yale case 08-023 January 18, 2008

Law and Strategy

Background Memo Two State and Society Series (2008)
Constance E. Bagley1
Douglas W. Rae2

The top management team (TMT) of a firm evaluates and pursues opportunities for value
creation and capture while managing the attendant risks. Value is created whenever the value of a
product or service to the customer exceeds the cost of producing it. All or part of that value can be
captured by the various players in the value chain, including suppliers of raw materials and other
tangible resources, employees and other providers of human capital, investors and other providers
3
of financial capital, and customers. Given the characteristics of the TMT and their personal
values, the parameters set by the public law, the firms position within the competitive
environment, and the nature and distinctiveness of the firms resources, the top management
team defines the value proposition and selects and performs the activities in the value chain.
Compliance with law is just the baseline for managerial behavior. Legally astute managers
4
consider not only what the firm can do but also what it should do. Accordingly, business
5
decisions consist of continuous, interrelated economic and moral components and the moral
6
aspects of choice are the final component of strategy.
In a democracy, society grants rights and powers to business, which society can revoke if firms do
7
not act responsibly. As Tom Stephens, CEO of Manville Corporation, put it when he decided to
add labels to Manvilles 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
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businessman who doesnt read the laws of society and understand them. Moreover, ethical
considerations often affect how the laws on the books are interpreted and applied.

Public Policies Underlying Business Regulation

Public lawthe formal rules embodied in constitutions, statutes enacted by legislatures, judicial
decisions rendered by courts, and regulations promulgated by administrative agenciesboth
reflects and helps shape social expectations. The laws and regulations applicable to U.S. business
in the early twenty-first century further, or purport to further, four primary public policy
objectives: promoting economic growth, protecting workers, promoting consumer welfare, and
9
promoting public welfare. This typology is depicted in Figure 1.
Other advanced states tend to have laws that further, or purport to further, these same objectives,
albeit with varying degrees of emphasis on the different objectives and varying ways of pursuing
10
them. 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, debtholders, employees,
customers, and suppliers and to the protection of the environment.

FIGURE 1: Underlying Public Policy Rationales of U.S. Laws

PromoteEconomic
PromoteEconomicGrowth
Growth
Protect
Protect
Property
Property
Rights
Rights

Enforce
Enforce
Contracts
Contracts

Allocate
Allocate
Risks
Risks

Facilitate
Facilitate
Capital
Capital
Markets
Markets

Create
Create
Incentives
Incentivestoto
Innovate
Innovate

Promote
PromoteLiquid
Liquid
and
andSkilled
Skilled
Labor
Markets
Labor Markets

Provide
ProvideEconomic
Economic
Incentives
Incentivesand
and
Infrastructure
Infrastructure

Promote
Promote
Free
FreeTrade
Trade

Protect
ProtectWorkers
Workers
Regulate
RegulateCertain
Certain
Terms
Termsand
and
Conditions
Conditionsofof
Employment
Employment

Require Employer to Provide Certain

Benefits

Protect
ProtectCivil
Civil
Rights
Rightsinin
Workplace
Workplace

Promote
PromoteConsumer
ConsumerWelfare
Welfare
Promote
PromoteSafe
Safe
Products
Productsand
and
Services
Services

Facilitate
FacilitateLow
Low
Cost
CostProducts
Products
and
Services
and Services

Prevent
Prevent
Deceptive
Deceptive
Practices
Practices

Facilitate
FacilitateInnovative
Innovative
Products
Productsand
andServices
Services

Promote
PromotePublic
PublicWelfare
Welfare
Promote
Promote
Effective
Effective
Administration
Administration
ofofJustice
Justice

Collect
Collect
Taxes
Taxesand
and
Spend
SpendMoney
Money

Protect
Protect
Fundamental
Fundamental
Rights
Rights

Protect
Protect
Environment
Environment

Source: Constance E. Bagley, Winning Legally: How to Use the Law to Create Value, Marshal Resources, and
Manage Risk (Boston: Harvard Business School Press, 2005), p. 27.

Effect of Law on the Competitive Environment and Firm Resources

Law helps shape the competitive environment and affects each of the five forces that determine the
attractiveness of an industry: buyer power, supplier power, the competitive threat posed by current rivals,
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the availability of substitutes, and the threat of new entrants. Table 2 offers examples of how managers
can use law and public policy to affect the five forces, organized by the public policies furthered by
business regulation.
Law also limits the manner in which firms can marshal and deploy physical, financial, and human
resources. For example, laws regarding at-will employment, wrongful termination, and employment
discrimination govern the firms relationships with its workers. Judicial decisions that increase the
directors exposure to personal liability for corporate decisions affect corporations ability to attract and
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retain qualified independent directors.

2 law and strategy

FIGURE 2: Using Law and Policy to Affect the Competitive Environment

Direct
Competition

Threat of Entry

Substitution

Promote
Economic
Growth

Obtain
development
subsidies, tax
breaks for
domestic firms;
litigate to enforce
antitrust laws

Secure patents and

other IP rights;
obtain
protectionist
tariffs to
advantage
domestic firms

Secure
trademarks;
protect trade
secrets; enter
into
employment
agreements with
covenants not to
compete; subject
employee stock
to vesting

Enter into
long-term
supply
contracts;
reduce import
duties and
quotas

Secure cost-plus
government contracts
and no- bid contracts
from DoD; enter into
exclusive dealing
contracts; use
contracts or IP to tie
products; litigate to
weaken scope of
antitrust laws

Protect
Worker
Interests

Restrict visas
needed by rivals:
tighten OSHA
regulations to
detriment of lesser
rivals

Penalize foreign
outsourcing; enact
antitakeover
protection

Increase funding
for education;
secure
restrictions on
worker layoffs

Prohibit union
abuses

Restrict availability
of goods made with
child or prison labor

Promote
Consumer
Welfare

Outlaw competing
products on safety
grounds

Impose licensing
regime; demand
posting of bond
by service
providers

Require labeling
of foreign
parts; outlaw
substitute
products on
safety grounds
or require
extensive safety
testing before
approval

Impose
mandatory
licensing
requirements;
litigate and
legislate to
weaken patent
protection

Impose product
safety standards

Promote
Public
Welfare

Obtain ethanolstyle subsidies for

firms product;
limit emissions to
detriment of lesser
rivals; seek federal
regulation that
preempts more
burdensome local
laws

Limit bidding on
government
contracts to
domestic firms

Lower taxes and

reduce
government
funding on
reseach and
development to
avoid deficit

Impose
domestic
content
requirement to
foil importers;
improve
transportation
infrastructure

Secure regulatory
approval for
monopoly to provide
universal access to
services; require
deposits on recyclable
products; provide
government trust
fund for personal
injury victims that
caps total damages

Supplier
Power

Buyer Power

Failure to integrate law into the development of strategy and of action plans can place a firm at a
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competitive disadvantage and imperil its economic viability. Consider the demise of investment bank
Drexel Burnham in the wake of the insider trading scandals of the 1980s; the collapse of the savings and
loan industry as a result of massive fraud; the implosion of Barings, Englands oldest merchant bank after
illegal trades by Nick Leeson; and the disintegration of the once venerable accounting powerhouse Arthur

3 law and strategy

Andersen. In the case of WorldCom, $200 billion of shareholder value was lost in fewer than twelve
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months, making it the largest corporate fraud in history.
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 a firms image with customers and
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other stakeholders, raising capital costs, and reducing sales volume. Researchers found that Fortune 500
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firms convicted of legal violations earned significantly lower returns on assets than non-convicted firms.
In 2000, Cendant paid $3.19 billion to settle securities fraud cases arising out of its fraudulent financial
reporting. The market capitalization of the firm had dropped $14 billion in one day after the fraud came to
light. Violation of the criminal laws can also land an executive in prison, as happened to Jeffrey Skilling,
former CEO of Enron, who was convicted of fraud and sentenced to more than twenty-four years in
prison.
Law does more than regulate and constrain, however. It also enables and facilitates. Corporate laws
granting limited liability to investors, bankruptcy laws giving fresh starts to entrepreneurs, and securities
laws requiring transparency and limiting insider trading make it easier for firms to raise financial capital.
Intellectual property protections, ranging from patents and copyrights to trade secrets and trademarks,
help firms erect barriers to entry, differentiate their products, command premium prices, reduce costs,
generate revenues, and create a culture of innovation.
Managers can make their own private law by entering into contracts enforced by the state and by
crafting certain governance structures. Contracts can strengthen relationships, reduce transaction costs,
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and enhance performance. The availability of a limited partnership as a form for organizing a venture
capital fund and of convertible preferred stock, with a variety of rights, preferences and privileges, was key
to the growth of the U.S. venture capital industry.
At least under certain circumstances, the ability to proactively go beyond the letter of the law can result in
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competitive advantage. In fact, regulation may prompt firms to innovate, making them more
19
20
competitive. Legally astute management teams practice strategic compliance management. They view
the cost of complying with government regulations as an investment, not an expense. For example, a bank
that viewed compliance with the Community Reinvestment Act as an opportunity to become a better
corporate citizen was able to develop new and profitable products to appeal to theretofore underserved
21
lower-income customers.
Instead of just complying with the letter of the law, legally astute managers seek out and embrace
operational changes that will enable them to convert regulatory constraints into innovation
22
opportunities. For example, firms that replaced the mindset of reducing pollution to meet government
end-pipe restrictions with a search for environment-friendly processes to create value achieved superior
23
financial performance. CEO Jeff Immelt of General Electric justified his decision to launch GEs
24
Ecomagination green initiative by the prospect of accelerating economic growth. PepsiCo responded
to proposed regulations by the Food and Drug Administration to require trans fat labeling by removing
trans fats from its potato chips and other Frito Lay snacks, then used the absence of trans fats as a
marketing edge.
Firm activities in the value chain, including lobbying, can affect not only the value and allocation of firm
resources and the competitive environment but also the laws that regulate business and the ways they are
interpreted and applied over time. Conduct that affects the broader society in an adverse way may also
prompt changes in the public law. Laws enacted in response to corporate misdeeds, such as accounting
fraud in the case of the Sarbanes-Oxley Act of 2002, improper disposal of hazardous waste in the case of
the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, and massive
bribery in the case of the Foreign Corrupt Practices Act in 1978, often impose greater restrictions and costs
on business than would have been imposed had firms acted more responsibly at the outset. The subprime
mortgage crisis has already led to calls for more regulation.
4 law and strategy

Law and the Value Chain

As seen in Figure 3 below, there are legal aspects of each activity in the value chain.
For example, the Uniform Commercial Code and the Convention on the International Sale of Goods
provide default rules, which the parties can modify by express contractual provisions. These include rules
specifying who bears the risk of loss if goods are lost or damaged prior to delivery, and when is
performance excused due to frustration of purpose or commercial impracticability. Court cases and
statutes impose strict liability on firms in the chain of distribution for defective products. Liability extends
to manufacturers, distributors, wholesalers, and retailers. A variety of state and federal statutes and
regulations protect consumers from deceptive advertising, sales, lending, and pricing practices and from
invasions of privacy.
The contract of sale as well as any express or implied warranties will determine a firms ongoing service
obligations. Customer releases, disclaimers of implied warranties, and provisions limiting liability to
replacement or repair and disclaiming liability for consequential damages can limit the sellers exposure
for property damage if a product does not meet the purchasers expectations.
The decision to outsource part of the value chain (such as manufacturing or service) rather than to
perform those functions internally rests on the assumption that the other firm will be legally required to
perform the outsourced activity at the agreed upon price. Courts will enforce such provisions as long as
they do not allocate risk in an objectively unreasonable manner.
Potential legal liability also affects the boundaries of the firm. Researchers found that exposure to liability
stemming from employees on-the-job exposure to hazardous materials made firms more likely to adopt a
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non-vertically integrated production system.

Developing the Managerial Capability of Legal Astuteness26

At its core, legal astuteness is the ability of managers to communicate effectively with counsel and to work
together to solve complex problems. Legal astuteness has four components: (1) a set of value-laden
attitudes about the importance of law to firm success, (2) a proactive approach to regulation, (3) the
ability to exercise informed judgment when managing the legal aspects of business, and (4) contextspecific knowledge of the law and the appropriate use of legal tools.
Value-Laden Attitudes
Legal astuteness begins with respect for the law. Legally astute management teams appreciate the
importance of meeting societys expectations of appropriate behavior and of treating all stakeholders
fairly.
They 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. 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.
Proactive Approach
Legally astute managers include legal considerations at each stage of strategy development and
implementation. They bring counsel in early and do not wait until a deal has been struck or a problem has

5 law and strategy

FIGURE 3: Laws Role in the Value Chain

Support Activities

Firm
Infrastructure
Human resource
management
Technology
development
Procurement

Limited liability, corporate governance, choice of business entity, tax

planning & securities regulation
Employment contracts, at-will employment, wrongful termination,
bans on discrimination, equity compensation, Fair Labor Practices Act,
National Labor Relations Act, workers compensation & Employment
Retirement Income Security Act
Intellectual property protection, nondisclosure agreements,
assignments of inventions, covenants not to compete, licensing
agreements, & product liability
Contracts, Uniform Commercial Code, Convention on the
International Sale of Goods, bankruptcy laws, securities regulation &
Foreign Corrupt Practices Act
Primary Activities

Inbound logistics

Contracts

Operations

Workplace safety &

labor relations
Environmental
compliance

Environmental
compliance

Process patents and

trade secrets

Marketing
and sales

Contracts

Contracts

Environmental
compliance

Uniform Commercial Code

Convention on
the International Sale of
Goods
Consumer
protection laws,
including privacy
protection

Service

Strict product
liability
Warranties
Waivers &
limitations of
liability

MARGIN

Antitrust limits on
exclusive dealing
contracts

Outbound
logistics

Doctrine of
unconscionability
Customer privacy

Bans on deceptive
or misleading
advertising or
sales practices
Antitrust limits
on vertical and
horizontal market
division, tying,
and predatory
pricing
Import / export
controls
World Trade
Organization

Sources: Diagram and text in roman from Michael E. Porter, Competitive Advantage: Creating and Sustaining
Superior Performance (1985); text in italics adapted from Bagley, Winning Legally, and M.E. Porter and M.R.
Kramer, Strategy and Society: The Link Between Competitive Advantage and Corporate Social Responsibility,
Harvard Business Review (Dec. 2006): p. 78.

6 law and strategy

arisen to seek legal advice. They demand legal advice that is business oriented and expect their lawyers to
help them address business opportunities and threats in ways that are legally permissible, effective, and
efficient.
Exercising Informed Judgment
Legally astute managers 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
advisors, including lawyers, get it wrong sometimes. A lawyers judgment can be clouded by personal
interests, such as increasing billable hours or angling for more power within the firm, or by over27
sensitivity to risk or over-confidence bias. Legally astute managers take this into account when factoring
in legal advice.
28

Every legal dispute is a business problem requiring a business solution. Legally astute managers take
responsibility for managing their disputes and do not hand them off to their lawyers with a you-takecare-of-it approach.
Contextual Knowledge of the Law and Legal Tools
Legally astute managers have content-specific knowledge of the law and the application of legal tools.
Managers 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 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 firms overall strategy, its external environment, and
with the stage of development of the business. Certain tools, such as contracts, have broad application.

Copyright 2008 Yale University. All rights reserved. Reprinted with permission of Yale University School of Management. To
order copies of this material or to receive permission to reprint any or all of this document, please contact the Yale SOM Case
Study Research Team, PO Box 208200, New Haven, CT 06520.

Endnotes

Richard S. Ely Professor of Management & Professor of Political Science, Yale School of Management.

Visiting Associate Professor of Business Administration, Yale School of Management.

See Garth Saloner, Joel Podolny, and Andrea Shepard, Strategic Management (Upper Saddle River, NJ: Prentice
Hall, 2002).

C. R. Christensen et al., Business Policy, 6th ed. (Homewood, IL: Irwin, 1987): p. 121. On legal astuteness, see
Constance E. Bagley, Winning Legally: The Value of Legal Astuteness, Academy of Management Review, vol. 33
(2008).

7 law and strategy

D.L. Swanson, Addressing a Theoretical Problem by Reorienting the Corporate Social Performance Model,

Academy of Management Review, vol. 20 (1995): p. 43.

6

E.P. Learned, C.R. Christensen, K.R. Andrews, and W.D. Guth, Business Policy: Text and Cases (Homewood,
IL: Irwin, 1969).
7

D.J. Wood, Corporate Social Performance Revisited, Academy of Management Review, vol. 16 (1991): p. 691.

W. Glaberson, Of Manville, Morals and Mortality, New York Times (October 9, 1988).

This typology is discussed further in Constance E. Bagley, Winning Legally: How to Use the Law to Create
Value, Marshal Resources, and Manage Risk (Boston: Harvard Business School Press, 2005), pp. 26-43.
10

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 the members of the supervisory boards of
large German corporations are elected by the workers and unions, and half are elected by the shareholders.
11

Michael E. Porter, How Competitive Forces Shape Strategy, in On Competition (Boston: Harvard Business
School Press,1996), pp. 21-22. See also Richard G. Shell, Make the Rules or Your Rivals Will (New York: Crown
Business, 2004).
12

M.R. Kaplan and J.R. Harrison. Defusing the Director Liability Crisis: The Strategic Management of Legal
Threats, Organization Science, vol. 4, no. 3 (1993): pp. 412-432.

13

Bagley, Winning Legally.

14

See Richard Breeden, Restoring Trust, filed with the WorldCom bankruptcy court on August 26, 2003.

15

M.S. Baucus and D.A. Baucus, Paying the Piper: An Empirical Examination of Long-Term Financial
Consequences of Illegal Corporate Behavior, Academy of Management Journal, vol. 40 (1997): p. 129.

16

Ibid.

17

Bagley, Winning Legally.

18

Ibid.

19

B.M. Mitnick, The Strategic Uses of Regulationand Deregulation, in B.M. Mitnick (ed.), Corporate Political
Agency: The Construction of Competition in Public Affairs (Newbury Park, CA: Saga Publications, 1993); M.E.
Porter and C. van der Linde, Green and Competitive, Harvard Business Review (May 1995): p. 120.
20

Ibid., pp. 50-86.

21

S.J. Fox-Wolfgramm, K. B. Boal, and J. G. Hunt, Organizational Adaptation to Institutional Change: A

Comparative Study of First-Order Change in Prospector and Defender Banks, Administrative Science Quarterly,
vol. 43, no. 1 (1998): pp. 87-126.
22

B.M. Mitnick, The Strategic Uses of Regulation; Porter and van der Linde, Green and Competitive.

23

C. Nehrt, Maintainability of First Mover Advantages when Environmental Regulations Differ Between
Countries, Academy of Management Review, vol. 23 (1998): p. 77.
24

Amanda Griscom Little, G.E.s Green Gamble, Vanity Fair (July 10, 2006).

25

J.B. Barney, F.L. Edwards, and A.H. Ringleb, Organizational Responses to Legal Liability: Employee Exposure
to Hazardous Materials, Vertical Integration, and Small Firm Production, Academy of Management Journal, vol. 35
(1992): pp. 328-349.

26

This discussion is drawn from Bagley, Winning Legally.

27

D.C. Langevoort and R.K. Rasmussen, Skewing the Results: The Role of Lawyers in Transmitting Legal
Rules, Southern California Law Review, vol. 5 (1997): p.375.
28 Constance E. Bagley, Legal Problems Showing a Way to Do Business, Financial Times (November 27, 2000):
p.2.

8 law and strategy