May 07, 2014
Governing the Fragmented Firm: The Challenge of Identifying and Transmitting Incentives in a Global Value Chain
Posted by Kish Vinayagamoorthy

Many thanks to David for inviting me to visit.  As he mentioned, I just completed my first year at Washington and Lee University School of Law, where I taught International Business Transactions and Corporate Social Responsibility. One theme I explored in these courses concerned the challenge of governing the “fragmented firm” that has outsourced and offshored many of its functions to other actors in a global value chain (“GVC”).  My students and I were particularly engaged with the question of how to ensure compliance with human rights standards in a GVC that involves a variety of different firms operating in a variety of different countries.

California addressed this problem with the California Transparency in Supply Chains Act of 2010 that requires that covered firms disclose their efforts to ensure that their supply chains are free from slavery and human trafficking.  However, the Act’s effects are limited because of the problem of misaligned incentives in the GVC.  A GVC involves both buyers and suppliers and the Act's incentives are designed for the buying end.  As I explain in my forthcoming article, effective governance of the GVC requires an incentive structure that is appropriate for the diversity of actors who operate in the "fragmented firm."

Under the California Act,  a covered firm must disclose to what extent it does the following:

  •  “Engages in verification of product supply chains to evaluate and address risks of human trafficking and slavery.”
  • “Conducts audits of suppliers to evaluate supplier compliance with company standards for trafficking and slavery in supply chains.”
  • “Requires direct suppliers to certify that materials incorporated into the product comply with the laws regarding slavery and human trafficking of the country or countries in which they are doing business.”
  • “Maintains internal accountability standards and procedures for employees or contractors failing to meet company standards regarding slavery and trafficking.”
  • “Provides company employees and management, who have direct responsibility for supply chain management, training on human trafficking and slavery, particularly with respect to mitigating risks within the supply chains of products.”

Here are links to examples of disclosures produced in compliance with the Act: Patagonia, Nestle

The problem is that the California Act offers incentives that are more appropriate for the model of a single, integrated firm rather than the present reality of a diversity of actors operating in a global value chain.  It risks privileging the interests of the buying end of this value chain (e.g. brand name firm) to the neglect of the other actors in the chain, such as suppliers.  This is a problem because suppliers often undermine the objectives of the California Act and similar initiatives when supplier incentives are ignored.  For example, one way to improve transparency in the supply chain is to perform audits of the supplier facilities in order to evaluate compliance with human rights standards.  However, suppliers counteract the threat of on-site inspections by orchestrating the process to provide a false image of compliance.  These are among the reasons that increased monitoring and auditing will not lead to the desired results.

Suppliers engage in such audit evasion because of the subordination of their interests in the incentive structures of international, national, and private initiatives aimed at improving human rights in global business.  In these various approaches, there is an underlying assumption of harmony of interests among the variety of actors who operate in the modern global value chain.  However, the different firms that operate in the global value chain have varying – even conflicting – interests and vary in location, size, capacity, and functional specialties.  It is these interests and differences that determine the receptivity or resistance of suppliers to improving human rights standards.  Disproportionate attention to multinational brand name buyers fosters conclusions that media exposure, consumer boycotts and other forms of reputational risks can secure better practices in global value chains.  However, suppliers (such as local factory owners and managers in overseas facilities) are motivated by other sets of factors.  The incentives that would win their cooperation for improving standards vary from those of their multinational customers.  Moreover, they are the parties who are “on the ground” and can determine the degree of implementation of improved practices.  

As explained in my forthcoming article, Outsourcing Corporate Accountability, the real challenge is to formulate an incentive structure that speaks to all actors in the value chain.  This task requires a “decentralized approach” to governance: (a) a decentralized view of the firm that acknowledges the variety of actors in the global value chain, and (b) decentralized form of multi-stakeholder coordination that is capable of transmitting these incentives in a global value chain.   

     Of course, the fragmented firm raises a variety of other challenges for transnational governance, and I will discuss some of these other problems in the next couple of weeks.

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