Columbia Law School Scholarship Archive Faculty Scholarship Faculty Publications 2018 Can Restitution Save Fragile Spiderless Networks? Ariel Porat Tel Aviv University, [email protected] Robert E. Scott Columbia Law School, [email protected] Follow this and additional works at: https://scholarship.law.columbia.edu/faculty_scholarship Part of the Business Organizations Law Commons Recommended Citation Ariel Porat & Robert E. Scott, Can Restitution Save Fragile Spiderless Networks?, 8 HARV. BUS. L. REV. 1 (2018). Available at: https://scholarship.law.columbia.edu/faculty_scholarship/2494 This Article is brought to you for free and open access by the Faculty Publications at Scholarship Archive. It has been accepted for inclusion in Faculty Scholarship by an authorized administrator of Scholarship Archive. For more information, please contact [email protected]. CAN RESTITUTION SAVE FRAGILE SPIDERLESS NETWORKS? ARIEL PORAT* & ROBERT E. Scorr** This Article examines the dramatic increase in business networks in recent decades and considers whether the law can play a useful role in supporting the efficient functioning of these inter-firm relationshipsfor coordinationand coop- eration. Repeat play, reputationalsanctions, and norms of trust and reciprocity are the common explanationsfor the flourishing of networks in many industries and places. But the evidence also shows that a certain class of networks often fails to survive or function effectively and beneficial cooperation among these network members is impaired. These fragile networks develop organically with- out a controlling party or hierarchy at the center of the network to facilitate network formation. Lacking a controlling entity, they are "webs without any spider." Clusters of industrial districts are traditionalexamples of this class of networks. More recently, the information revolution has stimulated a dramatic increase in another type of "spiderless" network: networks of strategicalliances are now a common means of organizing collaborations among firms in high technology and R&D intensive settings. In both types of spiderless networks there are no legal mechanisms to control moral hazard and free riding risks during the period of network formation and operation. We show how in theory the law could support spiderless networks by allowing firms who externalize benefits to other firms in the network to recover for those benefits. Practical considerationsmay limit the implementation of a full-blown right of restitution. Nevertheless, by recognizing a limited right to recoverfor uncompensated costs and benefits in appropriate cases, the law can function as a background norm for sharing costs and benefits among network members, motivating them to overcome daunting coordinationproblems. We consider several implementation issues, show how they might be resolved, and apply our analysis to a set of well- known spiderless networks. TABLE OF CONTENTS INTRODUCTION................................................... 3 I. BUSINESS NETWORKS AND THE EXTERNALITY PROBLEM ..... 7 A. Factors that Distinguish Networks and their Governance ....................................... 7 1. Networks with Spiders ........................... 7 2. Spiderless Networks ............................. 9 B. Characteristicsof Spiderless Networks and the Governance Problem ............................... 12 1. Network Formation and Resulting Value ............ 12 * Alain Poher Professor of Law, Tel Aviv University and Fischel-Neil Distinguished Visit- ing Professor of Law, the University of Chicago. ** Alfred McCormack Professor of Law and Director, Center on Contract and Economic Organization, Columbia University. We thank Lisa Bernstein, Giuseppe Dari-Mattiacci, Clay Gillette, Sharon Hannes, Ron Gil- son, Eric Posner, George Triantis and participants at the Law and Economics workshop at Columbia Law School for very helpful comments. Mark Cherry, Bar Dor and Daniel Kopilov provided excellent research assistance. 2 Harvard Business Law Review [Vol. 8 2. Moral Hazard and Free Riding Risks to Achieving a Reciprocity Equilibrium ......................... 13 3. Relational Governance of Spiderless Networks ...... 15 C. Four Exemplars of Externalities in Spiderless Networks . 16 1. Magnet Firms and Late Arrivals ................... 16 2. Free riding on Indirect Ties....................... 18 3. Exploiting "Structural Holes" ..................... 19 4. Exploiting Informational Synergies................. 20 5. The Effects of Externalities on Network Performance and Longevity ................................. 21 II. RESTITUTION THEORY AND SPIDERLESS NETWORKS .......... 22 A. Liability for Unrequested Benefits ..................... 22 1. Prevailing Law ................................ 22 2. Private Production of Public Goods ................ 23 B. Liability for Ill-Gotten Benefits ....................... 24 C. A Restitution Model ................................ 26 1. Case 1: Unilateral Creation of Benefits with Passive Beneficiaries .................................. 27 2. Case 2: Unilateral Creation of Benefits with Active Beneficiaries .................................. 28 3. Case 3: Multilateral Creation of Benefits ........... 29 4. Case 4:Increasing (or Decreasing) Costs of Joining the Network .. ................................ 32 5. Allocating the Network's Surplus .................. 33 6. Negative Externalities ........................... 35 7. Summary ..................................... 35 III. IMPLEMENTING A RESTITUTION REGIME .................... 36 A. Applying Low-Powered Restitution Remedies to the Four Exemplars ....................................... 37 1. Magnet Firms and Late Arrivals ................... 37 2. Free riding on Indirect Ties ....................... 39 3. Exploiting "Structural Holes" ..................... 40 4. Exploiting Informational Synergies................. 41 B. Crowding Out and Chilling Effects .................... 42 1. The Crowding Out Problem ...................... 42 2. Chilling Effects ................................... 45 C. Further Objections ................................ 46 1. Governmental Intervention ........................ 46 2. Evaluation Difficulties ........................... 47 3. Enforceability ................................. 48 D. Restitution as a Bargain-EnablingDefault.............. 48 CONCLUSION .............................................. 50 2018] Can Restitution Save Fragile Spiderless Networks? 3 INTRODUCTION When business parties want to collaborate they have traditionally pur- sued either market transactions or integration. Starting in the twentieth cen- tury, but continuing at a much greater pace in the past two decades as a product of the "information revolution," business networks have emerged as a third avenue for cooperation. Inter-firm networks are mechanisms for coor- dination and cooperation between formally independent but functionally in- terdependent firms. They provide firms with access to essential capabilities and resources that are under the control of other firms in their environment. Firms in networks frequently contract with others in the network to further their network project. These contracts can create benefits for, or impose costs on, other network members who are not contract parties. Addressing the moral hazard, free riding, and distributional issues raised by these exter- nalities in the absence of formal legal ties among participants has challenged economists, sociologists, and organizational theorists. In lieu of legal mecha- nisms, repeat play, reputational sanctions, and norms of trust and reciprocity are the common explanations for the flourishing of networks in many indus- tries and places. Until recently, the question of why some networks are durable and others are fragile has been largely ignored by legal scholars.' This lack of attention to how networks emerge and stabilize owes, in part, to the fact that legal intervention in networks is relatively rare. In addition, the overly broad focus on a network as a generic mode of cooperation and collaboration is too capacious to permit useful legal analysis. Some networks, for example, can deploy standard contractual mechanisms-whether in the form of a master contract as in the case of a franchise, or a bureaucratic contractual structure as in the case of trade associations-that support network collaboration. These relationships have a "spider in the web"-a controlling party or hier- archy at the center of the network that facilitates network formation and maintains stability.2 Other networks, however, are fundamentally symmetric or parity-based. Lacking a controlling entity, they are webs without any spi- der. In the case of these "spiderless networks," there are fewer legal mecha- nisms to control moral hazard and free riding risks during the period of network formation and operation.' As a consequence, the evidence shows ' Some significant exceptions are Alan Schwartz & Robert E. Scott, Third-PartyBenefi- ciaries and Contractual Networks, 7 J. OF LEGAL ANALYSis 325 (2015), and Lisa Bernstein, Beyond Relational Contracts: Social Capital and Network Governance in Procurement Con- tracts, 7 J. Legal Analysis 561 (2016). 2 We are grateful to Ron Gilson for suggesting the metaphor of the web with and without a spider. "There is not a sharp distinction between spider and spiderless networks. The distinction we draw is primarily instrumental to the goals of this Article. We use the designation of a spiderless network to describe any environment