A Team Production Theory of Corporate Law

1. A Team Production Theory of Corporate Law Margaret M. Blair and Lynn A. Stout (1999) Virginia Law Review, 85(2): 247- 328. This version: Anand RV

2. Outline • Background • Part 1 - Economic theory of the firm • Principal-agent analysis • Property rights analysis • Part 2 - Basic structure of corporate law to assess, • Team production model • The mediating hierarchy • Part 3 – Preliminary analysis, application of team production model • Conclusion

3. Background • Who owns a corporation? • Economist and legal scholars: Shareholders • Bundles of asset collectively owned by shareholders (principals) who hire directors and officers (agents). • So the primary challenge is to • A) Reduce "agency costs" by keeping directors and managers faithful to shareholders. • B) Maximize shareholder wealth • The firm exists to minimize agency costs and maximize wealth • But this does not explain the public corporation. • Authors suggest that the main challenge is the team production problem

4. Economic theories of the firm Basic question in economic theory: Why do firms exist? • Ronald Coase’s work provide three paths to address this question, • The principal-agent approach • The firm helps address contracting problems between the principal and the agent through a nexus of contracts • The property rights approach • The firm helps address the residual rights problems through allocation of property rights • The team production approach • The firm helps address team production problems • Both the principal-agent approach as well as the property rights approach are incomplete in that they don’t explain why the corporation should become public • Specifically,how a theory of the public corporation as a solution to team production problems can explain key aspects of corporate law that scholars who favor the 1st two approaches have found troubling.

5. Principal – agent approach • Focus on bilateral relationships • Efficiency problems stem from monitoring challenges and decoupling between efforts and results • Approach is useful in analyzing contractual relationship but ignores production within the corporation, particularly less likely take into account that, • the agent might have trouble getting the principal to perform their end of the deal. • nor does it address situations in which part of the agent's job is to figure out what needs to be done (“a situation we suspect is the norm rather than the exception in most public corporations”) • Also many relationships are ambiguous

6. The property rights approach • This organizational problem arises when parties deal with each other over the course of a long-term productive relationship. • Complete contract is expensive or even impossible • Incomplete contract: how parties in a working relationship can fill in gaps in their understandings about who does what and who gets what in the course of a long-term productive relationship. • Though one mechanism identified is that joint enterprise, which, • Provides common ownership and control. • Shortcomings • It is not a theory of the publicly-traded corporation, per se. • Mis-characterizes the legal realities of most public corporations.

7. A theory of hierarchy • Combining the property rights and principal-agent approaches • All the relationships of the interest in production process are vertical. • Beyond that, • Hierarchy in corporations can play an important role in gathering and processing information. • Emphasizes the importance of the coordination that happens from top to bottom, and lateral among team members. • Particularly, the law of public corporations appears to actually eliminate the role of principal, imposing in its place an internal governance structure: mediating hierarchy – designed to respond to problems of horizontal coordination inherent in certain forms of team production,

8. Part 2 – team production analysis • Problem of organizing joint production team examined by, • Alchian and Demsetz (1972) • Holmstrom (1982) • Rajan and Zingales ( 1998) • Alchian and Demsetz (1972) • This article defines team production as “ production in which: (1) several types of resources are used; (2) the product is not simply a sum of separable outputs of each cooperating resources; and (3) not all resources used in team production belong to one person. • Alchian and Demsetz (1972) argue that hierarchies arise as a way to solve these problems. • They proposed that in a hierarchical production system, one member of the team should be assigned role of being a monitor, • Who makes us sure no one else shirks? • Hierarchies arise as a way to solve the problem with a monitor position. • Who monitors the monitor? The monitor becomes the residual claimant. • Assume that their monitoring could effectively detect and punish shirking among employees.

9. Holmstrom (1982) • Alchian and Demsetz ( 1972) assumption ignores the difficulty of monitoring the agent. • Ultimately acknowledges shareholder primacy • Whether it was possible to design a contract that prevented shirking. • Specially Holmstrom (1982) addresses how to write an employment contract that provides appropriate incentives for each member of a team to work hard and for the monitor to reduce employees from shirking. • Examined if it was possible to design a contract that prevented shirking and also satisfied a budget constraint. • Meaning that all of the joint output from team production is allocated to members of the team. • However concluded that such a contract could not be written

10. The mediating hierarchy approach • Rajan and Zingales (1988) • Modified the team production analysis in a subtle but critical way. • Those who adopt a property rights approach, have argued that if both parties, investments are difficult to monitor and measures and to reduce to explicit contracts, the best solution is to allocate control rights over joint venture. • Analysis suggests that the property rights solution to certain team production problems suffers from a serious shortcoming. • Although property rights can protect at least one team member's specialized investment, they can also empower that "owner" to capture economic rents by exploiting the other member's specialized investment. • Alternative approach by Rajan and Zingales (1988) suggests that both team members might improve their welfare by agreeing to give up control rights to a third party, an “outside” to the actual productive activity.

11. The mediating hierarchy theory of the (public) firm

12. A team production analysis of the law of corporations • Contemporary corporate scholars tend to posit that the function of the directors’ is to maximize the economic interests of the corporations’ shareholders. • Opposing camp of theorists emphasize the interests of other potential stakeholders such as employees, creditors, consumers, suppliers , or the local community require to run corporations. • Still some scholars argue that derivatives suits and shareholder votes provide shareholders primacy • Beyond that, hierarchy approach provides a more solid theoretical foundation for the basic structure of corporation law.

13. The role of the Board • Legal role of directors’ and their duties. • They are trustees more than agents • Can still be removed by shareholders • Owe their fiduciary duties to the corporate personality (i.e., to the corporation as a whole), and includes: • Duty of loyalty; • Duty of care – A narrowly defined concept when self dealing of the most obvious transactions and taking a “ corporate opportunity. • If they act in best interest of company then the protection of directors via Business judgment rule is applicable. .

14. Conclusion • Is the nexus of contracts a sufficient explanation? • This article propose an approach to thinking about public corporations that does not reject such contracting thinking but builds on it by acknowledging the limits of what can be achieved by explicit contracting or by assigning property rights • The firm exists to solve team production problems • Mediating hierarchy model offers many important aspects of corporate law much more robust than its alternatives, especially principal-agent model. • Highlights the importance of team production dynamics in the rise of public corporation • Team production theory concerns the fundamentally political nature of the corporation.