Business Law and Innovation Project

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A. Project Goals

Growth in per capita income for the developed countries of Japan, the United States, and the European Community comes primarily from increased knowledge—improved skills and innovation in the form of improved products and processes —not from capital deepening. For innovative ideas to make their contribution, however, new investment is generally required. The most promising new investment project proposals in an economy are likely to be innovation based, because, if they are not, the potential for above normal returns is likely to have already been competed away by other firms making similar investments. Thus, the better an economy is at allocating its scarce savings to implementing the most promising proposed investment projects, the higher the level of innovation. Business law (corporate, securities, and contract law) helps shape the institutions that make the decisions that determine which of an economy’s investment project proposals get implemented and which do not. By affecting the ability of an economy to choose the best proposed investment projects, business law can affect the level of innovation and hence the rate of improvement in a country’s economic welfare.

Neither scholars nor policymakers have given this link between law and innovation sufficient attention. Theory is underdeveloped and what exists is underinformed by actual experience. Japan, the United States and the European Community, each has a rich history of both successes and failures in identifying and implementing highly promising, innovative investment projects. The lessons of the history of each economy, however, are insufficiently understood by its own scholars and even less well understood by scholars from the other two economies. In order to remedy these deficits, the project in business law and innovation will gather the best scholars in the world working at the intersection of law, the economics of contracts and organization, finance and innovation. The papers contributed by these scholars will seek to account for what has happened across three economies with significantly different institutional two characteristics. The theory of innovation will be deepened by this better understanding of what works and what does not under various circumstances and why, as well as of the tradeoffs involved. The ultimate goal would be for policymakers in Japan, the United States, and the European Community to be able to refine their legal systems in ways that will promote welfare-enhancing innovation, based on a better understanding both of what has happened in their own economy and of what has happened in each of the other two.

This project includes a planning session, conference in New York at which preliminary drafts of the papers are discussed, and two follow up conferences, respectively in Amsterdam and Tokyo, where final papers will be presented and further input from European and Japanese commentators and participants received. The result will be a coordinated set of papers in a book published by a major university press.

B. Patterns of Innovation Finance

Framework for Analysis

A survey of the three economies reveals that innovative investment project proposals are financed through 14 different pathways. Each pathway represents a different combination of the initial source of finance, the vehicle that makes the actual decision to provide the financing, and the later stage financing, if any, to pay off the initial financing and to provide continued new funds as needed. Each pathway is used to some extent in each of the three economies, but, for each, the proportion of innovations financed through it differs greatly from one economy to another. The pathways can roughly be categorized as follows:

Questions to be Answered:

Each of these pathways represents a way that an economy makes choices as to which investment project proposals to implement and which to reject. In order to maximize innovation-driven economic growth, an economy must select the most promising proposals. With this observation in mind, there are a number of questions that the endeavor proposed here should seek to answer. Business law is potentially relevant to the answers of a number of them because these laws help structure the internal decisionmaking of the corporations and other business entities involved, affect the legal relations among business entities and between them and individuals, and affect the depth, liquidity, and price accuracy of public securities markets. What is the relative use of each pathway in each of the three economies currently and over the last few decades?For each of the economies, what are the differences in the kinds of projects financed by each of the pathways? Why do the differences among the three economies in the relative use of each of the pathways occur and what is the role of business law in determining the mix? For each of the economies, what can be said about how successful each of the pathways is as a route for finding and implementing the most promising projects in the economy and what, if any, is the role of business law in that level of success? How successful has the overall mix of paths utilized by each of the economies been in promoting innovation? Can a consideration of longer history, say 150 years, provide additional insights beyond what can be gleaned from the last few decades?

Questions 1 and 2 are largely descriptive, but answers gathered in one place in comparable form would be very helpful. Questions 3, 4, 5 and 6 are obviously enormously complicated. For Question 3, differences among the overall mix of paths may have deep historical roots reflecting a number of social and political factors over time. Figuring out which factors have explanatory value without a large cross sectional sample always involves some historical “what if” type speculation. The design of corporate and securities law may be a product of the design of the institutions to which these more fundamental explanatory factors gave rise. Because of path dependency, whether, as a practical matter, significant effective change in law is possible today and whether, if undertaken, it would lead to institutional change and change in the mix of pathways are, at the outset at least, open issues. For Question 4, simply examining the returns on funds through the different pathways will not be very informative for a number of reasons. To start, they will not capture the returns earned by the project proponents as a result of the deal they made with the sources of finance. Also these returns may not reflect differences in the systematic riskiness of sectors that each pathway tends to serve. Most importantly, they say nothing about the number of promising projects that the system failed to identify and implement.

For question 5, the higher rate of innovation and per capita income growth over the last two decades in the United States compared to Japan and the European Community is a matter of record. But to what extent is the U.S. mix of pathways the explanation, as some U.S. scholars suggest, as opposed to other factors. To the extent that the U.S. mix of pathways is indeed essential for U.S. success, to what extent would its replication elsewhere result in similar success and could that change in pathways elsewhere be accomplished through changes in corporate and securities law? The fact that Questions 3, 4, and 5 (and, by implication, Question 6) are complicated does not mean that progress cannot be made in answering them through the classic techniques of good social science: developing plausible hypotheses and testing them against the available observable variations over time, space and circumstance in the explanatory variables identified by the theory. Ultimately, any findings that would point to change in law as a policy instrument for promoting innovation would be enormously valuable given the critical role that innovation plays in increasing economic welfare.

C. Contract, Organization, and Innovation

Framework for Analysis

The issues that are raised by the questions posed above are similar in kind to those that arise when the focus turns to the modes of economic organization that best support innovation. In recent years, industries characterized by rapid innovation just have not been behaving the way theory expected. The conventional industrial organization theory explains that when contracting parties in the supply chain have to make transaction specific investments, then the risk of opportunism will drive them toward vertical integration. This pressure toward common ownership will be especially powerful in innovative industries where the rate of technology change results in supply relationships characterized by uncertainty; that is, where future states cannot be predicted probabilistically. In the presence of uncertainty, contemporary contract theory offers no general solution to the problem of assuring ex ante efficient levels of transaction-specific investment and ex post adjustment to an efficient outcome when uncertainty is resolved. When contract cannot address opportunism, hierarchy should dominate markets as a means to organize supply relationships.

Despite the conventional theory, practice is going in the other direction, strongly suggesting that the people doing the work know something that the theorists have not yet figured out. Rather than vertical integration, we observe vertical disintegration, as product producers recognize that they cannot themselves maintain cutting edge technology in every field required for the success of their product. Increasingly, the supply chain has disintegrated, with companies electing to acquire by contract components that in the past they would have made themselves. And despite the theoretical gaps, the parties are developing patterns of contracting that do not fit any of the models of contract theory.

In response to the evidence of contract replacing the integrated firm, some theorists have focused on “modularity:” the claim that new production tools permit parties to standardize the interface between separate stages of production. Each module can serve many purposes and can fit a variety of different products. The result is a moderation in the intensity of firm-specific investments and a resulting reduction in the risk of opportunism. But modularity is a double-edged sword: it may trap a firm in a no longer competitive technology. To avoid the “modularity trap,” firms instead are engaging in a process of iterative collaboration and co-design. Other theorists have suggested, therefore, that rather than modularity, this collaborative process is governed by purely relational contracting. Here the focus is on the dominance of social bonds and informal cooperation as the primary governance mechanism. But neither of these polar alternatives fit the contracting patterns that parties have devised to cope with the continuous uncertainty caused by rapid technological change.

Questions to be Answered:

The preceding framework raises a number of questions that this project will seek to answer.

How can we reconcile the emerging practice with theory? What organizational structures are replacing the vertically integrated firm? Has the apparent change in the boundary of the firm given rise to new forms of contracting? If so, what are their key characteristics?Does the drive to control opportunism explain the new forms of organization? If so, is the problem addressed in the absence of vertical integration? Do the answers to the preceding questions suggest any changes in contract law or rules of interpretation that would help facilitate innovation?

Question 1 asks us to learn from what has happened in the real world to frame a theoretical explanation of the redefined boundaries of the firm and the organizational location of critical efforts at innovation, as well as the contracting practices that have developed to support this cross-organizational innovation. For Question 2 we will seek to explore the effects of vertical disintegration. Perhaps the vertical disintegration of the supply chain is mediated by fully specified interfaces that allow suppliers to produce a modular piece of the ultimate product without reference to what other suppliers are doing Alternatively, we may find entirely implicit relational contracts supported only by the expectation of future dealings. Question 3 suggests that neither of the polar alternatives noted above accurately describe the emerging patterns of contract and organization. Rather, it seems plausible that the change in the boundary of the firm has given rise to a new form of contracting between firms—what we might call contracting for innovation. Question 4 suggests that as with the conventional account of the forces pushing toward vertical integration, opportunism likely plays a central role in explaining the organization of disintegrated innovation in the supply chain, but it is equally probable that it is addressed in a radically different fashion. Question 5 considers the policy implications of this whole line of enquiry.

D. Structure of the Project

The project will build on the successful February 2006 RIETI conference in Tokyo, “What Financing Mechanisms and Organizations of Business Entities Best Facilitate Innovation,” which was primarily oriented at the roles played by the different legal business forms. As developed above, this project asks a broader set of questions, following the many different project-financing pathways from initial funding through relative project maturity.

A preliminary planning session for the project was held in New York at the Columbia Law School on November 16, 2007. Patrick Bolton, Merritt Fox, Ronald Gilson, and Joseph McCahery were in attendance. A concept paper was also submitted by Robert Scott, who could not attend. The presentations were aimed at refining the questions to be answered, reporting on existing research, identifying the questions that require new original research, and developing a list of project participants.

The first full conference of the project will involve the presentation of preliminary draft papers. The intent of the first conference is to make the final product of the project more coordinated and in particular to expose the theoretical contributions to the empirical ones and vice versa. The conference will be structured to promote intensive discussion among the presenters so as to maximize the impact of the papers on each other. The conference will also include, as commentators and participants, a group of top academics in corporate and securities law and in the economics of contracting and organization. The purpose of including them is not only to further improve the presenters’ papers, but also to help shape the research agendas of these other academics to include efforts to answer the questions posed by the project. The conference is scheduled to be held in New York City at Columbia on October 31-November 1, 2008.