06/17/1996
Forbes
188
COPYRIGHT 1996 Forbes Inc.
LAST JULY David Lax and his wife found the perfect house. On a leafy street in historic Concord, Mass., it was large and within walking distance of a terrific school. Their challenge: getting this dream house, ideally for less than the $379,000 asking price.
The 87-year-old owner had just moved into a nursing home, but wanted to be able to change her mind and move back if she was unhappy. With the help of her five daughters, she put the house on the market. But she did not want to complete the sale until September.
Lax, a former Harvard Business School professor who now runs a consulting firm called Conifer Group, put his negotiating skills to work. His house strategy: Worsen the seller's other alternatives.
One of Lax's strong points was that he wasn't in a hurry to move in. He had another home and his children were not old enough to enroll in school. But he knew that competing offers were likely to come from families who did want to be in place by Labor Day in order to enroll in the school system.
Lax knew that the seller's refusal to close before September could work to his advantage, since it would turn off a lot of buyers. But he had to be careful that this proviso in the negotiations not be turned against him. The seller might get a firm offer from Lax and then use it to bargain some other bidder up to a better price.
Lax checked out the seller. He found that among her sons-in-law were Frederick Joseph, once the chairman of Drexel Burnham, and Dean Witter III. He knew she was going to be well represented.
So Lax crafted a careful proposal. He made a low but not offensive bid, $325,000. Then he asked that if the owner accepted his bid she (1) sign a contract with him to reimburse him for expenses if she decided to return to the house, and (2) agree not to accept any bids until she had finished negotiating with him. In his proposal letter he described this agreement as a concession to him for allowing the family to back out later. His bid was accepted, and he got back the signed contract within a week.
Lax's goal was to lower the chance that the seller's family would get other bids. The contract with Lax ensured that if the family held an auction--which it ultimately did--other bidders would be scared off: They would know their bids wouldn't be considered before September and that Lax's bid would be considered first.
It worked. There were no other bids on the house. The sale closed in November, after Lax raised his offer to $348,900.
Lax and others have been trying to codify the lessons of game theory, decision theory and negotiation analysis into practical tools that can be taught. Two years ago Harvard Business School added a required course on negotiation to its M.B.A. program. Stanford University and Northwestern University sell out conferences designed to teach negotiation skills to executives.
Negotiation theory, a branch of economics, has traditionally been too abstract and mathematical for laymen to understand. It had another problem: It was often wrong. As in other areas of economics, academics devised solutions based on actors who were totally rational and valued all payoffs in economic terms. The difficulty was taking into account personal preferences, emotional reactions such as sense of fairness or slight, and differences in the way people deal with uncertainties. In short, traditional negotiation theory would have been useless in helping David Lax buy his Concord house.
But over the last two decades experimental data and psychological research by people like Amos Tversky at Stanford have lent some practical insight into how people behave when they are negotiating. From these insights, theorists like Harvard's Howard Raiffa and practitioners like Lax have developed tools that can help make the art and intuition of a gifted negotiator accessible to the rest of us.
Here's one trick: anchoring. Anchoring is the process of subconsciously influencing someone's thinking by dropping a number as a reference point. When your college class agent calls and asks for a $25,000 contribution, he's anchoring. This can be remarkably effective, even if there is no validity to the number.
In one of Tversky's experiments, two groups of students were asked what percentage of countries in the United Nations were in Africa. In each group, a roulette wheel was spun. In the first group, the wheel landed on 10 and the participants were asked if they believed the percentage was higher or lower than 10%. Most thought it was higher. The second group's wheel landed on 65 and the same question was asked. Most thought lower.
A discussion ensued and both groups were asked to make estimates. The mean estimate of the first group was 24%; the mean of the second was 45%. Their estimates were strongly anchored by the roulette wheel's results, even though the students had all witnessed how completely arbitrary these starting points were.
David Lax used the anchoring phenomenon when working with a client who was selling his technology firm. The acquirer had discussed a price range of $18 million to $20 million. Lax didn't want any negotiating anchored around those numbers. So he did some research on prices of similar public companies, in relation to earnings and growth.
When he met with the buyer, he outlined his research, which had led him to a target price of $28 million. Then he invited discussion on his methodology, not on the figure.
The buyer didn't debate the $28 million figure because it wasn't the point of discussion. But the new $28 million figure subtly became anchored as the basis of further discussion. Ultimate selling price: $22 million initially, with a contingency payment of up to $10 million more if the company met its growth targets.
James Sebenius, who teaches negotiating skills at Harvard, got his practical experience as a Law of the Seas negotiator for the U.S. government and as a vice president at Blackstone Group, the New York investment firm.
Subliminal clues can have a powerful effect on outcomes, Sebenius says. He once had half his class work on strategies for an auction titled "Winning on Wall Street." The other half of the class worked on an identical auction titled "Community Value Game." The winning price among the first group was subtantially higher than that in the second group.
If you are interested in reading more about the latest developments in game and negotiation theory, and how these concepts can be used by laymen in their business and personal lives, check out these books:
The Art and Science of Negotiation, by Howard Raiffa, Harvard University Press, 1982.
The Manager as Negotiator: Bargaining for Cooperation and Competitive Gain, by David Lax and James K. Sebenius, Free Press, 1986.
Negotiating Rationally, by Margaret Neale and Max Bazerman, Free Press, 1992.
Micromotives and Macrobehavior, by Thomas C. Schelling, W. W. Norton, 1978.
PATRICIA CAVIN, a former Washington, D.C. radio show host and public relations executive, was dying of leukemia in 1981. She decided to leave part of her estate to her younger son, Brooks, in trust for his lifetime. Brooks suffers from a chronic mental disorder, and Cavin feared he would never be able to handle his own financial affairs.
By the time his mother died in 1984, Brooks, then 24, had been employed only twice in his life: as a gas station attendant when he was 13 and as a tie salesman during Christmas 1982. Brooks' $250,000 in trust was a vital safety net.
In her will Patricia Cavin appointed what is now Crestar Bank in Richmond, Va. and Nancy Hirst, a college friend, as Brooks' cotrustees. They were to pay out all of Brooks' trust income every year, and principal at their discretion.
The safety net broke. The trust ran out of cash in 1992 and suspended payments to Brooks. From 1986, when the estate was settled, until 1992, trust income totaled $68,000, while fiduciary fees totaled $67,000, according to the trust's tax returns.
In 1991 Brooks landed a $5-an-hour job changing bedpans. Now he's about to be laid off from his job as a nurse's aide, while still supporting a wife and two small children. "The last ten years have been tough," he says.
Trusts are supposed to be a blessing, but for many heirs, like Brooks Cavin, they turn out to be a curse. When Heirs Inc., a fledgling organization for trust beneficiaries, held its first conference last December in Sarasota, Fla., 80 people showed up to swap stories about high fees, dismal service and poor investment performance. Many well-intentioned people who create trusts would spin in their graves to know the mess they've left their heirs in--needlessly, since a carefully crafted trust anticipates problems and provides, in advance, for solutions.
One problem with Brooks Cavin's trust was liquidity. It started with $153,000 in cash and a 25% interest in 300 acres of raw land in northern Virginia. The land has appreciated smartly, which is good for Brooks' long-term interests, but has pushed up the trust's asset value, on which the trustees claim their fees. Brooks' brother Chandler, co-owner of the land, and Crestar, argued over whether and when to sell the property, but could never agree.
Brooks, now 36, is suing his trustees, Crestar and Hirst, on the theory that they should have sold the land--forcing a partition with his brother if necessary. Brooks also claims the fees the trustees took were improper. The trustees say they did their best in a tough situation; that their fees were more like $42,000; and that the shortage of cash is at least partly Brooks' fault, since he dipped into principal after he got married in 1988.
Brooks' efforts to improve his cash flow have created another potential drag on the trust. Crestar has run up $135,000 in legal fees, and the money may come out of Brooks Cavin's hide. Generally, trustees can pay their legal fees out of trust assets if they win a case and can prove they were protecting the trust, not themselves.
There you have the classic dilemma of trust beneficiaries. They can sue their trustees to get better treatment, but may only succeed in making themselves poorer in the process.
Consider poor John Upp. He was the named plaintiff in a class action suit against Mellon Bank. The suit accused Mellon of charging exorbitant fees for sweeping the cash in trust accounts into interest-bearing investments. Mellon lost in a lower court, where a judge ruled the bank was "feathering its own nest." Then it appealed and won on technical grounds. Now the bank wants $1.15 million from Upp's trust or from his lawyers to pay its legal fees, potentially wiping out most of the trust. Says Upp: "I have many a sleepless night."
Why do trust beneficiaries so often get into fights with banks? Because they are captive customers. Whoever left the money behind wanted it that way.If parents trusted their offspring to handle bequests wisely, they could leave the money to the kids outright.
There is a middle ground. It is possible to set up a trust in such a way that the beneficiary does not have unfettered access to the money, but does have a way to fire the bank if she thinks she's being treated poorly--without burying herself in legal fees.
Here's how to give your heirs the flexibility they need:
Name a bank as trustee, but spell out in the trust document the right of the heirs (or their guardian) to substitute another bank. To avert some possible tax problems, the new trustee should not be related or subservient to the person with the removal powers (FORBES, Dec. 18, 1995). And by giving your beneficiaries the right to remove the trustee, while vesting the right to appoint a successor trustee to a family member or adviser, you can prevent mischief, says Michel Kaplan, a tax and estates lawyer in Nashville.
Next, have a talk with the head of the bank's trust department. The bank should show you its current fee schedule, agree in writing never to assess a termination fee if it gets dumped, and agree to send the beneficiaries a crisp annual summary of its fees. A favorite ploy of bank trust departments is to bury fees in thick, indecipherable accounting statements. Indeed, some years ago Security Pacific (since acquired by Bank America Corp.) raised fees for 20 years on trusts with stated fee agreements; many beneficiaries never blinked until an employee blew the whistle. Write into your will an instruction to your executor to find another bank if your chosen one has raised its fees and/or is waffling on termination fees.
Finally, don't make your bank's job impossible. Plan for adequate liquidity in, and income from, the trust. Be careful about setting up fractional interests in real estate or other illiquid assets. These sometimes make tax sense, but they can also create bad heir days if your beneficiaries don't get along with one another.
Copyright © 2000 Dow Jones & Company, Inc. All Rights Reserved.