The private order of innovation networks.

Author:Jennejohn, Matthew
Position:Introduction through II. Multivalent Contracting A. Expanding the Menu of Exchange Hazards, p. 281-323

Table of Contents Introduction I. Formal and Informal Governance in Alliance Contracts. A. Defining the Unit of Analysis: The Alliance Agreement B. The Lessons of Incomplete Contract Theory 1. The recipe for opportunistic "holdup" 2. Formal and informal responses to opportunism 3. Braiding formal and informal contracting. 4. Summary. C. The Limits of Braided Governance II. Multivalent Contracting A. Expanding the Menu of Exchange Hazards 1. Spillovers, or appropriability problems. 2. Entropy, or coordination problems B. The Implications of Multidimensional Exchange Hazards III. Demonstrating Proof of Concept. A. Building Intuition with Three Illustrative Collaborations B. Analyzing a Larger Sample of Collaborations 1. Constructing the dataset. 2. Variables and hypotheses. a. Spillover variables. b. Entropy variables. c. Opportunism variables. d. Control variables e. Methods 3. Results. C. Revisiting Gilson et al.'s Three Examples. D. Summary and Theoretical Implications. IV. Reframing Enforcement Policy. A. Braided Governance in the Courts: The Argument for Low-Powered Sanctions. B. Reinterpreting the Case Law. C. Bifurcated Dispute Resolution Systems. Conclusion. Introduction

The question of how law promotes innovation has attracted intense scholarly interest for well over a generation. Research has explored several answers to the problem, the most familiar being the role intellectual property rights play in incentivizing creative activity. (1) Additional work is progressing apace on how prizes and tax incentives complement intellectual property in promoting innovation, (2) how antitrust law affects innovation, (3) and how corporate and securities laws support the United States' "vibrant venture capital market." (4)

Less attention has been paid to understanding contract law's place in the legal infrastructure supporting innovation, however. This is curious given the increasingly critical role contracts play as firms pursue innovation collaboratively. Rather than relying entirely on in-house R&D capacity, firms in many high-technology industries ranging from pharmaceuticals to semiconductors now create technology through contractual alliances by which they partially integrate development capabilities via contract, short of consummating a full acquisition. (5) Recent examples include Google's collaboration with Novartis for the development of smart contact lenses, (6) Apple's partnership with IBM to develop mobility solutions for the corporate market, (7) and GlaxoSmithKline and the National Institute of Health's joint work on developing a long-awaited Ebola vaccine. (8) Buffeted by highly competitive global markets, many firms hope that innovating through collaborative approaches will produce new technology in a way that is better, faster, and cheaper.

Unfortunately, that hope is frequently unrealized. Consider a timely example from the aerospace industry: few recent industrial gambles rival the bet Boeing made in its collaborative approach to the design and production of the 787 Dreamliner. Under pressure throughout the 1990s to respond to a surging Airbus, which had attracted 50% of the passenger aircraft market by 1997, (9) Boeing responded in 2003 with an ambitious plan to recapture market share by developing a technologically advanced wide-body aircraft. (10) Use of carbon composite materials and a revolutionary battery system would increase the aircraft's operating efficiency, reducing costs for carriers while also improving passenger experience by transforming long-haul routes that once required a layover into nonstop flights. (11) Furthermore, an extensively outsourced design and production process would bring this advanced aircraft to market at a low price and record pace, with initial projections showing a forty percent reduction in development costs and thirty-three percent reduction in development time. (12) The collaborative approach to innovation familiar in industries ranging from pharmaceuticals to electronics to automobiles was coming to Boeing's commercial aerospace program.

Demand for the 787 exceeded expectations, with 848 orders for the new aircraft booked. (13) However, not all went as planned. Development of the 787 went dramatically over budget, and rollout was delayed at least seven times, resulting in a debut three years behind schedule. (14) And as delivery to carriers began in 2011, system malfunctions quickly mounted. The main landing gear did not extend properly. (15) Engines failed. (16) Hydraulics problems arose. (17) Fuel lines leaked. (18) Two battery fires occurred: while a 787 taxied in Boston and while another flew over Japan, (19) which subsequently led to the grounding of all 787s around the world. (20) Congressional hearings ensued. (21) To some, the 787 had become "an object lesson in how not to build an airplane." (22)

According to a joint Federal Aviation Administration and Boeing study issued in 2014, a source of Boeing's problems was its poorly structured collaborative approach to innovation. (23) For prior aircraft programs, Boeing had pursued a "build to print" sourcing strategy, by which Boeing designed specifications for parts, contracted directly with a large number of suppliers for the production of those exact parts, and then assembled those parts into subsystems and, in turn, the complete aircraft. (24) Abandoning past practice for the 787, Boeing followed a "build to performance" sourcing model, by which it devolved design and assembly responsibility for distinct subsystems (e.g., fuselage sections, wings, landing gear, etc.) to fifteen tier-one suppliers, leaving Boeing to coordinate efforts and handle final assembly. (25) In other words, rather than providing specific directions on what parts to provide, Boeing gave the tier-one suppliers a framework of performance targets for their respective subsystems, allowing suppliers to determine how those targets would be met. This approach was intended to leverage supplier expertise and reduce Boeing's upfront capital expenditures, (26) but coordination problems quickly overwhelmed the process. In a number of cases, subsystems from different suppliers did not work with one another properly, requiring Boeing engineers to develop expensive work-arounds. (27) Incentive mechanisms in Boeing's supplier contracts only made matters worse: because the contracts provided that suppliers would not be paid until all subsystems were assembled correctly, a lag by one supplier undercut other suppliers' incentives to be on time. (28) A mechanism meant to prod the supply base forward actually held it back. Problems with one supplier, Vought Aircraft Industries, became so severe that Boeing eventually acquired the Vought factory involved with the Dreamliner, controlling that portion of the production process through ownership rather than contract. (29)

Such challenges are not unique to Boeing. The failure in Autumn 2014 of Apple and GT Advanced's collaboration to create sapphire screens for the iPhone 6, which precipitated GT Advanced's bankruptcy, provides another recent example. (30) A number of studies have found that a majority of alliances fail. (31) Such failures are all the more troubling as we come to appreciate the collateral economic risks involved with shifting to more collaborative production arrangements. Evidence continues to mount that decisions to outsource and offshore can erode the R&D, engineering, and manufacturing capabilities often held within networks of individuals and companies. (32) Dismantling enterprises without realizing a net benefit in return is a poor trade.

Interfirm alliances thus present a paradox. On one hand, parties are relying on contracts more than ever before to realize innovation outcomes; on the other hand, contract's limits as a governance device are routinely exposed. Contract's tensile strength, to borrow an engineering term, (33) is impressive, but it has limits. What causes those limits? Relatedly, how should courts intervene when collaborations founder? For example, how should contract doctrine apply in the context of collaborative innovation? Answering those questions is critical for private parties and their counsel trying to design more effective agreements, and for public officials attempting to craft policy responses.

Given the complexity of collaborative relationships, and the multidisciplinary toolkit required for accurate analysis, understanding the limits of contract as a governance device in innovation networks is a Herculean task. But a new line of legal research, anchored by Gilson, Sabel, and Scott's comprehensive theory of contracting for innovation, is undertaking to do just that. (34) This scholarship takes the economics literature on contract design as its starting point. (35) It then applies and, in its most ambitious moments, extends contract economics to explain how collaborators fashion novel contractual governance mechanisms to incentivize each collaborator's behavior in situations where high uncertainty creates openings for opportunistic behavior. (36) Gilson et al. argue, for example, that contracting for innovation depends upon a unique blend of both formal contract provisions, enforceable in a court of law, and informal constraints, which rely upon extralegal sanctions to police behavior. (37) In short, they argue that formal contract provisions create unique information-sharing routines, which foster informal governance by (1) making each collaborator's performance more transparent, (2) revealing whether the parties are prone to cheating, and (3) locking the parties into the partnership as they make mutual investments in relationship-specific learning. (38) This "braid" of formal and informal contracting harnesses the opportunism problems Gilson et al. see plaguing interfirm collaborations. (39) In Gilson et al.'s telling, braided contracting is an important theoretical advance that not only illuminates how collaborations are governed, but...

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