CHAPTER LAW, VALUE CREATION, AND RISK MANAGEMENT 1 INTRODUCTION WINNING LEGALLY Governments immerse modern organizations “in a sea of law.” 2 regulation, including burdensome licensing requirements and Public law provides the rules of the game3 within which firms filing fees, can hamper new venture formation.8 compete to create and capture value. Law does more than “Legally astute” managers who understand and proactively regulate and constrain, however. It also enables and facili- manage the legal aspects of business can use the law and the tates. 4 Indeed, multiple-country studies reveal that the effi- legal system to increase both the total value created and the share ciency of a country’s capital markets is directly related to the of that value captured by the firm.9 As Tom Hinthorne remarked, country’s legal environment. 5 Researchers found a statistically “[L]awyers and corporate leaders who understand the law and significant relationship between a country’s economic pros- the structures of power in the U.S.A. have a unique capacity to perity, as measured by the per capita gross domestic product, protect and enhance share-owner wealth.”10 For example, compa- and each of the following: nies can use patents, copyrights, trademarks, and trade secrets to differentiate their products, command premium prices, erect bar- ● Judicial independence. ● Adequacy of legal recourse. Managers can also make their own “private law” by entering into ● Police protection of business. contracts and crafting certain governance structures. A variety of ● Demanding product standards. ● Stringent environmental regulations. ● Quality laws relating to information technology. ● Extent of intellectual property protection. ● Effectiveness of antitrust laws.6 For example, adequate protection of minority shareholder rights increases investment in new ventures.7 Conversely, excessive riers to entry, sustain first-mover advantage, and reduce costs. legal tools, ranging from insurance policies to contractual indemnification provisions and limitations on liability, can help firms allocate and manage risk. Finally, managers can lobby and work with regulators to change the rules of the game. CH APTER OV ERVIEW The purpose of this chapter is to provide a framework for analyzing the intersection of law and management. It introduces the systems approach to business and society, a descriptive framework that integrates legal and societal considerations 1. See generally Constance E. Bagley, Winning Legally: How to Use the Law to Create Value, Marshal Resources, and Manage Risk (2005). 2. Lauren B. Edelman & Mark C. Suchman, The Legal Environments of Organizations, 23 Ann. Rev. Soc. 479 (1997). 3. Douglass C. North, Institutions, Institutional Change and Economic Performance 3–4 (1990). 4. Mark C. Suchman, D.J. Steward & C.A. Westfall, The Legal Environment of Entrepreneurship: Observations on the Legitimization of Venture Finance in Silicon Valley, in The Entr epr eneurship Dynamic: Origins of Entrepreneurship and the Evolution of Industries (C.B. Schoonhoven & E. Romanell, eds., 2001). 5. R. La Porta, F. Lopez-de-Silanes, A. Shleifer & R.W. Vishny, Legal Determinants of External Finance, 52 J. Fin. 1131 (1997). 6. Michael E. Porter, Enhancing the Microeconomic Foundations of Prosperity: The Current Competitiveness Index, in World Economic Forum, The Global Competitiveness Report 2001–2002 (2002). 7. S. Johnson, R. La Porta, F. Lopez-de-Silanes & A. Shleifer, Tunneling, 90 Am. Econ. Rev. 22 (2000). with mainstream theories of competitive advantage and social responsibility. The chapter then outlines the four primary public policies furthered by business regulation in the United States. It concludes with a discussion of how legally astute managers can enhance realizable firm value. 8. S. Djankov, R. La Porta, F. Lopez-de-Silanes & A. Shleifer, The Regulation of Entry, 117 Q.J. Econ. 1 (2002). 9. See Constance E. Bagley, Winning Legally: The Value of Legal Astuteness, 33 Acad. Mgmt. Rev. 378 (2008). 10. Tom Hinthorne, Predatory Capitalism, Pragmatism, and Legal Positivism in the Airlines Industry, 18 Strategic Mgmt. J. 509 (1996). See also George J. Siedel, Six Forces and the Legal Environment of Business: The Relative Value of Business Law Among Business School Core Courses, 37 Am. Bus. L.J. 37 (2000). Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 1 11 THE SYSTEMS APPROACH TO BUSINESS AND SOCIETY Society grants rights and powers to business, but society can revoke those rights and powers if firms do not act responsibly.11 As Tom Stephens, CEO of Manville Corporation, put it when Manville decided to add labels to its fiberglass products, warning of possible carcinogenic risks, “The laws of society are more powerful than any law that Congress can put on the books. Woe to any businessman who doesn’t read the laws of society and understand them.”12 As a result, “the task of anticipating, understanding, evaluating, and responding to public policy developments within the host environment is itself a critical managerial task.”13 As shown in Exhibit 1.1, firms operate within a broader societal context, which directly affects the competitive environment and the value of firm resources.14 At the center is the top management team (TMT), which evaluates and pursues opportunities for value creation and capture while managing the attendant risks. Given the characteristics of the members of the TMT and their values, the parameters set by the public law, the firm’s position within the competitive environment, and the nature and uniqueness of the firm’s resources, the TMT defines the value proposition and selects and performs the activities in the value chain. EXHIBIT 1.1 Systems Approach to Business and Society Public Law Competitive Environment Top Management Team Firm's Resources Value Proposition and Activities in Value Chain Societ al Cont ext 11. D.J. Wood, Corporate Social Performance Revisited, 16 Acad. Mgmt. Rev. 691 (1991). 12. William Glaberson, Of Manville, Morals and Mortality, N.Y. Times, Oct. 9, 1988. 13. Lee E. Preston & James E. Post, Private Management and Public Policy: The Principle of Public Responsibility 4 (1975). 14. See generally Constance E. Bagley, What’s Law Got to Do with It?: Integrating Law and Strategy, 47 Am. Bus. L.J. 587 (2010). LAW, VALUE CREATION, AND RISK MANAGEMENT 3 1-1a Meeting Societal Expectations The systems approach recognizes that “business decisions consist of continuous, interrelated economic and moral components.”15 It also builds on stakeholder theory’s insight that firms have relationships with many constituent groups, which both affect and are affected by the actions of the firm.16 1-1b Effect of Law on the Competitive Environment and the Firm’s Resources Law helps shape the competitive environment and affects each of the five forces, identified by Michael Porter, that determine the attractiveness of an industry: buyer power, supplier power, the competitive threat posed by current rivals, the availability of substitutes, and the threat of new entrants.17 Exhibit 1.2 shows how managers can use law to affect these forces and also indicates the public policies behind the relevant laws. Law also affects the allocation, marshaling, value, and distinctiveness of the firm’s resources. Under the resourcebased view (RBV) of the firm, a firm’s resources can be a source of sustained competitive advantage if they are valuable, rare, and imperfectly imitable by competitors and have no strategically equivalent substitutes.18 Legal astuteness is a valuable managerial capability that may be a source of sustained competitive advantage.19 Conversely, failure to integrate law into the development of strategy and of action plans can place a firm at a competitive disadvantage and imperil its economic viability.20 Consider the fall of Enron and its once venerable accounting firm Arthur Andersen (described in Chapter 2) and the collapse of WorldCom in the wake of massive accounting fraud; the implosion of Barings, England’s oldest merchant bank, after illegal trades by Nick Leeson; and the collapse of mortgage brokerage firms implicated in predatory lending (described further in the “Inside Story” in Chapter 18). Violation of criminal laws can also land an executive in prison, as happened to Jeffrey Skilling, former CEO of Enron, who was convicted of fraud and originally sentenced to more than twenty-four years in prison. (His sentence was reduced to fourteen years in June 2013 as part of a court-ordered reduction and plea bargain.) 15. D.L. Swanson, Addressing a Theoretical Problem by Reorienting the Corporate Social Performance Model, 20 Acad. Mgmt. Rev. 43 (1995). 16. Thomas Donaldson & Lee E. Preston, The Stakeholder Theory of the Corporation: Concepts, Evidence, and Implications, 20 Acad. Mgmt. Rev. 65 (1995). 17. Michael E. Porter, How Competitive Forces Shape Strategy, in On Competition 21–22 (1996). See also Richard G. Shell, Make the Rules or Your Rivals Will (2004). 18. Margaret A. Peteraf & Jay B. Barney, Unraveling the Resource-Based Tangle, 24 Managerial & Decision Econ. 309 (2003). See also George J. Siedel, Using Law for Competitive Advantage (2002). 19. Bagley, supra note 14. 20. Bagley, supra note 9. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 4 UNIT I EXHIBIT 1.2 FOUNDATIONS OF THE LEGAL AND REGULATORY ENVIRONMENT Using Law to Affect the Competitive Environment Public Policy Objectives Porter’s Five Forces Supplier Power Direct Competition Threat of Entry Substitution Buyer Power Promote economic growth Obtain development subsidies, tax breaks for domestic firms. Litigate application of antitrust laws. Secure patents and other IP rights. Lobby for protectionist tariffs to advantage domestic firms. Secure trademarks. Bundle products. Enter into longterm supply contracts. Secure cost-plus government contracts and no-bid contracts from Department of Defense. Enter into exclusive dealing contracts. Use contracts or intellectual property rights to bundle products. Protect worker interests Restrict availability of visas needed by rivals. Lobby for tighter worker safety regulations to detriment of lesser rivals. Seek limits on overseas outsourcing. Enter into employment agreements with covenants not to compete. Subject stock to vesting. Litigate definition of “employee.” Lobby for ban on products made with child or slave labor. Promote consumer welfare Seek to outlaw competing products on safety grounds. Promote expedited regulatory approval of generic drugs and biologics. Disclose product ingredients and place of manufacture. Impose licensing regime. Demand posting of bond by service providers. Seek to outlaw substitute products on safety grounds. Require labeling of “foreign” parts. Require purchasers to buy services from state-licensed providers. Promote public welfare Obtain ethanol-style subsidies for firm’s product. Lobby for tougher environmental standards. Resist reforms designed to reduce the costs of incorporating, obtaining licenses, and issuing securities. Seek to grandfather existing products and facilities from new taxes and regulatory requirements. Lobby for reduced import duties on foreign suppliers. Lobby for domestic content requirements and higher transportation taxes. Promote bans on the payment of bribes. Source: Bagley, supra note 14, at 599. Even if the firm survives, noncompliance destroys value. Illegal conduct can put a firm at a competitive disadvantage by diverting funds from strategic investments, tarnishing the firm’s image with customers and other stakeholders, raising capital costs, and reducing sales volume. 21 Researchers found that Fortune 500 firms convicted of illegal conduct earned significantly lower returns on assets than unconvicted firms. In the case of WorldCom, $200 billion of shareholder value was lost in less than a year, making it the largest corporate fraud in history.22 More recently, JPMorgan Chase, the largest U.S. bank based on assets, agreed during one three-month period in 2013 to pay billions of dollars in fines and settlements. They included a $13 billion settlement with the Justice Department stemming from its subprime mortgage business,23 penalties of $920 million to settle charges relating to $6.2 billion of losses from risky trading (the 21. Melissa S. Baucus & David A. Baucus, Paying the Piper: An Empirical Examination of Long-Term Financial Consequences of Illegal Corporate Behavior, 40 Acad. Mgmt. J. 129 (1997). 22. See Richard Breeden, Restoring Trust, filed with the WorldCom bankruptcy court on August 26, 2003. 23. Jessica Silver-Greenberg & Ben Protess, JP Morgan Reveals How It Formed Mortgages, N.Y. Times, Nov. 20, 2013, at B1. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 1 so-called London Whale trades),24 and an additional fine of $100 million by the U.S. Commodity Futures Trading Commission after admitting that reckless behavior had led to the London Whale debacle.25 In contrast, at least under certain circumstances, the ability to proactively go beyond the letter of the law can result in competitive advantage.26 Legally astute management teams practice strategic compliance management.27 They view the cost of complying with government regulations as an investment, not an expense. Instead of just complying with the letter of the law, they seek out and embrace operational changes that will enable them to convert regulatory constraints into innovation opportunities.28 Proactive strategies for dealing with the interface between a firm’s business and the natural environment that go beyond environmental regulatory compliance have been associated with improved financial performance.29 Yet firms’ ability to reduce pollution became a source of competitive advantage only after managers replaced the mindset of reducing pollution to meet government end-pipe restrictions with a search for ways to use environment-friendly processes to create value.30 LAW, VALUE CREATION, AND RISK MANAGEMENT 5 1-1d Law Is Dynamic just a static external force acting upon managers and their firms. Instead, law and organizations are “endogenously coevolutionary.”31 By lobbying legislators and members of the executive branch, forming coalitions, and working directly with regulatory bodies, managers can help shape the environment in which they do business.32 As with any other activity, managers engaged in lobbying and other political activities must be mindful of the ethical aspects of their actions. Unfortunately, enlightened self-interest is not always a substitute for government regulation. Paul Krugman criticized former Federal Reserve Board Chair Alan Greenspan and other banking regulators for ignoring warnings about predatory lending practices,33 which ultimately contributed to the subprime mortgage crisis in 2007–2008. Krugman quoted a 1963 essay in which Greenspan dismissed as a “collectivist myth” the idea that business leaders, left to their own devices, would “attempt to sell unsafe food and drugs, fraudulent securities and shoddy buildings”; instead, Greenspan asserted that “it is in the self-interest of every businessman to have a reputation for honest dealings and a quality product.” Krugman faulted Greenspan for putting “ideology above public protection.”34 Greenspan himself subsequently remarked: “Those of us who look to the self-interest of lending institutions to protect shareholder equity have to be in a state of shocked disbelief.”35 Laws enacted in response to corporate misdeeds often impose greater restrictions and costs on business than would have been imposed had firms acted more responsibly at the outset. A prime example is the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (discussed in Chapters 6, 17, 18, 21, and 23), which was enacted after widespread abuses in the subprime mortgage market led to near-global financial collapse. The systems approach recognizes the dynamic nature of law. Law affects the market and market players, but market players also affect the law and the way it is interpreted, applied, and changed over time. Thus, law is not 12 1-1c Law and the Value Chain As shown in Exhibit 1.3, each activity in the value chain has legal aspects. From a firm’s choice of business entity to the warranties it offers and the contracts it negotiates, law pervades the activities of the firm, affecting both its internal organization and its external relationships with customers, suppliers, and competitors. 24. Jill Treanor, JP Morgan Boss in Talks Over Fine for Sub-Prime Bond Sales; Bank May Have to Settle on Record $11bn Penalty, The Guardian (U.K.), Sept. 27, 2013, at 37. 25. Virginia Harrison, JP Morgan to Pay Fresh $100M London Whale Fine, CNNMoney (Oct. 16, 2013), http://money.cnn.com/2013/10/16/news/ companies/jpmorgan-whale-settlement. 26. Bagley, supra note 9. 27. Bagley, supra note 1. 28. Regulation may prompt firms to innovate, making them more competitive. Barry M. Mitnick, The Strategic Uses of Regulation—and Deregulation, in Corporate Political Agency: The Construction of Competition in Public Affairs (Barry M. Mitnick ed., 1993); Michael E. Porter & C. van der Linde, Green and Competitive, Harv. Bus. Rev., May 1995, at 120. 29. See William Q. Judge & Thomas J. Douglas, Performance Implications of Incorporating Natural Environmental Issues into the Strategic Planning Process: An Empirical Assessment, 35 J. Mgmt. Stud. 241 (1998); Robert D. Klassen & D. Clay Whybark, The Impact of Environmental Technologies in Manufacturing Performance, 42 Acad. Mgmt. J. 599 (1999). 30. Chad Nehrt, Maintainability of First Mover Advantages When Environmental Regulations Differ Between Countries, 23 Acad. Mgmt. Rev. 77 (1998). LAW AND PUBLIC POLICY Public law—the formal rules embodied in constitutions, statutes enacted by legislatures, judicial decisions rendered by courts, and regulations promulgated by administrative agencies—both reflects and helps shape societal expectations. The laws and regulations applicable to U.S. business further four primary public policy objectives: promoting economic growth, protecting workers, promoting consumer welfare, and promoting public welfare. This typology is depicted in Exhibit 1.4. 31. Edelman & Suchman, supra note 2, at 501. 32. See L.G. Weber, Citizenship and Democracy: The Ethics of Corporate Lobbying, 6 Bus. Ethics Q. 253 (1996). 33. Id. 34. Paul Krugman, Disastrous De-Regulation: For Greenspan and Bush, Ideology Trumps Oversight, Pittsburgh Post-Gazette, Dec. 22, 2007, at B7. 35. Alan Greenspan, We Will Never Have a Perfect Model of Risk, Fin. Times, Mar. 17, 2008, at 13. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 6 UNIT I EXHIBIT 1.3 Support Activities FOUNDATIONS OF THE LEGAL AND REGULATORY ENVIRONMENT Law and the Value Chain Firm infrastructure Limited liability, corporate governance, choice of business entity, tax planning, and securities regulation Human resource management Employment contracts, at-will employment, wrongful termination, bans on discrimination, equity compensation, Fair Labor Practices Act, National Labor Relations Act, workers’ compensation, and Employee Retirement Income Security Act Technology development Intellectual property protection, nondisclosure agreements, assignments of inventions, covenants not to compete, licensing agreements, and product liability Procurement Contracts, Uniform Commercial Code, Convention on the International Sale of Goods, bankruptcy laws, securities regulation, and Foreign Corrupt Practices Act Inbound logistics Operations Outbound logistics Marketing and sales Service Contracts Workplace safety and labor relations Contracts Contracts Environmental compliance Uniform Commercial Code Strict product liability Antitrust limits on exclusive dealing contracts Environmental compliance Environmental compliance Consumer privacy Strict product liability Process patents and trade secrets Warranties Convention on the International Sale of Goods Waivers and limitations of liability Consumer protection laws, including privacy protection Doctrine of unconscionability Bans on deceptive or misleading advertising or sales practices Customer privacy Antitrust limits on vertical and horizontal market division, tying and predatory pricing Import/export controls World Trade Organization Primary Activities Margin Sources: Diagram and text in roman type from Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (1985); text in italic type adapted from Bagley, supra note 1, and M.E. Porter & M.R. Kramer, Strategy and Society: The Link Between Competitive Advantage and Corporate Social Responsibility, Harv. Bus. Rev., Dec. 1, 2006, at 78. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 1 EXHIBIT 1.4 LAW, VALUE CREATION, AND RISK MANAGEMENT 7 Underlying Public Policy Rationales of U.S. Laws Promote Economic Growth Protect Property Rights Enforce Contracts Allocate Risks Facilitate Capital Markets Create Incentives to Innovate Promote Liquid and Skilled Labor Markets Provide Economic Incentives and Infrastructure Promote Free Trade Protect Workers Regulate Certain Terms and Conditions of Employment Require Employer to Provide Certain Benefits Protect Civil Rights in Workplace Promote Consumer Welfare Facilitate LowCost Products and Services Promote Safe Products and Services Prevent Deceptive Practices Facilitate Innovative Products and Services Promote Public Welfare Promote Effective Administration of Justice Collect Taxes and Spend Money Other major economic powers tend to have laws that further these same objectives, albeit with varying degrees of emphasis on the different objectives and varying ways of furthering them.36 Indeed, much of the current debate on what constitutes good corporate governance turns on how much weight each country gives to the interests of shareholders, debt holders, employees, customers, and suppliers and to the protection of the environment. 1-2a Promoting Economic Growth Various laws and regulations promote economic growth. As Exhibit 1.5 shows, this is done by protecting private property rights; enforcing private agreements; allocating risks;37 facilitating the raising of capital; creating incentives to innovate; promoting liquid and skilled labor markets; providing subsidies, tax incentives, and infrastructure; and promoting free trade in the global markets. 36. For example, Germany seeks to promote economic growth by facilitating the capital markets, but its goal of protecting workers has led to the system of codetermination whereby half of the members of the supervisory boards of large German corporations are elected by the workers and unions, and half are elected by the shareholders. 37. For an excellent discussion of government’s role in allocating risk, see David A. Moss, When All Else Fails: Government as the Ultimate Risk Manager (2001). Protect Fundamental Rights Protect Environment 1-2b Protecting Workers Worker protection constitutes a second major public policy underlying U.S. business law. This is accomplished by regulating certain terms and conditions of employment, requiring the employer to provide certain benefits, and protecting workers’ civil rights, as outlined in Exhibit 1.6. Complying with these requirements imposes costs on employers that society, acting through the legislature and the courts, has deemed appropriate for employers to bear. 1-2c Promoting Consumer Welfare Business regulation is designed to promote consumer welfare by encouraging the sale of safe and innovative products and services at a fair price, preventing deceptive practices, and protecting consumer privacy, as shown in Exhibit 1.7. 1-2d Promoting Public Welfare As depicted in Exhibit 1.8, business regulation promotes public welfare by ensuring the effective administration of justice, collecting taxes and spending money, protecting fundamental rights, and protecting the environment. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 8 UNIT I EXHIBIT 1.5 FOUNDATIONS OF THE LEGAL AND REGULATORY ENVIRONMENT How U.S. Law Promotes Economic Growth Promoting Economic Growth Promote Free Trade Protect Property Rights WTO NAFTA Property law Other free-trade agreements Enforce Contracts Allocate Risks Contract law Strict liability for products Provide default rules Environmental liability Strict liability for ultrahazardous activities Respondeat superior Create Incentives to Innovate Facilitate Capital Markets Choices of business entity Intellectual property protection Securities regulation Agency law Abolition of slavery At-will employment Nonconfiscatory taxes Provide Economic Incentives and Infrastructure Subsidies Tax incentives Infrastructure Ban on unreasonable covenants not to compete Bankruptcy law Doctrine of unconscionability EXHIBIT 1.6 Promote Liquid and Skilled Labor Markets Public education How U.S. Law Protects Workers Protecting Workers Regulate Certain Terms and Conditions of Employment Require Employer to Provide Certain Benefits Protect Civil Rights In Workplace Minimum wage Workers’ compensation Bans on discrimination Safety rights Unemployment insurance Bans on harassment Social Security and Medicare taxes Privacy protection Consequences of wrongful termination Right to ply trade Right to form unions Regulation of employee benefit plans Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 1 EXHIBIT 1.7 LAW, VALUE CREATION, AND RISK MANAGEMENT 9 How U.S. Law Promotes Consumer Welfare Promoting Consumer Welfare Promote Sale of Safe Products and Services Product liability law Product safety requirements Facilitate LowCost Products and Services Antitrust law Bans on unfair business practices Facilitate Innovative Products and Services Prevent Deceptive Practices Intellectual property protection Ban on deceptive advertising Limits on postemployment restrictions on competing Fair lending requirements Unconscionability Prospectus delivery and periodic reporting requirements Protection of consumer privacy Other consumer protection laws EXHIBIT 1.8 How U.S. Law Promotes Public Welfare Promoting Public Welfare Ensure Effective Administration of Justice Define torts and crimes Enforce laws and punish violators Provide impartial judicial system Collect Taxes and Spend Money Protect Fundamental Rights Tax laws Due process Provide government funding Equal protection Redistribute wealth Spur investment 1-2e Policy Conflicts Sometimes, these public policies conflict. In the following case, the Supreme Court considered whether the public Free speech Protect Environment Environmental law Land use Voting Jury trial Unenforceability of unconscionable contracts policy of ensuring freedom of expression outweighed the interest of physicians in keeping their prescribing practices private and the interest of the state in reducing health-care expenses. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 10 UNIT I FOUNDATIONS OF THE LEGAL AND REGULATORY ENVIRONMENT A CASE IN POINT SUMMARY Sorrell v. IMS Health Inc. Facts!A Vermont statute prohibited pharmacies from selling prescriber-identifying information for marketing prescription drugs without the prescriber’s consent. This information identifies the drugs and dosages that individual doctors prescribe for their patients. Data miners analyze such information and sell it to pharmaceutical manufacturers, which use the information to refine their sales pitches to physicians and thereby increase sales of brandname drugs. Vermont data miners and an association of brand-name drug manufacturers challenged the statute as a violation of their free-speech rights under the First Amendment of the U.S. Constitution, as applied to the states by the Fourteenth Amendment. Supreme Court of the United States 131 S. Ct. 2653 (2011). CASE 1.1 Issue Presented!Is a state law banning the sale of prescriber-identifying information to pharmaceutical firms without the prescriber’s consent constitutional? Summary of Opinion!The U.S. Supreme Court began by noting that speech in aid of drug manufacturing is protected by the Free Speech Clause of the First Amendment. The Vermont statute precluded detailers— drug reps who meet with physicians to provide details about brand-name drugs and often free samples—from obtaining prescriber-identifying information but permitted its purchase by others. Because the statute disfavored speech with a particular content (marketing) and disfavored specific speakers (detailers), it was subject to “heightened judicial scrutiny.” For the statute to pass muster, Vermont had to show that it directly advanced a substantial government interest and that it was narrowly drawn to achieve that interest. “the State may not seek to remove a popular but disfavored product from the marketplace by prohibiting truthful, nonmisleading advertisements that contain impressive endorsements or catchy jingles.” As for disruptive visits, physicians are free not to meet with detailers. Vermont argued that the law was necessary to protect the privacy of prescribing physicians and to reduce the likelihood that physicians would prescribe expensive brand-name drugs that are not in the best interests of patients or the State. The legislature found that detailing “increases the cost of health care and health insurance; encourages hasty and excessive reliance on brand-name drugs, before the profession has observed their effectiveness as compared with older and less expensive generic alternatives; and fosters disruptive and repeated marketing visits tantamount to harassment.” While conceding that these interests were “significant,” the Court concluded that they did not justify the burden the statute placed on protected expression. The statute made prescribing information available to an almost unlimited audience (including researchers and health departments promoting the use of generic drugs) but banned its sale to “a narrow class of disfavored speakers.” Even if pharmaceutical marketing efforts influence prescribing practices, Comments!In a dissent in which Justices Ginsburg and Kagan joined, Justice Breyer argued that this regulation of commercial speech should be evaluated under a less strict “intermediate” standard, which upholds laws and regulations that significantly restrict speech “as long as they also ‘directly advance’ a ‘substantial’ government interest that could not ‘be served as well by a more limited restriction.’” He cautioned: “If the Court means to create constitutional barriers to regulatory rules that might affect the content of a commercial message, it has embarked upon an unprecedented task—a task that threatens significant judicial interference with widely accepted regulatory activity.” The dissent charged that the majority approach “threatens to return us to a happily bygone era when judges scrutinized legislation for its interference with economic liberty. History shows that the power was much abused and resulted in the constitutionalization of economic theories preferred by individual jurists. See Lochner v. New York, 198 U.S. 45, 75–76 (1905) (Holmes, J., dissenting).” THE LEGALLY ASTUTE MANAGER At its core, legal astuteness is the ability of a manager to communicate effectively with counsel and to work with counsel to solve complex problems.38 For example, legally astute managers can (1) negotiate contracts as complements to trust building and other relational governance techniques to define and strengthen relationships and reduce transaction costs, (2) protect and enhance the realizable value of the firm’s resources, (3) create options through contracts and other legal tools, and (4) convert regulatory constraints into opportunities.39 38. Bagley, supra note 9. 39. Id. 13 The Court acknowledged that “[t]he capacity of technology to find and publish personal information . . . presents serious and unresolved issues with respect to personal privacy and the dignity it seeks to save.” If Vermont banned the sale of prescriber-identifying information except in narrow circumstances, “then the State might have a strong position.” But Vermont “cannot engage in content-based discrimination to advance its own side of a debate.” Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 1 LAW, VALUE CREATION, AND RISK MANAGEMENT As discussed further in “The Responsible Manager” at the end of the chapter, legal astuteness has four components: ● ● ● ● ● A set of value-laden attitudes about the importance of law to the firm’s success. A proactive approach to legal issues and regulation. The ability to exercise informed judgment when managing the legal aspects of business. Context-specific knowledge of the law and the appropriate use of legal tools.40 Exhibit 1.9 shows how legally astute managers can use law to create and capture value and to manage risk during the five stages of business development: ● ● Evaluating the opportunity and defining the value proposition, which includes developing the business concept for exploiting the opportunity. ● Assembling the team. ● Raising capital. 40. Id. EXHIBIT 1.9 Developing, producing, and marketing the product or service. Harvesting the opportunity, through sale of the venture, an initial public offering (IPO) of stock, or reinvestment and renewal. 41 Exhibit 1.9 does not purport to be an all-inclusive list of techniques for using the law to increase realizable value while managing risk. Rather, it is intended to suggest both the variety and the pervasive nature of the tools available. 41. Professors Stevenson, Roberts, and Grousbeck break down the entrepreneurial process into five steps: (1) evaluating the opportunity, (2) developing the business concept, (3) assessing required resources both human and capital, (4) acquiring needed resources, and (5) managing and harvesting the venture. Howard H. Stevenson, Michael J. Roberts & H. Irving Grousbeck, New Business Ventures and the Entrepreneur 17–21 (2d ed. 1985). The five steps in Exhibit 1.9 are based on this model with modifications to reflect the fact that very different but significant legal issues arise in the course of marshaling human resources and raising money and in the course of managing the development, production, marketing, and sale of the product or service and in harvesting the venture. Legal Tools for Increasing Realizable Value While Managing Risk Evaluating Opportunity and Defining Value Proposition Assembling Team Raising Capital " # Ask whether idea is patentable or otherwise protectable. " # Choose appropriate form of business entity and issue equity to founders early. " # Examine branding possibilities. " # Structure appropriate equity incentives for employees. " # Be prepared to negotiate downside and sideways protection and upside rights for preferred stock. " # Ask whether anyone else has rights to opportunity. 11 " # Enter into nondisclosure agreements and assignments of inventions. " # Document founders’ arrangements and subject founders’ shares to vesting. " # Analyze any covenants not to compete or trade secret issues. " # Require arbitration or mediation of disputes. " # Comply with antidiscrimination laws in hiring and firing. Institute harassment policy. " # Be prepared to subject at least some founders’ stock to vesting. " # Sell stock in exempt transaction. " # Be prepared to make representations and warranties in stock-purchase agreement with or without knowledge qualifiers. " # Choose business entity with limited liability. Developing, Producing, Marketing, and Selling Product or Service " # Implement trade secret policy. " # Consider patent protection for new business processes and other inventions. Select a strong trademark and protect it. Register copyrights. " # Enter into licensing agreements. " # Create options to buy and sell. " # Secure distribution rights. " # Decide whether to buy or build, then enter into contracts. " # Enter into purchase and sale contracts. " # Impose limitations on liability and use releases. " # Buy insurance for product liabilities. Recall unsafe products. " # Create safe workplace. " # Institute compliance system. Harvesting " # If investor, exercise demand registration rights or board control to force IPO or sale of company. Rely on exemptions for sale of restricted stock. Ask whether employee vesting accelerates on an IPO or sale. " # Negotiate and document arrangements with underwriter or investment banker. " # Be mindful of difference between letter of intent and contract of sale. " # Consider entering into no-shop agreements if buyer. Negotiate fiduciary out if seller. " # Disclose fully in prospectus or acquisition agreement. CONTINUED Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 12 UNIT I EXHIBIT 1.9 Evaluating Opportunity and Defining Value Proposition FOUNDATIONS OF THE LEGAL AND REGULATORY ENVIRONMENT Legal Tools for Increasing Realizable Value While Managing Risk (Continued) Assembling Team Raising Capital Developing, Producing, Marketing, and Selling Product or Service " # Avoid wrongful termination by documenting performance issues. " # Respect corporate form to avoid piercing of corporate veil. " # Do due diligence before buying or leasing property to avoid environmental problems. " # Caution employees on discoverability of e-mail. " # No horizontal price fixing or tying, but product integration is generally OK. " # Provide whistleblower protection. " # Be active in finding business solutions to legal disputes. " # Avoid misleading advertising. Harvesting " # Secure indemnity rights. " # Perform due diligence. " # Allocate risk of unknown. " # Make sure board of directors is informed and disinterested. " # Ban insider trading and police trades. " # Do tax planning. File tax returns on time and pay taxes when due. Global View Lobbying in the European Union “This shows you are never too old to get surprised,”#42 remarked then sixty-six-year-old Jack Welch, CEO of General Electric, after the European Commission rejected GE’s proposed $40 billion merger with Honeywell International on the grounds that the vertical combination would have anticompetitive effects in the European Union (EU).43 The deal would have vertically integrated two aerospace industry leaders. GE builds engines and leases aircraft, while Honeywell makes avionics components. The decision, delivered in 2001, marked the first time a merger of two U.S.-based corporations was derailed by EU officials.44 Welch remarked, “In this case, the European regulators’ demands exceeded anything I or our European advisers imagined, and differed sharply from antitrust counterparts in the U.S. and Canada.”#45 Even though GE had hired Finsbury International Political and Regulatory Advisers to present its position to regulators in individual nations,46 GE did not make concerted efforts to influence the outcome until after the competition commission, a branch 42. GE Pessimistic on Merger, CNNMoney.com (June 14, 2001), http://money .cnn.com/2001/06/14/europe/ge. 43. Edmund Andrews & Paul Meller, Europe Ends Bid by G.E. for Honeywell, N.Y. Times, July 4, 2001, at 1. 44. Id. 45. GE Pessimistic on Merger, supra note 42. 46. Boris Grondahl & James Ledbetter, Cutting Europe’s Red Tape, Industry Standard, July 9, 2001. of the European Commission, had released a preliminary draft opinion opposing the combination.47 The competition commission makes recommendations to the EU regarding issues that affect economic competition within the member states.48 After the adverse preliminary opinion was released, GE representatives met with competition regulators and official members of the European Commission,49 but by then the die had been cast. GE’s experience illustrates the reality that now faces U.S.-based corporations wishing to do business in the EU’s twenty-eight member states: finalizing a deal requires spending significant time in Brussels, Belgium, the EU’s center of operations. 50 “Every company of a certain size has a Washington representative. Increasingly the same is true of Brussels,” commented Hogan & Hartson LLP partner Raymond S. Calamaro. 51 Indeed, the European Union has been called a “regulatory superpower,” spawning an “influence business in Brussels . . . rivaled only by Washington’s.”52 CONTINUED 47. Andrew Ross Sorkin, G.E.-Honeywell: If at First . . . , N.Y. Times, June 27, 2001, at 1. 48. Andrew Ross Sorkin, U.S. Businesses Turn to Europe to Bar Mergers, N.Y. Times, June 19, 2001, at 1. 49. Id. 50. European Imperialism, Wall St. J., Oct. 31, 2007, at A20. 51. Nicholas Kulish, Euro Brash, Wash. Monthly, Apr. 1, 2004, at 24. 52. Eric Lipton & Danny Hakim, Lobbying Bonanza as Firms Try to Influence European Union, N.Y. Times, Oct. 19, 2013, at A1. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 1 As Europe continues to consolidate its economic power, the impact of the European Union on corporate planning and strategy becomes ever more obvious, and the effects involve many areas of the law. Consumer privacy, emissions standards, chemical usage, and accounting standards are just a few areas where EU and U.S. law differ. 53 Companies doing business globally may find themselves having to conform to EU regulations that impose higher standards than those they face in the United States. Managers hoping to participate in creating the rules governing their business are thus well advised to maintain a presence in Brussels. The importance of “face time” was evident in October 2013 when lawyers and lobbyists of Covington & Burling, a prestigious Washington, D.C., law firm, met at the firm’s Brussels office with executives from a number of large oil companies, including Chevron and France’s Statoil, to “help shape the European Union’s policies on the gas and oil drilling technology known as hydraulic fracturing, or fracking.”#54 As part of these lobbying efforts, the Covington lawyers and lobbyists met with a top environmental official and other senior policy makers. Recognizing the need to be proactive, a Covington advisor said, “It’s key to us to be ahead of when the political debate starts,” because once the debate has started, it may be too late to influence the results. 55 Global law firms such as Covington cite a number of successes in their efforts to influence EU decision makers on behalf of business clients. These include assisting an American semiconductor company in getting an exemption to use a 53. Kulish, supra note 51; European Imperialism, supra note 50. 54. Lipton & Hakim, supra note 52. 55. Id. LAW, VALUE CREATION, AND RISK MANAGEMENT 13 potentially hazardous substance in its manufacture of computer chips; helping a group of American chemical companies bypass the retesting of their products to meet a new chemical safety law, which involved “striking an alliance with animal rights groups that did not want animals used for the retesting”; and promoting an amendment to data privacy legislation to ease restrictions on how companies can use personal data collected from consumers. 56 At the same time, the lobbying methods used by these firms have come in for criticism. For example, the EU ethics rules applicable to former government officials are relatively weak, so past government officials can “begin exploiting their connections the day they leave office.” 57 Hiring these insiders was once relatively unusual, but global lobbying firms have “stepped up the recruiting of European politicians,” with accompanying “fat paychecks.”58 Critics also claim that lobbying firms are blocking efforts to bring more transparency to lobbying in Brussels, in part by asserting lawyer-client confidentiality. Lobbyists in Brussels, unlike those in the United States, are not required to disclose the identities of either their clients or the targets of their lobbying efforts. In addition, meetings with clients and regulators can remain secret, which is not the case in the United States. A vice president of the European Parliament expressed concern with the current system, stating, “I am not against lobbying, but I am against lobbying opacity. . . . We have to know who works for whom and how much money they are being paid”#59 56. 57. 58. 59. Id. Id. Id. Id. The Responsible Manager DEVELOPING A LEGALLY ASTUTE TOP MANAGEMENT TEAM Legal astuteness begins with respect for both the letter and the spirit of the law. Legally astute management teams appreciate the importance of meeting society’s expectations of appropriate behavior and recognize that “the moral aspects of choice” are the “final component of strategy.”#60 Legally astute managers evaluate legal considerations at each stage of strategy development and implementation. They bring counsel in early and do not wait to seek legal advice until after a deal has been struck or a problem has arisen. They demand legal advice that is business oriented and expect their lawyers to help them address business 60. E.P. Learned, C.R. Christensen, K.R. Andrews & W.D. Guth, Business Policy: Text and Cases 578 (1969). opportunities and threats in ways that are legally permissible, effective, and efficient. Legally astute managers accept responsibility for managing the legal dimensions of business and recognize that it is the job of the general manager, not the lawyer, to decide which allocation of resources and rewards makes the most business sense. They understand that legal analysis is often ambiguous and that managing the legal aspects of business requires the exercise of informed judgment. Even the most skilled and experienced advisers, including lawyers, sometimes get it wrong. A lawyer’s judgment can be clouded by personal interests, such as increasing billable hours or angling for more power within the firm, or by oversensitivity CONTINUED Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 14 UNIT I FOUNDATIONS OF THE LEGAL AND REGULATORY ENVIRONMENT to risk or overconfidence bias.61 Legally astute managers take this into account when factoring in legal advice. At the end of the day, as long as counsel has not advised that a particular course of action is illegal, it is up to the management team to determine whether a particular risk is worth taking or a particular opportunity is worth pursuing. As discussed further in Chapter 3, every legal dispute is a business problem requiring a business solution.62 Legally astute managers take responsibility for managing their disputes and do not hand them off to their lawyers with a “you-take-care-of-it” attitude. Legally astute managers have context-specific knowledge of the law and the application of legal tools. Managers 61. D.C. Langevoort & R.K. Rasmussen, Skewing the Results: The Role of Lawyers in Transmitting Legal Rules, 5 S. Cal. L. Rev. 375 (1997). 62. Constance E. Bagley, Legal Problems Showing a Way to Do Business, Fin. Times, Nov. 27, 2000, at 2. who can harness the creative power of legal language are more adept at seeing and shaping the legal structure of their world. They are also better equipped to communicate effectively with their lawyers. The law offers a variety of tools that legally astute management teams can use to increase realizable value and to manage risks. For example, the choice of business entity (e.g., corporation, partnership, or limited liability company) will determine the investors’ liability for the debts of the business, the rights and responsibilities of the managers and equity holders, and the level at which tax is levied. The legal tools of greatest relevance to managers will vary with the firm’s overall strategy, its external environment, and the stage of development of the business. Certain tools, such as contracts, have broad application. A M A NAGER ’S D ILEMM A : P UTTING IT I NTO P R ACTICE JPMORGAN AND ITS HIRING PRACTICES IN CHINA: NETWORKING JPMorgan Chase’s “Sons and Daughters” hiring program, which involved hiring the children of China’s ruling elite, is part of a U.S. federal bribery investigation that began in 2013.63 At issue is whether the bank “improperly swapped job offers and consulting contracts for business with state-owned Chinese companies” and thereby violated the Foreign Corrupt Practices Act.64 As discussed further in Chapter 24, that act makes it illegal for a company to exchange anything of value with a foreign government official to obtain an improper advantage in business dealings. Citibank, Credit Suisse, Goldman Sachs, and Morgan Stanley are also under investigation. Internal documents obtained from JPMorgan during the investigation allegedly show that the Sons and Daughters program was initially designed to prevent questionable hiring practices. However, the program reportedly ended up being a gateway to business with large, state-owned companies in China’s tightly regulated economy. One document, for example, recorded the bank’s “‘track record’ for converting hires into business deals.” Documents also showed that, although the people hired under the program were qualified, they were not subjected to the same level of scrutiny as other applicants. JPMorgan had not, as of early 2014, been accused of any legal wrongdoing. One media source noted that there was no indication that executives at JPMorgan’s New York headquarters were aware of the hiring practices and that the investigation could reveal that even though the bank’s program was aggressive, it “did not cross a legal line.”65 63. Ben Protess & Jessica Silver-Greenberg, Bank Tracked Business Linked to China Hiring, N.Y. Times, Dec. 8, 2013, at A1. 64. Id. 65. Id. OR BRIBERY? U.S. attitudes toward programs like Sons and Daughters are generally negative, but attitudes in China are different. The criminal law of China prohibits businesses from paying bribes to government officials, but a payment of money is not considered a bribe unless the amount is significant.66 In addition, the practice of guanxi, which depends strongly on personal relationships, has a long tradition in China.67 Guanxi has been defined as “an informal, particularist personal connection between two individuals who are bounded by an implicit psychological contract to follow [specific social norms,] such as maintaining a long-term relationship, mutual commitment, loyalty, and obligation,”68 Accordingly, although a survey of 195 executives attending the Huazhong University of Science and Technology (HUST) revealed a consensus that it is unethical to give money or gifts to government officials or to provide paid travel, most of the HUST respondents considered hiring the offspring of government officials ethically acceptable. 69 Assume that you are the new manager of JPMorgan’s China operations. Would you continue the Sons and Daughters program? Why or why not? 66. Yongqiang Gao & Wenchuan Wei, Are Corporate Political Actions Ethical? An Investigation of Executives in Chinese Enterprises, 1 Int’l J. Bus. Innovation & Res. 464 (2007). 67. See generally Shuangge Wen, The Achilles Heel That Hobbles the Asian Giant: The Legal and Cultural Impediments to Antibribery Initiatives in China, 50 Am. Bus. L.J. 483 (2013). 68. For a discussion of guanxi, see Xiao-Ping Chen & Chao C. Chen, On the Intricacies of the Chinese Guanxi Development, 21 Asia Pac. J. Mgmt. 305, 306 (2004). 69. Gao & Wei, supra note 66. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 1 LAW, VALUE CREATION, AND RISK MANAGEMENT 15 INSIDE S TORY The Obesity Epidemic: Who Is Responsible? In 2013, the American Medical Association officially recognized obesity as a disease.70 This classification affects issues ranging from medical cost reimbursement and insurance rates, to the development and marketing of drugs to combat obesity, to the question of who bears responsibility for the calories we consume—the companies marketing food products, the government, or the consumer. Related to the issue of responsibility is the question of whether companies should advertise, or even provide, purportedly unhealthful food and drinks, especially to children. The Link Between Childhood Obesity and Targeted Advertising An alarming 16.9% of children and adolescents between the ages of two and nineteen are obese.71 Between 1980 and 2008, obesity rates tripled for children.72 The food and beverage industry spends about $2 billion a year marketing products to children and teenagers.73 An Institute of Medicine review of 123 empirical studies concluded that “television advertising ‘influences children to prefer and request highcalorie and low-nutrient foods and beverages,’ and ‘influences the short term consumption of children ages 2–12.’”74 Children are exposed to tens of thousands of fast-food commercials each year; researchers suggest that a ban on fast-food commercials could reduce the number of obese young children by 18%.75 Nevertheless, proposals to limit advertising to children face stiff political opposition and heightened judicial scrutiny, given recent Supreme Court decisions that apply free-speech rights to marketing and advertising.76 Advocacy groups, such as Action for Children’s Television (ACT), and government actors, from Congress to the Federal Trade Commission (FTC) to state legislatures, continue to pressure “family-oriented” companies to consider the impact 70. Andrew Pollack, A.M.A. Recognizes Obesity as a Disease, N.Y. Times, June 19, 2013, at B1. 71. Cheryl Fryar, Margaret Carroll & Cynthia Ogden, Prevalence of Obesity Among Children and Adolescents: United States, Trends 1963–1965 Through 2009– 2010, Sept. 2012, available at http://www.cdc.gov/nchs/data/hestat/obesity_ child_09_10/obesity_child_09_10.pdf. 72. Centers for Disease Control & Prevention, Obesity, Halting the Epidemic by Making Health Easier at a Glance 2011, available at http://www.cdc. gov/chronicdisease/resources/publications/aag/obesity.htm, last updated May 26, 2011. 73. Brian Stelter, Chronicling the Pounds, Their Risks and Causes, N.Y. Times, May 13, 2012, at AR28. 74. Juliet B. Schor & Margaret Ford, Perspectives on the Problem: From Tastes Great to Cool: Children’s Food Marketing and the Rise of the Symbolic, 35 J.L. Med. & Ethics 10, 14 (Spring 2007). 75. Fast Food TV Ads Linked to Child Obesity, Study Finds, FOXNews.com, Nov. 20, 2008, http://www.foxnews.com/story/0,2933,455028,00.html. 76. Brown v. Entm’t Merchs. Ass’n, 131 S. Ct. 2729 (2011) (Case 4.2); Sorrell v. IMS Health Inc., 131 S. Ct. 2653, 2671 (2011) (Case 1.1). of their advertising on children’s diets.77 Some industry leaders have responded to this pressure by voluntarily restricting their advertising. Others, however, oppose not only stricter government regulation but even voluntary restrictions. Ronald McDonald . . . McDonald’s mascot clown—Ronald McDonald—is prominently featured in so many advertisements that he is “as recognizable as Santa Claus.”78 McDonald’s fast-food-plus-toy children’s meal is “arguably the most successful marketing strategy in human history . . . turning a visit to a fast food restaurant into a favored activity for children.”79 Corporate Accountability International and other advocacy groups have called for an end to Ronald’s role in marketing unhealthy food to children.80 Notwithstanding Ronald’s critics, McDonald’s CEO James Skinner has announced that the clown mascot is not nearing retirement.81 In 2011, however, McDonald’s announced an initiative to make its children’s Happy Meals healthier by cutting the size of a serving of french fries and including a serving of fruits or vegetables. 82 As of 2013, a cheeseburger Happy Meal has 515 calories, a 20% reduction from the previous 640 calories, and 19.5 grams of fat, down from 26 grams. 83 In September 2013, McDonald’s announced that it would “only advertise milk, juice and water with Happy Meals.”84 . . . and Mickey Mouse In 2006, Walt Disney Company announced that it was not renewing a successful co-marketing agreement with McDonald’s that had been in effect for ten years. 85 Although spokespeople for both companies denied that health concerns CONTINUED 77. Jess Alderman, Jason Smith, Ellen Fried & Richard Daynard, Prevention and Treatment: Solutions Beyond the Individual: Application of Law to the Childhood Obesity Epidemic, 35 J.L. Med. & Ethics 90, 94 (Spring 2007). 78. Andrea Simakis, Ronald McDonald: Evil Genius? The Kid-Friendly Clown Is Under Fire for Leading Our Children Astray, Cleveland Plain Dealer, May 21, 2011, at E1. 79. Schor & Ford, supra note 74, at 12. 80. Simakis, supra note 78. 81. Id. 82. Kristeen Moore, Nutrition Changes Underway for McDonald’s Happy Meals, ThirdAge.com, Aug. 7, 2011, http://www.thirdage.com/news/ nutrition-changes-underway-for-mcdonald-s-happy-meals_08-07-2011. 83. Current calorie and fat content in a cheeseburger Happy Meal calculated from the nutritional information disclosed on the McDonald’s website (last visited on Sept. 20, 2013), http://www.mcdonalds.com/us/en/food/meal_bundles/happy_meals. html. 84. Neil Munshi & Shannon Bond, Food Inc Acquires Taste for Healthier Options, Fin. Times, Oct. 25, 2013. 85. Rachel Abramowitz, Disney Loses Its Appetite for Happy Meal Tie-Ins, L.A. Times, May 8, 2006, at A1. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 16 UNIT I FOUNDATIONS OF THE LEGAL AND REGULATORY ENVIRONMENT played any role in the decision, 86 Disney announced new advertising guidelines five months later. Disney CEO Robert Iger remarked, “A company such as ours, with the reach we have, has a responsibility because of how much we can influence people’s opinions and behavior.” He also noted the strategic implications of the new guidelines: “There’s also a business opportunity here.”87 As part of the initiative, Disney permits its characters to pitch children’s foods only if they meet specific health guidelines, including limits on calories, total fat, saturated fat, and added sugar.88 Disney has also altered the kids’ meals in its theme parks.89 Low-fat milk, juice, or water replaced soft drinks, and a healthier side dish (such as applesauce or carrots) replaced french fries.90 Since 2006, Disney Consumer Products has licensed various food products featuring Disney characters on the packaging and labels to help kids make more nutritious food choices.91 The Center for Science in the Public Interest commended Disney’s new guidelines, saying the move put Disney “head, shoulders, and ears” above other children’s entertainment companies, such as Nickelodeon’s parent company Viacom, Inc. whose “programming is filled with junk-food ads and whose characters grace all kinds of junk-food packaging.”92 Critics, however, pointed to continued junk food ads on the company’s websites and on its ABC television network, as well as the continued presence of McDonald’s vending carts in Disney theme parks.93 Nickelodeon’s Position After Disney announced its stricter nutritional standards, groups fighting childhood obesity turned their attention to Nickelodeon. 94 Unlike Disney, Nickelodeon argued that “[n]utritional standards . . . must be decided by regulators and food companies, not Hollywood.” 95 The television company also faulted the Center for Science in the Public Interest for ignoring the positive steps Nickelodeon had taken on its own initiative. For example, Nickelodeon sets aside 10% of promotional airtime for “health and wellness messaging”; it restricts licensing of certain characters, such as SpongeBob SquarePants, to advertise junk food; and once a year, for 86. Eric Noe, Did Childhood-Obesity Worries Kill Disney-McDonald’s Pact? ABCNews.go.com, May 8, 2006, http://abcnews.go.com/Business/ story?id=1937651&page=1. 87. Merissa Marr & Janet Adamy, Disney Pulls Its Characters from Junk Food, Wall St. J., Oct. 17, 2006, at D1. 88. Press Release, Walt Disney Company, The Walt Disney Company Introduces New Food Guidelines to Promote Healthier Kids’ Diets (Oct. 16, 2006), available at http://corporate.disney.go.com/news/ corporate/2006/2006_1016 _food_guidelines.html. 89. Id. 90. Id. 91. Disney Adds to Branded Food Line, License Mag., Oct. 25, 2012, http://www. licensemag.com/license-global/disney-adds-branded-food-line. 92. Marr & Adamy, supra note 87. 93. Drew McLellan, Does Disney Really Care If Your Kids Are Fat? The Marketing Minute Blog, Oct. 30, 2007, http://www.drewsmarketingminute. com/2007/10/does-disney-rea.html?referer=sphere_ related_content. 94. Brook Barnes & Brian Stelter, Nickelodeon Resists Critics of Food Ads, N.Y. Times, June 19, 2013, at B1. 95. Id. three hours, it suspends programming on all its channels and websites to participate in the “Worldwide Day of Play.” 96 Some experts claim that these steps are adequate to prevent Nickelodeon from being seen “as an uncaring corporation peddling junk food to children.”97 Others argue that Nickelodeon needs to do more. In 2012, four senators wrote to Nickelodeon management, urging the company to follow Disney’s lead with respect to nutritional standards. Efforts at Industry Self-Regulation Historically, food advertisers have successfully fought off enhanced government oversight of advertising to children. In 1974, the industry created the Children’s Advertising Review Unit (CARU), a voluntary association, to forestall proposed government regulations that would have curbed marketing targeted at children.98 Following a protracted battle, during which members of Congress were lobbied hard by advertising representatives, Congress rescinded the FTC’s jurisdiction over advertising to children in 1980 and left oversight of children’s advertising to the CARU.99 Food ads featuring unhealthy foods did drop after 2005, but critics complained that progress was too slow,100 prompting certain members of Congress to reconsider the decision to take away the FTC’s jurisdiction over children’s advertising.101 In 2011, the Federal Trade Commission, the Centers for Disease Control, the Food and Drug Administration, and the U.S. Department of Agriculture proposed voluntary nutritional guidelines for food marketed to children, but the industry objected, asserting that these guidelines were “overly broad.”102 Giants in the food industry have created two self-regulatory groups to respond to the food marketing issue: the Children’s Food and Beverage Advertising Initiative and the Sensible Food Policy Coalition. The Children’s Food and Beverage Advertising Initiative comprises sixteen companies, including Burger King, Coca-Cola, Kraft Foods, General Mills, and McDonald’s, which have pledged to improve the nutritional content of the food featured in ads aimed at children.103 The initiative announced in 2011 that it had developed uniform nutrition criteria for food advertisements to children, which were scheduled to go into effect in 2014. The criteria are based on U.S. dietary guidelines. In contrast, some of the nation’s largest food makers, fast-food chains, and media companies (including Viacom CONTINUED 96. 97. 98. 99. 100. Id. Id. Alderman et al., supra note 77, at 97. Id. at 98. Nickelodeon’s food ads dropped from 90% in 2005 to 69% in 2012. Barnes & Stelter, supra note 94. 101. See Alderman et al., supra note 77, at 98. 102. See Interagency Working Group on Food Marketed to Children, available at http://110428foodmarketproposedguide.pdf. 103. Press Release, CFBAI Highlights Significant Progress in Child-Directed Food and Beverage Advertising, May 7, 2012, available at http://www.bbb.org /us/article/cfbai-highlights-significant-progress-in-child-directed-food-and -beverage-advertising-34176. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 1 LAW, VALUE CREATION, AND RISK MANAGEMENT 17 Benjamin Schwartz/The New Yorker Collection/Cartoon Bank.Com and Time Warner) have campaigned to derail even voluntary restrictions.104 Their advocacy group—the Sensible Food Policy Coalition—argues that parents, not lawmakers, should be responsible for deciding what their children eat and whether they can have toys with their meals.105 Those arguments have thwarted a number of proposed bans across the country.106 In September 2013, First Lady Michelle Obama convened a food-marketing summit that included representatives from the food and media industries.107 The First Lady called on the attendees to “market responsibly to our kids,” noting that childhood diabetes is a major consequence of being overweight. A War on Soft Drinks? Although children’s diets have been a central focus of health advocates concerned about obesity, other products have gained attention as well. For example, health advocacy groups, as well as lawmakers, have been increasingly vocal about the high calorie content of sodas. High calorie intake can lead to obesity, which can lead to health problems. A study published in Health Affairs estimated that a decrease in soda consumption could “avert 2,600 deaths, 9,500 heart attacks and 240,000 new cases of diabetes every year.” 108 In an effort to fend off criticism that its products contribute to obesity, Coca-Cola, the world’s largest beverage company, announced in 2013 that it would include clearer nutritional information on packaging, promote diet drinks in emerging markets, stop advertising to children under twelve, and “encourage consumers to adopt more active lifestyles.” 109 Coca-Cola also ran advertisements in 2013 “aimed at getting on the healthy side of the national debate over obesity.” 110 The advertisements emphasized the company’s commitment to help consumers make healthier choices. New York City’s Ban on Super-Sized Drinks During 2013, then New York City mayor Michael Bloomberg and the city’s board of health tried to ban “super-sized” sugary drinks by capping the serving size at sixteen ounces at restaurants, food carts, and theaters.111 The city reasoned that banning high-calorie beverages was an “innovative way to fight 104. Sharon Bernstein, Fast-Food Industry Quietly Fights Ban, Pittsburgh Trib. Rev. May 22, 2011, http://www.pittsburghlive.com/x/pittsburghtrib /business/s_738333.html. 105. Id. 106. Id. 107. Darlene Superville, Michelle Obama Calls Food Marketing Summit to Ask Companies to Stop Advertising Unhealthy Foods to Kids, Huffington Post (Sept. 18, 2013), http://www.huffingtonpost.com/2013/09/18/michelle-obama-foodmarketing_n_3948115.html. 108. Raising Junk Food Prices Could Spur People to Consume Less: Study, Huffington Post (Dec. 12, 2012), http://www.huff ingtonpost. com/2012/12/12/junk-food-prices-soda-cost-consume-less_n_2279285. 109. Coke Acts to Fend Off Obesity Criticism, Fin. Times, May 13, 2013. 110. Stephanie Strom, In Ads, Coke Confronts Soda’s Link to Obesity, N.Y. Times, Jan. 15, 2013, at B7. 111. Michael Grynbaum et al., Court Halts Ban on Large Sodas in New York City, N.Y. Times, Mar. 12, 2013, at A1. obesity.” The soft-drink industry countered that the ban was a “bureaucratic overreach approved without legal authority.” 112 The conflict ended up in a New York court, which struck down the ban as “arbitrary and capricious.” The court pointed out that the rules applied “only to certain sugared drinks” and not to others—milkshakes, for example. In addition, it stated that enforcement would be “uneven” because the ban applied only to certain establishments, exempting convenience stores, for instance, but not delis in the same neighborhood.113 The Bloomberg administration appealed the case, but the intermediate appeals court held the regulation invalid in July 2013 after finding that the board of health had not acted “within the bounds of its lawfully delegated authority.” 114 In June 2014, the Court of Appeals of New York, the highest state court, affirmed that the regulation was invalid. More Restrictions Ahead? Taxation is another possible governmental approach to reducing soft-drink consumption. Indeed, a New Zealand study found that taxing carbonated drinks would result in lower consumption and thereby improve health.115 Mexico may soon learn whether this approach is effective. Globally, Mexico ranks first in per-capita soda consumption, and more than two-thirds of the country’s adults are overweight, according to the head of Mexico’s Center of Investigation in Nutrition and Health.116 In an effort to curb this trend and improve health, Mexican president Enrique Peña Nieto proposed a tax CONTINUED 112. Michael Grynbaum, City Argues to Overturn Ruling That Prevented Sugary Drink Limits, N.Y. Times, June 12, 2013, at A21. 113. Grynabaum et al., supra note 111. The ban was also struck down on other grounds. For example, it was not within the jurisdiction of the board of health to approve the ban (“the board overreached in approving the plan”). The March 11, 2013, ruling can be accessed at http://www.online.wsj.com/public /resources/documents/sodaruling0311.pdf. 114. In re New York Statewide Coalition of Hispanic Chambers of Commerce, 110 A.D.3d 1, 1 (N.Y. App. Div. 2013). 115. Raising Junk Food Prices, supra note 108. 116. Joshua Partlow, Mexico’s Soda Companies Fear Junk-Food Tax, WashingtonPost.com, Oct. 27, 2013, available at 2013 WLNR 26979007. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 18 UNIT I FOUNDATIONS OF THE LEGAL AND REGULATORY ENVIRONMENT increase on soda and other sugary drinks and snacks, which was approved in 2013 and scheduled to take effect in 2014.117 Manufacturers and marketers of soda, as well as owners of the convenience stores that sell the products, oppose the tax, fearing a loss of revenue. What can U.S. businesses do to avoid such governmental actions? Even modest steps such as those taken by McDonald’s, Disney, and Coca-Cola may provide protection from more onerous restrictions in the future. These steps might also contribute to enhanced market share. Marketing healthier products does not guarantee improved sales, however. PepsiCo’s efforts to promote two of its healthy food brands, Quaker Oats and Tropicana, were not as successful as it had hoped.118 117. Id.; Patricia Rey Mallen, 4 Takeaways from Pena Nieto’s First Year as Mexico’s President, Int’l Bus. Times News, Dec. 23, 2013, available at 2013 WLNR 30323347. 118. Coke Acts to Fend Off Obesity Criticism, Fin. Times, May 13, 2013. KEY WORDS AND PHR ASES legal astuteness 10 resource-based view (RBV) strategic compliance management 3 5 systems approach to business and society 2 QUESTIONS AND CASE PROBLEMS This chapter introduced important conceptual frameworks to be used while reading the cases and text and analyzing the Questions and Case Problems in each of the following chapters. Questions to consider include: 1.5 How could the managers in this case have avoided the litigation that ensued? 1.6 What are the “moral aspects of choice” implicated by the conduct at issue? 1.1 What public policies are furthered by this law? To what extent are there conflicts among the policies served, and how will they affect the way the law in this area is interpreted, applied, and changed? 1.7 Does this conduct meet societal expectations? If not, what new laws would be likely to result if a substantial number of firms acted this way? 1.2 What effect does this body of law or legal tool have on the competitive environment and the firm’s resources? 1.8 Did the manager in this situation exemplify the four components of legal astuteness? If not, what could the manager have done differently? 1.3 Where does this body of law or legal tool fit in the value chain? 1.4 How can managers responsibly help shape this aspect of the legal environment? Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 2 CHAPTER ETHICS AND THE LAW INTRODUCTION ETHICS MATTER When asked which qualities were most important for success- Maintaining a reputation for integrity and honesty is ful leaders, legendary investor Warren Buffett responded, more important than ever as customers vote with their feet “Integrity, intelligence and energy. Without the first, the other and boycott clothing made in sweatshops or gasoline made two will kill you.”1 from oil transported in pipelines built with slave labor. As Compliance with the law is just the baseline for effec- General Electric learned after its protracted and ultimately tive and responsible managerial action. If managers confuse unsuccessful battle with the Environmental Protection what’s “allowed” with what’s “right,” they risk cutting their Agency about cleaning up the PCBs it had (at the time, law- ethical discussions short and missing opportunities both for fully) dumped into the Hudson River, “governments are cus- the encouragement of morality by law and for the reform of tomers too.”6 They not only purchase goods and services but law in the light of society’s expectations. also directly affect the firm’s regulatory environment. For Legally astute managers consider not only what the example, Rupert Murdoch’s News Corporation was forced firm can do but also what it should do. 2 Greatness in the to abandon its $12 billion bid to acquire full control of British global marketplace requires attention to ethics and social Sky Broadcasting, Britain’s largest pay-television broad- responsibility as well as to the financial return to sharehold- caster, after word leaked that News Corporation reporters ers. Conversely, failure to meet the firm’s responsibilities had illegally hacked into phones in the United Kingdom and to employees, customers, the community, and the environ- elsewhere.7 The UK parliamentary committee handling the ment “puts at risk the company’s ability to operate, grow, review of the phone-hacking scandal subsequently declared and deliver future value to shareholders.”4 that Rupert Murdoch was “not fit” to “exercise the steward- 3 Good ethics are simply good business. As the Business ship of a major international company.”8 Roundtable, the leading association of CEOs in the United Current and prospective employees also care. When States, proclaimed, “[Long-term] shareholder value is enhanced evaluating a potential employer, job hunters use postings when a corporation . . . treats its employees well, serves its cus- on social network sites, questions in job interviews, and con- tomers well, fosters good relationships with suppliers, maintains tacts with present and past employees to search for clues to an effective compliance program and strong corporate gover- a firm’s ethical values. The mere existence of a code of con- nance practices, and has a reputation for civic responsibility.” duct or a toothless ethics program is not enough to attract 5 individuals who are not just looking for employment, but also 1. Ibolya Balog, Ethics on Their Shoulders: Boards Bear the Burden, Acct. Today, Nov. 27, 2006, available at http://www.accountingtoday.com /ato_issues/2006_21/22603-1.html (last visited June 26, 2013). 2. C. Roland Christensen et al., Business Policy: Text and Cases 121 (6th ed. 1987). On legal astuteness, see Constance E. Bagley, Winning Legally: The Value of Legal Astuteness, 33 Acad. Mgmt. Rev. 378 (2008). 3. Lynn Sharp Paine, Value Shift: Why Companies Must Merge Social and Financial Imperatives to Achieve Superior Performance (2003). See also Constance E. Bagley & Karen L. Page, The Devil Made Me Do It: Replacing Corporate Director’s Veil of Secrecy with the Mantle of Stewardship, 36 San Diego L. Rev. 897 (1999). 4. Robert S. Kaplan & David P. Norton, Strategy Maps: Converting Intangible Assets into Tangible Outcomes 165 (2004). 5. Principles of Corporate Governance, 2010, Bus. Roundtable, Mar. 31, 2010, at 32, available at http://businessroundtable.org/studies-and-reports /2010-principles-of-corporate-governance (last visited June 26, 2013). want to protect their personal integrity, retirement savings, and future employability by working only for upstanding organizations. The ethical reputation of an employer makes a difference to its current employees as well. In 2013, the 6. Constance E. Bagley et al., General Electric Ecomagination: An Examination of GE’s Corporate Environmental Strategy (Yale Sch. of Mgmt. Case No. 08-041, 2008). 7. Jeremy W. Peters & John F. Burns, Father and Son Split on Tactics in Murdoch Family Drama, N.Y. Times, July 13, 2011. 8. Ben Fenton, Salamander Davoudi & Andrew Edgecliffe-Johnson, Murdoch “Not Fit” to Run Global Company, Fin. Times, May 1, 2012. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 20 UNIT I FOUNDATIONS OF THE LEGAL AND REGULATORY ENVIRONMENT “Employment Cost of a Bad Reputation Survey” showed that 84% of the respondents would consider leaving their current employers for a company with an excellent reputation. 9 Finally, as demonstrated graphically by the passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010,10 corporate conduct that violates society’s expectations can also result in “[n]ew forms of regulation or effective enforcement . . . without regard for feasibility or cost.” 11 Accordingly, “government regulation is not a good substitute for knowledgeable self-restraint.” 12 CH APTER OV ERVIEW The purpose of this chapter is to provide a framework for analyzing how ethics, business, and law interact. It explains the business leader’s role in setting the ethical tone of the firm and provides an example of a high-profile executive who failed to fill that role. The chapter then presents the Ethical Business Leader’s Decision Tree, a tool managers can use to evaluate the legal and ethical aspects of their strategy and its implementation.13 After examining several incidents in which companies failed to meet societal expectations for ethical behavior, the chapter concludes by providing several positive examples of responsible behavior and suggesting steps managers can take to promote ethical behavior. 21 THE RELATIONSHIP BETWEEN LAW AND ETHICS The law does not prohibit all “bad” behavior. Conduct may be “clearly unethical and morally reprehensible,” but still be legal.14 As one court put it, “the law is one thing, and, unfortunately, ethics and morals are another.”15 Ethics and law are related, however. First, a judge or jury’s assessment of the ethical character of an action may determine how the law is interpreted and applied in a 9. Rebekah Mintzer, Bad Reputation Is Big Turnoff to Job Seekers; Wrongdoing Is Game-Changer, Despite Slow Economy, 36 Nat. L. J. 8, Dec. 14, 2013. 10. Pub. L. No. 111-203, 124 Stat. 1376 (2010). 11. Christensen et al., supra note 2, at 461. 12. Id. 13. Adapted from Constance E. Bagley, The Ethical Leader’s Decision Tree, Harv. Bus. Rev., Feb. 1, 2003, at 18. 14. Devnew v. Brown & Brown, Inc., 396 F. Supp. 2d 665, 677 (E.D. Va. 2005). 15. Id. at 677. See also Bammert v. Don’s Super Valu, Inc., 646 N.W.2d 365 (Wis. 2002) (public policy exception to the employment-at-will doctrine does not apply when an at-will employee is fired in retaliation for the lawful actions of her nonemployee spouse). The Wisconsin Supreme Court acknowledged that firing an employee because her husband arrested her employer’s wife for drunk driving was retaliatory and “reprehensible” but still provided no remedy. The dissenting judge asserted that “society owes its police officers a duty not to put them in the no-win position that [the employee’s] husband was placed in.” At-will employment is discussed in Chapter 12. given case.16 Second, law often reflects society’s consensus about what constitutes appropriate behavior. Third, law can help define the roles managers play, how they play those roles, and whether they have played them well.17 Fourth, patterns of unethical behavior tend to result in illegal behavior over time. As Martin L. Grass put it prior to being sentenced to eight years in prison for accounting fraud while CEO of Rite Aid: “In early 1999, when things started to go wrong financially, I did some things to try to hide that fact. Those things were wrong. They were illegal.”18 Therefore, creating an organization that encompasses exemplary conduct may be the best way to prevent damaging misconduct.19 2-1a Unethical Conduct Can Lead to More Onerous Regulation Another way in which law is related to ethics concerns regulation. As noted earlier, unethical conduct tends, over time, to lead to more onerous business regulation. Passage of the Sarbanes–Oxley Act of 2002,20 in the wake of widespread accounting fraud, and the Foreign Corrupt Practices Act of 1977,21 in response to the payment of government bribes by Gulf Oil, Lockheed Aircraft, and other major U.S. corporations, are but two examples of this phenomenon.22 The Enron Accounting Scandal The Enron accounting scandal, in which Enron officers were convicted of various criminal charges, figured prominently in the enactment of the Sarbanes–Oxley Act. The act established the Public Company Accounting Oversight Board (PCAOB), which oversees the public accounting profession, and imposed new, more burdensome reporting and auditing requirements. At its pinnacle, Enron was the nation’s seventhlargest public company in terms of revenue, with 32,000 employees worldwide. The firm filed for bankruptcy in 2001 after it became apparent that its executives had improperly employed various structured finance tools, including special-purpose entities, and fraudulent devices to hide debt, manufacture profits, and fabricate capital.23 16. Model Rules of Prof’l Conduct R. 2.1 cmt. 2 (2002) (“moral and ethical considerations impinge upon most legal questions and may decisively influence how the law will be applied”). 17. J. Nesteruk, A New Role for Legal Scholarship in Business Ethics, 36 Am. Bus. L.J. 515 (1999). 18. Mark Maremont, Rite Aid’s Ex-CEO Sentenced to 8 Years for Accounting Fraud, Wall St. J., May 28, 2004, at A3. 19. Lynn Sharp Paine, Managing for Organizational Integrity, Harv. Bus. Rev., Mar.–Apr. 1994, at 106, 117. 20. Pub. L. No. 107-204, 116 Stat. 745 (2002). 21. 15 U.S.C. § 78dd-1. 22. See Gisela Bolte, Jonathan Beaty & Christopher Byrons, Big Profits in Big Bribery, Time, Mar. 16, 1981, available at http://www.time.com/time /magazine/article/0,9171,922462,00.html. 23. The discussion that follows is based on Bethany McLean & Peter Elkind, The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (2003) and other public sources. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 2 Enron’s employees lost not only their jobs but also more than $3 billion in Enron stock held in retirement and employee stock ownership plans.24 In 2004, CFO Andrew S. Fastow pleaded guilty to two counts of wire and securities fraud and was sentenced to six years in prison.25 Former CEO Jeffrey Skilling was found guilty of fraud and conspiracy26 and ultimately sentenced to fourteen years in prison.27 The sentencing agreement required Skilling to distribute nearly $42 million to fraud victims.28 Arthur Andersen, LLP, the accounting firm responsible for auditing Enron’s financial statements, ultimately saw its criminal conviction for obstruction of justice overturned by the Supreme Court,29 but not before the firm had collapsed.30 When a firm’s business is predicated on integrity and trust, as Andersen’s was, a criminal indictment can be tantamount to a death sentence. Enron’s collapse spawned a host of civil litigation. Former Enron shareholders recovered $7.2 billion in settlements through a lawsuit that named former Enron executives and directors, as well as Enron’s investment bankers, as defendants.31 Citigroup alone agreed to pay $1.66 billion to settle claims that it had misrepresented Enron’s financial condition to secure the company’s investment banking business.32 22 THE ETHICAL TONE IS SET AT THE TOP The chief executive officer plays the most significant role in instilling a sense of ethics throughout the organization. As William F. May, chair of the Trinity Center for Ethics and Corporate Policy, explained: “The CEO has a unique responsibility; he’s a role model. What he does, how he lives, and the principles under which he operates become 24. Jo Thomas, Enron’s Collapse: Fading Nest Eggs; Labor Dept. Reviews Ban on Stock Sale, N.Y. Times, Jan. 24, 2002, at C6. 25. Fastow was originally expected to serve a ten-year sentence per his plea agreement; however, the trial judge reduced the sentence to six years. 26. In Skilling v. United States, 130 S. Ct. 2896 (2010), the Supreme Court reversed Skilling’s conviction for three counts of violating the “right of honest services,” holding that this section of the antifraud statute, 18 U.S.C. § 1346, applies only to bribes and kickbacks. The U.S. Supreme Court remanded his case to the appeals court to determine whether his conviction for more than twenty-five counts of substantive securities fraud, wire fraud, and insider trading, as well as making false representations to Enron’s auditors, should stand. The Fifth Circuit Court of Appeals subsequently affirmed the conviction for these counts. United States v. Skilling, 638 F.3d 480 (5th Cir. 2011). 27. Peter Lattman, Ex-Enron Chief ’s Sentence Is Cut by 10 Years, N.Y. Times, June 22, 2013, at B2. 28. Id. 29. Arthur Andersen, LLP v. United States, 544 U.S. 696 (2005) (jury instructions erroneously stated that Arthur Andersen could be found guilty even if the jury did not find that Andersen employees acted with knowledge and intent to commit a crime). 30. Linda Greenhouse, Justices Reject Auditor Verdict in Enron Scandal, N.Y. Times, June 1, 2005, at 1. 31. Kristen Hays, Possible $7.2 Billion Enron Settlement Emerges, Hous. Chron., July 28, 2007, at 1. 32. Eric Dash, Citigroup Resolves Claims That It Helped Enron Deceive Investors, N.Y. Times, Mar. 27, 2008. ETHICS AND THE LAW 21 pretty much those the rest of the corporation emulate.”33 Ben Heineman, Jr., former general counsel at General Electric, expanded this leadership responsibility to include all corporate executives and noted how even small quips or gestures can hinder company ethics objectives: Companies are preternaturally attuned to leadership hypocrisy. The stirring call for performance with integrity at the large company meeting can be eroded by the cynical comment an executive makes at a smaller meeting, by the winks and nods that implicitly sanction improprieties, by personal actions (dishonesty, lack of candor) that contradict company values. It is fundamental: A culture of high standards for employees requires high standards from the CEO and the senior operating and staff officers. 34 This is not to downplay the role of middle management. An employee’s immediate supervisor often has the most direct effect on the employee’s choices. Nevertheless, direction from the top signals to middle management that the CEO has a serious commitment to ethics. 2-2a The Imperial CEO In 2013, the average total compensation of a CEO of a company in the Standard and Poor’s 500 Index approximated $11.7 million, or more than 331 times the average worker’s salary of $35,200.35 The multiple had been less than 150 in 1990.36 In September 2013, perhaps in response to this trend, the Securities and Exchange Commission proposed rules under Section 953(b) of the Dodd–Frank Act to require public companies to disclose the ratio of the median compensation of the chief executive officer to the median compensation of the other employees.37 Critics of overly generous executive compensation packages argue that putting CEOs on a compensatory pedestal often leads to greedy and unethical behavior and reinforces narcissistic tendencies. Sam Vaknin, former director of an Israeli investment firm, who was himself diagnosed with narcissistic personality disorder while imprisoned for engaging in stock manipulation, described the disorder: “The narcissist lacks empathy—the ability to put himself in other people’s shoes. . . . He does not recognize boundaries—personal, 33. Alden Lank, The Ethical Criterion in Business Decision Making: Operational or Imperative? in Touche Ross & Co., Ethics in American Business: A Special Report 28 (1998) (hereinafter Touche Report). 34. Ben W. Heineman, Jr., Avoiding Integrity Land Mines, Harv. Bus. Rev., Apr. 2007, at 100. 35. Executive Paywatch, American Feder ation of Labor– Congress of Industrial Organizations, available at http://www.af lcio.org /Corporate-Watch/Paywatch-2014 (last visited June 27, 2014). A separate survey of the top 200 CEOs of companies with at least $1 billion in revenues reported a median 2012 pay package of $15.1 million. Gretchen Morgenson, That Unstoppable Climb in C.E.O. Pay, N.Y. Times, June 30, 2013, (Sunday Business), at 1. 36. Phred Dvorak, Theory and Practice: Limits on Executive Pay: Easy to Set, Hard to Keep, Wall St. J., Apr. 9, 2007, at B1. 37. Press Release, SEC, SEC Proposes Rules for Pay Ratio Disclosure (Sept. 18, 2013), available at http://www.sec.gov/News/PressRelease/Detail /PressRelease/1370539817895#.Up3ui8RDtTI. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 22 FOUNDATIONS OF THE LEGAL AND REGULATORY ENVIRONMENT UNIT I corporate or legal.”38 Perhaps the “poster child” of the imperial CEO is Dennis Kozlowski of Tyco International. Tyco’s Dennis Kozlowski Leo Dennis Kozlowski took over as CEO of Tyco in 1992 and became chair in 1993. In 2001, at the pinnacle of his career, Kozlowski appeared on the cover of BusinessWeek. Less than two years later, Kozlowski was forced to resign when he was charged with tax evasion after allegedly having art he had bought in New York shipped out of state to avoid paying $1 million in New York sales tax. Soon thereafter, Kozlowski and Mark H. Swartz, Tyco’s former chief financial officer, were charged with stealing $600 million from the company. During Kozlowski’s reign, Tyco’s stock price dropped from a high of $63.21 in 2001 to a low of $6.98 in 2002.39 At trial, uncontested testimony revealed that Kozlowski had had sexual affairs with at least two Tyco employees and spent tens of millions of Tyco’s money to purchase and outfit apartments in New York.40 Kozlowski allegedly spent $2 million on his wife’s birthday party and billed 38. Tim Race, New Economy; Like Narcissus, Executives Are Smitten, and Undone, by Their Own Images, N.Y. Times, July 29, 2002, at C4. 39. Floyd Norris, Tyco to Pay $3 Billion to Settle Investor Lawsuits, N.Y. Times, May 16, 2007, at 1. 40. Alex Berenson, The Tyco Mistrial: The Chief; Tyco Chief and His Deputy Avoid Convictions, but Not Tattered Reputations, N.Y. Times, Apr. 3, 2004, at C5. EXHIBIT 2.1 half of the cost to Tyco. Among other items paid for as corporate expenses were a $6,000 shower curtain, a $15,000 poodle-shaped umbrella stand, a $6,300 sewing basket, two sets of sheets for $5,960, a ...
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