"Law, Contract & Reputation in International Business: What works?", By THOMAS W. WAELDE

The paper by Manfred Perlitz discusses the managerial challenges posed by the absence of a stable legal system ("rule of law" - "Rechtssicherheit").  He uses as main criteria the "enforceability" and written character of law.   In his view - reflecting probably the consensus of management sciences - the absence of a stable and suitable legal system is a disincentive for trade and investment.  Such disincentives can be overcome (only) in countries presenting very attractive business opportunities, but requires the application of a number of risk management techniques, many of them related to the "political risk" management approach.  This - standard and conventional - approach has its virtues.  It highlights the difficulties international companies (in particular from Western countries) have in dealing with unfamiliar, non-existent, unenforced and sometimes ineffective legal framework conditions in international investment and trade. Their preference is to operate in countries with a "good" system of law.  These countries are similar to their home states, and the various practices to deal with the legal and political risk of operating in unfamiliar environments with very different systems of law, or countries which have a low intensity of law as compared to, for example, the US.  US cultural and societal characteristics are very important for the assessment of foreign legal systems as, firstly, most international companies originate from the US and, second, management science has been deeply imbued by US concepts.  These have a way of generalizing specific US characteristics in general theory so that mere difference becomes a problematic deviation.  In other words, there are elements of cultural projection in the theory of management science: It views economies which are legally and culturally different as pathological cases ("sick") which require a particular risk management approach ("therapy").

What this comment intends to do is to add differentiation to the conventional, and in our view too simplistic, model of the role of law in international trade and investment.  We do not wish to reject the concept that a Western model of law (written - comprehensive - predictable - enforceable) is a supportive, perhaps even essential pre-condition for advanced capitalist economic development nor that its existence facilitates commercial transactions, and in particular long-term investment. But it is necessary to differentiate this quite simplistic model, to incorporate contradictory evidence and modern and more complex understanding of the role of law and contract in international business.  In a way, management sciences uses a concept of law imported much earlier from the discipline of legal science and seems to ignore that such earlier and more simple concept has been undergoing a significant evolution over the last 25 years.  The outcome should be a more realistic, and sophisticated understanding of the role of law and contract in international investment and trade.

2) The role of law - the "legal framework" - in international investment and trade

The existence of a modern legal system has been considered a precondition for economic development, both in the earlier "law and development" discussion and in the current emphasis of international development institutions on legal reform.  Similar considerations have been made with respect to international trade, but in particular international investment.  Investment, being longer-term than trade, exposes the investor to much higher risk than a trader.  Hence, the availability of law-based protection and stability of terms is generally considered to reduce investment risk.

But there is no evidence that a developed and effective legal framework is either a necessary condition neither for economic development nor for a growth in international trade and investment.  Economic development has been most rapid over the last 40 years in Asia, though Asian societies rank notoriously low on the scale of "law-intensity".  Similarly, Asian economies have attracted a very high share of foreign investment and trade.   It is also argued that the high-risk of foreign investment requires extensive law-based protection.  So one would assume that the very large and high investment projects typical for the oil & gas and mining industry would only be carried out on the basis of a developed, comprehensive, favourable and stable system of law.  But the contrary is the case: The world's most massive oil & gas investments in the Gulf were carried out without any basis in a developed system of law, but mainly on the basis of legally problematic state - investor agreements.  Similarly, in many other areas of the world (Guinea, Indonesia, China), massive petroleum and mining projects were undertaken largely on the basis of a direct contract, without much precedent, support and authority from legislation.  On the other hand, the very active legislation process in a post-soviet society such as Russia has by now produced a lot of legislation, but virtually no substantial foreign petroleum or mineral investment.

One can speculate about the reasons.  I have argued that a familiar legal system is a plus from a Western investor's perspective, but this is far from the whole story. The potential reward of an investment, can outweigh legal risk by far, and investors have a number of risk management techniques available to deal with legal risk.  Non-Western societies may have non-legal, but reasonably equivalent ways of providing the requisite assurance and predictability and this can satisfy some (though perhaps not all Western) investors.  International law may appear non-legal to eyes trained for and familiar with the idea that law, to be effective, must be enforceable in courts, but it does give some additional credibility, effect and support to agreements and proprietary rights in the relationship between foreign investor and host state.  The home state support will also, directly and in interaction with international law, be able to support at least sometimes such agreements.  The state-investor relationship based on a specific legal instrument such as contract, concession or license may also have intrinsic reasons for lasting. First, there is some reciprocity in the relationship that makes both parties better off by maintaining, if not the contract, the relationship throughout the various pressures and tensions, which are bound to arise.  Second, the effectiveness of such agreements outside the traditional law context based on judicial enforceability may have to do with host state's understanding that their reputation, and thereby ability to attract investment, is linked to their respect for state-investor contracts.  States which breach agreements, and which are widely known for severe and disruptive breaches of such agreements, will find themselves "blacklisted".  Risk-averse investors will be discouraged, other more venturesome companies will build in risk premia and the cost of risk management into their contract position.   We will revert to this question later.

The preliminary conclusion we are reaching is less clear-cut than the starting position: Law in its classic Western conception - written, comprehensive, specific and judicially enforceable - may help foreign investment and trade, particularly with respect to companies familiar with such systems and less able to cope with an unfamiliar environment.  A current study by Amanda Perry on attitudes of foreign investors in Sri Lanka suggests that the legal framework does not count much or at all for small investors; presumably they deal away from the formal legal and institutional system in a grey economy setting. It does seem to count for middle-sized investors; possibly, these are used to a Western legal system, depend on its protection and without the competencies and resources which extra-legal bargaining with the state machinery requires.  Surprisingly, large investors report to be least interested in the legal system. Arguably, large investors have the skills, staying power and resources to implant themselves firmly in a host country setting. They then operate rather on the basis of their political-economic leverage than on the basis of law - and the restrictive tendencies often found in host state economic regulation are seen by them rather than as an impediment but as advantageous.

Possibly, these issues are related to the level of development of host states.  Perhaps, law is less significant for simpler forms of transaction, while becoming more relevant to the type of highly complex transactions, which occur, in developed economies.  But this hypothesis is far from certain: Foreign investment, financial and commercial transactions have for a long time been carried out in relatively low-law-intensive Japan. While one can not really qualify the long-term complex investment, project finance plus long-term commercial arrangements now used, for example, in developing energy and infrastructure projects in developing and transition economies as not complex.

It may also be wrong to assume automatically that a high level of legal development is an essential pillar of investment and trade.  We have learnt that the rich Western societies tend to move from wealth creation to excessive regulation to accommodate the political pressures to provide more social welfare and other protectionist interest groups.   This could mean that there is a level of economic development where the legal environment becomes too restrictive and in fact discourages again trade and development.  The search would therefore be for an "optimal" level of legal development where investment and trade are supported by the provision and enforcement of suitable legal instruments and transaction costs minimised, while the dead hand of regulatory excess has not yet become overwhelming.   Western societies in fact seem to have an in-built dynamic towards excessive regulation flowing from the popular sentiments of the moment.  Environmental regulation and the idea of corporate responsibility for human rights violation committed by governments seem to be current themes.  As these are translated, by legislative or judicial action, into law they may contribute to an excess of law which, like an undersupply of law in some transition and developing countries, can act as an investment and trade disincentive.

To sum up: Distinct from simplistic notions postulating an automatic favourable correlation between law on one hand and economic development, investment and trade, the real situation is more complex and far from certain.  "Good law" may indeed often facilitate transactions and help to manage legal risk. But this is just one element in a basket of many more relevant elements.  "Good law" may be good for some, and bad for other companies.  And good law may become bad law if it overshoots a reasonable balance between freedom of action and regulatory intervention.

3) Law, Culture and Institutional Setting

Simplified notions of legislative reform (characteristic in the early years of the legislative reform, approach, first developing, and now post-soviet societies) and sometimes the concepts of law as employed by non-law disciplines (e.g. management sciences), easily succumb to the temptation to focus exclusively on "written law". They equate "black-letter law" or "law in books" with "law in action", understood as the totality of legal rules as they are applied, respected, complied with and enforced in a society.   While the former reflects a formal, positivistic and normative approach, the latter leans rather to a sociological understanding.   The formal approach suggests that all that countries suffering from underdeveloped law need to do is to import transplants from successful developed countries; the material approach, on the other hand, suggests that transplanted law may work differently in the recipient setting from the way it worked in the exporting country.   The conclusion is that looking at formal, written law as evidence of law satisfying the requirements of foreign investors, financiers and traders is unsatisfactory.  Such a paper-comparison may be psychologically comfortable since it provides an illusion of familiarity.  But it can not cover the fact - as all practitioners of foreign trade and investment know - that what counts is the way law works, and not how it is formulated.

The way law works has very much to do with culture and the institutional setting in which law is prepared, enacted, determined, applied, respected and enforced.  An excellent survey of cultural differences in Southern and Northern Italy co-existing under the roof of a century-old uniform legal system has illustrated how culture, and less formal law, determines how legal rules work and impact in a societal context.  In a culture with an innate respect for law, there is less need for transaction costs generated by lawyers, less litigation and less problems of compliance. In a culture with a tradition of litigation, there may not be automatic respect for law, but law can be enforced by - costly - litigation.  In a culture where respect for law and recourse to litigation is not well anchored (such as Asian societies or the post-Soviet countries), formal law is unlikely to be very effective.  It may require efforts at formal compliance, but more as ex-post decoration of action than as real motivator and constraint of human action.  The Western concept of "living law" is not only anchored in the formal, textual "surface" of the legal system, but rather in the existence of strong professional communities (judges, prosecutors, lawyers, corporate counsel and civil servants). This community creates, maintains and administers a system of law which is semi-separate from society at large and which functions due to the respect and interaction between the legal institutions and the commercial actors.  The advising and the corporate in-house lawyer facing both the client and the ethical demands of the professional community act as transmission belt for making law serve society, and society submit (to some degree) to the demands of the legal system.  When such cultural and institutional elements are absent, the professional community non-existent or weak and under-resourced, then formal law is likely to remain law in the books, but have little impact on society.

The implication of this cultural and institutional perspective on the question, to what extent law is necessary, or useful to international trade and investment? Are as follows: A reference to a "good law" means presently the desired security for property rights, elegance of legal instruments to engineer the now increasingly complex commercial and financial transactions while also an ability to correct "market failures" through legally formulated socio-economic policies. But such good law is much more than just a codification of legislative acts or judicial awards - it is in essence the characteristic of a efficiently organised society.  Such a society is efficiently organised because the society's culture, institutions, social and legal norms interact efficiently, translate a mutually shared sense of justice and common values and facilitate transactions within a society and with external commercial agents. But it is no longer  "just" the legal system in the traditional understanding.  To ascertain law is, for the foreign trader and investor, no longer an easy matter of reviewing legal documentation to see if it fits with their notions of stability, fairness and efficiency, it is rather to evaluate a whole society in its suitability for commercial exchange.  Law is just an element within such an assessment, and the crucial focus, and great difficulty, then is of understanding how the formal law works within the overall society and with respect to the foreign trader and investor.

With this notion, we are much closer to the studies on "competitiveness" which review a large number of relevant elements in a country's make-up, including law, legal institutions, taxes, impact of economic regulation, public infrastructure and access conditions and so on.  Law and the legal process is one element, and one that interacts with other elements, and which can not be separated very easily from the social environment in which it functions.   This conclusion also leads us to understand that actions targeted solely at improving specific components of the legal system - say the pay, working conditions, training and technical resources of the judiciary as  a typical subject for international aid - can only bring marginal, and often not lasting improvements. 

From an investor and trader's perspective, the significance of culture and institutional setting means that a much more thorough study of the host state's conditions is required for systematic project analysis. Such study will have to focus on how the law works, and identifying the experiences of already established investors and traders usually does this.  There may be cases where the existing culture may compensate for the absence of "proper law", for example by emphasis on relationship, on reputation and on personal trust.  In other cases, local culture may be characterised by an absence of trust and commitment, discretionary administration, local favouritism and other factors making in particular for newcomer companies and domestic operations unpredictable and very risky.  Here, good law would help, but it is unlikely to emerge and if it were to emerge in a formal sense, it is unlikely to become "good law in action".  

Corruption is always cited in this context as an undesirable element of non- or bad-law situations. But again the situation is more complex: Corruption can increase transaction costs make procedures for licensing and tax more unpredictable and can deny the protection of the law for property rights.  On the other hand, corruption (in particular if relatively standardised) can be a mechanism that compensates for over-rigid regulation and bureaucratic inertia.  Investors familiar with a host country setting will often prefer corruption to a prohibitive and inflexible regulatory framework - newcomer companies unfamiliar with a host state, will on the other hand, view corruption as a discouraging feature.   In the end, the assessment of host state law for purposes of investment & trade will end up not very far from identifying the "reputation" of a host state for purposes of business, thus bringing the at initially distinct categories of "law" and "reputation" together.   The assessment of host state conditions - and thereby reputation - is not easy.  Local experts usually consulted will often have difficulty in identifying precisely what the needs and problems of the foreign investor are.  The often used interview & survey technique suffers from the fact that it only reproduces the culturally formed perceptions and prejudices of the interviewees and not necessarily their "real" motivating factors:   Corporate managers questioned will tend to reproduce a stereotyped description of what their company's official policy is, rather than describe reliably what their company actually does.

4) International Law: Little Enforceability, but some Impact?

There seems to be very little analysis of the relevance of international law for international business transactions.  While there is currently a large, and not - for our purpose - that useful debate on compliance, enforcement and effectiveness, it centres mainly on compliance by states, and sometimes effectiveness within states, of international law obligations assumed by states by way of international treaty.   To what extent do such treaties - which in tradition and principle only obligate states, and not private actors - affect international business opportunities?

A first response would be that international law, being, at least traditionally, only intergovernmental and with no direct effect on private actors, is of little if any relevance to traders & investors.  Contrary to national law, they could not rely on rights and obligations which exist only between states.  Moreover, as is always emphasised by realists, international law does not get enforced the same way as domestic law by way of litigation, except in very rare and exceptional circumstances, and even then there is no enforceability of such (arbitral or International Court of Justice awards) against sovereign states.  In a strict, traditionalist and formal view, one could therefore omit any consideration of international law proper, and focus on national law which may transpose the international law commitment of a state into - for private actors directly effective - national law.

But such view would not do justice to the realities.  International law, in particular as it is currently evolving, can be of relevance to investors in an increasing number of both direct and indirect ways.  It is interrelated with the reputation of governments as defined by specific industries, professional communities and ultimately the relevant global markets.

First, international law - as illustrated by multilateral treaties in particular - is an indication of national law to come.  While compliance is far from automatic and judicial enforcement close to zero, international law obligations tend to work their way through to national legislation.  In some legal systems (in particular on the European Continent, in US and EU law), treaties are sometimes given direct effect, i.e. they operate directly as national law,  though this effect is at this time not accepted for international trade law (GATT/WTO). Modern bilateral and multilateral investment treaties have gone further and revolutionised the traditional state-state orientation of international law: They impose obligations towards treatment of foreign investors directly on states, and allow private companies to enforce such rights by direct, treaty-based arbitral litigation against governments.   Given that domestic litigation before national courts is a no-win situation for foreign investors, this novel facility, which flies into the face of established international law practice, is the first method allowing a foreign investor to enforce treaty-based rules of state conduct before an international tribunal. These modern treaties - chiefly the 1992 North-American Free Trade Agreement (chapter XI) and the 1994 Energy Charter Treaty (Art. 26) - do not only set up an arbitration facility for investors against states, they also provide substantive rules constraining the otherwise unfettered discretion of states versus foreign investors.  In short, they have the ability to replace non-existent, bad or not properly enforceable national law by both an international set of rules plus an international enforcement procedure.  It should be noted that while international investment law has advanced into this direction, international trade law has not. Trade law complaints are subject to the GATT/WTO dispute settlement process, by panels which are under the control of governments; complaints can not, as yet, be formally initiated by private traders.

But apart from such direct usage of international economic treaties, they can also have a possibly more significant impact indirectly.   Accession (i.e. signature and formal ratification) to treaties has a formal legal meaning but also a less direct signalling and symbolic effect.  By accepting a bilateral or multilateral investment treaty, the government of a country signals its acceptance of rules and procedures which are normally accepted by the community of Western market economies. In essence, it means the re-emergence of the classical concept of "civilised nations" with the acceptance of a treaty as equivalent to membership in that select club.  A government signifies that its domestic political process has accepted the formal legal implications, and that it wishes to be held accountable to such treaty obligations.  Not only does such acceptance bestow a number of legal privileges to foreign investors, at the cost of government sovereignty, but it also expresses a formal decision to accept a rules and value system characteristic of developed market economies.  The host state signals to investors - and to the global markets - that it is at least its intention to behave as developed market economies do or are expected to do. For the markets, this means the prospect of a lowering of the political risk rating as the treaty obligations are formally, and subsequently materially accepted and implemented. For the state, it means an enhancement of its reputation as a reasonable host state for foreign investment and trade.

But such modern economic treaties can have further effects: In countries with no fully developed legal framework for investment and trade - i.e. developed and transition countries - the Treaty becomes a model and benchmark, against which national legislative action is measured and by which it is inspired.   Deviations from the Treaty - always likely based on nationalist, socialist or protectionist tendencies - will have to overcome the threshold of legitimacy, which the treaty now provides.  The global markets are therefore right in perceiving in otherwise problematic countries accession to the major modern economic treaties a signal for improvement of investment conditions - like a reasonable promise that is likely (but not certain) to be fulfilled in the future.

Such treaties, though,  go further in influencing the host state - investor interaction in the explicit and implicit bargaining processes between both.  International investors, and sometimes traders will inevitably get into problems with host states - triggered by change in host state policy and legislation, by protectionist forces against foreign competition provoked by national competitors, by rent-seeking politicians and bureaucrats, by nationalist ideologies and exploitation of the political benefit in chasing foreign business. In negotiations - implicit or explicit - the foreign investor or contractor will inevitably seek to rely on his property and contractual rights while the government will rely on "sovereign" regulatory and tax powers.  National law and court jurisdiction would not be of any advantage to the foreign company as they are largely under the control of the domestic political process. The foreign investor will use references to existing agreements, international law supporting such commitments , to expect future benefit and the implication of the host state's reputation.  A relevant, and legally and politically accepted international treaty, will exercise on such negotiations a subtle effect in two ways: First, it may provide a formally applicable set of rules and procedures. Bargaining then takes place "in the shadow of the law" and both parties will be aware of the treaty's procedures and the costs, risks and benefits of both breaching the treaty and of applying its sanctions.  But there is a second effect, which illustrates an interesting interaction between law and bargaining.  Schelling has referred to the help provided by "magnetic points" in negotiations with a large bargaining range. Such magnetic points  - derived from custom (50 - 50), or from accepted standards of legitimacy - help parties to settle a deal on an area within the overall bargaining range.  They can be particularly useful if parties have no other way of finding an easily available point of settlement in a large range, with the risk of the deal being scuppered by high-risk bargaining strategies. A widely accepted and legitimised multilateral treaty can here serve to help both parties - plus the negotiators within the various parties (i.e. intra-corporate and intra-governmental bargaining processes) - to find a settlement of their dispute.  The treaty provides arguments of legitimacy - when pure force and bargaining power does not impose a specific settlement.  It provides a way for both parties to save face by agreeing on what can be seen and sold, externally to the public and internally to detractors on both sides, as legitimate and required by a system of law outside the control of both parties.  Insofar, it is not the enforceability of a set of rules (as in the scenario of arbitral litigation or even bargaining in the shadow of the law), but the pure quality of recognised legitimacy which gives an effect to the treaty by way of bargaining.

To conclude: Surprisingly, international economic law may contribute more to the comfort of foreign investors than national law - though the attributes of law so prized by conventional views popular both in economics and management sciences, namely judicial enforceability, are at least traditionally not very prominent features.  There is now a novel tendency towards direct enforceability by private parties - at least in investment law (not yet in trade law). But a major impact is through the legitimacy effect in negotiations and the implication of a country's reputation and wish to be a member of the club of modern civilised nations signalled by both accession and adherence to modern investment treaties.

5)The Role of Contract and Enforceability in international investment and trade

Perlitz has raised in his contribution the importance of contract enforceability in host states from a management perspective.  The first observation to be made is that transnational commercial contracts are very difficult to enforce.  High transaction cost (national and foreign legal and specialised litigation and arbitral counsel, high costs of producing and submitting evidence; additional costs for recognition and enforcement of judicial or arbitral awards) and even higher opportunity cost in terms of management attention (in home and host state), and reputation costs (unfavourable image as a litigation-prone business partner; unwanted negative publicity which can be mobilised for politicised bashing of foreign companies) are added on the cost side over and above what domestic litigation would entail;  higher risk in view of the domestic defendant bias of most courts and of the home advantage of the foreign defendant increase the risk. As a result, a corporate cost-benefit analysis will in almost all cases make enforcement by court or arbitral litigation undesirable.  In fact, transnational litigation should in most cases be seen as a pathological evidence of management failure.

International companies rarely litigate - even before international arbitral tribunals, in particular against each other.  We have tried to study arbitral cases within the international oil & gas industry. The survey conducted indicates that such cases rarely exist.  Disputes between companies who continuously are involved with each other in upstream and downstream joint ventures are as a rule settled between the management of the involved companies.  Litigation would risk the ability of such companies to continue their many joint ventures together and would affect a company's competitive position by reducing its scope for partnership with both the other party to a dispute and with other companies avoiding habitual litigants.  Litigation, if occurring at all, is typically an end-game move: Ending a relationship that has gone definitively sour and unlikely to be revived.  Or high-risk adventurous companies who are outside the mainstream of industry and try to develop profit rather from the litigation than from the preceding business initiate it.  Litigation between major international companies can also occur if there is a radical change of market structure and newcomer companies are not as well integrated, and therefore not so concerned over litigation souring current and future partnerships.

Litigation, including by arbitration (supra) against a government is even rarer.  This may change to some extent.  Arbitration with the International Centre for Investment Disputes is reportedly increasing rapidly.  The direct investor-state arbitral facility now included in modern bilateral and multilateral treaties is the likely reason. But still it is safe to assume that very few investor-state contracts will go to arbitration. Why is that so? The main reason is that it is usually very risky to litigate against a government.  Winning a case against a government means causing a loss of face to that government. And governments have many ways to retaliate in visible and less visible ways.  Blacklisting for new concessions and licenses, difficulty in obtaining necessary permits, tax audit, impediments to government procurement are all instruments which Western, developing and post-Soviet governments have used to penalise difficult foreign investors.  One needs, though, to refine this very low-profile view on the enforceability of international contracts.  While it may be both costly and risky for a foreign investor to actually mobilise an arbitration facility against a host state for the reasons listed, it is equally problematic for a host state to provoke such litigation.  Non-participation in such arbitration proceedings - which governments have chosen at times - and non-compliance with an arbitral award usually has negative effects on a country's reputation, political risk rating and thereby increases the cost of doing business for the country in the future. Internally, a loss of a visible and then often politicised arbitration case will often mean resignation for the Minister in charge. So before an arbitration procedure is initiated, both parties negotiate with each other in the shadow of the relevant law and procedure, but also under the shadow of the considerable risks litigation involves.  The impact of the arbitration clause is therefore less in its actual use, as in its implicit threat to both parties.  Risk-averse parties, viewing the high risks of litigation, for both,  will  be encouraged to settle.

In a conventional understanding - exported from the legal to management and economic sciences - a contract that is not, at least in practice, enforceable has difficulty in being accepted as a "proper contract".  But the enforceability is, as we have seen, less likely, less practical, and also less of an issue than is assumed in the conventional model.  So contract and enforceability are at times a couple, but they are not necessarily wedded together for all times and all situations. So what is then the role of contract if not to be the basis for state-based compulsion of the party in breach?

We suggest that the main function of contract, both in national and international business, is to serve as a planning instrument, both internally, committing an organisation's internal process, and externally, co-ordinating both parties' contributions.  It is possible to live in continuous negotiations and flexibility if starting a business; but it is impossible to do this once an organisation emerges.  From this - very early - point of organisational evolution, contract becomes a major organisational instrument. It acts as an internal manual and guideline instructing competent staff what needs to be done, when, how and often by whom.  Corporate staff will implement the contract often irrespective of what specific corporate interests may be since it constitutes the main written planning instrument and set of instructions.  In international business, this function increases in significance.  Here, easy access for renegotiations and adaptation is often absent.  Tacit understandings which often change the content of an agreement are harder to achieve, document and execute.  Cultural distance - now perhaps getting more important than communicative distance - means one can not easily and continuously readjust a relationship and its terms so that the one written document which is available and accepted as authority by both parties gains in relative weight.  Contracting has therefore become an essential tool of international business and its full role as an instrument of management may not be fully realised.  International business contracts were in the past shaped by several approaches related to legal and national culture. The Japanese/Asian approach, viewing the contract as an instrument to build a relationship and the Continental European approach using the contract to set forth the major principles of contract - relying on available legal culture (interpretation practices; custom; court judgements and a system of shared legal principles and values) to provide the specific terms. The Anglo-American approach using very specific and detailed contractual language to insulate the contract from applicable law and pre-determine as many scenarios and prescribed action as specifically and closely as possible.  The Anglo-Saxon approach now prevails in international business. There are good reasons: The dominant position of both the US and England (London) as centres for international commerce and finance and the spread of the Anglo-American legal approach by way of law firms are reasons. But the main cause for the success of the Anglo-American approach to contract drafting is that it relies much less than Asian or civil law traditions on a cultural homogeneity.  In societies where values, language, meaning, traditions and customs are shared, in particular among commercial and legal elite, general principles of a relationship can be sufficient. In a multicultural global economy, such sharing, attributing a common meaning to general principles, works less.  So specificity of contract is a much more suitable method of governing complex, long-term and detailed relationship among transnational parties.

For the role of contract beyond enforceability, this means that the modern transnational commercial contract is in most cases a very detailed document which serves, and is due to its specificity very suitable for serving, as an internal corporate organisational instrument as much as an instrument to co-ordinate both or various parties.  While there will still be disputes, (over interpretation; defective contract-engineering; unforeseen gaps; unwillingness of a party to accept the agreed-upon allocation of risk; unexpected changes in the relative weight of risks, benefits and contributions etc), these will often have been managed by the specificity of the contractual document, including the frequent use of reference to established trade rules and uniform conditions.  If disputes arise nevertheless, the road to judicial or arbitral enforcement is much longer than envisaged in theory, for the reasons already discussed.  A normal international company will be loath to invest the time and effort required, and to assume the risk and damage to reputation, before litigating.  There will be pressure on the sometimes litigation-friendly outside advisers (litigation friendly for economic reasons) not to get the company onto a path from which it is difficult to exit.  Corporate rewards will rarely go to managers choosing the path of litigation.

But apart from the function as an internal planning guideline, international contracts also serve in the post-dispute and pre-litigation bargaining.  Two concepts to which I have referred earlier ("bargaining in the shadow of the law" and "magnetic point") are as useful in understanding the role of contract in bargaining.  In the "real" life of interacting parties to a contractual relationship, the contract is not always adhered to, and rarely do parties live up to the word of a contract.  There are very few studies comparing the "real" interaction between parties and the normative expectation set up by the contract.  What seems to be the case is that while the lived contractual relationships will often deviate from a written contract (lawyers could argue that this constitutes an implicit modification), the more, the longer the relationship lasts, the written documents plays some role. First, in case of dispute, the parties (in particular their legal counsel) will inevitably refer back to the written document and such referral (which would be much stronger in case of litigation) plays a role in the bargaining between the parties.  Commercial actors wills in most cases of contractual relationships, not insist on the written terms with the strategy to seek judicial enforcement. Such prospect plays a role in the balancing of factors. The identification of relative bargaining power and in the arguments advanced both within a company and with the other party.   Similarly, in bargaining between the parties (irrespective of the possibility of seeking access to litigation as last resort), the written contract document constitutes what game theory has termed (supra) "magnetic points".  Since it was once formally agreed and endorsed, usually at a higher corporate level than the level of execution where the dispute now arises and since it usually was negotiated with considerable effort, it carries certain legitimacy.  This - mutual - legitimacy enables the written contract to acts as a reference point when the bargaining range is large and no other clear factor (overwhelming bargaining power; re-negotiation of the deal using substantial new bargaining with new bargaining assets and reciprocal concessions or identification of new bargaining optima) prevails.  While this may not lead in case of a dispute to an automatic re-assertion of the precise content of the original contract, it will make the original contract function at least as a starting point, with new give-and-take bargaining modifying it.  This is not a very precise analysis; bargaining processes are very diverse and all sorts of factors play a role in all sorts of commercial and cultural bargaining environments. But it is hard to deny that in such processes the original written contract, in particular if very specific, and the result of extensive bargaining, does play a legal and a moral role. It also plays a role in providing the magnetic point of legitimacy to which parties, in default of better, mutually accepted standards, often need to have recourse.   This role of the written contract increases as contracts are more specific (hence another advantage of the Anglo-American model of commercial contracting) and as other unifying factors (cultural and value-based commonalties) are absent.   There will evidently be cultural differences as to the precise weight to be given to a written contract, with the less law-intensive or contract-focused cultures being less taken by its legitimacy (e.g. Asian or post-Soviet) than the "sanctity of contract" cultures (i.e. Anglo-American business culture).

6) Confidence, Reputation, Self-Enforcement and other Non-Law Contract Enhancement Mechanisms

Non-legal literature has identified a number of other factors explaining why contracts, contrary sometimes to what might appear as immediate ad-hoc self-interest, are complied with.  

Contracts can be engineered as to develop a one-sided dependency, which will allow the -stronger - contract partner to minimise disruptions, by the other party's compliance, mainly by withholding future inputs (technology and technical assistance; financing; reinvestment; offtake of production).  A careful analysis of upstream oil & gas investment contracts of recent date illustrates a technique where the host state subsidiary is legally insulated, and then by way of contract made dependent on the supply of numerous often proprietary services by companies under the parent company's control.  The terms of such contract are not balanced nor negotiated at arm's length. The, fully intended, consequence is to minimise any assets exposed to the host state and to create a system of continuous dependency on future services (with key information held outside the host state) as a technique of managing the political risk (and reducing the host state tax potential).   Similarly, in a more equal setting, the parties can insert automatic or discretionary sanctions, arrange for reciprocal hostage situations, develop a contract's performance in tranches so that any new sequence in a contractual performance requires the satisfactory completion of a previous performance.  Contractual arrangements will be formulated so as to involve powerful third parties (purchasers of output; financing institutions; home state government agencies), so that breach on one contract will lead to an automatic or discretionary cross-default. For example, lending contracts with the result that funds required by the project will no longer be available or more powerful financing institutions will require immediate repayment or exercise other default clauses in their - linked - contracts.  The more transnational and long-term a contractual arrangement - be it a long-term trade or investment arrangement- the most will the contract engineering be aimed at avoiding the risk and hassle of necessary recourse to litigation/arbitration and replacing it with internal mechanisms or with linking to other significant commercial relationships.

A major and possibly the most important lever to obtain contract compliance is trust and reputation.   Fukuyama has pointed out the contribution of trust in society towards economic development and more creative business transactions. If trust exists, many of the described precautionary methods (all costly in terms of transaction cost and type and scope of business relation) are less necessary.  Trust can be part of - usually - homogeneous cultures where values and perceptions are shared. The classic English "old boys network" based on common class, upbringing, closed communication and lifestyle allowed (at least in the past) much less reliance on formal contract and rules. Participants in the game shared the relevant values and if there was deviation, social sanctions focusing on damaging reputation and membership were effective.  The merchant bankers of the "Gilded Age" relied similarly on a shared social origin, education, class, lifestyle in close proximity; not surprisingly, legal sanctions were usually reserved for outsiders, while the insiders' constant concern was the safeguarding of their reputation.   Interesting recent work by Ripperger (1998) provides numerous situations where specialised communities of traders emphasise use and sanction reputation as a guarantee of contract compliance.  Where trust is absent and reputation not existent or not relevant and sufficiently effective, then transnational contracting becomes very difficult.  Internalising it into family networks, setting up a multinational company or constructing, as did centrally planned economies, an intergovernmental framework/ foundation for enterprise-to-enterprise contracts have been solutions.

It is important, against the focus of most legal scholars on the formally applicable law, with little regard to its actual application and effect, to emphasise the many solutions international business has developed to compensate for the material weaknesses of formal law.  Many of those - including the deployment of reputation in international business - are functionally equivalent, and may often be superior, to the solutions a formal legal approach provides (arbitration/litigation; execution and enforcement of awards).  But one should not lose out of sight that these non-law drivers of contract compliance are far from perfect.   Trust usually works only within narrow communities sharing values, perception and continuous interaction.  In transnational business, it usually does not exist at all, though much of transnational business skills consist in building up trust  - much as the concept of "confidence-building" measures discussed in disarmament theory.  

Reputation is not just an ancient merchant quality, but is as well relevant in modern transnational - and internet-based - business.  The importance of legal remedies against action leading to unjustified damage to reputation witnesses the continuing significance of reputation.   Reputation can, by electronic means, now spread, or be undone, much more rapidly.  The use of professionally centred Internet fora provides greater speed of dissemination, but also a much wider participation. The global economy so creates its own - necessary - intelligence gossip networks in which reputation can emerge - and suffer.  But reputation does not work in all situations. We know well that people who behave as perfect gentlemen in their own setting change their conduct dramatically when dealing with people outside their community: natives, foreigners and others not recognised as equals.  Similarly, all established moral and social codes of conduct are broken at times, usually when a well-established and balanced situation changes.  Then newcomers, mavericks break the rules of the game to invade markets and opportunities otherwise and hitherto closed.   So contracts relying on reputation as a guarantee of compliance need to appreciate its relativity.  Reputation works less well with aggressive newcomers seeking to establish a position in defiance of establishes rules of the game. It also suffers from the risk of discontinuity - such as the sudden and unexpected readiness of New York investment bank Morgan Stanley to advise on mergers against previous clients in order not to lose out on new commercial opportunities.  Reputation works best in equilibrium situations.  Companies - or governments - who have lost their reputation may find that the cost of re-building it is too costly and adopt rather an adventurous attitude - which makes contracts with them without other internal or external defence mechanisms very risky.  Reputation also diminishes in significance as business spreads from closely-knit communities (family - ethnic traders - public school and college classmates) into a global community. Here - until new forms of reputation sanctions emerge - reputation that is valid in a particular subgroup is much less relevant.  Reputation, for example, on the Internet is just emerging: How to appreciate the reputation of traders appearing it seems, out of the nowhere of electronic space?

In the case of governments, reputation is more or less equivalent with the concept of political risk.  While purporting to express a likelihood of actions in the future, it is mainly based on identifying and weighing actions in the past - on the (mostly linear) assumption that the past is the best predictor of the future.  And reputation, as used for business purposes, is identical: It relies on identified and accepted actions in the past (building up the reputation) to predict the high probability of corresponding action in the future.  This similarity if not identity leads us to a better understanding of reputation as it functions in global markets.  Rather than the unspoken assumption - the gentle "nod and wink" of "old boys" and mandarins - it has become the measurable rating in modern markets.  Credit ratings - of governments and companies, political risk ratings - of government and other ratings used publicly or internally by banks, insurers and traders are nothing but a modern formulation of reputation.   They are based mainly on the past and thus carry the risk of each linear prediction - that it is bound to fail if discontinuities occur.  Where no formal rating occurs, the global markets, mediated through the very informed intelligence and debate in the major journals, develop their idea on the reputation of countries and large companies.  

Reputation is not a unified concept or fact.  There can be a reputation for honesty, creditworthiness and contract compliance - contrasting with a bad reputation for ruthlessness and disregard for modern duties (human rights; environmental protection).  Reputation is not only a matter of an objective corporate record, but - very similar to political risk - equally a matter of corporate (and personal) public relations.  As a reputation is built up - by efforts and public relations, it in fact can be valued.  Methods to measure brand value and corporate good will are available. For corporate decision-making, a decision affecting its reputation (i.e. breach an agreement with a likelihood of public knowledge) can lead to a balancing between the benefit of such action, and the - measurable - effect on its good will and reputation, as well as higher cost in the near future in entering into contracts.

As we compare the formal legal remedies available for enforcing contracts and the relation between reputation and contract compliance on the other hand, one is struck by two issues: A legal procedure is at least in theory neat and specific. It looks very specifically at the behaviour at issue; employs very formal and specific rules of procedure and rules of substantive law and comes to very differentiated decisions (i.e. to pay so and so much).  The implication of reputation is less specific.  Damage to be reputation is a matter of perception by a not necessarily fully informed and expert relevant constituency.  Good public relations can correct such damage.  On the other hand, a company affected by a loss of reputation (justified or not), has much less remedies.  Its impact can be much more dramatic: A large multinational company will in most cases rather pay out damages than suffer the much greater damage to its reputation with repercussions on its activities around the world.

So far, the various instruments to get contract compliance are kept in neatly separated compartments: Lawyers treasure their formal processes of enforcement, with little interest (apart from the corporate counsel lawyer compelled to bow to business sense) in its actual workings.  Business scientists and economists are keen to study non-law methods and develop their own academic ownership in them. But the two areas are not so distinct as it seems - there is just no proper discipline looking at the linkage rather than at the two distinct types of compliance mechanisms.  The legal process is in so far superior to reputation as it provides a distinct, specific and professionally regulated procedure to deal with contract compliance.  But reputation is linked to it, proper rating and creditworthiness analysis will prefer to deal with a formal, distinct and professionally achieved result. Determining, for example that a government breaches an agreement, does not pay compensation, refuses to honour an arbitral agreement - than with gossip or surveys based on sometimes-problematic methodology.  Markets, particularly in specific industries, will find it easier to impose, for example, a risk premium on individual countries if some formal event has taken place (e.g. repudiation of debt; non-compliance with a judicial or arbitral award) than basing it purely on the volatile sentiment of a moment.  Similarly, formal events such as accession to a relevant treaty (see supra) will affect the political risk rating and reputation of a country since it is an easily verifiable event while forecasts projecting the past in a linear way into the future are inherently speculative, and have often proved wrong.  Market factors - such as reputation, political risk rating and trust  - are therefore not separated, but linked to legal events.  In fact, one can argue that the reason developed market economies have evolved roughly comparable distinct legal systems may well be that markets need such systems of distinct, partly insulated and professionally owned and managed rules of governance which the markets itself have difficulty of providing.

But as markets may be helped by and require some measure of a formal legal process, so do formal legal processes in the field of transnational business require markets to be effective. In practical terms, arbitral and judicial awards achieved by intelligent strategy (e.g. forum shopping; exploitation of superior legal skill, domestic bias and greater deployment of resources into litigation) are useless in both achieving correction and influencing action if they can not be practically enforced and if they can easily be disregarded.  When markets, however, add their sanction, then the legal rule, and the legal process dealing with the rule, becomes much more effective.  Markets can compel governments in a way neither tribunals nor other governments can achieve.  It is therefore not surprising that a significant element of litigation, rarely appreciated in formal legal literature, tries to enlist non-law factors to achieve its purposes: Legal harassment - and the threat and prospect of such harassment - in order to use up the opponent's management time; litigation in order to create public relation effects, use of defamation remedies to defend against actions affecting business reputation.

7) Conclusions: Governance Systems for the Global Economy

This comment has tried to dance on the thin rope which separates legal analysis, a mainly formal and professional method dealing with facts in a way that is limited by existing rules and methodology, and economic and management sciences' analysis, a view that is informed mainly by economic and management science models trying to capture the presumed rational behaviour of economic actors.  There are a number of concepts around - bargaining in the shadow of the law, "magnetic points" facilitating agreement in a game-theory perspective - which allow to appreciate some contribution the various forms of law and contract can make, without that the conventional attributes of law - judicial enforceability - need to be triggered.  Judicial enforceability is viewed in a conventional perspective as a constitutive element of law; as such, it has been imported and accepted without much questioning in management sciences and economics. But as our examination has shown, law can become effective without that there needs to be, in theory or practice, a reasonable chance of enforceability. Even if law, or contract, is unlikely to be enforceable, it can work by way of its function as a necessary, often unquestioningly accepted internal organisation guideline and plan, by linkage to the reputation of commercial actors and the forces of public opinion acting upon corporate decision-making.

Much of the role of law, facilitating and enforcing, and sometimes obstructing and prohibiting transactions, depends on the cultural context. Low-law-intensity societies (Asia, post-Soviet countries) will show a law/non-law configuration that is different from high-law-intensity countries, such as in particular the US.  But it is not certain that it will remain this way.  One can raise the question if the global economy will not favour, or require, a greater role for formal law. The emergence of the US model of detailed, specific commercial contract documentation as the standard practice in transnational business transactions may indicate that in a global economy, with a diversity of (legal and other) cultures to integrate, the detailed and specific document may be most appropriate.  It provides most regulatory power and needs less recourse to extra-legal cultural elements.  While cultural preferences may still play a role in international business, there is also the emergence of an international professional class of lawyers, negotiators and executives, which share common commercial values and approaches. These are, not unsurprisingly, usually aligned on the US model.  Perhaps the legal recourse now being opened by bilateral and multilateral investment treaties - direct arbitration by investors against states - may indicate a gradual projection of national legal procedures on transnational transactions in the global economy.  But whatever the form of law and contract, what is interesting to investigate is the interaction between the distinct formal legal procedures and the power of markets, often relying on the result of legal standards and adjudicative procedures, to provide the sanctioning powers which international litigation lacks.  The interaction between legal process and reputation as it develops and is controlled by international markets and the professional elite operating therein is a subject for future study.

The economic analysis of law and constitutional political economy approaches have developed very interesting concepts which suggest an explanation of the role and impact of law on international business. But these models need now to be tested in empirical research, which requires moving much closer to the reality of the practices of the global business community. Without such empirical tests, such models can be plausible, sometimes persuasive, often elegant, but they do lack substantive explanatory, predictive and application power.  For students of international economic and commercial law, the challenge is to combine a professional mastery of rules and procedures with an understanding of how they work, should work or could work, in real life.  For this purpose, we need to engage a continuous friendly, but not uncritical dialogue over the inter-disciplinary divide.

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