12 Dec 2005  Research & Ideas

Using the Law to Strategic Advantage

Used proactively, corporate legal departments can give you a strategic advantage, argues HBS professor Constance Bagley. It's time for a new relationship between managers and legal.

 

Most managers think the legal department is that office down the hall where they go to keep out of trouble or write a binding patent agreement. And that's shortsighted, says Harvard Business School professor Constance Bagley. A company that makes proactive use of the law not only manages corporate risk, but also enhances shareholder value. The law isn't just for lawyers, either, she says. Managers must become more astute about the legal environment around them, and be willing to challenge and work with counsel to achieve best outcomes. At the same time, lawyers should understand the business environment, participate in corporate decisions, and be ready to push back when executives head toward murky ethical or legal waters.

Bagley's latest book, Winning Legally: How to Use the Law to Create Value, Marshal Resources, and Manage Risk, breaks new ground in this area, proposing to "bridge the communications gap" between lawyers and managers.

Sean Silverthorne: You argue that managers shouldn't just view the law as a compliance issue, but rather something that can be used actively to increase the firm's value and shareholder value. Could you expand on this idea a little?

Constance Bagley: Yes, I'd be happy to. The law offers a variety of tools managers can use to manage the firm more effectively. They range from contracts, which can be used to strengthen business relationships, allocate risk and reward, and preserve options, to various forms of intellectual property protection, such as patents, trade secrets, and trademarks. A trademark offers a way to capture the brand equity of a company or a product. BusinessWeek recently calculated that the value of the Coca-Cola brand was worth more than $65 billion. That value would quickly dissipate if Coca-Cola Co. failed to police its trademark by preventing others from using it to refer to something other than the Real Thing. Shareholder value is enhanced when a firm chooses an appropriate form of business organization, ranging from a limited liability company with pass-through taxation to a corporation with a corporate governance structure tailored to the firm.

Q: What should CEOs be thinking about in terms of better leveraging their legal resources? Are new organizational structures needed to support this? Better training for both managers and legal staff?

A: CEOs should be mindful of several things. First, there are legal dimensions to business and they, like the financial or IT functions, need to be managed. They are too important to delegate to persons, i.e., lawyers, who may not understand the broader business objectives.

Second, the law is often not at all clear-cut. It is very fact-specific. Moreover, moral and ethical considerations may decisively influence how the law is applied. As a result, purely technical legal advice is often inadequate. CEOs should be looking for lawyers with wisdom and the courage to push back if they believe the client is pursuing an unwise course of action. A counselor at law, not a hired gun.

Third, the organization must encourage the free flow of legal and business information to and from managers and lawyers so the lawyers understand the context in which a decision is being made and the competing considerations.

Fourth, CEOs need to be proactive and encourage general managers to bring counsel in early in the decision-making cycle; they should not wait until the last minute to fight a fire that has already started or to bless a deal that has already been struck. The available options to create and capture value and to manage risk increase substantially when the managers and lawyers work as partners both to craft the objectives and to devise the means of accomplishing them.

Fifth, every firm should have a general counsel or chief legal officer—one person either in-house or in an outside firm who oversees the legal functions and reports directly to the CEO. In many cases, the chief legal officer should be a member of the top management team who is expected to weigh in on all issues, not just represent the legal function.

Q: What managerial levels are we talking about here?

A: Certainly, every general manager needs to develop a degree of legal astuteness appropriate to their firm and industry. At a minimum, they need to know where the lines are on the field: that is, what conduct is legal and what is not. They also need to be able to spot legal problems before they become legal issues and to identify opportunities to use the law to create value and manage risk.

Q: Most managers don't have law degrees, so who do they turn to get the legal background they will need to work with legal staff on the issues you identify? Will they need special training?

A: I like to think that reading Winning Legally will give managers a real leg up as they strive to become more legally astute. I am very proud of the fact that both Jim Kinnear, former CEO and chair of Texaco, and Arthur Rock, venture capitalist extraordinaire, endorsed the book as a must-read for aspiring CEOs and managers. Companies also need to make sure that they provide in-house training on those issues of particular sensitivity in their industry. Exhorting employees to be ethical is not enough. As one manager convicted of price-fixing put it: "I thought I had morals. I still think I do. I didn't understand the laws."

The best training is firm-specific and focuses on those issues and tools of greatest relevance to the managers being trained. For example, managers of a firm like Microsoft need to know how to preserve the patentability of inventions, how to avoid infringing on the intellectual property rights of others, and how to compete hard but fairly. Intel has avoided antitrust run-ins in large part because it effectively trained its marketers about what were and were not permissible trade practices. The goal is not to train managers to be lawyers or to advise themselves but to give them the vocabulary and confidence to know when to call a lawyer and to be able to engage with their lawyers in deciding how to proceed.

Q: Just as managers have to become more learned about the law, you say that lawyers must become more business savvy. What is the lawyer's role in all this?

A: Lawyers advising firms or acting as in-house counsel need to learn enough about the general practice of management that they can communicate effectively with the management team. A lawyer who can't read an income statement or understand the rudiments of strategy is far less able to help the non-lawyers on the team consider alternate goals or ways of achieving them.

Our law schools need to do more in this area by offering courses in accounting, internal controls, and strategy. They are as important for a business lawyer as courses in civil procedure and evidence are to litigators. Practicing lawyers need to read the business press more widely and take advantage of executive education opportunities to increase their business acumen.

Q: How can managers ensure that legal strategy aligns with corporate strategy?

A: Framing is critical here. There are legal aspects to every corporate strategy. Law is not separate and apart from what managers do. The law affects each of Porter's Five Forces as well as the resources and capabilities of the firm. The availability of patents may be key to deciding what barriers to entry exist. The enforceability of covenants not to compete and assignments of inventions may determine who captures the value of knowledge created by employees. The risk of product liability may make it unwise to pursue certain marketing strategies, such as widespread direct-to-consumer advertising of a drug with known risk factors that must be balanced against the potential advantages of using the drug.

Vioxx, for example, might have been the right choice for people with chronic and painful arthritis who could not tolerate other painkillers, but not for someone with a less compelling need for pain relief. Legally astute managers are better equipped to take those considerations into account when deciding what to do during each stage of business development. Choices made early on can dramatically affect the options available later. A firm that permits a scientist to present a paper describing an invention to an international audience before filing a patent application has just lost the ability to patent the invention in Europe and Asia. Although the United States gives inventors one year from the date an invention is disclosed or sold to file a patent application, the rest of the world does not.

Legally astute managers are better equipped to convert constraints into opportunities because they recognize the enabling aspects of law and the value of compliance. Let me provide an example. Two banks failed to meet the Comptroller of Currency Community Reinvestment Act requirements for lending a certain amount of money to local customers. One bank brought in its lawyer and had him prepare a memo describing the minimum changes the bank had to make to comply. It went through the motions but did not change the way it did business in any meaningful way. The other looked at the requirements not as a constraint but as an opportunity. Their managers realized that there was an underserved population and figured out ways, such as increasing student loans, to not only comply but also gain profitable business in the process. Michael Porter and others have described a similar process occurring with respect to environmental compliance. By practicing strategic compliance management and treating compliance as an investment and not a cost, managers are more likely to not only keep out of trouble but also to find new opportunities for value creation and capture.

Q: You say that in many areas, and especially in the area of legal disputes, managers often defer too much to legal. What can managers do to resolve such a situation?

A: Every legal dispute is a business problem requiring a business solution. Instead of handing over disputes to the lawyers with a "you take care of it" attitude, managers need to take responsibility for their disputes. They need the same negotiating skills they use to close an acquisition or negotiate a contract to try to settle. If a case goes to litigation, you have already lost. As Priceline founder Jay Walker put it, it's not a matter of who wins, it's a matter of who loses less.

If the initial settlement efforts fail, the manager in charge needs to continually reassess whether it makes sense to continue litigation or put another offer on the table. Even decisions such as whether to put an expert witness on the stand that may seem best made by the litigators require managerial judgment. In a case brought against Texaco by Pennzoil over the acquisition of Getty Oil, Texaco's refusal to put on a damages expert proved to be a multibillion-dollar mistake. Convinced of victory in front of a jury, Texaco's lawyers decided against calling the expert, who would have testified that Pennzoil's damages should total, at most, $500 million. This testimony, the lawyers reasoned, would only dignify Pennzoil's claim. The jury heard only Pennzoil's expert—and awarded $7 billion in compensatory damages to Pennzoil. Jim Kinnear, then vice chair of Texaco, came away from the experience convinced that no CEO should put the company at risk in this way if avoidable. In contrast, Citigroup CEO and lawyer Chuck Prince paid $2.5 billion to settle claims related to Citigroup's work for WorldCom rather than take what Prince characterized as "a $50 billion roll of the dice."

Q: Which companies get this right?

A: No company gets it right all the time but several stand out as being more legally astute than others. These include Johnson & Johnson, Intel, PepsiCo, and eBay. When Johnson & Johnson was faced with the cyanide-tainted Tylenol capsules, its counsel recommended to CEO Jim Burke that J &J not admit responsibility for the capsules. Burke correctly perceived the issue to involve not just J &J's potential exposure for product liability but a threat to the brand and the credo of the firm. As a result, the resolution required the exercise of business judgment. He took responsibility for taking the product off the shelves, stopped selling it in capsule form, and added tamper-evident packaging even though those steps could have been used against J&J as an admission of guilt in a lawsuit.

When Intel first became dominant in its product market, top management instituted antitrust training that made it clear to Intel's managers that there are certain actions a firm with less market share can justify but that become illegal when taken by a firm with large market share. Intel did not let the legal concerns interfere with its fighting spirit but channeled that desire to be the best into creating better products, not foreclosing competition.

PepsiCo used litigation to protect its marketing strategy by successfully asserting that a former marketing manager who left to work for a competitor would inevitably use trade secrets for directly competing products if he were now permitted to work on marketing plans for the competitor. PepsiCo used a similar argument to prevent its advertising firm from working for a key competitor. PepsiCo's CEO worked closely with the CEO of its Frito-Lay unit and PepsiCo's general counsel to devise a strategy to remove trans fats from its products, then used the absence of trans fats not only as a hedge against potential product liability claims but also as a marketing edge.

Finally, eBay has used litigation in creative ways to protect the information on its sites from firms like Bidder's Edge that sought to aggregate it with data from other auction sites.

What all these firms have in common is the ability to integrate legal considerations into the firm's overall strategy, not only to stay out of trouble but also to create value and manage risk. That's what winning legally is all about.

Contracts Can Help Define and Strengthen Business Relationships

by Constance Bagley

The process of negotiating a contract can help the parties get to know each other better, clarify their objectives and expectations, and thereby strengthen their relationship. Although some argue that contracting can signal distrust and encourage opportunistic behavior,1 researchers have found that "clearly articulated contractual terms, remedies, and processes of dispute resolution" can complement trust-building behavior, such as flexibility, bilateralism, and repeated exchanges."2

If negotiated and structured properly, formal contracts can illuminate common objectives and avert potential disputes. They are not necessarily a sign of mistrust. As one lawyer put it, "I am sick of being told, 'we can trust old Max,' when the problem is not one of honesty but one of reaching an agreement that both sides understand."3

On the other hand, if poorly managed, the process of reducing an agreement to writing can create mistrust or generate ill will. Danny Ertel of Vantage Partners cautions negotiators to avoid focusing on just closing the deal without regard for how the deal will be implemented: "To be successful, negotiators must recognize that signing a contract is just the beginning of the process of creating value."4

Real business issues should be identified early, and the business parties should meet promptly to "discuss them in as amicable a manner as possible."5 Negotiators should avoid surprising the other side in public with potentially damaging or explosive information.

Rather than using the tactic of surprise or information asymmetries to try to get the other side to commit to something they might not commit to otherwise, negotiators should seek realistic commitments and ask tough questions about each party's ability to deliver.6 It is important to remember that the goal is to create value by crafting a workable deal, not to position the company for a lawsuit.

Lawyers should be told to resist the temptation to include redundant or unnecessary language from other deals. Instead, they should insist on only provisions that are truly necessary for their client.7 To do so effectively, the lawyers and managers need to work together so that the drafting attorney understands the company's business objectives.

The parties negotiating a contract should make every effort to be as clear as possible about their expectations. Slipping in a provision the manager knows would be unacceptable to the other side if it were pointed out is simply an invitation for a lawsuit. Instead of phrasing provisions that are unlikely to be well received in complicated jargon and burying them in lengthy drafts circulated to the entire working group, managers should instruct their lawyers to explain the provisions in understandable terms to the counterparty and their counsel and attempt to reach an agreement before circulating the drafts to the entire working group.8 It is far preferable to hash out any ambiguities at the negotiation stage while the parties are on good terms and in the mood to make a deal. Positions tend to polarize once the agreement is signed and a dispute arises.

Similarly, it is inappropriate to bury offensive terms in a pre-printed form contract in the hope that the other party will not spot them. Courts sometimes refuse to enforce such terms, especially when they appear in consumer contracts, conflict with the position taken in the negotiations, or are contrary to the spirit of the deal.

HP Services has successfully negotiated a number of larger outsourcing contracts. According to Steve Huhm, HP Services' vice president of strategic outsourcing, "Negotiating these kinds of deals requires being honest, open, and credible. Integrity is critical to our credibility."9

When negotiating a complex transaction, such as an acquisition, managers often find it helpful to have their counsel meet to resolve as many issues as possible while maintaining a list of open items. Periodically, the managers with decision-making authority then meet with their counsel present to go over the open items. After resolving whatever issues they can, the decision makers then meet separately with their lawyers and return to the bargaining table with a package offer that resolves the open items. This process provides a way for parties to trade issues that may be less important to them for issues that they value more. It also helps prevent the other side from using "salami tactics," which involve asking for a series of concessions with the suggestion that each concession is all that's needed to close the deal.

Excerpted by permission of Harvard Business School Press from Winning Legally: How to Use the Law to Create Value, Marshal Resources, and Manage Risk. Copyright 2005 Constance E. Bagley; all rights reserved.

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Footnotes:

1. See, for example, C. Hill, "Cooperation, Opportunism, and the Invisible Hand: Implications for Transaction Cost Theory," Academy of Management Review 15 (1990): 500–513.

2. Laura Poppo and Todd Zenger, "Do Formal Contracts and Relational Governance Function as Substitutes or Complements?" Strategic Management Journal 23 (2002): 707–725.

3. Quoted in S. Macauly, "Non-contractual Relatives in Business: A Preliminary Study," American Sociological Review 28 (1963): 58–59.

4. Danny Ertel, "Getting Past Yes: Negotiating as if Implementation Mattered," Harvard Business Review 82 (November 2004): 60–68.

5. Darin Bifani, "Win the Battle or Build a Relationship: How Japanese Style Could Help American Negotiators," Business Law Today 12, no. 5 (May/June 2003): 25. Darin Bifani, of the law firm of Baker and McKenzie, calls on American negotiators to pay more attention to the Japanese values of ningen kankei—human relationships—and wa—harmony. Japanese lawyers and managers are more likely to focus on the business relationship and, according to Bifani, "bend over backwards to correct business mistakes without being asked to, often at great corporate and personal cost and sacrifice." Ibid, 4. To maintain the appearance of harmony, conflicting positions are avoided, and people and their actions are very rarely, if ever, criticized in public.

6. David Yoffie, Judo Strategy (Boston: Harvard Business School Press, 2000), 201.

7. Ibid.

8. Ibid.

9. Louis V. Gerstner Jr., Who Says Elephants Can't Dance? (New York: Harper Business, 2002), 118.

About the author

Constance E. Bagley is an associate professor in the Entrepreneurial Management unit at Harvard Business School.