom trying to balance a heavy load. He blames the accident on Tom’s carelessness. Their stories are very different. And as Tom and the hotel interact, each
seeks to bolster its perspective and disconfirm the other side’s.
Partisan perceptions also can affect deal-making negotiations. Each side will see the legitimacy and paramount importance of its own interests. In the real estate transaction in Chapter 5, David Dirks may see his demands to pin down Victoria Leigh’s future behavior under a variety of contingencies as responsible prudence because of the need to guard against loopholes that she could exploit. At the same time, David, confident of his own good faith, may view as entirely reasonable maintaining his own flexibility in order to guard against unforeseen future developments. If Victoria asks for flexibility on a deal term, David may interpret her request as evidence that she does in fact seek to exploit him in the future. But if she refuses to grant David flexibility, he may see her as unreasonably cautious and untrusting, and for that reason may decide that she shouldn’t be trusted. Because each side will make such partisan attributions about the other’s motivations, the dynamic in deal-making can sometimes be very corrosive.
In both dispute resolution and deal-making, we are quick to recognize others’ partisan perceptions but slow to see our own. We each live thinking that what we see is objective reality, that we perceive the world as it really is. Ironically, while we fail to recognize the impact of biases in ourselves, we are quick to see them in others, especially those who don’t share our views.
All of this poses an important question: how does the introduction of lawyers affect the tendency of clients to see the world in a partisan way? Because lawyers see themselves as advocates, their presence may make matters worse. Sometimes in our workshops we ask our students to read a page of facts about a dispute. Everyone gets identical facts, but half get a page labeled “Plaintiff’s Facts” and the others get a page labeled “Defendant’s Facts.” We initially ask everyone to read the facts carefully and then turn in the sheets. When we later ask everyone to recall the key facts of the case, those people assigned to be plaintiffs’ attorneys select facts that are most in their favor and ignore or discount the facts favorable to the defense. And defense attorneys do the same.
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