Relational Governance and Contract Damages: Evidence from Franchising

Abstract

A substantial body of theoretical, qualitative, and experimental research has investigated whether reliance on legal threats “crowds out” informal, norm‐based ways of regulating behavior or, instead, whether the ability to enforce law formally enhances the ability of private parties to use these informal approaches. There has, however, been little quantitative, real‐world work that looks into this question. This article begins this process through a study of how franchisors regulate the incentives that their franchisees have to cut corners on the brand's quality and uniformity standards. One solution to this problem is to threaten to pursue a breach of contract action for violation of these standards, which allows the franchisor to obtain a damage award against a franchisee. Alternatively, a franchisor can rely on more informal means, such as awarding an extra franchise outlet to those franchisees who behave well. There is a tradeoff between these two mechanisms; the informal rewards are costly to provide, but easy to enforce, while contractual threats are cheap, but their enforcement is expensive. Moreover, the literature on relational governance suggests that the use of formal legal threats may undermine an agent's willingness to abide by reciprocation norms along noncontractible dimensions. These theories suggest that formal and informal mechanisms will act as substitutes and this study, which uses a newly collected data set of franchise agreements, provides strong evidence for that assertion. The analytical insight that permits this inference is the presence of liquidated damages provisions as an indicator of the willingness to use formal law. Courts have shown hostility to the use of the default rule of expectation damages, but they will enforce liquidated damages terms, which means that these provisions are a credible threat to use formal legal sanctions. This study finds that a limited number of franchisors use these terms and that their presence correlates negatively and significantly with variables that are associated with informal, nonlegal means of incentivizing franchisees.