Do Networks Govern Contracts?

• Author: Jennejohn, Matthew

1. INTRODUCTION 335 II. A PRIVATE ORDERING PARADOX 340 A. The Old Religion: Exchange Networks as 341 Unalloyed Benefits 1. The Classic Contracting Problem: Uncertain 341 Deals with Untrustworthy Parties 2. How Informal Sanctions Work 342 3. An Expansive Role for Networks 343 B. A New Perspective: The Overlooked Costs of Exchange Networks 345 1. Beyond Opportunism 345 2. How Network Position Can Exacerbate Those New Problems 347 C. Summary: Two Views of the Information that Diffuses in 348 a Network III. ADDRESSING NETWORKS' COSTS: JOINT DISCOVERY IN 348 BIOPHARMACEUTICALS A. Collaborating to Create New Drugs 350 B. Collaboration Leads to a Rich but Unpredictable 352 Industry Network C. Property Rights Blur as Collaborators Share Discoveries 354 D. Formal Contracts Address Collaboration's Spillover Risk 355 E. More Collaborative Companies Use More Robust 358 Formal Contracts 1. Research Design 359 2. Results 359 F. Summary: Formally Ordered Creativity 367 IV. CREATIVE ORDERING FOR PUBLIC PURPOSE 369 A. Contract Law for a Creatively Ordered Economy 371 B. Against Universal Legal Minimalism 371 C. Creative Ordering and an Expanded Purpose for Contract Law 372 D. Creative Ordering in the New Industrial Policy 374 V. CONCLUSION 380 VI. APPENDIX 382 I. INTRODUCTION

   A venerable line of scholarship, spanning both economics and law, argues that informal institutions, rather than the formal legal system, often enforce contractual obligations. (1) Economic exchange is "privately ordered" without reliance on state institutions. (2) Indeed, formal legal institutions may interfere with private ordering. (3)

   Numerous studies of early modern commercial activity identify evidence of private ordering, placing contemporary capitalism's roots in a stateless past. (4) The story of a 16th century trader provides an example of the type. In 1585, the young Dutch merchant Hans Thijs had a contracting problem. Stationed in Danzig at the time, Thijs was trading local leather goods to the Netherlands. (5) The problem was ensuring that he was not cheated of a fair price when his goods were sold in far-away Amsterdam. (6) So Thijs, like many Hanseatic merchants, turned to what he knew best: his personal relationships. (7) By dealing primarily with his relatives, he leveraged the power of informal sanctions to govern his trades. If a relative cheated Thijs on a transaction, Thijs could retaliate by disparaging their reputation within the broader family. Thijs' network of social relationships governed his deals. (8) He relied on this governance system as he expanded his trading business to selling jewels to Paris, Avignon, and Constantinople and later sourcing wine and cloth from Spain. (9) He was not unique. Social networks enforced contractual obligations throughout the Hanseatic League. (10)

   Private ordering is not only a matter of historical memory. Recent scholarship argues that private ordering provides the backbone for the thriving clusters of innovative companies that power modern capitalism. (11) The privately ordered enforcement institutions that a merchant like Thijs relied upon are also used in the large, dynamic markets of the 21st century economy, from Silicon Valley (12) to biopharmaceuticals (13) to automotive manufacturing. (14) Networks of relationships exist in the modern economy, circulating reputational information just like they did for the 16th century Hansa. (15) Informal sanctions run our entire economic system, from vernacular to advanced capitalism.

   This Article contests the private ordering claim as it is applied to modern markets. (16) It does not deny that social norms and informal sanctions matter in some 21st century markets--modern commerce is not entirely bereft of trust. Rather, this Article argues that private ordering scholarship has overlooked an important paradox at the heart of its theory of informal enforcement. Modern exchange networks also often pose a cost to transacting parties that prior scholarship has not recognized: the same social network that circulates reputational information throughout a market also allows valuable technical information to leak, or "spill over," to third parties, perhaps even competitors. (17) That spillover risk grows as a party's connections within an exchange network increase. Networks are a double-edged sword.

   Spillovers are most salient in innovative markets where new intangible technology is being developed. Consider the following example, which comes from the 21st century biopharmaceutical industry rather than the 16th century leather trading business. In 2003, a small biotechnology company named iBio landed its first big collaboration with a major pharmaceutical partner, Fraunhofer, a large German research organization. (18) For ten years, iBio and Fraunhofer collaborated on the development of new vaccines, sharing their proprietary information with one another to achieve new discoveries.

   iBio and Fraunhofer also entered into additional contractual relationships. (19) As they did so, iBio and Fraunhofer's network of relationships grew. In the end, that network proved particularly costly to iBio. Acting alone, Fraunhofer entered into agreements for related research with other companies, eventually using technology it had jointly developed with iBio in a different collaboration with one of iBio's competitors. (20) Valuable technology that iBio helped develop and saw as essential to its survival spilled over to a rival. A startup's worst nightmare had come true.

   This Article shows how companies like iBio use formal contracts to address the spillover risks that networks create. Companies do not rely upon informal sanctions in these markets. For instance, iBio did not turn to the court of public opinion to discipline Fraunhofer. Rather, iBio sued in Delaware state court to claw back its technology, arguing that Fraunhofer had breached the licensing terms of the parties' formal collaboration agreement. (21)

   The Article presents empirical evidence that iBio's reliance on the formal legal system reflects broader trends in the modern economy. A challenge an empirical analysis such as this faces is the sheer size and complexity of the subject of study--technological, organizational, and contractual complexity has grown enormously since Hans Thijs traded commodities across Europe. (22) To provide as comprehensive a picture as possible, this Article combines both qualitative and quantitative methods of analysis to study contemporary contracting behavior. (23) The setting of the study is the biopharmaceutical industry, a market where rich data on contracting behavior is publicly available. Over fifteen years of biopharmaceutical R&D alliances--exceeding over 30,000 contracts--are analyzed. Semi-structured interviews with industry insiders, such as law firm partners, general counsel, management consultants, and alliance managers, were also conducted. Both quantitative and qualitative approaches provide evidence that companies use unique formal contracts to address spillover risks. The governance of biopharmaceutical innovation is deeply legal.

   This Article refers to this use of formal contracting to address the spillover risks that networks create as "creative ordering." The term is meant to differentiate this form of contracting behavior from traditional private ordering while also evoking the context in which it arises--the development of new technology.

   Creative ordering contributes normatively to a reconfiguration of the relationship between the state and market. Rather than being a peripheral institution, the legal system occupies center stage in the creatively ordered economy. Importantly, however, the central role of the legal system does not arise because social networks are weak. (24) Rather, it is the potency of the network itself that demands legal intervention. Robust social networks and formal legal institutions operate hand-in-hand.

   This reconfigured relationship between state and market has normative implications in two major settings. The first setting is contract law. Creative ordering provides a new argument that courts should ignore private ordering advocates' sweeping claims that network governance can effectively substitute for formal contract law in a wide range of markets. Evidence that parties use formal contracts to address the risks that networks create, rather than use reputational sanctions, undercuts calls for minimal court intervention in contract disputes. To discourage courts from enforcing contractual obligations when parties are using contracts to address the spillovers that networks promote, is to cut innovative companies off from the very legal institutions upon which they rely. The private ordering thesis's prescription is exactly backwards. Contract law matters.

   At the same time, the legal system's central role in creative ordering raises a difficult new normative issue for contract design and enforcement: Should contract law be used to limit spillovers? While costly for individual companies, who want to reap the profits from their proprietary technology, spillovers can be socially beneficial. (25) This issue has been a longstanding topic of debate in intellectual property scholarship. (26) Creative ordering brings it to the heart of contract theory. (27)

   The second setting is the new industrial policy that is emerging in the United States, (28) an area that legal scholarship, with its preference for doctrinal analysis, might easily overlook. Creative ordering gives the administrative state a new tool for promoting economic development. In a sense, creative ordering democratizes innovation: new technology is developed through formal contracts and the standard legal system, rather than through private methods only the members of a specific commercial community can understand. That raises the possibility that creative ordering might be used not just between sophisticated private parties but also by the state itself. Indeed...