Lessons from ‘The Economics of Business Contracts’ by Professor Michael Klausner

I recently had the honour of attending Professor Klausner’s lecture on ‘The Economics of Business Contracts’ at NUS Law. Having a keen interest in both commercial law and economics, I was fascinated by Professor Klausner’s thesis that economic concepts can illuminate many aspects of contractual relationships. In this article, I hope to share some of the more notable and thought-provoking ideas from his lecture.

Professor Klausner raised a variety of case studies to illustrate his point that contract drafting and economic analysis should go hand-in-hand. Before delving into the specifics, however, I would like to explore 3 big ideas.

Big Idea 1: Contracts are born out of uncertainty

Whether we contract to study at a university or to embark on a joint venture with another company, we set out terms regarding an unknown future. We value certainty, and contracts provide assurances of future performance, payments, and obligations.

Big Idea 2: Uncertainty is not borne equally

Power asymmetry and imperfect information can create imbalances in the relationship between 2 or more parties. These imbalances are sometimes created or amplified by contracts between the parties.

Big Idea 3: Lawyers benefit from understanding economics

Economic theory can help plant red flags where an unequal relationship causes a party in a contract to be disadvantaged. In such situations, the terms of a contract – even terms that appear boilerplate – need to be examined closely.

With these big ideas flagged out, let us look at how economic analysis shed light in 3 different contracts.

 

PerkinElmer & Sonoran Scanners: Contingent Contracts

How much is a company worth? In a merger and acquisition, this can be a difficult question for buyers to answer, especially when there is potential for synergy with existing operations. Perhaps we can only truly tell how much a company is worth after the acquisition is completed and tangible benefits can be measured in sales figures or profits.

When PerkinElmer acquired Sonoran Scanners, they agreed on a contingent contract. On top of a base price, the owners of Sonoran Scanners would be paid a multiple of the number of Sonoran Scanners sold under PerkinElmer for a period of time after the acquisition. This way, it was presumed that Sonoran Scanners would be valued fairly based on how much additional sales it generated for PerkinElmer.

However, only 1 unit of Sonoran Scanners was sold in the 28 months after the acquisition. The owners of Sonoran Scanners alleged that PerkinElmer had overcharged, underdeveloped, and mismanaged the operation, failing to meet an implied obligation to grow the business in good faith.

The problem in this contract was that it levied a tax on PerkinElmer for each unit of Sonoran Scanners they sold. This created an incentive for PerkinElmer to undersell the scanners, and to delay sales until after they were no longer required to continue paying the owners of Sonoran Scanners.

The whole idea of contingent contracts is that future sales figures can be used to measure how much the acquired company is worth. However, this method of valuation is frustrated by the very existence of the contingent contract that reduces the buyer’s motivation to sell more units. As a result, the seller is systemically underpaid for their company.

 

Miami Dolphins: the Right of First Refusal and the Winner’s Curse

In the mid 1990s, the legendary NFL team the Miami Dolphins was jointly held by the Robbie Family and Wayne Huizenga. Facing financial pressures, the Robbie family wanted to sell a portion of their stake in the Miami Dolphins. Any sale, however, would first have to go through Huizenga, who held a right of first refusal which entitled him to match any sale offer made.

Being a part owner, Huizenga has a much more intimate understanding of the Miami Dolphins’ operations than external third parties. He is privy to information – financial or otherwise – that helps him value the franchise more accurately. This places him in an advantageous position to any bidder trying to purchase the Robbie Family’s share.

Imagine you are trying to buy the Robbie Family’s share in the Miami Dolphins. If you make an offer and Huizenga declines to exercise his right of first refusal – in other words, the offer is accepted by the Robbie Family – you should be worried. That Huizenga, a party in the know, refuses to match your offer can only mean that your bid is too high. This is known as the Winner’s Curse. On the other hand, any offer that is correctly valued or too low would be ‘refused’ by Huizenga. As an external buyer, there is no way you can win this auction.

Knowing this, many bidders were deterred from participating in the auction; despite the cachet of the Miami Dolphins, only one offer was made and at a significantly lower price than what analysts valued the Miami Dolphins at. A less competitive auction means that bids tend to be lower, disadvantaging the seller.

 

Levi Strauss & Designs Inc: Asset Specificity

In 1995, Levi’s and Designs Inc entered into a joint venture in which Designs Inc agreed to operate stores promoting and selling Levi’s jeans. The stores were conceptualised as monuments to the design and quality of Levi’s jeans, in a way similar to how the futuristic aesthetic of Apple stores contributes to the appeal of their gadgets.

Built into the contract between Levi’s and Designs Inc was a put-call option should either party want to end the joint venture. If Levi’s wanted to exit and sell their share to Designs Inc, they would have to make an offer – say $50 million dollars. However, Designs Inc has the option to counter-propose to sell their share to Levi’s instead at the same $50 million dollars figure. Because each offer to sell is simultaneously an offer to buy, the parties need to ensure that their offer price is as equitable as possible. Professor Klausner drew the analogy of how this is similar to one ingenious method of dividing a cake between 2 people: ask one person to cut the cake, and the other gets to choose first which slice to take. This incentivises the cutter to cut the cake evenly.

Although it seems like a clever way to value the joint venture fairly, the put-call option does not work in this case because of asset specificity. The stores that Designs Inc operate are specific to Levi’s; the marketing, store renovation, and sales staff are all geared towards selling more Levi’s jeans. If the joint venture ends, the stores are not worth much to Designs Inc alone. On the other hand, Levi’s can always find another contractor to operate the stores, so the stores are worth more to them.

To illustrate this next point more clearly, let us assign numerical values, assuming Levi’s and Designs Inc hold equal proportions in the joint venture (although in actual fact Designs Inc held a 70% share).

Value to Levi’s Value to Designs Inc
Held by Levi’s alone $100 million
Held by Designs Inc alone $60 million

In this case, Levi’s can offer to buy Designs Inc’s stake for $31 million. This is a lowball offer; a 50% stake in the joint venture is worth $50 million to Levi’s. However, Levi’s can make this low offer because they know that Designs Inc will not turn around and decide to buy Levi’s stake for $31 million – in their hands, a 50% stake in the joint venture is only worth $30 million. The imbalance caused by asset specificity creates an opportunity for Levi’s to manipulate the put-call option to wrestle Designs Inc into selling their stake for a lower price.

 

Concluding remarks

Professor Klausner expressed his hope that his lecture would help junior lawyers develop a better, more systematic understanding of the dynamics surrounding contractual relationships. While senior lawyers may have developed an intuitive – and maybe even subconscious – understanding of these principles, learning the concepts explicitly is a more efficient method to help junior lawyers better advise clients on drafting equitable contracts.

Talk is growing about how AI is breathing down the necks of the legal profession; prominent figures like Richard Susskind promise a world where routine legal busywork will be done more efficiently by AI. This leaves lawyers with having to focus on more complex advisory work. Lawyers will be valued for their ability to provide insights on navigating new situations by combining legal knowledge, industry expertise, and a nuanced understanding of how people behave in different situations. For this, economics can prove invaluable.


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