Georgetown University Law Center 2001 Working Paper series in Business, Economics, and regulatory Law and Public Law and legal Theory Research paper No. 281818 Team Production Theory and Corporate law Margaret m. blair This paper can be downloaded without charge from the ocial Science Research Network Electronic Paper Collection at http://papers.ssrncom/abstract-281818
Georgetown University Law Center 2001 Working Paper Series in Business, Economics, and Regulatory Law and Public Law and Legal Theory Research Paper No. 281818 Team Production Theory and Corporate Law By Margaret M. Blair This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection at http://papers.ssrn.com/abstract=281818
Team Production Theory and Corporate law Margaret m. blair Sloan Visiting Profe Georgetown University Law Center 600 New Jersey Ave NW Washington, DC 20001
1 Team Production Theory and Corporate Law By Margaret M. Blair Sloan Visiting Professor Georgetown University Law Center 600 New Jersey Ave. NW Washington, DC 20001
In recent years, there has been a surge in academic interest in the ownership"of corporations, and in the links between ownership and performance. The interest in this issue is driven by rapid changes going on in international capital markets, as well as in the corporate sector in many countries A substantial part of this recent literature regards owning shares of stock in a corporation as if owning shares were the same thing as"owning the issuing corporation itself. This essay considers the ideas of ownership, and of "property rights "as they apply to the corporate context Just as the idea of private property has been central to our understanding of the workings of of the firm and corporate governance in the last twenty years. Professor Oliver Hart, individuallyany capitalist economies, the idea of ownership" has been a key idea in much of the literature on the theo together with various coauthors, advanced our understanding of the role of property rights "in the theory of the firm by suggesting that" property rights should be understood as a mechanism for closing gaps in incomplete contracts. By this theory, the economic significance of "ownership"is that property ights have the effect of assigning to the"owner of an asset the right to make all of the decisions about the use of the asset, except those assigned by law or contract to someone else. In other words, the owner gets the"residual rights of control Furthermore, by this theory, economic decisions about the use of an asset made by the"owner are likely to be optimal because the residual right of control is bundled with the right to receive the residual income as well as the responsibility to bear the residual risk associated with the asset The theoretical work on property rights as a mechanism for closing gaps in contracts forms the basis for an additional literature in which property rights over assets define a firm, or at least, define the boundaries of the firm. This essay argues that, despite all this emphasis on"ownership rights"and their supposed importance in corporations, ownership of corporations is not a well-defined concept When a corporation is formed, a separate legal entity is created, and the corporation itself becomes the"owner" of the assets put into the corporation by the initial investors. The corporation subsequently has the residual income rights and the residual rights of control over those assets, as well as over the output from production, and over any further assets purchased by the firm. a central leg fact of the corporate form of organizatio, is that, once a corporation has been formed, and assets I See, e.g., Grossman and Hart(1986)p 691; Hart and Moore(1990)p. 1119 Hart(1988) p. 119; and Hart(1989)p. 1757 The corporate form emerged in the Middle Ages in Europe as a mechanism by which property could be held more or less in perpetuity by churches, monasteries, universities, municipalities, and eleemosynary institutions such as hospitals. The idea was to separate control rights from conveyance rights, so that a bishop, for example, could acquire or sell property for the church, but could not convey that property to his heirs
1 See, e.g., Grossman and Hart (1986) p. 691; Hart and Moore (1990) p. 1119; Hart (1988) p. 119; and Hart (1989) p. 1757. 2 The corporate form emerged in the Middle Ages in Europe as a mechanism by which property could be held more or less in perpetuity by churches, monasteries, universities, municipalities, and eleemosynary institutions such as hospitals. The idea was to separate control rights from conveyance rights, so that a bishop, for example, could acquire or sell property for the church, but could not convey that property to his heirs. 2 In recent years, there has been a surge in academic interest in the “ownership” of corporations, and in the links between ownership and performance. The interest in this issue is driven by rapid changes going on in international capital markets, as well as in the corporate sector in many countries. A substantial part of this recent literature regards owning shares of stock in a corporation as if owning shares were the same thing as “owning” the issuing corporation itself. This essay considers the ideas of “ownership”, and of “property rights” as they apply to the corporate context. Just as the idea of private property has been central to our understanding of the workings of capitalist economies, the idea of “ownership” has been a key idea in much of the literature on the theory of the firm and corporate governance in the last twenty years. Professor Oliver Hart, individually and together with various coauthors, advanced our understanding of the role of “property rights” in the theory of the firm by suggesting that “property rights” should be understood as a mechanism for closing gaps in incomplete contracts.1 By this theory, the economic significance of “ownership” is that property rights have the effect of assigning to the “owner” of an asset the right to make all of the decisions about the use of the asset, except those assigned by law or contract to someone else. In other words, the “owner” gets the “residual rights of control”. Furthermore, by this theory, economic decisions about the use of an asset made by the “owner” are likely to be optimal because the residual right of control is bundled with the right to receive the residual income as well as the responsibility to bear the residual risk associated with the asset. The theoretical work on property rights as a mechanism for closing gaps in contracts forms the basis for an additional literature in which property rights over assets define a firm, or at least, define the boundaries of the firm. This essay argues that, despite all this emphasis on “ownership rights” and their supposed importance in corporations, ownership of corporations is not a well-defined concept. When a corporation is formed, a separate legal entity is created, and the corporation itself becomes the “owner” of the assets put into the corporation by the initial investors. The corporation subsequently has the residual income rights and the residual rights of control over those assets, as well as over the output from production, and over any further assets purchased by the firm. A central legal fact of the corporate form of organization2 , is that, once a corporation has been formed, and assets
have been assigned to the corporation by the initial investors, none of the participants in the enterprise own those assets any more. nor do they own the output of the firm. nor do they own the assets has investors, but does not have any "owners"in the way people normally use that wag poration itself subsequently added by the reinvestment of profits or by injections of new capital. The cor Corporations have"shareholders", of course. Shareholders are often casually referred to as the"owners "of corporations. But shareholders do not have the set of rights and responsibilities that we associate with"ownership"in other contexts. Shareholders do not directly own any of the assets used in production, nor do they own the output of the firm. They do not directly make any of the decisions about the use of the assets. They do not even bear full liability for the activities of the firm Instead, what shareholders get in exchange for their initial contribution of resources to the corporation are specialized claims against the enterprise that come with some very limited rights Shareholders subsequently own their shares in all the ways that we normally mean when we say someone"owns"something. They bear the risk associated with the shares, they reap the gains, they can sell the shares, or transfer ownership to someone else, or otherwise control the disposition of the shares. But that is not the same as saying that they "own the corporation itself. One could argue that the point is merely a semantic one. But of the last two decades, the language of ownership has been used as a trump card, to curtail debate about the social and legal purpose of corporations. Hence it is useful to examine the use of this fully s9ompl. he legal fact is that none of the participants in the activities of a given corporation have the full ment of rights and claims and responsibilities that we normally associate with"ownership" and at, when bundled together, are supposed to fill in the gaps in incomplete contracts and provide appropriate incentives. Not the shareholders, not the directors, not the managers, not the creditors, not the employees. As a legal matter, and as a description of the economic realities, there are no"owners So, the paradox is, if ownership" is so important to the functioning of a capitalist economy, why does corporate law break up the bundle of claims and responsibilities that we normally associate with"ownership", and assign different parts of the bundle to different players? Why are there no owners"of corporations? See discussion of shareholders as"owners"in Blair(1995)p. 223-225, and also discussion of the"property conception"of the corporation, p. 208-210 I first challenged the appropriateness of the use of the word"ownership"in the corporate context in Blair(1995)p. 16-19
3 See discussion of shareholders as “owners”in Blair (1995) p. 223-225, and also discussion of the “property conception” of the corporation, p. 208-210. 4 I first challenged the appropriateness of the use of the word “ownership” in the corporate context in Blair (1995) p. 16-19. 3 have been assigned to the corporation by the initial investors, none of the participants in the enterprise own those assets any more. Nor do they own the output of the firm. Nor do they own the assets subsequently added by the reinvestment of profits or by injections of new capital. The corporation itself has investors, but does not have any “owners” in the way people normally use that word. Corporations have “shareholders”, of course. Shareholders are often casually referred to as the “owners” of corporations. But shareholders do not have the set of rights and responsibilities that we associate with “ownership” in other contexts. Shareholders do not directly own any of the assets used in production, nor do they own the output of the firm. They do not directly make any of the decisions about the use of the assets. They do not even bear full liability for the activities of the firm3 . Instead, what shareholders get in exchange for their initial contribution of resources to the corporation are specialized claims against the enterprise that come with some very limited rights. Shareholders subsequently own their shares in all the ways that we normally mean when we say someone “owns” something. They bear the risk associated with the shares, they reap the gains, they can sell the shares, or transfer ownership to someone else, or otherwise control the disposition of the shares. But that is not the same as saying that they “own” the corporation itself. One could argue that the point is merely a semantic one. But in corporate governance debates of the last two decades, the language of ownership has been used as a trump card, to curtail debate about the social and legal purpose of corporations. Hence it is useful to examine the use of this language carefully4 . The legal fact is that none of the participants in the activities of a given corporation have the full complement of rights and claims and responsibilities that we normally associate with “ownership” and that, when bundled together, are supposed to fill in the gaps in incomplete contracts and provide appropriate incentives. Not the shareholders, not the directors, not the managers, not the creditors, not the employees. As a legal matter, and as a description of the economic realities, there are no “owners” of corporations. So, the paradox is, if “ownership” is so important to the functioning of a capitalist economy, why does corporate law break up the bundle of claims and responsibilities that we normally associate with “ownership”, and assign different parts of the bundle to different players? Why are there no “owners” of corporations?
Some of the work that my colleague Lynn Stout and i have been doing in the last few ye provides an explanation for this paradox Consider the central economic and contractual problems that must be solved when a group of people get together to undertake some joint economic enterprise. Note that we assume that a"group of people" are involved. We do this because the corporate form would not be necessary for organizing production if all production were undertaken by individuals acting alone, using assets they own directly It would not even be necessary if all production were undertaken by individual property owners working with and directing the efforts of a group of employees. The individual proprietorship form has been used for centuries for such arrangements The corporate form came to be used, and continues to be used today, to organize production activities that are too large and too complex to be organized, managed, and financed by a single individual. To be sure, the corporate form has often been co-opted by individual proprietors who want the benefits of limited liability. But it is abundantly clear that the corporate form was not invented just to give limited liabil ity to individual proprietors. The form exists primarily, if not exclusively, to organize enterprises that require complex inputs from a large number of individuals Professor Stout and I use the phrase team production"to refer to the kind of complex organizational problem that we feel provides the primary rationale for the corporate form. We borrow the basic idea from work done in the early 1970s by armen alchian and harold demsetz who define team production as"production in which(1) several types of resources are used. (2)the product not a sum of separable outputs of each cooperating resource. and] (3)not all resources used in team production belong to one person We think this description probably applies to a very large part of production in modern economies. Team production presents severe contracting problems. Think about the complex interactions among numerous individuals required to develop a new drug to treat depression, for example. The research effort may involve the work of teams of biochemists, neurobiologists, and 5 See especially Blair and Stout(1999)p. 247 6 For small businesses, the choice of organizational form may also often be influenced by tax considerations 7 Early general incorporation laws in the United States usually required more than one party to be involved, and did not always provide for limited liability for shareholde See blair and Stout(1999) See Alchian and Demsetz(1972)p 779
5 See especially Blair and Stout (1999) p. 247. 6 For small businesses, the choice of organizational form may also often be influenced by tax considerations. 7 Early general incorporation laws in the United States usually required more than one party to be involved, and did not always provide for limited liability for shareholders. 8 See Blair and Stout (1999). 9 See Alchian and Demsetz (1972) p. 779. 4 Some of the work that my colleague Lynn Stout and I have been doing in the last few years provides an explanation for this paradox5 . Consider the central economic and contractual problems that must be solved when a group of people get together to undertake some joint economic enterprise. Note that we assume that a “group of people” are involved. We do this because the corporate form would not be necessary for organizing production if all production were undertaken by individuals acting alone, using assets they own directly. It would not even be necessary if all production were undertaken by individual property owners working with and directing the efforts of a group of employees. The individual proprietorship form has been used for centuries for such arrangements. The corporate form came to be used, and continues to be used today, to organize production activities that are too large and too complex to be organized, managed, and financed by a single individual. To be sure, the corporate form has often been co-opted by individual proprietors who want the benefits of limited liability6 . But it is abundantly clear that the corporate form was not invented just to give limited liability to individual proprietors7 . The form exists primarily, if not exclusively, to organize enterprises that require complex inputs from a large number of individuals. Professor Stout and I use the phrase “team production” to refer to the kind of complex organizational problem that we feel provides the primary rationale for the corporate form8 . We borrow the basic idea from work done in the early 1970s by Armen Alchian and Harold Demsetz who define team production as “production in which (1) several types of resources are used…(2) the product is not a sum of separable outputs of each cooperating resource…[and] (3) not all resources used in team production belong to one person”9 . We think this description probably applies to a very large part of production in modern economies. Team production presents severe contracting problems. Think about the complex interactions among numerous individuals required to develop a new drug to treat depression, for example. The research effort may involve the work of teams of biochemists, neurobiologists, and