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.

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"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)
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