My previous blogposts (one, two, three, four, five, and six) discussed why conspiracy prosecutions should be used to reach coordinated wrongdoing by agents within an organization. The intracorporate conspiracy doctrine has distorted agency law and inappropriately handicaps the ability of tort and criminal law to regulate the behavior of organizations and their agents.
My Intracorporate Conspiracy Trap article argues that the intracorporate conspiracy doctrine is not properly based in agency law, and that it should most certainly not be applied throughout tort law and criminal law. As a result of the immunity granted by the doctrine, harmful behavior is ordered and performed without consequences, and the victims of the behavior suffer without appropriate remedy. My Corporate Conspiracy Vacuum article argues that public and judicial frustration with the lack of accountability for corporate conspiracy has now warped the doctrines around it.
Courts have used a wide variety of doctrines to hold agents of enterprises responsible for their actions that should have prosecuted as intracorporate conspiracy. Some of these doctrines include:
But the new applications of these alternative doctrines are producing distortions that make the doctrines less stable, less predictable, and less able to signal proper incentives to individuals within organizations.
An example of how piercing the corporate veil has been used to defeat intracorporate conspiracy immunity can be seen in the Morelia case. A previous blogpost discussed how the intracorporate conspiracy doctrine has defanged RICO prosecutions of agents and business entities. In Morelia, which was a civil RICO case, the federal district court, obviously outraged by defendants’ behavior in the case, explicitly permitted plaintiffs to pierce the corporate veil to avoid application of the intracorporate conspiracy doctrine. In a creative twist invented from whole cloth to link the two doctrines, the Morelia court overruled its magistrate judge’s recommendation to announce:
"Since the court has determined that plaintiffs have properly alleged that the corporate veil should be pierced, the individual defendants may be liable for corporate actions and any distinction created by the intra-corporate doctrine does not exist."
Regarding its test for piercing the corporate veil, the Morelia court further overruled its magistrate’s recommendation by focusing on plaintiffs’ arguments regarding undercapitalization, and its decision included only a single footnote about the disregard of corporate formalities.
The Morelia court is not alone in its frustration with the intracorporate conspiracy doctrine and in its attempt to link analysis under the intracorporate conspiracy doctrine with the stronger equitable tenets of piercing the corporate veil. More subtly, courts across the country have started to entangle the two doctrines’ requirements as intracorporate conspiracy immunity has become stronger and courts have increasingly had to rely on piercing the corporate veil as an ill-fitting alternative to permit conspiracy claims to proceed. Even large public companies should take note. No public company has ever been pierced, but a bankruptcy court recently reverse-pierced corporate veils of the Roman Catholic Church, which is far from a single-person “sham” corporation. My Corporate Conspiracy Vacuum article discusses additional examples and repercussions for incentives under each of these alternative doctrines.
My next blogpost will examine how frustration with intracorporate conspiracy immunity has led to volatility in responsible corporate officer doctrine and related control person liability. Ironically, executive immunity from conspiracy charges fuels counterproductive CEO turnover.
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My previous blogposts (one, two, three, four, and five) introduced why conspiracy prosecutions should be used to reach wrongdoing by agents within an organization. The 2012 prosecution of Monsignor Lynn for twelve years of transferring predator priests from parish to parish at the command and for the benefit of the Archdiocese of Philadelphia was defeated by the intracorporate conspiracy doctrine. Moreover, this was not the first time that the Roman Catholic Church had used the doctrine to help its bureaucrats escape liability for suppressing sex abuse cases.
In 1997, employees of the Roman Catholic Church in Connecticut were alleged—very much like Lynn—to have covered up the sexual misconduct of a priest, enabling him to continue to abuse children entrusted to the Church’s care by virtue of his office. When sued for civil conspiracy by the victims, the employees’ defense was that they were acting in the best interest of the corporation.
The Connecticut court found that the test for whether an agent is acting within the scope of his duties “is not the wrongful nature of the conspirators’ action but whether the wrongful conduct was performed within the scope of the conspirators’ official duties.” If the wrongful conduct was performed within the scope of the conspirators’ official duties, the effect of applying the intracorporate conspiracy doctrine is to find that there was no conspiracy. Because covering up the priest’s sex abuse was in the best interest of the corporate organization, the court found that the employees were all acting on behalf of the corporation. The court never reached the issue of whether the employees’ actions rose to the level of a civil conspiracy. Under the intracorporate conspiracy doctrine, it was a tautology that no conspiracy could be possible.
This case is interesting not only because it documents the way that the intracorporate conspiracy doctrine protects enterprises from inquiry into conspiracies, but also because of the subsequent history of its allegations. The full extent of the Bridgeport Diocese’s wrongdoings—if current public knowledge is indeed complete—only came to light in December 2009, twelve years after the 1997 case. It took twelve years, the combined resources of four major newspapers, an act displaying public condemnation of the Roman Catholic Church by members of the state legislature, and finally a decision by the U.S. Supreme Court to release the documents that could have become the basis of the intracorporate conspiracy claim in 1997. There is still no conspiracy suit or any criminal charge against the Diocese. Additional details about the case are available in my article The Intracorporate Conspiracy Trap. The article will be published soon in the Cardozo Law Review, and it is available in draft form here.
Astonishingly, none of the extensive news coverage about the sexual abuse cases in Bridgeport over those additional twelve years has connected these facts to the original 1997 case defeated by application of the intracorporate conspiracy doctrine. If the intracorporate conspiracy doctrine had not provided immunity, the case might have revealed the Diocese’s pattern of wrongdoing long beforehand and in a much more efficient way.
My next blogpost reveals additional dangers from the spread of the intracorporate conspiracy doctrine: frustration with the intracorporate conspiracy doctrine has started to distort other areas of law.
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My previous blogposts (one, two, three, and four) introduced why conspiracy prosecutions should be used to reach wrongdoing by agents within a business organization. The same legal analysis applies to religious organizations.
We should have been able to charge Monsignor Lynn and the Archdiocese of Philadelphia that directed his actions to hide the sexual abuse by priests with criminal conspiracy. Instead, Pennsylvania charged Lynn with two things: child endangerment and conspiracy with the priests.
As international news outlets later reported, Lynn could not be guilty of child endangerment because the state’s statute could not apply to an administrative church official who did not directly supervise children.
Lynn could not be guilty of conspiracy with the priests because he did not share their “particular criminal intent.” As the jury understood, Lynn was not trying to help a predator priest get from parish to parish so that “he can continue to enjoy what he likes to do.” Lynn was trying to protect the reputation of his employer, the Archdiocese—if the priests benefitted, that was a side issue.
So why didn’t the prosecution charge Lynn and the Archdiocese with conspiracy? It was the Archdiocese that directly coordinated and profited from Lynn’s actions. The intracorporate conspiracy doctrine, as discussed before, would bar that prosecution. In Pennsylvania, it is “well-settled that a corporation cannot conspire with its subsidiary, its agents, or its employees.”
Finally, considering other options, Lynn could not have been charged with possible crimes such as obstruction of justice. Lynn was too good: Lynn and the Archdiocese were so successful at covering up the sexual abuse and silencing victims, there was no ongoing investigation to obstruct. “Aiding and abetting” the Archdiocese’s cover-up of the sex abuse would have been difficult to pursue (see more here) and is not allowed under RICO in the Third Circuit.
My next blogpost will demonstrate that the Monsignor Lynn case was also part of a pattern by the Roman Catholic Church in America to use the intracorporate conspiracy doctrine to hide the coordinated wrongdoing of its agents to cover-up sexual abuse by priests. Fifteen years before prosecutors attempted to try Monsignor Lynn, the silenced Connecticut sex-abuse case showed the Church how effective this defense could be.
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My previous blogposts (one, two, and three) introduced the topic of how the intracorporate conspiracy doctrine prevents the prosecution of coordinated wrongdoing by individuals within organizations. This post illustrates the doctrine’s effect in the context of a specific organization—here a religious one: the Roman Catholic Archdiocese of Philadelphia and the systematic transfer of predator priests. This post is based on my article The Intracorporate Conspiracy Trap to be published soon in the Cardozo Law Review. The article is available in draft form here.
For twelve years, from 1992 to 2004, as Secretary for Clergy, Monsignor William Lynn’s job within the Philadelphia Archdiocese was to supervise priests, including the investigation of sex-abuse claims. In 1994, Monsignor Lynn compiled a list of thirty-five “predator” priests within the archdiocese. He compiled the list from secret church files containing hundreds of child sex-abuse complaints. On the stand, Lynn testified that he hoped that the list would help his superiors to address the growing sex-abuse crisis within the Archdiocese. But for twelve years Lynn merely re-assigned suspected priests, and he hid the abuse within the church. His superiors never acted on the list that Lynn gave them—in fact, they ordered all copies of the list destroyed—and Lynn never contacted outside authorities. As late as 2012, one of the “predator” priests on Lynn’s list was still serving in a parish.
All parties agree that Lynn’s actions in transferring priests who molested children allowed those priests to continue to abuse children, sheltered the priests from potential prosecution, and directly protected the Philadelphia Archdiocese’s reputation.
In fact, Lynn’s actions had been ordered by the archbishop on behalf of the Archdiocese. Lynn reported what he was doing to his superiors, who rewarded Lynn with twelve years of employment and a prominent position within the Archdiocese for doing his job as they saw it. Moreover, the archbishop himself inadvertently revealed the existence of the number thirty-five “predator” priests to the media, and he was the one who ordered all copies of the list to be shredded to keep it from being discovered in legal proceedings.
The instinct here is that this behavior—the transferring of predator priests to cover-up the sexual abuse of children—should have been illegal for Monsignor Lynn to pursue. But the Commonwealth could not prosecute Monsignor Lynn and the Archdiocese for conspiracy. Furthermore, immunity for Lynn’s behavior is now the rule in most state and federal jurisdictions around the country. As described in an earlier blogpost, the intracorporate conspiracy doctrine provides immunity to an enterprise and its agents from conspiracy prosecution, based on the legal fiction that an enterprise and its agents are a single actor incapable of the meeting of two minds to form a conspiracy.
My next blogpost will further investigate why this behavior was not illegal under our current system, and how we should have tried Monsignor Lynn.
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My first and second blogposts introduced why conspiracy prosecutions are particularly important for reaching the coordinated actions of individuals when the elements of wrong-doing may be delegated among members of the group.
So where are the prosecutions for corporate conspiracy??? The Racketeer Influenced and Corrupt Organizations Act of 1970 (“RICO”, 18 U.S.C.A. §§ 1961 et seq.), no longer applies to most business organizations and their employees. In fact, business organizations working together with outside agents can form new protected “enterprises.”
What’s going on here? In this area and many other parts of the law, we are witnessing the power of the intracorporate conspiracy doctrine. This doctrine provides immunity to an enterprise and its agents from conspiracy prosecution, based on the legal fiction that an enterprise and its agents are a single actor incapable of the meeting of two minds to form a conspiracy. According to the most recent American Law Reports survey, the doctrine “applies to corporations generally, including religious corporations and municipal corporations and other governmental bodies. The doctrine applies to all levels of corporate employees, including a corporation’s officers and directors and owners who are individuals.” Moreover, it now extends from antitrust throughout tort and criminal law.
What is the practical effect of this doctrine? The intracorporate conspiracy doctrine has distorted agency law and inappropriately handicaps the ability of tort and criminal law to regulate the behavior of organizations and their agents. Obedience to a principal (up to a point) should be rewarded in agency law. But the law should not immunize an agent who acts in the best interest of her employer to commit wrongdoing. Not only does the intracorporate conspiracy doctrine immunize such wrongdoing, but the more closely that an employer orders and supervises the employee’s illegal acts, the more the employer is protected from prosecution as well.
My next blogpost illustrates how the intracorporate conspiracy doctrine operates to defeat prosecutions for coordinated wrongdoing by agents within an organization. Let’s examine the case of Monsignor Lynn.
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In my previous blogpost, I granted the merit of defense counsel’s argument that the actions of discrete individual defendants—when the law is not permitted to consider the coordination of those actions—may not satisfy the elements of a prosecutable crime.
But what is the coordination of individuals for a wrongful common purpose? That’s a conspiracy. And, for exactly the reasons that defense counsel articulates, these types of crimes cannot be reached by other forms of prosecution. The U.S. Supreme Court has recognized that conspiracy is its own animal. “[C]ollective criminal agreement—partnership in crime—presents a greater potential threat to the public than individual delicts.” When we consider the degree of coordination necessary to create the financial crisis, we are not talking about a single-defendant mugging in a back alley—we are talking about at least the multi-defendant sophistication of a bank robbery.
Conspiracy prosecutions for the financial crisis have some other important features. First, the statute of limitations would run from the last action of a member of the group, not the first action as would be typical of other prosecutions. This means that many crimes from the financial crisis could still be prosecuted (answering Judge Rakoff’s concern). Second, until whistle-blower protections are improved to the point that employees with conscientious objections to processes can be heard, traditional conspiracy law provides an affirmative defense to individuals who renounce the group conspiracy. By contrast, the lesson Wall Street seems to have learned from the J.P. Morgan case is not to allow employees to put objections into writing. Third, counter to objections that conspiracy prosecutions may be too similar to vicarious liability, prosecutors would have to prove that each member of the conspiracy did share the same common intent to commit wrongdoing. The employee shaking his head “no” while saying yes would not be a willing participant, but many other bankers were freely motivated by profit at the expense of client interest to cooperate with a bank’s program.
My next blogpost will ask: where are the prosecutions for corporate conspiracy?
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It is a pleasure to be guest-blogging here at The Glom for the next two weeks. My name is Josephine Nelson, and I am an advisor for the Center for Entrepreneurial Studies at Stanford’s business school. Coming from a business school, I focus on practical applications at the intersection of corporate law and criminal law. I am interested in how legal rules affect ethical decisions within business organizations. Many thanks to Dave Zaring, Gordon Smith, and the other members of The Glom for allowing me to share some work that I have been doing. For easy reading, my posts will deliberately be short and cumulative.
In this blogpost, I raise the question of what is broken in our system of rules and enforcement that allows employees within business organizations to escape prosecution for ethical misconduct.
Public frustration with the ability of white-collar criminals to escape prosecution has been boiling over. Judge Rakoff of the S.D.N.Y. penned an unusual public op-ed in which he objected that “not a single high-level executive has been successfully prosecuted in connection with the recent financial crisis.” Professor Garett’s new book documents that, between 2001 and 2012, the U.S. Department of Justice (DOJ) failed to charge any individuals at all for crimes in sixty-five percent of the 255 cases it prosecuted.
Meanwhile, the typical debate over why white-collar criminals are treated so differently than other criminal suspects misses an important dimension to this problem. Yes, the law should provide more support for whistle-blowers. Yes, we should put more resources towards regulation. But also, white-collar defense counsel makes an excellent point that there were no convictions of bankers in the financial crisis for good reason: Prosecutors have been under public pressure to bring cases against executives, but those executives must have individually committed crimes that rise to the level of a triable case.
And why don’t the actions of executives at Bank of America, Citigroup, and J.P. Morgan meet the definition of triable crimes? Let’s look at Alayne Fleischmann’s experience at J.P. Morgan. Fleischmann is the so-called “$9 Billion Witness,” the woman whose testimony was so incriminating that J.P. Morgan paid one of the largest fines in U.S. history to keep her from talking. Fleischmann, a former quality-control officer, describes a process of intimidation to approve poor-quality loans within the bank that included an “edict against e-mails, the sabotaging of the diligence process,… bullying, [and] written warnings that were ignored.” At one point, the pressure from superiors became so ridiculous that a diligence officer caved to a sales executive to approve a batch of loans while shaking his head “no” even while saying yes.
None of those actions in the workplace sounds good, but are they triable crimes??? The selling of mislabeled securities is a crime, but notice how many steps a single person would have to take to reach that standard. Could a prosecutor prove that a single manager had mislabeled those securities, bundled them together, and resold them? Management at the bank delegated onto other people elements of what would have to be proven for a crime to have taken place. So, although cumulatively a crime took place, it may be true that no single executive at the bank committed a triable crime.
How should the incentives have been different? My next blogpost will suggest the return of a traditional solution to penalizing coordinated crimes: conspiracy prosecutions for the financial crisis.
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The Freeport case was filed as a so-called “derivative” lawsuit, in which shareholders sue board members and others on behalf of the company itself.
In a typical derivative suit, that money would go back to the company itself. This model has drawn criticism from some legal experts, who say these types of cases benefit plaintiffs’ lawyers but not the shareholders they purport to represent.
Freeport, however, will pay out most of the money in a special dividend to its shareholders, people familiar with the settlement said. After legal fees and other costs, Freeport investors are likely to get more than $100 million, or at least 10 cents a share, they said.
This appears to be the first example of such a payout, lawyers say.
It looks like the suit aligns the interests of the company and the shareholder plaintiffs by getting the insurer to fund the special dividend. Is that always the case, though? I would think that directors would be happy to admit to mistakes if it meant that the insurance company would send investors a check. Or even the corporate treasury a check. But anyway, it makes it surprisng that this settlement would be the first of its kind.
5 days ago the WSJ published an opinion piece on Delaware's fee shifting bylaws. I read it with interest, thinking "Maybe I should blog about that." Life intervened. In the meantime, my friend Steve Bainbridge posted not one, but two blogposts--footnoted, no less--on the topic.
I feel dispiritingly inadequate. But I also feel hearteningly efficient: Steve's made my work easier by first describing the fee-shifting bylaw on the merits (first post), and then applying an interest group analysis (second post)
You should read both Steve's posts, but what grabs me is the interest-group question. Steve takes as his starting point Larry Ribstein's riff on Macey & Miller's article, which is a candidate for the single law review article that most changed my view of corporate law. Usually at the end of my Corporations class's discussion of the duty of good faith, I say something like, "Yes, it's fuzzy. Maybe it's supposed to be..." Cue M&M:
Delaware could stimulate litigation by supplying legal rules that are unclear in application. The bar therefore has some interest in reducing the clarity of Delaware law to enhance the amount of litigation. But the bar risks killing the proverbial goose that laid the golden egg because it is primarily the certainty and stability of Delaware law that creates the opportunities for profits in the first place. The bar as a whole does not have an interest in making the law so unclear that corporations begin to move elsewhere in large numbers. The bar should instead favor an equilibrium point of uncertainty at which the marginal increase in bar revenues from litigation fees equals the marginal loss in revenues due to reduced incentives to incorporate in Delaware.
By this point in the semester I've waxed rhapsodic to my class about Delaware law. So I feel some guilt at disillusioning them by suggesting that the indeterminacy that so bedevils them and their outlining efforts may be by design. I can't help it, though. It's too much fun.
I digress. Steve's second post first asserts that:
Both sides of the litigation bar thus have a strong interest in banning fee shifting bylaws. Such bylaws would raise plaintiff costs, deterring lawsuits, reducing fees for all litigators.
To which I say, "Amen, brother." But then Steven suggests that
All corporate lawyers—litigators and transactional—have a strong incentive to oppose fee shifting bylaws. Hence, it was no surprise that the Delaware legislature—dominated in this area by the Delaware bar—leaped to ban such bylaws. The business groups that favor fee shifting bylaws were able to delay that action. But the final decision remains pending.
But that's not quite true, right? Certainly litigators want litigation. But deal lawyers don't want it--at least, not this particular kind of litigation. Indeterminacy over doctrinal areas like good faith is good for transactional types as well as litigators, because it gives them more nuances and risks to have to explain at length to boards as they advise on various types of action. The type of fee-shifting bylaw we're discussing, in contrast, is bad for deal lawyers--at least, if you think, as Steve does, that
There is a serious litigation crisis in American corporate law. As Lisa Rickard recently noted, “where shareholder litigation is reaching epidemic levels. Nowhere is this truer than in mergers and acquisitions. According to research conducted by the U.S. Chamber Institute for Legal Reform, lawsuits were filed in more than 90% of all corporate mergers and acquisitions valued at $100 million since 2010.” There simply is no possibility that fraud or breaches of fiduciary duty are present in 90% of M&A deals. Instead, we are faced with a world in which runaway frivolous litigation is having a major deleterious effect on U.S. capital markets.
If these suits amount to nothing more than a litigation tax on deals, then they discourage deals. And that's bad for deal lawyers.
Steve's posts left me with 2 questions:
- Small bore: Where are Delaware's transactional lawyers?
- Large bore: Will Delaware really be so short-sighted as to kill its corporate franchise goose?
In an exciting day for the University of Georgia, PepsiCo's CEO Indra Nooyi spoke on campus yesterday. Her remarks were titled "The Role of the Corporation in the Modern Age," and she spoke to our business and law students about Pepsi's "Performance with Purpose" initiative. She drew a sharp contrast between two visions of corporate social responsibility. The first, dominant in the 90s when she joined Pepsi, focused on "what we do with the money we make" (corporate philanthropy, volunteering at local organizations). The second type of corporate social responsibility focuses on "how we make our money," and has led Pepsi towards acquisitions like Tropicana and Quaker Oats, to diversifying their offerings with more nutritious foods, and to working towards water conservation in its manufacturing around the globe. Of course, there are limits to diversification: the public seems to be moving away from fruit juices. And Nooyi stressed that Quaker Oat's Gatorade was for athletes, not "people sitting on the couch watching athletes."
One student asked about the NFL domestic violence controversy, and she said she's said publicly all she would about that. But then she said that they were a corporate partner and held them to high ethical standards, and they were waiting to see the results of the Mueller investigation.
Asked for advice about becoming a CEO, Nooyi said this (I'm paraphrasing) "Don't go in thinking you want to be a CEO--that guarantees you won't ever become one. If you have an office with two windows, don't be thinking about how to get one with three. Instead, be brilliant at the job you're doing. Ask for the hard jobs. You might think you want the easy jobs, but you don't get noticed if you do an easy job well."
Interestingly, Nooyi said she had never asked for a promotion, but instead had always been recognized for doing a good job and tapped for the next level. The standard advice to women in the corporate world used to be to ask for raises and promotions, like men do. But recent studies suggest there is a social cost to women who do negotiate.
All in all, a great day for UGA. It's not every day the world's 13th most powerful woman visits campus.
In this post, which follows our earlier discussion of legal strategy, we’ll offer examples of companies situated within each of the five pathways. As Robert and I mentioned in our article, most companies follow the compliance pathway. Such companies insource legal compliance through their in-house legal department, or they may choose to partner with an external compliance verification service. A firm such as ISN, for example, has built a business handling compliance issues for corporations and their subcontractors. According to the Society of Compliance and Corporate Ethics, compliance is a thriving industry due to the increased legal penalties and regulations that companies face in today’s heightened legal environment.
The avoidance pathway is less frequent, given the high stakes and liability attached to this type of strategy. General Motors may have engaged in avoidance if it misled regulators about its faulty ignition switches. Avoidance issues tend to be costly to deal with, given the loss of trust and enhanced penalties that arise from this behavior.
The more interesting and rare pathways involve prevention, value, and transformation. An interesting and controversial prevention legal strategy involves trademark policing, which, in its most egregious form, devolves into the unethical and legally dubious practice of trademark bullying. For example, Chik-fil-A employs an aggressive strategy that targets large and small companies alike and uses the threat of trademark litigation to prevent anyone from encroaching upon its trademarked brands and brand equity. Setting aside the overreaching and legally dubious aspects of this approach, some companies legitimately use a preventive legal strategy that involves cease and desist letters, litigation, and U.S. Patent and Trademark Office administrative oppositions to protect the value of their brands and advertising. The Chik-fil-A case serves as a useful reminder, however, that aggressive legal strategies may push the boundaries of ethical behavior, sound legal argument, and public opinion.
Two recent examples illustrate how employing a legal strategy in the value pathway can generate positive and tangible financial returns. The first instance involves hedge funds investing in a corporate acquisition target and then filing suit in Delaware to challenge the valuation and seek an appraisal from the court. This legal strategy is referred to as appraisal arbitrage. Many of these cases either settle or result in substantially higher prices for the party seeking the appraisal.
Another value strategy that has been in the headlines recently involves tax inversions. Burger King’s recent decision to acquire Canada’s Tim Horton’s will yield business synergies, but it also exploits a legal maneuver allowed under current tax law permitting a company acquiring a foreign entity to reincorporate in the foreign jurisdiction. By reincorporating in Canada, Burger King will effectively lower its tax rate from 35% to 15%.
The last and rarest of legal strategies is transformation. This occurs when the top executives in a corporation integrate law as a core aspect of the firm’s business model to achieve sustainable competitive advantage. Few companies are able to achieve this strategic pathway, and it’s certainly not for everyone. One company that notoriously used law to achieve abnormally large market share and margins in the ticket processing industry was Ticketmaster. The ticket service provider used venue ticket licensing contracts that included several key provisions such as long term renewable exclusivity terms (up to 5 years), and more infamously, fee sharing provisions. Ticketmaster’s business model was, essentially, to take the bad rap for charging exorbitant convenience fees and sharing those fees with the venue, thus contractually locking them into a highly profitable and exclusive business system. It didn’t hurt that Ticketmaster’s pioneering CEO Fred Rosen was a Wall Street attorney turned impresario.
Another company that is showing signs of attempting to pursue a transformative legal strategy is Tesla Motors. Tesla’s recent announcement to offer open licensing terms for its battery and charging station patents illustrates a pioneering mentality that seeks to build a business ecosystem with other auto manufacturers. By doing so, Tesla has made a major legal bet that giving up patent exclusivity rights in the short term will yield long-term competitive advantage by helping to diffuse electric battery and recharging technology. The other legal strategy Tesla has pursued relates to its pioneering distribution model of direct sales to the consumer, bypassing the traditional dealership model established for conventional automobiles. To achieve this direct-to-customer model, Tesla has engaged state regulators to achieve exemptions from state dealership franchise laws. Tesla is clearly strategizing and innovating along many fronts that involve business, technology and law. It remains to be seen, however, whether these legal strategies will offer Tesla a long-term sustainable competitive advantage.
In our next and last post, we’ll discuss our experience teaching the five pathways of legal strategy to business students and how it has been a valuable resource in the classroom.
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The guilty verdict for Virginia ex-governor Bob McDonnell on charges of public corruption is a major headline of today. I've been thinking a lot about corruption for the past few months, so here are a few thoughts:
-Corruption is in the eye of the beholder. My Essay turns on the proximity of time of two donations and legislative action. In the most notable case, a member of the House introduced a bill the day after receiving a $1000 donation. Readers' reactions to the story fall into two distinct camps. One: OMG! I can't believe that! Two: So what? Why does that necessarily mean there's corruption? In answer I say:
-Timing does matter. From the WaPo:
[Prosecutors] backed up his story by using other evidence to weave a strong circumstantial case that an agreement had been reached between the businessman and the first couple based on the close timing of Williams’s gifts and loans and efforts by the McDonnells to assist Williams and his company.
In one instance, McDonnell directed a subordinate to meet with Williams on the same night he returned from a free vacation at his lake house. In another, six minutes after e-mailing Williams about a loan, McDonnell e-mailed an aide about studies Williams wanted conducted on his product at public universities.
-definitions are the name of the game. The Supreme Court's 2014 McCutcheon decision narrowed the definition of corruption to only cases of quid pro quo corruption--cases where there's an actual exchange. The McDonnell defense apparently conceded that there was an exchange, but contested whether the quo in question--events at the governor's mansion, setting up meetings for the donor--counted as "official acts." This is a broad definition.
-Corporations are always going to participate in political life. We expect them to lobby for positions favorable to their firms. See here for a recent WSJ article on disclosure of political spending, with quotations from some sterling law professors, including friends-of-Glom Mike Guttentag and Steve Bainbridge, who quite rightly observes that the risk is that managers spend the corporation's money "on their own preferences, as opposed to what's good for the company."
-So in corporate governance terms the question is how to sort the "good" spending that is for the benefit of the company from the "bad" spending that is driven by idiosyncratic managerial preference and doesn't do the corporation any good. But in political governance terms, the question is how to regulate even "good" corporate spending that we find to be corrupting. I at least don't have a good idea of how to draw that line. The Court says trading donations for access is fine, and so are donations that secure a candidate's gratitude. My hunch is a lot of people might call those corruption. But corporations need to be able to explain to candidates how the government's rules and regulations affect their business. I'm certainly not confident that the average politician knows much of anything about any particular issue.
So where does that leave me? Still wondering about corruption, and eager to get back to corporate and securities law, that's where!
This week’s Economist has a column praising my UCLAW colleague Stephen Bainbridge’s and University of Chicago law professor Todd Henderson’s creative proposal, published in the Stanford Law Review, to replace individual directors with professional-services firms acting as Board Service Providers (BSPs). (That article can be accessed here.) The column nicely summarizes the possible impact of such a change:
“Messrs Bainbridge and Henderson argue that this would require only a simple legal change but could revolutionise the stick-in-the-mud world of boards. It would replace today’s nod-and-a-wink arrangements with a market in which rival BSPs compete. It would create a new category of professional director. And it would allow BSPs to exploit economies of scale to recruit the best board members, introduce more rigorous training programmes and develop the best proprietary knowledge. Now, even the most diligent board member can only draw on his or her experience. BSPs would be able to draw on the expertise of hundreds. This would increase the chances that corporate incompetence will be corrected, corporate malfeasance found out and corporate self-dealing, in the form of inflated pay, countermanded.”
The BSP idea is very creative. (Frankly, I am always puzzled by the extent to which academics have trouble appreciating creativity. Perhaps—and I’m speculating here—traits such as creativity are weakly correlated with succeeding in the academic tournament—getting high LSAT scores, writing good law school exams, getting judicial clerkships, and placing law review articles?) I also agree that introducing market competition by enabling firms to compete on performance will likely benefit consumers and shareholders, as well as increase the leverage of the board vis-à-vis executive officers.
That said, I worry about uncontrolled expenditures as BSPs find yet another reason to bill the corporation another $250,000 for yet another “critical project.” My prior experience as general counsel of a corporation (plus my six years of practicing law in a law firm) make me skeptical of the incentives of partners within firms (“Bill, bill, bill!”). I worry about the ratio of the value of services to cost. While we may see a decrease in executive compensation as a result of increased board leverage, are we going to see an increase in the effective compensation (i.e., including billings) of the board? My guess is yes.
I also worry about the audit/gatekeeping function of the Board. After all, we have plenty of experience with auditors being firms, rather than individuals. And the record there doesn’t look so hot. Remember Enron and Arthur Andersen? And remember Ted Eisenberg’s and Jonathan Macey’s empirical study suggesting that Andersen was not an outlier but typical? While gatekeeping theory provides that market gatekeepers, such as investment banks and accounting firms, are incentivized to work hard to prevent malfeasance out of fear that their longstanding reputations will be damaged, the reality is that the reputational informational markets are noisy and manipulable. Moreover, the incentives of the firm’s agent – the functional gatekeeper – may diverge from the incentives of the firm. In other words, large firms may suffer from principal-agent problems, as has often been alleged with David Duncan, the lead audit partner responsible for the Enron account at Andersen. (In prior work, I wrote about the incentives of firms vs. individuals for the audit/gatekeeping function.)
But I suppose Henderson and Bainbridge would respond that still, those reputation markets would work better with firms competing with one another than the status quo—little to no competition with respect to individual directors (for various reasons).
Perhaps there’s room for compromise. If you’ve been following the accounting profession, you know that the PCAOB (the body that regulates the accounting of public companies) in an effort to improve the transparency of audits has proposed to require the disclosure of the name of the engagement partner for the most recent period’s audit. Also, it has been suggested that the engagement partner individually sign the audit report. It should not be surprising that accounting firms uniformly dislike these suggestions. This indicates that they are probably good ideas. Perhaps, then, as a means of dealing with the principal-agent problem within BSPs themselves and to ensure that the incentives of the firm’s agents (the persons who actually sit in board meetings) are more properly aligned, similar measures should be taken.
Since reading Barbarians at the Gate in the early 1990s, I have been a huge fan of business histories. Although I have read scores (perhaps hundreds) of business histories, my list of "must reads" is still long. Recently, I decided to read one of the books on that list, The Soul of a New Machine, Tracy Kidder's account of Data General's efforts to build a minicomputer in the 1970s. This book was published in 1981, and it deals with events during my high school years, so it is a great trip down memory lane.
Here is an observation about the founders of Data General early in the book:
Some notion of how shrewd they could be is perhaps revealed in the fact that they never tried to hoard a majority of the stock, but used it instead as a tool for growth. Many young entrepreneurs, confusing ownership with control, can't bring themselves to do this.
Hmm. The distinction between ownership and control is a familiar one in corporate law circles, but this Berle-Means concept is typically applied to large corporations. What does it mean in the startup context?
Chuck O'Kelley examines the connection between entrepreneurship and the Berle-Means corporation in his 2006 article, The Entrepreneur and the Theory of the Modern Corporation, 31 J. Corp. L. 753, but I am curious about viewing this from the other direction. As noted by O'Kelley, the separation of ownership and control is used by Berle and Means to describe firms after the decline of the classical entrepeneur, so it seems somewhat surprising to see Kidder use those terms to describe a startup.
Founders often exert a tremendous influence on a company, even when shares are held by other employees and investors. This control may emanate from their formal positions within the company (CEO, CTO) or perhaps from the respect they are paid from other employees. But I think it is fair to say that ownership matters a great deal in the startup context because it is more concentrated than in the public company context. Thus, to a large extent, ownership is control in a startup.
As Joan Heminway has pointed out, I participated in a discussion group at the SEALS annual conference last week entitled "Does the Public/Private Divide in Securities Regulation Make Sense?" It was an engaging discussion with a lot of interesting ideas and views shared. Part of the discussion focused on the notion of "publicness" as that term was used by Hillary Sale, Don Langevoort and Bob Thompson. That is, a public-driven demand for regulation of public corporations that accounts for more than just managers and their shareholders, but also for a corporation's "societal footprint" and its impact on non-shareholder constituents. As Sale puts it, "the failure of officers and directors to govern in a sufficiently public manner has resulted not only in scandals, but also in more public scrutiny of their decisions, powers and duties." Sale suggests that because the definition of public corporation and the public's view of the corporation has evolved, directors' and officers' understandings of their obligations needs to evolve. I was in Boston this past weeked at the ABA annual meeting, and it struck me that the ongoing back and forth at the grocery chain Market Basket raised some interesting issues surrounding publicness.
Market Basket is a private company with 25,000 employees and 71 stores in Massachusetts, New Hampshire and Maine caught in a battle for control. In June 2014, then president Arthur T. Demoulas and two other executives were ousted by the board, controlled by Arthur T.'s cousin Arthur S. Demoulas. Since that time, the company has been plagued by rallies, strikes, and protest, one attracting crowds of over 5,000, seeking to reinstate Arthur T. According to the Boston Globe, the turmoil apparently has "crippled" the company's operations, resulting in the company losing "millions of dollars a day," "stores with little food," and a "steep decline in business." Apparently, the outpouring of support for Arthur T. stems from his support of employees, which includes not only ensuring that managers and other employees are well-compensated and receive regular bonuses and special benefits, but also his "personal touch"--remembering the names of low-level employees and their sick relatives.
Last Friday, Massachusetts Governor Deval Patrick entered the fray, which news outlets found remarkable because until that time the governor had insisted that he would not get involved in what he termed a "private" dispute between a company and its shareholders. But it seems like the public impact of that dispute compelled him to act. The governor wrote a letter to the Market Basket board offering to help resolve the dispute. Although the governor insisted that he would not take sides, the letter noted that the dispute had gotten "out of hand." The letter went on to state, in part: "Your failure to resolve this matter is not only hurting the company's brand and business, but also many innocent and relatively powerless workers whose livelihoods depend on you."
The dispute is still ongoing and involves a lot of important issues both related to employees and the struggle for control of the company, but the dispute and the letter is an interesting commentary on publicness and the idea that even directors of private companies must be aware of the impact of public scrutiny and the manner in which that scrutiny may shape their decisions, powers, and duties.