A Team Production Theory of
Corporate Law
Authors: Margaret M. Blair and Lynn A. Stout
Virginia Law Review, Vol. 85, No. 2 (Mar., 1999): 247-328
Presented by Nan Zhang
Overview
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Motivation
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Standard Economic Theory of the Firm
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Principal-agent analysis
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Property rights analysis
Team Production Analysis with Mediating Hierarchy Approach
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Traditional team production model
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The mediating hierarchy approach
Application of Team Production Analysis
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Corporation law with mediating hierarchy approach
Conclusion and Comments
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Motivation
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Who owns a corporation?
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Principal-agent model: Shareholders (principals) hire
directors and officers (agents) to manage bundles of
assets on their behalf.
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Two recurring themes in the literature:
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The central economic problem addressed by corporation
law is reducing “agency costs” by keeping directors and
managers faithful to shareholders’ interests.
The primary goal of the public corporation is maximizing
shareholders’ wealth.
Limitations of principal-agent model
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Not unique in public corporation.
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Only focus on shareholder primary norms, but ignore
the interests of all other parties.
Team production approach – Mediating Hierarchy
Model.
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Standard Economic Theory of the Firm
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Why do firms exist?
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Ronald Coase’s approach: The Nature of the Firm (1937)
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“Hierarchical” structure is introduced when it is too
costly and complicated to write contracts to direct and
control the product or service a shareholder is buying.
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Blair and Stout argue “using separate employment
contracts between the entrepreneur and each employee”
would solve the problem.
Further developed paths:
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The principal-agent approach;
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The property rights approach;
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The team production approach (which is not fully
explored in literature).
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Standard Economic Theory of the Firm:
Principal-agent approach
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A “principal” who wants to accomplish some project
she cannot do by herself hires an “agent” to do that
project on her behalf.
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Efficiency problem: How can the principal write a
contract that motivates the agent to do his best to
accomplish the principal’s goals?
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Useful in analyzing certain kinds of contractual
relationships, but ignore the possibilities that:
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The agent might have trouble getting the principal to
perform her end of the deal;
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Part of the agent’s job is to figure out what needs to be done
(more common in public corporations);
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The principal and agent relationship might be ambiguous
without a single more powerful authority over the other.
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Standard Economic Theory of the Firm:
Property rights approach
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When too costly to write and enforce complete
contracts, incomplete contracts become more
practical.
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Assigning property rights to one of the parties is a
solution for closing contractual gaps by giving that
party a residual right of control over the assets used
in the joint enterprise.
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Common ownership (common control).
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Limitation: Not applicable for public corporations.
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It is not a theory of corporation: Corporate law is clearly
not needed to achieve common ownership of assets.
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Mis-states the nature of shareholders’ interest in public
corporations.
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Standard Economic Theory of the Firm:
A Theory of Hierarchy
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Combing principal-agent and property rights approaches.
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Not for public corporations.
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Limitation:
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Ignore horizontal lateral interaction among team members;
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Transaction costs and other market imperfection often make it
impossible to achieve the required coordination through
individuals in markets or a set of explicit contracts.
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Traditional Team Production Analysis (1)
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Alchian and Demsetz (1972):
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Defined team production as: 1) several types of resources are
used; 2) the product is not separable; and 3) not all resources
used in team production belong to one person.
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Designing efficient incentives
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Shirking problems: Free-rider with in advance agreement.
Rent-seeking problems: Wasteful behavior without any agreement.
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Hierarchies arise as a way to solve these problems with a
monitor position.
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Ignore some of the most interesting economic questions:
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What are the sources of the economic surpluses in team production?
How can they best be harnessed and directed?
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Traditional Team Production Analysis (2)
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Holmstrom (1982):
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Addressed the agency cost problem (the difficulty of
monitoring the agent) and the free-rider problem.
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Whether it was possible to design a contract that prevented
shirking and also satisfied a “budget constraint”?
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“Holmstrom’s impossibility theorem”: Such a contract cannot
be written.
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One possible answer: Arranging for an outsider to absorb any
surplus that is not distributed to the team members but
without any control rights which can be used to influence the
outcome of the team’s efforts.
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Team members (executives and rank-and-file employees) vs.
budget breakers (shareholders).
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Mediating Hierarchy Approach (1)
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Rajan and Zingales (1998)
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Property rights approach cannot guarantee the investment
incentives of either the parties with and without control rights.
Both team members might improve their welfare by agreeing to
give up control rights to a third party, an “outsider” to the actual
productive activity.
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A “nexus of contracts” (firm-specific investment from one
individual) vs. a “nexus of firm-specific investments” (several
different groups contribute unique and essential resources).
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Team members (shareholders, executives, and employees) vs.
budget breaker (corporation itself as a mediating hierarchy).
Team members all agree to give up control rights over the output
from the enterprise and over their firm-specific inputs.
• No one party as the principal, but a board of directors.
• Third functions of a corporation: Encouraging firm-specific
investment in team production by mediating disputes among team
members about the allocation of duties and rewards.
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Mediating Hierarchy Approach (2)
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Sources of surplus: vertical coordination (hierarchy)
plus horizontal interactions among team members.
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The primary job of board of directors
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Not as an agent to pursue shareholders’ interests at the
expense of employee, creditors or other team members;
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But to act as trustees for the corporation itself –
mediating hierarchs – to balance team members’
competing interests to keep everyone in the coalition.
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Mediating Hierarchy Approach (3)
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Notes
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Private corporations (grand-design principal-agent model) vs.
public corporations (mediating hierarchy model).
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Directors do NOT actually manage the corporation on a dayto-day basis. Instead, most corporate decisions are made
among team members at lower levels.
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Not all team members that making firm-specific investment
will receive EQUAL, or FAIR, shares of the surplus, but at least
SOME portion.
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Directors are not required to be unselfish.
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Mediating hierarchy model is not perfect, but at least secondbest one.
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A Team Production Analysis of the
Law of Corporations (1)
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Literature describes American corporate law
following the shareholder primacy model.
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A “contractarian” or “law and economics” approach:
grand-design principal–agent model.
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A “communitarians” or “progressive” approach: serving
interests of shareholders as a ground and other
stakeholders.
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“Derivative suit” and voting rights of shareholders.
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However, corporate law does not treat directors as
shareholders’ agents but “independent hierarchs
who are charged not with serving shareholders’
interests alone, but with serving the interests of the
legal entity known as the corporation.”
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Thus, the mediating hierarchy approach provides a
more solid theoretical foundation for the basic
structure of public corporation law.
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A Team Production Analysis of the
Law of Corporations (2)
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Directors’ legal role: Trustees more than agents.
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The basis of principal-agent model (directors as agents)
is misleading from a legal perspective (Clark 1985).
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As the ultimate decision makers, directors are NOT
subject to direct control or supervision by anyone.
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Shareholders can elect and remove directors, but not
commend the board to action.
Corporation itself is as a “legal person”, serving as
“budget breaker”.
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Corporate directors owe their fiduciary duties to the
corporate personality.
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Derivative suit: Shareholders can only sue in derivative
cases to serve the interests of the firm as a whole, rather
than the interests of shareholders per se.
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A Team Production Analysis of the
Law of Corporations (3)
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Directors’ fiduciary duties
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Duty of loyalty: A narrowly defined concept (only when selfdealing of the most obvious transaction; and taking a
“corporate opportunity”).
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Duty of care (only theoretically)
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Protection of directors via “Business judgment rule”: only when
acting in the best interests of “the company”.
Case law interpreting the business judgment rule often explicitly
authorizes directors to sacrifice shareholders’ interests to protect
other parties.
Why courts apply the protections of the business judgment rule
to “mixed motive” cases where directors appear to benefit
themselves?
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The pursuit of directors’ nonmonetary interests in mixed motive
situations often benefits other stakeholders in the firm, even as it
harms shareholders.
Better sit in mediating hierarchy model than shareholder primacy
norm.
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A Team Production Analysis of the
Law of Corporations (4)
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Re-examining shareholders’ voting right
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Shareholders’ voting right appears to support the
shareholder primacy claim via able to elect board of
directors and fundamental corporate changes.
However…
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The voting rights are so weak as to be virtually meaningless
(at least in publicly-traded corporations).
Shareholders can only vote “yes” or “no” when directors
propose a corporate change; however, directors often can
restructure transactions without triggering a shareholder
vote.
As a safety net to protect against extreme misconduct.
How corporate law keeps directors faithful?
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Directors want to keep their position.
Directors are offered severely limited abilities to serve
their own by duty of loyalty.
Directors are encouraged to serve the firm by corporate
cultural norms of fairness and trust.
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Conclusion
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As it is too complex and costly to have all kinds of joint
production governed by explicit contracts, gaps in explicit
contracts can be filled by assigning residual control rights
(“property rights”) to a third party – the board of directors –
which is largely away from the direct control of any of the
various economic interests.
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The mediating hierarch model:
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Explains many important aspects of corporate law much more
robustly than its alternatives, especially principal-agent theories.
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Cannot reduce agency costs, but to serve the interest of all
company parties, or the corporation as a whole.
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Other lessons:
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Highlight the importance of team production dynamics in the rise of
public corporation;
Concerns the fundamentally political nature of the corporation.
Offers possible interpretation of the redirection of corporate wealth
from employees to shareholders during the late 1960s and 1970s.
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Comments
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The paper is very well-written with a clear logic behind it.
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The authors incorporate the corporate law into the corporate
governance context in the way that even people without any
legal background can still understand the story.
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It is really a long paper with more than 80 pages mainly due
to the content itself and detailed descriptions. Therefore, it
does take time to read but is worth spending hours reading it.
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