The end of the semester hit like a ton of bricks, so there are a few blogposts that I semi-composed in my head and left unwritten. Plus this Associate Dean thing can make life a bit busy. But lest I get out of the habit of blogging entirely, here's a belated rant on Michael Malone's WSJ opinion piece, Reviving the Flagging Spirit of Silicon Valley.
Malone paints a picture of the vibrant, Wild-West Silicon Valley of yesteryear, where "anyone with brains, hard work, the guts to take real risks, and a whole lot of luck can become successful beyond their wildest dreams. That “anyone”—scientist, entrepreneur, secretary or receptionist—has a shot at the brass ring."
In Malone's story
The great turning point came with the dot-com bubble and its bust at the turn of the century. The bust allowed powerful institutions to get their hands on a place considered too renegade, too independent, and too successful to decide its own destiny. The federal government, long believing the Valley’s great companies were not displaying sufficient fealty—i.e., lobbyists and campaign money—came down hard on the tech industry. And as we all know, the Valley caved.
Then came a series of regulatory handcuffs. First was Sarbanes-Oxley, sold to the public as a curb on the corruption of the stock markets by over-pumped IPOs. In reality Sarbox was a way for Washington and big, mature tech companies to suppress new competitive startups that would lure away their talented employees. Next came the expensing of stock options by the Financial Accounting Standards Board.
I'm struggling with why my reaction to Malone's op-ed is so viscerally negative. After all, I teach and write in entrepreneurship. I like startups. And, for the record, what Malone says about the political economy is clearly right--it paid the price for thumbing its nose at Washington. Silicon Valley now spends a lot more money on Capitol Hill, and has reaped handsome returns, viz the JOBS Act.
Here's the rub for me: A lot of the policy arguments for the JOBS Act amounted to "We don't have as many IPOs/public companies as we used to! That's bad! Let's fix that!" To which I respond: How do you know what the right number of IPOs/public companies are? Just because they used to be at a certain level--say, in 2000--doesn't mean that's the right number. Maybe there are other reasons why IPOs declined, that have nothing to do with U.S. securities law.
To be fair, Malone 's gripe focuses on the fact that companies no longer widely distribute stock options to secretaries, receptionists, and the like. He blames FASB's move to expense stock options in 2004. But I keep coming back to Warren Buffet's simple questions: "“If stock options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world do they go?” FASB's rules should make sure that a corporation's books accurately reflect its finances. They're not about social engineering or fostering startups.
Malone mistakes correlation for causation thusly: "Say what you will, but the pre-Sarbanes, pre-FASB, pre-RSU Silicon Valley worked." It's not clear that the pre-Sarbanes, Pre_FASB Silicon Valley world was sustainable, even in a world without Sarbanes-Oxley or options-expensing. Moreover, his argument seems a particularly strange one given that Silicon Valley-style startups don't need any encouragement right now. A landscape with 83 private firms valued at $1 billion or more seems more bubblicious than moribund.
And, for the second time, get off my lawn.
As promised, the Yik Yak founders spoke at UGA yesterday. For those of you not in the know, Yik Yak allows users to post ("yak") anonymously in a 1.5-mile radius.
Coincidentally, the app had made the news on UGA just last week, for unfortunate reasons. Last Thursday night an undergraduate was found dead in her dorm room, apparently for still unexplained health reasons. While any loss of young life is sad, this particular student sounds like a really exceptional person. If you read the linked article, you will see that a racist idiot posted something offensive on Yik Yak as news of the student's death was unfolding. Institutional reaction was swift, and UGA's President decried the post.
So Yik Yak's founders walked into a charged atmosphere last night, to say the least. Honestly, we discussed canceling the talk, but felt that it would be good for us as a community to discuss the role of apps like Yik Yak on campus. A third-year student served as moderator and--in a "meta" move I lobbied heavily for--we took questions from the audience via Yik Yak. More on that in a separate post. Here are some highlights of what the founders had to say:
- They very much positioned themselves as just like the college students in the crowd. Tyler and Brooks started the app because wanted to give everyone an equal voice on campus--an equal chance to have their content spread. They painted college life as the ideal place for the young entrepreneur: no job, food and housing are taken care of, and you have an "awesome" group of beta users--the people you live with. Just cut out some partying, Netflix, or Chipotle, and you have time to launch a business!
- They said that bullying and racism were terrible, and that they are always updating filters to prevent it. The UGA bomb threat I blogged about in my first post was their first "big incident," and now if you want to yak something that the app deems dangerous a pop up will say, "Are you sure you want to post this? Yik Yak and law enforcement take this very seriously."
- On the racism/bullying/sexism front, Tyler and Brooks made the argument that Yik Yak offers a far more efficient response than Twitter or Facebook. With those services you have to go through an "arduous" reporting process. On Yik Yak, if 5 people downvote the post, it's gone. I'll note that, based on the screenshot, last week's racist comment received 4 negative votes within 39 seconds of being posted. Presumably it disappeared soon after, once it got the 5th vote. Honestly, to me as a minority teaching in a school in the deep South, the story is a positive one for Georgia. There are going to be jerks everywhere, and anonymity makes it easier for them to express themselves. But our community responded immediately and negatively to that horrible yak, and it disappeared quickly.
- How is Yik Yak going to raise money? A popular question, and the founders answer was that they were focusing on trying to grow the user base right now. "After that, shame on us if we can't figure out how to make money." Hmm, I'm not sure about that business plan, boys. But I'm not really the target demographic (or am I? Tune in tomorrow for more).
- Their advice to budding entrepreneurs: start simple and see what works. They had a nice story about spending 14 months designing an app that no one used and went nowhere. In contrast, Tyler threw together the first Yik Yak in a day and a half.
- Oh, as you redeem the Yakarma points you rack up using the app for Yak swag on the Yak campus tour. Apparently the socks are very popular.
The WSJ has launched the Billion Dollar Startup Club, which tracks venture-backed private firms valued at over $1 billion. I am getting crotchety in my old age, and view the fact that 73 companies fall into this category as a sign of extreme and unsustainable froth. After all, only 35 firms topped $1 billion in the dot-com bubble (adjusted for inflation).
For me these billion-dollar startups are a product of the JOBS Act's schizophrenia. On the on hand, Title I created the emerging growth companies that made it easier to go public. Because that's what we want, right? More public companies? But simultaneously Titles II, IV, and V made it easier for companies to stay private. Because that's what we want, right? For private firms to be able to raise money more easily and stay private longer? Hence the schizophrenia: the JOBS Act isn't sure what it wants, but it wants companies to be able to do it easier, whatever it is.
Now I sound like a hater, and I'm not. I just find it interesting that, for all of the talk of the need to make U.S. capital markets more amenable to new public companies, more and more VC-backed firms are staying private even with sky-high valuations.
Also, get off my lawn.
It has been a pleasure to guest-blog for the last two weeks here at the Glom. (Previous posts available here: one, two, three, four, five, six, seven, eight, and nine.) This final post will introduce the book that Lynn Stout and I propose writing to give better direction to business people in search of ethical outcomes and to support the teaching of ethics in business schools.
Sometimes bad ethical behavior is simply the result of making obviously poor decisions. Consider the very human case of Jonathan Burrows, the former managing director at Blackrock Assets group. Burrows’s two mansions outside London were worth over $6 million U.S., but he ducked paying a little over $22 U.S. in train fare each way to the City for five years. Perhaps Burrows had calculated that being fined would be less expensive than the inconvenience of complying with the train fare rules. Unluckily, the size of his $67,200 U.S total repayment caught the eye of Britain’s Financial Conduct Authority, which banned Burrows from the country’s financial industry for life. That’s how we know about his story.
But how do small bad ethical choices snowball into large-scale frauds? How do we go from dishonesty about a $22 train ticket to a $22 trillion loss in the financial crisis? We know that, once they cross their thresholds for misconduct, individuals find it easier and easier to justify misconduct that adds up and can become more serious. And we know that there is a problem with the incentive structure within organizations that allows larger crises to happen. How do we reach the next generation of corporate leaders to help them make different decisions?
Business schools still largely fail to teach about ethics and legal duties. In fact, research finds “a negative relationship between the resources schools possess and the presence of a required ethics course.” Moreover, psychological studies demonstrate that the teaching of economics without a strong ethical component contributes to a “culture of greed.” Too often business-school cases, especially about entrepreneurs, venerate the individual who bends or breaks the rules for competitive advantage as long as the profit and loss numbers work out. And we fail to talk enough about the positive aspects of being ethical in the workplace. The situation is so bad that Luigi Zingales of the University of Chicago asks point-blank if business schools incubate criminals.
New business-school accreditation guidelines adopted in April 2013 will put specific pressure on schools to describe how they address business ethics. Because business schools are accredited in staggered five-year cycles, every business school that is a member of the international accreditation agency will have to adopt ethics in its curriculum sometime over the next few years.
We hope that the work outlined in my blogposts, discussed at greater length in my articles, and laid out in our proposed book will be at the forefront of this trend to discuss business ethics and the law. We welcome those reading this blog to be a part of the development of this curriculum for our next generation of business leaders.
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My previous blogposts (one, two, three, four, five, six, seven, and eight) discussed the dangers of granting intracorporate conspiracy immunity to agents who commit coordinated wrongdoing within an organization. The last two blogposts (here and here) highlighted the harm that public and judicial frustration with this immunity inflicts on alternative doctrines.
In addition to exacerbating blind CEO turnover, substituting alternative doctrines for prosecuting intracorporate conspiracy affects an executive’s incentives under Director’s and Officer’s (D&O) liability insurance. This post builds on arguments that I have made about D&O insurance in articles here and here.
In traditional conspiracy prosecutions, the Model Penal Code (MPC) provides an affirmative defense for renunciation. The MPC’s standard protects the actor, who “after conspiring to commit a crime, thwarted the success of the conspiracy, under circumstances manifesting a complete and voluntary renunciation of his criminal purpose.” This means that the executive who renounces an intracorporate conspiracy faces no charges.
In contrast with conspiracy prosecutions, responsible corporate officer doctrine and its correlates fail to reward the executive who changes course to mitigate damages or to abandon further destructive behavior. Although the size of the damages may be smaller with lesser harm if the executive renounces an organization’s course of conduct, the executive’s personal career and reputation may still be destroyed by entry of a judgment. Modest whistle-blower protections are ineffectual.
Specifically, because of the way that indemnification and D&O insurance function, the entry of judgment has become an all-or-nothing standard: an employee’s right to indemnification hinges on whether the employee is found guilty of a crime or not. To receive indemnification under Delaware law, for example, an individual must have been “successful on the merits or otherwise in defense of any action, suit or proceeding.” Indemnification is repayment to the employee from the company; D&O insurance is a method that companies use to pass on the cost of indemnification and may contain different terms than indemnification itself.
Indemnification and D&O insurance are not a minor issues for executives. In fact, under many circumstances, employees have a right to indemnification from an organization even when the alleged conduct is criminal. Courts have acknowleged that “[i]ndemnification encourages corporate service by capable individuals by protecting their personal financial resources from depletion by the expenses they incur during an investigation or litigation that results by reason of that service.” And when hiring for an executive board, “Quality directors will not serve without D&O coverage.” Because of this pressure from executives, as many as ninety-nine percent of public U.S. companies carry D&O insurance.
So what does this standard mean for executives prosecuted under responsible corporate officer doctrine instead of for traditional conspiracy? Executives are incentivized either not to get caught, or to perpetrate a crime large enough that the monetary value of the wrongdoing outweighs the potential damage to the executive’s career. Because an executive’s right to indemnification hinges on whether he is found guilty of a crime or not, he has an enormous incentive to fight charges to the end instead of pleading to a lesser count. Thus, unless the executive has an affirmative defense to charges, like renunciation in traditional conspiracy law, there is no safety valve. Litigating responsible corporate officer doctrine cases creates a new volatile high-wire strategy. Moreover, as discussed in my last blogpost, responsible corporate officer doctrine imposes actual blind “respondeat superior” liability. Regardless of the merits, the executive may be penalized. So you can see the take-home message for executives: go ahead and help yourself to the largest possible slice pie on your way out the door.
I argue that in sending this message, and in many other ways, our current law on corporate crime is badly broken. My last blogpost for the Glom will introduce the book that Lynn Stout and I propose writing to give better direction to business people in search of ethical outcomes.
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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 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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Last week I visited Atlanta Tech Village, which opened last year in Buckhead and is founded and funded by David Cummings, a co-founder of Pardot who sold it for a reported $100 million. Cummings is channeling a significant part of his money into ATV, which is basically a big cool office building for startups. It's got standard Silicon Valley accoutrements: game rooms, snacks galore, 24-hour beer on tap, in-house coffeehouse open 7am-8pm (the signboard outside trumpeted that "extended hours" were coming soon!).
The idea is that it's a space for startups with 1-25 employees. The lower floors have smaller office space and as you move up larger spaces are available. Each floor had co-working space, and each wall was covered with scribblings from dry erase markers. Some looked like protobusiness plans or fancy equations, and others looked like artistic meanderings. They made me feel surrounded by creativity and innovation, and a bit intimidated.
Comapnies have to apply to get in, and have to agree to ATV's 4 values:
- Be Nice.
- Dream Big.
- Pay it Forward.
- Work Hard. Play Hard.
ATV isn't an incubator, because it doesn't take equity in the companies--it's more like a landlord, renting space and propel Atlanta forward as a place for startups and innovation. Because I'm an org-geek, I wondered about its organizational form: it's a for-profit, but according to our guide it's probably not going to pay for itself for decades.
So much for the descriptors. Is it going to work? I don't know. I'm by nature a skeptic, and many have tried unsuccessfully to recreate that Silicon Valley startup magic. But I want it to work, and I sure liked what I saw. I attended the weekly "startup chowdown": open to the public, $10 gets you 2 slices of pizza, salad, a drink, and a place to talk to entrepreneurs in ATV and around Atlanta. Then came Pitch Practice, an entertaining hour where anyone could take the mike, explain the context of their pitch, try it out, and get feedback from the crowd. We heard from 1) an entrepreneur who was attending a contest and had 30 seconds to convince attendees to vote for him so that he could give a longer pitch, 2) an entrepreneur with a 60-second pitch, and 3) 2 entrepreneurs with a 60-second pitch. It was really fun--the crowd was supportive, and really focused on helping each entrepreneur do a better job at conveying his message and accomplishing his personal goal.
Here's some language from the website that captures what I think ATV is trying to do:
Your workspace should be more than just a desk and a place to hang your hat – – it should bring the community together, promote serendipitous interactions, and be a powerful tool for recruiting the best talent. The Village is designed as a campus for cool people doing cool things in technology.
Fingers crossed, ATV.
In our last post, we discussed our framework for legal strategy called the five pathways. Today, we’d like to address how companies navigate within these pathways to attain the best results. As we mentioned in our MIT Sloan article, there is no one-size-fits-all approach to developing a legal strategy. Companies and industries are simply too diverse for such a simplistic solution. Instead, what we find is that legal strategy often is dependent on internal and external variables, such as company size, corporate culture, regulation, pace of technological change and the company’s maturity stage.
That is not to say, however, that a large and mature company in a regulated industry cannot cross the divide from risk management to a value creation pathway. One well established transportation company recently engaged in a strategic and cross functional (legal and finance) assessment of freight contracts to evaluate which ones to renew, cancel or negotiate. The company, which was operating at full capacity, changed its legal strategy to optimize its operations for the near and medium terms. This type of strategic contract assessment clearly fits within the value pathway.
To cross the divide and move from a risk management pathway (avoidance, compliance, prevention) to a value-enabling pathway (value and transformation) we suggest that C-level executives must view the law as an important and enabling resource for achieving strategic goals. This perspective requires a strong working knowledge of law, or legal astuteness, and organizational commitments such as the deployment of resources and authority to develop and test legal strategy.
Our research suggests that successful legal strategies require a champion, or what we refer to as a chief legal strategist. This is someone who is authorized by top management and recognized across the organization as the point person for driving legal strategies. Sometimes that individual is the general counsel, such as Twitter’s former chief legal officer, Alexander Macgillivray, who once stated that fighting for free speech is more than a good idea, it is a competitive advantage for the company. We find, however, that an associate general counsel is more often able to devote time to legal strategy execution. These individuals often possess strong legal and business fluency, leadership capabilities and the ability to work dynamically in teams.
For our next post, we'll offer more examples of companies operating within each pathway.
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.
Two recent developments in the law and practice of business include: (1) the advent of benefit corporations (and kindred organizational forms) and (2) the application of crowdfunding practices to capital-raising for start-ups. My thesis here is that these two innovations will become disruptive legal technologies. In other words, benefit corporations and capital crowdfunding will change the landscape of business organization substantially.
A disruptive technology is one that changes the foundational context of business. Think of the internet and the rise of Amazon, Google, etc. Or consider the invention of laptops and the rise of Microsoft and the fall of the old IBM. Automobiles displace horses, and telephones make the telegraph obsolete. The Harvard economist Joseph Schumpeter coined a phrase for the phenomenon: “creative destruction.”
Technologies can be further divided into two types: physical technologies (e.g., new scientific inventions or mechanical innovations) and social technologies (such as law and accounting). See Business Persons, p. 1 (citing Richard R. Nelson, Technology, Institutions, and Economic Growth (2005), pp. 153–65, 195–209). The legal innovations of benefit corporations and capital crowdfunding count as major changes in social technologies. (Perhaps the biggest legal technological invention remains the corporation itself.)
1. Benefit corporations began as a nonprofit idea, hatched in my hometown of Philadelphia (actually Berwyn, Pennsylvania, but I’ll claim it as close enough). A nonprofit organization called B Lab began to offer an independent brand to business firms (somewhat confusingly not limited to corporations) that agree to adopt a “social purpose” as well as the usual self-seeking goal of profit-making. In addition, a “Certified B Corporation” must meet a transparency requirement of regular reporting on its “social” as well as financial progress. Other similar efforts include the advent of “low-profit” limited liability companies or L3Cs, which attempt to combine nonprofit/social and profit objectives. In my theory of business, I label these kind of firms “hybrid social enterprises.” Business Persons, pp. 206-15.
A significant change occurred in the last few years with the passage of legislation that gave teeth to the benefit corporation idea. Previously, the nonprofit label for a B Corp required a firm to declare adherence to a corporate constituency statute or to adopt a similar constituency by-law or other governing provision which signaled that a firm’s sense of its business objective extended beyond shareholders or other equity-owners alone. (One of my first academic articles addressed the topic at an earlier stage. See “Beyond Shareholders: Interpreting Corporate Constituency Statutes.” I also gave a recent video interview on the topic here.) Beginning in 2010, a number of U.S. states passed formal statutes authorizing benefit corporations. One recent count finds that twenty-seven states have now passed similar statutes. California has allowed for an option of all corporations to “opt in” to a “flexible purpose corporation” statute which combines features of benefit corporations and constituency statutes. Most notably, Delaware – the center of gravity of U.S. incorporations – adopted a benefit corporation statute in the summer of 2013. According to Alicia Plerhoples, fifty-five corporations opted in to the Delaware benefit corporation form within six months. Better known companies that have chosen to operate as benefit corporations include Method Products in Delaware and Patagonia in California.
2. Crowdfunding firms. Crowdfunding along the lines of Kickstarter and Indiegogo campaigns for the creation of new products have become commonplace. And the amounts of capital raised have sometimes been eye-popping. An article in Forbes relates the recent case of a robotics company raising $1.4 million in three weeks for a new project. Nonprofit funding for the microfinance of small business ventures in developing countries seems also to be successful. Kiva is probably the best known example. (Disclosure: my family has been an investor in various Kiva projects, and I’ve been surprised and encouraged by the fact that no loans have so far defaulted!)
However, a truly disruptive change in the capital funding of enterprises – perhaps including hybrid social enterprises – may be signaled by the Jumpstart Our Business Start-ups (JOBS) Act passed in 2012. Although it is limited at the moment in terms of the range of investors that may be tapped for crowdfunding (including a $1 million capital limit and sophisticated/wealthy investors requirement), a successful initial run may result in amendments that may begin to change the face of capital fundraising for firms. Judging from some recent books at least, crowdfunding for new ventures seems to have arrived. See Kevin Lawton and Dan Marom’s The Crowdfunding Revolution (2012) and Gary Spirer’s Crowdfunding: The Next Big Thing (2013).
What if easier capital crowdfunding combined with benefit corporation structures? Is it possible to imagine the construction of new securities markets that would raise capital for benefit corporations -- outside of traditional Wall Street markets where the norm of “shareholder value maximization” rules? There are some reasons for doubt: securities regulations change slowly (with the financial status quo more than willing to lobby against disruptive changes) and hopes for “do-good” business models may run into trouble if consumer markets don’t support them strongly. But it’s at least possible to imagine a different world of business emerging with the energy and commitment of a generation of entrepreneurs who might care about more in their lives than making themselves rich. Benefit corporations fueled by capital crowdfunding might lead a revolution: or, less provocatively, may at least challenge traditional business models that for too long have assumed a narrow economic model of profit-maximizing self-interest. James Surowiecki, in his recent column in The New Yorker, captures a more modest possibility: “The rise of B corps is a reminder that the idea that corporations should be only lean, mean, profit-maximizing machines isn’t dictated by the inherent nature of capitalism, let alone by human nature. As individuals, we try to make our work not just profitable but also meaningful. It may be time for more companies to do the same.”
So a combination of hybrid social enterprises and capital crowdfunding doesn’t need to displace all of the traditional modes of doing business to change the world. If a significant number of entrepreneurs, employees, investors, and customers lock-in to these new social technologies, then they will indeed become “disruptive.”
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Last week, Elon Musk—CEO of Tesla Motors—announced on the company’s blog “All Our Patent Are Belong To You” (apparently an homage to a late 90s, ungrammatical internet meme--thx Brian Gividen for pointing this out). Musk claims to adopt an “open source” policy for Tesla’s patents. He elaborates, “Yesterday, there was a wall of Tesla patents in the lobby of our Palo Alto headquarters. That is no longer the case. They have been removed, in the spirit of the open source movement, for the advancement of electric vehicle technology.”
Musk’s move has been hailed widely in the blogosphere as an act of altruism (e.g., here & here). Most of this sentiment has been fairly unreflective. (However, for a certain-to-be prescient analysis that focuses more on the business implications of Musk’s move, see my colleague Orly Lobel’s comments over at Prawfsblawg and Harvard Business Review blog. While I’m quite sympathetic to most of Orly’s observations, as I explain below, I’m quite skeptical of her view that the move will be “good for faster industry innovation.”)
However, like most patent “give-aways,” legal loopholes usually spoil the party. Specifically, Musk stated that “Tesla will not initiate patent lawsuits against anyone who, in good faith, wants to use our technology” (emphasis added). Of course, “good faith” is a legal term of art large enough to drive a diesel-spewing, 18-wheeler through, much less a zero-emissions Tesla (and this loophole has been roundly noted by a few observant journalists).
Most importantly, is Musk (or his lawyers) expecting that others that use Tesla’s patented technology also make their patents available to Tesla? In more narrow terms, is the result similar to Twitter’s supposed “give-away” that reserved to Twitter the right to sue a competitor if the competitor sued Twitter? Probably so.
Thus, like Twitter, Tesla’s giveaway appears ultimately to boil down to a generalized offer to cross-license with competitors, including potential entrants. As such, Musk’s “give away” is not terribly radical, because cross-licensing in the high-tech and auto industries is fairly commonplace (veritable “keiretsus” in Scott Kieff’s words).
In this regard, as Michael Schallop, an IP attorney recognized, Tesla “wants to encourage others to develop on a common platform, and to the extent that they’re doing so, Tesla is not going to stop that by using its patents offensively.” Indeed, as I have described elsewhere, forcing smaller competitors and potential entrants to cross-license typically provides the incumbent (here, Tesla) a strong advantage, because the incumbent often controls “complementary assets” that provide competitive advantages aside from IP, like robust sales & marketing channels, access to capital, and the like. So, at worst blush, Tesla’s putative altruism could actually keep small, innovative entrants out of the commercial marketplace by effectively forcing them to license their patents to Tesla.
Furthermore, as others have noted, much of the Tesla patent portfolio does not seem particularly strong, nor does it appear to include much of its fundamental technology (which appears to be kept largely as trade secrets). Like IBM’s giveaways of several years ago, one wonders if Tesla found that giving away its patents would yield more revenue by seeding its technology widely—benefiting not only from potential infrastructure effects, but also from the consulting and joint venture dollars that go along with actually explaining to licensees how to implement the technology (specifically by using Tesla’s trade secrets and know-how, which Musk is not divulging). So perhaps Tesla is “patent washing” to offer the proverbial “Trojan horse” (sorry, last cliché) to the larger auto manufacturers (and even lure gullible “anti-patent” engineers to Tesla—see Orly Lobel’s points on these issues).
Or maybe Musk truly thinks he’s being altruistic. Unfortunately, contrary to Musk’s proclamation, “giving away” patents (even putting aside the “good faith” loophole) usually doesn’t mean “open source.” The reality is that Musk’s act is likely to redound much more to his self-interest than society’s.
If Musk were truly concerned about society being able to use Telsa’s technology, he’d specifically agree to the following terms: a royalty-free license to all Tesla current and future patents to any comer in writing with the single exception of maintaining an enforcement right against incumbents or large entrants (but not startups or small entrants) who sue Tesla for infringement. Additionally, Tesla would disclose all of its trade secrets under similar terms and use vigorous efforts codify Tesla’s know-how in so doing.
Of course, Tesla’s “give-away” is quite a ways from this much more thoroughly “open source” approach. As such, I’m not particularly optimistic that Tesla’s current policy will ultimately promote faster innovation or the more rapid adoption of electric vehicles. Perhaps even more unfortunate is the general inability of the press even to spot these issues, much less analyze their ramifications.