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The Team Production Theory of Corporate Law

I had recently access (thanks to a post at Corpgov.net) to a video by Margaret Blair in which she fantastically described her Corporate Law Theory, the “Team Production Theory”, which she defends with Lynn Stout and others. (1) (2).

This led me to recover an article by Margaret Blair, (3) to which I will dedicate this post.

Mrs Blair first brings forward the fact that the previous main advocates of the Principal-Agent theory of Corporate law have somehow changed their views. Those that strongly defended that the corporate purpose should be maximizing shareholder value and that boards should have primarily an “oversight” role, (such as Jensen , Jack Welch, Lucien Bebchuk and others) at least admit now some loopholes in their previous statements.

She then presents a different theoretical framework, that arises after recognizing the firm as a tool where a “team production problem” is solved, where all participants in a complex productive activity want others to “fully cooperate providing their inputs”, but are unable to draft the complete and detailed contracts that would help them achieve that objective. (4)

The theory challenges the Principal-Agent proposal, as it doesn`t make a choice as to who in the team is the principal; all of them are interested in obtaining the maximum cooperation from the rest of participants, and, according to the theory supporters, it explains better actual boards` behavior and depicts a different picture of how they should act.

a)    The Theory.

The “team-production problem” appears when different inputs are needed, not all of them belong to the same entity, and they are not always easy to identify. Every ex-ante rule for distributing assets or profits incentives shirking, and every ex-post rule promotes rent-seeking activities. Alchian and Demsetz proposed a hierarchy where the “boss” should be entitled to hire and fire. (5) and would receive the surplus after compensating others for their opportunity cost. This was a theory of the firm, but as the boss was also an owner, it didn`t allow for a theory of Corporate Law and, didn`t explain the role of a board.

Grossman and Hart (6) propose to assign property rights to the party holding more specific assets or investments in the firm. Rajan and Zingales (7) argue that this leaves a problem if the owner can sell the assets instead of investing in the firm; others would also follow and underinvestment will ensue. Consequently they propose a better solution arises when members give that power to an outsider, the right to choose the team and allocating the surpluses, compensating him/her with a fraction of the surplus. Blair and Stout identify the role of that outsider with the role of the board. They cannot sell the assets, they generally don`t have specific investments in the firm, they will not capture any surplus, etc. So, if we follow the Team Production theory, separation of ownership and control is not something that needs to be corrected, but an optimal result for a team production problem.

b)    The Corporate Form as a solution to the Production Problem.

Some of the features of Corporations are problematic when analyzed through the lens of the Principal-Agent theory, as agency costs appear, etc. Prof. Blair argues the Team Production theory deals better with the following features:

–                           Corporation as a separate legal entity: the PA theory usually avoids this feature, thinking of the firm as a “nexus of contracts”; the TP theory thinks of a firm entity as allowing shareholders putting inputs in common, so that no one can sell them by himself, even the assets he contributed; finally, it makes it easier to establish a common target, (instead of having one for each of the participants, as the PA theory proposes).

–                           Limited liability: it makes sense when a separate legal entity is introduced in the picture, as the TP theory coherently does. Participants may lose their contribution, and if we don`t think of them as owners, limited liability makes sense; if we instead keep the idea that they are owners, it is more difficult to explain why any damage to a third-party exceeding the common resources does not fall on them.

–                           Transferable shares: the ability to lock in capital and not the capital provider is one of the best features of a corporation; in the PA theory, it is difficult to keep the dogma that a corporation must be run in the interest of shareholders, as they are a completely changing set of members with different agendas. The TP theory is perfectly prepared to explain how the team manages to establish a permanent principle for the distribution of assets among participants, so that each of them gets enough to remain in the firm. The share value maximization principle does not hold.

–                           Delegated management under a board structure: we have already seen how the corporate structure fits with the TP theory.

–                           Investor ownership: according to the PA theory, those that contribute capital to the firm have the right to control the firm and obtain the net earnings. But in fact, investors only have the right to decide what the board proposes to them, and to get what the board accepts to give them. This actual way of things fits with the TP theory.

–                           Indifinite existence: it allows the accumulation of assets to occur, and is consistent with the idea of capital and assets lock-in until the board decides a distribution event to take place. That makes sense it the TP theory, where the board protects all participants, and not only the capital contributors.

c)     Shareholder Primacy starts to lose its dominance.

Blair exposes how several recent events have forced even the major “shareholder-centric Principal-Agent theory” defendants to accept that it has some failures.

First, the causal relationship between weak (strong) shareholder rights and weak (strong) performance does not appear to be empirically demonstrated.

Second, the actual way in which firms are organized doesn`t fit either with the PA theory.

Third, the derivative market existence puts into question the idea that shareholders are really interested in maximizing value. Even if they keep the risk exposure, shareholders might have their own agenda, opposed to the interest of the firm, or the interest of other shareholders.

Michael Jensen has admitted after the crisis that the value of other assets also need to be maximized, not only the value of shares, (debt, warrants, preferred stock, and so on). Spamann and Bebchuk also admit that maximizing the share value can lead to an excessive risk taking attitude by managers and boards.

Even Jack Welch has demonized the maximizing share value principle.

Blair argues that the TP theory accommodates all those aspects that those scholars are now admitting. But in spite of that, Blair notes that Corporate Governance dominant theories and policy still keep the same way: efforts are being only made to protect the shareholders` interests, as if the lack of protection had caused the recent events through a bad implementation of the correct shareholder-centric corporate governance prescriptions.

Professor Blair concludes wondering if the Team Production theory will ever receive the attention it deserves by policy-makers, scholars and corporate governance advocates, given the fact that it better accommodates and explains many of the main features of the firm, and also many of the actual corporate governance realities.

(1)     See the video here, http://www.youtube.com/watch?v=VgwThLU8478.

(2)     and the post also here: http://corpgov.net/2014/01/video-friday-margaret-blair-making-the-hard-call-the-unheralded-role-of-corporate-boards-of-directors/.

(3)     Corporate Law and the Team Production Problem, http://ssrn.com/abstract_id=2037240.

(4)     Margaret M. Blair & Lynn A. Stout (1999) A Team Production Theory of Corporate Law, 85 Virginia Law Review, 2, 247 – 328, and also Williamson (2002). “Theory of the Firm as a Governance Structure: From Choice to Contract,” 16 Journal of Economic Perspectives, 3, 171 – 195.

(5)     Alchian and Demsetz, (1972). “Production, Information Costs, and Economic Organization,” 62 American Economic Review, 777.

(6)     Raghuram G. Rajan & Luigi Zingales (1998). “Power in the Theory of the Firm,” 113 Quarterly Journal of Economics, 387.

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