Agency problem
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The design of organisations and products
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The agency problem describes the intrinsic conflict of interest any agent working on a commission faces, and that is that as long as it gets its commission, it doesn’t really care a hill of beans what its principal gets, however much it might protest to the contrary.
In a sense, this is an articulation of the prisoner’s dilemma, shouldn’t surprise anyone and should be cured by repeat iterations: clients have memories and will remember when you ripped them off.
But the iterated prisoner’s dilemma has a couple of natural limits: One is that it relies on repeated interactions with an indeterminate end-point: the promise of another opportunity, on another day, to clip your ticket. When the sky is falling on your head, it looks like a final interaction, and the calculus is different.
Second, it takes no account of “convexity” effects: I can build up my reputation incrementally by faithfully carrying out thousands of small transactions — I can look like a five-star collaborator — only to blow it on one big position. I can sell ten thousand ball point pens in utter good faith and welch the one time I sell a Ferrari.
When that one outsized reward more than compensates for all the thousands of pennies in front of the steamroller, the normal rules don’t apply and an iterated game of prisoner’s dilemma becomes a one-off. This is what Nassim Nicholas Taleb calls the “Rubin Trade”.
Thus, the agency problem is the classic “skin in the game” problem: an agent gets paid, no matter what. The investment manager puts no capital up, takes a small slice of yours, by way of a fee, no matter what.
Nice work if you can get it. A lot of people in the city can get it.
The agency problem and corporate personality
This tension, between the overriding life goals of an agent and those of her principal is the crux of the agency problem. They do align — but only so far.
Theory: the “legal revolution” theorists — academics, GCs, COOs and thought leaders generally — make the category error of assuming the interests of client corporations drive the market. This aligns with legal theory: a corporation is a person and has its own personality, interests and desires. But the corporation as a “res legis” — a legal thing — is only a “thinking thing” through the agency of its representatives, each of whom is a thinking thing in her own right.
The critical difference between human person and corporate person is that a corporation cannot speak for itself. A human principal, being a thinking, animate thing, can apprehend the conflicts of interest of which he may be a casualty, and police them. A pile of papers filed at companies house cannot. It can only crowd-source defence of its own interests to its “friends” who are animate, but who have interests of their own. It can seek to nullify any one agent’s conflicting interest by asking the aggregated weight of its other agents to represent its against that one agent in a kind of “wisdom of crowds” way — their individual interests disappearing through some kind of phase cancellation effect to which their common interest — furthering the interest of their mutual principal the corporation — is immune. This works as long as the self-interests of each of the other agents do cancel themselves out: if all the agents have a common self-interest which conflicts with the corporation’s interests, this crowdsourcing strategy won’t work.
So do all its agents have such a common conflicting interest? Yes.
Any one of its agents is charged with protecting the principal’s interests, but two overriding considerations will inevitably take priority: (i) their wish to protect and perpetuate their own role as agent, and protect its accompanying income stream — their need to persuade the principal that their role is needed whether or not it is needed — no turkey votes for Christmas; and (ii) their wish to not fuck up — not only is the role necessary but I am a suitable person to carry out that role.
Legal industry transformation and the agency problem
The JC humbly submits that any plan to revolutionise the legal industry that does not account for the agency problem will fail. Everyone who purports to speak for a corporation does so in a way that, above all else, does not prejudice his own agency with the corporation.
This puts our old friend the drills and holes conundrum into perspective: it is true that a corporation desires quick, cheap and effective legal services. In many cases, it does not need any legal services at all — it could do not just with legal protections delivered in a convenient format and by a less expensive source, but no legal protections at all. What percentage of legal agreements are ever litigated? But it is hard for an inanimate pile of papers filed at companies registry to have that sort of insight. It relies on its agents to arrive at that conclusion on its behalf. But who, amongst the byzantine control structure that those very agents have constructed to help it make decisions of that sort — its inhouse counsel, outhouse counsel, credit risk management, document negotiators, client onboarding team, compliance or internal audit — who of these people would ever say that? And even if one did, would he not be shut down by the consensus of the others?[1]
Big law and the agency problem
Just one can make the case that humans did not domesticate wheat so much as wheat domesticated humans,[2] so might one argue that investment banks did not cultivate big law firms as much as big law — oh, okay, and big consultancy — cultivated the investment banks. Our IB GC genealogy refers.
For there are certain pillars of bank activity — the conduct of litigation being one, the execution corporate advisory business another and let us throw in the wheel-spinning “industry” of industry associations for a third — whose conduct so depends upon, and is in thrall to, the memetic interests and commercial imperatives of law firms, to the outright detriment of anyone else involved, that it is hard to rationalise these activities other than as some kind of extended phenotype for private practice of commercial law.
In this view, the in-house legal department — a bank function all but unknown thirty years ago, but now so monstrous that it needs its own chief operating officer[3] — really only exists to make life as easy as possible for the law firms to optimise recovery of recorded chargeable time.
Big law’s neat evolutionary trick big here is to weaponise the agency problem by imposing structural intermediation between those who instruct them and those who are, ultimately, expected to pay for them. That intermediary —agent — has no skin in the infinite game and only one interest: to keep playing.</ref>See Finite and Infinite Games.<ref>
So, to take our three examples:
Advisory M&A, DCM, ECM etc.
The business of advising on mergers and acquisitions and primary transactions in the debt and equity capital markets is generally handled on behalf of target and acquiror by appointed investment banks.
Each bank will appoint it's own law firm to advise it — the target will have its own independent counsel too — principally on the underwriting, regulatory and reputational risks posed by being involved in the proposed transaction. The bank’s legal advisors will conduct due diligence, negotiate contracts, shareholders agreements, draft prospectuses, advise on all kinds of competition issues that may arise, and will issue batteries of legal opinions — enforceability opinions, true sale opinions, fairness opinions, security opinions, 10b5 opinions — you name it — all of which are designed to give the arranger and syndicates — the banks — comfort that their risk of shareholder action or regulatory censor is minimal. Who pays for all this legal advice? The bank’s client, of course. This, on top of the underwriting fee, will be in the first blushing exchanges of the engagement letter.
Once the client has agreed to this — and, for the most part, clients have no choice — the bank’s internal lawyers have little incentive, beyond basic compassion for defenceless multinationals, to constrain their legal spend, and will allow themselves to be led down every open manhole cover that any deal lawyer can contrive to fall into.
Inhouse teams are likely exempt from the usual rubber glove inspection — competitive tenders, law firm panels, methodological justifications —that follow requests from other parts of the legal department to incur “own legal spend”, even in nugatory amounts.
Litigation
The sorts of litigation banks get into tend to involve claims of art least hundreds of millions of pounds, and typically banks are on the wrong end of them — it is an unusual investment bank that makes a habit of suing its own, solvent clients — meaning that, unless it is prepared to just admit everything and pay up— this happens a lot more than you would think, thanks to an inverted instance of the agency problem — the bank has little control of the process. Unlike a commercial transaction, there is no critical path, since you don't know how the other side will play, so it is hard to fix or even estimate fees, so “time and attendance” tend to be the order of the day.
See also
References
- ↑ Those who don’t believe me should try proposing that you don’t need cross default in trading agreements. You will get bilateral consensus on this, in private conversations, from almost everyone; no-one will say it in public.
- ↑ A Yuval Noah Harari bon mot that owes something to Richard Dawkins’ idea of the extended phenotype, we feel.
- ↑ our history of inhouse legal refers.