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. By : Awais Ahmed

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 • Basic question of who owns corporations? • Economist and legal scholars: Stakeholder • Supported by principal – agent model • Bundles of asset collectively owned by shareholders (principals) who hire directors and officers (agents). • In literature model has raised two recurring themes • A) Corporate law reduce "agency costs" by keeping directors and managers faithful to shareholders. • B) Public corporation maximize shareholder’s wealth. • Certain issue linked to principal-agent model such that, • Less likely unique to public entity and more or less focus on shareholders. • This led the authors’ to suggest alternative approach such that team production approach • It explains both the distinctive legal doctrines that apply to public corporations and the unique role of these business entities.

4. Economic theory of the firm Basic question in economic theory: Why do firms exist? • Ronald Coase work provide three path to address question, • The principal-agent approach • Explores contracting problem that arises on others behalf. • The property rights approach • Examines problem associated with coordinating productive activities • The team production approach • Considers the role hierarchy may play in policing against shirking problems that may arise in coordinating team production. • When applied to public corporation 1st two are incomplete however, last one shed much needed light on both the fundamental economic nature of modern public corporations and the governance problems. • 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 • Approach deals bilateral relationships between agent and principal. • May lead to an efficiency problem • Such that how can the principal write a contract that motivates the agent to do his best effort to accomplish the principal's goals? • 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 her 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).

6. The property right 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, but 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. • Alchianand 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 arises 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 ignore the difficulty of monitoring the agent. • Address by the principal-agent model • 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. • Holmstrom's (1982) conclusion-sometimes called "Holmstrom's impossibility theorem“ - was that such a contract cannot be written. • This model is highly abstract and mathematical.

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 right 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 approach • In mediating approach it no longer obvious that employee should be viewed as agents, • instead hierarchies are formed to address team production to control shirking and to reduce economic rent seeking among team members. • This becomes a source of (wealth) surplus, which led to horizontal interactions among members. • The function of the board of directors include, • Act as trustee for the corporation itself – mediating hierarchies • Balance team member competing interests to keep everyone in the coalition (a stakeholder management view)

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. • It is derivatives suit and voting rights of shareholders. • Beyond that, hierarchy approach provides a more solid theoretical foundation for the basic structure of corporation law.

13. A team production analysis of the law of corporations • Legal role of directors’ and their duties. • Literature discusses legal role of directors such as • They are trustees more than agents • Decision makers that are notcontrolled by any other stakeholders • Interestingly, shareholders can remove and elect directors • Literature discusses duties of directors such as, • Corporate directors 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 • Economist and legal theorist view corporation as a “ nexus of contracts” explicit and implicit. • 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. • Here explores another possibility : assigning control rights not to shareholders and not to stakeholders in the firm but to the board of directors. • Which is largely insulated from the direct control of any of the various economic interests that constute the corporations. • 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. • Overall Blair and Stout (1999) introduce the corporate law into governance context.