Contracts Without Courts or Clans: How Business Networks Govern Exchange

Abstract

Legal scholars have long recognized the close-knit community as an alternative institution for supporting trade when contract law and trusted courts are unavailable. But recent research suggests that another option may be available: heterogeneous business networks. What’s interesting is that these networks lack features traditionally seen as essential to community-supported trade. In particular, they lack preexisting noncommercial social ties that allow reliable and trusted information to spread at low cost, make exiting the network difficult, and enable coordinated sanctioning of cheaters. As a result, some leading scholars doubt that these networks are doing the work of sustaining cooperation. This Article offers compelling evidence that these networks do indeed sustain high-stakes trade. Through an original case study of the reinsurance industry, it shows that when the gains from trade are sufficiently large, parties can build mechanisms to disseminate reliable information needed to support trade by starting with transactions that align incentives and require high transparency about behavior. Parties can then strengthen their commitments by both investing in the bilateral relationship and building a network in which each party is connected to several other parties, which helpfully allows information about behavior in trading relationships to spread at low cost. Once constructed, the network enables reputation-based bonding of higher-risk transactions and a greater variety of transactional terms than can be supported by incentive alignment alone. In short, this study of the reinsurance trade suggests that cultivated, freestanding business networks can support extralegal private ordering under a larger set of circumstances than legal scholars currently appreciate.

Keywords: contracts, private ordering, network governance, reinsurance, insurance

JEL Classification: k12, k41, l22, l23, l24, l14