Everything Old Is New Again: Lessons from Dodge v. Ford Motor Company. M. Todd Henderson THE LAW SCHOOL THE UNIVERSITY OF CHICAGO. - PDF

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CHICAGO JOHN M. OLIN LAW & ECONOMICS WORKING PAPER NO. 373 (2D SERIES) Everything Old Is New Again: Lessons from Dodge v. Ford Motor Company M. Todd Henderson THE LAW SCHOOL THE UNIVERSITY OF CHICAGO December
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CHICAGO JOHN M. OLIN LAW & ECONOMICS WORKING PAPER NO. 373 (2D SERIES) Everything Old Is New Again: Lessons from Dodge v. Ford Motor Company M. Todd Henderson THE LAW SCHOOL THE UNIVERSITY OF CHICAGO December 2007 This paper can be downloaded without charge at: The Chicago Working Paper Series Index: and at the Social Science Research Network Electronic Paper Collection: Draft: Please do not cite Everything Old Is New Again: Lessons from Dodge v. Ford Motor Company M. Todd Henderson On November 2, 1916, the day after his son Edsel s wedding, 1 Henry Ford received a copy of the complaint that instigated one of the most famous lawsuits in the history of American corporate law. The case, Dodge v. Ford Motor Company, 2 was about minority shareholders ability to challenge the authority of the board of directors to make business decisions that were alleged to be serving interests other than maximizing the value of plaintiffs shares. The plaintiffs, John and Horace Dodge, were not strangers to Henry Ford: they were his longest and most important business partners, they were fellow board members for over a decade (1903 to 1913), and they had celebrated together at Edsel s wedding the night before. The Dodges, who had recently founded their own firm to compete with Ford, objected to a decision by the board to withhold special dividends and spend the millions of dollars to build the world s largest auto manufacturing facility. Their claim was that the decision was based on Henry Ford s idiosyncratic preferences about doing social good for workers and customers as opposed to making the most money for shareholders. The Michigan courts struggled. Ford was emphatic in both his pretrial comments and his testimony that the decision to build the factory was about doing as much good as we can, everywhere, for everybody concerned... [a]nd incidentally to make money. 3 Faced with Ford s candor about using someone else s money to achieve his personal goals, the court ordered the payment of a large dividend (about $19 million), and enjoined construction of the factory. The intervention by the court was a radical and outrageous result. Courts generally do not interfere with business decisions deciding to build a factory is a quintessential one even in the face of allegations that they are not profitmaximizing decisions. As long as the board considered the issue seriously and there is some plausible claim that the decision is in the best interests of the firm, courts defer to the business judgment of management. This test was met here: regardless of Henry Ford s rhetoric, expanding manufacturing capacity may University of Chicago Law School. I am grateful to Douglas Baird and Mark Ramseyer for their help and to the Sarah Scaife Foundation and the John M. Olin Foundation for research funding. Ali Beyer provided extremely able research support. 1 There is a division of opinion about the timing of the suit that reflects the various opinions on the merits of the case. According to one historical account, the suit s timing seemed a calculated insult.... They had conversed congenially with the entire Ford family and said nothing about filing the suit. See STEVEN WATTS, THE PEOPLE S TYCOON 255 (2005). Another book takes a more benign view: The Dodges had already filed their suit when the invitations to Edsel s wedding arrived. They knew that the timing would upset Ford and they originally planned not to attend, but Edsel s fiancée, Eleanor Clay had been John Dodge s neighbor for six years, and she convinced the brothers to attend. See Gelderman, Carol Henry Ford: The Wayward Capitalist 72 (1989) Mich. 459 (1919). 3 See ALLEN NEVINS & FRANK E. HILL, FORD: EXPANSION AND CHALLENGE, , at (1957) (quoting interview). 2/ Henderson reduce costs and help increase profits. But Ford s comments made deference difficult for the court. The Michigan Supreme Court corrected the mistake. Focusing less on Ford s silly comments and more on the policy implications of the ruling, the Court lifted the injunction. Declaring that judges are not business experts, the court announced the widely accepted rule that courts generally will not substitute their judgment for those of boards. 4 It did not, however, give a complete victory to Ford. Splitting the baby, it held that the suspension of dividends allegedly needed to fund construction was an arbitrary and unlawful action by the board. Since there were other ways in which the company could fund the construction for example, Ford himself was to receive about 60 percent of the dividend, which he could then reinvest 5 this decision could send a signal that firms are about shareholder wealth creation, without inhibiting the firm from taking actions that might, after all, be good for shareholders in the long run. It did cost Ford personally, however, since tax rates on the forced dividend were quite high (about 70 percent), and therefore impressed on him and other business leaders the importance of shareholder wealth maximization. Viewed in this way, this seemingly Solomonic decision was arguably the right result. But there is much more to this case than meets the eye. Many of the practices common today in venture capital transactions and corporate reorganizations appear vividly in the back-story of this case and show students of law that seemingly new ideas are not always so. The case s history also foreshadows the nature of ubiquitous conflicts between majority and minority investors that would animate corporate law litigation for decades to come. In addition, it demonstrates how modern techniques for allocating control rights separately from economic rights would have helped the parties here avoid costly and acrimonious litigation. Perhaps most interestingly, however, the backstory of the case shows that it is not clear at all that the parties wanted to avoid litigation. Both the Dodges and Henry Ford used the legal process as a tool in what was at base a business dispute. To paraphrase von Clauswitz, litigation is business by other means. The history of this case provides a prototypical example. This essay examines the background of the litigation in an attempt to shed new light on the wisdom of what the Dodge court did, and to offer a new way of thinking about where the case fits in our modern understanding of corporate law. I. The Beginning: Lessons Ford Learned from Failure Like most entrepreneurs, Henry Ford was originally and repeatedly a failure. His first two companies, the Detroit Automobile Company and the Henry Ford Company, made no cars and no profits. 6 They lasted less than three years 4 Dodge, 204 Mich. at As discussed below, this would have been tremendously inefficient since tax rates on dividends increased to nearly 70 percent, which means less than a third of the dividend would have been available to reinvest. Ford had other options, however, including issuing new equity or borrowing from a bank. 6 As discussed below, the Henry Ford Company was a failure for Ford but it survived him, took a new name, and became an incredible success. See infra. 2 Lessons from Dodge v. Ford Motor Co. combined and lost over $200,000 in equity capital for investors. 7 After these failures, Ford s prospects did not look good. He had no obvious comparative advantage over hundreds of rivals racing to make the first commercially successful automobile. Ford was not the inventor of the automobile nor did he hold any valuable intellectual property rights in the new technology in fact, he openly flouted purported patents held on the automobile by others. His failures also alienated wealthy individuals in Detroit who were funding new automobile companies. Ford s failures, however, taught him lessons about corporate governance and law that ultimately enabled him to build one of the most successful companies of all time. Ford learned that majority shareholders (like the protoventure capitalists who backed him) are tough taskmasters that demand results and profits. Like many entrepreneurs, Ford was stubborn, arrogant, confident in his own abilities, and fiercely independent. Although he needed other people s money to turn his ideas into reality, Ford, like most inventors, didn t want their opinions or their oversight just the money. This is not the way things work. Entrepreneurs who use other people s money must account to those other people, often in disagreeable ways. Investors demand control rights in return for their investments, lest the entrepreneur take the money and divert it into self-serving ends, such as shirking, stealing, or merely following a self-utility maximizing, but not profitmaximizing, path. The backers of Ford and his first attempts to build a horseless carriage acted just as investors in start-ups do today: they took board seats; they installed managers of their choosing to supervise work; they contracted for the ability to bring in outsiders to monitor at certain times or under certain conditions; and they preserved their rights to control how the firm would grow or die. Control rights do not always work, however, and the history of Ford s businesses shows this clearly. Notwithstanding explicit and implicit control rights, Ford did not do what his backers wanted, and without his final designs delivered, the investors cut their losses and put the companies out of business. Examining the history of the failure of Ford s first two companies sheds light on his actions that led to litigation by the Dodges: in each case, Ford the inventor bristled and was ultimately forced out of what he viewed as his firms under the pressure of majority investors to deliver production cars and profits quickly. In short, Ford learned from his failures the perils of being a minority shareholder. Later, after Dodge, he would learn not to be a majority shareholder either. But we are getting ahead of ourselves. Let s start at the beginning. A. The Detroit Automobile Company Ford s first company, the Detroit Automobile Company, was a total failure. Ford blamed this on the investors who financed the company they demanded cars be made and sold, while Ford was busy perfecting his design. Ford bristled under shareholder supervision, and he actively subverted efforts of the managers 7 WATTS, supra note 1, at 4/ Henderson to generate immediate profits. This caused delays, frustration on both sides, and eventually shutdown. Many entrepreneurs raise their first capital from friends and family. Borrowing from family has its own perils, but for entrepreneurs, the ability to remain in control despite using other people s money is more likely when the other people are family. Ford had a troubled relationship with his father, however, so instead, he turned to the Detroit business community and individuals he worked with at the Edison Illuminating Company, where he was a mechanic. 8 George Peck, president of Edison, let Ford use a workshop to develop his first prototype, in return for a small equity stake. The Mayor of Detroit, William Maybury, provided loans, facilitated other loans with friendly banks, and greased the legal works, such as providing a license for Ford s first test vehicle when some citizens complained about the noise. Three other wealthy individuals Ford knew from prior work and social experiences invested $500 to help Ford build his second prototype in It was a success. With a workable car built and a fawning treatment by the local press, 10 Ford began to attract the attention of the local business community beyond his personal contracts. Ford s key fundraiser was William Murphy, a wealthy Detroit businessman who acted as a proto-venture capitalist. The first step for Murphy, as for any start-up investor then or now, was to determine the technology to bet on. It was far from obvious at this time that Ford and his horseless carriage was the one. Ford was an unknown mechanic working at a power company, and although he had built a successful prototype, he did not have any valuable intellectual property, his design was not unique or especially novel, and he was not alone in pursuing the technology there were over 500 nascent car companies in Detroit at the time. 11 Murphy s due diligence on Ford and his vehicle was an 80-mile test drive. It went well, and after he said to Ford: We will now organize a company. 12 Murphy planned to take a large stake in the new firm in return for his money, his business expertise, and access to his rich friends. Several famous Detroiters, including business owners, a United States Senator, life insurance executives, and wealthy heirs, invested a total of $15,000 and received 1500 shares in the Detroit Automobile Company, which was incorporated on August 5, Ford, as is typical in start-up firms today, invested no money but took a minority share of the equity in the firm in return for his designs and ideas. Things started promisingly, as they always do. The firm made investments in a workspace and a small workforce of 13. There was energy and hope on the floor of the firm s manufacturing space on Cass Avenue in Detroit. But hope was 8 DAVID L. LEWIS, THE PUBLIC IMAGE OF HENRY FORD: AN AMERICAN FOLK HERO AND HIS COMPANY 17 (1976). 9 WATTS, supra note 1, at Ford s Automobile Has New Features and Is a Novel Machine, DETROIT JOURNAL, Jul. 29, Charles E. Duryea, Motor s Historical Table, MOTOR, March J. BELL MORAN, THE MORAN FAMILY: 200 YEARS IN DETROIT 126 (1949). 13 WATTS, supra note 1, at 51. 4 Lessons from Dodge v. Ford Motor Co. not enough for the investors who had put money on Ford and his prototype. To protect their investment, holders of a large percentage of the shares dominated the board and installed their agents in senior management positions. These managers were supposed to closely supervise Ford to protect the shareholders investments. The governance protections, which resemble those in modern venture capital transactions, did not work. There were numerous problems. Ford went through several designs (including a truck), and he was constantly tinkering with the design. This made it difficult to begin production. At this point, Ford was simply much better at designing cars than producing them, and his interests were in creating one design that would last rather than producing cars from an inferior design. The battle lines here were short term versus long-term interests, and entrepreneur (a belief in the thing partially for its own sake) versus investor (a belief in the thing only for the cash it produces). Ford s initial car design was also not a good one, and no amount of management skill or corporate governance can save a company from a bad product. It is for this reason that successful venture capitalists today bet on the horse (the product) and not the jockey (the management) when funding startups. 14 Murphy and the other investors bet on a bad horse according to one of Ford s engineers, Ford s first car that investors wanted to force into production rarely worked and when it did it had few virtues. 15 Another problem was that Ford was not then interested in the manufacturing process, nor was he highly skilled in the machining of all necessary parts. Ford had shown he could make one car, but his short time running the shop at the Detroit Automobile Company showed that he did not know how to massproduce them to tight specifications. Ford would eventually solve this problem through outsourcing yet another seemingly modern phenomenon and then through a revolutionary manufacturing process, but that was years away. There is a deep irony here: the thing Ford was the worst at assembly would become his most enduring legacy. Ford also bristled under the supervision of investors and their manager agents. Aggressive governance had a high cost. Ford was still tinkering with his design, and he resisted pressure by the shareholders to finalize the design so that production could begin. Here we see the first signs of the schism between entrepreneur and investor that was to plague Ford until after the Dodge case. Ford was still a designer and not yet a businessman, and he did not understand the pressure for profits and that majority shareholders demand control. Ford s resistance to shareholder control took several forms, not the least of which was trickery. For example, when Ford heard that the investors were sending the company president, an investor-appointed stooge in his view, to visit the workshop to gauge progress and pressure Ford to move toward production, he ordered work done that would have the appearance of progress but that was 14 See Steven N. Kaplan et al., Should Investors Bet on the Jockey or the Horse? Evidence from the Evolution of Firms from Early Business Plans to Public Companies (August 2007). CRSP Working Paper No. 603 Available at SSRN: 15 WATTS, supra note 1, at 55. 5 6/ Henderson just obfuscation. The ruse worked, and the axels Ford ordered built during the visit were discarded as junk. 16 Sometime later when the investors started to panic, several arrived at the factory for inspections. As recounted by one of Ford s engineers, Ford ordered workers to pretend as if work was being done toward making a final version of the car: We had parts for about a half-dozen automobiles. We had a long bench, and all the parts we had finished were on it. [The investors] would come along and see all these parts on the bench... and it looked wonderful. 17 The success of these tricks would not last long. After several months without progress, investors with small stakes, little information, and no control began to look for ways of exiting. The lead investors were the only willing buyers, and as a result consolidated their ownership interests. Consolidation in times of financial distress is another modern phenomenon that the history of this case shows existed long ago. It was sensible here since the lead investors were wealthy and could afford the rising risk profile of the firm. Consolidation also reduced the collective action problem among investors in terms of monitoring. Fewer holders means lower decision costs on questions like whether to make additional investments, whether and how to monitor, and what should be done to dispose of assets in the event of a failure. This is a common feature of modern corporate reorganizations, 18 but it is also evident in the failure of the Detroit Automobile Company. When the fate of the firm was clear, investors Murphy and Mayor Maybury moved quickly and with force impossible with dispersed ownership. They called Ford to a meeting in November 1900 to discuss the lack of progress, demanding immediate action towards completion of a production version of the car. Ford refused to attend and kowtow before what he viewed as speculators and people only interested in money. Shortly thereafter in January 1901, the board dissolved the firm. B. The Henry Ford Company Some of the investors who steered the Detroit Automobile Company toward dissolution bought its assets in order to try again. They turned again to Ford, who they still believed had the best extant design. The investors, led by Murphy, funded Ford s work for about a year, at which point he had a new design. Murphy was willing to take a longer-term view, while the other remaining shareholders of the defunct Detroit Automobile Company would not. Murphy s 16 Id. at Id. 18 See Douglas G. Baird & Robert K. Rasmussen, Private Debt and the Missing Lever of Corporate Governance, 154 U. PA. L. REV (2006) (showing how creditors today routinely cash out minority investors or creditors on the eve of bankruptcy in order to reduce barriers to efficient decisionmaking during this period). 6 Lessons from Dodge v. Ford Motor Co. patience appeared to pay off. Ford developed a new prototype, and Murphy and Ford incorporated the Henry Ford Company in November 1901 to prosecute the design. Ford took a 17 percent equity interest in the firm in return for his contribution of his human capital and the new design. 19 Although the idea
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