Finding the Right Corporate Legal Strategy

Businesses have been “swimming in a sea of law” as they navigate increased regulation, varying international legal regimes, assorted lawsuits and the impact of stiffer legal penalties for infractions.1 As a result, senior executives have increasingly recognized that legal capabilities are crucial for ongoing corporate success, and they understand the importance of working with legal counsel. Indeed, one study found that 43% of U.S. companies had lawyer-directors in 2009, a notable increase from 24% in 2000.2 Other research has found that corporations generate tangible returns, such as higher stock market valuations, when they employ attorneys who serve as board members and when top corporate officers have legal knowledge.3

Paradoxically, the processes through which corporate legal departments provide competitive advantage remain poorly understood. The prevailing wisdom recognizes the need to incorporate legal considerations into top-level business decision making, but all too often executives still view the law as a constraint on managerial decisions, primarily perceiving it as an issue of cost and compliance.4 This limited perspective of the law, however, does not explain how some leading companies have managed to deploy their legal departments to shape the legal environment in order to secure long-term competitive advantage.

Consider, for example, the Walt Disney Company. Faced with the eventual expiration of its media copyrights, Disney executives transferred the value of that intellectual property into thousands of newly registered trademarks for various characters, names and images.5 This legal strategy achieved two important goals. First, it shifted the company’s property to a legal regime that offers an indefinite lifetime. Second, it facilitated the expansion of name and character merchandise licensing, which now accounts for a global, multibillion-dollar, high-profit-margin business. Without a working knowledge of the law, however, this shrewd strategy never would have been properly executed, and considerable shareholder value would have been lost. And Disney is but one of many companies that have successfully deployed sophisticated legal strategies to capture the profits of innovation-related activities, particularly in the field of intellectual property management.6

An example of a different type of powerful legal strategy involves Microsoft’s recent acquisition of Nokia’s handset division. An interesting aspect of that $7.2 billion deal was the decision to license the Nokia division’s extensive patent portfolio for $2.18 billion instead of purchasing it outright, as is customary. The acquisition has been viewed as part of Microsoft’s strategy to compete against Google in terms of that company’s mobile phone and Android operating system business. In the past, Microsoft has vigorously asserted its own patents against Google, and the licensing deal with Nokia allows Nokia to pursue actions against Google independent from Microsoft, thus creating a multifront attack against Google. For its part, Nokia will benefit from the unique arrangement because, having sold its operating business to Microsoft, the company won’t be subject to any patent infringement countersuits that Google might initiate. This example of a major corporate acquisition accompanied by a creative patent licensing structure reveals a deep level of legal proficiency and its application to top-level corporate strategy.

Sophisticated legal strategies like those deployed by Disney, Microsoft and Nokia are far more the exception than the rule. In our research,7 we have found that many executives view the law too narrowly as a cost or compliance issue, inevitably forsaking strategic opportunities.8 (See “About the Research.”) To help executives broaden their perspective, we have developed a framework that can help identify the various ways in which legal strategies can be used to gain competitive advantage and identify value-creating opportunities. Key elements in the framework include managers’ attitudes towards the law and their level of legal knowledge. Other important factors are the skill level of legal counsel and, in particular, the legal department’s ability to work with managers to achieve strategic business goals. Using the framework as an overall guide, executives can craft a legal strategy that best suits their particular business needs.

The Five Pathways of Corporate Legal Strategy

We have found that companies tend to use one of five different legal pathways. (See “Five Different Legal Strategies.”) The five, in order of least to greatest strategic impact, are: (1) avoidance, (2) compliance, (3) prevention, (4) value and (5) transformation. The following discussion presents details of each pathway with company examples to illustrate their different applications.

1. Avoidance

Some executives make the conscious choice to disregard or remain willfully blind to the legal consequences of their company’s actions. The prevailing attitude in such cases is that the law presents an obstacle to their desired business goals. Managers in the avoidance pathway believe that legal expertise provides little concrete value, so they make no effort to acquire it. Or they might gain knowledge of the law only so that they can circumvent it to achieve a desired objective. Companies operating in the avoidance pathway will often have lax internal controls or a failure to perform due diligence. In such companies, the role of legal counsel is typically defensive — helping to fend off investigations and lawsuits.

An avoidance strategy can sometimes be effective — a company might, for example, want to outsource certain activities to another jurisdiction to avoid burdensome local regulations — but it can also lead to disaster. For example, when the brokerage firm MF Global attempted to exploit legal ambiguity arising from being regulated by several agencies, the firm was able to sidestep the regulators’ intent. But this only hid many of the serious problems underlying its lax reporting controls and flawed risk-management practices, ultimately leading to a massive liquidity crisis and a Chapter 11 bankruptcy filing.

2. Compliance

Companies operating in the compliance pathway recognize that the law is an unwelcome but mandatory constraint on their activities. In such companies, managers view compliance mainly as a cost that needs to be minimized. This attitude leads to the attainment of some legal knowledge but only enough so that the business can operate within the legal bounds. From this vantage point, the law is viewed primarily as inflexible — externally imposed rules that cannot be changed or adapted to suit a particular corporate strategy. Consequently, managers in the compliance pathway do not believe that they can use the law to further their business goals, and legal counsel acts primarily as a watchdog that polices corporate conduct for illegal activity.9

For companies operating in the compliance pathway, strategic opportunities do not exist unless executives make a deliberate decision to engage in noncompliance activities after taking into account the consequences and costs of doing so. Indeed, some managers might appreciate the legal duties imposed on their business but choose noncompliance after a careful cost-benefit analysis. United Parcel Service, for example, pays millions of dollars annually for the parking fines that its delivery trucks incur in New York City rather than comply fully with local parking ordinances.10 For UPS, that expense is considered an acceptable cost of doing business in order to maintain its leadership in shipping and logistics.

In a typical technology company that operates within the compliance pathway, an in-house counsel oversees patenting and is responsible for employees filling out invention disclosure forms and patent applications. Patent departments in such organizations are seen as little more than administrative cost centers that are necessary to comply with the legal requirements of obtaining a patent. As such, any engagement between the patent counsel and the company’s top executives is generally minimal. But strategy may play a role when noncompliance is related to a broader corporate objective. A business might, for example, decide against complying with a patent owner’s valid and reasonable royalty demands because of strategic reasons. The company could want to develop a reputation for being tough against royalty demands, particularly if it wants to dissuade future lawsuits from aggressive entities such as patent trolls.

3. Prevention

The prevention pathway marks a notable change in legal strategy and attitudes among both managers and legal counsel. Here, executives acknowledge that the law can be used to further well-identified business goals. Unlike the avoidance and the compliance pathways, the prevention pathway calls for a proactive instead of reactive approach to the law — executives seek legal counsel rather than shy away from it. Managers operating in the prevention pathway understand the law as it relates to their functional business areas, and they appreciate how it can be used to minimize particular business risks. For its part, legal counsel proactively seeks partnerships with managers to help them achieve those risk-management goals. Corporate attorneys also begin to view legal data in a unique way: They fully recognize the importance of measuring and quantifying legal issues and data as part of a broader effort to support a business-oriented strategy.11

With respect to patent law, companies can adopt a prevention approach by deploying two types of tactics: defensive technical disclosures and “patent fencing.” Using the first tactic, companies like IBM, Motorola, Siemens and Xerox12 have chosen to disclose patentable technical information to prevent a rival from obtaining a patent and to preserve their freedom to operate in that technology space. IBM, for example, has routinely made technical software disclosures to protect its open-source server servicing business from the threat posed by Microsoft’s proprietary server operating system.13

Patent fencing occurs when a company establishes a patent position beyond the scope of an invention in order to limit the technology advancements of a competitor. This tactic requires legal counsel and engineers to coordinate their technology and patent law expertise. Take, for example, pharmaceutical companies that engage in sophisticated patent fencing techniques to maximize the value of their drug compounds. Executives of those drug corporations coordinate and manage their legal departments with research and development such that, throughout a product’s life cycle, they can obtain patent variations in the underlying drug and its molecular structure, isomer or crystal versions of the active ingredients, manufacturing processes, dosing combinations and fields of use.14 That tactic allows them to fend off would-be close imitators and generic equivalents, thus extending the lifetime of the underlying drug patents.

4. Value

Companies operating in the value pathway use the law to create tangible and identifiable value. To accomplish that, managers need to have a strong understanding of the legal system and how it can be tailored to generate value, and the legal department must view itself as a key stakeholder in helping the company to increase its return on investment. At this level of engagement, managers across functional areas work frequently with legal counsel and view them as partners in their strategic decision making. Legal counselors, in turn, assume a more entrepreneurial role and have enough business proficiency to discuss various issues fluently with managers. A key differentiating attribute of the value pathway is that managers and attorneys work together to devise legal strategies and techniques that increase ROI in ways that can be directly tied to a profit-and-loss statement. This can be accomplished in two ways.

First, the legal department can work with external stakeholders to reduce costs. Consider the following example of an elevator and escalator manufacturer that was able to reduce its product liability claims from incidents involving children who had been injured in department stores where the escalators were located. The manufacturer’s legal department conducted a strategic assessment of those accidents and discovered that they had occurred in stores where the escalators were located near perfume counters. Apparently, parents who were busy sampling products at those counters tended to lose track of what their children were doing, resulting in the increased rate of escalator injuries. Armed with that crucial knowledge, the legal department could then work with the department stores to relocate the perfume counters, resulting in a decrease of the manufacturer’s product liability claims.15

The second way to increase ROI in the value pathway is to generate additional revenues. Xerox pursued that approach in the late 1990s when it created a business unit specifically devoted to increasing the licensing income from its vast — but previously dormant — patent portfolio. Xerox’s legal counsel took an entrepreneurial role by viewing its mission in the following way: “[To] look at the total portfolio of patents and technology and figure out how to best package, market and sell them as we would any other product.”16 Legal counsel worked with management to identify groups of patents that could be licensed as a packaged deal, and it partnered with engineers in a “break-down” lab to determine whether competitors’ products had infringed on Xerox patents. Moreover, the company used sophisticated patent analytics and mapping software to determine whether competitors were citing Xerox patents, and that information was used to identify potential sources of licensing revenue.17

5. Transformation

In the transformation pathway, a company has incorporated its corporate legal strategy into its business model. Accomplishing such integration is difficult for the reasons discussed earlier (for example, a legal department that has inadequate expertise or a focus on compliance). But the few companies that attain this pathway possess a rare and valuable legal capability that can provide a competitive advantage that is difficult for rival businesses to imitate. A key aspect of a transformative legal strategy is that it is not only integrated within the company’s various value-chain activities; it is also linked with the value chains of important external partners as part of a larger business ecosystem.

Consider Qualcomm, the digital communications products and services company based in San Diego, California. Early in its history, Qualcomm had to decide whether to remain in the handset manufacturing business or shift to an entirely new business model that focused on its code-division multiple access (CDMA) wireless technology. At the time, the industry was dominated by large incumbent competitors with established manufacturing and branding resources that Qualcomm lacked. Also, wireless technology was evolving rapidly, and Qualcomm needed to act quickly if it wanted to establish CDMA as a viable technology. So the company decided to bet its future on CDMA and a business model that combined legal expertise related to patent standards with a shrewd approach to contract licensing. As Qualcomm cofounder Irwin Jacobs succinctly noted, “We’ll do the innovative part and let others do the manufacturing.”18

Choosing and implementing an effective legal strategy is a process that takes time, requiring careful consideration of the various internal and external variables needed to align the necessary resources.

Qualcomm’s new business model hinged on the following strategy: contribute CDMA wireless technology patents to develop an industry standard, and encourage key stakeholders, such as the wireless equipment vendors and network operators, to adopt that standard. The company achieved those seemingly conflicting objectives — diffusing technology while retaining some control — by implementing a sophisticated legal strategy. To encourage technology diffusion, Qualcomm inverted the idea of patent exclusivity in the wireless industry by offering anyone the opportunity to license its proprietary technology while it retained the rights to key technology know-how. In negotiating those licenses, Qualcomm offered specific terms to speed up the adoption of its technology and reduce the risks of an unproven technology. For example, the key licensing terms offered to equipment vendors and wireless network operators reduced their risk by offering dedicated technology support and a “try before you buy” option. These terms were exchanged for ongoing royalties and up-front fees that locked in those customers and provided Qualcomm with much-needed cash for additional research and development.19 Licensing income continues to be an important source of revenue for Qualcomm; licensing generated about 30% of the company’s revenue in fiscal 2013.20

Reaching the Right Pathway

When it comes to legal strategies, there is no one-size-fits-all approach. A technology startup in a relatively unregulated business like software would likely employ a different legal pathway than a mature corporation in a heavily regulated industry like insurance. Moreover, choosing and implementing an effective legal strategy is a process that takes time, requiring careful consideration of the various internal and external variables needed to align the necessary resources. Important factors like personnel, reporting structures, company culture and the competitive landscape need to be assessed to develop a viable action plan. And crafting and implementing that plan will invariably be an iterative process that takes learning and adaptation over time, both within the organization and among key external stakeholders.

To identify the best legal strategy for their business, executives should first note a fundamental difference between the different options. Of the five pathways discussed, the first three (avoidance, compliance and prevention) focus primarily on managing risk, whereas the remaining two (value and transformation) are also targeted toward generating business opportunities. If a company derives its competitive advantage from an entrepreneurial culture and management approach, then executives might best consider the value and transformation pathways. But a large corporation in a mature industry that is highly regulated may be better off pursuing a compliance pathway.

The ideal legal strategy in theory, however, is not always the best strategy in practice. Executives need to consider several fundamental issues that can clarify the process of choosing an appropriate legal strategy independent of the type of company in question. First, the reality is that the majority of companies currently operate somewhere within a risk-management paradigm, most likely following a compliance pathway. As will be discussed below, every company, regardless of industry, can achieve the highest risk-management pathway of prevention. But moving into the opportunity-generation paradigm might not be practical for some organizations.

Executives who want to identify their current pathway can conduct a legal strategy audit. (See “How to Conduct a Legal Strategy Audit.”) For companies that find themselves in the avoidance pathway, managers should consider taking quick and assertive actions to move toward compliance. (As discussed earlier, avoidance can be a useful pathway in certain cases, but it is not generally an effective long-term strategy.) This will require hiring a general counsel with a strong compliance background, or possibly even creating a new role for someone to serve as a chief compliance officer, reporting directly to the CEO and board of directors.21

In today’s heightened regulatory environment and due to various factors, such as the Sarbanes-Oxley Act and the Dodd-Frank Act in the United States, a company’s board of directors has the ultimate fiduciary responsibility to ensure that the organization maintains a robust compliance system. In some cases, a CEO might need to reorganize the existing structure of in-house counsel to achieve greater transparency and accountability. For example, a decentralized structure with attorneys working separately across different business units may create undue risks from a lack of central oversight. Enron, the energy, commodities and services company that filed for bankruptcy in 2001, had adopted this type of structure, and that decentralization has been attributed as a factor in the organization’s lack of adequate controls. The oversight weakness of decentralization is exacerbated when compliance officers are assigned to executives who manage overseas business units, because this further removes the arm’s-length relationship necessary to maintain objectivity and integrity. In addition to a centralized structure of in-house counsel, companies should consider implementing management training of basic legal issues concerning liability. This can take the form of internal compliance training sessions or external professional development courses on specialized legal topics.

Every company that operates at the compliance level has the opportunity to move up to the prevention pathway. At this point, line managers have a working knowledge of compliance issues related to their job duties but, to advance to the next level, attorneys advising these managers need to possess a better understanding of their business issues and the specific risks that can be mitigated through preventive legal action. One way for companies to promote this type of learning is through job rotations, in which in-house staff attorneys temporarily assume managerial responsibilities at the business unit or functional area that they advise. At one large utility company, for example, such job rotations are perceived as a necessary step for in-house attorneys to advance within the organization. The understanding between attorneys and managers that is gained from such a process can be invaluable in developing legal strategies that reduce business-specific risks, which is the hallmark of the prevention pathway.

Crossing the Divide

Moving from the prevention to the value pathway requires a fundamental change from managing risk to creating business opportunities. This shift in perspective requires two major elements that are difficult to achieve and signal a radical departure in terms of legal strategy.

The first essential element involves the attitudes among key senior executives and their view of the law as it relates to business outcomes and the company’s strategic direction. To cross the divide into the highest levels of legal strategy, top executives must regard the legal capabilities of the organization as a strategic resource. An analogy is the way in which different businesses view information technology. As one researcher has stated, IT can be a strategic activity and yet it is often underexploited, because top executives frequently lack IT savvy and fail to recognize how IT can affect performance, both operationally and strategically.22 Similarly, for advanced legal strategy to gain a foothold, the company’s CEO and other top executives must possess legal astuteness23 and regard the law as a key enabler of value creation.

Second, the CEO and general counsel must authorize and delegate an individual responsible for conceptualizing and spearheading legal strategies that generate business opportunities. This person, often referred to as a chief legal strategist, should be empowered and provided with the support and resources necessary to champion high-level strategic efforts within the organization. Selecting the right individual to be the chief legal strategist is an important task. In a small or medium-sized company, this person may be the top legal officer or the general counsel. In a large company, however, this person should be someone a level below the general counsel (for example, an associate general counsel). The reason is that the general counsel at a large corporation is responsible for dealing with myriad company-wide legal issues (including corporate governance, mergers, litigation, contracts and regulatory affairs) in addition to managing the legal department, overseeing its budget and maintaining the company’s relationships with external law firms. This level of responsibility can divert from the general counsel engaging in strategic legal planning at the operational level. (To get a better grasp of the chief legal strategist’s role and characteristics, see “Traits of an Effective Chief Legal Strategist.”)

Once a company has established those two fundamental elements, it is in a position to advance from the prevention to the value pathway. To make that transition, top management should authorize the development of a cross-functional strategic team composed of lawyers and nonlawyers who are guided by the chief legal strategist. The responsibility of this team is to hypothesize legal strategies that have a clear business impact. Specifically, any legal strategy that emerges from the team members should be couched in terms of its impact on the bottom line. Consider, for example, the legal department at a major U.S. software company that assembled a cross-functional team to strategically assess and benchmark its contracts against those of its competitors. The team found that the company’s contracts were much longer and more complex, which delayed the negotiation cycle and lengthened the sales process. That, in turn, had had a negative impact on customer relationships, retention and service, ultimately hurting the bottom line. So the cross-functional team performed an analysis of the legal complexity of various contracts and found ways to decrease their length, making them more readable and easier to negotiate.

To move from the value to the transformation pathway, the CEO and the board must recognize that legal strategy is a vital ongoing process that is linked directly to the company’s future competitiveness. The CEO should be involved in setting the overall tone and vision with respect to how the law is perceived and used as a strategic resource, and he or she must ensure that other top executives share this vision. A CEO operating in the transformation pathway will participate in key legal strategy meetings and will communicate the vision to managers responsible for implementing those strategies. Without that top-level oversight and direct involvement, a company’s transition to a transformation pathway could easily stumble. A weak reporting structure that transfers legal strategy oversight to the CFO or COO, for example, might lead to legal issues being viewed solely as a cost or risk-management issue. In contrast, CEOs who lead their organizations into the transformation pathway will ultimately support legal strategies that complement their enterprise’s business model and core competencies, and they will ensure that the entire organization supports that viewpoint.

 

Making the transition to a more strategic legal pathway is no simple task. Some organizations might need to establish a new business entity. This was the approach taken by companies like Qualcomm and Harley-Davidson, which created business units to manage intellectual property for specific strategic reasons.24 Other companies may have to implement an extensive training program to provide key management personnel with the relevant legal skills for their field of activity. IBM, for example, was able to transform its patenting capabilities by creating a “patent factory” that involved teams of patent attorneys and experienced inventors traveling to internal research and development units to educate engineers about patents and patent strategy.25 To be sure, such efforts may require considerable resources, but the potential gains can far outweigh those investments. The effect of IBM’s patent factory was a dramatic jump in licensing revenues from less than $20 million before 1991 to $1.1 billion in 1998, as well as greater cross-licensing opportunities that provided access to valuable technologies. Indeed, as companies like IBM have discovered, in-house legal departments can be more than just cost centers; they can be powerful instruments for generating value and securing a competitive advantage.