The Boundaries of "team" Production of Corporate Governance

• Publication year: 2014

SEATTLE UNIVERSITY LAW REVIEW Volume 38, No. 2, WINTER 2015

The Boundaries of "Team" Production of Corporate Governance

Anthony J. Casey and M. Todd Henderson(fn*)

ABSTRACT

We examine the cooperative production of corporate governance. We explain that this production does not occur exclusively within a "team" or "firm." Rather, several aspects of corporate governance are quintessentially market products. Like Blair and Stout, we view the shareholder as but one of many stakeholders in a corporation. Where we depart from their analysis is in our view of the boundaries of a firm. We suggest that they overweight the intrafirm production of control. Focusing on the primacy of a board of directors, Blair and Stout posit a hierarchical team that governs the economic enterprise. We observe, however, that for many of the most important governance decisions there is, in fact, no hierarchy. In those cases, governance emerges from an intertwined series of market transactions. To use the nomenclature of Blair and Stout, there are many players, but there is no coach, and thus, no "team." Rather, the firm is controlled by a series of relationships-some of which are governed within the firm and some of which are governed and enforced externally. Ours, then, is a true Coasean framework, suggesting that important implications arise when we differentiate cases where the value of market discipline on stakeholders exceeds the large transaction costs that could be reduced by integration or team creation from cases where the opposite is true. We provide some preliminary conclusions on those implications.

"Yet having regard to the fact that if production is regulated by price movements, production could be carried on without any organization at all, well might we ask, why is there any organization?"

-Ronald H. Coase, The Nature of the Firm(fn1)

I. INTRODUCTION

The scholarly debate about corporate governance is stuck in a rut. The root of the problem is the excessive focus on the board of directors, either as the mediator between the interests of ownership and control, as the coach of a corporate team, or as an obstacle to the will of a broad collection of stakeholders.(fn2) Most theories to date either extol or decry the role and importance of shareholders (broadly thought of as "owners") within the board-dominated firm hierarchy. These theories approach the problem with different operating assumptions about whether the firm is premised on team production, property rights, or something else. But they generally end in one of two places: a discussion of how the board facilitates optimal governance or how it should get out of the way of adequate corporate reform. The goal of our project is to get the scholarly debate out of this rut by examining how recent corporate practices illuminate a different locus of corporate governance. Only if we understand where corporate governance truly resides are we able to effectively regulate corporate activity.

We start with Ronald Coase's insight that cooperation in the production of a good or service can happen in many ways, not all of which happen inside of a firm or even on a team.(fn3) Coase's famous question-"why is there any organization?"-made this point salient.(fn4) The boundary of the firm, he reasoned, is defined by the relative costs and benefits of organizing activity by fiat (that is, within a firm) or by market transaction.(fn5) The question for Coase and those who followed has always been: why do some productions follow the first model while others follow the second?(fn6) Our key contribution is to demonstrate that Coase's insight applies not only to the production of firm outputs, but also to the production of corporate governance.(fn7)

Governance, which we define as the locus and mechanisms of residual corporate control, is no different from the supply of other things to the firm.(fn8) It can be produced within a firm or by external market forces, and the choice will depend on the relative costs and benefits of each approach. We would expect some firms, at some times, to "build" their own governance while other firms at other times "buy" governance in the market. This choice, which was the focus of Coase's pioneering work, is plain in the production of goods and services. Apple Computer employees design the iPhone, but another company, Foxconn, builds them under contract with Apple. This is presumably because engaging Foxconn leads to a more efficient production.(fn9) While outsourcing is well understood in this context, the concept is equally applicable for corporate governance.

This is most obvious when a firm is in its early stages and contracts out governance to a group of venture capital funds or when a firm is underperforming and does the same with a private equity fund. In both cases, while there is still a board, and managers still run the firm, the real governance rights exist in a series of state-contingent contracts between the firm, its shareholders, and the investment funds. The contracts in both of these cases slice and dice control in sophisticated ways that presumably increase the value of the firm. As we explore below, in these and other related contexts, the board of directors-often thought of as the central node of control-is a bit player, if relevant at all. Real governance power lies elsewhere, and largely outside of the gaze of modern corporate law scholarship.

More generally, much of corporate governance today is not "built" or housed within most firms, but rather emerges from the combination of inputs produced in an external "market of governance." Stakeholders of all types exercise small bits of governance, and the whole of that governance exists in an indefinable space characterized more by market forces than command and control. If there is a suite of control rights that constitutes governance, its production is divided among the board, senior lenders, bond holders, venture capital firms, private equity firms, hedge funds, institutional investors, and the like. But that is not all. Additional suppliers of governance may include unions and customers.(fn10) All of these players exercise some set of the components that add up to the whole of corporate governance. And despite the incompleteness of the contracting among the players, a centralized authority or organization rarely arises to coordinate them. Our hypothesis is that this lack of a central organization is a salutary result. It is the market production that Coase identified as an alternative to integration and merely reflects the costs and benefits of exercising governance power.

We suggest, then, that the best way to view the governance of firms is as a product that investors and all other stakeholders desire. Like any product, this can be produced within a firm or in the market. Importantly, this choice is independent of the same choice about whether other aspects of firm activity happen inside or outside the firm. Governance for an automobile manufacturer can be entirely external while production of the automobile is fully integrated or vice versa.(fn11)

In Part II below, we contrast this view to the existing accounts of firms and corporate governance. We then explore the common forms of governance over large firms of various types. Our preliminary analysis is that, while corporate governance is produced both inside and outside of a firm, the most important aspects-decisions about capital structure, long-term goals, acquisitions, and mergers-often emerge from market transactions. Internal governance decisions usually cover things in the category of hiring, short-term production and marketing strategies, compensation, and the like. This draws into question laws and theories that elevate the primacy of the board of directors. Internal hierarchies that may be described as teams (Coase's firm) might act in the direct production of the widgets that a corporation sells. But the governance structure for the firm is an organic network (Coase's ideal market production) that leads to the production of corporate control. They are distinct modes of production.

In Part III, we provide a number of examples that demonstrate the phenomenon we are illuminating; specifically, corporate governance can take place through the external controls created by market production. These examples primarily demonstrate the way in which creditors exercise control and handle problems of residual control using market-like mechanisms.

In Part IV, we explore the implications this has for the law of corporate governance and finance. For instance, the theory and practice that elevates the centrality of the board of directors, with attendant fiduciary duties, likely destroys value by limiting the ability of entrepreneurs and investors to contract in ways that narrowly tailor governance rights to optimize firm value. On the other side of the debate, attempts to curb board power by internalizing the market production of governance over the firm are equally misguided.

II. CHALLENGING THE EXISTING THEORETICAL LANDSCAPE

"My own favorite example is riverboat pulling in China before the communist regime, when a large group of workers marched along the shore towing a good sized wooden boat. The unique interest of this example is that the collaborators actually agreed to the hiring of a monitor to whip them."

-Steven N. S. Cheung, The Contractual Nature of the Firm(fn12)

While decades have been spent analyzing...