Thanks for joining this episode of the No. 86 lecture series, where we discuss basic principles and applications of Corporate Law along with landmark cases. Today’s episode features Robert T. Miller, the F. Arnold Daum Chair in Corporate Finance and Law. Professor Miller’s research concerns corporate and securities law, the economic analysis of law, and the philosophy of law. As always, the Federalist Society takes no position on particular legal or public policy issues; all expressions of opinion are those of the speaker. Professor Miller, why should a student take a corporate law class? What if they have no intention of practicing in an area that involves corporations or finance? Is this class still useful for them? Why should you study corporate and securities law, if these seem to you to be about the most boring subjects imaginable? The answer to that is corporate and securities law is the area of law where, along with antitrust, law and economics reaches the height of its powers. Law and economics is about employing economic concepts and methods to understand legal problems. And the thing about economics, as Milton Friedman once said, is that understanding an economic argument usually requires the ability to understand more than one step in reasoning. Here's what I mean. Suppose that in a franchise agreement between, say, McDonald's and a small business owner for the operation of a particular McDonald's location, you find a provision that says that McDonald's may terminate the franchisee for any reason or no reason, whenever it feels like doing so. In fact, you probably will find a provision like that. Who benefits from that provision? The simple answer is McDonald's does. It's called a guillotine provision. It looks like a terrible provision from the point of view of the franchisee. It's not. You might imagine that if we were to pass a law saying no provisions like this, if the franchisor, McDonald's, is going to terminate the franchisee, the small business person, that it has to be for cause, or it has to be a 90 days notice, or there has to be a hearing or due process, or something like that, you would think that you're benefiting the franchisee at the benefit of McDonald's. You'd be wrong, and here's why. In reality, there are going to be two types of franchisees, ones who do good jobs and ones who do bad jobs. The ones who do good jobs, McDonald's is never going to terminate, because McDonald's is in the business of franchising restaurants, and a franchisee who sells a lot of hamburgers? McDonald's loves that person. They're going to bend over backwards to keep that person. They're not going to terminate them without a decent reason. But then there are the bad franchises. Those are the ones McDonald's wants to terminate, and those are the ones you are making it harder for McDonald's to terminate. When you make it harder for McDonald's to terminate these people, however, what really happens is that McDonald's now knows it has to deal with two classes of people, the good franchisees and the bad franchisees, and the costs it incurs for the bad franchisees is going up. And for that reason, they're going to pay all franchisees less. All franchisees as a group are going to get a worse deal because of the added costs from the bad franchisees that McDonald's now has to deal with. You intended to transfer wealth from McDonald's to the franchisees. What you really did is you transferred wealth from good franchisees to bad franchisees, and it's even worse than you know. Because the reason that McDonald's normally terminates a franchisee is because the franchisee is not doing a good job. His or her restaurant isn't clean. In that restaurant, they allow the cheeseburgers to stay too long under the heat lamps, or they allow the shakes to melt, or whatever, but they produce food that is not up to McDonald's quality. When that happens, that particular location of McDonald's suffers, but so do all the other locations of McDonald's, because it impairs the McDonald's brand. If you go into one McDonald's and have a bad experience, you're going to be less likely to go into another McDonald'S. So, the provision in the franchise agreement that allows McDonald's to terminate bad franchisees quickly, for any reason or no reason, whenever it feels like it, not having to litigate the issue with the franchisees lawyers actually protects good franchisees from the bad acts of bad franchisees. If you want to understand the world and why people do things like this, create contractual provisions of this kind, you've got to think it through in economic terms. Perhaps this isn't the area of law you want to practice. It's a big world. There are lawyers who need to do all different kinds of things. But if you want to understand, either in a theoretical way or for some practical purpose or other, why economic activity gets organized the way it does, this is the type of course that will begin to tell you the reasons for that. What does a corporate lawyer do? How is it different from other types of legal practice? In both my mergers and acquisitions, and corporate finance classes, I spend most of the first class talking about the difference between transactional law and litigation. Litigation is what most non-lawyers know about the law. Lawyers go to court. They argue in trials, they cross examine witnesses, they make an argument to the jury. In appellate litigation, they go before courts like the United States Supreme Court, and they argue a case in front of a judge or judges. They are settling disputes. That's what litigators do, but that's not really what most lawyers do. Most lawyers are transactional lawyers, the kind of lawyer I used to be. Transactional lawyers don't get involved in disputes. It's our job actually to make sure disputes don't happen in the first place. Transactional lawyers advise clients, who are for the most part entering into business deals together. What kind of business deals? All kinds, banks lending money to companies, companies accessing capital markets by selling debt securities to the public, or to a bunch of investors in a private placement. One company acquiring another in a merger or an acquisition, the creation of new kinds of financial products like securitization transactions, licensing IP rights, all different types of business deals, in which lawyers participate by advising their clients and helping their clients structure the deal, to achieve the client's objectives in a way that also works for the parties on the other side, because this all involves a voluntary agreement between parties, unless both parties are willing to enter into the agreement. Obviously there is no agreement. This makes litigation very, very different from transactional work. Litigation, if you think about it, involves representing parties whose dispute has become so bitter that they cannot settle it themselves, but have to have the government do it for them. Transactional work involves representing parties who are going into business together in some form or another, because they think that both of them are going to get rich by doing it. It produces a completely different feeling. In a transactional setting, the parties who are coming together to do a deal already have a very high degree of trust in one another. If you think that the person on the other side of the negotiating table is a crook or a fraudster, or even just the kind of person who doesn't live up to his contractual obligations, you don't go into business with that kind of person. You have to have a pretty high degree of trust just to sit down at a negotiating table with someone. When a lawyer comes to that type of situation, what the lawyer is trying to do is to take the encoded business deal that the parties have already basically agreed to, and work out the details in ways that protect his or her own client's interests while at same time, making sure that the other party is still willing to enter into the deal. And that means pretty much making sure that that party's interests are respected as well. Because if that party's interests aren't respected as well, you can be pretty sure that the smart people on the other side of the deal on the other side of the table will figure that out pretty quickly, and there will be no deal. The art of transactional law is to figure out how to make everyone better off. That means when you come into a transaction as a deal lawyer, you have to understand the business is involved, how each party is making money, that involves knowing something about finance. That also involves knowing something about accounting, because accounting is how we keep track of the money we're making. And it also involves a great deal of a quality difficult to describe, but that might be called judgment or business sense in order to figure out what's realistically possible for the people around the table. I'll give you a good example of negotiating, which I draw from a political context, not from a business one, because it's more intelligible. During the Cuban missile crisis, the United States and the Soviet Union are basically negotiating over what's going to happen to those missiles in Cuba. And at one point, Khrushchev sent a letter to Kennedy, saying that if the United States were willing to withdraw its medium range missiles from Turkey, the Soviet Union would stand down about these missiles going into Cuba, and Jack Kennedy and his advisors dithered over it. And they didn't decide, couldn't decide whether it was a good idea or not. Is it a form of appeasement they were worrying about? They had more or less gotten to the point where they thought that this might be the best way out of the crisis. But then another letter arrived from Khruschev withdrawing this offer, and they didn't know what to do. And they were completely nonplussed, until Bobby Kennedy said, let's write back, accepting the offer anyway. That did not appear to be an option, but there's no reason why they couldn't do it, and that is exactly what they did. And when they wrote back, accepting the offer, pretending as if they had never gotten the second letter, that's how the Cuban missile crisis was resolved. It was resolved because Bobby Kennedy realized that there was a way of structuring an answer that no one else realized was there at the time. Business deals are very often like that. If you think of a new way of doing something, a new way of allocating rights and responsibilities, a new way of assigning risks to people that is actually efficient, that results in people who get the rights, who own the rights, valuing them more highly, people who get obligations being the ones who can fulfill them the most cheaply, people who are going to bear the risks, being the ones who can bear those risks most cheaply, you can create value. At the end of the day, the reason that we today in the United States are so much more wealthy than we were 10 years or 20 years or a hundred years ago, is because our economy works on the principle that voluntary exchange creates value. And that's what deal lawyers do. When you create new ways of facilitating voluntary exchanges that create value, you make the world a better place. That's one reason... There are many others, and I'll be talking about some of them today, but that's one reason I enjoyed being a transactional lawyer, and I think that anyone going to law school should think about being a transactional lawyer too. Do transactional lawyers ever end up in the courtroom? Is litigation ever a part of the job? If a transactional lawyer drafts an agreement and that agreement ends up in court, that transactional lawyer did not do his job correctly. Litigators think of contracts as things to be argued over in court. Transactional lawyers think of contracts as the guidebook for our continuing relationship. It's a plan about how we're going to live our life out together, while we're in business together. It is designed to avoid conflict, or to figure out how to solve those conflicts peacefully without litigation, without the involvement of anyone else later when they arise. Once again, it's the difference between conflict and agreement, between settling disputes and preventing them from ever occurring. It can be fun. And I'll give you a good example of how transactional lawyers make the world a better place. Several years ago, my wife and I bought a house in New York that was almost on the water, maybe within 500 feet of the water. And as we were buying this house, I called the insurance company that insured my old house that provided my own old homeowner's policy, and asked them to insure this house. And they said, no how no way, they would not insure this house. And I said, why? And they said, because it's in a hurricane zone being near the shore. Now that might strike you as somewhat strange. After all, if my house burns down in a fire, it costs a certain amount to rebuild it. If my house is knocked down by a hurricane, it costs a certain amount to rebuild it. What does the insurance company care what caused the loss? They just write the check for the amount, and they can of course limit the amount they write by capping their liability under the policy at the total amount insured. So why do they care? The answer is, that if my house burns down by fire on a given day, that does not affect the chances that my neighbor's house, half a mile away, burns down by fire. Those risks aren't correlated. But if my house is taken out by a hurricane, the chance that my neighbor's house a half mile away is taken out by a hurricane is extremely high. Hurricane losses are correlated, fire losses are not. And it gets worse, because the way hurricanes work is there are a lot of years when there are no hurricane losses, because there are just no hurricanes on the east coast of the United States. But in some years there are a lot of hurricane losses. So if you're an insurance company and you write homeowner policies, which are generally year to year policies, some years there'll be no hurricane losses. And other years there'll be a lot of hurricane losses. Compare that to fire losses, where they're pretty much the same every year. And of course the insurance company can't figure out which years will be the high hurricane loss years, and which ones will be the low hurricane loss years. And that means they can't price the risk, and hurricane losses become uninsurable. Well, starting from an idea in the academic literature, a bunch of very smart, transactional lawyers figured out how to solve that problem. They invented a new type of security called a catastrophe bond, and it works like this. A traditional insurance company writes policies that cover hurricane risk, say with maximum liability of $1 billion. Simultaneously with writing these policies, the insurance company goes into world capital markets and borrows the same amount, $1 billion. It takes that money and parks it in what we transactional lawyers call a special purpose, bankruptcy, remote subsidiary. That's a special kind of entity in corporate law, protected by certain types of agreements and certain types of corporate documents. And it basically means that the company can't touch the $1 billion, it just borrowed. In fact, it uses that $1 billion to secure the bonds, meaning that the bond holders have a right to get that particular $1 billion sitting in a lockbox as it were back one year from today. In addition, the insurance company pledges its full faith and credit, it becomes personally liable on the bonds, promises to repay the $1 billion, and promises to pay interest on that $1 billion as well. That makes these bonds incredibly safe for the investors, but there's a catch, and the catch is this. If those hurricanes come this year, and if the company has to pay out, say a billion dollars in losses on the policies, then the principal value of the bonds resets downward 95%. The insurance company keeps $950 million out of the billion, and the other $50 million goes back to the investors. They lose 95% of their principal. Now you might ask yourself, who in the world would buy a bond like that? And the answer turns out to be lots of people. And for the following reason. The risk on hurricanes is not correlated with the risk on most other bonds. In most other bonds, the primary risk comes from the business risk of the company issuing the bond. Business risks tend to be correlated across businesses, a recession in the economy will hurt all businesses pretty much the same, some more than others, but they all suffer. Hurricanes are not correlated with recessions, or with interest rate changes, or with other types of events that tend to affect businesses generally. Hurricane risk is uncorrelated with those risks. And if you know anything about portfolio theory in corporate finance, if you have a portfolio of bonds where all the risk is business risk, and you add to that portfolio a catastrophe bond, which has almost zero business risk, but a great deal of hurricane risk since the business risk and the hurricane risk are uncorrelated. The overall risk level of the portfolio goes down, not up. That means that lots of bond investors are delighted to buy cat bonds, catastrophe bonds. These bonds have turned out to be very successful. They're now a multi-billion dollar market for cat bonds. And the result is that a guy like me can get insurance for his house. The risk of hurricanes is transferred from the homeowner, to the insurance company, to a bunch of bond investors, a bunch of hedge fund people, all around the world. It moves from somebody who most certainly doesn't want it, the homeowner, to somebody, the insurer, who would like to take it but can't because he can't correctly price it, out to the hedge fund people who are happy to have it, creating a string of contracts and corporate structures that moves a risk from somebody who does not want to have it to somebody who is quite willing to bear it for a modest cost. It's a triumph of transactional law. Most cat bonds are not triggered, meaning that they don't reset downward. The investors get all their money back with a small amount of interest in addition. Several years ago, the first cat bonds were triggered. There was an earthquake in Japan and cat bonds related to that earthquake paid out and everyone, or at least some people, thought this is the end of catastrophe bonds. After these hedge fund investors took a bath and lost such a large amount of their principal on these cat bonds, no one would ever buy cat bonds again. That very Japanese insurer later that year went into the market to sell a new issue of cat bonds. And it was oversubscribed by more than 50%. In other words, if they were selling a billion dollars at the cat bonds, people were willing to buy 1.5 billion dollars worth of them. These things work, and they've continued to work in the market till today. What are some other ways that transactional lawyers create value for their clients? Imagine the following problem: The seller and the buyer are negotiating a merger. Not surprisingly, the seller thinks the company is worth more than the buyer thinks it's worth. Well, why would the seller think that? The seller will think that because the seller believes, or at least says he believes, that the earnings of the company are going to increase very rapidly in the future. Now, the buyer probably thinks the earnings are going to increase too. Otherwise he wouldn't be willing to buy the company. But he probably doesn't think that they're going to increase as rapidly as the seller thinks, or at least says how the earnings increase in the future completely determines the price today. So the question then becomes, how do we bridge the gap between the seller who thinks the earnings will increase quickly and the buyer who thinks that they'll increase, but not that quickly? Under the seller's scenario, for example, the company might be worth $150 million. Under the buyer's scenario, the company might only be worth $100 million. And the buyer and the seller might actually agree on all that. The only thing they're really disagreeing about is how the earnings will change in the future. So what do you do? If the seller will not sell for less than 150 and the buyer won't pay more than 100, then there's no bargain to be made and the deal falls apart. Well, it turns out creative lawyers might be able to solve that problem. There's a structure known as an earn-out. And the earn-out works essentially like this: We write an agreement that says, at signing, or at least at the closing of the deal, when the company changes hands, the acquirer pays $100 million to the seller. Something the acquirer is confident paying because he thinks the company will definitely be worth that much. But then, after the deal was closed, every year thereafter for, say, five years, this would all be subject to negotiation, we'll see how fast the earnings of the company actually increase. And if they are increasing at the levels that the seller has claimed that they will, then the seller gets additional payments. But if they're not increasing that fast or they're not increasing at all, then the seller gets either no additional payments or very small additional payments. In any event, the seller ends up with much less than the 150 he thought the company was worth. Conversely, if the earnings take off, the buyer pays more. And maybe the purchase price, when you include all the earn-out payments, gets up to the 150 the seller thought it was worth. What's going on here is the following: Usually, before the company is sold, the buyer bears no risk at all about the company's earnings. The seller bears all that risk. After the company is sold, the seller bears no risk and the buyer bears all the risk of the earnings. The earn-out provision manages to split the risk of the future earnings of the company. It puts some of the earnings risk back on the seller. But risk means upside risk and downside risk. If the earnings are less, the seller gets nothing. If the earnings are more, the seller gets paid more. The earn-out provisions in the agreement manage to split the revenue risk of the company between the buyer and the seller. You can think of it in more blunt terms as the seller putting his money where his mouth is. If he really thinks the company is likely to make so much more money in the future, we make the right to receive that extra money contingent on the company actually making that money in the future. Do you have any stories from your days at a law firm? Any examples that illustrate the difference between transactional and litigation practice? So if transactional lawyers are helping clients, who are going into business together to create wealth and split the joint surplus that their transaction creates between them, making them both better off, litigators are doing something quite different. In litigation, one party is effectively trying to take money away from another party. In litigation, if you lose, you're worse off. If you win, well, maybe you get what you were entitled to, less all that money you pay to your lawyers and experts. In litigation, even when you win, you kind of lose. This makes the practice of transactional lawyer and litigation completely different. When I was a Junior associate, I was a transactional lawyer, mergers and acquisitions lawyer, in fact. But my office was right next to the office of a litigation partner, and he and I shared a secretary. One day as I came back from lunch, this older fellow and the litigation partner was standing at his desk, screaming at his speakerphone. And it was apparent, he was yelling at a litigation partner from another firm. He was an older fellow, he was getting red in the face. I was worried he was going to keel over with a heart attack. And when he finally calmed down, I walked over, I knocked on his door and I said, Jack, everything okay? And he said, So and so from Weil Gotshal, a famous law firm in New York, his associate agreed that the deposition would be in our offices, and now he's trying to make us do the deposition in their offices, that no good SOB. Now that was very strange because Weil Gotshal's offices were about a thousand feet away from ours in Midtown Manhattan, and I'd been in those offices, they were beautiful, much like our offices. In fact, in a conference room, you might not even be sure whose offices you were in, ours or theirs. So why was it such a big deal, where the deposition would be held. Being a transactional lawyer I couldn't see any reason why it mattered. So I asked my senior litigation partner, Jack, what difference it makes? And he says, well, not, of course. But he agreed it's the principle of the thing. Ah, there you see. Litigators are out, always looking for every advantage, even if it doesn't really matter. We transactional lawyers have a different philosophy. When we have meetings, we don't really care where they are, except that we compete to see who can produce the nicest spread at lunch. The difference between transactional work and litigation affects everything. It affects the whole mood, it affects the whole attitude of the clients, and it even comes with an advantage that litigators don't appreciate. Litigators will tell you that one of the great things about a litigator is that they have to convince an impartial decision maker, a judge, or a jury of their position, and they're very proud of their ability to do it. And rightly so to a certain extent, but we transactional lawyers have a rather different scenario to deal with. When we go to a negotiation, a negotiation is really an argument. It's an argument in which you tell somebody who has a big financial interest, or so he thinks, in doing things one way, that he should actually do it your way. When you negotiate against somebody across a negotiating table, you are convincing somebody who's not an impartial decision maker, but is an entirely partial decision maker, to decide against what he perceives to be his own interest. So you have to convince him that in fact that's not really his interest, that the way that's best for everybody, is to do it the way you are saying. In my book, that's a much harder thing to do than to convince an impartial decision maker, like a judge of a jury. You look at portrayals of lawyers in popular culture, they're always litigators. Conflict is dramatic. It makes for great stories. All of these are great stories and many, the real ones, Brown versus Board of Education are really great stories, precisely because they did involve overcoming great injustices. The world does need litigators, and what they do is important, but it is about conflict. That is inevitable. Transactional lawyers are not about conflict. They're the exact opposite of conflict. They're about facilitating the transactions that make the world a better place. Thank you for listening to this episode of the No. 86 Lecture series on Corporate Law. The spirit of debate of our Founding Fathers animates all of the No. 86 content, encouraging discussion and critical reflection relative to how each subject is widely understood and taught in law schools and among law students. Subscribe to the No. 86 Lecture series on your favorite podcast platform to have each episode delivered the moment it’s released. You can also go to no86.fedsoc.org for lectures and videos on Federalism, Contracts, Jurisprudence and more. Thanks for listening. See you in class!