Connecting the Circuits

By uncovering and dissecting a creative new way companies use business contracts to spur commercial innovation, three Law School professors are at the leading edge of what might be the most influential contract law development in decades

By Peter Coy

Summer 2011

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Anomalies fuel science. It was the odd motion of Mars across the night sky that forced Johannes Kepler to the radical conclusion that planets’ orbits must be elliptical, not circular. For Columbia Law School Professors Ronald J. Gilson, Charles F. Sabel, and Robert E. Scott, a recent curiosity-fueling anomaly appeared, like Chinese food at a French restaurant, in a database of commercial contracts maintained by the Securities and Exchange Commission. Efforts to account for a seemingly unaccountable trove of documents initiated a quest that just might reshape the way that legal scholars and judges think about
commercial contracting in the 21st century.

“The puzzle was that these contracts seemed to be neither fish nor fowl,” says Scott, the Alfred McCormack Professor of Law, in his seventh floor office in Jerome Greene Hall. “They were radically incomplete. There were often no commitments as to an end product. But, on the other hand, they were not solely what we would call relational contracts with no legal structure. They had a very formal governance structure.”

What the Law School team had stumbled on was a new way of doing business—one that judges and law professors had somehow overlooked. The companies concocting these contracts, such as John Deere, Apple, and Bristol-Myers Squibb, were formulating productive new ways of dealing with each other under conditions of uncertainty—ways that did not comport with theory, legal precedent, or judges’ assumptions. The professors dubbed it “contracting for innovation,” a hybrid of formal contracting and informal relationship building.

Case in point: iPads may be “designed by Apple in California,” as noted on each shiny new model, but their display, memory chips, and brain come from Samsung. Apple needs the South Korean electronics giant to innovate on its behalf. Complicating matters is the fact that Samsung makes its own tablet computer, so it is as much a rival of Apple as a partner—a “frenemy,” in Silicon Valley lingo. A standard contract dealing with specs, volumes, and prices could not possibly handle such a fraught relationship. In the course of their research, the Law School professors dissected a predecessor to the Apple-Samsung deal—a contract from 1996 between Apple and the outsourcing manufacturer SCI. The key to it was a detailed procedure for “collaborative co-design,” including information sharing, penalties for breaches, and other rules to make sure neither side ripped off the other.

In other words, while Steve Jobs may be the creative genius of Apple, the company’s lawyers deserve some credit, too.

Contracts for innovation govern processes, not outcomes. Typically, they specify procedures for how two companies will cooperate toward developing a product or service that still can’t be fully imagined, whether it’s an iPad or a Boeing 787. They also set up an internal mechanism for resolving disputes without lawsuits—a “referee,” to use Scott’s terminology. This framework gives both parties the confidence to make costly investments in their joint project, quickly building trust and leading to innovations that otherwise might not have occurred.

The effort to understand contracting for innovation, and to develop a concept for how these contracts should be treated by the courts, has led the three professors on an exhilarating intellectual journey that is not over yet. “I think all of us would count it among the highlights of our scholarly careers,” says Scott. The three-way collaboration “is what universities are supposed to be about,” adds Sabel, the Maurice T. Moore Professor of Law. Gilson, the Marc and Eva Stern Professor of Law and Business, says simply that the trio’s work hit the “sweet spot” where legal practice leaves off and legal theory kicks in.

Like small mammals scurrying between the legs of dinosaurs, the new contracts evolved to cope with a new business environment of speed and uncertainty. An example that Gilson, Sabel, and Scott cite is a 1997 collaboration and licensing agreement between Bristol-Myers Squibb and a smaller, research-oriented company named Pharmacopeia Inc. During the early stage of the drug companies’ work together, when uncertainty is high, the collaboration is governed by a research steering committee that reports to the heads of both companies while doing its best to promote information exchanges and eliminate misunderstandings. Later, when a product is invented and the uncertainty is dispelled, a standard contract kicks in, spelling out which party has the right to commercialize the product under various conditions. The “braiding” of formal and informal contracts into a single relationship “is something nobody contemplated,” says Professor Charles Sabel.

Contracting for innovation does not jibe with standard law and economics theory, which holds that companies can either have formal contracts with each other, or have informal collaborations, but cannot have both at once. The formal “crowds out” the informal, it is said.
Theorists like to tell the true story of an Israeli day-care center that relied on informal social pressure to get parents to pick up their children on time. When the day-care center added the formal sanction of fines, lateness actually increased. Parents started feeling that it was acceptable to be late, as long as they paid the fine.

But Gilson, Sabel, and Scott say that the Israeli day-care center experience does not prove that crowding out must always occur. They say formal and informal measures can actually reinforce each other as long as each governs its own sphere. “The metaphor for me is a Picasso line drawing,” says Professor Ronald Gilson. “Picasso draws one line and somehow that one line organizes all of the empty space and how you see something. The formal element gives structure through which the uncertainty can be resolved, and without the risk that there subsequently will be a fight.”

A problem arises, though, when judges who do not understand contracts for innovation foul things up by going to one of two extremes: either declaring them unenforceable, or giving them more weight than the parties intended. “No matter how sharp the intuitions of experienced judges, courts unguided by a theoretical framework are prone to err,” the professors write in their chapter of a new law and economics book, Rules for Growth.

By supplying the missing theoretical framework underpinning the new-style contracts, the Law School professors hope to educate judges and make the legal system a lubricant for innovation instead of a source of friction. Robert E. Litan, an economist with positions at both the Kauffman Foundation—a pro-entrepreneurship organization that partially sponsored the research—and the Brookings Institution, says “they’re the cutting edge of thinking about contracts.”

The joint work of Gilson, Sabel, and Scott is an exemplar of fruitful collaboration. In 2006, after Professor Charles Sabel’s research assistant Matthew Jennejohn ’07 found those strangely worded documents in the SEC database, Sabel mentioned their existence to his colleagues. Sabel, Gilson, and Scott then met over a series of lunches at the Amsterdam Cafe, Sezz Medi, and elsewhere. Each of the three professors brought something to the table. Professor Ronald Gilson is an expert in corporate finance and Silicon Valley innovation. He has studied how venture capital firms prevent opportunistic behavior by the managers of firms they invest in. Sabel is fascinated by governance issues, the organization of production, and networks. Professor Robert Scott is the contracts expert of the group.

The team’s first article on this topic for the Columbia Law Review, in April 2009, described the rara avis they had discovered. “Rapidly innovating industries are not behaving the way theory expects,” they began. The errant theory to which they referred, based on research by Ronald Coase, says that transaction costs—annoyances like attorney and accountant fees and time-wasting negotiation—determine how companies organize work. If transaction costs are low, it will be efficient for a company to acquire what it needs through arm’s-length dealings in the open market. If transaction costs are high, companies will avoid those costs by bringing work in-house. Nobel laureate Oliver Williamson of the University of California, Berkeley, argued that the most important transaction cost is the risk that a firm will be “held up,” Bonnie and Clyde–like, by an unscrupulous business partner that waits until its counterparty is in deep and then seizes the fruits of their joint investments. (For example, a freelance writer could hold up his editor by demanding more money to make a final round of changes on an article that is about to be published.)

Gilson, Sabel, and Scott say modern theories of the firm such as Williamson’s do not adequately explain corporate behavior now, if they ever did. And Coase seems to agree with them. Remarkably, the man is still alive, having turned 100 this past December. As recently as 2006, he wrote an article rebutting latter-day interpretations of his much-cited 1937 paper “The Nature of the Firm,” which helped win him the Nobel Prize in economics in 1991. The three Law School professors say their work is a natural extension of the original Coase. In their new telling, firms are organized to deal with a wide range of challenges, the risk of hold-up that Williamson emphasizes being just one among them. “This is a generalization of the Coasian idea,” says Sabel. “We come to the conclusion that the firm doesn’t have a ‘nature.’ As the problems change, the firms change.”

Having dissected the rare bird they discovered, the professors wrote a second article for the Columbia Law Review in October 2010 that instructed judges on how to enforce contracts for innovation. Their advice: Not too hard; not too soft. Violations of the early-phase, process portion of an agreement should be punished, they suggested, but only for clear-cut, “red face” infractions. And violators should not be held responsible as if they had reneged on a full-fledged contract, they said.

Gilson, Sabel, and Scott have high hopes that their work will be applied widely. They are drafting a third law review article on the subject, after which they plan a book. They are also organizing a late 2011 conference for scholars who are building on or critiquing their formulation.

Waxing enthusiastic during the office interview, Scott calls contracting for innovation “the holy grail of my life’s work.” And its applications are potentially enormous. Emile Durkheim, the French sociologist, said that contracts depend on social trust, but also erode trust over time. Daniel Bell, the American sociologist who died in early 2011, worried about the same thing. Gilson, Sabel, and Scott think that contracting for innovation might give society a way out—a system that braids together the best aspects of contract-based and trust-based ways of doing business. “Could it be,” they ask in the conclusion of their October 2010 law review article, that the emergent system they identified could renew social cooperation “even as the conditions of cooperation become more uncertain?”

Peter Coy is the economics editor at Bloomberg Businessweek.

Illustration by Ken Orvidas

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