Comment on Manfred Perlitz, Territorialitaet des Rechts als Problem des internationalen Managements (for: Special issue of Constitutional Economics, 1999, based on a conference in Saarbruecken October 1998)

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) , 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 in 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 revivable . Or it is initiated by 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. 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 risk 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, coordinating 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 renegotiation 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; the Continental European approach using the contract to set forth the major principles of contract - relying on available legal culture (interpretation practices; custom; court judgments and a system of shared legal principles and values) to provide the specific terms and 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 elites, 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 coordinate 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 will in most cases of contractual relationships not insist on the written terms with the strategy to seek judicial enforcement, but 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 a 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, but also 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 commonalities) 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).

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) .

Reputation is not just an ancient merchant quality, but is as well relevant in modern transnational - and internet-based - business. 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 amd 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 defense 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 mandarines - 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.

Thomas W. Waelde