1. Authors: Margaret M. Blair and Lynn A. Stout Virginia Law Review, Vol. 85, No. 2 (Mar., 1999): 247-328 Presented by Nan Zhang A Team Production Theory of Corporate Law

2. Motivation Standard Economic Theory of the Firm Principal-agent analysis Property rights analysis Team Production Analysis with Mediating Hierarchy Approach Traditional team production model The mediating hierarchy approach Application of Team Production Analysis Corporation law with mediating hierarchy approach Conclusion and Comments Overview 2

3. Who owns a corporation? Principal-agent model: Shareholders (principals) hire directors and officers (agents) to manage bundles of assets on their behalf. Two recurring themes in the literature: 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 Not unique in public corporation. Only focus on shareholder primary norms, but ignore the interests of all other parties. Team production approach – Mediating Hierarchy Model. Motivation 3

4. Why do firms exist? Ronald Coase’s approach: The Nature of the Firm (1937) “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. Blair and Stout argue “using separate employment contracts between the entrepreneur and each employee” would solve the problem. Further developed paths: The principal-agent approach; The property rights approach; The team production approach (which is not fully explored in literature). Standard Economic Theory of the Firm 4

5. A “principal” who wants to accomplish some project she cannot do by herself hires an “agent” to do that project on her behalf. Efficiency problem: How can the principal write a contract that motivates the agent to do his best to accomplish the principal’s goals? Useful in analyzing certain kinds of contractual relationships, but ignore the possibilities that: The agent might have trouble getting the principal to perform her end of the deal; Part of the agent’s job is to figure out what needs to be done (more common in public corporations); The principal and agent relationship might be ambiguous without a single more powerful authority over the other. Standard Economic Theory of the Firm: Principal-agent approach 5

6. When too costly to write and enforce complete contracts, incomplete contracts become more practical. 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. Common ownership (common control). Limitation: Not applicable for public corporations. It is not a theory of corporation: Corporate law is clearly not needed to achieve common ownership of assets. Mis-states the nature of shareholders’ interest in public corporations. Standard Economic Theory of the Firm: Property rights approach 6

7. Combing principal-agent and property rights approaches. Not for public corporations. Limitation: Ignore horizontal lateral interaction among team members; 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. Standard Economic Theory of the Firm: A Theory of Hierarchy 7

8. Alchian and Demsetz (1972): 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. Designing efficient incentives Shirking problems: Free-rider with in advance agreement. Rent-seeking problems: Wasteful behavior without any agreement. Hierarchies arise as a way to solve these problems with a monitor position. Ignore some of the most interesting economic questions: What are the sources of the economic surpluses in team production? How can they best be harnessed and directed? Traditional Team Production Analysis (1) 8

9. Holmstrom (1982): Addressed the agency cost problem (the difficulty of monitoring the agent) and the free-rider problem. Whether it was possible to design a contract that prevented shirking and also satisfied a “budget constraint”? “Holmstrom’s impossibility theorem”: Such a contract cannot be written. 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. Team members (executives and rank-and-file employees) vs. budget breakers (shareholders). Traditional Team Production Analysis (2) 9

10. Rajan and Zingales (1998) 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. 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). 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. Mediating Hierarchy Approach (1) 10

11. Sources of surplus: vertical coordination (hierarchy) plus horizontal interactions among team members. The primary job of board of directors Not as an agent to pursue shareholders’ interests at the expense of employee, creditors or other team members; But to act as trustees for the corporation itself – mediating hierarchs – to balance team members’ competing interests to keep everyone in the coalition. Mediating Hierarchy Approach (2) 11

12. Notes Private corporations (grand-design principal-agent model) vs. public corporations (mediating hierarchy model). Directors do NOT actually manage the corporation on a day- to-day basis. Instead, most corporate decisions are made among team members at lower levels. Not all team members that making firm-specific investment will receive EQUAL, or FAIR, shares of the surplus, but at least SOME portion. Directors are not required to be unselfish. Mediating hierarchy model is not perfect, but at least second- best one. Mediating Hierarchy Approach (3) 12

13. Literature describes American corporate law following the shareholder primacy model. A “contractarian” or “law and economics” approach: grand-design principal–agent model. A “communitarians” or “progressive” approach: serving interests of shareholders as a ground and other stakeholders. “Derivative suit” and voting rights of shareholders. 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.” Thus, the mediating hierarchy approach provides a more solid theoretical foundation for the basic structure of public corporation law. A Team Production Analysis of the Law of Corporations (1) 13

14. Directors’ legal role: Trustees more than agents. The basis of principal-agent model (directors as agents) is misleading from a legal perspective (Clark 1985). As the ultimate decision makers, directors are NOT subject to direct control or supervision by anyone. Shareholders can elect and remove directors, but not commend the board to action. Corporation itself is as a “legal person”, serving as “budget breaker”. Corporate directors owe their fiduciary duties to the corporate personality. 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. A Team Production Analysis of the Law of Corporations (2) 14

15. Directors’ fiduciary duties Duty of loyalty: A narrowly defined concept (only when self- dealing of the most obvious transaction; and taking a “corporate opportunity”). Duty of care (only theoretically) 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? 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. A Team Production Analysis of the Law of Corporations (3) 15

16. Re-examining shareholders’ voting right Shareholders’ voting right appears to support the shareholder primacy claim via able to elect board of directors and fundamental corporate changes. However… 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? 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. A Team Production Analysis of the Law of Corporations (4) 16

17. 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. The mediating hierarch model: Explains many important aspects of corporate law much more robustly than its alternatives, especially principal-agent theories. Cannot reduce agency costs, but to serve the interest of all company parties, or the corporation as a whole. Other lessons: 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. Conclusion 17

18. The paper is very well-written with a clear logic behind it. 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. 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. Comments 18