Facebook 101

A Documentary Companion to The Social Network

(Version 1.1)

F. E. Guerra-Pujol

PPP
Prior Probability Press
www.priorprobability.com
For Sydjia
Contents
Disclaimers

Acknowledgements

Chapter 0.0, Logging In

Chapter 1.0, Hacking Harvard

Chapter 2.0, “Mr Zuckerberg, this is an Administrative Board hearing.”

Chapter 3.0, A Mark Zuckerberg Production

Chapter 4.0, $500,000

Chapter 5.0, Settle or Go to Trial?

Chapter 6.0, Facebook’s Secret Psych Experiment

Logging off (epilogue)

Mathematical Appendix

Image Credits

Bibliography

Author Bio

Index {forthcoming}
THIS PAGE IS INTENTIONALLY LEFT BLANK
 DISCLAIMERS

Image: Warning Icons

This textbook does not constitute the solicitation or provision of legal advice, nor should it be
used as a substitute for obtaining legal advice from an attorney authorized to practice law in your
State or jurisdiction. You should consult a qualified attorney regarding any specific legal
problem or matter.

Although this textbook explores the founding of Facebook as depicted in the 2010 movie The
Social Network, it has not been prepared, authorized, or endorsed by the creators and producers
of the film.
 ACKNOWLEDGEMENTS

Image: Facebook Emojis

As usual, I don’t know where to start, so let me begin by thanking the folks at Kendall Hunt who
made this book possible: my editors Greg Derosa and Theresa Sands. Readers will always judge
a book by its cover, so I am especially grateful to Rachel Guhin and Jeni Fensterman for creating
such a beautiful cover for my book.

Next up are my friends and colleagues Orlando Martinez, Sean Melvin, and Larry Trautman, as
well as my students Ginger Snapp and Summer Tayon, for taking the time to read my manuscript
and give me feedback. (I will still run afoul of “the paradox of the preface.” If there are any
errors in the book, those are all my fault.)

I also want to thank my many friends and colleagues at the University of Central Florida, all of
whom have taken the time to enter the world of ideas with me and all of whom have inspired me,
albeit in different ways, to make my business law courses more dynamic and engaging, including
Eric Main, Jeff Reinking, Sean Robb, Rob Tennant, Greg Tompeter, and Anna Turner.

Lastly, I am eternally grateful to my wife Sydjia, to whom this work is dedicated, for her love
and loyalty. I also wish to acknowledge my four children--my son Kleber and my girls Adys,
Aritzia, and Adela. This book is for you too. Finally, thank you mom and dad, Oilda and
Francisco, for all you have given me.

F. E. Guerra-Pujol
Orlando, Fla.
June 26, 2017
0.0 INTRODUCTION

Logging In

Image 0.0: Login Icon

 0.0 INTRODUCTION

Are you the next Mark Zuckerberg?

If so, this book is written for you, wherever you are!

About

When I began teaching business law in 2014, I resolved to use the founding of Facebook, as
depicted in the movie The Social Network, to introduce my undergraduate students to the main
legal and ethical issues in business. Starting with the facemash fiasco, when the fictional Mark
Zuckerberg (played by Jesse Eisenberg) hacks his way into Harvard’s computer network; his
subsequent administrative hearing at Harvard; the creation and launching of the original
Facebook website from his dorm room; the decision to become a Delaware corporation in the
summer of ’04; and the epic litigation battles thereafter (not only with his business rivals, but
also with his own business partner), the founding of Facebook has it all. Or, in the calmer words
of our Canadian colleague and friend Shelley McGill: “the movie’s story makes an ideal
foundation for business law or legal environment courses.” (McGill, 2013, p. 46. See also
Guerra-Pujol, 2016.)

Furthermore, who can deny the importance of Facebook in the world today? When the movie
The Social Network was released in the fall of 2010, Facebook had already amassed 500 million
users. Today, nearly two billion people visit Facebook monthly, about 1.2 billion of them daily.
(See Manjoo, 2017, p. 40. See also Statista: https://www.statista.com/statistics/264810/number-
of-monthly-active-facebook-users-worldwide/.) For better or for worse, Mark Zuckerberg’s
creation has made us more connected.

Most importantly, Facebook was built by college students, the target audience of this book.
Moreover, most students today are already familiar with Facebook and with social media
generally. They already use Facebook and other social networking platforms like Instagram (now
owned by Facebook), Snapchat, Twitter, Yik Yak, etc., and many students are naturally curious
about the legal and ethical aspects of these Internet platforms.

Site map

Thematically, this book outlines the main stages of Facebook’s founding as depicted in The
Social Network. Specifically, the book is divided into six separate chapters or segments, and each
segment contains one or more artefacts relating to the founding of Facebook, a chapter essay
exploring a particular area of law and ethics, and a problem set consisting of questions for further
discussion.

This book is thus organized as follows:

Chapter 1.0 (“Hacking Harvard”) begins with sources of law by exploring the law and ethics of
Facemash, a clandestine website created by Harvard sophomore Mark Zuckerberg in the fall of
2003. By all accounts, Zuckerberg had hacked into Harvard’s computers and downloaded photos
of co-eds without authorization, but what laws make “hacking” illegal? Chapter 1.0 uses the
Facemash fiasco to introduce students to the major sources of Anglo-American law, such as
natural law, statutes and regulations, and judge-made common law.

Chapter 2.0 (“Mr Zuckerberg, this is an administrative board hearing”), by contrast, examines
the procedural side of law by introducing students to the fundamental procedural concepts of due
process and burdens of proof. Specifically, when you are accused of breaking the rules, as
Mark Zuckerberg was for this role in the Facemash affair, you are entitled to certain basic
procedural rights and protections, but the scope and degree of these rights vary depending on the
precise nature of the accusations against you.

Next, Chapter 3.0 (“A Mark Zuckerberg Production”) explores intellectual property or “the law
of ideas.” Although technically speaking the law does not create property rights in ideas per se,
intellectual property law does allow you to protect the expression of your ideas, if certain legal
requirements are met. By way of example, Zuckerberg created many valuable forms of
intellectual property when he built the beta version of Facebook in early 2004.

Chapter 4.0 (“$500,000”) traces the evolution of Facebook’s legal structure. In brief, when an
entrepreneur starts a new venture, like Mark Zuckerberg did when he launched “thefacebook” at
Harvard, he or she must also decide what legal structure their business will take, such as a sole
proprietorship, a partnership, a limited liability company, or a corporation. Accordingly, in
this chapter we will revisit three critical moments in the founding of Facebook: (i) Eduardo
Saverin and Mark Zuckerberg’s initial partnership agreement in late 2003/early 2004, (ii)
Facebook’s articles of organization when it became a Florida LLC (limited liability company) in
April 2004, and (iii) Facebook’s subsequent decision in July/August 2004 to become a Delaware
corporation after venture capitalist Peter Thiel agreed to make a $500,000 angel investment in
the social network startup in exchange for 10% of the company.

Thereafter, Chapter 5.0 (“Settle or Go to Trial?”) examines the epic legal battle between
Facebook and rival ConnectU and introduces students to many strategic aspects of civil
litigation, especially the decision whether to settle or go to trial. Among other things, Chapter 5.0
explains why going to trial can be both risky and costly, explores the idea of a settlement range,
and builds a simple model of litigation and settlement.

Lastly, Chapter 6.0 (“Facebook’s Secret Psych Experiment”) concludes by asking whether
Facebook is an ethical company. Beyond the law, what moral duties, if any, does Facebook owe
to its users. Specifically, Chapter 6.0 explores the ongoing controversy over the ethics of A/B
testing.

A word of warning

No one can deny that The Social Network, like most Hollywood productions, is a misogynistic
movie. For starters, the film lacks any three-dimensional female characters, or in the sharp words
of one film critic (Davis O’Brien, 2010), the female roles are limited to mere “props” and
“doting groupies, vengeful sluts, or dumpy, feminist killjoys.”
Hyperbole? Consider the Bechdel Test (pictured below), a simple rule for evaluating the
portrayal of women in film:

Image 0.1: Bechdel Test

To pass this test, a movie must have at least two women in it, and they must talk to each other at
least once … about something or other besides a man. (See Wikipedia entry for Bechdel test.
This test is named in honor of its inventor, graphic artist Alison Bechdel, whose work appears
above.)

By this measure, The Social Network fails miserably, as none of the women in the movie ever
even talk to each other. (See, e.g., Cantrell, 2013.)

In its defense, however, one could argue that The Social Network is simply a reflection of Silicon
Valley’s “Cult of Male Ego” (Smith, 2014), i.e. an unfortunate effect, not the cause, of gender
inequality in academia, business, sports, and society as a whole. In the words of Minnie Ingersoll
(2016), co-founder of Shift, “Silicon Valley’s culture rewards the kind of aggressive, think-on-
your-feet, answer-with-confidence interactions that are prevalent among men.” At times, The
Social Network seems to celebrate this male ethos, not question it.

So, should we just forget The Social Network and play it safe, sticking with a less controversial
production or a standard business law textbook instead? No, that is the last thing we should do.
The movie has some acute blind spots and many serious flaws. Among these are the shameful
and shabby way in which women are portrayed and the film’s gratuitous glorification of “bro-
culture.” But censorship is no cure for these evils.
Instead, let’s acknowledge these shortcomings openly and discuss them up front. A good place to
start is Sheryl Sandberg’s TED Talk “Why we have too few women leaders” and Liza Mundy’s
essay in The Atlantic “Why Is Silicon Valley So Awful to Women?” In other words, we won’t
pretend The Social Network doesn’t perpetuate the myth that startups, science, and technology
are the exclusive domains of men. But let’s not ignore the movie either. Let’s engage with it and
address these problems head on.

Personal note

Let me conclude this prologue with a personal note. I opened my first Facebook account
(https://www.facebook.com/fe.guerrapujol) in the summer of 2007, after my close friend and
colleague Dennis W.K. Khong told me that Facebook was not just for college students anymore.
At the time, we were attending a seminar on game theory (taught by NYU professor Rebecca
Morton) at the University of Ljubljana in Slovenia. Professor Khong described to me how
Facebook was a great tool for connecting with other academics across the globe, so I signed up
for Facebook that same day. Prof. Khong even helped me take my very first Facebook profile
picture (see below) on his digital camera at Ljubljana Castle:

Image 0.2:
Profile Pic of the Author

In addition to being an early Facebook user, I feel a deep personal connection to the movie The
Social Network. The movie is based on the bestseller “The Accidental Billionaires” by Ben
Mezrich (2010). I bring this up not only because I happen to have a first edition of the book. I
mention this because I can still recall the circumstances surrounding my acquisition and first
reading of “The Accidental Billionaires.” I was in our nation’s capital, Washington, D.C., and
my hotel was close to Dupont Circle, so I paid an old friend a visit, Kramer Books, one of my
favorite bookstores in D.C. Somehow, I stumbled upon a copy of “The Accidental Billionaires”
and just began reading. I literally could not put this book down. Its story of genius and betrayal
was so compelling that I read the entire book in one sitting. Then, I bought the book and read it
again!

The movie version was released soon after my first reading of Accidental Billionaires. Although
no movie is ever as good as the book on which it is based, The Social Network is one of the few
exceptions to this general rule of cinema. As it happens, my wife and I saw the movie on its
opening night--Friday, October 1st, 2010--and I still remember the day and time we first saw the
film for two reasons. One reason is personal. My wife Sydjia and I were dating at the time, and
this movie was our first date! The other reason is the movie itself. Beginning with the opening
scene, we were glued to every word of dialogue. Somehow, Aaron Sorkin’s screenplay not only
does justice to Ben Mezrich’s novel; it also transforms it into a beautiful work of art.

Personally, a whole lot has changed since those early Facebook days in Slovenia and my first
date with Sydjia. My Blackberry is long gone, and Sydjia and I are now married, with
children(!), and I rarely go on Facebook these days. Nevertheless, some things remain the same.
Mark Zuckerberg is still Facebook’s CEO, and his firm continues to grow and keeps generating
fresh controversies …

So, whether you admire Facebook or despise it, I hope you find the legal and ethical topics in
this book engaging and entertaining.
 1.0 SOURCES OF LAW

Hacking Harvard

Image 1-1: The Elo chess ranking algorithm

 1.0 ARTEFACT
Hot or Not? Website
Briefly Judges Looks
By Bari M. Schwartz,
November 4, 2003
Harvard students often compete in the
classroom, but for at least a few hours this
weekend, only one thing helped them make
the grade—their looks.
Just over a month after two Harvard alums
competed in the Miss America Pageant, a
website created by Mark E. Zuckerberg ’06
gave students a chance to rate their peers
using ID photos taken from online House
facebooks.
“Were we let in for our looks? No. Will we be
judged on them? Yes,” proclaimed the site,
which Zuckerberg has now taken offline.
Zuckerberg … said he created the site—
www.facemash.com—by hacking into House
online facebooks and compiling ID photos
onto his website, allowing viewers to vote for
the “hotter” of two randomly chosen photos
or rate the looks of students in a particular
House against fellow-residents.
A link to the site was forwarded on many
House and student group e-mail lists over the
weekend--including the Institute of Politics
(IOP), Fuerza Latina, and the Association of
Black Harvard Women (ABHW)--prompting
both praise and criticism across campus.
But by Sunday night, outrage from
individuals and student groups led
Zuckerberg, who said he never expected
such widespread publicity, to shut down the
site for good. By that time, Zuckerberg said,
there had been 450 visitors to the site who
had voted on their peers’ photos at least
22,000 times.
“I don’t see how it can go back online. Issues
about violating people’s privacy don’t seem
to be surmountable. The primary concern is
hurting people’s feelings,” Zuckerberg said.
“I’m not willing to risk insulting anyone.” ***
According to Zuckerberg, it was his intention
to only show a few friends to get their opinion
on the site, but someone forwarded the link
to a friend and the chain of e-mails continued
from there. “When I returned from a meeting
at around 10 p.m.,” he wrote in the letter,
“traffic was out of hand, and after thinking
about the best course of action, I shut down
the site around 10:30.” ***
Zuckerberg said his interest in computer
science and boredom on a Tuesday night
were the ingredients behind his rating recipe.
It took less than a week for him to create the
site—and he chronicled the process in a
journal published on the site itself.
He began at 8:13 p.m. last Tuesday: “I need
to think of something to occupy my mind.
Easy enough—now I just need an idea...”
Just 95 minutes later, at 9:48 p.m., he added
another entry.
“The Kirkland facebook is open on my
computer desktop and some of these people
have pretty horrendous facebook pics,” he
wrote. “I almost want to put some of these
faces next to pictures of farm animals and
have people vote on which is more
attractive.”
Then, just before 1 a.m., a new post:
“12:58am. Let the hacking begin.” ***
 1.0 CHAPTER ESSAY

Have you ever broken any rules?

College sophomore Mark Zuckerberg apparently did when he hacked into Harvard’s computer
network and created a clandestine website called Face Mash (“facemash”).

But what exactly is “hacking”? What laws make it illegal? And what are the possible
consequences of breaking these laws against hacking? To answer these fundamental questions,
we must do two things. First, we must go over the facts of facemash. Then, we must consider the
main sources of law.

THE FACEMASH FIASCO

Without further ado, here is how facemash went down:

After their freshmen year, undergrads at Harvard are assigned to one of twelve residential houses
As in the movie, Mark was upset about a girl. (Kirkpatrick, 2010, p. 23.) To take his mind off
her, Mark decided to create a new website: www.facemash.com.

At the time, Mark wrote on his blog:

“9:48pm. I’m a little intoxicated, not gonna lie. So what if it’s not even 10pm and it’s a Tuesday
night? What? The Kirkland facebook is open on my computer desktop and some of these people
have pretty horrendous facebook pics. I almost want to put some of these faces next to pictures
of farm animals and have people vote on which is more attractive ….”

Notice the reference to the “Kirkland facebook” in Mark’s 9:48 pm blog post. Kirkland House
was Zuckerberg’s assigned dorm. (He lived in Suite H33 back then.) But Kirkland is just one of
twelve residential houses at Harvard, and at that time, before there was Facebook, each House
maintained its own separate “facebook,” an electronic directory of photos of students living in
each House, but the House websites were not interactive, and since each House had its own
website, there were twelve separate “facebooks” at Harvard at the time.

(By the way, in case you’re wondering, those original “facebook pics” on the house websites
probably were “horrendous,” as Mark says. The pictures were generally of very poor quality
because they were the official student I.D. photos that were taken the day students arrived for
orientation. See Kirkpatrick, 2010, p. 23.)

At some point, at 11:09 pm to be more precise, Zuckerberg decides to drop the farm animals:
“11:09pm. Yea, it’s on. … I like the idea of comparing two people together. It gives the whole
thing a very Turing feel, since people’s ratings of the pictures will be more implicit than, say,
choosing a number to represent each person’s hotness like they do on hotornot.com.”
Before proceeding, notice the level of sophistication of Mark’s 11:09 pm blog post, especially
the reference to the great computer scientist Alan Turing. Notice too Mark’s preference for a
cardinal ranking system over an ordinal one.

The website “hot or not,” for example, uses ordinal ranking. Users assign a score to each picture,
using an ordinal scale from 1 to 10, and the overall score for each photograph is the cumulative
average of all its scores.

Facemash, by contrast, would implement a cardinal ranking system. Instead of assigning a score
to each picture individually, the user would be presented two pictures of the same gender at the
same time, and the user would then decide which picture was “hotter.”

In short, Mark is building a website that will figure out who the “hottest” student at Harvard is.
To accomplish this task, Mark needs two ingredients: he needs a cardinal ranking algorithm, and
he needs some pictures ***

The algorithm

Zuckerberg decided to use a probabilistic algorithm originally designed to rank chess players, the
Elo rating system. Named after its inventor, physics professor Arpad Elo, this ranking system is
used to measure the relative skill levels of contestants in two-player games like chess. (Jones,
2010.)

Here is a simplified explanation of how the facemash algorithm worked:

 First, every girl or guy starts off with a rating of x, where x is the total number of students
of the same sex being ranked. (For example, if there are 50 pictures of guys in the
facemash database, each guy starts off with a score of 50.)
 At first, since everyone has the same score, pictures are paired together randomly by the
algorithm.
 Suppose guys A and Z are paired together in round one. Let’s assume a user rates guy A
hotter than guy Z. The ranking of A will go up by some factor, from 50 to 52, while the
ranking of Z will decrease by some factor, say from 50 to 48.
 Next, suppose guys B and Y are paired together in round two. If B wins this round, the
same logic as before applies: B = 52; Y = 48;
 Now, here is the ingenious thing about the facemash algorithm: if A and B--the winners
from rounds one and two--are paired in round three, the ranking of the winner of this
contest will go up by an even greater factor than before, since the winner is competing
against another highly-ranked contestant. For example, if A wins round three. his ranking
will go up by an even greater factor, say from 52 to 55, instead of from 52 to 54.
 By the same token, if A had been matched against Y in round three, and if A had defeated
Y in that round, then A’s score would go up, but by a smaller factor, say from 52 to 53,
since Y is lower-ranked contestant.
 The general idea is this: After every game, the winning player takes points from the
losing one, and the difference between the ratings of the winner and loser determines the
total number of points gained or lost after each round.
  Thus, in a series of rounds between a high-rated player and a low-rated player, the high-
rated player is expected to score more wins. If the high-rated player wins, then only a few
rating points will be taken from the low-rated player.
 This means that this rating system is self-correcting, or in the words of one commentator
(Haseeb, 2010), “The beauty of the game as set up in Facesmash is that you have the
opportunity to have the game played a lot of times, and the ability to set up players (girls
faces) at random. This would give an extremely accurate ranking of whose girls face is
really considered hot by the community of horny college guys.”

If the reader is interested in the technical details of the facemash algorithm, we recommend the
comments in this blog post: https://shotgunapproach.wordpress.com/2010/10/08/the-algorithm-
for-facemash-in-the-social-network/.

Hackathon

If facemash is going to figure out who the “hottest” student on campus is, Mark’s new website is
going to need pictures, lots of them. But in his 11:09 pm blog post, Mark recognizes that
obtaining those pictures won’t be so easy: “Unfortunately, Harvard doesn’t keep a public
centralized facebook so I’m going to have to get all the images from the individual houses that
people are in.” (Emphasis added.)

Then, in his very next blog post, Mark confesses to a crime he is about to commit: “12:58pm. Let
the hacking begin.”

Here, then, is our “smoking gun”!

Zuckerberg will hack his way in and take what he needs, and after an eight-hour hackathon
session lasting until the wee hours in the morning (4:00 am), he will have hacked his way into
the computer networks of nine of Harvard’s twelve houses. (Kirkpatrick, 2010, p. 23.) In one
case, Zuckerberg even snuck into a House and plugged in an old-school Ethernet cable (old
school by today’s standards) to hack his way into that house’s online facebook. (Ibid.)

Going viral

Mark activated his clandestine website from his laptop on the afternoon of Sunday, November 2.
(Kirkpatrick 2010, p. 24.) Mark then emailed a link to his new website to his suitemates in H33
and to a few close friends. His intention was simply to test his ranking algorithm and receive
some feedback from his buddies. But once Mark emailed the link to his friends, they then
forwarded the link to their friends, and so on …

Facemash would go viral in a matter of hours!

For example, according to David Kirkpatrick (2010, p. 24), “One gay resident of a suite near
Zuckerberg’s was elated when, in the first hour, his photo was rated most attractive among men.
He of course alerted all his own friends, who then started using the site. When Zuckerberg
returned to his room at 10 pm from a meeting, his laptop was so bogged down with facemash
users that it was freezing up.”

By the time Harvard’s computer office shut down Zuckerberg’s Internet access, around 10:30
pm, facemash had been visited by 450 students, who had voted more than 22,000 times.

Busted!

Suffice it to say, Facemash pissed off a lot people. A huge uproar ensued, for as more and more
students got wind of facemash, they were appalled, even horrified, by what they saw. By
enabling students to rate the hotness of their fellow students anonymously, facemash was
pandering to the worst side of human nature. Two student groups in particular, Fuerza Latina and
the AHBW (Association of Harvard Black Women), deemed facemash to be an ugly outlet for
digital discrimination.

The director of Harvard’s office of computer services, Kevin S. Davis, was also none too
pleased. After all, a mere sophomore had somehow hacked into Harvard’s computer network on
his watch! Davis not only shut off Mark’s Internet access; he also brought a formal complaint
against Zuckerberg before Harvard’s Administrative Board, accusing him of violating
copyrights, breaching security, and invading the privacy of fellow students.

We will delve into the Ad Board in more detail in the next chapter. For now, however, let’s focus
on the law and ethics of hacking.

Hacking must be illegal, right? But what is “hacking,” really? Specifically, what laws apply to
hacking, how do these laws define this conduct, and what are the penalties for hacking?

To answer these questions about hacking, or about any legally wrongful activity, we must first
understand what the law is and where the law comes from. In short, we must pinpoint the main
sources of law.

SOURCES OF LAW

Did Mark Zuckerberg break any laws when he created facemash? If so, what legal rules did he
break, and where do these rules come from? Here, we explore the law and ethics of hacking.

Broadly speaking, there are three major sources of law: the common law (judge-made rules),
legislation (statutes and regulations), and natural law. (See, e.g., Rembar, 1980, pp. 43-51.)
Although the law of hacking is still evolving, all three types of law potentially apply to an
activity like hacking.

Common law

The common law is a body of law developed by judges and encompasses many traditional areas
of law, including property, contract, and torts, just to name a few. Broadly speaking, when a case
presents a question of law (e.g. is downloading pictures of co-eds illegal?), the judge is required
by precedent and the principle of stare decisis to look to past decisions of relevant courts. Stare
decisis, the linchpin of the common law system, is the principle that like cases should be decided
alike, so if a similar dispute has been resolved in the past, the judge is bound to follow the
reasoning used in the prior decision. (See, e.g., Rembar, 1980, pp. 53-54.)

One highly-developed and fundamental body of common law is the law of torts. A “tort” is a
private wrong that causes harm or injury to another person. Trespass, invasion of privacy, and
conversion are all examples of torts; moreover, all three torts could potentially apply to an
activity like hacking. (See Chapter 2.0 of this book.)

Tort law imposes civil liability on persons who are found to commit a private wrong or tort. That
means that the wrongdoer could be required by a court to pay monetary compensation to the
person harmed.

Statutes and regulations

Beyond these torts (i.e. theft, trespass, invasion of privacy), hacking is also considered a crime
under federal and State laws.

In general, statutes and regulations are written rules enacted by the government and enforced by
the courts. In the USA, for example, federal statutes are enacted by the Congress, while federal
regulations are promulgated by executive agencies like the Department of Treasury and by
independent agencies like the Federal Communications Commission. (FYI: executive agencies
are under the direct authority of the President; independent agencies are not.)

By way of example, Zuckerberg may be guilty of hacking under the Computer Fraud and
Abuse Act, a federal statute that makes it illegal to use a protected computer “without
authorization or exceeding authorized access.” (Note that the Computer Fraud and Abuse Act
defines “protected computer” broadly to include any computer which is used in or affecting
interstate or foreign commerce or communication.)

In addition to this federal law, all 50 States, including the Commonwealth of Massachusetts
(where Harvard University is located), have enacted computer crime laws. These laws prohibit
and penalize computer fraud and computer trespass. (Some State laws also directly address other
specific types of computer crime, such as spyware, phishing, denial of service attacks, and
ransomware. In Massachusetts, for example, the relevant State statute states:

Whoever, with intent to defraud, obtains, or attempts to obtain, or aids or abets another
in obtaining, any commercial computer service by false representation, false statement,
unauthorized charging to the account of another, by installing or tampering with any
facilities or equipment or by any other means, shall be punished by imprisonment in the
house of correction for not more than two and one-half years or by a fine of not more
than three thousand dollars, or both. As used in this section, the words “commercial
computer service” shall mean the use of computers, computer systems, computer
programs or computer networks, or the access to or copying of the data, where such
use, access or copying is offered by the proprietor or operator of the computer, system,
 program, network or data to others on a subscription or other basis for monetary
consideration.

Notice that the State statute quoted above imposes criminal liability on hackers. That means that
a person convicted of hacking under the statute could be imprisoned or could be required to pay
a fine to the government.

Natural law

Beyond these sources of man-made law (e.g. common law, statutes, and regulations), one could
also argue that Facemash was morally wrong under universal principles of natural law.

Broadly speaking, “natural law” refers to the idea of higher law, the notion that law ultimately
consists of a set of universal moral principles and that these principles are discoverable through
human reason. (See Wacks, 2008, pp. 81-82.) The work of medieval scholar St. Thomas Aquinas
contains the most comprehensive statement of natural law, though one of the most forceful
natural law arguments ever made appears in the Rev. Martin Luther King’s “Letter from a
Birmingham Jail.”

Thus far, we have been exploring the legality of hacking, but what about the ethics of hacking?
Specifically, is hacking always morally wrong? Was facemash? The answer is (drumroll please)
… It depends! Specifically, it depends on your moral yardstick or moral lens.

THEORIES OF ETHICS & MORALITY

Although what follows is a huge oversimplification of centuries of dialogue among disparate

moral philosophers (cf. Rachels & Rachels, 2014; Broad, 1930), there are essentially three
competing schools of thought for judging the morality of human behavior: consequentialism,
Kantian ethics, and virtue ethics

Consequentialism encompasses a large family of kindred ethical theories. What all these
theories have in common is the idea that the consequences of one’s conduct are the ultimate
yardstick for measuring the morality (i.e. rightness or wrongness) of that conduct.

Kantian ethics, by contrast, roundly rejects consequentialism. The 18th Century philosopher
Immanuel Kant argued that it was not the consequences of an action that makes it right or wrong
but the motives of the person who carries out the action. But the Kantian approach raises a new
question: how does one evaluate or judge the motivation for an action?

Kant himself devised a new moral theory, which he called “the categorical imperative,” for
judging the morality of one’s motivations. Kant formulated his categorical imperative in
different ways:

“Act in such a way that you always treat humanity, whether in your own person or in the person
of any other, never simply as a means, but always … as an end.”
“Act only according to that maxim by which you can also will that it would become a universal
law.”

Whereas consequential and Kantian theories attempt to evaluate the morality of actions, either by
emphasizing the consequences of those actions or by examining the motives them, virtue ethics
focuses instead on the moral character of the actor. The main insight here is that one must be
morally virtuous in order to recognize the rightness or wrongness of one’s actions. Moreover,
theories of virtue ethics have an ancient pedigree. They can be traced all the way back to
Classical Greece. Plato’s Republic, for example, contains an extensive discussion of the Four
Cardinal Virtues: wisdom, justice, fortitude, and temperance. For his part, Plato’s student
Aristotle identifies additional moral virtues in his Nicomachean Ethics.

To sum up, the rightness or wrongness of hacking may in large part depend on your moral
framework. If you follow a virtue ethics approach, you are more likely to focus on the moral
character of the hacker. By contrast, if you a Kantian, you are more likely to focus on the
motivations of a hacker before you pass moral judgement on the hacker’s actions. And if you are
a consequentialist, you are more likely to focus on the effects of the hacker’s actions. Was
anyone harmed?

Postscript

Although the facemash affair really happened, the movie version of these events is inaccurate in
several ways. First, facemash was not just about ranking girls. Both guys and girls were being
ranked. (The details of my narration of the facemash fiasco are based on Zuckerberg’s own
contemporaneous account (he wrote about facemash on his personal blog) and on the in-depth
reporting of David Kirkpatrick, who interviewed Zuckerberg while he was writing his 2010 book
“The Facebook Effect.”)

Secondly, Zuckerberg was not the only student to be “adboarded” for the facemash fiasco,
though he was the only one who was even nominally punished. (According to David Kirkpatrick
(2010, p. 25), Harvard put him on academic probation and made him see a counsellor.)

Thirdly, Eduardo Saverin played no role, either direct or indirect, in the creation of Facemash, or
if he did, he was not caught.

Lastly, facemash did not cause Harvard’s computer network to crash (Larochelle, 2010),
although the computer services department at Harvard did shut down Mark’s Internet access.
(Kirkpatrick, 2010, p. 24.)

Nevertheless, despite these discrepancies, the movie essentially got it right. Zuck was upset over
a girl. (“[Name redacted] is a bitch,” Zuck wrote on his blog.) He did consider adding farm
animals to his website, although it was another student’s idea to add the farm animals. (“Billy
comes up with the idea of … putting a farm animal in there. Good call Mr. Olson!”) He did hack
into the websites of nine of the twelve residential houses at Harvard. (“12:58pm. Let the hacking
begin.”) And he was drinking Beck’s beer during his late-night hacking foray. (“I’m a little
intoxicated, not gonna lie.”)
Most importantly, facemash really did go viral, and Zuckerberg did get adboarded, as we shall
see in Chapter 2.0.
 1.0 PROBLEM SET

1. Is hacking always unethical?

2. What laws apply to computer hacking?

3. Did Mark Zuckerberg break any of these laws when he created Facemash?

4. Do students have a reasonable expectation of privacy in their I.D. photos?

5. How does the common law differ from statutory law?

THIS PAGE IS INTENTIONALLY LEFT BLANK
 2.0 DUE PROCESS & THE BURDEN OF PROOF

Chapter 2.0

“Mr Zuckerberg, this is an Administrative Board hearing.”

Image 2-1: Lady Justice

 2.0 ARTEFACT

Facemash Creator Survives Ad Board

By Katharine A. Kaplan, CRIMSON STAFF WRITER, November 19, 2003

The creator of the short-lived but popular
Harvard version of the Am I Hot or Not?
website said he will not have to leave school
after being called before the Administrative
Board yesterday afternoon.
Mark E. Zuckerberg ’06 said he was accused
of breaching security, violating copyrights
and violating individual privacy by creating
the website, www.facemash.com, about two
weeks ago.
The charges were based on a complaint from
the computer services department over his
unauthorized use of on-line facebook
photographs, he said.
Zuckerberg said he will not be forced to
withdraw or leave school for any amount of
time, but declined to elaborate on whether
the board took some lesser action.
He said he was notified on Nov. 3 that his
case would appear before the Ad Board, the
day after he decided to take the site down,
partly due to sharp criticism of the site’s use
of ID photos and ranking students according
to attractiveness.
Comments on the e-mail lists of both Fuerza
Latina and the Association of Harvard Black
Women blasted the site.
“I heard from a friend and I was kind of
outraged. I thought people should be aware,”
said Fuerza Latina President Leyla R. Bravo
’05, who forwarded the link over her group’s
list-serve. ****
 2.0 CHAPTER ESSAY

Have you ever been accused of breaking the rules?

Mark Zuckerberg was, and by Harvard’s Administrative Board, no less.

This chapter will take a closer look at the Ad Board proceedings against Zuckerberg. First, we
will carefully evaluate the substance of the charges against Mark Zuckerberg. Did he really do all
the bad things he was accused of doing? Then, we will consider the procedural side of the law.
Specifically, what rights do you have when you are accused of misconduct, and what burden of
proof applies in such cases?

2.1 THE CHARGES AGAINST ZUCKERBERG

To begin with, here is the opening of the relevant scene from the screenplay of The Social
Network:

ADMINISTRATOR

Mr. Zuckerberg, this is an Administrative Board hearing. You’re being accused of

intentionally breaching security, violating copyrights, violating individual privacy by
creating the website, WWW.FACEMASH.COM. You’re also charged with being in
violation of university policy on the distribution of digitized images. Before we begin
with our questioning, you’re allowed to make a statement. Would you like to do so?

These are some serious charges. If you were in Mark Zuckerberg’s precarious position, how
would you respond?

First, let’s focus on the three substantive charges against Zuckerberg. In real life, as in the movie,
Zuck was charged with intentionally breaching security, with copyright infringement, and with
invasion of privacy. These charges can be restated in terms of one simple common law rule:
“keep off.” (Epstein, Simple Rules, p. 91.) Almost all other legal rules derive from this simple
rule. But will the charges against Zuckerberg stick?

2.2 PRIVACY TORTS

Although Zuckerberg is accused of invasion of privacy, more broadly he is being accused of

harming his fellow students when he created facemash, the harm being the invasion of their
privacy. (The Ad Board’s argument must be that Mark invaded the privacy of his classmates by
posting their pictures on his facemash website and then sending the link to his website to his
friends.)

The right to privacy is protected by tort law--invasion of privacy is an intentional tort--and courts
have generally recognized four types of privacy torts: (i) intrusion of solitude and seclusion, (ii)
(ii) appropriation of a person’s name or likeness, (iii) public disclosure of private facts, (iv)
“false light.” (See, e.g., Restatement (Second) of Torts, § 652A.) Let’s consider each one in turn:
Mark’s use of the student I.D. photos could constitute an intrusion upon solitude or seclusion.
Hacking into someone else’s computer, for example, is a type of intrusion upon privacy, but to
prove invasion of privacy, the law requires two things: the victim must have a reasonable
expectation of privacy, and the intrusion must highly offensive to a reasonable person. (See
Restatement (Second) of Torts, § 652B.) {What about damages?} Was facemash highly
offensive to a reasonable person, and do students have an expectation of privacy in their I.D.
photos? Here, Harvard’s case begins to fall apart. Paradoxically, the fact that facemash went
viral makes it hard to prove that facemash was highly offensive to a reasonable person.

Next, let’s consider the tort of appropriation. After all, by posting the photos of his fellow
students on facemash, Zuckerberg was using their “likenesses” (i.e. images) without their
consent. Legally speaking, appropriation occurs when a person uses the name or likeness of
another person for personal gain or commercial advantage. (See Restatement (Second) of Torts,
§ 652C.) Facemash, however, was not a commercial website, just an offensive or ingenious
prank, offensive or ingenious depending on your point of view. Again, Harvard doesn’t really
have a case against Zuckerberg, at least not for appropriation.

What about the tort of public disclosure of private facts? By posting Harvard photos on his
facemash website, Mark was arguably disclosing private information to anyone with access to
the Internet. Again, the law requires two things: the disclosure must be highly offensive to a
reasonable person, and the victim must have a reasonable expectation of privacy. (See
Restatement (Second) of Torts, § 652D.) So, again, Harvard’s case begins to unravel. After all,
how can I.D. pictures be considered “private”?

Lastly, what about “false light”? By enabling users of facemash to rank the “hotness” of Harvard
students, one could argue that Zuckerberg presented his fellow students in a false or misleading
light. The law, however, requires two things: (a) the conduct constituting false light must be
highly offensive to a reasonable person, and (b) the person accused of false light must have acted
with “actual malice.” That is, he must have known that his conduct would place the victim in a
false light, or he must have acted with reckless disregard towards his victims. (See Restatement
(Second) of Torts, § 652E.)

Here, Harvard has a much stronger case for invasion of privacy, but Mark could try to argue in
his defense that he did not act with actual malice, since his main motive in creating facemash
was to test his computer programming skills.

But Mark is not out of the woods yet. He was also charged and with copyright infringement (a
form of theft) and with hacking Harvard’s computers, i.e., intentionally breaching security (a
form of trespass), so let’s move on …

2.3 THEFT (COPYRIGHT INFRINGEMENT)

Among other things, Mark is charged with copyright infringement. As we shall see in Chapter
3.0, a copyright is just special type of a property right, one that grants the creators of original
works of art the exclusive rights to control the use of their works.
So, when Mark is accused of copyright infringement by the Ad Board, he is really being accused
of theft, the unauthorized taking of someone’s else property. Why? Because the pictures on the
facemash website did not really belong to Zuckerberg. Legally speaking, those pictures were
either Harvard’s property or the property of the students themselves, and either way, Zuckerberg
did not have previous permission to use them.

Nevertheless, the theft argument poses two further questions. First, who really owns the legal
rights to the student I.D. photos that Mark “stole,” Harvard or the students themselves?
Secondly, regardless of who owns the pictures, does facemash qualify for the “fair use” defense
of copyright law? Let’s discuss these two issues further:

Ownership issue

Does Harvard own the legal rights to the student photos, or do the students?

This is a critical question because, if Harvard owns these pictures, it has standing to enforce its
legal rights, but if the students own their own pictures, where is the injury to Harvard, even if
Mark took those pictures without authorization?

Harvard could argue that it owns the legal right to the pictures because Harvard staff took the
student pictures during orientation week, or because the students signed a contract transferring
their legal rights to the pictures to Harvard.

Nevertheless, an argument can be made that Harvard does not really own those pictures; the
students do. For example, when you take a selfie on your phone, you own the legal rights (i.e.,
the copyright) to your picture. But the moment you post that pic on Instagram, Instagram obtains
a non-exclusive license to use your selfie in any way it sees fit.

But where did Instagram obtain this license? From you! When you initially signed up for
Instagram, you agreed to their “terms of use.” (See Updated Terms of Use, www.instagram.com
(19 January 2013), available at https://help.instagram.com/478745558852511. See also Oliver
Smith, “Facebook terms and conditions: why you don’t own your online life,” The Telegraph (04
Jan 2013), available at http://www.telegraph.co.uk/technology/social-media/9780565/Facebook-
terms-and-conditions-why-you-dont-own-your-online-life.html.)

In case you did not read the fine print when you signed up for Instagram, its user agreement
states:

Instagram does not claim ownership of any Content that you post on or through
[Instagram]. Instead, you hereby grant to Instagram a non-exclusive, fully paid and
royalty-free, transferable, sub-licensable, worldwide license to use the Content that you
post on or through [Instagram] …
In other words, what if Harvard students only granted Harvard a license to use their pictures. In
that case, Harvard is not the legal owner of the pictures; the students are.

Fair use issue

Regardless of who owns the pictures, facemash might constitute “fair use” under U.S. copyright
laws.

What is “fair use”? Courts originally developed the fair use doctrine to strike a reasonable
balance between copyright owners and the public. But how do courts strike this balance in a
consistent and reasonable way?

Courts use four factors to determine whether a given use of copyrighted materials constitutes
“fair use.” (See also 17 U.S. Code § 107.) The four factors are as follows:

1. The purpose and character of the use, including whether such use is of a commercial
nature or is for nonprofit educational purposes.
2. The nature of the copyrighted work.
3. The amount and substantiality of the portion used in relation to the copyrighted work as a
whole.
4. The effect of the use upon the potential market for or value of the copyrighted work.

Now, let’s apply these four factors, in reverse order, to facemash:

1. The last factor, market effects, is a bit tricky, since there is no secondary market for
student I.D. photos. It’s possible that the highest-ranking facemash students might gain
some fame from being highly-ranked on facemash, and that this might create a new
market for their photos, but this argument is very speculative, since facemash was shut
down so quickly.
2. The third factor, amount used, probably goes to Harvard. Although Zuckerberg was not
able to access freshmen photos, he ended up downloading pictures from nine of the
twelve residential houses at Harvard.
3. The second factor, the nature of the copyrighted work, might be a draw, since the
copyrighted materials here consisted of garden variety student I.D. photos, not artistic
works like music files or movies.
4. The first factor, purpose and character of use, goes to Zuckerberg. After all, facemash
was not of a commercial nature. In addition, by his own admission, Zuckerberg’s stated
motive for building facemash was to test his programming skills, so facemash might even
be considered to have an educational purpose!

Moreover, courts have ruled that “transformative uses” also qualify as fair use under the first
factor. (See Campbell vs. Acuff-Rose Music, Inc., 510 U.S. 569 (1994).) That is, copiers may
use copyrighted materials to create something entirely new. To determine whether a given use of
copyrighted work is transformative, ask yourself the following two questions:
  Has the material you have taken from the original work been transformed by adding new
expression or meaning?
 Was value added to the original by creating new information, new aesthetics, new
insights, and understandings?

One could thus argue that facemash was “transformative.” It took ordinary, garden-variety I.D.
photos and created something entirely new.

The important point here is that no legal right is absolute, even a right as important as the right to
property.

Another important point is that legal rights are often unclear or contested. When we apply the
law to the facts of a case, even a relative clear-cut one like the facemash fiasco, the outcome of
the case might still be in doubt.

2.4 TRESPASS (INTENTIONALLY BREACHING SECURITY)

Time to move on. In addition to invasion of privacy (harm) and copyright infringement (theft),
Mark is also being accused of “intentionally breaching security” -- in other words, hacking.

To be more precise, he is being charged with intentionally interfering with the security protocols,
however weak these protocols were, that Harvard had established to protect the data stored on its
computers.

Legally speaking, “intentionally breaching security,” or hacking, could fall under the law of
trespass. A trespass occurs when one person intentionally interferes with the legal rights of
another, and courts have generally recognized three types of trespass: trespass to land, trespass to
persons, and trespass to personal property. Arguably, hacking into another person’s computer
could be considered a form of trespass to personal property. Simply put, Harvard students are not
supposed to circumvent Harvard’s security protocols, yet Mark went ahead and flouted them
anyways.

But even though hacking is a type of trespass, it’s not so simple, because the law of trespass
requires three things. Specifically, the plaintiff (the person who is alleging the commission of a
trespass) must prove three elements: (i) an intentional interference with a property right, (ii) lack
of consent, and (iii) actual harm.

Intentionality. Let’s start with intentionality. Intentional means that Mark’s conduct was not
accidental or mistaken, that he knew exactly what he was doing when he hacked into Harvard’s
computers to take the pictures he needed for facemash. Does anyone doubt that Zuckerberg’s
hacking activities were intentional?

Lack of consent. Again, this element should be easy to prove, since at no time did Harvard ever
consent to Zuckerberg’s intrusion into its computers. In fact, Harvard had an internal rule against
this.
Actual harm. In the movie, facemach goes viral and causes Harvard’s computer systems to crash.
If this really happened, then Harvard should be able to prove actual harm, since it’s going to cost
the university a lot time and money to restore the functionality of its computer systems.

But what if Harvard’s computers did not crash? How can Harvard prove damages if its
computers were not harmed? And if Harvard can’t prove actual harm, then the case against Mark
falls apart yet again!

2.5 DUE PROCESS, BURDENS OF PROOF, AND THE RULE OF LAW

Thus far, we have delved into the nitty gritty details of substantive law. But it’s important to note
that Mark Zuckerberg was brought before the Harvard Administrative Board, not a court of law.
He thus faced an administrative procedure, not a civil lawsuit or criminal prosecution

Back in the fall of 2003, when Mark was adboarded, the Ad Board had jurisdiction to hear
student misconduct cases, and it also had the power to punish students, including the power to
recommend expulsion. (Conway & Lee, 2014.) But are there any limits to the Ad Board’s
disciplinary powers, and if so, what are they? We shall consider these critical questions below.

Procedural fairness is fundamental to the rule of law. Everyone is entitled to some form of “due
process.” But how much?

At a minimum, when someone is accused of breaking the rules, he or she or it must be given
notice of the charges against them, and they must be given an opportunity to defend themselves
against those charges. But where do these procedural limits come from, and do they apply to
privately-owned entities like the Harvard Ad Board?

Anglo-American legal historians generally trace the idea of the rule of law back to the Magna
Carta of 1215. (See, e.g., Baker, 1979, p. 83. See especially clauses 39 and 40 of the original
Magna Carta.) The purpose of the Great Charter was to limit the powers of the English king.
Procedural fairness is so fundamental to the rule of law that the relevant clauses of the Magna
Carta are worth quoting in full:

 Clause 39: “No freeman shall be taken or imprisoned or deprived of his freehold or of his
liberties or free customs, or outlawed, or exiled, or in any manner destroyed, nor shall we
go upon him, nor shall we send upon him, except by a legal judgment of his peers or by
the law of the land.”

 Clause 40: “To no one will we sell, to no one will we deny, or delay right or justice.”

The main ideas here are that justice cannot be bought and sold and that every person is entitled to
his day in court.

Not to be outdone by the English Magna Carta, the U.S. Constitution contains two separate due
process clauses as well. One appears in the Fifth Amendment and applies to all federal officials,
including federal judges! The other due process clause shows up in the Fourteenth Amendment
and applies to all State and local officials.

Combined, both constitutional due process clauses are designed to protect the rights of the
people and limit governmental power. How? By prohibiting the government from depriving
people of their life, liberty, or property without due process of law. Specifically, before the
government can take any adverse action against you, you must be provided adequate notice of
the charges against you; you must be afforded a fair and neutral hearing; and last but not least,
you must be given an opportunity to defend yourself.

For example, when the government wants to put someone in jail, like the notorious drug lord El
Chapo, the Government must give him fair notice of all the charges against him. In addition, no
matter how heinous his alleged crimes are, a criminal defendant is entitled to a fair and speedy
trial and has the right to present his own defense at trial. Most importantly, he is presumed
innocent. This means it is the prosecutor who has the burden of proving--proving beyond a
reasonable doubt--that the accused is guilty of the crimes he is accused of.

Furthermore, due process applies not just to criminal cases; it also applies to civil cases, i.e. cases
involving private harms or private wrongful acts, such as trespass, defamation, breach of
contract, etc. For example, when one person is harmed by another and sues for monetary
damages, the party initiating the lawsuit (the plaintiff) must provide the party being sued (the
defendant) with a copy of the plaintiff’s complaint, along with a summons. In addition, it is the
moving party who has the burden of proving his case. In civil cases, the plaintiff must prove his
case by a preponderance of the evidence. That is, he must persuade the jury that his allegations
are “more likely than not” to be true.

But do these constitutional limits apply to the Ad Board? After all, the Ad Board is a private
entity, not a governmental actor. (Under the judicially created “state action doctrine,” people
may assert their constitutional rights only against the government, not against private entities.)

Nevertheless, courts have created an important exception to the state action doctrine: the public
function exception. Under this exception, a private person’s actions constitute state action if the
private person performs functions that are traditionally performed by the government. Arguably,
since the Ad Board has the power to suspend students or even expel them, one could argue that it
is exercising a public function: adjudication.

Regardless whether the public function exception applies to the Ad Board, due process is so
fundamental and so essential to the rule of law that it permeates every aspect of our legal
environment, even private methods of adjudication.

Indeed, Mark Zuckerberg’s Ad Board hearing--as depicted in the movie The Social Network--
provides a nice illustration of due process in action. Let’s go back to the relevant scene from the
movie (emphasis added):
 ADMINISTRATOR

Mr. Zuckerberg, this is an Administrative Board hearing. You’re being accused of

intentionally breaching security, violating copyrights, violating individual privacy
by creating the website, WWW.FACEMASH.COM. You’re also charged with being in
violation of university policy on the distribution of digitized images. Before we begin
with our questioning, you’re allowed to make a statement. Would you like to do so?

Notice how the movie version of Zuckerberg is notified of the charges against him and how he is
given an opportunity to defend himself against these charges.

To sum up, the rule of law and due process are fundamental values that permeate every aspect of
our legal environment. When someone is facing the possibility of expulsion from college, even a
private one, he or she is--at a minimum--entitled to notice and a hearing.
 2.0 PROBLEM SET

1. In a criminal prosecution, which party generally has the burden of proof?

A. the accused
B. the plaintiff
C. the prosecutor
D. the defendant

2. Ricky sues Lucy for breach of contract, a private law claim. What burden of proof applies in this
case?
A. scintilla
B. preponderance
C. probable cause
D. reasonable doubt

3. At a minimum, what does procedural due process require?

A. adequate notice
B. procedural fairness
C. a fair hearing
D. all of the above

4. The Due Process Clause is found in what part of the U.S. Constitution?
A. the 5th Amendment only
B. the 14th Amendment only
C. neither the 5th nor 14th Amendment
D. both the 5th and 14th Amendments

5. Which of the following causes of action is not a tort?

A. breach of contract
B. invasion of privacy
C. conversion
D. trespass
THIS PAGE IS INTENTIONALLY LEFT BLANK
3.0 INTELLECTUAL PROPERTY RIGHTS

A Mark Zuckerberg Production

Image 3-1: Facebook’s original logo

 3.0 ARTEFACT
Hundreds Register for
New Facebook Website
By Alan J. Tabak, CRIMSON STAFF
WRITER, February 9, 2004
When Mark E. Zuckerberg ’06 grew
impatient with the creation of an official
universal Harvard facebook, he decided to
take matters into his own hands.
After about a week of coding, Zuckerberg
launched thefacebook.com last Wednesday
afternoon. The website combines elements
of a standard House face book with
extensive profile features that allow
students to search for others in their
courses, social organizations and Houses.
“Everyone’s been talking a lot about a
universal face book within Harvard,”
Zuckerberg said. “I think it’s kind of silly that
it would take the University a couple of
years to get around to it. I can do it better
than they can, and I can do it in a week.”
As of yesterday afternoon, Zuckerberg said
over 650 students had registered [to] use
thefacebook.com. He said that he
anticipated that 900 students would have
joined the site by this morning.
“I’m pretty happy with the amount of people
that have been to it so far,” he said. “The
nature of the site is that each user’s
experience improves if they can get their
friends to join it.” ***
Zuckerberg’s site allows people with
Harvard e-mail addresses to upload their
pictures and personal and academic
information. Just as with the popular
website Friendster, which Zuckerberg said
was a model for his new website, members
can search for people according to their
interests and can create an online network
of friends. ***
Zuckerberg said that the most innovative
feature of the site is that people can search
for other students in their classes so that
they can branch out to form friendships and
study groups. ***
Zuckerberg said that the extensive search
capabilities are restricted by a myriad of
privacy options for members who do not
want everyone to be able to look up their
information.
“There are pretty intensive privacy options,”
he said. “You can limit who can see your
information, if you only want current
students to see your information, or people
in your year, in your house, in your classes.
You can limit a search so that only a friend
or a friend of a friend can look you up.
People have very good control over who
can see their information.”
Zuckerberg said that he hoped the privacy
options would help to restore his reputation
following student outrage over
facemash.com, a website he created in the
fall semester. ***
 3.0 ARTEFACT

Image 3-2: Facebook’s original homepage

 3.0 CHAPTER ESSAY

Have you ever created any intellectual property?

For example, although Zuckerberg said it only took him “about a week of coding” to get his new
website up and running (Tabak, 2004), when he finally launched “The Facebook” from his dorm
room on 04 February 2004, he potentially created many valuable forms of intellectual property.

Now, then, is a good time to check out Facebook’s original home page. (See Image 3-2.)

First, notice the copyright notice on the bottom of the page: “Thefacebook © 2004.” Broadly
speaking, copyright law protects works of authorship, so long as those works are original and
fixed in a tangible medium of expression. Moreover, a work receives copyright protection the
moment it is created and fixed in a tangible form.

(Time out. Say cheese! Go ahead and take a “selfie” on your phone. You have just created a
work of intellectual property. In particular, creative works like photographs, stories, essays, etc.
receive copyright protection the moment they are created and fixed in a tangible form. See
Library of Congress, “Copyright in General” (not dated), available at URL =
https://www.copyright.gov/help/faq/faq-general.html.)

So, what legal rights was Zuckerberg trying to protect when he added the copyright symbol to
his homepage? The rights to the design and layout of the homepage? The rights to the name
“facebook”? The rights to his source code? (Note: In computing, “source code” refers to any
collection of instructions written using a computer programming language, like JavaScript,
Python, HTML, etc. These instructions tell a computer what to do. See, e.g., Wikipedia entry for
“source code.”)

Although ideas and discoveries are not protected by copyright law, the way in which ideas are
expressed can be. The copyright symbol on the bottom of Facebook’s original homepage thus
puts the world on notice that Zuckerberg owns the legal rights to his source code and the look
and design of his website.

What about the name “Facebook,” or “The Facebook,” as the site was first called? Could
Zuckerberg own the legal rights to this name?

Who owns the name “Facebook?

It’s early 2004. Zuckerberg has just launched his new website at Harvard,
www.thefacebook.com. According to the student paper, The Crimson, everyone on campus is
signing up for Facebook, and Zuckerberg will soon open his social network to students at Yale,
Columbia, and Stanford. (Kirkpatrick, 2010, p. 36.)
But does Zuckerberg own the exclusive legal rights to use the word “facebook”? Could he be
able to prevent other institutions (like Harvard or potential Internet rivals) from using the word
“facebook” to describe their products and services?

You see, long before Zuckerberg created Facebook, many colleges had published catalogues
containing pictures and biographical data of their students. These catalogues were distributed to
all students at the beginning of the academic year and were often referred to as “face books”
because the pictures, arranged alphabetically and by year of graduation (e.g. freshmen,
sophomores, juniors, and seniors), consisted mostly of head shots.

And even before the launching of Zuckerberg’s website, the Crimson had reported on Harvard’s
efforts to create a “campus-wide online facebook.” (See “Put Online a Happy Face: Electronic
facebook for the entire College should be both helpful and entertaining for all,” 11 Dec 2003,
available at URL = http://www.thecrimson.com/article/2003/12/11/put-online-a-happy-face-
after/; see also Kaden, 2003.) Recall that Harvard College is divided into twelve separate
residential Houses. (After their freshmen year, students are assigned randomly into one of the
Houses.) At the time, each House published a separate “face book” listing the students assigned
to that House, but Harvard lacked a central or university-wide “face book” for all the Houses.

Moreover, many months before Zuckerberg launched his website, a senior by the name of Aaron
Greenspan had already created a new website for Harvard students called “houseSYSTEM,” and
Greenspan had also added a feature to his website called “the Universal Face Book.” (See
Kirkpatrick, 2010, p. 79. See also Greenspan, 2008, ch. 26.)

So, who, if any one, owns the legal rights to the words “face book” or “facebook”?

This is a question of trademark law. Broadly speaking, a mark is a distinctive word, name,
phrase, or symbol that identifies the maker or provider of a product or service. (To be more
precise, trademarks are used to identify products, while service marks are used to identify
services, but we will use the term “trademark” to refer to both types of marks.)

Trademarks are valuable intellectual property because they not only allow firms to build their
brands; trademark law gives firms the exclusive legal rights to their brands. But there’s a catch.
Not every word, name, or phrase is protected by trademark law. Your mark must be distinct or
unique in some way.

In other words, as a general rule, only marks that are arbitrary, fanciful, or suggestive can be
trademarked. Neither generic marks like nor descriptive marks are protected by trademark law.
Thus, back in ’04 when Zuckerberg first launched his website, the words “face book” and
“facebook” were arguably generic or descriptive, so no one could assert the legal rights to these
words.

At the same time, however, it’s worth noting that the beta version of Facebook was originally
called “Thefacebook,” spelled as one word, and with the word “the” attached to the beginning of
the name. (In fact, Facebook’s first trademark application was for “thefacebook.” See Trademark
Electronic Search for “thefacebook,” available at URL =
http://tess2.uspto.gov/bin/showfield?f=doc&state=4803:2twu6n.2.1.)

In other words, Zuckerberg may have been trying to make his mark as unique and distinctive as
possible. Could this be why Facebook was called The Facebook when the website was launched
in 2004?

Furthermore, descriptive marks that have acquired a “secondary meaning” are protected under
the Lanham Act. (This statute has been amended many times since it was enacted in 1946 and is
codified in volume 15 of the United States Code, §§ 1051-1041n.) Today, for example, there is
no doubt that the word “Facebook” has acquired a secondary meaning in the minds of most
consumers. Most Internet users think of Mark Zuckerberg’s website when they hear or see the
words “facebook.”

Before concluding this section, it’s worth noting that the Lanham Act creates a federal,
nationwide registration system for trademarks.1 Nevertheless, registration is not required; you
don’t need to register your mark to hold the legal rights to it. Why not? Because trademark rights
arise under common law from use. That is, as soon as you start using a mark in commerce, say
by launching a distinct website, you own the legal rights to your mark. But remember, to be
valid, your mark must be distinct or must have acquired a secondary meaning in the minds of
consumers.

Lastly, although registration is not required, federal registration provides many benefits. Among
other things, registration creates a legal presumption of the registrant’s ownership of the mark
and the registrant’s exclusive right to use the mark nationwide. In addition, registration allows
you to enforce the rights to your mark in any federal court in the United States.

In addition to copyrights and trademarks, another valuable form of intellectual property is trade
secrets.

Did Mark steal any code?

According to the Crimson article describing the debut of Facebook (Tabak, 2004), it took
Zuckerberg “about a week of coding” to launch the beta version of Facebook. That Zuckerberg
was able to build his website so quickly raises a delicate question: Did Zuckerberg steal any code
from the members of the Winklevoss team, who were developing their own social network
(Harvard Connection, later renamed ConnectU) at the time?

Consider, for example, Victor Gao’s sworn statement dated 19 September 2007, available here:
https://docs.justia.com/cases/federal/district-
courts/massachusetts/madce/1:2007cv10593/108516/113. Gao was hired by the Winklevoss team

1
The U.S. Patent & Trademark Office (USPTO) employs several hundred trademark examining
attorneys. (According to Jeong (2017), there were 456 trademark examiners as of 2015.) Their main job is
to make sure each trademark registration is up to snuff--by comparing it with existing registered
trademarks in the federal database, by reviewing the application materials in support of the registration,
and by looking up the dictionary definitions of any words used. (Ibid.)
in August 2003 to develop the source code for the Harvard Connection. According to his sworn
statement (para. 7), Gao met with Zuckerberg on 9 November 2003. At this meeting (para. 9),
Gao showed Zuckerberg the Harvard Connection website in its then-current stage of
development and explained to him the technical aspects of the project. Later that same day (para.
11), Gao emailed Zuckerberg the sever location and password for the unfinished Harvard
Connection website.

So, based on Victor Gao’s testimony, we can establish that Zuckerberg was given access to the
source code of the Harvard Connection, but did Mark steal any code? That is, although the
fictional version of Mark Zuckerberg in the movie The Social Network vehemently denies using
even a single line of the Winklevoss team’s source code, did the real-life Mark Zuckerberg
commit the tort of misappropriation of a trade secret?

Trade secrets are proprietary information, and trade secret law prohibits one from stealing or
misappropriating another’s trade secrets. Legally speaking, “misappropriation” can occur when
someone either acquires a trade secret knowing or having reason to know that the trade secret
was acquired by improper means, or when someone discloses or uses another’s trade secret
without the owner’s permission.

If a trade secret is improperly acquired or disclosed, the owner may seek money damages in
court. (See, e.g., Juran, 2001.) Furthermore, according to Seth Northrop, a trial attorney and
expert on trade secret law, “Trade secret verdicts are increasingly taking their place on the
intellectual property leaderboard with more than half of the largest intellectual property verdicts
over the last year relating to trade secrets, not patents. Those verdicts include a multi-billion
dollar award to St. Jude, a $919 million dollar verdict to DuPont (just recently overturned by the
Fourth Circuit), and a $465.4 million verdict in favor of Lexar Media.” (See Northrop, 2014.)
Moreover, trade secret misappropriation also can result in criminal penalties under federal law.
(See entry for the “Economic Espionage Act” in Wikipedia.)

In fact, when the Winklevoss team eventually sued Mark Zuckerberg in federal court in
September 2004, the very first cause of action in their complaint is for misappropriation of trade
secrets. (See ConnectU’s Complaint in Chapter 5.0.) Nevertheless, although a strong case can be
made that Zuckerberg acquired the Winklevoss team’s source code through improper means (i.e.
by pretending to be diligently working on the Harvard Connection website when, in fact,
Zuckerberg was busy creating his own website all along), it is not easy to prove
“misappropriation.” Why not? Because trade secret law does not protect every idea or secret.
(See entry for “Trade Secret” in Wikipedia.) Instead, the law protects only those ideas or secrets
that comply with the following stringent conditions:

(1) The secret must derive economic value from not being generally known.
(2) The owner of the secret must make reasonable efforts to maintain the secrecy of his idea.

Did the Winklevoss team take reasonable efforts to keep their idea a secret? On the one hand,
they did not share their website idea with everyone. They shared their idea with Mark
Zuckerberg only after Zuckerberg said he would help them out with their Harvard Connect
website. But at the same time, the Winklevoss team did not get Zuckerberg to sign a non-
disclosure or confidentially agreement.

So, did Mark steal any code?

3.0 PROBLEM SET

1. Did Mark Zuckerberg steal the Winklevoss twins’ code?

2. Could Facebook receive trademark protection for the particular shade of blue it uses on its
website?

3. If you take a selfie and then post it on Instagram, what type of intellectual property is your
selfie?

4. Who owns the legal rights your selfie once it is posted on Instagram?

5. Does Instagram’s terms of use (see below) change your answer to Question #4 above?
Instagram does not claim ownership of any Content that you post on or through the
[Instagram] Service. Instead, you hereby grant to Instagram a non-exclusive, fully paid
and royalty-free, transferable, sub-licensable, worldwide license to use the Content that
you post on or through the [Instagram] Service …*

* In other words, when users sign up for Instagram and agree to Instagram’s terms of use, they agree to grant Instagram a non-
exclusive license to use their content in any way it sees fit. (See Updated Terms of Use, www.instagram.com (19 Jan 2013),
available at URL = https://help.instagram.com/478745558852511. See also Oliver Smith, “Facebook terms and conditions: why
you don’t own your online life,” The Telegraph (04 Jan 2013), available at URL = http://www.telegraph.co.uk/technology/social-
media/9780565/Facebook-terms-and-conditions-why-you-dont-own-your-online-life.html.)
4.0 CHOICE OF BUSINESS ENTITY

$500,000

Image 4-1: 1 Hacker Way

 4.0 ARTEFACTS

ARTICLES OF ORGANIZATION OF THE FACEBOOK LLC:

http://search.sunbiz.org/Inquiry/CorporationSearch/ConvertTiffToPDF?storagePath=CO
R%5C2004%5C0415%5CH0077355.Tif&documentNumber=L04000028443

[NEXT PAGE: STOCK CERTIFICATE OF FACEBOOK, INC.]

 4.0 CHAPTER ESSAY

Have you ever been betrayed?

Facebook cofounder Eduardo Saverin apparently was.

Worse yet, if there is any grain of truth to the movie The Social Network, it was his own friend
and business partner Mark Zuckerberg who betrayed him!

But first things first. When Eduardo was booted out of the company, Facebook was a Delaware
corporation. But before that, it was a Florida limited liability company (LLC). And before it was
an LLC, it was a general partnership under Massachusetts law, and originally, before that, it was
a sole proprietorship, the most common type of business entity in the USA.

This chapter will thus retrace Facebook’s evolution from a sole proprietorship to a general
partnership to a Florida LLC to a privately-held Delaware corporation. (Note: We will discuss
Facebook’s 2012 decision to become a public corporation in a future edition of this book.)

Sole Proprietorship

Before launching Facebook from his dorm room in February 2004, Zuckerberg spent endless
hours writing source code and working on a plethora of computer projects. For example, in
September of 2003, during the first week of his sophomore year, he wrote a program called
“Course Match” that allowed students to see what courses other students had signed up for.
(Kirkpatrick, 2010, pp. 19-20.) Then, during the last week of October of 2003, he created the
notorious facemash website, which we discussed in detail in Chapters 1.0 and 2.0 of this book.

Next, in November, Zuckerberg made amends with the members of the Association of Harvard
Black Women, who had complained about facemash, by helping them set up their own website
(Kirkpatrick, 2010, p. 26.), and in January of 2004, he created a dedicated website for his Art in
the Time of August course. (Ibid., pp. 25-26.)

During these pre-Facebook days, while Zuckerberg was working on all these multifarious
projects, he was essentially operating as a sole proprietor. In summary, a sole proprietorship is an
unincorporated business owned and operated by one person. Because there is no legal distinction
between the business and the owner, a sole proprietor is entitled to all profits and is personally
responsible for all the debts, losses, and liabilities of his or her business.

A sole proprietorship is the simplest way to start a business, since no formal action is required to
start one up. In fact, you may already own a sole proprietorship without knowing it. For example,
if you are a freelance writer or graphic designer, you are a sole proprietor! If you are the only
owner of a firm, you are automatically a sole proprietor.

But by the time Zuckerberg had the idea for Facebook, he decided to become partners with his
best friend, Eduardo Saverin.
General Partnership

Legally speaking, Facebook began as a general partnership between college classmates Mark
Zuckerberg and Eduardo Saverin. According to one report, for example, Zuckerberg and Saverin
became partners in late 2003 or early 2004, when they each agreed to contribute $1,000 to their
new venture. (Kirkpatrick, 2010, p. 30.)

Before proceeding, it is worth noting that no formal writing or public filing is required to create a
general partnership. Instead, the law recognizes an association of two or more persons as a
partnership so long as such persons have demonstrated an intent to carry on as co-owners of a
business for profit. (See, e.g., Lipshaw, 2017, pp. 116-117. See also Revised Uniform
Partnership Act of 1997 (RUPA), § 202; Uniform Partnership Act of 1914 (UPA), § 6(1).)

But why did Mark choose Eduardo to be his first business partner? There are several possible
reasons. By all accounts, Zuckerberg and Saverin were close friends at the time, and Saverin
knew a lot about the business world. He had made over $300,000 investing in oil futures while
he was still in college, and he was president of the Harvard Investment Association, a student
organization on campus. (See: https://www.facebook.com/harvardinvestment/.)

In addition, Zuckerberg needed funds to launch a new campus website (TheFacebook.com) that
he was developing. For example, in this text message dated 8 January 2008 addressed to a friend,
Zuckerberg described his business deal with Saverin as follows (Tate, 2010):

Zuckerberg: Eduardo is paying for my servers.

Friend: A sucker born every day.
Zuckerberg: Nah, he thinks it will make money.
Friend: What do you think?
Zuckerberg: Well I don't know business stuff. I’m content to make something cool.

But Facebook was not a general partnership for long. The original Facebook website was
launched in February of 2004, and the partnership then became a Florida limited liability
company (LLC) in April of that same year, just a few months after Eduardo Saverin and Mark
Zuckerberg first became partners. In addition, when Facebook became an LLC, Eduardo and
Mark brought in a new partner, classmate Dustin Moscovitz …

Florida LLC

Why did the founders of Facebook choose to restructure their partnership as an LLC?

In two words: limited liability!

LLCs are designed to have the same characteristics as a partnership along with the benefits of
limited liability. The owners of an LLC are generally not personally liable for the business debts
of the company, and legal liability (tort and contract) is imposed on the company, not on its
owners.
Put yourself in Eduardo’s shoes for a moment. You’ve made $300,000 trading in oil futures
during the previous summer, and you are now business partners with your best friend, Mark
Zuckerberg. Yet, as Mark’s business partner, you are personally liable for all the debts and legal
liabilities of the partnership. In other words, a general partnership exposes Saverin’s personal
assets to unlimited legal liability, since partnership law imposes joint and several liability on all
general partners.

Moreover, as the movie The Social Network shows, soon after the launching of Facebook, Mark
receives a threatening demand letter from the Winklevoss twins, who alleged that Zuckerberg
had stolen their idea, among other things. A demand letter puts the recipient on notice that he or
she could be sued, but as Mark’s business partner, Eduardo could also personally be “on the
hook” if the Winklevoss bring their lawsuit.

Eduardo can solve this dilemma by reorganizing Facebook as an LLC. In general, to become an
LLC the owners of a firm must follow the following steps:

1. The first step is to figure out what the name of the firm will be. At a minimum, the name must
be different from existing LLCs, and the name must indicate that the firm is an LLC, so you must
include the initials “LLC” or the words “Limited Company” in the name of the company.
Facebook, for example, chose the name “thefacebook LLC” when it became an LLC.

2. The next steps are to choose a registered agent and file “articles of organization” in your home
State. Facebook, for example, chose to file its articles of organization in Florida. (By the way,
Facebook’s Florida filing illustrates a unique feature about corporate governance in the USA: a
firm is free to organize in any State, even if the firm does not conduct any business or have any
physical presence in its “home” State.)

3. Ideally, the owners of the LLC--called managers or members depending on their level of
involvement in the firm--should draft an operating agreement. The operating agreement is
important because it establishes the internal rules for the operation of the business. (See Melvin
& Guerra-Pujol, 2017, pp. 470-472.) In the case of Facebook, Eduardo eventually wrote up a
draft operating agreement during the summer of 2004, but Mark would refuse to sign it. Suffice
it to say that Mark and Eduardo had different ideas about how Facebook should be run, and the
lack of an operating agreement created a lot of friction between Mark and Eduardo.

In addition, the owners of an LLC must keep their personal assets separate from those of the
LLC. Any comingling of personal and business assets could result in the loss of limited liability
protection.

One last point about LLCs. The principals of an LLC owe special fiduciary duties to each other.
These fiduciary duties include the duty of loyalty as well as the duty of care. (Frankel, 1998,
pp. 127-128.) As a result, business owners must not put their own interests ahead of the interests
of their company. In addition, they must act in a reasonably prudent when they act on behalf of
the company.
Most courts follow a three-part test to determine whether a business actor has breached his or
fiduciary duties. First, a fiduciary must always act in good faith. Second, he or she must act with
the same level of care that an objectively prudent person in a similar position would exercise
under like circumstances. Third, fiduciaries must carry out their duties in a manner that is
reasonably calculated to advance the best interests of the company. (See, e.g., Melvin & Guerra-
Pujol, 2017, p. 500.

In any case, when angel investor Peter Thiel decided to invest $500,000 in Facebook in the
summer of 2004, Facebook’s legal structure would change yet again …

Delaware Corporation

Peter Thiel was Facebook’s first outside investor. Here is how the movie The Social Network
depicts this pivotal moment in Facebook’s founding. We don’t get to see Zuckerberg’s pitch to
Thiel. Instead, we see this:

PETER

We took a look at everything and congratulations. We’re

gonna start you off with a $500,000 investment. Maurice is
gonna talk to you about some corporate restructuring.

MAURICE

We’ll file as a corporation in Delaware and come up with

a stock structure that allows for new investors.

PETER

Now lemme ask you something. Who’s Eduardo Saverin?

Here, we will consider why Facebook became a Delaware corporation. After all, when Thiel
became Facebook’s first outside investor, Facebook was already legally structured as a Florida
LLC. So, why did Thiel want to restructure Facebook as a Delaware?

It turns out that Peter Thiel and Facebook are not alone in preferring Delaware. Today, more than
60 percent of all Fortune 500 companies worldwide and more than 50 percent of all publicly-
traded corporations in the United States --like Facebook, whose shares are listed on the
NASDAQ--are incorporated in Delaware. (See State of Delaware, “About Agency,” not dated,
available at URL = http://www.corp.delaware.gov/aboutagency.shtml.)

Why do so many businesses prefer Delaware?

One reason is Delaware’s modern and flexible General Corporation Law. Delaware was one of
the first legal jurisdictions in the world to enact streamlined incorporation procedures, allowing
anyone to create a corporation simply by raising money and filing the necessary articles of
incorporation with the state’s Secretary of State. Another reason is Delaware’s Court of
Chancery, a specialized business court that has decided most of the leading business law cases
involving corporations. Moreover, the Court of Chancery is a “court of equity,” not a “court of
law.” As a result, business cases are decided by judges, called chancellors, not juries.

One of the most important legal principles developed by the Court of Chancery is the business
judgement rule. Recall our previous discussion of fiduciary duties. A fiduciary duty is the
highest duty that the law can impose on business actors. In the case of a corporation, the officers
and directors of the corporation must act with care and must not put their own interests ahead of
the corporation’s interests. (By the way, these fiduciary duties apply to all directors and officers
regardless of whether the corporation is large or small or whether the directors are paid or
unpaid, and they also apply to controlling shareholders in relation to other shareholders. See,
e.g., Melvin & Guerra-Pujol, 2017, p. 500.)

Delaware courts, however, have established a legal rule that protects the officers and directors of
corporations from shareholder allegations of misconduct. The rule is that when an officer or
director of a corporation makes a business decision, courts should presume that he or she has
acted on an informed basis, in good faith, and in the honest belief that the action taken was in the
best interests of the company. In other words, whenever a shareholder of a corporation alleges
that an officer or director breached his fiduciary duties toward the corporation, it is the
shareholder who carries the difficult burden of rebutting this presumption.

With this rule in mind, we can circle back to Mark Zuckerberg’s decision to restructure
Facebook as a Delaware corporation. Remember, Eduardo and Mark were still business partners
when Peter Thiel offered to make his angel investment. Zuckerberg, however, wanted to dilute
Eduardo’s stake in Facebook, and he apparently devised an ingenious plan to accomplish this
goal:

First, Facebook, Inc. (the new corporate entity) would buy out Eduardo’s 30% interest in
Thefacebook LLC; in exchange, Eduardo would receive shares in the new Facebook. At the
same time, Mark would reserve the right to issue additional shares to himself, to Peter Thiel, to
Sean Parker, and to any new investors, at his sole discretion. By the time Eduardo finally figured
out what had happened, his ownership share in the new Facebook had been diluted from over
34% to under 10%. Here is how the movie The Social Network depicts the dramatic moment
when Saverin realizes that he has been betrayed:

EDUARDO

You issued over 24-million new shares of stock.

MARK

You were told that if new investors came along--

EDUARDO

How much were your shares diluted? How much were his?!

****
 MARK

You signed the papers.

EDUARDO

You set me up.

MARK

You’re going to blame me because you were the business

head of the company and you made a bad deal with your own
company?!

EDUARDO

It’s gonna be like I’m not part of Facebook.

Eduardo’s dilution led to a lawsuit. We will discuss some strategic aspects of litigation in the
next chapter …
 4.0 PROBLEM SET

1. What special duties did Mark and Eduardo owe each other as business partners and co-
founders of Facebook?

2. In your opinion, Eduardo breach any of these duties when he froze Facebook’s bank
account? Did Mark, when he brokered a deal with angel investors like Peter Thiel without
telling Eduardo beforehand?

3. If you were to start a new venture today, what type of business entity would you use, e.g. sole
proprietorship, partnership, LLC, or corporation, and why?
5.0 THE STRATEGY OF LITIGATION

Settle or Go to Trial?

Image 5-1: Lucky Dice?

 5.0 ARTEFACTS

CONNECTU COMPLAINT HERE:

https://docs.justia.com/cases/federal/district-
courts/massachusetts/madce/1:2007cv10593/108516/1

SUMMONS HERE:

https://docs.justia.com/cases/federal/district-
courts/massachusetts/madce/1:2007cv10593/108516/7
 5.0 CHAPTER ESSAY

“You better lawyer up, asshole …”

In the most dramatic scene of the movie The Social Network, Eduardo discovers that his stake in
Facebook has been diluted. He confronts Zuckerberg and threatens to sue him: “ You better
lawyer up …”

What the movie does not show, however, is that it was Zuckerberg who sued Saverin! (See
Appendix *: Second Amended Complaint dated 7 March 2005.) Of course, after Zuckerberg
initiated his lawsuit, Saverin fought back and brought several counterclaims against his former
business partner. (See Appendix *: First Amended Cross-Complaint dated 21 July 2005.) But it
was Mark who sued Eduardo first.

So, instead of discussing the legal merits of this complex case or the business ethics of
Zuckerberg’s alleged betrayal, in this chapter we shall consider the following simple question:
why was it Zuckerberg who sued Saverin first, and not the other way around?

Simply put, Facebook’s decision to sue Saverin first was a brilliant strategic move and
preemptive strike on Zuckerberg’s part.

Why? Because there is a major first-mover advantage in the game of law, especially in complex
multi-party cases involving parties from different States or parts of the country. Specifically,
since it is the plaintiff (i.e. the party that initiates a private lawsuit) who gets to choose in which
court he will bring his case, plaintiffs often engage in “forum shopping,” a strategic practice that
consists of choosing the most plaintiff-friendly court possible. By way of example, the strategic
advantage in moving first can be as simple as securing “home court advantage.”

But why is there a home court advantage in litigation? Isn’t the law supposed to be neutral and
impartial? Aren’t judges supposed to be neutral umpires? Aren’t juries supposed to be impartial
decision-makers? Sure they are, but the problem is that laws are administered by people, not
machines (not yet, at least), and people are rarely if ever perfectly neutral and impartial, no
matter how hard we try!

To see home court advantage in action, let’s go back Zuckerberg’s alleged betrayal of Saverin
and the resulting litigation between Zuckerberg and Saverin. In real life, Zuckerberg sued
Saverin first, and he sued him in a State court in Santa Clara County in Northern California. (See
Appendix *: Second Amended Complaint dated 7 March 2005.) By suing first, Zuckerberg not
only secured home court advantage; he prevented Saverin from getting home court advantage.

To see why Zuckerberg’s preemptive strike was so brilliant, consider this case from Eduardo’s
point of view. Eduardo believes (perhaps rightly) that Mark betrayed him. But where does
Eduardo have a better chance of winning his case against Mark? Before a jury in Santa Clara
County, California, or before a jury in Dade County, Florida? If you are Eduardo--the son of
cosmopolitan Brazilian immigrants--the choice is clear. You want to bring your case in South
Florida, where you grew up and where your parents still live, not 3,000 miles away in Silicon
Valley. You’d rather take your chances with a polyglot jury in your own hometown, in the heart
of Spanish-speaking Miami.

Now, consider this case from Mark’s perspective. If you are Mark--an Anglo tech geek--South
Florida is the last place you want to be sued You’d rather take your chances with a tech-savvy
jury in the heart of Silicon Valley.

But once a lawsuit is initiated, the parties must make a strategic decision: should they settle their
case out of court, or should they go all the way to trial?

***

In ordinary business litigation, one party (the plaintiff) is suing another party (the defendant) and
requesting the court to provide some legal remedy. In the remainder of chapter, we introduce a
key strategic question confronting the parties in business litigation--the choice between
settlement and going to trial.

In short, when should you settle, and when should you go to trial?

Let’s consider the first major lawsuit in Facebook’s history: the legal action brought by the
Winklevoss twins against Mark Zuckerberg.

After Tyler and Cameron Winklevoss twins and their business partner Divya Narendra graduated
from Harvard, they sued Mark Zuckerberg in federal court. Their initial Complaint, which they
brought in September of 2004, is included in the artefacts section of this chapter.

Recall that Narendra and the Winklevii were the founders of “ConnectU,” a rival social network.
(Originally, their project was called “The Harvard Connection.”) They sued Zuckerberg for theft
of trade secrets, fraud, breach of contract, and other causes of actions. Later, they amended their
complaint to include a copyright infringement claim.

Under U.S. copyright law, registered copyright owners who can prove infringement are entitled
to recover not only “actual damages” but also any lost profits resulting from the infringement.
(See 17 U.S. Code § 504(b).) In addition, plaintiffs who can prove willful or intentional
infringement are also entitled to damages up to $150,000 for every separate work that is copied
without authorization. See 17 U.S. Code § 504(c)(2). But the founders of ConnectU weren’t just
suing for money damages. They also asked for injunctive relief in their amended complaint,
petitioning the court to shut Facebook down.

If you were in Mark Zuckerberg’s shoes, and you were sued for copyright infringement, what
would you do? Would you prefer to take your chances and go to trial, or would you prefer to
avoid the uncertainty and expense of litigation by settling this case out of court? If the latter,
what would be the most amount of money you would be willing to pay ConnectU to settle this
case out of court?
By the same token, if you were in the shoes of the Winklevoss twins, what course of action
would you prefer? Would you rather settle or take your chances by going to trial? What’s the
minimum amount of money you would accept to settle?

Place your bets

Going to trial is a lot like placing a bet. Why? Because litigation is costly, and the outcome of a
case is often uncertain or risky.

To see why, consider the ConnectU case from the plaintiff’s perspective. If the Winklevii decide
to settle out of court instead of going to trial, they may have to settle for less than what they think
their case is really worth. But if they decide to go to trial, they may get nothing at all. In other
words, the plaintiff could win it big if he takes his case to trial, but there is a risk of recovering
nothing if he goes to trial.

Now, consider the decision to settle or go to trial from the Zuckerberg’s standpoint. To settle out
of court, he may have to pay the plaintiffs more than what he thinks is fair, but if he goes to trial,
you might get hit with an even larger judgment against him.

By settling out of court, both parties are able to avoid the direct cost of further litigation, and
they can also avoid the risk and uncertainty of going to trial. But how much should the parties
settle their case for? What determines the “settlement range” in any given legal case?

The settlement range

One of the most interesting properties of litigation is that a lawsuit is not just about conflict.
Litigation also opens up the possibility of cooperation through settlement.

On the one hand, it’s obvious that the parties are in conflict: The plaintiff, after all, is suing the
defendant and would like to obtain as much money damages as he is entitled to. The defendant,
in turn, would like to minimize the amount of damages. At the same time, the parties also share a
common interest in avoiding the risk and cost of going to trial. They may thus share a common
interest in reaching a mutually beneficial settlement out of court.

At the same time, even when the parties share some common interests, they are still in conflict.
After all, from a plaintiff’s perspective, why should he agree to a low settlement offer if there is a
chance he could win it big at trial? Likewise, from a defendant’s point of view, why should she
agree to pay a large settlement when she may not have to pay anything if she wins at trial or on
appeal? We can thus refer to litigation as a “mixed conflict-cooperation game” or “mixed-motive
game.” (See Schelling, 1980, pp. 86-89.) In other words, litigation can be modeled as a game
involving a complex mixture of conflicting and common interests.

Therefore, for settlement negotiations to succeed, both parties must agree that an out-of-court
settlement is in their mutual interest. That is, there must be a viable settlement range, i.e. an
overlap between what the defendant is willing to pay and what the plaintiff is willing to accept.
A mutually beneficial settlement range, or zone of possible agreement, exists when the minimum
amount or price that the plaintiff is willing to accept to settle his case out-of-court is less than the
maximum price the defendant is willing to pay to settle the case. We can picture the settlement
range or zone of possible agreement as follows:

In this diagram, the blue rectangle represents the amount of money the defendant is willing to
pay to settle the case out of court. The yellow rectangle represents the amount of money the
plaintiff is willing to accept to settle out of court. The green rectangle thus represents the
settlement range (or zone of possible agreement) in which a mutually beneficial agreement is
possible.

Some simple math

But how do we formally calculate this settlement range? The settlement range depends crucially
on what the parties to a case expect to gain or lose from going to trial. Specifically, the
settlement range is a function of two crucial factors: legal liability and monetary damages.

Legal liability refers to a person’s legal responsibility for her wrongful acts or for the wrongful
acts of certain third parties. Did the defendant or one of the defendant’s agents breach a legal
duty or harm the plaintiff in some unlawful way?

The legal liability of a defendant, however, is not always clear-cut or obvious. Again, consider
the case of ConnectU vs. Facebook. According to the facts alleged in ConnectU’s complaint,
Mark Zuckerberg, then a sophomore at Harvard, had initially agreed to help Tyler and Cameron
Winklevoss launch their website The Harvard Connection in the fall of 2003. The complaint also
alleges that the Winklevoss twins shared their source code and other trade secrets with
Zuckerberg during this time. But would the Winklevoss twins be able to prove that Zuckerberg
used their code or stole their trade secrets when he launched Facebook from his dorm room in
February 2004?

In short, the issue of liability is often a probabilistic one. The ultimate question on liability is,
“What are the odds that the plaintiff can prove that the other party is legally liable?” In a close
case, each party might assign odds of 50:50 to a finding of liability. Or, the parties may have
different probability estimates about whether the defendant will be found legally liable. Thus,
whether a case gets settled depends to a large degree on how realistic each party is in its
probability estimates about the most likely outcome of the case
Monetary damages refer to the amount of compensation a plaintiff is awarded when a defendant
is found liable for a civil wrong or other legally-recognized harm suffered by the plaintiff. The
plaintiff is usually required to spell out his damages in his complaint, but just because you ask
for something does not mean you will get the full amount you are asking for.

There is no one formula for calculating money damages. Damages depend on the extent and
severity of the plaintiff’s injuries and also on the type of case being litigated. Consider, for
example, a car accident case involving an injured plaintiff. If the plaintiff can prove that the
defendant is solely liable for his injuries, the plaintiff will potentially be entitled

(i) his out-of-pocket expenses for past and future medical bills
(ii) lost wages—the difference between how much the plaintiff would have made were he
not injured and how much he can earn now
(iii) compensation for his pain and suffering and emotional distress resulting from the car
accident.

This third category of damages is often called “non-economic damages.” Unlike medical
expenses and lost wages, pain and suffering/emotional distress damages are left to a jury to
decide.

Furthermore, the parties may often disagree about how to value the plaintiff’s damages. Non-
economic damages in particular (“pain and suffering”) can be very subjective and hard to prove.
The amount of lost wages can also be a matter of controversy, especially if the plaintiff is still in
school or is self-employed. Medical expenses too can generate disagreement; the defendant
might dispute some medical treatments as unnecessary or excessive.

In short, damages can be hard to pin down or estimate, especially when the parties disagree on
how much the plaintiff’s case is worth. A good rule of thumb is to visualize damages as
consisting of a range. The range starts at zero (if the jury rules for the defendant) and goes all the
way up to the plaintiff’s most optimistic assessment (the full amount of damages the plaintiff is
asking for in his complaint).

As a result of this inherent uncertainty about liability and damages, combined with the cost of
litigation, the decision whether to settle or go to trial becomes a strategic decision. The inherent
uncertainty and costliness of litigation is why we compared the decision of going to trial to the
act of placing a bet earlier in this chapter.

To sum up,

 In deciding whether to settle or go to trial, each party must first try to figure out the
settlement range of the case. If you are the plaintiff, you must ask yourself, “What is the
least amount of money I am willing to accept in order to settle my case out of court?” If
you are the defendant, you must ask, “What is the most I am willing to pay to settle?”

 The settlement range of a case, in turn, is a function of the parties’ expectations about
liability and damages.
 5.0 PROBLEM SET

1. Is “forum shopping” ethical?

2. In what court did the Winklevoss twins sue Mark Zuckerberg and Facebook? Why do you
think the twins chose that particular forum?

3. What are the pros and cons of settling out of court?

4. If you were Mark Zuckerberg, would you have settled your lawsuits with ConnectU and
Eduardo Saverin out of court, or would you have taken your chances and go to trial?

5. If you were Mark Zuckerberg (CEO of Facebook, Inc.), what actual or potential litigation
risk should you be most worried about, and what steps would you take to reduce or minimize
this risk? (Hint: be sure to identify the type of litigation risk in question, i.e. civil litigation,
criminal prosecution, or regulatory enforcement action, as well as the type of strategy you
would use, i.e. evasion, compliance, prevention, etc.)
6.0 ETHICS IN THE DIGITAL AGE

Facebook’s Secret Psych Experiment

Image 6-1
 6.0 ARTEFACT

“Editorial Expression of Concern”

Editorial Expression of Concern …

PSYCHOLOGICAL AND COGNITIVE SCIENCES PNAS is publishing an Editorial Expression of Concern

regarding the following article: “Experimental evidence of massive-scale emotional contagion through
social networks,” by Adam D. I. Kramer, Jamie E. Guillory, and Jeffrey T. Hancock, which appeared in
issue 24, June 17, 2014, of Proc Natl Acad Sci USA. This paper represents an important and emerging
area of social science research that needs to be approached with sensitivity and with vigilance regarding
personal privacy issues.

Questions have been raised about the principles of informed consent and opportunity to opt out in
connection with the research in this paper. The authors noted in their paper, “[The work] was consistent
with Facebook’s Data Use Policy, to which all users agree prior to creating an account on Facebook,
constituting informed consent for this research.” When the authors prepared their paper for
publication in PNAS, they stated that: “Because this experiment was conducted by Facebook, Inc. for
internal purposes, the Cornell University IRB [Institutional Review Board] determined that the project
did not fall under Cornell's Human Research Protection Program.” This statement has since been
confirmed by Cornell University.

Obtaining informed consent and allowing participants to opt out are best practices in most instances
under the US Department of Health and Human Services Policy for the Protection of Human Research
Subjects (the “Common Rule”). Adherence to the Common Rule is PNAS policy, but as a private
company Facebook was under no obligation to conform to the provisions of the Common Rule when it
collected the data used by the authors, and the Common Rule does not preclude their use of the data.
Based on the information provided by the authors, PNAS editors deemed it appropriate to publish the
paper. It is nevertheless a matter of concern that the collection of the data by Facebook may have
involved practices that were not fully consistent with the principles of obtaining informed consent and
allowing participants to opt out.

Inder M. Verma

Editor-in-Chief
 6.0 CHAPTER ESSAY

What ethical or moral duties does Facebook owe to its users?

For a week in January 2012, over 689,000 Facebook users were secretly experimented on
without their knowledge or any meaningful consent. But was this experiment ethical, or even
legal?

THE SECRET PSYCH EXPERIMENT

Researchers at Facebook, Cornell, and UCSF (the University of California, San Francisco)
conducted a massive social psychological experiment on hundreds of thousands of Facebook
users by tinkering with their individual News Feeds--the continuous stream of status updates,
photos, and news articles that appears on each user’s Facebook account. Facebook secretly
altered the algorithm that determines what content shows up in each user’s News Feed. Some
people were shown mostly positive or happy News Feeds, while others were shown mostly
negative or sadder-than-average News Feeds.

The researchers working with Facebook were studying how emotions might spread in a
population of Facebook users, and they eventually published their research results in the
Proceedings of the National Academy of the Sciences in June 2014. (See Kramer, et al., 2014.)
In particular, the researchers claimed to have found evidence of “emotional contagion”; that is,
by modifying the Facebook News Feed to contain slightly more positive or more negative
postings, the researchers were able to observe a small but statistically significant impact on
users’ posting habits. For example, if you see lots of positive posts on Facebook, you are
marginally more likely to post something positive yourself.

HOW A/B TESTING WORKS

Facebook’s secret psych experiment is a textbook example of “A/B testing.” The essence of A/B
testing is to separate an otherwise undifferentiated population based on a single factor and then
to evaluate the behavior of one group against another. Online, this usually means silently
redirecting visitors to a landing page programmed to display variations on a sales pitch, and then
noticing which approach results in more clicks on the primary call-to-action button. In stores, it
can mean shelving the same items differently across otherwise identical Walmart stores, playing
upbeat or downbeat background music on alternate weeks at Starbucks, or experimenting with
the color and size of the lettering on the value menu at McDonald’s.

Facebook’s secret study, however, generated a huge public outcry and produced a lot of negative
publicity for Facebook. The Proceedings of the National Academy of the Sciences even
published an “Editorial Expression of Concern,” and one law professor, James Grimmelmann,
who teaches at the University of Maryland, argued that the actions of Facebook were “illegal,
immoral, and mood-altering.” (See Grimmelmann, 2014.)
In addition, the Electronic Privacy Information Center (EPIC) filed a formal complaint with the
Federal Trade Commission on July 3, 2014, claiming that Facebook had broken the law when it
conducted the study on the emotions of its users without their knowledge or consent. In its
complaint, EPIC alleged that Facebook had deceived its users by secretly conducting a
psychological experiment on their emotions: “At the time of the experiment, Facebook did not
state in the Data Use Policy that user data would be used for research purposes. Facebook also
failed to inform users that their personal information would be shared with researchers.” (See
Electronic Privacy Information Center (EPIC), “In re: Facebook (Psychological Study),” not
dated, available at URL = https://epic.org/privacy/internet/ftc/facebook/psycho/.)

Although Sheryl Sandburg, Facebook’s COO, issued a half-hearted non-apology apology on

behalf of Facebook, stating that the study “was part of ongoing research companies do to test
different products” and that it “was poorly communicated and for that [lack of] communication
we apologize,” the reality is that Facebook and other major websites like Google and OkCupid
continue to engage in this practice.

THE CONSENT ISSUE

Facebook did not inform its users of this particular experiment ahead of time or allow any of
them to opt out of the experiment.

From Facebook’s perspective, one could argue that it is not required to do these things. After all,
when users first sign up for Facebook, they must accept Facebook’s terms of use, which
incorporates a detailed data policy. (See Facebook user agreement, available at URL =
https://www.facebook.com/terms.) Specifically, here is the relevant clause in Facebook’s terms
of use:

Your privacy is very important to us. We designed our Date Policy to make important
disclosures about how you can use Facebook to share with others and how we collect
and can use your content and information. We encourage you to read the Data Policy,
and to use it to help you make informed decisions.

Notice that Facebook’s terms of use make reference to a separate “Data Policy.” You actually
have to click on the words “data policy,” which takes you to a new page, and then click again on
“View the complete Data Policy,” in order to read the entire policy. (See Facebook Data Policy,
available at URL = https://www.facebook.com/full_data_use_policy.) Among other things,
Facebook’s data policy states:

We collect the content and other information you provide when you use our Services,
including when you sign up for an account, create or share, and message or
communicate with others. This can include information in or about the content you
provide, such as the location of a photo or the date a file was created. We also collect
information about how you use our Services, such as the types of content you view or
engage with or the frequency and duration of your activities.
Is this fair or ethical? Some legal scholars consider Facebook’s user agreement to be a weak
form of consent. They argue that Facebook should provide its users the option to opt out from
these experiments. (See, e.g., Grimmelmann, 2014.)

Nor did Facebook submit its secret social psychology experiment to an Institutional Review
Board (an independent ethics committee that requires scientific experiments to abide by consent
and safety standards) for pre-approval. Instead, the social giant considered its experiment just
another A/B test, which most tech companies and start-ups engage in on a regular basis.

THE HARM ISSUE

One way of deciding whether A/B testing is ethical is to focus on whether there is a risk of harm
when a test is done. For example, if Facebook wants to know which shade of blue to use in its
user interface, it might use A/B testing to try a few different shades and measure users’
responses. This is ethical because no user is harmed, especially if the only result is that the
service better serves users.

Other uses of A/B testing might be unethical. Consider a study in which users are incited to
commit violent acts against immigrants in order to test the psychology of racism in an online
environment. Such a study would have to be unethical because it generates significant risk of
harm. So the question is not whether A/B testing is always ethical or unethical, but rather where
companies like Facebook draw the line between ethical and unethical uses. Where would you
draw this line?

One possible solution is to consider the risks of each test on a case-by-case basis. Specifically,
where the risks are minimal, A/B testing (even without consent) might not be ethically
objectionable, as in the shades-of-blue example. (See, e.g., Felten, 2014.) But at the same time,
where the risks are extremely high or there are significant risks to nonparticipants, as in the
immigrant-violence example, the test is most likely unethical even with consent from
participants. (Ibid.)

Where exactly to draw this line, and what processes a company should use to avoid stepping
over the line, is left to the reader.
 6.0 PROBLEM SET

1. Did Facebook’s purposeful manipulation of users’ News Feeds create any substantial risk of
harm to those users? Why or why not?

2. Should online experiments be strictly regulated by the government, or would strict regulation
be counterproductive?

3. As a matter of ethics, should Facebook give its users the option to opt-out of A/B testing in
the future? What ethical theory do you think is relevant to this question?

4. Christian Rudder, the president of OkCupid, an online dating site, defended Facebook’s
actions by pointing out the prevalence of A/B testing in the online world: “Guess what,
everybody: if you use the Internet, you’re the subject of hundreds of experiments at any
given time, on every site. That’s how websites work.” Is this argument morally compelling or
persuasive? Why or why not?

5. As a publicly-traded corporation, the law imposes on Facebook’s directors and officers a

fiduciary duty to act in the best interest of their shareholders and institutional investors. In
addition, does Facebook owe any legal or extra-legal duties to its users or to society at large?
 EPILOGUE

Logging Off

It’s time to log off, so to speak.

Recall opening scene in The Social Network, the crowded bar scene, when Mark asks himself:
“How do you distinguish yourself in a population of people who all got 1600 on their SATs?”
(Sorkin, 2010, p. 1).

The same preoccupation pops up in the 2001 movie “A Beautiful Mind,” when a young John
Nash says: “I can’t waste time with textbooks or classes. I have to come up with a truly original
idea. It’s the only way I’ll distinguish myself.” (Goldsman, 2000, p. 6)

This is no coincidence.

Although Nash and Zuckerberg ended up distinguishing themselves in radically different ways--
one man devoted himself to mathematics; the other, to creating an Internet empire--both
individuals changed the way we see the world.

Among other things, the mathematician John Nash went on to become a Nobel Laureate for
discovering and formulating the “Nash equilibrium” solution concept in game theory. Although
the doctoral dissertation in which he announced his eponymous equilibrium is only 27 pages (see
Kuhn & Nasar, 2002, pp. 53-84), his idea was so original and useful that Nash forever changed
the mathematical world.

For his part, Mark Zuckerberg went on to become the youngest billionaire on the planet.
Although it only took him “about a week of coding” to create the beta version of Facebook
(Tabak, 2004), he was able to distinguish himself early on by creating a “clean and simple”
Internet platform for his fellow college students, a digital social network that ended up touching
the lives--for better or worse--of hundreds of millions of people.

***

We close with a question from Peter Thiel, Facebook’s first outside investor. Thiel wrote a how-
to book for startups called Zero to One, and he opens his book with the following provocative
question: “What important truth do very few people agree with you on?” (Thiel, 2014, p. 5.)
Notice that Thiel’s question and Zuckerberg’s (in the opening scene of The Social Network) are
really one and the same. Whether it’s “The Facebook” or the concept of Nash equilibrium or
your own secret truth, one way of distinguishing yourself is by coming up with your own good
answer to Thiel’s question.

But let’s not end with Zuckerberg, Thiel, or Nash. As great as their accomplishments are, this
isn’t the end of our story. Nash, Thiel, and Zuckerberg raise a newer and even more important
question:

How in the world are you going to distinguish yourself?

So, what are you waiting for? This is not the end; it’s only the beginning. Log back on and get
started …
 MATHEMATICAL APPENDIX

“Essentially, all models are wrong, but some are useful.”

(Box & Draper, 1987, p. 424.)

Here, we present a formal model of the decision whether to settle or go to trial. But before we
proceed any further, let’s explain what a formal model is and why such models can be useful. A
formal model is a thought-experiment, a conjecture about the world. (Lipshaw, 2017, p. 81.) For
example, what would happen to A if we did B? In addition, models boil a problem down to its
most essential elements, so models tend to be simple and abstract.

Is this a feature, or a bug? Because models are so reductionist, it’s tempting to dismiss models as
contrived or pointless. Nevertheless, there are several reasons why models can still be useful.
(See Epstein, 2008.) To begin with, models can help us become better thinkers. How? By
requiring us to state our assumptions about the problem we are modelling up front. Models can
also help us become better decision-makers by challenging our deepest intuitions about the
problem we are modelling. But most importantly, models help us understand the world around
us.

With this background in mind, let’s build our simple model of the decision whether to settle or
go to trial.

The Model

Assume the plaintiff’s expected gain from going to trial is the judgment if he wins, discounted by
the plaintiff’s estimate of his probability of winning, minus his litigation costs. This general idea
can be stated formally as follows:
Jp = (J × Pp) – C

Note how we subtract the plaintiff’s litigation costs, C, from his expected gain, J × Pp, since he
must pay his lawyer to take his case to trial and collect the judgment.

Next, assume the defendant’s expected loss from going to trial is the judgment if she loses,
discounted by the defendant’s estimate of the plaintiff’s probability of winning, plus her
litigation costs. Again, this can be stated formally as follows:

Jd = (J × Pd) + C

(Here we add the defendant’s legal fees to her expected loss because the defendant must pay her
own legal fees even if she loses the case.)

For simplicity, let’s make the following assumptions:

(1) The parties are risk-neutral;

(2) they share the same valuation of the case--that is, both sides think the case is worth J; and
(3) the costs of going to trial, C, are the same for both sides.

In other words, we are holding the variables J and C constant in order to focus on Pp and Pd, each
party’s respective probability estimates of the plaintiff’s chances of winning. Given these
simplifying assumptions, we would expect litigation to occur when the plaintiff’s net expected
gain from going to trial is greater than the defendant’s expected loss from going to trial, that is,
when Jp > Jd.

This simple model of litigation and settlement is useful because it shows the crucial role the
parties’ probability estimates play in determining the size of the settlement range. In addition,
this model also shows how the parties’ probability estimates influence the decision whether to
settle or go to trial.

Specifically, we would expect the parties to go to trial instead of settling when both sides are
optimistic about their chances of winning if the case goes to trial, i.e., when Pp > Pd. Both parties
will be willing to incur the costs of litigation, since both sides believe they will win. By contrast,
when both parties’ probability estimates about the likely outcome of the case are the same (i.e.,
when Pp = Pd), we would expect the parties to settle for some amount within the settlement range
in order to avoid the costs of litigation.

Lastly, if the plaintiff is more pessimistic than the defendant about the likely outcome of the case
(i.e., Pp < Pd), we would also expect the parties to settle to avoid the costs of litigation.

Numerical Example

To illustrate this simple model, let’s consider an arithmetical example in which Jp is greater than
Jd (Jp > Jd). Assume J is $100 and C is $30. Let’s also assume that Pp is 0.9 and that Pd is 0.5. In
other words, the plaintiff is optimistic about his chances: he thinks he has a 90% chance of
winning his case. The defendant is less confident about the outcome; she believes she has, at
best, a 50% chance of winning. Now, let’s plug these values into our formal model of litigation
and settlement.

For the plaintiff:

Jp = (J × Pp) – C

Jp = ($100 × 0.9) – $30 = $90 – $30 = $60

Likewise, for the defendant:

Jd = (J × Pd) – C

Jd = ($100 × 0.5) – $30 = $50 – $30 = $20

In other words, the plaintiff thinks the case is worth $60, given his probability estimate. The
defendant believes the case is worth only $20, given her probability estimate. Therefore, we
would expect this case to go to trial because there is no room for a mutually beneficial
agreement.

Next, consider a numerical example in which Jp is less than Jd (Jp < Jd). Again, for consistency,
let’s assume that J is $100 and C is $30. This time, though, let’s assume that the plaintiff is not
as optimistic about winning as the defendant is. Specifically, let’s assume Pp is 0.6 and Pd is 0.8.
Plugging these values into our model, we see that:

Jp = (J × Pp) – C = ($100 × 0.6) – $30 = $60 – $30 = $30

and

Jd = (J × Pd) – C = ($100 × 0.8) – $30 = $80 – $30 = $50

We would thus expect this case to settle: The plaintiff thinks the case is worth $30, while the
defendant believes it’s worth $50. In other words, in this example there is a settlement range, i.e.,
the range is between $30 and $50, so there is room for the parties to reach a mutually beneficial
agreement to settle their dispute out of court. (Instead of explaining what happens when Jp = Jd,
we leave this as an end-of-chapter exercise for the student to work on.)

But what deal would we expect the parties to reach when there is room for a mutually beneficial
agreement? Specifically, how would they divide this potential surplus if they settle out of court
(i.e., the difference between $30 and $50 in this example)? There are two possibilities. The
parties might agree to “split the difference,” or they might engage in brinksmanship, i.e., they
might make unrealistic offers in order to obtain the lion’s share of the surplus.
To recap, our model is overly simplistic, so why is it useful? For starters, it formalizes our
intuitions about settlement ranges in law cases and help us understand when a litigant is more
likely to settle his case out of court or more likely to go to trial. Specifically, our model teaches
us the following lessons about this decision:

 Settlement negotiations will not occur unless there is a mutually beneficial settlement
range.

 The settlement range depends crucially on the parties’ probability estimates of the
outcome of their case if it goes to trial.

 In general, the better a plaintiff expects to do if his case goes to trial--i.e., the more likely
he believes he will win and the greater the amount of damages he expects to recover--the
greater the settlement amount he will have to be paid as a condition for agreeing to settle.

 By contrast, the better a defendant expects to do if the case goes to trial, the less she will
be willing to pay to settle the case. Divergent party beliefs about the likely outcome of
trial thus make it more likely a bargaining impasse will occur; i.e., more likely the case
will go to trial.

Postscript: Nash bargaining

In Chapter 5.0, we saw that settling out of court has the advantage of allowing the parties to
avoid the risks and costs of litigation. At a minimum, a settlement agreement will generate a
surplus for the parties in the form of saved litigation costs.

But how will the parties divide this surplus?

After all, the existence of a settlement range itself does not tell us what price the parties will
settle for. (See, e.g., Posner, 2003, p. 568, emphasis in original: “the existence of a range means
that there is no unique settlement price”) One possibility is for the parties to “split the difference”
by choosing the midpoint of the settlement range.

Mathematician John Forbes Nash (pictured below), for example, developed what he called the
axiomatic approach to bargaining. In the context of litigation, this approach predicts that the
parties to a lawsuit will agree to “split the difference” by settling at the midpoint of the
settlement range.
To understand Nash’s approach, let’s revisit our formal model of litigation from the previous
section. We modelled both parties’ financial expectations from going to trial as follows:

 The plaintiff’s expected gain is the judgment if he wins, discounted by the plaintiff’s
estimate of his probability of winning, minus his litigation costs: Jp = (J × Pp) – C.

 The defendant’s expected loss is the judgment if she loses the case, discounted by the
defendant’s estimate of the plaintiff’s probability of winning, plus her litigation costs:
Jd = (J × Pd) + C.

In other words, without a settlement, the plaintiff’s payoff is Jp, and the defendant’s is Jd. Thus,
Jp and Jd represent the “outside options” or “disagreement values” of the parties. With a
settlement, each party earns some fraction of S if they agree to settle the case out of court.

As we mentioned previously, John Nash developed the so-called axiomatic approach to

bargaining. Nash’s approach predicts that the parties to a lawsuit will agree to “split the
difference” by settling at the midpoint of the settlement range. If the gains from bargaining are
positive, that is, if S – (Jp + Jd) > 0, then the axiomatic approach predicts that such gains will be
split evenly by the parties as follows:

The plaintiff obtains: Jp + [S – (Jp + Jd)]/2 = (S + Jp – Jd)/2

Similarly, the defendant obtains: Jd + [S – (Jp + Jd)]/2 = (S + Jd – Jp)/2

This model of bargaining shows that each player’s share of the split depends on two estimates:

(1) how much the settlement agreement itself is worth; and

(2) the parties’ “outside options” (Jp and Jd) or alternatives to settlement, that is, what the parties
expect to gain or lose if the case goes to trial. (See generally Hay & Spier, 1998.)

This axiomatic result (i.e., “split the difference”) allows us to see the importance of the parties’
outside options in litigation. Before a plaintiff files his complaint in court or sends a demand
letter to the defendant, the defendant has less to gain to by reaching agreement, since the
possibility of litigation is still remote. But after the plaintiff files a complaint or after he signals
his intent to sue through a demand letter, the defendant has more to gain by reaching agreement.
Moreover, the more likely the plaintiff will win his case, the stronger the plaintiff’s outside
option is. In that situation, he can become a tougher bargainer, since he has less to gain by
reaching agreement than by going to trial.

The general logic of this analysis is as follows: When one party has a good alternative to
settlement--i.e., a high probability of winning if the case goes to trial--we would expect that party
to be less eager to settle out of court. Why? Because that party’s potential gain to reaching an
agreement is smaller than the other party’s potential gain. Put another way, the other party has
more to lose if the case goes to trial.

This result also tells us how litigation costs might shape the outcome of bargaining in settlement
negotiations. Previously, we assumed that the costs of going to trial were the same for both
parties. In reality, however, one party may have greater litigation costs than the other.

For simplicity, let’s assume the litigation costs of the plaintiff are twice as large as the litigation
costs of the defendant and that both sides estimate the plaintiff’s chances of winning if the case
goes to trial at 50/50. Given these assumptions, the plaintiff now has more to gain by reaching
agreement, since he will avoid the cost of 2C if he settles out of court.

In general, the axiomatic view of bargaining tells us that when one party has more to gain by
reaching agreement, he is in a weaker bargaining position than the other side, all other things
being equal.

But what if the parties disagree about the values of their outside options or their alternatives to
settlement?

To sum up:

 Settlement negotiations are form of bargaining.

 One method of bargaining is to “split the difference.”
 The view of litigation and settlement as bargaining emphasizes the “outside options” or
alternatives to settlement of the parties.
 When a party has less to gain by reaching agreement, he is in a stronger bargaining
position than the other side.
 The plaintiff, for example, will obtain a more favorable settlement than otherwise if his
outside option of going to trial is better than the defendant’s (i.e., if Jp > Jd).
 By the same token, when one party has more to gain by reaching agreement (because his
chances of winning at trial are low or because his litigation costs are high or both), he is
in a weaker bargaining position than the other side.
 APPENDIX: PROBLEM SET

1. Does the scenario below have a settlement range? If so, what is it?

* Plaintiff sues defendant for $1 million.

* Legal fees will cost each side $100,000 if the case goes to trial.
* Each side believes that the chance of plaintiff winning at trial is ½.

2. Does the scenario below have a settlement range? If so, what is it?

* Plaintiff sues defendant for $1 million.

* Legal fees will cost each side $100,000 if the case goes to trial.
* Plaintiff believes his chance of winning is ¾.
* Defendant believes the plaintiff’s chance of winning is only ¼.
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 IMAGE CREDITS

Cover Page, Disclaimers, and Acknowledgements

Collage of Facebook profile pictures

Warning icons (page *) -- Shutterstock: https://www.shutterstock.com/image-vector/vector-

illustration-warning-icons-610721816

Facebook emojis (page *) -- Shutterstock: https://www.shutterstock.com/image-photo/kiev-

ukraine-november-07-2016-new-511610545

Chapter 0.0

Login icon (page *) -- Shutterstock: https://www.shutterstock.com/image-photo/prague-czech-

republic-january-22-login-176484542

Bechdel test (page *) -- Wikipedia: https://en.wikipedia.org/wiki/Bechdel_test

Facebook profile picture of author (page *) -- F. E. Guerra-Pujol

Chapter 1.0

The Elo chess ranking algorithm (page *) -- F. E. Guerra-Pujol

Chapter 2.0

Lady Justice (page *) -- Shutterstock: https://www.shutterstock.com/image-illustration/statue-

god-justice-themis-femida-balance-56760070327

Chapter 3.0

Facebook;s original logo (page *)

Facebook’s original homepage (page *)

Chapter 4.0

1 Hacker Way (page *) -- Shutterstock: https://www.shutterstock.com/image-photo/20161226-

facebook-headquarters-1-hacker-way-552496291

Facebook stock certificate (page *) -- Securities and Exchange Commission:

https://www.sec.gov/Archives/edgar/data/1326801/000119312512046715/g293924g51e47.jpg
Chapter 5.0

Lucky dice? (page *) -- Shutterstock: https://www.shutterstock.com/image-vector/dice-icon-two-

game-dices-casino-517066324

Zone of possibile agreement (page *) -- Joseph Neurauter: http://strategicaccords.com/go-ahead-

make-the-first-salary-offer/

Chapter 6.0

Legal/ethical chart (page *) -- F. E. Guerra-Pujol

Epilogue

Log off icon (page *) -- Shutterstock: https://www.shutterstock.com/image-vector/turn-off-

vector-icon-illustration-style-582050101

Mathematical Appendix

Science equations (page *) -- Shutterstock: https://www.shutterstock.com/image-vector/physical-

notation-equations-figures-schemes-plots-519740920

John Forbes Nash (page *) -- Shutterstock: https://www.shutterstock.com/image-photo/john-

nash-academy-awards-3242002-la-187220042

About the Author

Picture of the author (page *) -- F. E. Guerra-Pujol

 GLOBAL BIBLIOGRAPHY

A word about citations. If a parenthetical citation contains a page number, this means that the
cited source is printed material, such as a book, scholarly article, or other printed matter. On the
other hand, if the citation does not contain a page number, this means that the source was
published on the Internet, such a blog post, electronic essay, or other web-based publication.
Legal sources are listed separately.

PRINT SOURCES

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C. D. Broad, Five Types of Ethical Theory, Routledge (2013) [1930].

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_______________, “Cybertrespass,” The University of Chicago Law Review, Vol. 70, No. 1
(Winter, 2003), pp. 73–88.

Tamar Frankel, “Fiduciary duties,” in The New Palgrave Dictionary of Economics and the Law,
Vol. 2, Peter Newman, editor, Palgrave Macmillan UK (1998), pp. 127–128.

Akiva Goldsman, Screenplay for “A Beautiful Mind,” Universal Pictures (2001).

Aaron Greenspan, ***

F. E. Guerra-Pujol, “Facebook 101,” Faculty Focus, Vol. 15, no. 1 (2016), pp. 5–6.

Bruce L. Hay and Kathryn E. Spier, “Litigation and Settlement” in The New Palgrave
Dictionary of Economics and the Law, Vol. 2, Palgrave Macmillan UK (1998).

David Kirkpatrick, The Facebook Effect: The Inside Story of the Company that Is Connecting
the World, Simon & Schuster (2010).

Adam D. Kramer, Jamie E. Guillory, and Jeffrey T. Hancock, “Experimental Evidence of

Massive-scale Emotional Contagion through Social Networks,” Proceedings of the National
Academy of Sciences, Vol. 111, no. 24 (2014), pp. 8788–8790.

Harold W. Kuhn and Sylvia Nasar, editors, The Essential John Nash, Princeton (2002)

Jeffrey Lipshaw, Beyond Legal Reasoning: A Critique of Pure Reasoning, Routledge (2017).
Farhad Manjoo, “Can Facebook Fix Its Ultimate Bug?,” The New York Times Magazine (30 Apr
2017), pp. 38-42 & p. 60.
Shelley McGill, “The Social Network and the Legal Environment of Business: An Opportunity
for Student-Centered Learning,” Journal of Legal Studies Education, Vol. 30, no. 1
(Winter/Spring 2013), pp. 45-97.

Sean Melvin & F. E. Guerra Pujol, The Legal Environment of Business: A Managerial
Approach: Theory to Practice, 3rd edition, McGraw-Hill (2017).

Ben Mezrich, The Accidental Billionaires: The Founding of Facebook, a Tale of Sex, Money,
Genius, and Betrayal, Anchor Books (2010).

John F. Nash, “The Bargaining Problem,” Econometrica, Vol. 18, No. 2 (Apr 1950), pp. 155–
162.

Richard A. Posner, Economic Analysis of Law, 6th edition, Aspen Publishers (2003).

James Rachels and Stuart Rachels, The Elements of Moral Philosophy, 8th edition, McGraw-Hill
(2014).

Charles Rembar, The Law of the Land: The Evolution of Our Legal System, Simon & Schuster
(1980).

Thomas C. Schelling, The Strategy of Conflict, 2nd edition, Harvard (1980).

Aaron Sorkin, Screenplay for The Social Network, Columbia Pictures (2010).

Peter Thiel, Zero to One: Notes on Startups, or How to Build the Future, Crown Business
(2014).

Raymond Wacks, Law: A Very Short Introduction, Oxford (2008).

WEB SOURCES

Bianca Bosker, The binge breaker,” The Atlantic (Nov 2016), available at
https://www.theatlantic.com/magazine/archive/2016/11/the-binge-breaker/501122/.

Jeffrey W. Bullock, Secretary of State (Delaware), About agency, Delaware Division of

Corporations, available at http://www.corp.delaware.gov/aboutagency.shtml.

Asher Cantrell, Ten famous films that surprisingly fail the Bechdel test, filmschoolrejects.com
(11 Nov 2013), available at https://filmschoolrejects.com/10-famous-films-that-surprisingly-fail-
the-bechdel-test-e54ce002bcfc.
Rebecca Davis O’Brien, The Social Network’s female props, The Daily Beast (03 Oct 2010),
available at http://www.thedailybeast.com/articles/2010/10/03/the-social-networks-women-arent-
prizes-theyre-props.html.

Joshua M. Epstein, Why model?, Santa Fe Institute Working Paper 2008-09-040 (2008),
available at http://www.santafe.edu/media/workingpapers/08-09-040.pdf.

Ed Felten, On the ethics of A/B testing, Freedom to Tinker (08 Jul 2014), available at
https://freedom-to-tinker.com/blog/felten/on-the-ethics-of-ab-testing/.

Akiva Goldsman, Screenplay for A Beautiful Mind, available at

http://www.cinefile.biz/script/beautifulmind.pdf.

James Grimmelmann, “Illegal, immoral, and mood-altering: how Facebook and OkCupid broke
the law when they experimented on users,” Medium (23 Sep 2014), available at
https://medium.com/@JamesGrimmelmann/illegal-unethical-and-mood-altering-8b93af772688.

Minnie Ingersoll, Silicon Valley’s gender gap problem is really a culture problem,” Quartz (07
Apr 2016), available at https://qz.com/656436/silicon-valleys-gender-gap-problem-is-all-about-
the-culture/.

Jason J. Jones, The algorithm for facemash in The Social Network, The Shotgun Approach (8
Oct 2010), available at https://shotgunapproach.wordpress.com/2010/10/08/the-algorithm-for-
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Belinda M. Juran, Trade secret protection for source code, WilmerHale (17 Jul 2001), available
at https://www.wilmerhale.com/pages/publicationsandnewsdetail.aspx?NewsPubId=91018.

Sarah Jeong, Should we be able to reclaim a racist insult--as a registered trademark?, The New
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a-registered-trademark.html.

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http://www.pnas.org/content/111/24/8788.full.

David Larochelle, How the social network got it wrong: facemash and the dangerous
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facemash-and-the-dangerous-propagation-of-the-myth-of-network-scarcity/.

Liza Mundy, Why is Silicon Valley so awful to women?, The Atlantic (Apr 2017), available at
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women/517788/.
Seth A. Northrop, Software and trade secrets: rethinking IP strategies after CLS v. Alice,
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strategies-after-cls-v-alice#_ftn1.

Mansi Shah, Is your code protected?, medium.com (28 Aug 2015), available at
https://medium.com/swlh/is-your-code-protected-70735e2e386.

Aaron Sorkin, Screenplay for The Social Network, Columbia Pictures, available at
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y.pdf.

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HARVARD CRIMSON

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available at http://www.thecrimson.com/article/2003/11/19/facemash-creator-survives-ad-board-
the/.

Alan J. Tabak, Hundreds Register for New Facebook Website, The Harvard Crimson (09 Feb
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facebook-website/.

Bari M. Schwartz, Hot or Not? Website Briefly Judges Looks, The Harvard Crimson (04 Nov
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judges/.
[THIS PAGE IS INTENTIONALLY LEFT BLANK]
 AUTHOR BIO

Professor F. E. Guerra-Pujol was born in Los Angeles, California to Francisco Guerra and Oilda
Pujol. He attended college at the University of California at Santa Barbara, graduating with
highest honors, and received his Juris Doctorate from Yale Law School.

After practicing law for several years, Professor Guerra-Pujol began his academic career at the
Pontifical Catholic University of Puerto Rico. He is currently teaching at the University of
Central Florida.

His areas of research include IP, ethics, and the philosophy of law, and he is also the author of
many scholarly papers, journal articles, and book chapters, including “Gödel’s Loophole,” “A
Bayesian Model of Litigation,” and “The Poker-Litigation Game.” You can access his work
here: https://scholar.google.com/citations?user=-JOeicwAAAAJ&hl=en.
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