October 23, 2008
The Mythology of Value Creation: Lawyers, Neckties, and Balinese Cock-Fighting
Posted by Jeff Lipshaw

Usha's post below, with its reference to Ronald Gilson's 1984 article on value creation by lawyers, prompts me to a short rant, not about Usha's post, but about the article, which Usha rightly calls a "classic" and  "the reigning academic account of what business lawyers actually do."  Honestly, with all due respect to Professor Gilson (who joined the Stanford faculty the year I left as a student), the article has bugged me since I read it a couple years ago; indeed, I have a comprehensive list from a Lexis search I did a while back of every article that had cited it, because I was trying to do a literature search to see if anybody else had said what I'm about to say here.  Since I haven't followed up on my list, I don't know, and I therefore apologize if I'm repeating a critique somebody has already written.  I also apologize for the stream of consciousness approach that follows.

What about the article bugs me?  Let me count the ways:

1.  If I were taken with law and economics in 1984, but had no way of showing empirically that the reams and reams of hours that lawyers spent doing deals actually produced anything with intrinsic value (which Professor Gilson forthrightly admitted, at pp. 247-48 of the article), but was inclined to hope that they did, with an interest in justifying their existence (as again Professor Gilson forthrightly admitted at footnote 149), this is, I suppose, exactly the article I would write.  What we have here is an attempt to make sense of the world, by way of scientific (or quasi-scientific) theory, but it is "over-determined" in the sense that the theory selected happens to be rational actor economics, rather than, say, the theoretical view Clifford Geertz applied to Balinese cock-fighting.

2.  The theory is capsuled as follows.  All transactions occur because buyers value an asset more than sellers.  The difference between the two values is surplus.  Haggling over the split of the surplus is of no interest generally to economists; that is mere strategic bargaining.  Each party, being rational, would know that hiring a lawyer to grab a bigger portion of the surplus won't work, because the other side will respond in kind, and the lawyers, not the parties, would get the benefit of the surplus.  So, in the long run, rational actors being what they are, it must be the case that "[t]he increase must be in the overall value of the transaction, not merely in the distributive share of one of the parties. That is, a business lawyer must show the potential to enlarge the entire pie, not just to increase the size of one piece at the expense."  That's a rational actor trope, and one that I have criticized in another context here.

3.  As I said in a comment to Usha's post, if I were to apply an economic model to lawyers in deals it would be the Prisoner's Dilemma. Both clients would be better off cooperating by throwing all the lawyers out of the room for most of the issues in the deal, hence eliminating the transaction cost of arguing over myriad reps and warranties and other contract niceties that don't make any difference anyway. So imagine a Prisoner's Dilemma matrix with Party A and Party B, and the choice for each is "Lawyer" or "No Lawyer." The payoff for each side choosing "No Lawyer" is a huge reduction in costs (say, 5, 5) compared to both sides choosing "Lawyer" (say, 10, 10)" But both sides keep their lawyers, for fear of the (1, 20) or (20, 1) outcomes in the Lawyer/No Lawyer boxes that are akin to one prisoner confessing but the other one not.

4.  There are places where lawyers reduce transaction costs, say, by mediating between two positions to reach a solution, but there's nothing particularly lawyerly about that. That's a negotiating skill.  Moreover, lawyers may well be necessary to getting the deal through the regulatory thicket, whether it is Hart-Scott-Rodino pre-merger notification or CFIUS review.  But that hardly seems fair, because lawyers created the regulatory thicket.

5.  We have a neighborhood association in northern Michigan.  A lot of people in the association are rich.  When something happens that they don't like, they say things like, "if you do that, I'll have 10 lawyers from the Humungous Law Firm, who I have on retainer, up here the next day."  Since I'm a lawyer, and I used to be a partner at the Humungous Law Firm, I laugh at that, but it's an effective club when wielded against non-lawyers.  I rarely hear non-rich people say this, which goes to my next point.

6.  Professor Gilson's "empirical" testing of this theory is to walk through the most heavily lawyered of all documents, the typical business acquisition agreement.  If lawyers really created value accordingly to the theory, we ought to be able to test it not in mega-million or mega-billion dollar deals, but in little deals that happen all the time.  But the reality there is that most transactions occur without lawyers.  Sometimes there is boilerplate that lawyers had a hand in.  But if a lawyer being involved in a transaction necessarily made the pie bigger, why don't lawyers appear in almost all transactions?

7.  Professor Gilson spends many pages on the information-exchanging value of representations and warranties, and puzzles over the lack of any indemnification mechanism in public company deals (the representations and warranties expire at closing largely because once the proceeds in stock or cash are distributed to widely dispersed shareholders, there's no putting Humpty-Dumpty back together again). He acknowledges that indemnification may be partial or limited in time (there's also the "basket" or deductible, but I don't think that gets mentioned), but the real question, it seems to me, is whether the actual instances of acting on the indemnification clauses warrant the investment in the reps and warranties.  My guess is they have some amount of in terrorem effect, but neither of us have a whole lot of data to go on.  (The one empirical study of which I'm aware on this subject is by Steve Schwarcz, and it is based on surveys of clients who hire transactional lawyers.  To quote Steve's abstract:  "Contrary to existing scholarship, which is based mostly on theory, this article shows that transactional lawyers add value primarily by reducing regulatory costs, thereby challenging the reigning models of transactional lawyers as 'transaction cost engineers' and 'reputational intermediaries.'")

8.  My equally non-testable theory is that lawyers sometimes add value to deals, sometimes subtract value, and appear most of the time during the deal for the same reason neckties do:  it's part of the ritual.  There is no intrinsic reason they have to be there.  Lawyers, like neckties, have value, not because they necessarily make the pie bigger, any more than neckties make the pies bigger, but because somebody values the lawyer enough to pay more for her to be there than it cost for her to get there (marginally speaking, of course).  That's the reason we buy $75 neckties and Rolex watches as well.  But we don't feel a need to justify the presence of the necktie or the watch as a "transaction cost mechanism."

9.  I am persuaded by years of observation that great lawyers (like Jim Freund, who Professor Gilson cites repeatedly) help make deals, but that there is nothing particularly lawyerly about it.  It is, as Vic Fleischer suggests, quarterbacking, or as David Zaring suggests, closing.  That strikes me as an aspect of leadership, something business schools teach, but with which law schools and law (qua law) struggle immensely. 

10.  Mostly, though, I step back and see the process as something akin to a Balinese cockfight, a ritual or ceremony that gives us some limited assurance of certainty in a highly uncertain and contingent world.  I find it equally plausible that the presence of all those lawyers doesn't do a damned thing to make the pie bigger - but they are necessary, and they do have value, just as the accoutrements to the cock-fight have value to the participants.  Their value is in what they do to give us the courage to overcome fear, panic, seller's remorse, buyer's remorse, and risk averseness. Again, as I said over in the comments, lawyers provide an alternative model for resolving disputes about the deal that is better than pistols at twenty paces, but the idea that the contract language provides certainty in anything other than trivial cases is a self-justifying illusion for lawyers.  I suppose what really bugs me comes from my intuition that the Gilson thesis is theory-laden in the sense that Ian Shapiro criticized in The Flight from Reality in the Human Sciences.  What comes first is the economic model and its assumptions about value and rationality, which is then imposed on a linguistic exercise, which is itself an imperfect model of a complex world.

Law & Economics, Legal Theory, M&A, Rants | Bookmark

TrackBacks (1)

TrackBack URL for this entry:

Links to weblogs that reference The Mythology of Value Creation: Lawyers, Neckties, and Balinese Cock-Fighting:

ยป http://prawfsblawg.blogs.com/prawfsblawg/2008/10/jeff-lipshaw-ha.html from PrawfsBlawg ...
"Jeff Lipshaw has a great post on the value of lawyers in business deals. He posits (in part) that la ..." [more] (Tracked on October 23, 2008 @ 9:41)
Comments (13)

1. Posted by Usha on October 23, 2008 @ 6:47 | Permalink

Great post, Jeff! I'm winging my way to a conference, but I think there's a longer conversation to be had about this.

2. Posted by Tina Stark on October 23, 2008 @ 7:34 | Permalink

I have student conferences in one half-hour so this has to be quick.
I think clients do need lawyers. They need lawyers to take the business deal to which they have agreed and to translate it into contract concepts that establish the legal basis for parties to interact and which can be enforced. Further, when memorializing the deal, each lawyer must look at the contract and determine whether there is a way to further advance the client's goals or to reduce its the risk. Others cannot do this because they don't have the knowledge or the skill to deal with the intersection between law and the business deal.
More later.

3. Posted by Mike Guttentag on October 23, 2008 @ 9:11 | Permalink

Agreed. As for point 10, this is why the lawyer who can close the deal is so valuable. He or she is able to help the client overcome the challenge of entering into a transaction in a highly uncertain world.

4. Posted by Ted McClure on October 23, 2008 @ 12:29 | Permalink

The empirical evidence on the business school side suggests that the primary motivation of managers is the avoidance of uncertainty. While transactional lawyers may be valuable for other reasons, the primary reason they are called in is to minimize the possibility of any departure from the parties expectations.

5. Posted by Conan on October 24, 2008 @ 16:31 | Permalink

That essay by Geertz is one of my favorite anthropological papers ever and the favorite of one of my undergraduate history professors who had a degree in Social Thought from University of Chicago. It gave me a bit of a shock seeing it applied to law but I think it fits in my limited perspective (I'm still a student).

6. Posted by Michael on October 25, 2008 @ 9:58 | Permalink

Not to disparage the ritual value of lawyers (and, in many countries, of notary publics), but I see transactional lawyers as performing at least three useful functions, in addition to the function Tina Stark alluded to (which I think of as akin to computer programming, probably because I've read too much Lessig).

1. Distilling bad outcomes.

Law firms keep form documents. When they become aware of attacks, especially successful attacks, on certain provisions of a document of that type, they adjust the form document to repel a similar attack in the future. The revised form document does not generally contain a reference to the actual attack, but part of the informal "lore" that is passed along with the form is "Make sure not to change that in this way, because if you do then someone could argue that...".

For example, how many firms pored over their form commitment papers after the Solutia case, to make sure their market MAC clauses were not vulnerable to the kinds of attacks that eventually led the syndicate in that case to come back to the table and hand over the funding they had committed? Three years from now, lawyers in those firms may not refer specifically to Solutia (or remember it) but they will still tell the junior associate "Make sure not to change that in this way, because someone could then argue..."

"Bad outcomes" aren't just cases. They can be instances where a borrower was able to funnel cash to the sponsor in a way the lender did not anticipate, or a buyer was able to get more of an indemnity payment than the seller thought it was on the hook for.

Think of the law firm as an oyster keeping the form document as a pearl; every time a blemish in the pearl starts irritating the oyster, it slaps another layer onto the pearl to make it more perfect. (And yes, form documents often bloat when law firms engage in the same process).

So, the first function of deal lawyers is to maintain a form document that distills, in it, the lessons learned from countless past "bad outcomes", together with a body of informal lore that law firms are, often, not very good at handling (but knowledge management is a topic for a different thread), but which allows practitioners to *use* the forms. The client, if given a form without the lore, would not be able to keep its protections through the negotiating process. In effect, law firms - ironically given their own KM non-prowess - are acting as a sort of KM repository for the business community.

2. "Quarterback" - managing conversations.

The first function often occurs away from clients' awareness - just lawyers discussing with each other how to revise the draft without impairing the distilled lessons, the protections, embedded into the document. This second function involves orchestrating the right kinds of conversations with the clients. Some portions of an agreement operate, in effect, like a giant checklist.

"Labor disputes. Do you have any? If you do, you need to schedule them here."

"Oh. I didn't realize this was going to come up. Hmmm. Guess I'd better go talk to them first, give them some context for this."

Have you ever heard a client complain that every time her lawyers turn the document, they just raise more issues? The lawyers aren't raising the issue, they're flagging pre-existing issues and giving the clients an opportunity to discuss them. This is perhaps related to Tina Stark's point above, about translating a business deal into a legal document with enforceable legal concepts; but it goes a step further, by forcing the business parties to face, and consider, the ramifications of what they are doing. No-debt covenant? Start thinking about what carveouts your business needs, and have a discussion with the lender about those.

There's nothing particularly lawyerly about coordinating reams of schedules, or about the process management aspect of arranging conference calls, reminding relevant parties of deadlines, etc. However, I would argue that it is a lawyerly function to understand the repercussions of any proposed resolution of an issue, and how that affects the ultimate skein of enforceable obligations at the end of the process. This means that if a client gives an answer that causes a problem elsewhere, the lawyer will be able to point it out and ask a follow-up question.

Put differently, the lawyer's role here is as a "dynamic checklist" - once you tick an item off, the checklist reconfigures itself based on your answer and presents you with a revised list of remaining questions, including any issues raised by your last answer. Since transactions involve inter-related issues that cannot be adequately captured by a static, "Questions 1 through 217" checklist, this is a valuable role.

3. Priest, not necktie.

Lawyers also serve a ritual role, but not a passive one. Certain rituals have to be performed in certain ways, or else courts may have trouble enforceing the rights that a party thought it had. One of the directors is incommunicado in the Australian outback this quarter? Well, according to [State] law, we need to get a quorum of the remaining directors in a room together because separate written consents require unanimity, and we do need board approval of this deal. Lawyers help the clients perform the rituals. One might decry this role, saying that the rituals were crafted by lawyers to begin with; but I don't think that's a fair argument against transactional lawyers. The rituals were put in place for reasons having to do with governance, admonition, and the like. I don't think there's a transactional lawyer lobby that fights to keep the apostilling requirements in place. So transactional lawyers play a role in solving a "problem" (if you think these rituals serve an insufficiently beneficial purpose) that they do not, in fact, play a role in maintaining.

7. Posted by kevin on May 13, 2011 @ 21:51 | Permalink

Point 10, that's why the attorney who is able to close the deal is so important.

They're in a position to assist the client get over the task of getting in a transaction in a extremely unstable world

8. Posted by Coach Factory on April 24, 2012 @ 1:13 | Permalink

I didn't know Curley Howard played for BYU!

9. Posted by Coach Outlet on April 24, 2012 @ 5:26 | Permalink

Good!This post is creative,you'll find a lot of new idea,it gives me inspiration.I believe I will also inspired by you and feel about extra new ideas.

10. Posted by Cowboys Snapback on July 30, 2012 @ 22:00 | Permalink

I rarely hear non-rich people say this, which goes to my next point.

Post a comment

If you have a TypeKey or TypePad account, please Sign In

Recent Comments
Popular Threads
Search The Glom
The Glom on Twitter
Archives by Topic
Archives by Date
August 2016
Sun Mon Tue Wed Thu Fri Sat
  1 2 3 4 5 6
7 8 9 10 11 12 13
14 15 16 17 18 19 20
21 22 23 24 25 26 27
28 29 30 31      
Miscellaneous Links