UvA

The impossibility of writing complete contracts causes loss of profitable transactions among firms, since their managers cannot ex ante bind themselves to future actions. The author shows how a reallocation of ownership rights into a network of mutual shareholdings among a coalition of firms produces an efficient enforcement mechanism. Cooperation is achieved by exchanging control rights until a mutual threat of capture of control is established. By making control over their firms vulnerable to a takeover by the other members of the coalition, each firm is able to make a credible commitment to future efficient actions. In equilibrium no punishment is administered, so that the arrangement achieves the outcome under complete contracts. More generally, it is proved that a mutual hostage exchange may dominate the threat of loss of reputation as an enforcement mechanism.