The Function of Transactional lawyers

In honor of the AALS Business Associations Teachers Conference I'm attending this week, here's an old TCS Daily column:

Transactional lawyers play a critical role in virtually all business transactions. But why is this so? The reason people hire litigators is obvious—either they are being sued or they want to sue somebody else. Unauthorized practice of law statutes and bar admission rules give lawyers a near-total monopoly on litigation. The rationale for hiring transactional lawyers, by contrast, is less obvious. Much of the work of transactional lawyers entails giving advice that could be given by other professionals. Accordingly, it seems fair to ask: why does anybody hire transactional lawyers?

The question is neither an idle nor a rhetorical one. As Ronald Gilson and Bernard Black have observed, business people often have a "quite uncharitable view of what business lawyers do. In an extreme version, business lawyers are perceived as evil sorcerers who use their special skills and professional magic to relieve clients of their possessions."

In his book, The Terrible Truth About Lawyers, Mark H. McCormack, founder of the International Management Group, a major sports and entertainment agency, wrote that "it's the lawyers who: (1) gum up the works; (2) get people mad at each other; (3) make business procedures more expensive than they need to be; and now and then deep-six what had seemed like a perfectly workable arrangement. Accordingly, I would say that the best way to deal with lawyers is not to deal with them at all."

Pretty depressing stuff, especially if you hope to make a living as a transactional lawyer.

Part of the problem is that law schools mainly train their graduates to be litigators. While good litigators typically have good negotiating skills (most lawsuits being settled, after all), there is a fundamental difference between the largely zero sum context of litigation and transactional lawyering.

Successful transactional lawyers build their practice by adding value to their clients' transactions. From this perspective, the education of a transactional lawyer is a matter of learning where the value in a given transaction comes from and how the lawyer might add even more value to the deal.

Two competing hypotheses suggest themselves. The first might be termed the "Pie Division Role." In this version of the transactional lawyer story, lawyers strive to capture value—maximizing their client's gains from the deal. Although there are doubtless pie division situations in transactional practice, this explanation of the lawyer's role is flawed. Pie division assumes a zero sum game in which any gains for one side come from the other side's share. Assume two sophisticated clients with multiple advisers, including competent counsel. Is there any reason to think that one side's lawyer will be able to extract significant gains from the other? No. A homely example may be helpful: You and a friend go out to eat. You decide to share a pizza, so you need to agree on its division. Would you hire somebody to negotiate a division of the pizza? Especially if they were going to take one of your slices as their fee?

The second hypothesis might be termed the "Pie Expansion Role." In this version of the story, people hire transactional lawyers because they add value to the deal. This conception of the lawyer's role rejects the zero sum game mentality. Instead, it claims that the lawyer makes everybody better off by increasing the size of the pie.

The emphasis herein on the pie expansion model is consistent with our concomitant emphasis on transaction costs economics. For the most part, lawyers increase the size of the pie by reducing transaction costs. One way of lowering transaction cost is through regulatory arbitrage. The law frequently provides multiple ways of effecting a given transaction, all of which will have various advantages and disadvantages. By selecting the most advantageous structure for a given transaction, and ensuring that courts and regulators will respect that choice, the transactional lawyer reduces the cost of complying with the law and allows the parties to keep more of their gains.

An example may be helpful. Acme Corporation wants to acquire Ajax, Inc., using stock as the form of consideration to be paid Ajax shareholders. Acme is concerned about the availability of appraisal rights to shareholders of the two corporations. Presumably Acme doesn't care about the legal niceties of doing the deal—Acme just wants to buy Ajax at the lowest possible cost and, by hypothesis, with the minimal possible cash flow. In other words, the client cares about the economic substance of the deal, not the legal form it takes. As Acme's transactional lawyer, you know that corporate law often elevates form over substance—and that the law provides multiple ways of acquiring another company. A solution thus suggests itself: Delaware law only permits shareholders to exercise appraisal rights in connection with mergers. Appraisal rights are not allowed in connection with an acquisition structured as a sale of assets. Hence, while there is no substantive economic difference between an asset sale and a merger, there is a significant legal difference. By selecting one form over another, the transactional lawyer ensures that the deal is done at the lowest possible cost.

Parties would experience some transaction costs even in the absence of regulation, however. Reducing those nonregulatory costs is another function of the transactional lawyer. Information asymmetries are a good example. A corporation selling securities to an investor has considerably greater information about the firm than does the prospective buyer. The wise potential investor knows about this information asymmetry and, as a result, takes precautions. Worse yet, what if the seller lies? Or shades the truth? Or is itself uninformed? The wise investor also knows there is a risk of opportunistic withholding or manipulation of asymmetrically held information. Note that this is a species of the agency cost problem. One response to agency costs is monitoring, which in this context takes the form of investigation—due diligence—by the buyer. Another response to agency costs is bonding by seller, which in this context would take the form of disclosures including representations and warranties. In either case, by finding ways for the seller to credibly convey information to the investor, the transactional lawyer helps eliminate the information asymmetry between them. In turn, a variety of other transaction costs will fall. There is less uncertainty, less opportunity for strategic behavior, and less need to take costly precautions.

All of which is why both legal education and the apprenticeship served by young associates must emphasize not only legal doctrine but also economics and business. It may still be possible for someone lacking any knowledge of finance and economics to be a successful mergers and acquisitions lawyer, but I doubt it. As Mark McCormack observed, "when lawyers try to horn in on the business aspects of a deal, the practical result is usually confusion and wasted time." Transactional lawyers therefore must understand the business, financial, and economic aspects of deals so as to draft workable contracts and disclosure documents, conduct due diligence, or counsel clients on issues that require business savvy as well as knowing the law.

Comments

[save_the_rustbelt]

I have, over 35 years, worked with many transactional lawyers who have added immense value to client transactions (I'm a CPA and consultant).

Much of the value is in anticipating issues and limiting risk, and much is simply putting all of the technical nuts and bolts in place.

In some areas (mine being health care) specialized knowledge has immense value (such as coping with Stark I, II, III).

Some bad news though. As a generalization, the more elite the law school the lower the value-for-$$$ equation - too much ego and too many associates to feed. There are exceptions.

The best transactional lawyers will listen to other advisors with specialized knowledge, the worst will not (too much lawyerly ego).

[LDC]

In my not entirely limited experience, corporations hire transactional lawyers because they have no choice. You're right that generally they do not consider us to add value, but rather they view us as a necessary evil. For better or worse, you can't just go out there and sell securities without legal advice or you will, rather often, have just given away a put right to all of your investors and you won't even know it. If you are a company purchasing another company, the laws are so complicated that even an intelligent business person would have a difficult time actually effecting a legal transfer of assets or securities. None of this is to say that lawyers OUGHT to be necessary, but certainly the regulatory system we have today makes it us indispensible. I like to think that we are kind of like guides through the wilderness. It's true that a liberal arts major like myself has had to struggle to understand what is going on well enough to be as helpful to clients as possible, and yes, reviewing something like MD&A is especially difficult for a person with no finance background, but you don't have to be an accountant (thank God!) to, for example, draft a no-action letter request, review an ethics code, draft an 8-K, or even analyze and explain Revlon duties. But yes, eventually, to be a good lawyer you have to be able to understand your client's business and goals. As for how things work out in the absence of market regulation, 5th century BC Athens might make for an important point of comparison.