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Introduction

Business Law is typically a two-semester sequence at business schools throughout the United States. The first semester involves what is known as the Legal Environment of Business. This focuses on the relationships of marketplace actors among one another. The second semester involves what is known as the Regulatory Environment of Business. Here, attention turns to the relationship between the firm and the various levels of government that regulate the conduct of the firm. This textbook is directed toward the Legal Environment of Business.

For many managers, the legal environment is, at first, a curiosity. Managers are curious about how the legal environment affects them, but they quickly realize that fully understanding the law is time consuming and difficult. Instead of implementing legal strategy into agreements, negotiations focus on total cost (T) as some function of price per unit (p), quantity (q), and negotiating skill (n). That approach could be defined like this:

T=f(p,n,q)=∫n*qdpdq

This approach is badly misplaced however. A manager who is focused on price and quantity will quickly find that taking large legal risks without accounting for changes in price in the face of a constant quantity can be very dangerous. This manager discovers that there is a worst case scenario (X) and some probability that it will happen, which has nothing to do with price or quantity:

E[X]=∫−∞∞x*f(x)dx

where

f(x)=12πe−x22

the probability density of the standard normal distribution. This book challenges that f(x), the function of something going wrong, is mere randomness. Rather, a legal strategy operates to 1) locate risks, 2) assign costs to risks, and 3) determine whether risks are worth taking.

The legal strategy of a firm or a future firm can be modeled, at least at generally, with Michael Porter’s Five Force Model.1 Porter analyzes industries as a whole and not firms, but the framework is still helpful. He considers the competitive nature of the industry, the availability of substitute products, the ability for new entrants to come into the industry, the power of suppliers, and the power of customers.

Porter’s model is static and simply measures the competitive landscape of an industry at a specific point in time. Legal strategy leverages legal tools and techniques to become more competitive over time by managing 1) risks within the firm, including relationships between owners and employees; 2) risks between the firm and its suppliers; and 3) risks between the firm and its customers. This monograph models these risks through microeconomic theory.

Chapter 1 lays out a microeconomic framework that is used throughout the text. There are buyers and sellers in the marketplace. Most firms are buyers and sellers in different markets at the same time. Firms have limited resources and need to select the marketplaces that they enter carefully. The chapter concludes with deviations from neoclassical models provided by inefficient information.

When acting in the presence of inefficient information, actors behave differently in the marketplace and engage in games. These games involve players who, much like actors under neoclassical theory, want to ensure the best outcomes for themselves.

These games have a common goal—profit and a common enemy—transaction cost. Chapter 1 introduces the protagonist of the story—Ronald Coase—whose legal strategies set forth much of the remainder of the text by finding ways to reduce transaction cost, determine risk, and assign the risk between parties.

Risk has two components: likelihood and magnitude. Chapter 2 deals with magnitude of risk where the defendant prevails. In the United States, in the absence of a statute to the contrary, each side in a lawsuit pays its own expenses. It is rare that a manager would be satisfied with assurance of winning a legal dispute. Rather, the manager would want to know the cost it would incur to win the legal dispute.

In general, there are three tiers of cost. The lowest tier of cost is where the claim against the manager has no legal basis. These claims are cheaply dismissed. The second tier of cost is where the claim against the manager has an inadequate factual basis. These claims require much more work to defeat. Where a claim has a legal and has a factual basis, the manager faces the greatest amount of cost and should prepare for trial. Chapter 2 puts those risks into context using the Federal Rules of Civil Procedure.

Determining whether a claim has a legal or a factual basis is the subject of Chapters 3–8. Chapter 3 deals with claims that result from personal injuries or tort law. The law selected for this chapter comes from the Second Restatement of Torts except where it has been superseded by the Third Restatement of Torts. While not the law of any particular jurisdiction, the Restatements provide approaches to determining liability that are nonetheless generally applicable.

In this chapter, Ronald Coase sets a chain of events in motion that gets managers to rethink whether being able to recover for an injury is good for society in the first place. A proof using game theory explains that different kinds of injuries should have different kinds of remedies and some should have no remedy at all.

Chapter 3 can be viewed as covering liability in the absence of an agreement. Chapter 4 deals with liability in the presence of an agreement. In particular, service agreements are treated in detail based on the law found in the Second Restatement of Contracts. Returning to Michael Porter’s model, virtually all American businesses either buy or sell services. This chapter discusses identifying and mitigating risks when one party fails to perform in a service contract. Contract provisions are discussed to encourage parties to perform in order to limit risk involved in transactions with venders and customers.

Chapter 5 continues the discussion of Chapter 4, but deals with contracts for the sale of goods instead of contracts for services. The law here resides in Article 2 of the Uniform Commercial Code. The major difficulty in goods contracts is not so much that one party simply doesn’t perform, but rather that the goods are of a different quality than negotiated. With regard to Porter’s model, it is much easier to use restrictive provisions in sales contracts than services contracts. When resources can be pooled and controlled, it is difficult for other market participants to compete against the manager’s firm.

Chapter 6 deals with the situation of protecting against default. This takes a more holistic look at risk as described in Article 9 of the Uniform Commercial Code. It is rare that a creditor would allow a debtor to undertake a project where the potential downside is losing everything. Collateral is a way to solve that problem and spread risk. Being able to turn inventory quickly is a large competitive advantage within an industry. Creditors want a system where their risk is very low before they are willing to help a debtor’s business. Those transactions are considered in detail in Chapter 6.

Chapter 7 turns inward to the operation of the firm as a whole and asks a very common question in business, “Should I hire an employee or an independent contractor?” Fortunately, our protagonist, Ronald Coase, has a Nobel prize winning answer to that question. The rights and duties between principals and agents are known as Agency law, and the Third Restatement of Agency provides a legal basis for this chapter.

Chapter 8 culminates the book by showing how the principals of Agency law evolve when principals join together to form firms. Partnerships are discussed using the Uniform Partnership Act. Limited Partnerships are discussed using the Uniform Limited Partnership Act. Limited Liability Companies are discussed using the Uniform Limited Liability Company Act. Corporations are discussed using the Revised Model Business Corporation Act. The rights and duties between owners of all of these businesses are considered in detail.

While the rights and duties between business owners vary considerably, the most common reason that one business entity or another is selected has to do with tax treatment. In particular, owners need to make decisions as to whether election under Subchapter S is wise. Chapter 8 integrates legal environment principals of corporate rights and duties with the regulatory environment of taxation in order to provide a comprehensive landscape for business entity selection. Hopefully by the end of this book, the reader will have a better framework for recognizing and allocating risk in routine business transactions.

Throughout the book the following features provide a way to navigate the material presented

“Game on!” is a game theory application of common law principles.

“Getting real” provides a practical application of the adjacent material.

“Under the microscope” explains the microeconomic (or macroeconomic) underpinnings of a legal rule.

“Case Problems” are scenarios that are based on real cases that are answered in an appendix to the text.

1Michael H. Porter, How Competitive Forces Shape Strategy, Harv. Bus. Rev. (March–April 1979) available at: https://hbr.org/1979/03/how-competitive-forces-shape-strategy.