Contracts Without Courts or Clans: How Business Networks Govern Exchange

• Publication year: 2022

Contracts Without Courts or Clans: How Business Networks Govern Exchange

Sadie Blanchard

Contracts Without Courts or Clans: How Business Networks Govern Exchange

Cover Page Footnote

Associate Professor, Notre Dame Law School. I wish to thank Lisa Bernstein, Robin Effron, Anna Gelpern, Matthew Jennejohn, Daniel Markovits, Ed Morrison, Mark Ramseyer, participants in the American Law and Economics Association Annual Meeting, the Society of Institutional and Organizational Economics Annual Meeting, the Canadian Law and Economics Association Annual Meeting, the Chicagoland Junior Faculty Workshop, the Junior Business Law Scholars Workshop, and the Young Bankruptcy Scholars Workshop, as well as in workshops at Brigham Young University, Brooklyn Law School, Indiana University Maurer, Notre Dame, Penn State University Park, Seton Hall, Tulane, and the University of Chicago. I am also grateful to the reinsurance professionals who generously agreed to speak with me and, for excellent research assistance, to Zachary Beculheimer, Kevin Constantine, John Dugan Delp, William Eisenhauer, Mairead Fitzgerald-Mumford, Holly Lanchantin, Justin Maroni, Sravya Nallaganchu, and Marquan Robertson. Any errors are mine.

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CONTRACTS WITHOUT COURTS OR CLANS: HOW BUSINESS NETWORKS GOVERN EXCHANGE

Sadie Blanchard^*

Legal scholars have long recognized the close-knit community as an alternative means of supporting trade when contract law and trusted courts cannot. But recent research suggests that another option may be available: heterogeneous business networks. What is interesting is that these networks lack features traditionally seen as essential to community-supported trade. In particular, they lack preexisting social ties that allow reliable information to spread at low cost, make exiting the trade difficult, and enable the coordinated sanctioning of cheaters. As a result, some leading scholars have come to doubt that these networks are capable of sustaining cooperation.

This Article offers compelling evidence that heterogenous business networks can indeed sustain high-stakes trade. Through an original case study of the reinsurance industry, it shows that when the gains from trade are sufficiently robust, parties can build mechanisms to spread the reliable information needed to support trade by starting with transactions that align incentives and require high transparency. Parties can then strengthen their commitments by both investing in the bilateral relationship and building a network that connects each party to the other's contacts. This

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strategy helpfully allows information about behavior in trading relationships to spread at low cost. Once constructed, the network enables reputation-based bonding of higher-risk transactions and a greater variety of transactional terms than can be supported by incentive alignment alone. In short, this study of the reinsurance trade suggests that cultivated, freestanding business networks can support extralegal private ordering under a broader set of circumstances than legal scholars currently appreciate.

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TABLE OF CONTENTS

I. INTRODUCTION...................................................................237

II. CONTRACTING WITHOUT COURTS OR CLANS: TRADE IN A FREESTANDING BUSINESS NETWORK...............................242

A. COURTS...................................................................243
B. CLANS OR CLOSE-KNIT COMMUNITIES............................
C. COMBINING LEGAL AND EXTRALEGAL OR FORMAL AND INFORMAL ORDERING..............................................248
D. FREESTANDING BUSINESS NETWORKS......................251

III. THE REINSURANCE TRADE..............................................251

A. INDUSTRY OVERVIEW...............................................254

1. The First 130 Years..........................................254
2. The Last Fifty Years.........................................260

B. EXTRALEGALITY AND INFORMALITY IN REINSURANCE ...............................................................................261

1. Incomplete Contracts.......................................262
2. Vague Norms....................................................265
3. Purely Extralegal Obligations.........................271
4. Equitable Private Dispute Resolution.............273

C. WHY EXTRALEGALITY AND INFORMALITY IN REINSURANCE CONTRACTS......................................276

IV. AN ECONOMIC ANALYSIS OF REINSURANCE CONTRACTING ..........................................................................................280

A. THE BASIC ECONOMICS OF THE REINSURANCE MARKET ...............................................................................280
B. REINSURANCE CONTRACTING HAZARDS....................281
C. CONTRACT GOVERNANCE WITHOUT THE COURT OR THE CLAN.......................................................................283

1. Incentive Alignment.........................................283
2. Investigation of Prospective and Current Counterparties..................................................286

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3. Construction and Maintenance of a Small-World Network............................................................289
4. Targeted Investment in Relationships.............291
5. Creation of Mass Information Channels.........297
6. Cultivating Solidarity......................................300

V. CHANGE IN REINSURANCE AND THE CONTINGENCY OF INSTITUTIONS...................................................................303

VI. CONCLUSION....................................................................306

APPENDIX: INTERVIEW METHODOLOGY.................................310

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I. INTRODUCTION

Legal scholars have long recognized that when formal contracting is unavailable to a group of traders, the clan or close-knit community is an alternative institution that can support trade through reputational governance. The classic example in the legal literature—described in the most-cited contract law article of the last quarter century—is the community of Orthodox Jewish diamond merchants in New York.¹

The features of close-knit communities that enable reputation-backed trade, though, are widely viewed as existing only within a narrow set of circumstances.² The close-knit community or clan is able to support risky cooperation, the theory goes, for two reasons: its members have multidimensional relationships that transcend commercial matters and exiting the community is prohibitively costly.³ Reputation works in these communities, it is thought, because they are densely connected, closed networks.⁴ Members trust one another because word of misbehavior will assuredly spread widely, leaving wrongdoers with nowhere to hide and nowhere to go.

Contrast the close-knit community with business networks that are geographically dispersed and heterogenous—networks in which people may come and go with relative ease, and connections are

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fewer and weaker. Traders can do business outside the network. Word of misbehavior might fail to reach all potential trading partners. More fundamentally, since ties are weak, it might be hard for others to tell who is really at fault when a deal goes badly. Each of these factors would seem to make reputation less effective. As a result, some leading scholars are skeptical of recent research suggesting that geographically dispersed and heterogeneous business networks might support robust, reputation-based governance of complex obligations.⁵ Can such business networks sustain high-stakes cooperation on matters that courts cannot reach? if so, how?

This Article shows that loose-knit business networks can indeed sustain complex, high-stakes cooperation and explains how they can do so. it provides an original case study of a sophisticated, high-stakes trading network that was built for commercial activity. The business network examined here is the reinsurance industry from its inception in the late nineteenth century until around 1980. The experience of reinsurance—insurance for insurance companies⁶ —shows that the challenges to network-based reputational governance among a loosely connected group facing noisy signals can be overcome when the expected gains from trade are large enough and stable enough and commitments cannot be backed cost-effectively by law and courts.⁷

Details about the reinsurance trade—which sustained the global insurance industry for over 100 years—were gathered from published writings by, and original interviews with, people who worked in the industry as well as from recent scholarly work by historians and sociologists.⁸ What surfaces is that groups without preexisting ties can initiate and sustain reputation-backed trade by aligning incentives, committing to transparency, making targeted investments in bilateral relationships, and—by bootstrapping from

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those mechanisms—building a network that allows useful information about traders' behavior to spread. In short, when the gains from trade are sufficiently large and legal institutions cannot support exchange, intentionally cultivated business networks can.

The risk spreading that was essential for reinsurance to work required traders to transact with a large number of others at great distances, including on different continents. The trade was established during a time when the legal and communications infrastructures available for long-distance trade were rudimentary. Courts were in practice unsuitable for dispute resolution because of the need for confidentiality and adjudicators with a deep understanding of the trade.⁹ Therefore, reinsurance agreements were for most of their history governed extralegally.¹⁰ parties eschewed courts and directed industry arbitrators not to interpret contracts literally but instead to view the parties' relationships as "honorable engagements" or "gentlemen's agreements."¹¹ This is remarkable in light of the high stakes, uncertainty, and complexity involved. it is also instructive.

In lieu...