Contract Governance over Corporate Governance: The Way Forward

Neoclassical economics textbooks proclaim that markets endowed with laws governing private property rights, contracts and bankruptcy are better equipped to deliver economic wonders—efficiency and equity. But in the real world, as is incidentally being experienced amid the ongoing global economic crisis, it does not happen that way, at least always.

Even the prophet of market economy, Adam Smith, was perhaps aware of it when he said: “Creating harmony between the pursuit of self-interest and the pursuit of social welfare depends on the constraints on self-interest.”

This reminds us of what David Hume said: humans have learned to confirm themselves to a certain set of conventions so as to make cooperation possible in a world of scarcity and limited foresight.

But the scope for the operation of such a ‘constraint’ on man’s behavior appears slim, for ‘Man’, as enunciated by Bhishma, the grandsire in the Mahabharata, is a slave to money—‘arthasya purusha dasah’. The ongoing world economic crisis—collapse of organisations as also the resultant worldwide contagions—is, perhaps, a vindication of this prophecy.

Fortunately, there are off-beat researchers of modern day who have analyzed as to why the world looks the way it does—different from the ideal world found in classical textbooks—and explained as to what works in it. The Nobel Prize winners in Economic Sciences for the year 2009, Elinor Ostrom of Indiana University, Bloomington, US, and Oliver Williamson of the University of California, Berkeley, US, are two such researchers who carried out independent research into economic governance—the rules by which people organise, cooperate, relate and exercise authority in companies and economic systems.

Williamson “developed a theory where business firms served as structures for conflict resolution.” He argued that hierarchical organisations, such as companies, represent alternative governance structures, which differ in their approaches to resolving conflicts of interest. His ‘transaction cost theory’ that encases the opportunistic behaviour of agents who can renege on their commitments, bounded rationality of agents and asset specificity, where assets are only valuable in certain uses and certain economic relationships that offer a scope for the parties transacting with each other to engage in ‘holdup behaviour’ indeed highlights the nature of real-world market organisations.

He argued that “large private corporations exist primarily because they are efficient. They are established because they make owners, workers, suppliers, and customers better off than they would be under alternative institutional arrangements.” He also clarified that “when corporations fail to deliver efficiency gains, their existence will be called into question,” which means firms cannot grow infinitely either.

This led to the belief that corporates are better equipped to handle the drawback—haggling and disagreement—associated with markets by virtue of their authority to ‘mitigate contention’ through a broad range of organisational compacts such as the choice and design of contracts, ‘information impactedness’, corporate financial structure, the function and operation of political systems, and the size and scope of firms, etc.

Interestingly, as the world is entangled in governance issues—failure of boards of directors to moderate excessive compensation or bonuses that encourage excessive risk-taking, leading to not only the collapse of organisations but also worldwide contagion of risk—Florian Möslein, comes up with an argument that ‘contract governance’—a combination of “insights from governance research and contract theory”—is better equipped to help avoid future market crises, for it takes into account markets too. 

At its broadest sense, contract governance “covers various and very diverse issues of governance in contract law and contract practice, just as corporate governance does for company law and finance.” It represents a holistic and comprehensive approach paving the way for mutual and consensual forms of coordination and decision making among all the agencies involved in market relationships and the resulting operations. Essentially, it is an interdisciplinary endeavour—engulfing not only economics but also sociological and neuro-scientific knowledge—and hence it is expected to facilitate a dialogue across disciplinary borders. In turn, it shall provide a better means to usher in good order in the allocation of risk by the financial institutions by affording the much needed transparency in the market. There is of course a downside: it acquires greater complexity challenging the wit of markets.

But looking at the behaviour of man over the ages, one wonders if there is any ‘governance’ model that can ever rein in man’s greed for money, which incidentally is the driving force behind all the ingenuity in his breaching the regulations.