Global Order Beyond Law: How Information and Communication Technologies Facilitate Relational Contracting in International Trade 9781474202008, 9781849465403

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To Benjamin and Frederik

Acknowledgements I am grateful for the constructive advice I have received from friends, colleagues and sometimes anonymous participants in seminars around the globe. Gralf-Peter Calliess, Marina Kurkchiyan and Stefan Vogenauer read the draft of the manuscript. I would like to thank A Claire Cutler, Patrick Emmenegger, Christian Joerges, Walter Mattli, Andreas Maurer, Moritz Renner, Saskia Sassen, Susanne K Schmidt, Jure Vidmar, Peer Zumbansen and two anonymous reviewers for their especially helpful comments. This book-project benefited from financial support from the Volkswagen Foundation. I am also indebted to the Institute of European and Comparative Law, University of Oxford. I have been able to spend two years at the Institute and it has been a very congenial and stimulating place to think and write in. I owe a special debt of gratitude to Patty Lawson, Sarah Newton and Carly Vidmar who provided excellent copy-editing.

List of Figures Figure 1: A taxonomy of public- and private-order contract enforcement institutions Figure 2: The effect of processes of economic modernisation on the efficiency of public and private economic governance Figure 3: Development of cross-border trade Index (1950 = 1) in constant prices, Growth in percentage, worldwide 1950 to 2008 Figure 4: Overall results of the German scenario Figure 5: Overall results of the Bulgarian–Romanian scenario Figure 6: Overall results of scenario 3 Figure 7: Overall results of scenario 4 Figure 8: Overall synopsis of the empirical study Figure 9: The impact of globalisation and technological progress on the efficiency of public and private economic governance

List of Tables Table 1: Case study scenarios Table 2: Overview of scenario 1 Table 3: Overview of scenario 2 Table 4: Overview of scenario 3 Table 5: Overview of scenario 4 Table 6: The insignificance of state contract law for the generation of transactional security from a German perspective Table 7: The significance of state contract law for the generation of transactional security from a German perspective Table 8: Fragmentation of law as a reason for the insignificance of state contract law from a German perspective Table 9: Complexity as a reason for the insignificance of state contract law from a German perspective Table 10: Alternative meanings of contracts Table 11: The reliability check of a foreign software provider from a German perspective Table 12: The significance of self-enforcing contracts in the generation of transactional security Table 13: The monitoring of a foreign software provider by a German customer Table 14: The significance of reputational networks for the generation of transactional security from a German perspective Table 15: The significance of reputational networks for the generation of transactional security from a German perspective Table 16: The significance of private governance regimes for the generation of transactional security from a German perspective Table 17: The significance of state transaction law for generating transactional security from a Bulgarian and Romanian point of view Table 18: Assessing the reliability of a German customer from the Bulgarian and Romanian point of view

xviii List of Tables Table 19: The significance of self-enforcing contracts for generating transactional security from a Bulgarian and Romanian point of view Table 20: The significance of reputational networks for generating transactional security from a Bulgarian and Romanian point of view Table 21: The significance of state contract law from an Indian point of view Table 22: The significance of private governance regimes for generating transactional security from an Indian point of view Table 23: Assessing the reliability of German customers from an Indian point of view Table 24: The significance of the self-enforcing contract for generating transactional security from an Indian point of view Table 25: The significance of state contract law Table 26: Reasons for the insignificance of state contract law Table 27: Statistical data provided by the Heidelberg Report on the use of the Brussels I Regulation (EC) N0 44/2001 in European Union Member States Table 28: Foreign trade ratio EU and application of the Brussels I Regulation Table 29: The significance of virtual close monitoring systems Table 30: The significance of social networks for reputation Table 31: Arbitration requests filed at the ICC, LCIA and SCC between 2000 and 2010 Table 32: The age of private governance regimes in international trade Table 33: Private enforcement in specialised international commercial arbitration

Introduction If I choose German law, I get my right; but if I appear with this ruling in India and want to enforce it, the Indians might just laugh at me. (CEO of a German software company)

A

TFB IS A German company selling accounting software. In May 2013, Michael Dittmar, a key sales account manager at ATFB, reported to the board that his client companies complained about the safety of the accounting software. It turned out that outsiders could get online access to confidential internal company data. The board immediately reacted to this problem and consigned Frederic Wirth, head of the quality department at ATFB, to replace major parts of the software in order to resolve this safety risk. In 2011, ATFB had decided to downsize the development department in order to focus primarily on sales efforts. Therefore, from that point forward, if there was ever a demand for new software development, ATFB would need to outsource this work to specialised software companies. Consequently, in 2013, Frederic Wirth, charged with solving the safety problems, began looking for a business partner that could perform the reprogramming. Frederic Wirth first screened the domestic market, but, as he compared the national prices for software development with prices in Eastern Europe and Asia, he immediately recognised a great business opportunity. Working together with a partner in these regions could reduce the cost for software development up to ten times. Thus, Frederic Wirth screened the global market and convinced the board to approach MBD, an Indian company located in Bangalore. When Sujit Mohanty, chief executive officer at MBD, checked his email account on 1 June 2013, he saw a message from Frederic Wirth asking for a telephone meeting to discuss a software development project. Sujit Mohanty immediately responded. Two days later the managers had a phone conversation, which was the first step of a very fruitful business relation that ultimately ended with ATFB paying MDP a reasonable price for reprogramming major parts of its accounting software. There is nothing unusual about this agreement. It simply reflects significant economic trends of the last few decades during which companies have reacted to global competition by focusing on their core businesses while purchasing other production steps at the market. When companies

2 Introduction purchase resources from other companies, they are not confined to domestic markets, but seek the best business partner wherever it is located in the world. Therefore, not only companies from traditional industrialised Western countries and Japan are involved in complex and risky transactions but also companies from transition countries and emerging economies that were rarely involved in those kinds of transactions twenty years ago. In fact, every day, all kinds of different companies in all kinds of different industries from various regions engage in countless cross-border transactions to realise potential gains from global trade. Thus, the example above simply reflects the existence of today’s globalised markets. As students of institutions, we know that the emergence of complex transactions on competitive markets involves very complex social interactions.1 There are major uncertainties involved in the contractual relation for both the client ATFB and the supplier MDP. For example, if ATFB moves first and transfers the payments to MBD, then it faces the risk that MDP uses the money without delivering the desired software product in return. That is why ATFB would probably want to receive the programmed software before payment. However, this arrangement would only shift the risk to MDB, which would now face the problem that ATFB might receive the software product without paying for it. In this situation, neither ATFB nor MBD would be willing to enter the contract unless effective contract enforcement institutions enable both parties to expect that the other will cooperate, even when it is in a position to cheat. Contract enforcement institutions support cooperation by affirming that a breach of contract is followed by a sanction which is costlier than the effort necessary for the actor to fulfil his part of the contractual promise as agreed upon. This book will show later the distinctions between state-provided contract law and a variety of private-order institutions. As the example of ATFB and MBD shows, in the absence of good contract enforcement institutions, companies might not engage in transactions that would otherwise increase their economic situation. The quality of contract enforcement institutions is a crucial factor in determining a society’s welfare. Identifying and understanding those institutional settings that help parties enter into complex transactions in modern markets is therefore a central question in law and the social sciences. This book sets up a carefully designed case study about cross-border transactions in the global software industry. In this study, 41 software industry experts in Germany, India, Bulgaria and Romania were asked how they enforce complex and risky cross-border software development. Despite the fact that over the last few decades an increasing part of economic transactions has transcended the borders of nation states,

1

Greif, 2005, 727; McMillan, 2002; 3–13; North, 1993.

Introduction

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we still possess very limited knowledge about the contract enforcement institutions that are used in today’s globalised markets to facilitate crossborder exchange contracts. The book contributes to the debate about transnational law and the creation of order for global commerce beyond national legal systems. Within modern nation states, contractual relations take place in the shadow of local law.2 Globalisation is challenging this interrelation; nation states face profound structural problems in coping with the challenges resulting from increasingly interdependent globalised economies and societies. These structural problems affect the area of contract law. Today, most national economies are deeply integrated into the world economy, whereas the organisation of state legal systems remains basically national.3 The general question this book addresses is whether companies engaging in cross-border transactions rely on state courts and enforcement authorities as mechanisms of ultimate appeal to enforce their contracts or whether they, instead, turn to alternative private institutions that evolve in the transnational realm. In order to coordinate fragmented national legal systems, states have established conflict-of-law rules. Furthermore, states are trying to create supranational enforcement orders such as those most advanced in the European Union (EU). States could thus remain crucial actors in establishing a legal shadow also for global commerce. On the other hand, the literature on transnational law and international commercial arbitration courts suggests that globalisation triggers the emergence of new, private legal orders beyond the state.4 In addition, we find a smaller literature that highlights the role of social networks and relational contracts for the facilitation of cross-border trade. Although these informal institutions are well known for playing significant roles in domestic transactions, scrutiny reveals that their significance might increase in the transnational realm. In the absence of comprehensive statistical databases, this book examines a case study of cross-border software development contracts to test the force of these different positions. The approach taken in this book is best described as a law-in-action approach, as developed by scholars like Macaulay,5 Ellickson6 or Bernstein.7 Law-in-action approaches typically use the results of in-depth empirical case studies in very specific settings to generate broader theoretical conclusions. This book follows this research strategy. The case study about cross-border software development contracts creates a microeconomic

2 3 4 5 6 7

Llewellyn, 1931. Dietz, 2012. Teubner, 1997; Stone Sweet, 2006. Macaulay, 1963. Ellickson, 1991. Bernstein, 1992.

4 Introduction data set which is used to identify those kinds of public or private contract enforcement institutions that companies actually rely on when they engage in complex and risky exchange across borders. The book explicitly presents a positive institutional analysis of crossborder contract enforcement institutions. Most of the existing literature in the field has been produced by legal scholars who adapt a doctrinal or normative perspective. Many informative books have thus been written on the formal and legal aspects of present conflict-of-law rules, EU contract law,8 or international arbitration courts and the new lex mercatoria.9 This book takes a different focus. It looks at contract enforcement institutions through the lens of economic agents who might or might not use these institutions to enforce their cross-border contracts. In short, the book is interested in the question of how different institutions factually contribute to the emergence of order in the transnational realm. Stated bluntly, the interviewees describe state-provided contract law as a legal system that shows fundamental signs of dysfunction across borders. Companies engaged in globalised exchange processes therefore rarely use this mechanism to enforce their contracts. Even the efforts of the European Union to create a unified supranational enforcement order turn out to be rather insignificant in practice. These results are in line with relational contract theory. Scholars like Stewart Macaulay or Ian Macneil have argued for a long time that businessmen rarely litigate, but, rather, prefer to preserve relationships and reputations by negotiating solutions to their disputes.10 There are costs to enforcing contracts in courts and, particularly when business relations become complex and contracts remain incomplete, it does often not make sense to pay the price of litigation. Yet, the underlying threat of litigation serves an important function in relational contract theory. The possibility of legal sanctions forces the contracting parties to make credible commitments.11 If one party breaks up the relation by cheating in an opportunistic manner, the other party can invoke the courts as a last resort to enforce her contractual rights. Contractual relations are therefore viewed as taking place in the shadow of law. This situation changes, however, in globalised exchange. The interviews make clear that, even if they wanted it, parties to cross-border contracts have, de facto, no access to reliable courts. Globalised exchange does therefore not take place in the shadow but often in the absence of effective state courts.

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Miller, 2012. Redfern and Hunter, 2004. 10 Macaulay, 1963; Macaulay, 1965; Macaulay, 1977; Macaulay, 1985; Macaulay, 1986; Macneil, 1971; Macneil, 1978; Macneil, 1980; Macneil, 1985a; Macneil, 1985b; Macneil, 1999–2000. 11 Macaulay, 2003. 9

Introduction

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Moreover, against all expectations, the institutions most highlighted in the pertinent legal literature to replace state law in cross-border exchange—namely, international arbitration courts applying the norms of a new lex mercatoria—are also judged to be considerably limited in their capability to provide an effective and low-cost legal infrastructure for global commerce. This book therefore sheds a critical light on current theories of transnational law. According to the empirical data generated in this book, no efficient public or private formal global legal order yet exists on which companies could rely to enforce their contracts across borders. The empirical study further describes how economic agents react to this lack of formal order by creating their own informal private-order contract enforcement institutions. In doing so, these agents largely benefit from the rapid developments of modern information and communication technologies. The interviewees describe how complex exchange on global markets between unknown agents emerges today even in the absence of an efficient global legal order. To cross-check data and to generalise results, the qualitative interview material is enhanced with the available statistics and surveys in the field and then used as a springboard for engaging in more theoretical questions about the emergence of order beyond the state in today’s globalised markets. Three points are most important. First, in comparison to other books in the field, this book develops a much deeper understanding of the reasons that limit nation states from establishing a workable legal infrastructure for global commerce. Legal scholars usually refer to flawed conflict-of-law rules to explain the shortcomings of state-enforced contract law in situations of cross-border exchange.12 This view is important but can be further specified. In fact, the book shows that a global legal system, composed of territorially fragmented national legal systems of different natures and qualities, faces profound legal, cultural and economic problems that render it almost impossible to provide efficient cross-border contract enforcement institutions. Moreover, this book’s analysis suggests that most of these problems prevail even when supranational organisations like the EU try to unify national contract laws and enforcement orders. Second, the book points to the economic limitations of international commercial arbitration courts. The doctrinal and normative literature in this field usually considers arbitration legally superior to litigation in terms of confidentiality, flexibility, neutrality and costs. Legal scholars interested in arbitration therefore often claim that arbitration has become the accepted method of resolving cross-border disputes in international commerce.13 This widely shared notion is certainly not wrong, but the

12 13

Berger, 1999; Stone Sweet, 2006. Born, 2009.

6 Introduction law-action-approach taken in this book proves it to be too simplistic. The book looks at international arbitration courts through the lens of economic actors in order to understand the practical economic relevance of these private courts for the emergence of cross-border exchange. In doing so, it becomes clear that, for various reasons, companies engaged in crossborder exchange do not rely on these institutions to safeguard their crossborder transactions against fraud and opportunistic behaviour. Including case load statistics and further economic figures in the analysis only strengthens this position. The book therefore concludes that, despite their superiority over state courts, international arbitration courts in their present form still fall short of providing an efficient, low-cost legal infrastructure for global commerce. The most important shortcomings identified are the flawed enforcement structures of arbitral awards and the cartelised inner structure of these private legal institutions. Third, the results of the empirical study about cross-border software development contracts point to the crucial significance of informal contract enforcement institutions. Over the last several years, many important books have highlighted the role of informal institutions in promoting cooperation and facilitating economic exchange.14 However, with a few exceptions,15 the literature on transnational law and global economic governance has not adequately applied these insights to their concepts of global order. This book is the first in the field of transnational law and governance to develop a systematic analysis of informal institutions in crossborder exchange. The case study describes in great detail how economic agents react to the dysfunctional formal global legal order by creating their own private contract enforcement institutions. Moreover, the book explains how the development of new information- and communicationtechnologies (ICT) enhances the efficiency of these informal institutions. The last point in particular makes reading this book rewarding not only for students of law and governance but also for a broader economic and social science audience. Global Order beyond Law explains the rise of informal virtual private ordering. The Internet allows information to be exchanged extremely fast and inexpensively, even between agents who do not know each other personally nor are part of the same social or economic community. Global Order beyond Law presents an example of how companies rely on ICT-enabled reputational networks and relational contracts to enforce their contracts across borders. The book concludes that theories of transnational law and governance are incomplete when they fail to take into account the crucial roles that these virtual informal institutions play for the generation of order beyond the state.

14 15

Greif, 2006. Landa, 1981; Belloc, 2006.

Introduction

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In a nutshell, this book makes the following argument: Globalisation is a force that decreases the efficiency of state-provided contract law. A territorially fragmented, state-enforced global legal order faces severe limitations in a borderless, transnational economy. Since international arbitration courts are still closely connected to state legal systems, these institutions—despite their growth rates—are not yet capable of providing an efficient legal infrastructure for global commerce. ICT is a force that enhances the efficiency of private ordering. Spontaneous and informal institutions are the only mechanisms currently capable of supporting complex exchange, and can even do so between actors unknown to each other in broad competitive markets. Globalisation and ICT together trigger the effect that the institutional infrastructure provided by states dissolves in favour of communicatively integrated network structures in the transnational realm. The entire book is embedded in a theoretical framework that is outlined in Part I. Chapter one develops a taxonomy of public and private contract enforcement institutions. Drawing on the concepts of institutional economics, game theory, and economic sociology, four different types of contract enforcement institutions are distinguished: (i) self-enforcing contracts, (ii) reputational networks, (iii) private governance regimes, and (iv) state-enforced contract law. The first three mechanisms constitute the group of private contract enforcement institutions, as they rely on private sanctions like the termination of an ongoing business relation or the exclusion of the cheating party from a trader’s network. Private governance regimes differ from the other two private institutions in that the former are formally organised as private legal systems. In contrast, the fourth mechanism relies on enforcement by the state, which means that the state puts its monopoly on force at the disposal of private persons, if a contractual party does not conduct an agreed exchange as expected. Contract law prescribes, and the state courts decide, in which cases the state enforces private business agreements. In systematic terms, this taxonomy is of crucial importance as it establishes a set of terms which structures both the further empirical and theoretical argumentation of the book. The second chapter focuses on the particular economic relevance of state-enforced contract law. It explains that the transaction costs associated with complex exchange between multitudes of unknown agents in modern markets rapidly become prohibitive if states fail to provide market actors with reliable state-enforced contract laws. Historically, modern market economies could therefore develop only in those countries in which the state took over the governance function of enforcing contractual agreements. On the basis of chapters one and two, the research question of the book is: How does economic globalisation affect the crucial governance function of states of providing for effective contract-enforcement institutions? Chapter

8 Introduction three systematically reviews the contesting answers to this question and concludes that, despite the vast literature in the field, there is a remarkable lack of positive institutional analysis. What kind of public or private contract enforcement institutions companies factually rely on to enforce cross-border contracts still remains a widely unexplored question. The empirical Part II builds the centrepiece of the book. Chapter four outlines the research design of the empirical study. The empirical results are then presented in four different scenarios. First, chapter five shows how German customers enforce cross-border software development contracts in Asia and Eastern Europe (scenario 1). Chapters six and seven take on different viewpoints by exploring problems of cross-border contract enforcement from the perspective of Bulgarian and Romanian firms (scenario 2) and Indian suppliers (scenario 3), respectively, selling software products to firms located in advanced OECD countries. Chapter eight compares some of the results to a follow-up study (scenario 4) that was conducted in 2010, five years after the initial case study. The follow-up study again focuses on firms from Germany, Bulgaria and Romania, but after the latter two countries joined the EU in 2007. Chapter eight has been particularly set up to study the changes in the institutional environment of cross-border contracts when states use international politics to create supranational enforcement orders. Finally, chapter nine summarises the overall results of the empirical study. In short, the empirical study shows that companies engaged in complex and risky transnational exchange mostly avoid public or private formal institutions in favour of creation of their own informal order of contract enforcement. In conclusion, Part III aims to explain these results and elaborates on their theoretical implications. Chapter ten explains why nation states turn out to be incapable of providing a workable legal infrastructure for global commerce. Chapter eleven lays out the limits of international commercial courts in providing for effective and low-cost contract enforcement institutions for global commerce. Finally, chapter twelve explains the crucial roles of relational, self-enforcing contracts, and reputational networks for the facilitation of complex and risky exchange in today’s globalised markets. In particular, the book asserts that that the spread of advanced ICT has led to the emergence of new, considerably more efficient forms of private ordering which, in contrast to the formal institutions, are capable of facilitating transnational exchange in the global economy. In short, these institutions establish a global order beyond law.

1 Contract Enforcement Institutions COOPERATION: THE THEORETICAL PROBLEM

G

ENERALLY, HUMAN BEINGS strive to improve their material and social living conditions. This holds true for the inhabitants of modern industrial states as well as for people in transitional and developing countries. Yet, the improvement of living conditions leads to a major problem. Societal resources usually do not suffice to enable every individual to lead a life according to the highest living standards. The experience of scarcity is therefore an important fact of economic reality, and reducing scarcity is the main task of all economic actions. Ultimately, the goal is to allocate existing resources in a way that maximises the satisfaction of individual needs in a given society.1 Division of labour and specialisation are crucially important for overcoming the problem of scarcity.2 Adam Smith demonstrated this connection in his famous needle example. If every worker specialises in one specific step in the production of needles, the combination of workers produces a significantly higher amount of needles than if all production steps were carried out by each worker alone. Assigning specific operations to specialised agents enhances the skills, knowledge, and experience of each worker in his particular field of activity, which, in turn, increases the output per worker per time unit. For Adam Smith, specialisation and division of labour were decisive driving forces behind the ‘Wealth of Nations’.3 However, this process has another side. The more the division of labour advances, the harder it becomes for each individual to maintain economic autonomy. Division of labour demands that every individual specialises in a particular activity, which in turn makes it impossible for an individual to become knowledgeable in different fields. In contrast to our ancestors, who were living under conditions of self-supply, agents today produce by themselves only a small part of the goods and services they consume. As a result, specialised agents become increasingly dependent on exchanging goods and services with other specialised agents in order

1 2 3

Mankiw, 2008, 1–3. Smith, 2003, 9. Ibid.

12 Contract Enforcement Institutions to satisfy their daily needs. In addition to the division of labour and specialisation, exchange also plays a major role in the development of wealth in modern industrial societies.4 In societies with private property, exchange is organised as a voluntary contractual agreement. The contractual parties commit themselves to perform a service that both sides accept. These reciprocal agreements are governed by the principle do ut des (I give as you give). In other words, a contractual party is committed to performing her service under the condition that her counterpart delivers that party’s service in return. The exchange of goods and services can take place simultaneously with the conclusion of the contract (buying an apple at a local market), or a time gap can exist between the conclusion of the contract and the actual performance of the services (arranging for the manufacture and future delivery of a product). Moreover, contractual parties can agree to perform their services at different points in time. One party moves first and then waits for her counterpart to complete the agreed-upon exchange.5 In transactions where the involved parties cannot instantaneously verify the quality of a contractual performance, the first mover cannot know whether her contractual partner will indeed live up to the agreement or, instead, behave opportunistically6 and, thereby, destroy part of the cooperation surplus to secure a larger share of it. A delivery might not be performed after it has already been paid for; the quality of a delivered service can be insufficient; or there may be time delays as well as financial difficulties which lead to non-payment problems. Consequently, being engaged in a transaction not only means realising potential cooperation gains but also means exposing both contractual parties to the risk of losing resources and receiving nothing in return.7 Since agents are usually risk averse, it follows that economic exchange in real markets will only take place under the condition that none of the contractual parties evaluates the risks of the transaction as being too high. If, on the contrary, one of the agents expects to become a victim of opportunistic behaviour of his potential cooperation partner, an otherwise beneficial transaction will not be conducted. Therefore, before economic exchange takes place, the problem of cooperation needs to be solved. Only when the involved parties reliably expect the adherence of contractual agreements are they willing to bear the risks of transactions.

4

Ricardo, 1817. See: Furubotn and Richter, 2000b, 82; Kobler, 2000, 26–28. 6 Opportunism can be defined as ‘an act in which someone destroys part of the cooperation surplus to secure a larger share of it’. See: Cooter, 1996, 150; in addition: Williamson, 1985, 54. 7 See: Dixit, 2004, 1–2. 5

The Function of Contract Enforcement Institutions

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The emergence of voluntary exchange at markets depends on institutions that guarantee the performance of contractual agreements.8 THE FUNCTION OF CONTRACT ENFORCEMENT INSTITUTIONS

The function of contract enforcement institutions is to guarantee the performance of contractual agreements.9 According to Avinash K Dixit, contract enforcement institutions govern individual behaviour in contractual relationships by manipulating the incentives of the involved agents.10 More specifically, contract enforcement institutions support cooperation by threatening punishment of a cheating agent. A breach of contract is followed by a sanction which is costlier than the effort necessary for the actor to fulfil his part of the contractual promise as agreed upon.11 In short, contract enforcement institutions establish transactional security.12 In doing so, they induce agents to bear the risks inherent in economic transactions. PUBLIC AND PRIVATE CONTRACT ENFORCEMENT INSTITUTIONS

When we think of contract enforcement institutions, we usually think of state courts and state-enforced contract law. However, institutional economists have pointed out that, apart from state law, there exist alternative private mechanisms. An array of public and private contract enforcement systems are described and summarised below to introduce the great variety of institutions that are capable of enforcing contractual agreements. The first mechanisms that will be explained are the so-called self-enforcing contracts.

Self-enforcing Contracts Game theory shows that actors involved in a transaction are able to enforce a contract without the mediation of a third party merely by the available

8

See: North, 1993. Golberg, 2005, 491. 10 Dixit, 2004, 1–2. 11 Dixit writes to this point: All successful mechanisms theory as well as in practice, work by creating a future cost to the individual of taking an action that brings him an immediate personal benefit. The nature and the size of the cost can vary widely across different situations; the common requirement is that future cost should outweigh the immediate benefit in the individual’s own calculation based on its own preferences. (Dixit, 2004, 60). 12 For the term ‘transactional security’ see, Kronman, 1985. 9

14 Contract Enforcement Institutions means of terminating business relations.13 Although self-interested actors do not cooperate when they play only once, they are interested in cooperation when they interact repeatedly. As long as both contractual parties expect that the future returns from business dealings outweigh the benefit of non-performance of a contract in the present, they will meet their contractual obligations without needing to safeguard their transactions with the help of additional institutions.14 Under the condition of repeated games, the threat that an actor will conduct future transactions only if his counterpart is cooperative remains sufficient to ensure contractual performance. Robert Axelrod summarises this argument concisely: What makes it possible for cooperation to emerge is the fact that the players might meet again. This possibility means that the choices made today not only determine the outcome of this move, but can also influence the later choices of the players. The future can therefore cast a shadow back upon the present and thereby affect the current strategic situation.15

However, this mechanism of enforcing contracts does not work when the number of repetitions is already limited at the beginning of the game. If the actors know when the game ends, cheating again dominates. Since one might foresee that the interaction partner will cheat in the last round, it becomes rational to cheat in the penultimate round, etc. In this way, no cooperation develops.16 In game theory, this problem is also known as the problem of the endgame. Safeguarding transactions with the help of repeated interaction only becomes possible in the shadow of the future. It requires the existence of a stable and lasting business relation, which does not have a foreseeable end. The reason being that once a manufacturer begins to go under, even his best customers begin refusing payment for merchandise, claiming defects in quality, failure to meet specifications, tardy delivery, or what-have-you. The great enforcer of morality in commerce is the continuing relationship, the belief that one has to do business again with this customer or this supplier.17

In effect, economic transactions safeguarded by the mechanism of repeated interaction need to be firmly embedded in an economic and/or social web of relationships transcending the single individual transaction. Therefore, personal relationships in the past, present, and future are of particular significance. Only in this way are the contractual parties able to agree implicitly or explicitly on the relational norms with which they

13 14 15 16 17

Axelrod, 1990. Telser, 1980. Axelrod, 1990, 12. Ibid, 10. Mayer, 1974, 280; cited in Axelrod, 1990, 60.

Public and Private Contract Enforcement Institutions

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intend to solve future interaction problems, monitor rule compliance, and sanction rule violations with the termination of business relations.18

Reputational Networks The mechanism of repeated interaction can be transferred from a twoperson game to a group of actors. More specifically, if the past conduct of an actor is not only known to his direct opposite but is also discoverable by all other potential transaction partners, the shadow of the future prevents opportunistic conduct in the present with the same actors having to interact repeatedly.19 Actors can therefore respond to the conduct of unknown transaction partners as if they had interacted with them in the past. This behaviour only applies, however, if there is a high likelihood of meeting an actor again, ie, the number of involved actors must not be too big. Only if members interact regularly or are able to obtain reliable information about the past conduct of potential interaction partners will opportunistic conduct lead to a loss of reputation. The effect then is that the respective actor is excluded from further business opportunities.20 Robert C Ellickson provides a practical example of how information exchange can be organised within a reputational network: The mildest form of self-help is truthful gossip. This usually works because only the extreme deviants are immune from the general obsession with their neighborliness … People tend to know each other, and they value their reputation in the community. Some ranching families have lived in the area for several generations and include members who plan to stay indefinitely. Members of these families seem particularly intent on maintaining their reputations as good neighbors. Should one of them not promptly and courteously retrieve a stray, he might fear that any resulting gossip would permanently besmirch the family name … One long-time resident, who had also lived for many years in a suburb of a major California urban area, observed that people in the Oak Run area ‘gossip all the time’, much more than in the urban area.21

18 Milgrom North and Weingast describe the functioning of self-enforcing contracts as follows: [I]f the relationship itself is a valuable asset that a party could lose by dishonest behaviour, then the relationship serves as a bond: a trader would be unwilling to surrender this bond unless the gain from dishonest behaviour was large. (Milgrom North and Weingast, 1990, 1). See Macaulay, 2003, for one of the best empirical studies about self-enforcing, relational contract. For further helpful empirical studies see: McMillan and Woodruff, 1999b; for further information about theoretical foundations of self-enforcing contracts see: Abreu, 1988; Townsend, 1979. 19 See: Kandori, 1992. 20 Greif, 2006; Kali, 1999, see also: Abreu, Pearce and Stacchetti, 1991. 21 Ellickson, 1991, 57.

16 Contract Enforcement Institutions Empirical studies offer rich evidence that informal talks among the members of a reputational network (gossip) are an appropriate means to ensure contractual performance in business relations. Avner Greif describes, for instance, the activities of the so-called Maghribi Traders’ Coalition—an ethnically and religiously shaped reputational network, which organised lively trade relations in the Southern and Eastern Mediterranean in the eleventh century: For diversification, traders were associated with many traders residing in different trade centers. It was customary for merchants to supply their business associates with trade-related information, which was crucial to business success … Within the Maghribi traders’ group these information flows together with merchants’ experience, reduced the asymmetry of information possessed by merchants and agents, enabling the merchants to monitor agents. These information flows also enabled agents to signal that they were honest. Just as modern firms hire auditors to establish the legitimacy of their financial statements, eleventh-century Maghribi agents generally conducted important business in the presence of other coalition members.22

These examples highlight that reputational networks are usually linked to exclusive groups of actors, which are confined ethnically,23 religiously,24 or geographically.25 Only within these socially connected groups does it seem possible to organise the exchange of information in a way that prevents opportunistic behaviour.26 Reputational networks that are organised on the basis of a clearly confined group of actors, as in the case of the Maghribi Traders, usually have the ability to apply not only economic but also social sanctions27 in order to ensure transactional security. This means that reputational networks not only have the effect of excluding actors with a bad reputation from future business opportunities but they also control the cultural, social and religious life of the actors, so that opportunistic behaviour leads to a loss of status within the community. An extreme example of the workings of social sanctions can be found among the ultra-Orthodox Jews who control the largest part of the diamond trade in New York. Members of the community convicted of

22

Greif, 2006, 64–65. A very good example of an ethnic network is provided by Landa, 1981. An overview about the significance of ethnic networks for the emergence of economic exchange is provided by Rauch, 2001. 24 The best account of a religious reputational network is provided by Max Weber (2006, 184f) who highlighted the significance of protestant sects for the development of the American economy in the 19th century. 25 See for this point: Zucker, 1986, 53f; Casari, 2007, 199f. 26 See: Charny, 1990, 373; Casari, 2007, 198f; Kali, 2003, 66. 27 A very good overview of the significance of social sanctions is provided by Stephan Panther. See: Kali, 2003; Panther, 2000. 23

Public and Private Contract Enforcement Institutions

17

cheating in their business life are excluded from all communal religious festivals and celebrations, preventing them from leading a life according to the rules of their religion.28 Many other examples of social sanctions originate in Southeast Asia where close kinship still exerts a big influence on economic life.29 The fact that economic exchange within a reputational network is conducted on the basis of informal contracts, to which state law is not applied, does not mean that no universally binding rules exist to regulate the conduct of actors. On the contrary, the respective literature in economic and legal sociology indicates that a plethora of unwritten laws and traditional customs exists in these networks that structures and regulates economic conduct.30 Unwritten rules and traditional trade habits exist in various forms in modern economies. Robert C Ellickson, among others, established this in a study about the way in which the rural inhabitants of Shasta County in California settle disputes regarding damages caused by straying cattle. He demonstrated that the residents of Shasta County almost never go to court; they rather follow a complex set of unwritten rules in order to settle conflicts. Overall, Ellickson concludes that the inhabitants of Shasta County settle their conflicts not in the shadow of the law but beyond the law.31 The terms ‘self-enforcing contract’ and ‘reputational network’ express that contractual relations regulate themselves under certain circumstances. In the framework of long-lasting business dealings, both the conduct of a transaction and its embedding in the context of a reputational network link the actions of the involved actors so closely to each other that opportunism becomes an unprofitable plan of action. In both cases, the direct reciprocity in closely knit groups is enough to guarantee cooperative conduct. As a result, an informal and spontaneous form of contract enforcement emerges that enables the involved actors to risk economic transactions without the need to steer the conduct of actors with the help of deliberately created external institutions, such as state law.32

28

Richman, 2004, 2345. Fukuyama, 1995; Landa, 1981; Hughes and Weidenbaum, 1996; McMillan and Woodruff, 1999b. 30 A very good description of the normative structure of informal networks is provided by Raja Kali: He writes: Business networks are more than just the platitudinous ‘life is about relationships’. These relationships are highly commercial and structured even though contracts are not formally written. Trading relationships within the network are governed by clear and well understood norms and it is important to adopt these norms in order to become a member of a business group. (Kali, 1999, 619). See in addition: Colson, 1974; Ellickson, 1991. 31 Ellickson, 1991, 41f. 32 See for this point Avner Greif, who systematically differentiates between informal and designed contract enforcement institutions: Greif, 2005, 730f. 29

18 Contract Enforcement Institutions Private Governance Regimes However, when contractual agreements are not self-regulatory, actors have to rely on third-party enforcement mechanisms (‘private providers of order’) in order to safeguard transactions against opportunistic behaviour.33 In this context, the term ‘private governance regime’ denotes the safeguarding of contractual performance by a private third party. In principle, private governance regimes work according to the same principle as the reputational networks. Parties in breach of contract are excluded from further business opportunities; in this way, the shadow of the future gives rise to cooperative behaviour in the present. However, in contrast to reputational networks, in which the information necessary to trigger the punishment of an actor is largely exchanged in personal conversation among group members, private providers of order formally organise both the provision of relevant information and the punishment of actors in breach of contract.34 Credit information companies or certification agencies systematically collect, prepare and make available to potential customers information on a company’s past activities.35 The functioning of private arbitration courts can be described similarly, since their judgments serve as a source of information about the business practices of an actor in recent exchange processes. To the extent that their judgments are not recognised by the state, arbitration courts do not replace the reputational mechanism. But, arbitration courts become the centre of an information system. They increase the efficiency of the reputational mechanism, because they provide reliable information about the willingness of an actor to cooperate, even if the latter does not interact repeatedly or belong to a close-knit reputational network.36 [T]he arbitration system alone cannot force compliance and thus cannot explain consistent contractual performance. Nonetheless, the arbitration board yields real power. Its muscles lie in accurately publicizing individuals who fail to cooperate. This leads to a very interesting conclusion. The purpose of the NYDDC’s arbitration board is not to enforce contracts; it is to maintain the accuracy of reputations. Individuals only comply with the board’s rulings so they can continue to transact in the DDC. The board’s decisions have no inherent power.37

Apart from furnishing reliable information, private providers of order also organise the sanctioning of parties in breach of contract.38 Transactional

33 34 35 36 37 38

See: McMillan and Woodruff, 2000a, 2423; Dixit, 2004, 13–17. See: Milgrom, North and Weingast, 1990; McMillan and Woodruff, 2000a. See: Dixit, 2004, 13. See: Milgrom, North and Weingast, 1990, 19. Richman, 2002. See: Milgrom, North and Weingast, 1990, 10.

Public and Private Contract Enforcement Institutions

19

certainty can only succeed with the help of the reputational mechanism if the punishment of an opportunistic actor is a collective act. Only when it is guaranteed that even actors who are not directly affected by a breach of contract exclude the breaching party from future business opportunities in the name of the victim will business partners refrain from opportunistic behaviour and perform contracts as agreed. If the punishment is not collective, cheating becomes attractive for actors, since they can move on to alternative business partners after a breach of contract.39 Private providers of order can coordinate the dissemination of relevant information in various ways that ensure collective punishment of a party in breach of a contract. An early example is the organisation of the medieval Champagne Fairs. At the time, specialised fair courts applied medieval merchant law (lex mercatoria) in order to settle disputes between buyers and sellers. When a party refused to pay the judicially specified penalties for a breach of contract, such behaviour was documented by the court and stored centrally. In this way, fair courts acted as an information provider, increasing the effectiveness of the reputational mechanism. Such a structure arose because, ultimately, this system of order could only work if the actors actually enquired with the courts about the status of a potential trading partner. Since such enquiry was associated with substantial information costs, there was a strong incentive for traders to become free riders, ie they did not participate in this system, as long as the other traders provided for the effective exclusion of parties in breach of contract.40 The organisation of the trade fair solved the free-rider problem of the collective punishment of a party in breach of a contract by allowing participation by only those traders who had previously enquired about the status of their trading partners. On the part of traders, this created a strong incentive to actually participate in the joint information system. Every trader who was unwilling to pay the information fee was vulnerable and without protection against the potentially fraudulent activities of his transaction partners. Even today, numerous industrial associations, business clubs and exchange fora still coordinate the collective punishment of opportunistic actors without resorting to a state judiciary.41 Industrial associations may, for example, prohibit their members from doing business with companies that are known to have breached contracts.

39 See: McMillan and Woodruff, 2000a, This paragraph is based on the assumption that transactors are risk averse in the sense that that they refuse to trade with partners who turned out to be cheats in the past. See for this point: Greif, 2005, 737. 40 Milgrom, North and Weingast, 1990, 1–22. 41 For a literature overview to this point, see: McMillan and Woodruff, 2000a.

20 Contract Enforcement Institutions The American Popular Priced Dress Manufacturers’ Association offers an example of such a practice. This industrial association of the clothing industry maintains an office to check all complaints by retailers about producers. The industrial association blacklists retailers who complain about product quality without justification and who refuse to make payment. Under the threat of substantial penalties, all members of the association are prohibited from doing business with these retailers. Exchange fora and business clubs offer more empirical evidence of how the sanctioning of parties in breach of a contract can be coordinated by a private third party. In these organisations, it is mainly courts of arbitration that stand at the centre of the sanctioning systems and decide on conflicts between transaction partners on the basis of independent industry-specific rules.42 If a party refuses to implement an arbitration decision, the court can exclude the party from further business through the targeted dissemination of information among the other members of the organisation. Since their rulings are not recognised by the state, courts of arbitration do not replace the reputational mechanism, as do state courts whose rulings can be enforced with coercion; however, they become the centre of a system of information. They increase the efficiency of the reputational mechanism, since they provide actors with reliable information about another actor’s willingness to cooperate, even when the actors have not interacted repeatedly and are not part of a closely-knit reputational network.43 The following quote, which refers to the Diamonds Dealers’ Club (DDC) in New York, expresses the complexity of such a reputational system: The DDC supports information exchange with several mechanisms. First, the floor of the trading hall is bustling with information about parties and market conditions, and some traders spend time on the trading floor just to keep abreast of available information. Traders on the floor will ask others about potential business partners and get references, and supplementary credit reports about diamond buyers float throughout the trading community. Certainly DDC members share information outside the Club’s hall as well, and enjoying mere membership gives a merchant entry into a global information network. Thus, the Club creates both a physical and a psychic infrastructure that facilitates information sharing between members. A second mechanism is the wall of the trading floor. The wall posts the pictures, background, and references of any visitor to the club, providing easy referral for potential business dealings (most visitors also require a sponsor by member, who is cited along with the visitor’s picture), and also invites comment from members regarding the induction of dealers applying for Club membership. More important, the judgements of all arbitration boards’ determinations are posted on the wall along with the pictures of any party who is responsible for an outstanding debt. This information is shared with all of the world’s bourses, so pictures of delinquent debtors

42 43

Bernstein, 1992; Bernstein, 2001. Richman, 2004, 2339–367.

Public and Private Contract Enforcement Institutions

21

from across the world are prominently posted in the NYDDC trading hall. Conversely, maintaining good standing as a DDC member—and preventing your picture from ever reaching the wall—also becomes well known and functions as an important information signal.44

In sum, the provision of order by private third parties differs from the previously described informal and spontaneous mechanisms of economic governance, especially in their higher degree of formalisation and organisation: both the provision of relevant information and the punishment of opportunistic behaviour is organised on the basis of explicit private rules by private governance regimes. Ultimately, however, this mechanism of economic governance also works on the basis of repeated interaction and reputation.

State-enforced Contract Law In the pertinent literature, the three hitherto-mentioned mechanisms of contract enforcement—self-enforcing contracts, reputational networks and private regimes—are usually subsumed under the generic term ‘private ordering’.45 In contrast, there is the governance of contractual relations through state’s contract law. Here, economic actors cooperate on the basis of legally enforceable documents (contract under private law) enforced by the state, which puts the state’s monopoly on force at the disposal of private persons if a contractual party does not conduct an agreed exchange as expected. The regulations of contract law prescribe, and state courts decide, in which cases the state enforces private business agreements. In this sense, the state can be seen as a predictable machine, since it is not at the discretion of a state court to decide whether a claim is enforced with the help of state enforcement bodies; the latter is rather determined by the rule of law. State action is strictly bound to statute law and law as a whole. Within its territory, the state has the monopoly on enforcing contractual agreements with coercive force.46 In contrast to all other hitherto-mentioned institutions, state-enforced contract law is mainly characterised by its universally binding nature. Its rules can, in principle, be applied to all processes of economic exchange. The use of state-enforced contract law works independently from economic, social, or organisational structures, which depend on the functioning of the mechanisms of a private order. The state’s contract law replaces the reputational mechanism and, therefore, in principle has universal scope, in stark contrast to the mechanisms of a private order.47 44

Richman, 2002, 102. See: Richman, 2004, 2338. For a very good description of the functionality of state enforced contract law, see: Weber, 1980, 198. 47 See: Li Shuhe, 1999. 45 46

22 Contract Enforcement Institutions A TAXONOMY OF CONTRACT ENFORCEMENT INSTITUTIONS

The considerations of this section are summarised in the taxonomy illustrated in Figure 1.

State Contract Law Formal third party contract enforcement

Public-order contract enforcement: based on the coercive power of the state

Private Governance Regimes

Informal & spontaneous contract enforcement

Reputational Networks

Private-order contract enforcement: based on repeated interaction & reputation

Self-Enforcing Contracts

Figure 1: A taxonomy of public- and private-order contract enforcement institutions

In conclusion, the relationship of the individual mechanisms of economic governance is twofold: First, the individual mechanisms of economic governance can replace each other as functional equivalents. They all possess the function of ensuring the performance of contractual agreements concluded by private actors for the purpose of the exchange of economic goods. The fact that the individual mechanisms of economic governance can replace each other does not mean, however, that they are mutually exclusive in their operation. In fact, on the contrary, the governance structure of an economic transaction usually consists of a combination of different mechanisms. Therefore, second, the individual governance mechanisms can also complement each other. The importance of the individual governance mechanisms for the occurrence of an exchange relationship depends on transaction-specific as well as social, political and cultural conditions, which must be analysed individually.

2 State-enforced Contract Law and the Development of Modern Market Economies Trade does exist even in stateless societies. Yet … the inability of societies to develop effective low cost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment in the third world.1 Historically the growth of economics has occurred within the framework of well-developed coercive politics. We do not observe political anarchy in highincome countries.2 (Douglass C North)

EFFICIENCY

T

HE PREVIOUS CHAPTER introduced the problem of cooperation in processes of economic exchange and distinguished between four functionally equivalent contract enforcement institutions. However, the fact that those institutions are functionally equivalent says nothing about their economic significance. To understand the economic value of a certain contract enforcement institution, we have to study its efficiency3—ie, first, its effectiveness and, second, the costs at which it is able to safeguard the performance of contractual agreements.4 Contract enforcement institutions are subject to a competitive selection process. The basic idea is simple: individual institutions differ with regard to their performance. These differences cause stronger mechanisms to displace weaker ones or to spread by imitation.5 Ultimately, effective contract enforcement institutions succeed in the competition, since those companies that organise their external relations on the basis of inefficient

1 2 3 4 5

North, 1990, 54. Ibid, 14. In this work I use the term efficiency in relative rather than absolute terms. Hadfield, 2005, 179–80. Kubon-Gilke, 1997, 15; Roe, 1995, 641–42.

24 State-enforced Contract Law and Modern Market Economies institutions operate with higher transaction costs that will cause them to exit the market sooner than the companies with lower transaction costs. Transaction costs denote essentially those costs incurred in solving the opportunism problems discussed in chapter one. Factually, they are caused by the search for suitable transaction partners and the completion, monitoring and enforcement of contractual agreements.6 Transaction costs can be studied not only from the perspective of a single company but also from a macroeconomic viewpoint. In the latter context, they exert a decisive influence on the degree of division of labour and, hence, on the production of welfare within the entire economic system. In general, it can be said that, the more efficiently contract enforcement institutions work, the lower the incurred transaction costs and the higher a company’s incentives to actually engage in economic exchange. However, in the absence of effective institutions, transaction costs exceed potential trade gains, so that a welfare-maximising exchange beneficial to all sides does not occur. Ronald H Coase states in this context: Businessmen, in deciding on their ways of doing business and on what to produce, have to take into account transaction costs … If the costs of making an exchange are greater than the gains which that exchange would bring, the exchange would not take place and the greater production that would flow from specialization would not be realized.7

Both from the perspective of a single company and from a macroeconomic perspective, the crucial question is not whether the mechanisms introduced in the taxonomy (see chapter one) are able to foster cooperation but, rather at what cost they fulfil this function and how effectively they work. Modern competitive economies with complex high-risk exchange relations and a high degree of economic growth can, in the end, only develop when they are supported by sufficiently efficient contract enforcement institutions. PUBLIC VERSUS PRIVATE ORDERING

Having explained the interrelations between transaction costs, contract enforcement institutions, and the intensity of economic exchange, the question arises of precisely what kinds of contract enforcement institutions are needed for complex exchange in modern market economies to come into being? A brief glance at the literature on law and economic development makes clear that a workable state-provided legal infrastructure is more efficient than private institutions.8 Certainly, it was possible to carry 6 7 8

Furubotn and Richter, 2000a. Coase, 1992, 10. Ahrens, 2002.

The Decline of the Traditional Order

25

out risky transactions a long time before the emergence of modern states in Europe and later in America, and, nowadays, private mechanisms of economic governance are still used as additional monitoring and control mechanisms in order to reduce transaction costs in the shadow of national contract laws. Overall, however, the prevailing view is that the performance of private contract enforcement institutions alone is not sufficient to enable complex and risky transactions in modern competitive markets.9 Rather, in the course of economic modernisation in the nineteenth and twentieth centuries, state-enforced contract law prevailed over traditional private institutions, which had originated in the Middle Ages. It is this development that enabled the emergence of modern competitive economies in Western industrial states. Mary M Shirley argues in this vein: Traders even today rely principally on private means to enforce contracts. And norms of trust and cooperation are still important in reducing transaction costs and fostering exchange. But for increasingly impersonal exchange, private ordering and norms of conduct must be strengthened with the support of third party rules and enforcement, as happened in Europe, for example when the codes of conduct of guilt merchants evolved into merchant law and were gradually integrated into the body of laws enforced by states.10

In the following sections, it will be explained why, in the course of economic modernisation in the nineteenth and twentieth centuries, the performance of traditional private-order contract enforcement institutions did not suffice to enable complex exchange at modern competitive markets to come into being and why powerful economies with complex exchange patterns and high growth rates could only develop in countries in which the state provided economic actors with functioning contract law. Only when we have understood the significance of state contract law for the emergence of complex impersonal exchange in modern market economies will we be able to capture the legal problems economic actors face today when they engage in transnational cross-border transactions in globalised markets. THE DECLINE OF THE TRADITIONAL ORDER

The central feature of the traditional societal order in the Middle Ages and the early modern era was a hierarchical structure of society tiered into different estates (feudal and privileged society). The upper estates dominated the lower ones, which condition had a severe impact on the existing economic order, since the economic right of disposal was fully determined

9 10

Macneil, 1978, 887–88. Shirley, 2005, 614.

26 State-enforced Contract Law and Modern Market Economies by corporate power relations. Undivided, individual properties—in the sense of the concept of property under private law—that economic actors had at their disposal to pursue their self-determined goals practically did not exist.11 A comprehensive separation of economic and political power emerged through the liberal reforms of state and society in the early nineteenth century. Until then, economic activity was mainly based on coercion (forced labour, forced dues, manorial system) or on the explicit authoritarian issue of privileges, either directly to individual traders (manufactory) or to corporations of traders who, in turn, determined the extent of permissible commercial activity (trade guilds, craft guilds).12 In medieval and early modern times, the most important supply institutions were local weekly markets, at which country people exchanged their excess goods for commercial products. However, the exchange was not a voluntary one based on individual agreements. Rather, both farmers and craftsmen were obliged to sell specified quantities of their goods at prices determined by the authorities. In addition, foreign goods were largely kept out of urban markets in order to protect domestic trade. Estimates for France quantify the share of this highly regulated, local economic exchange to over 90 per cent of all economic transactions in the Middle Ages and the early modern period.13 Liberal markets, where goods could be exchanged under free pricing and on the basis of voluntary agreements, were an exception.14 Still, large regional fairs and small local fairs were organised periodically up until the early modern period; they allowed a growing number of consumer and luxury goods to be traded freely. Separately, a vibrant long-distance trade existed, which linked especially the main European coastal cities. In quantitative terms, however, free market exchange played only a peripheral role. It was, as Karl Polanyi noted, only an accompaniment of pre-modern economic life.15 The performance of a contract in pre-modern Europe was mainly safeguarded by private contract enforcement institutions. At local markets, the very same actors interacted with each other over and over again. The probability of repeated interaction was high, so that contractual arrangements largely enforced themselves. At super-regional trade fairs, contractual performance was safeguarded by private governance regimes; specialised fair courts organised the dissemination of information in such a way that exposed parties’ opportunistic behaviour and prevented further business opportunities for those parties.16 In addition, the long-distance

11 12 13 14 15 16

Böhm, 1966. Berman, 1983; Wischermann, 2004. Hook, 1997, 12. Böhm, 1966, 109. Polanyi, 1978, 102. Milgrom, North and Weingast, 1990.

The Decline of the Traditional Order

27

trade worked on the basis of the so-called medieval lex mercatoria—a private governance regime consisting of traditional trade practices; it was especially utilised in the large sea and river ports and enforced via the sanctions of the merchant guilds.17 In medieval and early modern times, the state did not provide merchants with a support structure adequate to safeguard compliance with contractual agreements.18 Although the establishment of a marketplace, seaport, or national fair was ultimately a privilege granted by the premodern corporative state, the organisation of trading places largely fell within the autonomous realm of the merchants. Pre-modern European customary contract law was not yet linked to state coercive power, but it was embedded in the social and economic structures of existing merchant communities.19 The fundamentals of the corporative, predominantly agriculturally and locally oriented economic order of the Middle Ages and early modern period underwent rapid changes in the nineteenth and twentieth centuries. Based on the ideas of political and economic liberalism, the emerging European nation states fundamentally reformed their economic systems. Trade was freed from the restrictions of corporative rule, and the relationship of economy and politics was reorganised. Of central importance were the following reforms: First, the state guaranteed individual, exclusive private property, which separated the exercise of the economic right of disposal from corporative privileges of rule. Second, the state abolished the obligation to join a guild and enforced the general freedom of trade. Participation in the market was, thus, no longer dependent upon an authoritarian legal decision but, in principle, possible for every citizen. Restrictions existed only with regard to legal age, personal reliability, and cases of danger to the public. Third, the state abolished internal tariffs and created big national markets.20 In addition to these institutional reforms, technology developed rapidly in the eighteenth and nineteenth centuries: New sources of energy were developed; machinery ensured a surge in productivity and increasingly replaced human labour. The railway revolutionised transportation, allowing even the most distant markets to be reached in a short time. The population migrated from the countryside into the cities and grew at an unprecedented rate. New materials were constantly invented; relentless technological change was the norm.

17 18 19 20

Calliess, Dietz, Konradi, Nieswandt, Renner and Sosa, 2008; Burdick, 1902. Greif, 2006. Calliess, Dietz, Konradi, Nieswandt and Sosa, 2007; Greif, 2006. Berman, 1983.

28 State-enforced Contract Law and Modern Market Economies As a result of both the institutional and technological developments of the eighteenth and nineteenth centuries, the shape and patterns of economic activity changed dramatically. Agriculture ceased to be the dominant economic activity; industrial production and services took its place. Freed from corporate constraints, bartering left the sideline and eventually evolved to such an extent that the market, as an institution, coordinated the economic activities of people. Countless companies and products emerged, competition became a process of discovery and specialisation, and the division of labour increased. From that point on, prices, rather than the ruling authority, allocated the factors of production in the economic sectors in which they were needed most. Henry S Maine21 (from status to contract), Ferdinand Tönnies22 (Gemeinschaft und Gesellschaft) and Emile Durkheim23 (mechanical and informal solidarity) described in different terms this shift from organic, corporative, informal communities to a complex market society based on the division of labour. THE RISE OF STATE-ENFORCED CONTRACT LAW

The process of economic modernisation also affected the traditional private contract enforcement institutions, which in pre-modern Europe had enabled economic exchange. In the course of the nineteenth century, the function of enforcing contracts in economic exchange was largely adopted by the state. From then on, contract law that was linked to the state’s coercive power regulated the economic relations between citizens, while private institutions rapidly lost significance (nationalisation of commercial law).24 In the view of institutional economics, a new institutional arrangement will not arise unless the private benefits of its creation promise to exceed the costs.25 The historical transition from private ordering in the Middle Ages to formal state-enforced contract at modern markets can also be explained by this theory. In the course of modernisation and industrialisation, the medieval private-order contract enforcement institutions became inefficient, and therefore insignificant, while state-enforced contract law emerged in order to meet the institutional demands of industrialised market economies. The following sections explain how, under the condition of modern market economies, state-enforced contract law prevailed because it was able to safeguard the performance of contractual agreements both more effectively and at a lower cost than the traditional medieval private-order institutional arrangements. 21 22 23 24 25

Maine, 1861. Tönnies, 1988. Durkheim, 1992. Calliess, 2006. North and Thomas, 1973.

The Rise of State-Enforced Contract Law

29

Efficacy It is important to remember that self-enforcing contracts and reputational networks can only work if two conditions are met: first, interactions have to follow the model of the repeated game (repeated interaction), and, second, the number of players involved should not be too high (high re-encounter probability). More specifically, the maximum size of a reputational network depends on how comprehensively, quickly and reliably individual participants can acquire information about the past behaviour of a potential transaction partner. If both conditions are met, the actors involved consider the risk of lost reputation—which would result in the termination of a business relationship or exclusion from the social community of market participants—as being so significant that they would not dare violate the contractual agreements. The shadow of the future has the effect that social norms of cooperation enforce themselves. Clearly, the two conditions for the functioning of self-enforcing contracts and reputational networks were met at the local markets of premodern Europe. The number of participants was limited to local farmers and craftsmen, while merchants from outside were kept away from the markets. There were no modern means of transportation, the scope of traded products was relatively small, and frequent reiteration of a transaction with the very same persons was the norm.26 But how did the massive upheavals of the nineteenth and twentieth centuries affect this stable organisational structure of pre-modern local trade? What happened when markets expanded in the nineteenth century and when the narrowly limited local communities were destroyed that until then had controlled the economic activities of actors? The answer is that the functional conditions for the spontaneous and informal mechanisms of economic governance deteriorated rapidly in the course of the processes of modernisation in the nineteenth and twentieth centuries. In modern economic systems, business relations are not established permanently, or business relations are, at least, likely to end. In addition, modern markets usually involve a broad exchange population that far exceeds the circle of a limited reputational network. In other words, the massive upheavals of the nineteenth and twentieth centuries destroyed the very social and economic structures that had previously enabled the effective control of opportunistic behaviour in local exchange relations. The threat to end a business relationship has no effect when a merchant can, without issue, find a new business partner after a breach of contract. The greater the exchange population is, the more difficult it becomes to identify behaviour in breach of contract and to disseminate

26

Volckart, 1999.

30 State-enforced Contract Law and Modern Market Economies reliable information among market participants. In the words of Peter Milgrom and Berry Weingast: In the right circumstances, then, private order can be achieved spontaneously. In larger, anonymous communities, however, where people can enter and leave and where alternative trading partners are readily accessible, spontaneous private order may not be feasible. More is needed than social norms or self-enforcing dealings. Private order, if it is to operate at all, needs to be organized.27

But it was not only the spontaneous and informal contract enforcement institutions which lost a significant part of their effectiveness in this transition from traditional to modern society. The organised private governance regimes, which had especially enabled interregional as well as long-distance trade in pre-modern Europe, were also affected by the processes of market expansion in the nineteenth and twentieth centuries. Private governance regimes are not dependent to the same degree on the condition of a high re-encounter probability as are informal institutions in their operation. Organised blacklisting makes it possible to extend reputational effects to actors who are not personally connected to each other. Ultimately, however, these organised institutions also lost their effectiveness when it became possible for parties to engage in commercial transactions beyond the institutions’ control during the course of large-scale industrialisation. Private governance regimes can successfully prevent opportunistic behaviour only when they have a monopolistic position, so that the economic agents depend upon the use of the regime. Once this monopoly falls, ie actors can switch to alternative marketplaces without major obstacles, the threat to exclude a merchant from a private regime in case of a contract breach becomes irrelevant. As long as trade activity was limited to a few marketplaces due to the various restrictions of the medieval and early modern economic order, the pre-modern merchant communities were able to effectively safeguard the performance of contractual requirements. But when business opportunities outside of traditional venues rapidly increased due to the liberalisation of markets, the private governance regimes originating in the Middle Ages reached the limits of their effectiveness. At the extended national domestic markets, the problem of cooperation could no longer be solved with the help of private merchant courts applying the traditional lex mercatoria. Thus, the demand increased for a new mechanism which allowed the actors to realise the many benefits of trade that modernised competitive markets offered.28 In contrast to the traditional medieval institutions, state-enforced contract law has a general character. It works independently of cartel-like

27 28

McMillan and Woodruff, 2000b, 2. North, 1990; Zucker, 1986.

The Rise of State-Enforced Contract Law

31

circles of organised merchants. Even without the integration of exchange in the traditional social and economic structures of pre-modernity, economic actors can enforce their contractual claims if they organise their exchange on the basis of a state-backed document.29 Private ordering ultimately rests in voluntary cooperation achieved through influencing individual interest calculations. It is always the prospect of future profits which inhibits opportunistic behaviour in the present. In contrast, state law determines the rules of the game and enforces them with coercive power: If an agent transfers a particular good, her contractual partner must provide the agreed service in return. It does not matter whether it is still in her interest to complete the exchange. If she fails to complete the contract, the state can, as a third party, enforce the performance of the contract. Given this capability, modern state contract law is more effective than the traditional private-order institutions. It provides a higher degree of stability and planning reliability because the involved parties can enforce their claims with the help of state courts and enforcement authorities, independently of the social or economic structures in which the actual exchange is embedded. In this sense, Max Weber wrote at the beginning of the twentieth century: Conceptually the ‘state’ is … not indispensable to any economic activity. But an economic system, especially of the modern type, could certainly not exist without a legal order with very special features which could not develop except in the frame of public order. Present-day economic life rests upon opportunities acquired through contracts. It is true, the private interests in the obligations of contract, and the common interests of all property holders in the mutual protection of property are still considerable, and people are still markedly influenced by convention and custom even today. Yet, the influence of these factors has declined due to the disintegration of tradition … The tempo of modern business communication requires a promptly and predictably functioning legal system, ie, one which is guaranteed by the strongest coercive power. Finally, modern economic life by its very nature has destroyed those other associations, which used to be the bearers of law and thus of legal guarantees. This has been the result of the development of the market. The universal predominance of the market consociation requires on the one hand a legal system the functioning of which is calculable in accordance with rational rules. On the other hand, the constant expansion of the market … has favoured the monopolization and regulation of all ‘legitimate’ coercive power by one universalist coercive institution through the disintegration of all particularist status-determined and other coercive structures which have been resting mainly on economic monopoly.30

Unlike private ordering, state contract law is still effective when markets expand and a personal, network-like or organisational connection among

29 30

Richman, 2004. Roth and Wittich, 1978, 336–37.

32 State-enforced Contract Law and Modern Market Economies the actors is absent. This is why the various exchange benefits in modernised competitive markets can be realised on the basis of state contract law.

Costs The hypothesis that state contract law succeeded in the course of the nineteenth and twentieth centuries because it was more efficient in safeguarding the performance of contractual agreements than the traditional private-order institutions can be justified with reference not only to effectiveness but also to costs. However, this first requires determining the cost structures of private ordering in more detail. As explained by John McMillan and Christopher Woodruff (in the quotation below), enforcing contracts on a bilateral level through repeated interaction mainly involves two kinds of costs. First, the actors have to check the reliability of a potential transaction partner before the start of the business relationship (initiation costs). This implies mainly the checking of investments on which the business model of a potential contractual partner is based. Potential cooperation partners who have invested heavily in their businesses are, according to their utility function, less interested in short-term fraud than long-term business success. Put differently, a transaction partner who has invested much will try harder to meet contractual obligations because, under the assumption that opportunistic behaviour leads to the discontinuation of the business relation, it is only in this way that he can redeem his investments and gain profits.31 The transaction partner’s investments provide a kind of indirect advance payment, and, from the perspective of his counterpart, this means an increased likelihood that the partner will behave cooperatively during the course of the business relationship. To begin a relationship from scratch, each party needs to be able to locate a potential trading partner and to identify its reliability. Managers research potential trading partners before the relationship begins and continue to gather information during the course of the relationship. This activity absorbs a considerable amount of the manager’s time … Gathering information is not merely a matter of locating a partner able to make a desired input or wishing to buy the firm’s product. The crucial information … is reliability of the potential trading partners.32

Second, the agents have to monitor their partners in the course of the business relationship, ie they need to check whether the partner respects the relational norms on which the relationship rests or violates them with opportunistic intent (monitoring costs).33 Sanctions, such as the ending of 31 32 33

Watson, 1995. McMillan and Woodruff, 1999a, 650. Milgrom and Roberts, 1992, 601.

The Rise of State-Enforced Contract Law

33

a business relationship, only bear an effect on behaviour if it is assured that opportunistic behaviour will be discovered in the first place. If, on the other hand, an actor assumes that fraud will remain undetected, he will not shy away from enriching himself at the expense of the other. In this case, the sanction has no effect. When transactions are organised as self-enforcing contracts, the monitoring problem becomes particularly significant because, in long-term business relationships, firms generally collaborate on the basis of implicit norms and do not lay down every aspect of the cooperation in their contractual agreement.34 Consequently, in cases where a service is not provided as expected, without previous close monitoring, a party can hardly determine whether the missing service provision is due to opportunistic behaviour of the transaction partners or whether the lacking service provision is due to other, for instance, technical, reasons for which the partner cannot be held responsible. Van Damme highlighted the point that, with insufficient monitoring, ambiguous information can quickly lead to a breakdown of cooperation.35 Self-enforcing contracts therefore require that the transaction partners spend time and effort to monitor their business partners in order to establish whether they behave in a cooperative or opportunistic manner in the course of the business relationship. Punishing a firm that reneges through no fault of its own destroys the cooperative relationship; but not punishing a firm that is behaving opportunistically encourages further opportunism, also undermines cooperation … Successful cooperation might therefore require that firms make monitoring efforts so as to recognize when a customer’s failure … is opportunistic.36

Compared to self-enforcing contracts, reputational networks entail a different cost structure, since the network members can refer to the experience of other actors in verifying the reliability of a potential transaction partner. In a reputational network, it is sufficient to identify the last business partners of a potential business partner and to ask them for information. Thus, reputational networks relieve individual agents of the task to personally obtain all information necessary to initiate a business relationship. The monitoring costs, however, remain unchanged. Since agents in reputational networks also cooperate on the basis of implicit standards, it is necessary to observe the behaviour of transaction partners closely, in order to see in which cases a sanction is advisable, just as in the case of self-enforcing contracts. Each member of a reputational network who makes efforts to monitor potential transaction partners, and to sanction them if they have breached a contract in the past, prevents opportunistic behaviour and contributes in this 34 35 36

Hart and Moore, 1990. Van Damme, 1989, 206. McMillan and Woodruff, 1999a, 643.

34 State-enforced Contract Law and Modern Market Economies way to the provision of a public good.37 However, if the costs of information dissemination increase with the number of members in a reputational network, a second-order cooperation problem emerges. The collective production of transactional security as a public good comes to a halt because, with increasing information costs, the willingness of agents to reliably answer the inquiries of other companies decreases. On the other hand, the tendency of actors to refrain from monitoring potential transaction partners increases, in the expectation that all other members carried out this review carefully and, thus, prevented opportunistic behaviour (free-riding).38 Private governance regimes provide specific ordering functions by means of which the two second-order cooperation problems can be solved. Private governance regimes store transaction-relevant information centrally and disseminate it specifically among its members. They thus relieve actors of the task of sharing relevant transaction information within their personal networks. As private governance regimes also provide their members with private arbitration tribunals, which decide in cases of conflict whether a party has breached a contractual agreement in an opportunistic manner, agents are also relieved of potentially incurring monitoring costs. For the provision of this ordering function, private regimes usually require their members to pay a usage fee. Thus, the initiation and monitoring costs of informal and spontaneous forms of economic governance are transformed into organisational costs, which have to be provided by the participants if they want to use the service of a private governance regime.39 A look at the socio-economic conditions in the Middle Ages and early modern period makes clear again that the costs of using self-enforcing contracts, reputational networks and private governance regimes were relatively low before processes of modernisation began in the nineteenth and twentieth centuries. Local traders, craftsmen and farmers met at the traditional markets; businesses were passed on from father to son. For generations, economic exchange occurred in this way between the very same families, who knew each other well. Neither the acquisition nor the dissemination of transactionrelated information required much effort by the actors involved. In short, both self-enforcing contracts and reputational networks functioned at the local markets of the Middle Ages and early modern times at almost no cost. One way of reducing information cost is to create living conditions in which everyone knows everyone else. The denial of privacy serves to enlist the entire population as informers and policemen.40

37 38 39 40

Milgrom, North and Weingast, 1990, 10. North, 1990. Richman, 2004. Posner, 1980, 6.

The Rise of State-Enforced Contract Law

35

Second-order cooperation problems existed in pre-modern Europe exclusively at large trade fairs and in long-distance trade. But here again, the organisational costs of private governance regimes were small due to the manageable number of actors involved. Overall, it can therefore be stated with the words of Douglass C North that the most likely and indeed empirically observable state in which contracts are self-enforcing is that in which the parties have a great deal of knowledge about each other and are involved in repeat dealings with tribal and primitive societies and with small communities. Under these conditions, it simply pays to live up to agreements. In such a world, the measured costs of transacting are very low because of dense social networks interaction. Cheating, shirking, opportunism, all problems of modern industrial organization, are limited or indeed absent because they do not pay. Norms of behaviour determine exchange and formal contracting does not exist.41

The important question, again, is how the great transformation to modernity affected the cost structures of the traditional medieval private-order contract enforcement institutions? The answer is that the rapid expansion of markets in the nineteenth and twentieth centuries not only caused the traditional private-order contract enforcement institutions to lose their sanctioning power and, hence, effectiveness, but also caused the initiation, monitoring and organisational costs of private ordering to increase rapidly. As business expands, one needs to deal with partners with increasing search/ monitoring costs, or to develop increasingly more costly relations; one first does business with one’s brother(s), then with one’s cousin(s), then with the people from one’s hometown or one’s classmates, and finally with strangers. Thus, as the market expands from a local level to regional, national …, the numbers of business partners increases and the marginal cost of relations will eventually rise significantly.42

In other words, the larger the market becomes, the more alien business partners become, the less they know about each other, and the more costly it is to spread transaction-related information in a reputational network, to develop and monitor a sound business relationship or to organise a private governance regime. The destruction of the socio-economic structures in which economic exchange was embedded in medieval and early modern times had a very negative effect on the efficiency of traditional private-order institutions. Medieval private ordering limited exchange to a confined number of actors. As both the number of potential partners and the physical distance between the partners grew, medieval private ordering was not able to reduce transaction costs to a level at which impersonal exchange became

41 42

North, 1990, 55. Li Shuhe, 1999, 12.

36 State-enforced Contract Law and Modern Market Economies possible in modern competitive markets. Obtaining, verifying, evaluating, and disseminating transaction-relevant information causes such high operating costs in impersonal competitive markets that complex exchange processes would not emerge if they were not enabled by a considerably more efficient state- provided contract law. But why is state transaction law more efficient than traditional private mechanisms of economic governance at modern competitive markets? Providing a satisfactory answer to this question is not easy, since the opposite is initially true: unlike the use of private institutions, the use of state contract law causes very high fixed costs. From a macroeconomic perspective, the use of state contract law requires huge investments in the development and maintenance of functioning legal systems. Also, from the perspective of the individual company, it appears initially to be more cost-intensive to organise a transaction as a contract under state law than to resort to the private mechanisms, because, first, developing the appropriate contractual structures takes time; second, high legal costs for lawyers may be incurred; and, third, high costs may result from enforcing contractual claims in state courts. However, against the backdrop of a modernising economy, such investments into state contract law pay off. Once a national economy has established a functioning legal system, and once the individual companies—each one individually or as industry association—have adapted their contractual structures to their business needs, the operating costs for the monitoring and safeguarding of the performance of contractual agreements decrease significantly. Once created, contractual structures can be transferred to a large number of similar transactions with different business partners. Furthermore, it causes only minor additional costs to enforce each contract with the help of state courts and enforcement authorities once the relevant institutions are established.43 The reverse picture applies to the private contract enforcement institutions. In contrast to state law, the private regimes require only a low level of public order. They do not require the existence of a functioning state legal system, whose development involves high fixed costs. From the perspective of a single company, it is more cost effective to conduct a single transaction on an informal basis than to enter into a complex contract under private law. Thus, in contrast to state contract law, private contract enforcement institutions are based on implicit agreement structures. The development of private contract enforcement institutions is extremely inexpensive but cannot be transferred from one contractual relationship to the next. In effect, this means that the costs that a company invests in the development of a viable business relationship are lost, to the extent that

43

Dixit, 2004, 65–68.

Key Results

37

they generate no added value for the establishing of further business relationships. Each company must be reviewed individually, which causes specific costs each time. If the number of transactions increases, these costs reach a threshold beyond which it would be more effective to organise the economic exchange on the basis of a contract under state law.44 In sum, private contract enforcement institutions have a cost advantage over state contract law, if markets are small and the number of transaction partners is limited. Under these circumstances, the fixed costs associated with the use of state law are too high to render the use of this form of contract enforcement efficient. However, the costs of using state contract law decrease once the possibilities of exchange expand at modern markets and the number of potential transaction partners increases. Both from the perspective of a national economy and from the perspective of a single company, there is a point in economic development at which it is more cost-effective to turn to state contract law due to the high running costs of private mechanisms. The various exchange opportunities offered to actors by modern markets can thus ultimately only be realised if agents can rely on a functioning legal system. KEY RESULTS

In summary, as long as the markets in the Middle Ages and early modern period were agriculturally oriented, locally limited, and cooperatively organised, the traditional private mechanisms of economic governance provided an effective means for the performance of economic exchange. This changed, however, in the course of the processes of modernisation in the nineteenth and twentieth centuries. The liberalisation of markets and the industrialisation of production brought about the destruction of traditional socio-economic structures that had enabled an effective and inexpensive control of opportunistic behaviour in economic exchange. The need grew for more efficient institutions that allowed agents to realise the multiple exchange opportunities offered to them by modernised markets. The involved agents found this very mechanism in state contract law. In the eighteenth and nineteenth centuries, state contract law prevailed over traditional private mechanisms of economic governance because, first, it was more effective than the traditional private mechanisms of economic governance due to the coercive power of the state and, second, it had a more favourable cost structure.

44

Li Shuhe, 1999, 12.

38 State-enforced Contract Law and Modern Market Economies The key arguments of this chapter are summarised in Figure 2:

Figure 2: The effect of processes of economic modernisation on the efficiency of public and private economic governance

If an economy modernises, the efficiency of private ordering decreases for the reasons given (Curve 1), while the efficiency of state contract law increases (Curve 2). At a certain point, the economic development reaches a level at which it is more efficient to use state contract law than privately generated institutions (turning point). National economies that have, up to this point, not been able to develop a functioning contract law fall behind those states equipped with a state contract law. In other words, private ordering enables the development of a market economy only up to a certain point. Then the incurred costs for its use exceed the potential trade gains, so that no further exchange opportunities are realised. Economic development stagnates. Modern exchange economies with complex processes of exchange and high economic growth can ultimately only develop if the actors involved can enforce contractual agreements with the help of state-enforced contract law. In the words of Douglass C North: The more complex the exchange in time and space, the more complex and costly are the institutions necessary to realize cooperative outcomes. Quite complex exchange can be realized by creating third party enforcement via voluntary institutions that lower information costs about the other party; ultimately, however, viable exchange that would realize the gains from trade inherent in technologies of modern interdependent economies requires institutions that can enforce agreements by the threat of coercion.45

In short, every market needs a state. State contract law has been the decisive determinant in the emergence of complex exchange relations at modern competitive markets. 45

North, 1990, 58.

3 Does Globalisation Lead to a Decline of State Contract Law? ECONOMIC GLOBALISATION

T

HE BEGINNING OF the last chapter described how economic development in nineteenth century Europe was significantly influenced by the ideas of political liberalism. Nation states abrogated local tariffs and developed a unified national contract law that enabled merchants to realise the immense exchange opportunities at modernised domestic markets. However, this progress at the national level was still largely missing internationally. Here, nation states sustained an economic system which they had abolished domestically: protectionism.1 Although the middle of the nineteenth century saw the emergence of a relatively free network of international trading relations based on the principle of most-favoured-nation treatment,2 this period of free trade—supported by the then hegemonic super power of Great Britain—hit its peak already in the 1880s. In the following years, foreign trade restrictions rose again. Step by step, European states returned to protectionism. During the transition from the nineteenth to twentieth century, foreign economic policies were clearly subordinated to geopolitical national interests. Free trade was further restricted at the beginning of the First World War, until it entirely foundered in the course of the Great Depression in the 1920s and 1930s. World economic systems collapsed and, as a consequence, nation states turned to an extreme form of protectionism.3 Only after the end of the Second World War did international trade begin to recover slowly. The founding of both the International Monetary Fund and the World Bank in Bretton Woods in 1944 set up the institutional prerequisites for this development. Starting in 1947, the so-called Marshall Plan also fostered economic recovery in Western Europe. In addition, the General Agreement on Tariffs and Trade (GATT) was established in 1947,

1 2 3

See: Trebilcock and Howse, 2005, 21f. See: ibid, 49f. See: Kindleberger, 1973, 172.

40 Does Globalisation Lead to a Decline of State Contract Law? and it has, since then, built the framework for eight multilateral trade rounds. Both quota-based trade restrictions and tariffs on imports were largely abolished. Import tariffs on industrial goods have now decreased from around 40 per cent (during the war) to around 5 per cent. Moreover, since the 1950s, we have seen the development of an economically integrated Europe. The European Economic Community, set up in 1958 by six founding members, ultimately developed into the European Union in 1993 with 27 Member States. All Member States are unified in one single market with virtually no trade barriers. The European Union also serves as an example for other regional processes of economic integration in many parts of the world.4 15.1

15 14 13

Development

51%

12 11 10

INDEX

10

World Production 1960 to 2008: + 391.3 % World Export 1960 to 2008: + 1220%

9 8

World Export

85.2%

7 6 5

5.4 3.7

4 3 2 1

2.2 120% 1 1

0 1960

68.2% 42.9%

19%

45.9% 28.2% 30%

4.3

5.2

World Production

3.4

2.6

1.8 82.6%

1970

1980

1990

2000

2008

YEAR

Figure 3: Development of cross-border trade Index (1950 = 1) in constant prices, Growth in percentage, worldwide 1950 to 2008

The impact of the constant reduction of trade barriers in the second half of the twentieth century is reflected in international trade statistics. In order to illustrate the process of economic globalisation, there is no better figure than the changing relation between world production and world

4

Siebert, 1997, 200f.

Economic Globalisation

41

trade. Taking inflation into account, in 2008, the value of all worldwide exported goods amounted to more than 16 trillion USD—124 times higher than in 1960. Between 1950 and 2008, world trade in goods increased by a factor of 15:1, whereas the worldwide production of goods in the same period increased only by a factor of 5:1. On average, during that time period, world trade increased by 5.8 per cent per annum and world production by 3.5 per cent. As a consequence, the ratio of exported goods in the world domestic product between 1970 and 2008 stepped up from 9.7 to 27.3 per cent. Figure 3 makes another point clear. Compared to previous decades, exports have risen particularly fast since the 1990s. World trade in goods increased by around 85 per cent between the years 1990 and 2000. In the same period, the world production of goods only increased by around 28 per cent. This means that, during that decade, world trade grew around three times faster than world production—a high number not seen in previous decades. There are both political and technological reasons to explain this rapid increase of international trade since the 1990s. The invention of the Internet and broadband technologies has significantly reduced communication costs. In the realm of politics, the end of the Cold War was followed by a fundamental decrease in geopolitical tensions. Former communist states transformed their economic systems and became integrated into the world economy. Similar processes took place in many developing countries and emerging markets. India and China, in particular, significantly integrated their economic systems into the international division of labour in the 1990s.5 Globalisation is clearly not a new phenomenon. But it is clear today that processes of worldwide economic integration that began after the Second World War have achieved historically unprecedented levels. Economic activities increasingly cross the borders of national societies. Economic nationalisation in the second half of the nineteenth and the first half of the twentieth centuries has been followed by economic denationalisation and a worldwide economic reintegration.6 Whether this development will indeed culminate in a situation of dissolving national economies, in which it becomes obsolete to differentiate between domestic and foreign economic systems, is hard to predict.7 But, what is clear is that, even though the 2008 financial crisis had a negative impact on world trade, throughout the last few decades, cross-border trade has tremendously

5

Ibid, 10–11. For the notion of denationalisation see: Zürn, 1998; Zürn, 2001. 7 For an affirmative view of the dissolution nations see: Reich, 1991; For a critical view, see: Hirst and Thompson, 1996. 6

42 Does Globalisation Lead to a Decline of State Contract Law? increased in significance when compared to domestic trade. This trend will most likely continue into the future. RESEARCH QUESTIONS

These recent trends in economic globalisation lead us to this book’s central research topic: What is the impact of globalisation on the capability of state contract law to enforce contractual agreements in economic exchange? If we turn our focus to international trade, we immediately recognise that, along with the emergence of global markets, the reportedly crucial co-evolution of state-enforced contract law and modern market economies—as described in chapter two—might come to an end. As a matter of fact, today most national economies are deeply integrated into the world while the organisation of state legal systems still remains basically national. It has often been noted in law and the social sciences that state contract law cannot fulfil its function to safeguard the performance of contractual claims in today’s globalised markets with the same reliability that it achieves in domestic markets.8 Every state has its own contract law in force within its territory. Therefore, the possibility exists that national legal systems may collide once an economic transaction transcends national borders.9 From the perspective of actors interested in economic exchange, the territorial fragmentation of law leads to three main problems: First, uncertainty can emerge about the obligations of the contractual parties, as they can be assessed differently according to which law applies. Second, it can be unclear which legal system has jurisdiction. And, third, it is often doubtful whether the judgments of one state will actually be enforced in another.10 In more abstract terms, economic globalisation ends the congruency of economic and legal spaces.11 The far-reaching unity of state, law and economy is increasingly undone by this process.12 Therefore, the uncertainty about whether prospective contractual partners will behave in an opportunistic or cooperative manner is far higher in global than in domestic markets, as, in the transnational realm, actors have no unitary contract law system at their disposal with which to enforce contracts effectively.13 Firms from established market economies are used to relying on workable

8 9 10 11 12 13

Gessner, 2009, 179; Rodrik, 2000, 179. See: Berman, 2007, 1155; Gopalan, 2004; Rühl, 2006, 801. See: Schmidtchen, 1994, 274. See: Stone Sweet, 2002, 323. See. Zürn, 2001. See: Anderson and Marcouiller, 2002, 342; Belloc, 2006, 7; Rodrik, 2000, 179.

Research Questions

43

legal infrastructures when engaging in economic transactions. However, in global markets, this transactional security is not always present, and it is therefore a crucial question for both scholars and practitioners how firms govern their external relations with their counterparts under these conditions in today’s globalised markets. Although there is a broad consensus about the existence of the specific legal problems of international economic transactions in the relevant literature, the proposed solutions vary significantly. Three approaches merit discussion. The first approach presents the classical view of contract. It stresses that those problems arising out of the fragmentation of law in cross-border economic interactions are solved by dint of private international law. Private international law determines which law is applicable to a cross-border transaction. Concerning transactional security, cross-border transactions therefore approximate domestic business transactions.14 Ultimately, the argument here is that, due to working conflict-of-law norms, economic actors can rely on state courts and enforcement authorities both in the domestic and transnational realm.15 Animated by transnational law approaches, alternative views assume, on the other hand, that the globalisation of law cannot keep up with the globalisation of the economy.16 Scholars holding this view argue that nationally caused legal fragmentation (note that private international law is also national law) as well as the fact that different norm systems meet and block each other in cross-border transactions lead to significant regulatory gaps, norm collisions and enforcement deficits—resulting in growing problems of cross-border business. The legal context of cross-border trade thus resembles an anarchic state of nature rather than an area structured by law. In any case, under this view, transactional security is not provided by private international law. In fact, constitutional uncertainty exists, which hampers, rather than enables, cross-border exchange.17 However, according to these theorists, the constitutional certainty left behind by national legal systems at the global level might give rise to a new kind of transnational commercial law, which is usually referred to as ‘new lex mercatoria’.18 According to this approach, the categorical equation of law and state obscures the view of the development of new, privately generated, legal regimes which are based on common legal principles such as the UNIDROIT principles.19 In the theory of transnational law, private arbitration courts play an important role. They apply those norms

14 15 16 17 18 19

See: Rühl, 2008, 9. See: Berkowitz, Moenius and Pistor, 2005; Behrens, 2000, 17. See: Rodrik, 2000, 179–80. See: Schmidt-Trenz, 1990, 241; Schmidt-Trenz and Schmidtchen, 1991. See: Berger, 1999. See: Calliess and Zumbansen, 2010; Gaillard, 2001.

44 Does Globalisation Lead to a Decline of State Contract Law? that emerge autonomously in the social context of the global mercantile community and gradually specify, through their judgments, the legal framework of cross-border transactions.20 By contractually agreeing on an arbitration clause, the parties clearly avoid being subject to potentially conflicting national rule systems. Expensive, time-delaying and unforeseeable clarifications to determine place of jurisdiction and applicable law are excluded, and, furthermore, the enforcement of arbitral rewards is uniformly regulated in most countries (149 of 192 states in 2013) by the so-called New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards, which entered into force in 1959.21 Consequently, unlike public courts, international courts of arbitration are not limited in their work by the territorial fragmentation of national legal systems and are, therefore, considered as significantly more efficient in handling cross-border transactions.22 However, students interested in positive institutional analysis are well advised to take a critical look at the flourishing literature in this field, since most contributions are written out of a normative, legal perspective. The rise of international courts of arbitration and new lex mercatoria bothers legal scholars because it leads to deep questions about the nature of law and about the relationship between privately made law and state regulation. One position favours this new legal regime, as such a scheme seems to resemble their preferred libertarian model of a private law system that gradually evolves according to the needs of markets without much state interference.23 On the other hand, critics fear that contract law that is no longer regulated by democratic states but, rather, by private actors who belong to specific socioeconomic networks composed of transnational companies, their lawyers, and arbitration houses, will ultimately support the rich and powerful at the expense of weaker parties.24 For many years, scholars have produced voluminous literature on these questions, without a solution in sight. On the other hand, there is a remarkable paucity of positive work analysing to what extent the rise of transnational law and international arbitration courts actually adds value to the global economy. What kind of businesses use international 20

Berger, 2000; Berman, 1995; Calliess, Dietz, Konradi, Nieswandt and Sosa, 2007. The United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards, in short: ‘New York Convention’, was signed on the 10th of June 1958 and came into force on the 7th of June 1959. Bulgaria, Romania, India and Germany are members to the New York Convention See: United Nations Commission on International Trade law, 1958—Convention on the Recognition and Enforcement of Foreign Arbitral Awards—the ‘New York’ Convention available at: www.uncitral.org/uncitral/en/uncitral-_texts/arbitration/ NYConvention.html, last accessed: 17 January 2008. 22 See, eg: Arksen, 1990; Blackaby, Partisides, Redfern and Hunter, 2009; Craig, Park and Paulsson, 2000; Redfern and Hunter, 2004. 23 For this position see: Berman, 1995. 24 For this position see: Cutler, 2003. 21

Research Questions

45

arbitration and when? Is this system of transnational law really as ubiquitous and efficient as claimed by its supporters, and does this system really work independently from state law? Do market actors, in fact, rely on the work of international arbitrators to safeguard their cross-border transactions against fraud and economic behaviour? Comprehensive answers to these kinds of question are still missing. Undoubtedly, the rise of lex mercatoria has an impact on the performance of cross-border contractual relations. However, both the scope and the limits of this mechanism in explaining the emergence of complex transactions on widespread global markets are yet to be determined. A third answer to the puzzle of how firms govern their contractual relations on global markets highlights the significance of informal mechanisms. This perspective, embodied in the relational view of contract, transactions-cost economics, game theory and economic sociology, holds that cross-border transactions can manage even without a formal regulatory framework organised by third parties.25 From various case studies on transformation and developing countries we know that agents usually react to an inefficient, dysfunctional public order by creating an institutional environment for themselves, which allows them to exchange goods and services.26 Economic transactions are safeguarded either by stable bilateral contractual relations based on repeated interaction (relational contracts) or by reputational networks consisting of several parties. Past, present, and future relations are of importance, because the continuum, alone, allows the contractual parties to agree on rules implicitly or explicitly, with which they intend to solve future interaction problems (relational norms), to control rule compliance, and to sanction rule breaches with the termination of business relations or with the exclusion from the reputational network.27 Some evidence, primarily regarding Asian ethnic and family networks, suggests that this reaction might also take place in the global realm. As Marianna Belloc puts it: Social networks enhance cooperation and trust in inter-community trade, and cross-border ties help to overcome information and imperfect contract enforcement problems stemming from long distance between partners.28

However, this explanation also has its obvious shortcomings. It has often been noted in the literature on law and economic development that informal networks usually work for limited group sizes whereas they lose

25 See Belloc, 2006. The theoretical foundations of this approach are explained in chapter one under the headings of self-enforcing contracts and reputational networks. 26 For a literature overview, see: Murrel, 2001. 27 See ch 1. 28 Belloc, 2006, 6.

46 Does Globalisation Lead to a Decline of State Contract Law? efficiency when markets expand. Yet, rapid market expansion from the national to the transnational level is exactly the phenomenon we want to understand. As a matter of fact, very many complex transactions, such as the one set forth in the introduction between a German and an Indian software company, occur outside existing relations or close social networks, which makes it rather unlikely that informal institutional theories in the present form could provide us with a sufficient explanation for the emergence of globalised exchange. This is not to say that informally organised social networks and relational contracts are without significance in cross-border trade. But, again one has to ask the right questions. What kind of social networks emerge in cross-border trade? How do actors learn about the transactional history of a potential trading partner in a global market environment? What is the role of organisations such as international trade associations or chambers of commerce? Do these or similar organisations provide for effective structures to disseminate information relevant for transactions within a worldwide business community? How are relational contracts over great geographical distances initiated, monitored and enforced, and what role do the Internet and other forms of modern communication play for the conduct of global business relations? Like international arbitration courts and the new lex mercatoria, informal networks will also certainly be part of the governance structures that are used by firms to safeguard their cross-border contracts against fraud and opportunism. However, it is has to be clarified how exactly these institutions work and how significant they really are. A fourth factor relevant to identifying the institutional underpinnings of global commerce might be the role of international politics in the field of private law. So far, we have emphasised that, because of its territorial fragmentation, state-provided contract law might be incapable of providing for a workable legal infrastructure at global markets, which is why it might be replaced by anational, formal and informal private governance mechanisms. However, it is by no means clear whether the tendency to privatise contractual governance in global exchange is an irreversible process. The subordination of the medieval law merchant under state control in the sixteenth century is an example of how states in the past successfully regulated legal fields that had been only run before by social norms and private courts.29 An interesting question is whether such kinds of transitional processes—from spontaneous and evolutionary private ordering towards a designed state-enforced public order—can also be observed today. The European Union has made significant progress in the last decade with regard to both the enforcement of foreign-court rulings

29

See: Berman, 1983; Volckart and Mangels, 1999.

Research Questions

47

and the harmonisation of material private law.30 As a result, contracts in the EU are increasingly governed by a unified community rather than a fragmented national, private international law. However, as with the other mechanisms outlined above, the question of whether or not such kinds of supranational enforcement orders, indeed, enhance the capability of states to provide market actors with a workable legal infrastructure for cross-border trade remains to be answered. To sum up, this section demonstrates that we still have no clear picture of the contract enforcement institutions that underpin cross-border exchange on today’s globalised markets, despite their major economic importance. Today, most national economies are deeply integrated into the world economy, while the organisation of state legal systems remains basically national. The fragmentation of legal systems which results out of this uneven economic and legal development might undermine the capability of state-enforced contract law to provide for a workable legal infrastructure for cross-border exchange. As a reaction to such a dysfunctional public global order, formal and informal private-order contract enforcement institutions might be evolving. Yet, how these non-state mechanisms are organised, how they function and to what extent firms actually rely on them in order to govern their external relations with other firms on global markets is not clear. This book attempts to identify and explain the contract enforcement institutions that enable firms to engage in complex and risky transactions with unknown business partners in global markets. Regarding those institutions, four lines of inquiry are particularly important: Is state-provided contract law, indeed, capable of providing market actors with a workable legal infrastructure for cross-border trade on global markets despite its territorial fragmentation? Are the new lex mercatoria and international arbitration courts as important for cross-border contract enforcement as often claimed? What is the role of informal institutions such as reputational networks and relational contracts in cross-border trade? How do these mechanisms work in a global market environment and what is their significance? What follows when states use international politics to establish supranational enforcement orders such as within the European Union? Do these efforts significantly enhance the efficiency of state-provided contract law across borders? Is private order replaced by public order under these circumstances? In order to address these four research topics, this book draws upon a comprehensive empirical case study, whose research design is outlined in Part II. 30

See: McKendrick, 2004.

4 Research Design Markets are subtle organizations. The mechanisms that underpin transacting are intricate—and they are in everlasting flux. People are ingenious at finding way to make exchanges that bring mutual gains.1 (John McMillan)

CASE SELECTION

T

HE EMPIRICAL STUDY was designed to find answers to the question of the significance of public and private contract enforcement institutions in international trade. In order to select a suitable research object for the study, three criteria were identified as crucial to the case selection: anonymity, complexity and globality.

Anonymity The first criterion takes into account that economic transactions can take place in different settings. One feature that distinguishes transactions is the property law structure in which a transaction is embedded. Transactions can either take place between legally and economically independent companies or between companies that are linked under property law. The latter concerns transactions within corporate groups or within the framework of so-called strategic alliances and similar structures of minority holdings. Transactions can also be distinguished according to their social structure. Exchange can involve agents between whom close personal or family relations already exist or between agents who are unknown to each other when they meet at the market. Transactions that take place between companies linked neither under property law nor by personal or family relations are usually defined as

1

McMillan, 2002, ix.

52 Research Design transactions ‘at arm’s length’. Throughout this book, this type of transaction is also called an ‘anonymous’ or ‘impersonal’ exchange. On the other hand, the term ‘F-connections’ (family, friends and firm) refers to transactions that are either linked under property law (firm) or socially embedded (family, friends).2 Chapter two explained that state contract law is particularly important for the emergence of anonymous exchange because it provides contractual parties with a workable exchange structure that no other private institution is able to perform. In contrast, state- provided contract law is less important for F-connections, because, in those transactions, incentive structures between the contractual parties which exist prior to the transaction induce them to cooperate. In the case of socially embedded transactions, agents are bound by the rules of families and friendship; in the case of transactions that are embedded in a common asset structure, breaching a contract is irrational, since this behaviour would eventually also do damage to the investments of the cheating party. Thus, an empirical case study that aims at investigating the role of public and private contract enforcement institutions in international trade should focus on the arm’s-length type of transactions. It is not enough to present evidence that F-connections transactions take place in global markets without reliance upon state legal systems. This is an old and well-documented phenomenon that also exists in domestic markets. If, however, it turns out that, at today’s globalised markets, arm’s-length transactions also take place that are not organised as legally enforceable contracts but governed by private contract enforcement institutions, this finding would indeed be strong evidence for the privatisation of economic law and governance at global markets. In short, the empirical study needs to focus on anonymous market transactions that correspond with transactions at arm’s length.

Complexity A second criterion by which transactions can be distinguished is whether the exchange involves simple or complex goods.3 Examples for simple goods are agricultural products and raw materials as well as all industrial products whose quality is highly standardised. An example of a complex good is a machine which is specially tailored to the specific production needs of a particular client and which can therefore not be employed in different production contexts without major, expensive adaptations.

2 3

See: Ben-Porath, 1980. See: Rauch, 1999.

Case Selection

53

Simple goods are usually traded at spot markets where high numbers of both sellers and buyers are available for the same product. Transactions in spot markets do not entail significant transaction-specific investments (low asset specificity4), which, in turn, means that these transactions do not lead to a high degree of interdependency between the transaction partners that can be exploited by opportunistic behaviour (hold up5). When agents become unsatisfied with their counterparts at spot markets, they can switch to another contractual party very quickly and at low cost. The risks inherent in spot market transactions are rather low, which is why they are not highly reliant on workable legal contract enforcement institutions. Rather, the availability of market alternatives safeguards transactions at spot markets against fraud and opportunistic behaviour.6 Complex goods are not traded in a standardised form between high numbers of sellers and buyers at spot markets. Although buyers of production machines can initially select among a variety of potential suppliers—provided they do not act on niche markets—it is expensive for them to buy a second machine from a different supplier if quality problems or time delays occur in the course of the initial transaction after the order has been placed (high asset specificity). Moreover, in the event of a problem with the buyer, the supplier loses the costs of building the machine (sunk costs) because, in case of non-payment, he cannot sell the specifically tailored machine to another client without severe extra efforts. Put differently, the more complex the exchanged goods, the higher the risks for the involved parties. In complex transactions, there are no market alternatives to safeguard the contract against the hold-up problem.7 While spot market transactions usually take place without much reference to the courts, contract law is said to play an important role for the governance of complex exchanges: The more complex the goods, however, the more likely it is that additional misunderstandings occur and the more difficult it is to identify a common business practice. As a result, the propensity of disputes (and their costs) increases and so does the importance of legal institutions charged with resolving them.8

In other words, complex transactions require the existence of efficient courts and enforcement authorities to a considerably higher degree than

4 Asset specificity can be defined ‘as the value of investment that would be lost if in any alternative use’. Ménard, 2005, 285. 5 The hold-up problem can be defined as: ‘the detrimental ex-post appropriation of the quasi-rent by one or some partners’. Ibid, 285. 6 See: Williamson, 1985. 7 See: Williamson, 1996. 8 Berkowitz, Moenius and Pistor, 2005, 171.

54 Research Design simple transactions.9 Consequently, the following case study should look not only at anonymous but also at non-standardised transactions, which involve a high degree of asset specificity. If it turns out that even those kinds of transactions take place without reliance on state-provided contract law, then this is again a clear sign of the decline of state law and the rise of private ordering in global markets. Therefore, the empirical study needs to focus on complex rather than simple transactions.

Globality The third criterion for distinguishing transactions regards the nature of cross-border markets. Globalisation should be understood as a process in which domestic markets become increasingly integrated into the world economy. Yet, not all industries advance with the same speed. Some industry sectors are more deeply integrated than others. Given this, the case study should focus on an industry branch that is relatively deeply integrated into the world markets, because those industries that are less integrated into cross-border markets currently but will become more integrated in the future will presumably imitate the governance structures that proved successful in advanced industries. In short, the empirical study should focus on transactions that take place in an arena that resembles the model of a global market. CROSS-BORDER SOFTWARE DEVELOPMENT CONTRACTS

The next step in designing the case study consisted of applying these three selection criteria to the global market to determine a concrete research object. The software industry was chosen as the most appropriate topic. More specifically, the empirical study looks at cross-border software development contracts. These are exchange processes in which a client company approaches a supplier company to develop a software application that is individually tailored to the client’s specific requirements.

9

Oliver Williamson writes to this point: [V]iable middle range transactions will flee to one of the two poles—by moving to the spot market (attended by the sacrifice of asset specificity and resulting loss of productive value) or by moving to the hierarchy (with the added bureaucratic cost load). A high performance economy will support transactions of all three kinds rather than force polar choices … The quality of an economy’s contract law can thus be inferred indirectly by the evidence of hybrid contracting’. (Williamson, 1994, 181). See also: Trebilcock and Leng, 2006, 1521.

Cross-Border Software Development Contracts

55

Anonymity The software industry is a comparatively young industry. It began in the 1950s and developed rather slowly for about three decades. Both the processing power and the storage capacity of computers at that time were so small that the programs that could be run by them were very easy to write. Initially, hardware and software were not divided products that were traded separately. Hardware companies such as IBM supplied software along with their computers, or the users wrote the simple programs by themselves.10 However, as a result of exponential increases in processing power and storage capacity and other innovations like the Internet and broadband technologies, the software industry began to grow rapidly in the 1980s. Ever more efficient computers accommodated ever more complex software programs. However, in the course of this co-evolutionary development, it turned out that neither the hardware companies nor the end-users possessed sufficient knowledge to produce complex software products in-house. In a short period of time, a dynamic market for software products was triggered which, in turn, led to the emergence of a high number of specialised software companies both nationally and internationally.11 The divide between hardware and software development in the computing industry continues to this day. In addition, companies outside of the computing-industry that use computers and software for the daily organisation of their operations do not usually have their own software programming units because the costs are too high to permanently employ the necessary specialised workforce.12 The fact that, right from the beginning, software development processes usually did not become an integral part of hierarchically organised firms but, rather, were purchased via markets, has led to the result that inter-firm relations in this industry sector are much looser than in other sectors, such as the automobile industry. Certainly, the trend to replace hierarchical control by contractual outsourcing is ubiquitous. However, in doing so, these companies in most industries still usually remain very closely linked both economically and legally.13 In contrast, mostly because of their highly specialised knowledge resources, software companies have maintained a high degree of independence within the computer industry. Thus, hierarchies and quasi-hierarchical governance-structures between firms traditionally play a comparatively small role in this particular industry. 10 11 12 13

Johnson, 1998, 36; Campell-Kelly, 1995, 80. Campell-Kelly, 1995, 70. See for this point: Adler, 1990, 164. Neus, 2007, 135.

56 Research Design Additionally, the F-connections—friends and family—are also of low significance in the software industry. This industry has not grown up over long periods of time in relatively stable social and economic conditions but, instead, has been growing extremely quickly since the 1980s, driven by market forces and strong technical innovations. Families and long-term personal relations are simply incompatible with the dynamics of this process. Consequently, anonymous market relations characterise the software industry, meaning that relatively many transactions occur between companies that are neither linked under property law nor part of common ethnic or personal networks—not even in the Asian countries. As the software industry fulfils the criterion of an industry that is characterised by transactions at arm’s length, it was selected as the focus for the study. However, in order to ensure that the transactions examined in the study were only transactions that involved this type of impersonal exchange relations, the experts interviewed in this study were questioned exclusively about those software development contracts with business partners with which they had not collaborated in the past. It was not hard to meet this criterion due to the characteristics of the software industry described above.

Complexity In the software industry, one usually differentiates between standard software and tailor-made individual software. A typical company engaged in standard software first develops a software application and then tries to sell the same standardised product to as many customers as possible. A good example of such a company is Microsoft. On the other hand, companies that are specialised in individualised software solutions write specific programs according to the specific needs of particular clients. The following empirical study focuses only on individualised software development transactions, because these transactions correspond with the second criterion of complexity. Individualised software development contracts entail high asset specificity and, therefore, are significantly more reliant on the existence of functioning courts and enforcement bodies than standard software transactions.

Globality Initially, the markets for software development were restricted nationally. In the first three decades after the Second World War, national governments were the primary market for software products and, since most of these software applications were used in military contexts, they were

Cross-Border Software Development Contracts

57

not allowed to be written by foreign companies.14 The growing civil and economic use of computers in the 1980s then rapidly triggered the internationalisation of the software industry. The international focus started in India when American companies discovered the immense knowledge resources available there. For example, Jack Welch, then-CEO of General Electric, visited India in 1989 and recognised the immense potential to purchase high-quality software programs at considerably lower costs than at home. At the beginning of the 1990s, General Electric entered into a contract with Wipro, which is one of the biggest software companies in the world today. In the years following, the successful practice of outsourcing software development processes to companies in foreign countries spawned countless imitators. Additionally, this wave of cross-border contracting was fostered by both the invention of fibre optic cables and rapid improvements in the realm of satellite techniques, since these innovations made it possible to send huge amounts of data around the globe very quickly.15 Indian software industry sales, alone, reached a volume of around 52 billion US dollars in 2008. Most importantly, more than 80 per cent of this sales volume stemmed from exports.16 This means that the major portion of transactions that take place in the Indian software industry transcend the borders of the Indian nation state. Today, there exist about 3,000 different software companies in India, which export to more than 100 different countries. About 265 of the Fortune 500 companies are currently clients of the Indian software industry.17 Apart from India, many other countries in the EU and other world regions have emerged in recent years as important locations for the global software industry. The exports of some of these countries even exceed the Indian numbers. Many companies—particularly in Eastern Europe—find 100 per cent of their clients abroad.18 These numbers demonstrate why the software industry is considered to be one of the most globalised industries in the world economy.19 Transactions in this industry clearly take place in an arena that resembles the model of a global market. Hence, according to the three selection criteria (anonymity, complexity, globality), cross-border software development contracts constitute a very good general research object for studying the significance of private and public contract enforcement institutions in a global economy.

14 15 16 17 18 19

Campell-Kelly, 1995, 82. Sahay, Nicholson and Krishna, 2003. NASSCOM, 2008. Sahay, Nicholson and Krishna, 2003. Mroczkowski, Carmel and Saleh, 2002. Zeng, 2005.

58 Research Design FOUR SCENARIOS: GERMANY, BULGARIA–ROMANIA, INDIA, EUROPEAN UNION

Identifying cross-border software development contracts as a suitable general research object is not enough to develop the case study. Since it is impossible to analyse all contracts that are concluded in this field, a practical case study needs further specifications. Table 1 identifies the four different, very specific scenarios on which this book focuses. Table 1: Case study scenarios Scenario

Focus of Scenario

Dates of Interviews

Interviews

1

How German firms enforce contracts when they buy software products in Asia and Eastern Europe

02/2005–03/2006

10

2

How Bulgarian and Romanian firms enforce contracts when they sell software products to OECD countries

02/2005–03/2006

10

3

How Indian firms enforce contracts when they sell software products to OECD countries

02/2005–03/2006

11

4

Follow-up study: Enforcing contracts between German buyers and suppliers from Bulgaria and Romania after both countries entered the European Union in 2007

11/2010–12/2010

10

The first three scenarios investigate the significance of state-enforced contract law and private contract enforcement institutions in the global software industry from different firm and country perspectives. Specifically, between February 2005 and March 2006, 31 qualitative interviews were conducted overall with German (scenario 1), Bulgarian and Romanian (scenario 2) and Indian (scenario 3) software industry experts. The first scenario examines how client companies, which typically stem from an OECD country, enforce contracts when they buy software products abroad from companies in emerging markets or transformation countries. More specifically, this scenario involves 10 comprehensive qualitative interviews with German software industry experts.

Four Scenarios

59

In both the second and the third scenarios, the problem of enforcing contracts in globalised exchange is then analysed from the perspective of the suppliers, who typically stem from emerging markets and transformation countries and who sell software applications to companies in the OECD world. These scenarios consist of 10 interviews with Bulgarian and Romanian (second scenario) and 11 Indian (third scenario) experts of the software industry. On the supplier side, it is important to differentiate between the Bulgarian–Romanian scenario and the Indian scenarios, because these countries fundamentally differ in the structures of their software industries. India’s software industry is comparatively mature. India is the biggest software exporting nation in the world, and hundreds of companies already exist which produce for the global market. Thus, the Indian software industry perfectly represents globalisation as an economic modernisation process that transcends the borders of the nation state. Other nations that show similar developments in the software industry are China and Russia.20 In contrast, Bulgaria and Romania belong to the group of the so-called emerging software exporting nations.21 None of these countries, alone, is even close to reaching the volumes of the Indian software industry. However, from a worldwide perspective, the group of emerging software exporting nations has by far the most members. Including this group into the picture means dealing with one very important feature of economic globalisation: again and again, companies from transition and developing countries push to enter the world market. The Bulgarian and Romanian interviewees represent companies from emerging software exporting nations. The fourth scenario deviates in its structure from the first three scenarios. The interviews in this scenario were not conducted in 2005 and 2006, but in November and December 2010. No further firm or company perspective is added to the study. Instead, scenario 4 uses a time-series research strategy. It compares some of the interview material of the first three scenarios to a methodologically similar follow-up study five years later. Scenario 4, again, looks at how customers from Germany and suppliers from Bulgaria and Romania enforce software development contracts. The crucial difference here is that, between the point of time of the first interview series and the point of time of the follow-up study, Bulgaria and Romania became Member States of the European Union in 2007. Scenario 4 thus provides a unique research opportunity to study the impact of European contract law on

20 21

Carmel, 2003, 3. For this term, see: ibid, 3.

60 Research Design the significance of public and private contract enforcement institutions in cross-border trade. Overall, the case selection can be summarised as follows: in the software industry, complex transactions are concluded between anonymous agents on global competitive markets. Cross-border software development contracts therefore represent an excellent research object to study the significance of state-provided contract law and alternative, private-order contract enforcement institutions in today’s globalised markets. The focus on software companies from the countries of Germany, Bulgaria–Romania and India reflects important structural features of the process of economic globalisation. German experts represent the scenario of companies based in OECD countries which typically import software products from companies in transition countries and emerging markets. Indian experts stand for the scenario of a mature software exporting nation. Bulgarian and Romanian experts represent companies from emerging software exporting nations which are trying to establish themselves on the world markets. Finally, the fourth scenario particularly focuses on the impact of the European Union. In each of the four scenarios, I shall examine to what extent economic agents rely on state-enforced contract law and to what extent they rely on alternative private contract enforcement institutions. In so doing, the four scenarios together produce a microeconomic data set that will significantly enhance our understanding of the institutional underpinnings of global trade. METHODOLOGY

Part I, above, makes clear that, so far, we possess very little empirical knowledge about public- and private-order contract enforcement institutions in action in globalised transactions. Certainly, the pertinent interdisciplinary literature has formulated a variety of answers to the problems of cross-border contract enforcement—from private international law via lex mercatoria and international commercial arbitration to informal relational contracting and reputational networks. Yet, how these different institutions work in practice from the perspective of market participants is a vast, open and unexplored question. Thus, we face a disparate and lessadvanced state of empirical research regarding the institutional underpinnings of cross-border transactions, which means that drawing on an explorative, qualitative method might be the most rewarding research strategy.22 Too little proven knowledge exists up to this point about the research object of the institutional prerequisites of cross-border exchange to make it possible to formulate theoretical hypotheses which could then 22

See: Lamnek, 1993.

Methodology

61

be tested by means of quantitative methods. This book does not aim to produce a model with broad validity, nor is it about controlling existing theories. Rather, the present study strives for a detailed understanding of a few particularly interesting scenarios. The ultimate goal is the genesis of new, innovative theoretical knowledge in the field of institutions and globalisation.23 According to Barney Glaser’s and Anselm Strauss’ grounded theory, the taxonomy of public and private contract enforcement institutions developed in Part I works as a provisional theoretical framework to describe how firms in the global software industry safeguard their transactions against fraud and opportunistic behaviour. But, the following empirical study is also left open for novel or hitherto not sufficiently recognised mechanisms.24 Thus, the taxonomy not only functions as a heuristic device to identify the contract enforcement in action in globalised exchange processes in a systematic fashion but also builds the categorical starting point that will continuously be advanced throughout the empirical study.25 The qualitative interviews in all four scenarios were conducted as semistandardised expert interviews. In so doing, certain topics were stipulated in the interviews, but the interview was not guided by a fixed order of questions. Working through a predetermined questionnaire was considered as counterproductive given the less-advanced state of research in this field of study. The searchlight would have been set up too narrow to be able to detect the emergence of possibly new and innovative contract enforcement institutions in global exchange. However, the following topics were addressed in all interviews: The risks of transaction: This subject area includes questions about the risks enterprises face when they are involved in cross-border software transactions. Contract law provided by the state: This subject area includes questions about the significance of contract law provided by the state for the emergence of cross-border software transactions. Private-order contract enforcement institutions: This subject area includes questions about the significance of the private institutions for crossborder software transactions. The analysis of the interviews followed the technique of contents analysis proposed by Phillip Mayring. According to this method, the interview

23

See: Mayring, 2003, For an English version see: Mayring, 2000, 1–20. See: Glaser and Strauss, 1967. 25 For the inadequacy of using either an exclusively deductive or exclusively inductive approach to studying institutions and for the need to combine both, as in this book, see: Greif, 2006, 314–18. 24

62 Research Design material was first condensed into essential statements by the interviewees. Then the interview statements were integrated into comprehensive, theoretical categories.26 Two methodological tools were employed to organise the data. First, a categorical system was deduced from the taxonomy of public- and private-order contract enforcement institutions and applied to the qualitative interview material. This means that, at first, all statements regarding the relevance of formal contracts, state courts and state enforcement authorities were extracted from the interview data, numbered consecutively, and organised into specific tables. Then this strategy was repeated for all statements concerning the relevance of private contract enforcement institutions (self-enforcing contracts, reputational networks and private governance regimes). In so doing, 23 tables with a total of 278 statements were created (see Tables 6 to 26 and 29 to 30). Second, detailed quotations from the interview material are used as case examples to illustrate theoretical categories that turned out to be particularly important in the course of the study. Sources of quoted material are identified in Tables 2 to 5. THE INTERVIEWS

Generally, the expert interviews were conducted as follows.27 First, the interviews with German experts were conducted in German and later translated into English by the author. All interviews with Indian, Bulgarian and Romanian experts were conducted in English. Second, apart from one German interview, which was conducted as a telephone interview, all interviews were conducted at the premises of the experts. Third, all interviewed experts were granted anonymity. Fourth, although textbooks about qualitative empirical research often claim that it can be problematic to interview executive experts because, as a consequence of a very stressful business day, they only have very little time available, time restrictions for interviews were not a problem in this study. All interviewed experts showed great interest in the topic of the study. The interviews lasted, on average, one and a half hours. The experts spent sufficient time to give detailed information about their practices of crossborder contract enforcement in the software industry. Fifth, in most cases, the interviews were conducted with one person. Two interviews with Indian companies were conducted with several interviewees. But, even in these cases, the unit of analysis remained the aggregate interview that

26 27

See: Mayring, 2000; Mayring, 2003. The interviews were set up, planned and conducted together with Holger Nieswandt.

The Interviews

63

was conducted with the particular company. The three scenarios in which the expert interviews took place were: Scenario 1: Between February 2005 and January 2006, 10 interviews in total were conducted with experts of the German software industry. Eight interviews were conducted with chief executive officers or high-ranking managers. Two interviews were conducted with senior experts of business associations. The companies were contacted after detailed Internet research. The study was supported by a German IT-association which sent an email to its members asking them for interview dates. Five of the ten interviews were conducted at the premises of the companies, one interview was conducted via telephone, and four interviews were conducted at the trade fair Systems in Munich. The interviews were conducted with companies of various sizes—large companies (more than 1,000 employees), medium sized companies (100–1,000 employees) and small companies (fewer than 100 employees). Moreover, experts were selected on the basis of different work and knowledge backgrounds. Table 2 gives an overview of the German interview series. Table 2: Overview of scenario 1 Interview

Company size

Interviewee

Kind of Interview

G-I

Large

Vice President

Telephone

G-II

——

Head of IT Services (Business Association)

Face to face

G-III

Medium

Head of Quality Management

Face to face

G-IV

Small

Executive Director

Face to face

G-V

Medium

Executive Director

Face to face

G-VI

Large

Head of Development

Face to face

G-VII

Small

Chief Executive Director

Face to face

G-VIII

Large

Senior Vice President Strategic Research and Development

Face to face

G-IX

——

General Manager (Chamber of Commerce)

Face to face

G-X

Small

Executive Director

Face to face

Scenario 2: In November and December 2005, 10 interviews overall were conducted with Bulgarian and Romanian experts of the software industry. Again, eight interviews were conducted with chief executive officers or high ranking managers and two interviews were conducted

64 Research Design with senior experts of business associations. First contact with Bulgarian and Romanian companies was established at either the trade fair Systems in Munich or a so-called match-making event for IT companies at the Romanian Embassy in Berlin. After detailed Internet research on the many companies that were contacted in this initial phase, the most suitable were asked for interview dates. As in the German scenario, the Bulgarian and Romanian interviewees were selected to represent diverse experiences (company size, work and knowledge background). Additionally, in order to broaden the scope as much as possible, the interviews were conducted in both central and peripheral regions—companies both from the two most important business centres, Sofia and Bucharest, and from Sibiu, a much smaller city next to the Carpathian Mountains, were selected. Table 3 gives an overview of the Bulgarian–Romanian interview series. Table 3: Overview of scenario 2 Interview

Company size

Interviewee

Kind of Interview

BR-I

Large

International Sales Manager

Face to face

BR-II

Small

Director Business Development

Face to face

BR-III

Medium

Chief Executive Officer (CEO)

Face to face

BR-IV

——

Member of the Board (Business Association)

Face to face

BR-V

Medium

Managing Director

Face to face

BR-VI

Medium

President

Face to face

BR-VII

Small

Chief Executive Officer (CEO)

Face to face

BR-VIII

Small

General Manager

Face to face

BR-IX

——

President (Business Association)

Face to face

BR-X

Small

General Manager

Face to face

Scenario 3: In order to organise the Indian interview series, the IndoGerman chamber of commerce in Düsseldorf (Germany) was contacted in September 2005 to learn more about conducting an empirical study on the Indian software industry. The office of the Indo-German chamber of commerce in Bangalore (India) then agreed to support the study for a small payment in return. First, the chamber provided office space in India, and second, the chamber sent emails with enquiries for interviews

The Interviews

65

to a large number of Indian software companies and then provided lists of the software companies that could be contacted, if required. In India, again, diverse interviewees were selected, representing a variety of different work and knowledge backgrounds, companies of different sizes and a differentiation between centre (Bangalore) and periphery (Trivandrum) of the country. Table 4 gives an overview of the Indian interview series. Table 4: Overview of scenario 3 Interview

Company size

Interviewee

Kind of Interview

IND-I

Small

Vice President Delivery

Face to face

IND-II

Large

President and Managing Director, Associate Vice President Consulting Services, Assistant Vice President Projects

Face to face

IND-III

Large

Vice President Business Development, Manager Business Development, Manager Technical Marketing

Face to face

IND-IV

Large

President

Face to face

IND-V

Medium

Director, Manager Business Development

Face to face

IND-VI

Large

Associate Vice President

Face to face

IND-VII

Large

Company Secretary (Head Face to face of Legal Department)

IND-VIII

——

General Manager (Chamber of Commerce)

Face to face

IND-IX

Large

Head of Office (Chamber of Commerce)

Face to face

IND-X

Medium

Managing Director

Face to face

IND-XI

Large

Company Secretary (Head Face to face of Legal Department)

Scenario 4: The 10 interviews of this scenario took place between November and December 2010. Six interviews were conducted with Bulgarian and Romanian experts. It is important to note that these interviews were conducted with the same companies and trade associations as in 2005/2006. In four of the cases, they were even conducted with the same persons. On the other hand, it made no sense to interview the same German companies again because a German company that bought a

66 Research Design software product in 2005 would not necessarily have conducted a similar transaction between the years 2007 and 2010, and, in those cases where German clients do trade with the same supplier again, they would no longer fit into the sample because they are now engaged in an ongoing relationship where transactional security might have already been built up. Therefore, by drawing on Internet research, four new suitable companies were identified and approached. (See Table 5) Table 5: Overview of scenario 4 Interview

Company size

Interviewee

Kind of Interview

EU-G-I

Large

CEO

Face to face

EU-G-II

Medium

CEO

Face to face

EU-G-III

Small

CEO

Telephone

EU-G-IV

——

Board Member (Chamber of Commerce)

Face to face

EU-BR-I

Large

Key Account Manager, Foreign Clients

Face to face

EU-BR-II

Small

CEO

Face to face

EU-BR-III

Medium

CEO

Face to face

EU-BR-IV

——

Executive Director, Business Association

Face to face

EU-BR-V

Medium

CEO

Telephone

EU-BR-VI

Small

CEO

Face to face

This chapter has outlined the research design of the case studies. Chapters five to eight present the empirical results of the four scenarios. The presentation of the results follows the same structure for each scenario. First, the specific risks of cross-border transactions in the software industry are elaborated. Second, the significance of state-provided contract law to mitigate these risks is discussed. Third, the role of private contract enforcement mechanisms for the conducting of globalised exchange in the software industry is analysed. The results of all three scenarios are ultimately summarised in chapter nine before their theoretical implications are discussed in Part III.

5 Scenario 1: How German Companies Enforce Contracts When Buying Software Products in Asia and Eastern Europe Markets are subtle organisations. The mechanisms that underpin transacting are intricate—and they are in everlasting flux. People are ingenious at finding ways to make exchange that bring mutual gains.1 (John McMillan)

TRANSACTIONAL RISKS

T

HE ANALYSIS OF the expert interviews established four main risks that German enterprises encounter when they order software applications in Eastern Europe or Asia.2 First, there is the risk that the software application ordered is not delivered at the agreed date. Second, there is the risk that the software application does not meet the expected quality standards. Both of these risks are particularly serious if the customer has a contractual agreement with a third party whose fulfilment requires him to deliver the ordered software application in advance. In order to avoid falling behind, the German enterprise has to make sure that the ordered software application is delivered punctually and works faultlessly. Third, due to the almost cost-free reproducibility of software products, there is a high risk that the software supplier will resell the same or a slightly amended version to another enterprise—in the worst case to a competitor. Therefore, the German customer is concerned with making sure that the intellectual property rights to the developed software can be secured. 1

McMillan, 2002, ix. Parts of this chapter have been published in my Law & Social Inquiry article, see: Dietz, 2012. 2

68 German Contracts with Suppliers in Asia and Eastern Europe Fourth, for the buyer of a software application, there is the risk that the software producer obtains sensitive corporate data during software development, the use or distribution of which could jeopardise the business of the customer. Hence, the German enterprise needs a strategy with which it can prevent, as reliably as possible, the passing on of confidential information to third parties. STATE-ENFORCED CONTRACT LAW

What significance, then, do German enterprises attribute to the institution of state contract law in order to reduce these risks? To answer this question, one must first look at the typical structure of a software contract.

Software Development Contracts Due to the complexity of software, transactions usually consist of a number of contracts.3 These are: (1) a non-disclosure agreement, which is meant to guarantee that confidential information is not passed on to third parties even before a business transaction is begun; (2) a framework contract, which establishes the fundamental rights and obligations of the contractual parties for the duration of the business relationship; and (3) individual service-level agreements, which define the exact extent of work required. The empirical findings indicate that the involved actors usually prepare this contractual edifice with great care. The work required is comprehensively fixed through the creation of so-called requirement or performance specifications; furthermore, the framework contract defines an exact catalogue of sanctions in case foreign enterprises fall behind in the development of software or fall short of agreed quality standards. Moreover, in most cases it is agreed in detail what procedures have to be observed, if during a business relationship incidents occur which were unforeseen by the parties at the moment the contract was concluded (change request, project and executive committee, escalation procedures). Additionally, the patterns of conflict resolution are exactly pre-determined in case the parties cannot agree on them once a dispute occurs (arbitrator, applicable law, place of jurisdiction).4

3

Söbbing, 2006, 144. My description of contractual planning is based on the socio-legal works of Stewart Macaulay. Macaulay differentiates between three dimensions of contractual planning: definition of performances, effect of defective performances, legal sanctions. See: Macaulay, 1963, 2. 4

State-enforced Contract Law

69

From the perspective of legal sociology, the fact that the global software industry usually works with very elaborate contracts suggests, at first, that the involved parties indeed rely heavily on state enforcement authorities in order to safeguard the performance of contracts by their foreign business partners. Therefore, one would expect state contract law to be a necessary prerequisite for the generation of transactional security in cross-border business transactions.5 However, as the following analysis shows, this is not always the case.

Significance for the Generation of Transactional Security Tables 6 and 7 summarise how the 10 German experts assessed the role of state-enforced contract law in cross-border software transactions. The experts draw an unambiguous picture. As Table 6 shows, there are clear statements in all 10 German interviews that the state enforcement of contracts is actually insignificant to safeguarding cross-border software transactions nos 1–18). This assessment applies to all four of the risks facing customers who purchase software applications in Eastern Europe and Asia: the support of state contract law does not guarantee that delivery deadlines are met (nos 7, 8, 11), that the ordered software is of the required quality, that there is an exclusive transfer of intellectual property rights, or, finally, that confidential information is kept secret. In the words of one interviewee, the software contract is ‘only worth the paper it is written on’ (G-VII, 2). Table 6: The insignificance of state contract law for the generation of transactional security from a German perspective Interview

No

Original passage/paraphrase

G-I

1

So if, for example, you are doing business as a German organisation engaging with a small provider in India, the contract does not give you any protection. (p 1)

G-II

2

Contracts, of course, play a role in the software industry, but hardly any company operating in Central and Eastern Europe relies on them. (p 4)

G-II

3

If you collaborate with a company in Russia or the Ukraine, legal issues play no prominent role. (p 4)

G-III

4

Coercion is less effective in our business since we have potentially already fallen behind once we don’t get the expected quality. And it takes a long time to sue. (p 12) (Continued)

5

Ibid.

70 German Contracts with Suppliers in Asia and Eastern Europe Table 6: (Continued) G-III

5

Still, we enter into an agreement, but the contract is only worth the paper it is written on. (pp 20, 21)

G-III

6

With regard to the uncertainty of controlling the generated resources, state coercion plays no role. (pp 24, 25)

G-III

7

Also, with regard to the uncertainty of confidential information being passed on, the enforceability of contractual claims by dint of state coercion plays no role. (p 25)

G-IV

8

The fact that I have a contractual arrangement does not stabilise the expectation that the other party delivers in time or that the quality is all right. (pp 8, 9)

G-IV

9

State law is of no significance for enforcing the contractual stipulation that the supplier has to provide free updates for a year. (p 12)

G-V

10

The contract is of no significance for the collaboration itself. (p 10)

G-V

11

The opportunity to enforce contracts provides no certainty about product quality. (p 16)

G-VI

12

The course of action in the past: requirement specifications and target specifications, work delivery contracts, service contracts, ‘blah blah blah’; today we can say, ‘We don’t actually want that’. (p 3)

G-VII

13

One can sign a lot of paper, one can design voluminous contracts, in the end, mutual benefits only occur if one cooperates properly, even beyond any contractual arrangements. (p 3)

G-VII

14

The contract is only worth the paper it is written on. (p 3)

G-VII

15

We don’t really need contracts. (p 10)

G-VIII

16

In India, legal certainty does not exist. (p 1)

G-IX

17

Contracts are not really helpful. (p 1)

G-X

18

I don’t believe that contracts are the means to provide certainty; where I can say I can rest easy. (p 2)

However, as Table 7 indicates, three of the ten interviewed experts do not entirely share this position. Although interviews G-I, G-II and G-X principally corroborate the feelings of the insignificance of state law, they also indicate that state contract law plays some sort of role in these transactions. Both interview G-I and interview G-II argue that the ‘contract’ (G-I) as well as the ‘legal issues of cooperation’ (G-II) are of no significance for smaller companies in

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71

Table 7: The significance of state contract law for the generation of transactional security from a German perspective Interview

No

Original passage/paraphrase

G-I

19

So if, for example you are doing business as a German organisation engaging with a small provider in India, the contract does not give you any protection. But, if your organisation is Deutsche Bank (big organisation), and you are doing business with TCS (biggest software provider in India), the contract forms are structural framework. (p 1)

G-II

20

Globally active companies of a certain size have to pay particular attention to the legal issues of cooperation. For all others, different issues are relevant. They have to generate mutual trust: if this works, then they pay far less attention to legal issues than large-scale enterprises. (p 1)

G-X

21

That all works out because of the contract, I don’t think so. The contract is a legal fallback option, if all conditions change. (p 3)

transnational trade relations, but that they are significant for large multinational corporations, such as TCS (the largest Indian software company) or SAP (the largest German software company) (nos 19, 20). Furthermore, interview G-X indicates that state enforceable contracts could be important with regard to the exclusive protection of the intellectual property rights to the purchased software applications (no 21). However, these assertions are not really inconsistent with the prevailing opinion that state contract law is of no significance for cross-border economic exchange. A more detailed analysis of the interviews shows that, in the case of larger companies, it is not the potential power of the state enforcement bodies that help contracts generate transactional security, but, rather, the fact that contracts merely function as binding communication documents, which are ultimately enforced by reputation and, hence, in a private mode. Accordingly, directly after the claim that ‘contracts provide … a structural framework’ for the collaboration of large corporations, interview G-I states: If TCS found themselves in default of some contractual provisions or liable for some payments of financial remedies, then you would have their reputations playing into how they would conduct themselves under the auspices of the contract. The chances are that they would look for remedies they could themselves enact. This could be the provision of a service rather than a financial payment, but beyond that TCS wants it fixed, whether it is under German law, Indian law, UK or US law, they would have to fix the issue simply because that type of

72 German Contracts with Suppliers in Asia and Eastern Europe publicity, negative publicity, would damage them very considerably outside of any penalties that they were liable for under the contract. (G-I, 6)

In this sense, parts of interview G-II also support the claim that maintaining the image of the company holds more sway in the enforcement of legal issues than state power: If we discuss larger companies such as SAP or Software AG in Germany; naturally, they have to give higher priority to the legal framework of cooperation. Here, turnovers are concerned which amount to billions; companies are concerned which have a worldwide reputation; they cannot afford to experience a flop in an international cooperation. That would damage their image in general.6 (G-II, 1)

Only interview G-X explicitly asserts that state enforceable contracts help to sustain cooperation. Yet, even in this case, state contract law is mentioned only as an additional, rather weak mechanism to prevent the infringement of intellectual property rights in the event that the employees involved in a collaboration change companies. I don’t think that things work out because of a contract. The contract is a legal fall-back option, if all conditions change. If new management arrives, the thing is purchased, and then someone says OK let’s sell that stuff; and when you don’t have access to these people anymore, then you have to be able to say: look, that’s what you signed; that’s the situation, on that basis we have to talk to each other. (G-X, 3)

Because: If I don’t have a contract, I can’t even try to enforce my rights. Whether I believe that this has a positive end in court depends on very many factors indeed: however, it is pretty bad if I don’t have a contract at all; that leaves me without any position at all. (G-X, 3)

Moreover, it is evident in this case that it is private governance mechanisms that ultimately play the decisive role in preventing the misuse of intellectual property rights: And then they come and say: Oh, that’s a great piece of software; we can sell it everywhere now; no one will notice in Germany anyway; then they enter the Polish, Czech, Romanian market; at some point I notice what’s happening; then they put another business with me at risk, so they get seriously penalised. And I think that what works is that if such a thing happens, then the community of companies knows very quickly, without me publicising that they have stolen and sold my software. (G-X, 4)

6

In the same interview we also find the following consistent statement: A loss of reputation—a damage to reputation would be more damaging than a financial loss. And so you find that big companies will absolutely not want to go to court or arbitration or a dispute in the contract, because they don’t want the view that they are not capable of delivering on their responsibilities. (G-I, 7).

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73

Thus, it would seem that the possibility of enforcing contractual agreements with the help of state enforcement bodies is of (nearly) no importance for German enterprises when they purchase software applications in typical offshore countries such as India, Bulgaria or Romania. The statements of the interviewees provide further insight into why this situation occurs (see Table 8). First, there is deep distrust towards the legal systems of offshore states on the part of German enterprises (nos 22, 23, 25, 27–35, 38). The German enterprises therefore refrain from making their contractual relations subject to a foreign jurisdiction. The contracts are usually drafted according to German law. German courts have jurisdiction. The fact that German law is in effect does not, however, mean that state contract law can fulfil its function of enforcing contracts and enabling economic cooperation. In principle, it is indeed possible to successfully sue a foreign company for the performance of a contract in Germany (nos 25, 33), yet, according to the interviewed experts, the title cannot be enforced reliably in offshore countries (nos 22, 23, 24, 25, 32, 33, 35). This means that, even if the contractual parties have agreed that German law applies, there is no guarantee that foreign business partners would be effectively sanctioned in case of a breach of contract. In the end, from the perspective of a German enterprise, state contract law remains without effect because the territorial confinement of law prevents a reliable enforcement of German judgments in Eastern Europe and Asia.

Table 8: Fragmentation of law as a reason for the insignificance of state contract law from a German perspective Interview

No

Original passage/paraphrase

G-I

22

For a German company, the enforcement of contractual claims in India is extremely difficult. (p 1)

G-II

23

The enforcement of contractual claims in Eastern Europe would take an extremely long time. (p 4)

G-II

24

Contracts can internationally only be enforced with huge difficulty. (p 10)

G-III

25

In India, it is much harder to sue (than in Germany) and which law do you apply? If I apply Indian law, I run into the issue that an Indian court might be more inclined to decide in favour of an Indian company rather than a German one. If I choose German law, I get my right; but if I appear with this ruling in India and want to enforce it, the Indians might just laugh at me. (p 24) (Continued)

74 German Contracts with Suppliers in Asia and Eastern Europe Table 8: (Continued) G-IV

26

Although there is a clause in the contract stipulating that property rights are transferred, it remains uncertain whether one can take legal action to obtain them. (p 10)

G-VI

27

Sources received from our Indian partner, noted but unusable; they are thrown away. We have pondered legal action, like recently with Russia. But you need to calculate how much money you want to invest in order to get your right. Legally, we know that we are right, but it makes no sense to pursue our right; just try to take legal action in Russia. You will have a dispute between expert witnesses, and it is not even clear which court has jurisdiction. (p 4)

G-VIII

28

Given the judicial system in India, the chance is rather small that the case is decided within the next decade. The courts are not very experienced in that field. The duration of a trial is endless. Especially in India, where proceedings are endless, we must avoid ever entering into a legal conflict. (p 1)

G-VIII

29

On one hand, it is, of course, great that you have an independent judiciary in India. This is most welcome, if you compare this with other countries—like, for instance, China—where we also do development. On the other hand, the time it takes for such a judicial system to come to a decision is unacceptable for any kind of economic activity, ie the average duration of proceedings is ten years. If we wait that long, our office has gone bust or is closed. It is not reasonable to settle a conflict in court. (p 1)

G-VIII

30

Hearings don’t even occur. So you have to go to court every Wednesday; the court deals with about 800 cases. Today, they handle this one and that one and everyone else can go home. This happens week after week, so weeks go by. (p 1)

G-VIII

31

Everyone knows that it makes no sense to take legal action; both parties know that. No one will get his right because there will be no verdict. (p 2)

G-VIII

32

It will certainly not happen that a German verdict is enforced in India. (p 2)

G-IX

33

Only then, you have to know that contracts are important, but the problem is that they are ultimately not enforceable because India has no mutual assistance agreement. If you have a contract between a German and an Indian company, and it is stipulated that the Indians have to deliver at a certain point and they don’t, and I cannot sue them for contractual performance. If you take action in a German court, which might even be successful, perhaps because the contract stipulated German law, it still does not help since the legal title cannot be enforced in India. (p 1) (Continued)

State-enforced Contract Law

75

Table 8: (Continued) G-IX

34

You have to take action before an Indian court, but this takes a very long time. The main proceedings take at least six years. (p 1)

G-IX

35

In India nothing is enforced strictly. (p 1)

G-IX

36

The Indians perform a contract, because they want money; they will therefore make an effort to accommodate the demands of the German customers. Clearly that’s their intention, but the German side should not believe that matters could be enforced via contract or in court. (p 2)

G-IX

37

For the Indians, the contract is an idea that they ought to fulfil. But it’s not the case that they have an absolute standard like the Germans. The Indians perceive the contract first of all as a framework. They certainly try to perform the contract. If, however, insurmountable problems emerge, they will try to engage in dialogue or to amend the contract. (p 26)

G-X

38

If you ask me what I believe with regard to such legal disputes involving software, versions or parts of software, then I think it is very difficult to actually prove this and to prove it through all courts—in particular, if we deal with a partner who resides somewhere where you first have to find out how to get him. This is quite difficult. (p 3)

Second, the experts stressed that state courts are not able to contribute effective conflict resolution in the area of software development due to the technical complexities of the relevant subject matters. In order to understand the situation in a case, the responsible judges have to rely on expert reports, which greatly increase the costs of proceedings. Moreover, expert reports do not always bring more clarity; they often intensify the conflict when a conflict among experts ensues. Given these difficulties, it is hardly astonishing that judges tend to ‘push’ cases ‘towards settlement’. The result is that it is not always worthwhile to involve state courts, even for a party that thinks it is in the right. The outcome of the proceedings is too uncertain; the costs for the involved experts are too high. In short, entirely independent from the territorial confines of state law, the insignificance of state contract law can also be attributed to the lack of legal certainty in the area of software development. In general, it can therefore be concluded that state contract law is of no significance for German customers purchasing software applications in offshore countries. On the one hand, the outcome of proceedings in state courts is highly uncertain and generates high costs. On the other hand, the title of a German court, if acquired, cannot reliably be enforced in typical offshore countries. (See Table 9.)

76 German Contracts with Suppliers in Asia and Eastern Europe Table 9: Complexity as a reason for the insignificance of state contract law from a German perspective Interview

No

Original passage/paraphrase

G-III

39

If there’s a breach of contract, to then take legal action and to get damages that’s hard to comprehend in the software industry. (pp 20–21)

G-IV

40

Quality cannot be defined in such a detailed way that you could simply take legal action later; you need expert witnesses, which increase costs; you cannot spend the whole amount the thing costs. (pp 8–9)

G-VI

41

Clearly, we try to keep the courts out of this; they can’t help anyway. You end up with a dispute between expert witnesses, and all comes to nothing anyway. (p 3)

G-VII

42

First, the German judicial system is overtaxed, and, second, German district court judges have no clue what they do. They tend to protract things, achieve a settlement, or get—at least—an expert report. Since we know that this is one of the most expensive ways to settle a conflict, we try to avoid it. This is something we don’t do. (p 5)

G-X

43

If you ask me what I believe concerning such legal disputes involving software, versions or parts of software, then I think it is very difficult to actually prove this and to prove it through all courts. (p 3)

Excursus about the Alternative Meaning of Contract In light of the above, one issue remains: why do German enterprises conclude detailed contracts, in order to purchase software abroad, even though these contracts generate no transactional security? From an economic perspective, it is hardly sensible to use resources for the design and negotiation of contracts if they ultimately remain without effect on transactions. What purpose do contracts fulfil, if they do not generate transactional security?7 The experts provide some interesting insights (see Table 10). Enterprises need contracts in order to define their legal relationship with third parties, such as insurance companies, banks and tax authorities, who are not directly involved in the transaction. For example, contracts are the

7 For socio-legal scholars the fact that contracts fulfil alternative functions is not new. See eg: Sosa, 2007.

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77

basis for the creation of an insurance policy, the granting of credit or the determination of a tax liability (no 44). Contracts, therefore, are necessary documents for participation in modern business life, independent of their actual function, in order to secure a business relation against fraud and opportunistic behaviour. The empirical findings furthermore demonstrate that contracts can also be used to legitimise the actions of company management vis-a-vis its owners (no 47). No corporate management would like to be accused by its seniors of acting without a valid contract in case a transaction with a foreign company fails. The owner could see such action as flawed behaviour, resulting in negative career effects for the management. Members of the corporate management enter into contracts, therefore, because they ‘have to guard their back’ in case things go awry (no 48). However, the most important function of the contract is as a communication document (nos 45, 46). Relational contract theory argues that transactions are governed less by detailed contracts than by shared common goals, relational norms, and informal sanctions.8 To a great extent, this view also applies to contractual relations in the global software industry. However, unlike in the relational context, the observed contracts in the global software industry are carefully measured and specified. The reason for this contractual behaviour is that, in cross-border intercultural business relationships, no common socio-cultural relational norms exist that could implicitly govern the exchange beyond the contract itself. No transnational business culture yet exists. Enterprises are far more dependent at the transactional level than in the domestic context on the detailed explication of the behaviour they expect from their business partners and on turning their expectations into the written form of a contract. Thus, one expert stresses that, although contracts do not generate transactional security, ‘one still needs a contract as the basis of cooperation so that everyone knows what one talks about and what is expected’. (G-IX, 1). Contracts, and the private law applicable to them, are means of communication,9 which can be more easily universalised than social norms reproduced in exclusive ethnic or social contexts. Contracts serve

8 Macaulay, 1963; Macaulay, 1965; Macaulay, 1977; Macaulay, 1985; Macaulay, 1986; Macneil, 1971; Macneil, 1978; Macneil, 1980; Macneil, 1985a; Macneil, 1985b; Macneil, 1999–2000. 9 Hugh Collins writes to this point: I call the contract a form of communication system because this phrase emphasizes the point that the contract thinks about the relation between people in a particular way […] it functions in human interactions as a distinctive way of understanding relationships. The contract constructs an image of the human association that reduces its complexity to the elements and trajectories that have significance within the contractual framework. (Collins, 1999, 15).

78 German Contracts with Suppliers in Asia and Eastern Europe the function of mutual communication rather than that of the enforcement of legal claims as proponents of classical and neoclassical theories of contract law would assume. Table 10: Alternative meanings of contracts Interview

No

Original passage/paraphrase

G-V

44

An important aspect of the contract was VAT. It was important to include many details for the insurance, etc. This cost us a lot of money. Actually, it is of no significance for the collaboration itself. (p 10)

G-VII

45

Contracts facilitate communication. (p 10)

G-IX

46

One still needs a contract as the basis of cooperation so that everyone knows what one talks about and what is expected. (p 1)

G-X

47

My legal status already requires me to have a contract, in order to protect shareholders against such situations. (p 3)

G-X

48

However, if you realise a complete concept in a foreign country with foreign developers, and the concept is marketable, which you believe anyway, and someone takes it and runs and develops it with small changes and is lucky enough to bring it to the market quicker than you, then you need a contract and a licensing agreement, a production contract that in case such a thing happens, you are sure that there is no trouble. (p 3)

PRIVATE CONTRACT ENFORCEMENT INSTITUTIONS

As the preceding discussion shows, although contracts and state contract law take on numerous alternative meanings, they are not used as direct enforcement mechanisms to create transactional security for German enterprises ordering software applications in Eastern Europe or Asia. But, if German enterprises cannot resort to state enforcement authorities in order to safeguard their transactions against opportunist behaviour, how do they manage to safeguard the performance of contracts by their foreign offshore providers? This question will be answered below. The Initiation of Contractual Relationships German enterprises subject their potential business partners to a comprehensive evaluation process in the run-up to a transaction. They check not just the competence of a potential transaction partner but their reliability

Private Contract Enforcement Institutions

79

as well. In other words, before a transaction starts, German enterprises try to make sure to choose only foreign enterprises that show a low risk of default. One expert’s comments illustrate such a reliability test: If someone invests a certain amount of money to build up a business, he shows that he will be serious. It is the same with the companies in Romania. Usually after I am contracting them, who are you, how many employees do you have, 70, OK. You have an office? ‘Yes’. That is why we have such a nice office; we have video cameras outside, all kinds of good networks. This is an investment of two million euros. If I put so much money in the environment that means that I have the capability to do such a good job. Nobody is investing two million dollars into nothing. (BR-III, 9)

Table 11 demonstrates that German enterprises look at particularly three aspects when they conduct a reliability test. First, they check how much a potential foreign supplier invests in the quality of its employees (nos 53, 54, 55, 57, 60, 61). German enterprises are interested not only in the number but also the exact qualifications of the staff of the foreign company. Apart from university degrees, German firms attribute particular importance to fee- and examination-based training certificates from multinational corporations, such as Microsoft, SAP or IBM (nos 54, 55, 57, 60). Second, they check how much a potential business partner invests in the quality of its production processes. This evaluation is conducted based on both quality standards (nos 54, 56, 60) and test projects (nos 51, 52, 58). Concerning the quality standards, there is a distinction to be made between certificates issued by professional standardisation bodies (eg, ISO and SEI)10 and certificates issued by well-known multinational enterprises (eg, Microsoft Gold Partner and IBM Certified Partner). The certificates of big multinational corporations are apparently given more importance than the quality standards of professional standardisation bodies (nos 54, 56, 60). As the following interview passage exemplifies, the reason for this difference is that, although standardisation bodies establish global unitary norms, they are usually supervised by national offices, which apply different standards of accuracy in the certification process: Sure, I trust the certificates of globally active enterprises more than those based on a globally valid norm, as individual monitoring bodies in individual countries supervise the latter. A certificate under the ISO 9.000 standard is,

10 The ISO (International Organization for Standardization) is a network of national standardisation institutions in 147 countries with its headquarters in Geneva, Switzerland. For the software industry, certification according to IS0 9,000 is decisive. The SEI (Software Engineering Institute) is a state-financed research and development centre, which is supported by the US Department of Defense and situated at Carnegie Mellon University. Regarding cross-border software development, the CMM (Capability Maturity Model) has become the best-known quality certification. See, for further information, Amberg, 2005.

80 German Contracts with Suppliers in Asia and Eastern Europe for instance, in Germany monitored by a certification centre, accredited in Germany. In Italy, it is monitored by an Italian body, etc. I wouldn’t like to compare a German body with an Egyptian or Sudanese one—to take it to the extreme. (G-II, 16–17)

Third, they check on how much the enterprise has invested in its production facilities. They usually visit the production sites in person in order to review the quality both of the business premises and of the technical infrastructure as well as to appraise the investments made into the physical and virtual security arrangements (nos 49, 50, 53, 58). Table 11: The reliability check of a foreign software provider from a German perspective Interview

No

Original passage/paraphrase

G-I

49

So, for instance, China has a black mark, when you ponder its attitude towards intellectual property protection, if you will. But this specific company, whoever it may be, has very strong security measures in place around the physical location—the site. (p 8)

G-I

50

They have to show you the site security measures; they have got to show you the methods they put in place to protect things. And then in those circumstances you want not only to talk to the management team you also talk to people who are actually responsible for those areas. (p 8)

G-II

51

The rule is that companies with which you plan larger projects, first of all show some examples indicating what they are capable of doing. (p 2)

G-II

52

Trust emerges when the partners ask for a few examples of programming. (p 2)

G-II

53

The background of people is very important: How many people are there, how are they certified, what kind of technologies do they use, what kind of references are available, how is the financial situation? All aspects of the company are examined. (p 7)

G-II

54

Of large significance are certificates by global players. Are the experts of the companies certified by Microsoft or Cisco or IBM? Did they have to do courses and did they have to do exams? How many are there in the company? (p 14)

G-III

55

Concerning employees, certificates play an important role. For instance, some Indian universities are perceived as of good quality. (p 8) (Continued)

Private Contract Enforcement Institutions

81

Table 11: (Continued) Interview

No

Original passage/paraphrase

G-III

56

You should, rather, trust certificates by companies which operate globally and have global standards. (p 9)

G-IV

57

Concerning employees, certificates play an important role. (p 6)

G-IV

58

If things get serious, I travel there and then I can easily see how they are located—the business premise. That generates a kind of certainty. (p 16)

G-IV

59

Small test tasks are awarded. (p 17)

G-V

60

A short time ago, I talked about a company in Riga. Of course, there was the issue of how reliable they are. And they had a very crisp argument: they are certified by IBM and develop for them. (p 3)

G-VI

61

Partner companies invest in the training of the employees; the commitment is an indirect one, since partner companies invest in training first and then want to re-earn their money. (p 1)

The fact that a potential foreign business partner has made significant investments in all three areas signals to the German company that the party is interested in long-term business success and will therefore behave cooperatively. From the perspective of the German enterprise, a fundamental precondition is met for further cooperation among private institutions. In addition, German companies make extensive use of modern information and communication technologies (ICT) during reliability tests of potential transaction partners. Initial information on the number of employees or the certifications a company holds are obtained directly by German companies through a thorough search of the websites of the potential foreign transaction partners. The German companies receive additional information, such as the detailed qualifications of each employee, by sending a detailed questionnaire to foreign providers, which are completed and returned to the German companies. Only when these Internet-based pre-examinations have been completed successfully will staff members of the German enterprise visit the production sites of the foreign provider in person in order to gain a final impression of the latter’s willingness to cooperate: At the moment, many first contacts are established via the Web. It plays a very prominent role. They do research on the Internet, and in this way learn to know

82 German Contracts with Suppliers in Asia and Eastern Europe each other. Then, they will exchange information at first. Sure, at some point these people have to meet. (G-II, 16–17)

The Enforcement of Relational Contracts The phase of initiation is followed by the implementation of the transaction. Software development contracts are usually divided into different stages (milestones). See Table 12 (nos 63, 65, 66, 67, 72). This means that the final product is not delivered in one piece at the end of the transaction; delivery of a piece at the end of each stage is spread gradually throughout the entire development process. At the end of each milestone phase, the German client conducts a comprehensive test to determine, with the help of predefined quality criteria, whether the delivered intermediate product meets the agreed-upon specifications (no 65). The German company then pays a sum in line with the progress of the project—either a fixed agreed milestone payment (fixed-contracts) or the price of working hours spent by the foreign software producer to reach the milestone (time and material contracts). Only with the last milestone payment is the transaction completed entirely.11 However, if the foreign supplier cannot fulfil the milestone-related quality criteria as agreed or exceeds the delivery time, the German company can then suspend payments after a short grace period and, finally, even end the business relationship at low cost (exit clause) (no 73). Suppliers must, therefore, endeavour to meet the contractual requirements in every milestone phase, as this is the only way to reach the next level of payment. If a supplier behaves opportunistically, the prospects of future earnings are lost when the German enterprise terminates the business relationship. Obviously, by this structuring of the contractual relationship into various milestone phases, the German companies establish a simple but highly effective means for controlling the actions of their providers (no 71). Thus, German companies perceive ‘payment arrangements’ as more important than ‘legal terms’ (no 62), and the option to refuse to pay bills is deemed to be a ‘massive lever’ (no 64) to enforce contractual claims. In short, by structuring the business relationship in milestone phases, the transaction turns from a simple prisoner’s dilemma into a repeated game. The consciously created shadow of the future gives the foreign supplier an incentive to reliably fulfil contractual agreements. 11 In contracts where small and medium sized foreign software companies are involved, milestone payments usually range between 10,000 and 20,000 euros, which is a bearable risk even for small companies. In contracts where big companies are involved, the milestone payments can range to as high as 50,000 euros. Dietz and Nieswandt, 2009, 101–2.

Private Contract Enforcement Institutions

83

Table 12: The significance of self-enforcing contracts in the generation of transactional security Interview

No

Original passage/paraphrase

G-II

62

Payment arrangements are far more important than legal terms. (p 4)

G-II

63

Certain payment arrangements are agreed upon. After the award of contract, the supplier receives only a small initial payment. Payment is then made according to the way in which the project proceeds. (p 4)

G-III

64

We use non-payment as an opportunity to enforce quality standards. This provides a massive lever. (p 12)

G-III

65

Work packages are produced that can already be tested. Payment by instalments is agreed upon. (pp 14, 16)

G-III

66

Partition into sections and milestones offers the opportunity to intervene in order to recognise conflicts earlier. (p 17)

G-IV

67

We define milestones, and every milestone has got its own test procedure. (p 6)

G-IV

68

The exit option is important. (pp 9, 19)

G-IV

69

If the tests are not passed, we don’t proceed. (p 6)

G-??

70

The payment of the last milestone poses a critical risk, since the delivered product can show a fault after it worked for some time. Hence, a stipulation is agreed upon that requires the supplier to provide updates free of charge for a year. State transaction law has no bearing on the enforcement of this stipulation. However, what allows to enforce the stipulation is the fact that I collaborate with the supplier in other projects. Otherwise, I try to pay the last milestone as late as possible. (pp 11, 12)

G-IX

71

The Indians perform the contract, because they want to get their money for their service. They will therefore make an effort to satisfy the needs of the German customer. (p 2)

G-X

72

You have a time axis with milestone plans. If the milestones are not met, you have to escalate. (pp 1, 2)

G-X

73

If a milestone is not met, then you have waiting periods which amount to no more than a few days. After two days, I can block a project, and then I can cancel it and pay only a quarter of the actual working hours. (p 2)

84 German Contracts with Suppliers in Asia and Eastern Europe The Monitoring of Contractual Relationships Modern economic exchanges can be conducted between companies as market transactions or within the hierarchical structure of an enterprise. It is the central concern of transaction cost theory to specify the conditions under which it is more efficient to choose one or the other governance mode (make or buy decision), but this need not be of detailed concern here. In the context of this study, it is, however, important to note that the governance structures of these two transaction types, market and hierarchy, differ fundamentally in the way they arrange the monitoring of the involved parties. If a transaction is handled via the market, the contract, itself, serves as the basis for monitoring: The contract determines the required services and products as well as the time when contractual performance is due. When this point in time arrives, one party can verify, on the basis of the contract, whether the transaction partner has met its contractual obligations. In other words, monitoring is done with regard to the achieved result and, therefore, operates indirectly and impersonally, as one partner is not directly monitoring the transaction partner during the provision of services. In the case of a hierarchy, however, different units within the company cooperate on the basis of plans that are set by the corporate management and controlled bureaucratically. Here, the performance of individual employees is supervised directly and personally at their work place by their superiors. A particularly interesting finding of the empirical study is that major German companies, in particular, monitor their foreign transaction partners not only indirectly through review of the contractual obligations and specifications—as would be typical for a transaction between independent enterprises—but also directly through other control systems that structurally correspond more to the governance mode of hierarchy than of a market transaction (Table 13, nos 76–83). Table 13 reveals that the foreign providers allow their German clients access to their company-internal project management systems so that German enterprises can monitor and control the process of software development directly (nos 74–83). Although legally separate entities are formally concerned in this process, the involved companies, in this way, create a common organisational structure, which transcends a merely contractual relationship. This means that a system of monitoring and reporting is established between the involved corporate units, from the level of project managers up to that of senior management, which is based on monthly or weekly reports (nos 78, 80) and, in extreme cases, even includes real-time monitoring of foreign providers—where the German client can watch ‘live’ what happens on the computers of the foreign provider (real-time controlling) (nos 74, 75). One uncertainty of the customer is losing control. Usually he has a customer and a contract with that customer, with deadlines. He has to deliver good quality. Then there is a problem in the project management: You ask the project manager:

Private Contract Enforcement Institutions

85

Have you started the project? He says: Yes, and he has not. How much have you completed? Fifty per cent and so on. You lose control of deadlines. So, in the sales process you have to show him that you have a project management system. He can get in, you give him a password, and he can get in to check. (BR-I, 9)

The interviews indicate very clearly that such comprehensive and direct supervision of the foreign transaction partner would not be possible without the technological advances in the information and communication technologies created in recent years. This is reflected, for example, in the fact that monitoring and reporting is usually Web-based (no 77). The provider sets up an Internet portal into which it deposits those documents required for monitoring purposes; these password protected documents can then be accessed by the client from any point on Earth, if an Internet connection is available (nos 76, 77, 78, 83). In addition, information that serves to control the transaction partner can, if necessary, be sent cheaply and quickly via the Internet or be acquired by oral reports via telephone and videoconference (nos 78, 83). In short, the comprehensive technological interlink of the transaction partners significantly increases the transparency of the provider’s actions for the customer. With this, the German company is able to immediately identify opportunistic behaviour of the foreign provider in the course of the contractual relationship and to react with appropriate sanctions, even before the end of the respective milestone stage, if it turns out that the foreign partner was not able to perform the contractual arrangements reliably. Thus, the uncertainty related to software transactions is again reduced significantly. Table 13: The monitoring of a foreign software provider by a German customer Interview

No

Original passage/paraphrase

G-II

74

The monitoring of the cooperation partner poses no technological problem and is no issue anymore. These days, you have methods and development tools that allow you to see, in Germany, what happens abroad every day. (p 3)

G-II

75

Today, you are indeed able to see, in Germany, what momentarily happens on a computer in Novosibirsk. (p 16)

BR-I

76

For example, one uncertainty of the customer is losing control. Usually he has a customer and a contract with that customer, with deadlines. He has to deliver good quality. Then there is a problem in the project management: You ask the project manager: ‘Have you started the project?’ He says: ‘Yes’, and he has not. ‘How much have you completed?’ ‘Fifty per cent’, and so on. (Continued)

86 German Contracts with Suppliers in Asia and Eastern Europe Table 13: (Continued) Interview

No

Original passage/paraphrase You lose control of deadlines. So, in the sales process you have to show him that you have a project management system. He can get in, you give him a password, and he can get in to check. (p 9)

BR-VII

77

My people report exactly how they spend their working hours. We had a project here and it cost us 50,000 Euro; it was also Web-based. We made it to keep control. You can plan—you can state from the beginning that there are phases, tasks and so forth. That is one part. Then every member becomes part of a team and can see the tasks it has to fulfil. Then it has to state how the task is solved, so that you can see how the project progresses. And there is another part in which you can find all documents, with access distributed among teams, so that each team can only access the documents that concern its work. Then there is defect-tracking. This means that, if there is a defect, it gets booked who found it, how, etc. Then someone is asked to correct it. And this is done via the Internet. If you have a laptop and a small phone, you can see what you have. The customer is able to see this as well. The system also allows the customer to report defects he has found. The system provides me with control and there’s always a full alarm if something is not right. If we want to win a new customer, we discuss an E-project that allows very good control so that he can see the progress of the project. (p 14)

ING-II

78

One of the things that we make visible to the customer is the early warnings or the way the project is progressing. We use what is known as a portal for this. We give a lot of importance to the governance process. Because, at a project level, the governance is different. At the project level, you have the project manager and the project team, which meets very frequently and which talks of line-level items. Saying this is the activity that had to be performed; it may get delayed because of those things. So, what is it that we need to do? The client says that I need to work with my infrastructure team so that this improves or with my business team so that we get these qualifications. Our project manager says, ‘Alright, I will speed up the current activity on this project level’. This is a common and frequent kind of interaction, based upon weekly reports, based upon the weekly checkpoint minutes. The previous minutes are read, action point seen, risks eventually (Continued)

Private Contract Enforcement Institutions

87

Table 13: (Continued) Interview

No

Original passage/paraphrase identified, evaluated, reviewed, and out comes a report for the governance team and the steering team. The steering team typically is from the senior management teams of both of the companies and then they can provide their direction or take executive action where it is required. (p 28–29)

IND-II

79

So, here you can go to individual reports, here you have status reports, minutes of meetings, a project plan, and a matrix. And then each one of these folders will find me their documents. If I have access, I can see the whole status report here. (p 37)

IND-II

80

The portal contains an early warning system. Green means time is under control to schedule, cost and budget according to schedule, there are no red- or amber-related risks or issues in the project, and things are going fine. Amber means that there is a decision which is responsible for bringing it from yellow to green. Red means immediate attention. Let us say the timeline from here to here is two weeks. And at the end you have a deliverable A. Somewhere in the middle of the timeline, the project managers of both sides will know whether we can make the date or not. Because of that, the portal will turn into amber or red. (p 37–38)

IND-II

81

If the data is not current, then somebody speaks to the project manager and says why the latest information is not uploaded. So, the project manager always updates the portal at the end of the week. Therefore, there is an ongoing check. (p 39)

IND-II

82

The possibility to control starts by breaking the production process into very small pieces—breaking it down to weekly time buckets or monthly time buckets. The most usual time bucket is a weekly time bucket. So, you know that the project status report talks about what has been planned for this week, what has been achieved, and what has not been achieved. So, the client’s project manager can control the process. (p 41)

IND-VI

83

During the initial engagement meeting we decide the kind of reports that they would get—on a weekly basis, or on a monthly basis. And, we also tell them how often we will have telcons with them. Also we have customer portals where they can find out about the project status, what the current state of the project is. They can see the status of the projects and that increases their confidence. (p 9–10)

88 German Contracts with Suppliers in Asia and Eastern Europe The Limits of Self-Enforcing Relational Contracts Despite the extensive technological surveillance, relational, self-enforcing contracts meet the limits of their effectiveness as a business relationship nears the end of its contractual obligations: ‘Specifically, there is a critical risk in paying the last milestone, because it may turn out that the product is still faulty after it has run some time in practice’ (G-IV, 11–12). To avoid this risk, contracts usually contain a clause that obligates the provider to offer corrections to the software free of charge for a certain amount of time (in this case, one year) after delivery. Once again, however, the customer may have difficulty enforcing this part of the agreement, as it has lost an effective means of sanctioning—and, therefore, control—after the payment of the last milestone. As a solution to this problem, experts propose the possibility of either delaying the payment of the last milestone as long as possible in order to retain a means of sanctioning or continuing the repeated game by making further future orders. However, the next section shows that, instead, the mechanism of reputational networks can be of crucial importance for the enforcement of this rectification agreement, transcending the bilateral level.

Reputational Networks Before they begin a business relationship, German enterprises usually consult a list of businesses with whom a potential transaction partner has cooperated with in the past. See Table 14 (nos 85, 94, 95, 101, 98). These reference lists are an integral part of the Web presence of foreign providers and are therefore directly available to German companies.12 In general, German enterprises use these reference lists as a starting point from which they can do further research into the exchange history of a potential foreign business partner. It is common to phone or email the reference providers directly in order to find out how a potential transaction partner actually behaved in past exchange situations (nos 86, 87, 94, 95, 96, 97). Sometimes the management exchanges information not only on potential foreign business partners but also on the personnel that were directly involved in the technical implementation of a project (no 85). The interviewed experts attribute particularly high significance to the references of large multinational corporations because, in the case of large companies, there is a smaller perceived risk that two players would strategically agree to paint too positive a picture of a foreign potential transaction partner (nos 91, 96).

12 See eg: www.sirmasolutions.com/index.php?option=com_content&task=category&se ctionid=7&id =26&Itemid=136.

Private Contract Enforcement Institutions

89

One might question why German customers trust the information given by other companies at all. There is no incentive on the part of the reference provider to help a company find a suitable foreign partner. As a solution to this matter, first, the inquiring company does not ask direct competitors for information, and, second, experts do not disseminate false information within their industry for fear of immediately losing their own credibility and status: If you are asked as an expert by another expert, then you even tell a competitor: this company is really excellent. If you give false information, you can forget about your status as an expert. Things like this spread quickly. (G-II, 14–15)

In other words, the reference providers are, themselves, embedded in reputational networks, which safeguard the reliability of their information. Table 14: The significance of reputational networks for the generation of transactional security from a German perspective Interview

No

Original passage/paraphrase

G-II

84

If you provide a false certificate, your expert status in the industry is gone. This gets around quickly. There are also networks of German companies in Russia. There is an association of companies that operate in Russia, which establishes such network structures. There are a number of structures where such information is exchanged. (p 14, 15)

G-III

85

I ask for a list of references and would then try to talk to the referees at different levels (technology, quality, management). (p 7)

G-III

86

If a collaboration has not been successful, a customer can’t include me in his reference list. (p 13)

G-III

87

We would not enter the market and say that we had a bad experience with a partner. You have to be very careful when you report bad experiences publicly. At meetings of the discipline, and in smaller circles, one naturally tells one’s mind. (p 13)

G-III

88

If a third party reports bad experiences, we have to be careful with information we give. Or to assess a partner so that we don’t collaborate in the end. (p 22)

G-IV

89

Personally, I prefer references to certificates. (p 1)

G-V

90

I went to Tallinn myself and found out that my possibilities are limited when it comes to assessing things. Consequently, I looked for someone who was better qualified, someone who had already worked with the Estonians and someone I could trust because I had worked with him before. (p 2) (Continued)

90 German Contracts with Suppliers in Asia and Eastern Europe Table 14: (Continued) Interview

No

Original passage/paraphrase

G-V

91

A moment ago, I talked about the company in Riga; naturally, there was the question of how reliable they are. And they had a very crisp argument: they are certified by IBM and develop for them. That brought me back into a world I know very well. (p 3)

G-V

92

At a trade fair, companies told us about their experience with Estonia. (p 2)

G-VI

93

In the software industry, reputation plays a highly significant role. Once it is misused a single time, it is destroyed. (p 10)

G-VI

94

Reputational networks function on the one hand via references on the Internet (only good projects). On the other hand, one talks about references. Concrete questions to the potential cooperation partner: Would you mind if we talked with people you worked with before? One knows that in every project you have setbacks: the question is what have they done in such circumstances? (p 10)

G-IX

95

Only very rarely is the Indian software industry able to show commissioned work, due to secrecy. Accordingly, all software companies have their so-called lists of references. They report all customers but only if a customer does not object. But most of the time, if things work out, you can claim you worked for Telekom or the postal service; usually the heads of the IT companies know each other; they call each other and ask: ‘You have worked with them, was that OK?’ (p 12)

G-X

96

Importantly, are the references verifiable? Take Nokia as a case. There is a consumer training for mobiles listed in the references. And we asked whether there is anyone at Nokia able to provide some information. We followed that up, and there was a colleague in Düsseldorf who could confirm that there were orders placed with an Indian company; he told us that they are happy with the quality. If you talk about a major brand like Nokia, the Indians can’t simply call them before and say, ‘Someone will call could you make them happy?’ That’s inconceivable. (p 1)

G-X

97

They asked me, for instance, whether I could provide a reference for similar arrangements after we completed the project. I agreed—that’s give and take. (p 1) (Continued)

Private Contract Enforcement Institutions

91

Table 14: (Continued) Interview

No

Original passage/paraphrase

G-X

98

I would say references are the most important thing. (p 1)

G-X

99

Someone only claim that everything happens according to the contract if he is well meaning, or he can safeguard his belief by seeking references, which allow him insight and questions. How quick are they, are they reliable, how do they produce the documentation of their software development, etc? (p 2)

G-X

100

I would never threaten a partner with an experience I had. If we reach a point at which he doesn’t perform, then I tell him, ‘Look, if you don’t put an effort in, I will tell everyone.’ I would never do such a thing; I believe that would not be OK. But if someone approaches me directly, and I have a bad impression of a company because of its quality and procedures and the result was a disaster, then I would tell. (p 2)

G-X

101

But I would not keep a blacklist and say: ‘Hey, that and that company is a really bad one.’ I also don’t know of any explicit blacklists. (p 2)

G-X

102

And I think that what works is that, if such a thing happens, then the community of companies knows very quickly, without me publicising that they have stolen and sold my software. (p 4)

The crucial factor here is that foreign providers know that their potential customers are in touch with each other and exchange information about them: We think that if we try to give a commitment to the customer and the chances are that we may not be able to meet, then in the long term this causes big problems. It is a network society and word will easily go around. (IND-III, 4)

(See also Table 15, nos 103, 106, 107, 108.) Through this exchange of information, German enterprises generate, in addition to the possibility of ending the business relationship (bilateral governance), a trilateral means by which they can safeguard contract performance by the foreign provider. Thus, against the backdrop of communicating reference networks, in the case of a breach of contract, the foreign supplier faces not only the risk of losing its direct business partner but also the risk that it will not be able to find alternative transaction partners in the future. Once the past behaviour of a foreign supplier is known, not only by its direct opposite but also by other potential customers, a breach

92 German Contracts with Suppliers in Asia and Eastern Europe of contract leads to a loss of its reputation within the ‘business community’ that ultimately renders its survival at the market unlikely (nos 102, 105). As the following passage illustrates, the loss of reputation is seen as such a strong threat to business success that foreign providers only enter into a transaction if they actually believe with some certainty that they can meet the expectations of their customer: It is very competitive work. So, delivery commitments that are made by companies like us, if you don’t do this, it is not just a question of losing that half-million dollars or euros. It is a total lack of credibility in the business. It’s a small world. If I work with Audi tomorrow, they will say, ‘Can you give me a reference of another large German company?’ Now, if I have done a bad job, how can I request a reference? So, I know the repercussions of not delivering. Sometimes I leave it because I cannot deliver. (IND-IV, 17)

Therefore, the online reference-lists make it possible for the German firms to get access to the experiences of other firms even when these firms are not part of their personal networks. The lists generate communication networks that are capable of connecting so-far-unknown firms around the Table 15: The significance of reputational networks for the generation of transactional security from a German perspective Interview

No

Original passage/paraphrase

G-II

103

Russian companies learned very quickly that reputational networks exist and how they work. (p 15)

BR-II

104

We sent them presentations. If they want, they can verify this with the customers. (p 11)

IND-I

105

The decision to go to court is definitely not driven by my ego. My decision to go to court will be purely driven by business interests. If I feel that losing all to this client will hamper my further business objectives, it is going to be a negative mark in my record, I did not fulfil a particular client’s obligations, so, obviously, I will not find further clients in the same industry. I cannot use this client as a reference. I cannot risk that. I have to come clean on this account and say, ‘Look, I fulfilled my obligations. This is what was delivered according to what we have agreed upon, you have accepted.’ Money is important, but not compared to the other business that I can get. In this particular deal, I might lose a few thousand dollars, but over a period of time, I can make up this money by having more business leads. (p 3) (Continued)

Private Contract Enforcement Institutions

93

Table 15: (Continued) Interview

No

Original passage/paraphrase

IND-III

106

We think that, if we try to give a commitment to the customer and the chances are that we may not be able to meet, and then in the long term this causes big problems. It is a network society, and word will easily go around. (p 4)

IND-IV

107

It is a very competitive work. So, delivery commitments that are made by companies like us, if you don’t do this, it is not just a question of losing that half-million dollars or euros. It is a total lack of credibility in the business. It’s a small world. If I work with Audi tomorrow, they will say: ‘Can you give me a reference of another large German company?’ Now if have done a bad job, how can I request a reference? So, I know the repercussions of not delivering. Sometimes, I leave it because I cannot deliver. (p 7)

IND-VII

108

What does the customer do to satisfy himself that I will deliver all that I state? Set aside enforceability. If I make a mess there, the legal course may not be of much help, except it may give some financial compensation. In any case, you have lost something, your reputation in the market. How does the market feel about us? (p 8)

globe. Every company in the world can check the reputation of another company in nearly no time. The Internet thus leads to a new form of ‘information-pooling’ that, in turn, creates new forms of reputational networks that are capable of effectively enforcing agreements in exchange, even outside of close-knit communities.

Reputational Networks and Private Governance Regimes The empirical data also indicate that German companies are supported, on the one hand, by foreign trade chambers and, on the other hand, by various trade associations in their quest for a suitable offshore provider (Table 14, no 102; Table 15, nos 103–8; Table 16, nos 109–13). Foreign trade chambers support German companies mainly by acting as middlemen—passing on the companies’ order requests to foreign members at a cost and then returning offers to the German companies (Table 16, no 117). However, foreign trade chambers formally have no other ordering function beyond this mere brokering activity. They neither publish black lists, in which the misconduct of foreign companies is

94 German Contracts with Suppliers in Asia and Eastern Europe documented (Table 14, no 101; Table 16, no 119), nor do they exclude companies systematically from their organisation when they have breached a contract in the course of a business relationship. The generation of transactional security is therefore not among the official duties of foreign trade chambers. A different picture emerges at the informal level. Employees of foreign trade chambers informally collect important information about the transaction behaviour of their members and pass them on to German companies in order to warn them about business partners with a bad reputation: Reputation is our strong point. We do not publish information about companies, this is not allowed. But we already have this knowledge. And the Indian companies know that we are also very close to the consultants. We are also very close to the German community, on a one-to-one basis. But this is nothing official, because you asked me if there is a process in place. We cannot have this. We cannot say, ‘Here, there is a blacklist’. This is not allowed. We cannot do that. But, the Indian companies know already that we can discuss this issue in different forums. And if a German company should come to us saying: Ok, I am going to do business with such and such company. Do you think that is safe? Do you have a background? We may not even write it down in correct words because then it comes to defamation. But we could always pick up the phone and tell them, ‘No, they have done wrong sometimes, so please watch out’. That we would still do. And we are very closely-knit with the chamber of commerce in Germany, so there is a forum in which we can talk about these things. (IND-VIII, 5, 7)

In short, the foreign trade chambers become an important part of the informal reference networks through which German companies control their foreign transaction partners (Table 16, nos 109, 115, 118). In addition to the foreign trade chambers, various trade associations, such as the BITKOM, support German enterprises in their quest for foreign software suppliers (no 110). A widespread means for promoting cross-border cooperation is the organisation of contact forums, so-called match-making events, to which the trade associations invite both targeted German and foreign companies in order to facilitate business contacts for both sides (no 111). However, like the foreign trade chambers, trade associations refrain from systematically reviewing the transaction histories of the participants in the run-up to these events. Accordingly, an executive of ARIES (the leading association of the Romanian software industry) confirmed that the Romanian companies are not pre-selected before they are allowed to come to a match-making event in Germany. And an executive of BITKOM also stated that German companies are not pre-selected in the run-up to a match-making event. At most, trade associations probe which companies are invited to such events (no 111). This means that trade associations, like foreign trade chambers, focus primarily on the initiation

Private Contract Enforcement Institutions

95

of business contacts and do not create marketplaces with their own rules and arbitration, as would be characteristic for a private legal system based on the principles of lex mercatoria. An account of the importance of trade associations for the generation of transactional security would, however, be incomplete if it were limited to the organisation of match-making events. Much more important is the fact that the association links its members extensively. For example, BITKOM, according to its self-description, represents a big, powerful network and brings together the best minds and companies in the digital world. BITKOM organizes an ongoing exchange between professionals and managers and provides its members with platforms for cooperation among themselves and for contact with key customers.13

About 6,000 experts of the German IT industry are organised in BITKOM’s nearly 100 professional working groups (no 116), and, even if only few working groups address the issue of cross-border software transactions directly, this tight network still implies that German companies are constantly in touch with each other. With regard to transactional security, this means German companies learn ‘very quickly’ (no 112) in an informal way ‘who behaves badly where’ via the networks of the association (no 112). Like the foreign trade chambers, the trade associations also encourage, to a considerable extent, the informal exchange of information between German companies. Thus, they also become an important part of the informal reference networks, but without reaching the degree of organisation of a transnational private legal system. Table 16: The significance of private governance regimes for the generation of transactional security from a German perspective Interview

No

Original passage/paraphrase

G-II

109

For the establishing of personal contacts, network structures—like associations and chambers of commerce—are very helpful. (p 1)

G-II

110

Usually, trade associations are closely involved in the early phases of making contact. (p 5)

G-II

111

Association-like network structures probe which companies are allowed to take part in match-making events organised by the associations. (p 18) (Continued)

13

www.bitkom.org/de/wir_ueber_uns/99.aspx, last visited 2 June 2008.

96 German Contracts with Suppliers in Asia and Eastern Europe Table 16: (Continued) Interview

No

Original passage/paraphrase

G-II

112

Via our networks, we get information very quickly about who misbehaves. (p. 19)

G-II

113

In our working groups, more than 6,000 experts are involved; almost 100 working groups exist. That’s already a rather tightly-knit network. (pp 19, 20)

G-II

114

Today, knowledge transfer is mainly done in physical meetings. But, we are just about to develop a knowledgemanagement system that allows member companies of the association to cooperate. Then information exchange reaches another dimension and you are able to access the reports of third parties via the Internet. (p 20)

G-III

115

The AHK does not offer reports but provides experienced companies. (p 28)

G-IX

116

In India, about 400 companies are members of the Indian chamber of commerce, hence, almost all important companies are covered. (p 7)

G-IX

117

The chamber of commerce supports the process as follows: The request of a German company is anonymously sent to its Indian members; then offers arrive. The German company scrutinises the offers and decides we want to talk with these ten companies. Then, the German company visits India, meets the ten company representatives in the chamber of commerce and visits two or three on their premises. The chamber of commerce requires a fee for this service. (p 7)

G-IX

118

Every company can become a member of the chamber of commerce; there is only a selective process, once the companies can be put into contact with the German partner. The chamber investigates if they are reasonably serious, if they are known, if they have been active in another shape or form. (p 8)

G-X

119

There is no systematic blacklist, because the chamber of commerce usually does not become aware of the way a project progresses. There is rarely any feedback. Information is, rather, exchanged informally in IT networks. (p 14)

G-IX

120

This is also a reputational question. In India, after all you have an independent press and public judicial proceedings. If it is claimed such and such company has stolen my software, then legal action follows, and you have broad press coverage. (p 22)

Key Findings

97

KEY FINDINGS

This study examined which contract enforcement institutions German enterprises rely on when they purchase software in India and Eastern Europe. The findings of the empirical study can be summarised as follows. (Figure 4 provides a visual résumé.) Despite the fact that the enterprises involved usually settle on very detailed contracts, from the perspective of German companies, state contract law is of no significance for safeguarding contractual performance in cross-border software transactions. Contracts are necessary documents in order to participate in modern business life. For the management of an enterprise, they serve as a means of legitimisation vis-a-vis its owners, and they ease communication in intercultural contexts. Furthermore, they are necessary for tax reasons, but they provide no transactional certainty for German customers purchasing software in Eastern Europe or Asia. However, if German businesses cannot rely on both state and private arbitration courts, how do they ensure contractual performance by their foreign offshore providers? First, before a business transaction even takes place, German customers check the reliability of a potential foreign business partner on the basis of that party’s specific investments in its business. Once committed to work with an acceptably vetted foreign provider, the German enterprises make sure to divide transactions into different milestone phases. At the end of each milestone phase, the German enterprise can decide whether it wants to continue or to terminate business dealings. The looming potential loss of future business opportunities keeps foreign suppliers cooperative and deters them from turning opportunist. In short, the businesses, themselves, create the institutional context that enables them to conduct cross-border software transactions. They design the exchange in such a way that contracts are fulfilled without the need for outside intervention or enforcement. The interviews also identify systems of monitoring and reporting that are applied in the global software industry by the German customers to keep an eye on the activities of their foreign transaction partners. In many cases, the German firms get direct access to the supplier’s computer systems via the Internet, so that they can control in real time how the foreign company develops the software product (real-time monitoring). Due to this comprehensive virtual integration of transaction partners, the German customers are capable of immediately deploying adequate sanctions if the foreign supplier does not fulfil its contractual obligations. In sum, the transaction partners use modern ICT to organise the transaction so that it becomes self-enforcing (relational contracting). By dividing the transactions into different milestone phases, the involved actors turn the transaction from a simple prisoner’s dilemma into a repeated game, and the individual milestone phases are virtually monitored to control the process at any time.

98 German Contracts with Suppliers in Asia and Eastern Europe Moreover, German enterprises do not only control the activities of their foreign business partners with the help of bilateral sanctions. Crossborder software transactions are embedded in overarching reputational networks, which consist of other companies, foreign trade chambers, and trade associations. Hence, there is a further mechanism with which German customers can safeguard the contractual performance of foreign providers: In the case of a breach of contract, foreign providers have to fear not only the possibility of losing their direct business partner but also the possibility that they lose their reputation and become excluded from the entire business community due to the informal but intensive information exchange between German enterprises, foreign trade chambers and trade associations (trilateral sanction). Any company in the world can check the reputation of another company in nearly no time. The Internet thus leads to a new form of information-pooling, and, as a result of this process, new forms of reputational networks emerge that are capable of effectively enforcing agreements in exchange even outside of close-knit communities. In addition to relational contracts, the mechanism of reputational networks is of particular significance for German enterprises to safeguard the contractual performance of cross-border software transactions. In contrast, formally organised, private systems of law, which are based on norms of the new lex mercatoria, play no role in the provision of transactional security in this realm. Finally, German enterprises comprehensively use the opportunities offered by new developments in information and communication technology when it comes to initiating or controlling foreign business relations. It is due to such technical innovation that these two informal and spontaneous institutions of contractual enforcement—reputational networks and relational contracts—offer greater transactional security, reduce risk more directly, and are more efficient than systems of formal law (private or public) in the realm of cross-border business. SelfEnforcing Contracts

Reputational Networks

Private Governance Regimes

State Contract Law

High Significance

Medium Significance

Low Significance

Scenario 1 Germany

Figure 4: Overall results of the German scenario

6 How Bulgarian and Romanian Firms Enforce Contracts When Selling Software Products to OECD Countries The platform for a market in large part evolves by trial and error. The mechanisms for transacting develop from the bottom up, via innovations made by the participants.1 (John McMillan)

T

HE LAST CHAPTER outlined the contract enforcement institutions that enable German offshore customers to buy software applications in Eastern Europe or Asia. The second case study changes this perspective and examines how offshore providers ensure the contractual performance of their foreign customers. As with the German scenario, the Bulgarian–Romanian case study starts with outlining the risks entailed in the supply of software. TRANSACTIONAL RISKS

According to Bulgarian and Romanian experts, supplying a software application across borders comes with two main risks: first, the risk that the customer does not pay, and, second, the risk that an offshore customer woos away the staff of the supplier, thereby endangering the future operations of the latter. In order to cooperate successfully, Eastern European suppliers therefore need to ensure that they are paid for their products and services as agreed and that they do not lose their staff to a customer in the course of business dealings. STATE-ENFORCED CONTRACT LAW

This section analyses how much significance Bulgarian and Romanian experts attribute to the possibility of using state enforcement bodies to 1

McMillan, 2002, x.

100 Bulgarian and Romanian Contracts with OECD Countries enforce contractual claims in reducing the transaction risks. Table 17 summarises the interviewees’ answers addressing this issue.

Significance for Generating Transactional Security Similar to the findings of the survey of German experts, 10 interviews in the Bulgarian–Romanian case study contain clear statements stressing that state contract law is insignificant for generating transactional security (nos 127, 128, 129, 130, 132, 133, 134, 135, 138, 139, 141, 143, 144, 145, 148, 152). However, the reasons foreign suppliers give for the insignificance of state law differ from those given by German customers. To recapitulate, German companies argued that a main reason for state contract law’s insignificance is that the authorities of offshore states cannot reliably enforce contractual claims. The Romanian and Bulgarian experts, however, do not share this assessment of the OECD states, in which most of their customers typically reside. On the contrary, the Bulgarian and Romanian experts assume, in principle, that the legal systems of their target countries work (nos 133, 137, 146). In other words, in contrast to their German business partners, Bulgarian and Romanian software companies believe that they do have the opportunity to take legal action in order to ensure that their German customers fulfil their contracts. Practice, however, indicates that the Bulgarian and Romanian software companies, in most cases, cannot afford this form of state-guaranteed transactional security (nos 133, 139, 142, 146, 148, 149, 150, 151, 152). The comparatively young offshore providers in Bulgaria and Romania have to rely on rapid growth in order to keep a share of the very competitive global market. To achieve this goal, they usually allocate all of their resources to the acquisition and completion of orders, thereby foregoing the ability to safeguard cross-border transactions with the help of the law (nos 130, 133, 140, 146). Although the Bulgarian and Romanian companies are very aware that such economic activity comes with large risks attached, they feel that they have no alternative than to accept the contractual risks involved if they want to succeed in the dynamic world market. The following example highlights this point in particular: In Europe all the legality is taken care of, but my uncertainty is not reduced because I am not ready to act on those, if really bad things come along. If I would invest some money, hire lawyers and get all my contracts translated and signed in Bulgaria and some more negotiations on the legal stuff. If I do, I am fine. I do not do them because I am operating with limited amount of resources. What I am doing is trying to check the opportunities that we have, fit those with the resources that we have, and move forward as fast as we can. Dealing with legal stuff for the EU or Japan, for that matter it does not fit into my plan. (BR-V, 4, 6)

State-Enforced Contract Law

101

In addition to the fact that the Bulgarian and Romanian providers cannot usually afford the mechanisms of state contract law in order to safeguard their cross-border transactions, they, like the German companies, argue that the technical complexity of software development renders state contract law meaningless (nos 138, 147). The Eastern European experts are also of the opinion that state courts find it difficult to come to predictable and just decisions when it comes to questions of technical detail. Therefore, along with limited financial resources, the lack of legal certainty in the area of software development keeps Bulgarian and Romanian companies from using state contract law as a mechanism of governance. However, these statements by the Bulgarian and Romanian experts regarding the significance of state contract law concern only the risk of products and services not being paid by offshore customers. State contract law indeed seems insignificant for reducing this risk. Regarding the second risk mentioned above—the wooing away of staff—a somewhat more diverse picture emerges. Contracts about software development usually include a clause that bans foreign offshore customers from employing staff of the foreign provider for a certain period following the transaction (non-solicitation clause) (no 136), and it indeed seems of particular significance to the Eastern European offshore providers that they can enforce this clause with the help of the courts, if necessary: ‘You have to believe in the legal system of the client’s country because otherwise you face a big problem of losing your people.’2 The following example, however, indicates that the wooing away of staff members of a foreign provider by an offshore customer cannot be effectively prevented by the presence of such non-solicitation clauses in software development contracts. After all, if conflicts arise, once again, the financial resources of the expanding Bulgarian and Romanian companies are not sufficient to succeed against their foreign customers. Enforcing their contractually guaranteed legal position abroad causes ‘too much stress’ to the foreign provider, so they do not really consider it a legal solution: A French company took my developers. And what they did is this: they were supposed to pay me after two months. And it was more than two months that they should pay me. So, they delayed. And they said: we will pay you only when we receive a little paper that you accept the modification of the contract. The modification was that the French company can hire my developers. The contract was drafted under French law. To do something against them was too difficult. And I was too stressed about money and paying people. So, it was something on the limit. (BR-X, 8, 9)

2

BR-I, 7.

102 Bulgarian and Romanian Contracts with OECD Countries Thus, although—in contrast with their German business partners— Bulgarian and Romanian software providers see themselves, in principle, as able to enforce contractual claims with the help of state contract law, because they use the majority of their funds to expand quickly, Eastern European companies rarely use this mechanism of economic governance. In other words, state-enforced contract law exists for foreign software providers in the books but not as law in action due to their limited resources.3 As with their German-customer counterparts, Bulgarian and Romanian companies conclude contracts for reasons beyond the mere safeguarding of transactions against opportunistic behaviour. Contracts function, for instance, as a communication document (no 124), and Romanian banks and tax authorities require a contract that documents the transaction (nos 125, 126). Bulgarian and Romanian companies, therefore, need contracts in order to participate in modern economic life. Table 17: The significance of state transaction law for generating transactional security from a Bulgarian and Romanian point of view Interview

No

Original passage/paraphrase

BR-II

124

The contract is a communication protocol that is understandable from both sides. It is not a guarantee that nothing will happen, that we are secure. (p 4)

BR-II

125

In Romania, the banks require a contract when the money comes in from abroad. They want to know where the money is from. (p 6)

BR-X

126

So, we have a contract only when it was needed for me. I asked them about a contract because of the legal situation in Romania. The tax inspector sometimes asks: ‘Do you have a contract?’ Because it is a stupid law in Romania. (pp 3, 11)

BR-I

127

I have been selling offshore developments since 2001, and I have seen no trial. But I saw many contracts which have been cut by either the client or supplier. (p 5)

BR-II

128

Everything is based, from our perspective, on what has happened before, but not on the legal text that is inside the contract. (p 2)

BR-II

129

The main point is not the legal protection that you can gain through some centralized legal frame-work. (p 3) (Continued)

3

Pound, 1910, 12ff.

State-Enforced Contract Law

103

Table 17: (Continued) Interview

No

Original passage/paraphrase

BR-II

130

When we draft contracts under foreign jurisdiction, this does not give us certainty. And this is a business problem regarding to their systems. Do we have the knowledge of how every legal system works? We do not. Then we would have to be a law company, not a softwarecompany. If we have a question, we have a few companies [law firms]. We ask them: ‘What is your advice?’, and we consider. But most important, we have tried to manage the risk through our business rules of operation with our customers. (p 9)

BR-II

131

The milestones costs between 20,000 und 50,000 Euro. For that amount of money, I would not go to court. (p 16)

BR-IV

132

To my knowledge, there is no such case where the Bulgarian company succeeded in enforcing the contract. (p 5)

BR-V

133

In Europe, all the legality is taken care of, but my uncertainty is not reduced because I am not ready to act on those, if really bad things come along. If I would invest some money, hire lawyers, and get all my contracts translated and signed in Bulgaria and some more negotiations on the legal stuff. If I do, I am fine. I do not do them because I am operating with a limited amount of resources. What I am doing is trying to check the opportunities that we have, fit those with the resources that we have, and move forward as fast as we can. Dealing with legal stuff for the EU or Japan, for that matter, does not fit into my plan. (pp 6, 4)

BR-VIII

134

Unfortunately, the laws are not very well set up to solve those kinds of problems. And they are not working with us in this case. (pp 1)

BR-XI

135

From my point of view, if someone will not keep the contract, I do not go to court. (p 4)

BR-V

136

Especially when protecting my assets which are my people mostly—the teams, the know-how that we have ensuring the company, the company secrets, intellectual property—I use the law so I do not lose what I have. I do that with non-solicitation agreements that are US-agreements also with European clients. We have a contractual agreement and a non-solicitation agreement and an NDA [Non-Disclosure Agreement]. And my claims court is the municipal court in New Jersey. (p 6) (Continued)

104 Bulgarian and Romanian Contracts with OECD Countries Table 17: (Continued) Interview

No

Original passage/paraphrase

BR-I

137

You are expected to be treated fairly as a foreigner, going to the judicial system of Germany. (p 2)

BR-I

138

I think the capacity of the state legal system to deal with technical cases is very difficult. It could be difficult in Romania; it probably will be in most countries. (p 3)

BR-I

139

They do not go to court, because it is expensive and takes a lot of time and attention. So, if the loss is not very big, they prefer to accept the losses. (p 5)

BR-II

140

Bulgarian software companies do not have a lot of jurisdictional brain power. We do not think that we can protect our business interests in this way. (p 1)

BR-II

141

Given the fact that software development processes are highly complex and, therefore, subject to failures, it is bad reputation if one invokes the courts fast. (p 17)

BR-III

142

It is a request from an unknown person. We have a contract. Usually when it is a contract with an outside person, if something happened, in the contract it is written that everything will be according to the jurisdiction of the customer. If it is a 10,000 euro project I am doing, and then the customer does not pay me, I have to sue the customer. To hire a lawyer and to send him there to represent me will cost me 50,000 Euros. I say, ‘OK forget it, it is a loss for me.’ (p 3)

BR-III

143

There are never amounts at stake that I would consider suing. (p 4)

BR-V

144

My US clients are really my best clients. I have a good knowledge of US law, and good lawyers, actually in New York. We have 15- to 20-page contracts where everything is meticulously listed, and it is a very clear relationship. I find that, with my European clients, it is not like that. They are much more informal. My lack of knowledge of EU legislation as far as contractual agreements on software development goes, and my inability to get that fast at a reasonable cost prevent me from asking for that at this point. It is completely a company thing. Somebody has the resources or the willingness to do this, I would be much safer, if I had such agreements with, let us say, EU partners, which I do not. (p 2) (Continued)

State-Enforced Contract Law

105

Table 17: (Continued) Interview

No

Original passage/paraphrase

BR-V

145

My point is, we have a French client, we made almost 10 000 GPS devices already with the whole technology, and it costs quite a lot. And it is a good relationship, but he refuses to sign a contract in any language other than French. If we are to disagree with him on any part of the contract, we would have to go to the municipal court in Marseille, which means nothing to me. I cannot possibly win there, I am sure. (p 2)

BR-V

146

In the US, legal certainty guaranteed by state power gives me certainty: in Europe, it does not. But the reason is entirely on my part. I do not have the resources to make this happen. For that, I would need lawyers on our side and where my client is. And some knowledge, even cultural knowledge. I can infer that the company knows something about the legal system. Quite possibly, European law is much better than US law but the fact is that I have good US lawyers and a presence in NY. I, myself, am pretty knowledgeable in what I am doing there contractually, and I have all certainty, if for some reason I do not get paid, somebody solicits my guys. I can go there with my contract and seek an injunction. (p 2)

BR-VII

147

When the project is small, it is possible to specify it very well so that no uncertainties prevail. But, if it is a big project, let’s say for two years including 50 people, this will be very complex in this case, one cannot foresee everything. (p 10)

BR-IX

148

Generally, Romanian companies do not have enough money to go to the courts in Germany. They rather give up. (p 14)

BR-X

149

Usually, with a client, I am just starting things. I am not interested first in the contract, because sometimes it costs you more to write a contract than to develop the project itself. Because contracts for outside Romania are not cheap. (p 5)

BR-X

150

If you are working with a foreign company, the contract is not enforceable in both of the countries. Usually, the contract applies the rules of a single company, of a single country. So for me, I do not know German laws, they do not know Romanian laws. So maybe they put the contract in German laws. And for me to check how the contract is written, I have to talk with a law firm that has connections to Germany and they will charge me, and maybe they ask for more than the value of the contract. (p 7) (Continued)

106 Bulgarian and Romanian Contracts with OECD Countries Table 17: (Continued) Interview

No

Original passage/paraphrase

BR-X

151

A French company took my developers. And what they did is this: they were supposed to pay me after two months. And it was more than two months that they delayed. And they said, ‘We will pay you only when we receive a little paper that you accept the modification of the contract.’ The modification was that the French company can hire my developers. The contract was drafted under French law. To do something against them was too difficult. And I was too stressed about money and paying people. So it was something on the limit. (pp 8–9)

BR-XI

152

I prefer not to go to court. For me, it is too expensive. I give up that option. I reduce the risk in another way, how we manage contracts. In order to reduce the risk of not getting paid, we do phases. (p 4)

Exceptions that Prove the Rule Hitherto in this analysis, the interviews of the Bulgarian and Romanian case study have established that the mechanism of state-enforced contract law is not able to support an Eastern European company that supplies a software application to an OECD country. Among the 11 interviews conducted for this case study, only 1 interview seems to contradict this finding. With respect to the significance of state-enforced law for conducting a transaction, one Romanian expert answers, ‘Legal enforceability of contract is very important to me and it gives me certainty’4 and ‘the risk of non-payment is always legally reduced, contracts which are certain. When I say ‘I have delivered’ and they do not pay me, I go to court, Augsburg, Munich, whatever’.5 Taking a deeper look, it appears that the expert in interview BR-VII attributes more significance to state law and enforcement authorities than his colleagues due to his biographical background. He worked for a German company for more than 20 years. Germany has become his second home. He knows the local customs; he knows the German legal system; he already has experience with the workings of German courts; he has sufficient language skills to understand German contracts and 4 5

BR-VII, 2. BR-VII, 2.

Private Contract Enforcement Institutions

107

knows to which solicitor to turn, if he encounters a legal problem. In other words, due to his long stay in Germany, the expert in interview BR-VII has sufficient knowledge to actually use German law. In sum, however, this exception also proves the rule that state contract law can fulfil its function as a governance mechanism for cross-border transactions only with difficulty. State contract law provides certainty to the Romanian entrepreneur in interview BR-VII only in Germany. With regard to other OECD countries that he does not know that well, such as, for instance, France or the USA, the same argument holds—namely, that the resources of the emerging Eastern European companies are not usually sufficient to actually use state transaction law as a governance mechanism:6 I have a different feeling in Germany as an entrepreneur who was living in Germany for many years. What can be done? How to pursue my rights? Regarding these questions I have a different feeling than somebody who was not there. This is a big advantage for me. So I have more courage to invoke the courts. I know where to go and which are the best lawyers and so on and so forth. In contrast, at the moment we have a contract with a company in Miami and the manager chose Miami as the place of jurisdiction. Now he keeps saying ‘if not, then we go to court’. I have a bad feeling, I would not engage in such an action. Rather I would let some money go, even when it would be my right to claim it. It is very important that you are familiar with the environment. Although I also know the US, I have a very different feeling in Germany. Also in France I do not feel at home.7

PRIVATE CONTRACT ENFORCEMENT INSTITUTIONS

The Bulgarian and Romanian software companies, then, like the German customer companies, do not rely heavily on state contract law when they supply software applications to foreign customers. Yet, if they do not rely on the state, how do Eastern European companies safeguard the performance of contracts by their foreign customers?

6 The following interview passage make obvious that same picture applies to a Romanian entrepreneur, who set up a company in the USA before coming back to Romania. In the US legal certainty guaranteed by state power gives me certainty, in Europe is does not. But the reason is entirely on my part. I do not have the resources to make this legally happen. For that I would need lawyers. On our side and where my client is. And some knowledge even cultural knowledge. In terms of the company knows something about the legal system so that I can infer that. Quite possibly, European law is much better than US law but the fact is that I have good US lawyers and a presence in NY. I myself am pretty knowledgeable in what I am doing there contractually and I have all certainty, if for some reason I do not get paid, somebody solicits my guys. I can go there with my contract and seek an injunction. (BR-V, 2). 7 BR-VII, 11, 12, 13.

108 Bulgarian and Romanian Contracts with OECD Countries The Initiation of Contractual Relationships According to the experts, Bulgarian and Romanian companies do check the reliability of potential business partners before a transaction takes place (Table 18, nos 152, 157, 158). However, this evaluation process is not conducted as thoroughly as in the case of German companies. Only in cases in which a small, unknown, foreign company approaches the Bulgarian and Romanian providers does scepticism arise concerning the financial stability of the transaction partner (no 155). In such situations, the Bulgarian and Romanian companies often require an advance payment before they start to develop software (no 156). However, if the customer is an established company with a robust business model, Bulgarian and Romanian providers usually assume that this company is a reliable business partner (no 153). Under these conditions, the prerequisites for further collaboration on the basis of private governance mechanisms are met quickly.

Table 18: Assessing the reliability of a German customer from the Bulgarian and Romanian point of view Interview

No

Original passage/paraphrase

BR-II

152

Evaluation, history of the company, who are their business partners, something that we can check on the Internet, verify this. (p 2)

BR-III

153

A big company cannot afford to create a lot of noise because they did not pay for a project in Romania. They would be in the papers, they have shareholders, they have a lot of things that they would have to explain to the public. A three-person company would not care—‘We fooled another guy, so what!’ (p 5)

BR-III

154

If someone invests a certain amount of money to build up a business, he shows that he is serious. It is the same with the companies in Romania. Usually, after I contact them, ‘Who are you, how many employees do you have?’ ‘Seventy’, ‘OK. You have an office?’ ‘Yes’. That is why we have such a nice office; we have video cameras outside, all kinds of good networks. This is an investment of two million Euros. If I put so much money in the environment that means that I have the capability to do such a good job. Nobody is investing two million Euros into nothing. (p 11) (Continued)

Private Contract Enforcement Institutions

109

Table 18: (Continued) Interview

No

Original passage/paraphrase

BR-VII

155

A small company does not plan in advance to cheat. But, then it faces a situation where it is running out of money and cannot pay its bills anymore. The company would like to pay, but no money is left. You know what usually happens in these situations? This company never says ‘I am sorry, I don’t have any money at the moment, but you will get your money in two months.’ Most companies start to complain about the delivered product. ‘This is not what I ordered, I wanted something different’ in order to delay the whole process. (p 5)

BR-III

156

You can cover the risk of not getting paid a little bit. Usually, when I have a first time customer, I say, ‘OK, both will have to share the risk. You have to pay me this amount in advance, half maybe’. To be honest, that half covers most of my expenses, so if the guy will not pay me anything else, at least this is covered. But it is no profit. (p 4)

BR-III

157

I evaluate the company practically. I do some research, evaluating the risk of working with that company. (p 17)

BR-III

158

I do some research in the back, send some spies, and see what companies they are on, if they have a solid financial background, if they cheated one another. (p 9)

The Enforcement of Relational Contracts The previous scenario established that German offshore customers divide a transaction into different milestone phases in order to steer the activities of the foreign provider and to enforce contractual claims. Interestingly, the findings of the Bulgarian and Romanian case study show that this kind of self-enforcement of contractual claims is not just unidirectional—it also allows the Eastern European providers to control the behaviour of their foreign customers. Just as a German company can stop milestone payments if a supplier violates contractual arrangements, the provider can stop the process of programming if the customer does not make agreedupon payments for provided services. In short: ‘If I am not paid, I will stop working.’8 In this way, the structuring of the business relationship

8

BR-I, 5.

110 Bulgarian and Romanian Contracts with OECD Countries into different milestone phases allows both contractual parties to control the course of a business relationship (Table 19, nos 159–66). Indeed, the milestone system increases in effectiveness for the providers in the course of a business relationship: the further the development of a software product progresses, the greater the dependency of the German customer on the technical services of the foreign provider. At the end of the contractual arrangement, only the company that produced the software is sufficiently familiar with it in order to provide efficient maintenance of the software application (nos 165, 166). Therefore, in later milestone phases, the provider’s special product knowledge ensures that the foreign customer will not behave opportunistically, but fulfil its contractual obligations as agreed.9 The expert in interview BR-V illustrates how this technical enforcement of contractual claims plays out in practice: Since you make something for somebody, you could possibly have ways to make something just happen. You can put in back doors, etc. That is reality. This is a point of control. If somebody really makes things impossible and you cannot enforce it legally or with bad publicity, then you could turn to the last resort and enforce it technically. And since we are making very sophisticated products, you cannot possibly pinpoint where the problem is. You could just say: I will stop supporting this. (BR-V, 6)

Table 19: The significance of self-enforcing contracts for generating transactional security from a Bulgarian and Romanian point of view Interview

No

Original passage/paraphrase

BR-I

159

You need to take it slowly. You do not get involved with another company from the beginning without doing a test. And usually these kinds of contracts start with small jobs. Even if it is a big project, it is not like ‘I work one year and you pay me next year, for the whole year.’ The buyers define small projects. So the risk is small on both sides. And you generally have to bill every month (for time and material contracts). If the project is based for, let’s say, six months, you do not accept payment after six months, but you define some milestones. (p 3)

BR-I

160

If I am not paid, I will stop working. (p 5) (Continued)

9 Oliver E Williamson, 1975, 44, defines this inversion of the relationships of dependency as ‘fundamental transformation’.

Private Contract Enforcement Institutions

111

Table 19: (Continued) Interview

No

Original passage/paraphrase

BR-II

161

There is a project management methodology. This methodology helps to limit the risk of stages of development cycles. These stages are: customer requirements, specifications, analysis of these customer requirement specifications. Based on this, we provide our purchasing conditions (how much it is going to cost you). After the specification phase, there are eleven or twelve stages in the development cycle of software. (p 8)

BR-II

162

To make sure that these people are going to pay for the things we developed for them, we develop procedures which are incorporated in our contracts with them. (p 3)

BR-II

163

In many cases, the process begins with designing the software—what the software will do and how it will do it. Then the customer is asked, ‘Is this what you mean?’, and we ask them very hard. ‘Read it and sign it.’ Then, it is very a large problem that the customer says after some time that they do not care about what they signed. For this is the framework contract. There is a payment after signing of these documents. Not the full payment, but some payment (20–30%). Because when a person pays something, he is more responsible. (p 7)

BR-II

164

If the customer does not stick to the codes of conduct, we do not continue with the project. (p 17)

BR-VII

165

Interest in a long term relationship is of great importance. If you engage in a relationship with big projects, then the partner—the company in Germany—has great interests in your know-how and that you do the maintenance. There are many dependencies and this is of great importance. If they stop paying us, we can say, ‘OK we do not finish the project’ and this means great uncertainty for the German company. Most products are especially tailored so that only the people who have written the software can conduct cost-effective maintenance. (pp 3–4)

BR-V

166

Since you make something for somebody, you could possibly have ways to make something just happen. You can put in back doors, etc. That is reality. This is a point of control. If somebody really makes things impossible, and you cannot enforce it legally or with bad publicity, then you could turn to the last resort and enforce it technically. And since we are making very sophisticated products, you cannot possibly pinpoint where the problem is. You could just say: ‘I will stop supporting this.’ (p 6)

112 Bulgarian and Romanian Contracts with OECD Countries Reputational Networks Bulgarian and Romanian experts are unsure about the effectiveness of reputational networks to enforce their contracts (see Table 20). They stress that Bulgarian and Romanian companies are rather reluctant to disseminate information tarnishing the reputation of their customers, because they feel that the voice of Bulgarian and Romanian companies does not (yet) possess enough weight in the ‘Western world’, and they fear, furthermore, that bad news affects the image of their own company (nos 167, 168). Thus, Bulgarian and Romanian companies usually refrain from informing the public when a foreign customer is in breach of a contract. However, the empirical findings indicate that association-like structures exist in Bulgaria and Romania, which can be activated if necessary (nos 169, 170, 171, 172, 173, 174, 175). Therefore, even if the entire global business community does not learn about the misconduct of a foreign customer due to such a restrained information policy, information still spreads informally within Eastern European networks. The following example, taken from interview BR-VIII, illustrates how such networks function in practice: It happened once that we did not get paid. And the guys, they are from Austria. And they have a German subsidiary, and the specification was not very clear. So we discussed the specification, and of course when sticking to specifications you cannot deliver on time. And then they said, ‘OK, we cannot accept your project because you did not deliver it on time. We cancel. We will delete your code, which is bullshit’. At first I had some doubts whether the failure was made on our side, but when I returned from a trade fair we did some research and we found the other companies, but only from here. They had problems with the same company. So this is the way they act. So they give bad specifications like those. I just sent them an email that we are very committed to making this public and giving them a hard time. Unfortunately, the laws are not very well set up to solve those kinds of problems. And they are not working with us on this case. But there is an unwritten law. This industry is very small and there are a lot of associations, and there are a lot of companies that do mostly the same thing. And you know some of them, or sometimes in such cases you know a lot of them. Then what you do is, you make the case public. Inside the associations and on the web we hurt them because we know who their customers are, and we make the case public to softwareassociations. So well, they cannot go again and ask for outsourcing services. We connected the threat to make it public with a claim to be paid some money. It is not a big effort; it will take me something like one day to set up all those things: posting the case on the associations’ website with case studies. Then, if somebody needs more information, they can contact either us or the other companies for more information. If there is only one company who has a problem, it is very difficult to say where the truth lies. But, if it is more than one company, two or three, then if we post the same thing, then there is a problem. (BR-VIII, 1, 2, 5)

Private Contract Enforcement Institutions

113

Consequently, Romanian and Bulgarian associations function as catalysts that channel and accelerate the flow of information among network members. This interview passage also stresses the significance of the Internet for the dissemination of transaction-relevant information—because the Internet offers an inexpensive means for the dissemination of information, more information becomes available. As a consequence, even a small Eastern European company, with little weight in the global business community, can contribute to generating transactional security when its information merges with the information of other companies. If the bad reputation of a company becomes firmly established, even a larger German company will sooner or later have difficulty finding appropriate business partners in the respective countries (no 170). Hence, the mechanism of the reputational network helps generate transactional security for Bulgarian and Romanian companies when they supply software applications to an OECD country. Table 20: The significance of reputational networks for generating transactional security from a Bulgarian and Romanian point of view Interview

No

Original passage/paraphrase

BR-V

167

Reputation as a mechanism does not work in my point of view. Any bad publicity is bad publicity for everybody. I cannot say, ‘This client sucks’, as it reflects as badly on me as it reflects on the client. (p 1)

BR-V

168

Bulgarians in the Western World are still perceived of as part of that socialist block which does not really have any chance to do business, which is reality. In that respect, I cannot really frighten anybody who is my supposed client by spoiling his reputation. (p 1)

BR-III

169

It works so well because I do some research in the back, sending some spies and see what companies they are on, if they have a solid financial background, if they cheated one another. It is a big world, but it is small. A fake like that spreads immediately. (p 9)

BR-III

170

Even with regard to big companies, I am capable of spreading the bad news that IBM or another big company behaved in a bad manner. At least in Romania we know all the companies. If they are trying to go to another company, they will trust me, not IBM. I will tell our association: ‘I was fooled by IBM, please inform all our friends.’ They will come again to another company, asking to work for them, the Romanian company will (Continued)

114 Bulgarian and Romanian Contracts with OECD Countries Table 20: (Continued) Interview

No

Original passage/paraphrase ask them about fooling X, they will say: ‘Right now it is totally different’. The Romanian company will say, ‘OK, money in advance. We do not trust you, we can work for you, but we want some money in advance’. Then it will be IBM’s risk because they will pay the money, but they will not be sure if they will have the job done. And these guys will say, ‘If they fooled X, let’s fool IBM. We have the money, OK, you said that X was not right. Or I can give the money to X to cover his expenses, so we are even’. (p 10)

BR-V

171

Of course, informally, I would say to all the vendors that I know in this country: ‘Do not ever work with these guys, because they are not reliable.’ (p 1)

BR-V

172

At this point, with the three major projects that we are doing, we are taking control. First, by retaining some IP rights. Second, by spreading the bad news, not to the vendors, but to the Venture Capitalists. Two of my clients are VC funded. If something really turns sour, I will go for their VC (Venture Capital). I am also VC funded within our business line, and, since I am a US company that is venture funded and those funds know each other, I could always say: ‘Spread the bad publicity’, which is going to kill their business. Third, since you make something for somebody, you could possibly have ways to make something just happen. You can put in back doors, etc. That is reality. This is a point of control. If somebody really makes things impossible, and you cannot enforce it legally, or with bad publicity, then you could turn to the last resort and enforce it technically. And since we are making very sophisticated products, you cannot possibly pinpoint where the problem is. You could just say: ‘I will stop supporting this.’ (p 6)

BR-VIII

173

At first, I had some doubts whether the failure was made on our side, but, when I returned from a trade fair, we did some research, and we found the other companies, but only from here. They had problems with the same company. So this is the way they act. So they give bad specifications like those. I just sent them an email that we are very committed to make this public and give them a hard time. (p 1) (Continued)

Key Findings

115

Table 20: (Continued) Interview

No

Original passage/paraphrase

BR-VIII

174

But there is an unwritten law. This industry is very small, and there are a lot of associations, and there are a lot of companies that are doing mostly the same thing. And you know some of them, or sometimes, in such cases, you know a lot of them. Then what you will do is, you make the case public. Inside the associations and on the web we hurt them, because we know who their customers are and we make the case public to software-associations. So, well, they cannot go again and ask for outsourcing services. (p 2)

BR-VIII

175

We connected the threat to make it public with a claim to be paid some money. (p 2)

BR-VIII

176

All the communication is done by email, and this can prove that the other company tried to cheat. (p 5)

BR-VIII

177

It is not a big effort; it will take me something like one day to set up all those things up: posting the case on the associations’ web site with case studies. Then, if somebody needs more information, they can contact either us or the other companies for more information. (p 6)

178

If there is only one company that has a problem, it is very difficult to say where the truth is. But if there are more than one company, two or three, if we post the same thing, then there is a problem. (p 6)

KEY FINDINGS

In summary, when they supply software applications to customers abroad, Bulgarian and Romanian companies, like the German companies of scenario 1 (see Table 2), generally do not enforce their contractual claims with the help of state transaction law. The empirical results show that in this context, once again, state transaction law remains almost insignificant compared to private mechanisms of economic governance. In contrast to the German customers, this insignificance does not result from the fact that it is principally impossible to enforce contracts in an OECD country. Rather, Bulgarian and Romanian offshore providers do not use state transaction law as a governance mechanism for their cross-border transactions primarily due to a lack of relevant knowledge and financial resources. Bulgarian and Romanian companies safeguard the contractual performance of their customers mainly by means of private governance

116 Bulgarian and Romanian Contracts with OECD Countries mechanisms—the mechanism of the self-enforcing contract complemented by the mechanism of the reputational network. However, because of their transitional status in the ‘Western world’, Bulgarian and Romanian providers could not yet generate effective private governance regimes for contract enforcement. Figure 5 again summarises the findings of the second case study. SelfEnforcing Contracts

Reputational Networks

Private Governance Regimes

State Contract Law

High Significance

Medium Significance

Low Significance

Scenario 2 Bulgaria Romania

Figure 5: Overall results of the Bulgarian–Romanian scenario

7 How Indian Firms Enforce Contracts When Selling Software Products to OECD Countries Spontaneous evolution is the main driver for markets.1 (John McMillan)

T

HE THIRD CASE study, like the second, is also concerned with the perspective of companies supplying a software application to an OECD country. The object of research is, however, no longer the relatively young, developing software industry of Bulgaria and Romania. The focus is rather on India and, hence, on the biggest software exporting country in the world. TRANSACTIONAL RISKS

For Indian companies, cross-border provision of a software application comes with the same risks as already established for the Bulgarian and Romanian companies in chapter six: the danger that the foreign business partner will not make the agreed payments for services provided and the danger that said foreign business partner will woo away staff members of the Indian company in the course of the cooperation. SIGNIFICANCE OF STATE-ENFORCED CONTRACT LAW

What role does state contract law play for reducing these two transaction risks for Indian companies? The empirical findings initially indicate that Indian companies do not rely on the help of state enforcement bodies for enforcement of contractual claims when they provide a foreign customer with a software application (Table 21, nos 182, 183, 184, 185, 186, 188, 189, 190, 191). 1

McMillan, 2002, x.

118 Indian Contracts with OECD Countries Indian companies recognise that it is, in principle, possible to enforce contractual claims with the help of courts in countries like Germany (nos 179, 180). Yet, as in the Bulgarian and Romanian case study, the interviewees recognise that this legal protection remains a fiction in daily business life. It is usually the German customers that determine the shape of the contract and the applicable law (usually the law of their home country). According to the Indian experts, this contractual practice protects the interests of foreign offshore customers much better than those of the Indian providers (nos 183, 186). Indian companies are much less familiar with the legal systems of their foreign customers than with their own (no 181), but, for economic reasons, they cannot refuse to do business with other countries. In the end, this means that they are prepared to supply software applications abroad even without comprehensive legal protection: You write a contract, you say the jurisdiction of the contract is such and such, normally the customer is the king. So they will be insisting: I am here, so the law should apply here. But we do not know what that law is about, how it operates. If you say it is a one million dollar contract, can you say, unless it applies in India, I will not sign the contract? You have to take the risk. Although it is a little bit of an uncertainty from a legal perspective, from business perspective they think the dollar is more important. (IND-II, 2)

In addition, the Indian companies, like the companies in the previous two scenarios, identify the complexity inherent in the development of software development as a second reason for the insignificance of state contract law. Indian companies also stress that it is difficult to design a contract in such detail that a state court can enforce it reliably in case of conflict (no 187). Furthermore, the empirical findings indicate that Indian companies, like their study counterparts, attribute other functions to contracts and state contract law beyond the enforcement of contractual claims. This can be illustrated in particular by the following example given in interview IND-I: My decision to go to court will be purely driven by business interests. If I feel that losing all to this client will hamper my further business objectives, it is going to be a negative mark in my record, I did not fulfil a particular client’s obligations, so obviously I will not find further clients in the same industry, I cannot use this client as a reference. I cannot risk that. I have to come clean in this account and say: look, I fulfilled my obligations, this is what was delivered according to what we have agreed upon, you have accepted. Money is important, but is not very important compared to the other business that I can get. In this particular deal, I might lose a few thousand dollars, but over a period of time, I can make up this money by having more business leads. (IND-I, 3)

This expert stresses that, for him, it is not so important whether or not a court compels business partners to pay when they have violated contractual agreements—‘Money … is not very important’—but that it is crucial that courts support him by rejecting unjustified accusations of opportunism.

Significance of State-Enforced Contract Law

119

Because future business opportunities are of primary importance, the Indian expert wants to ensure that potential customers do not perceive him as an unreliable transaction partner due to unjustified accusations of opportunism. In other words, the Indian provider does not need courts to actually enforce his contractual claims, but he needs them to prove a clean slate among the community of market participants. Ultimately, this means that courts are no longer part of a state legal system which operates with the help of coercion but, rather, become part of the private reputational networks, which function on the basis of repeated interaction.2 Courts serve more to maintain a company’s good reputation within the business community than to enforce contractual claims with the help of state coercion. Table 21: The significance of state contract law from an Indian point of view Interview

No

Original passage/paraphrase

IND-IV

179

In Europe and the US, I am sure that if I have a problem, I will be legally protected. (p 9)

IND-IV

180

I do not have the perception of legal uncertainty in Europe or America because the law of the land is reasonably secured. (p 12)

IND-XI

181

The biggest uncertainty would be how the local law of that country operates. We cannot have absolute knowledge of the laws of the different countries. (p 1)

IND-XI

182

You write a contract, you say the jurisdiction of the contract is such and such, normally the customer is the king. So they will be insisting: I am here, so the law should apply here. But we do not know what that law is about, how it operates. If you say it is a one million dollar contract, can you say, ‘Unless it applies in India, I will not sign the contract?’ No. You have to take the risk. Although it is a little bit of an uncertainty from a legal perspective, from a business perspective they think the dollar is more important. (p 2)

IND-IX

183

The legal situation is always an uncertainty for us. There is an imbalance. The cooperation partners, when they write the contract, they know how the jurisdiction of their country is, how it operates in their country, how the language will be written in the contract, so they will be adequately protected. (p 3) (Continued)

2

See ch 1, section on Private Governance Regimes.

120 Indian Contracts with OECD Countries Table 21: (Continued) Interview

No

Original passage/paraphrase

IND-II

184

IND-III

185

IND-IV

186

IND-VI

187

IND-VI

188

IND-VII

189

IND-VII

190

If you really end up going to the court, it might take three years, five years, and it comes with certain costs. Now how do we reduce this uncertainty to a risk without going to the court? So, if I am doing a project for 200,000 Euros a year, I do not wait for the last month to know whether you are going to pay me or not. I limit my liability to maximum 20,000 Euros. How do I do that? You pay me every month. So, my risk is only 20,000 Euros. Those are the risk mitigation steps that we will take. (pp 12–13) In serious business, you try to avoid any court of law because definitely it will damage your credibility, if somebody is pulled to court. (p 8) In Audi, there is a big lawyer on their side looking at the contracts. And Audi always ensures that they have a 40-page document, and we look at very critical clauses and just sign it because they are not going to alter the contract and we have to do business with them. So they are protecting their interests much more than protecting me. (p 17) The requirements cannot always be specified clearly in the contract. The documents there do not always give you certainty. (pp 2–4) If there is a conflict, we cannot go on and fight with the client because we also want to build a relationship. So, in many cases, we do not stick to our contractual claims but act in a flexible way by putting some extra efforts in the project. It can happen that we hardly make a profit with a particular project. (pp 2–4) First try and evaluate the customer from other sources and find out about the customer’s behaviour in the past with other vendors or business community. These things will give a lot of comfort. Enforceability will not give me so much comfort. (p 9) The damage is already done. It is still a retrieval process. For example, if I am a very large entity, and I am dealing with a big entity, there is always a little inhibition with formal legal processes. There is hesitance on formal legal processes unless the stakes are very large. It is only a retrieval mechanism for me. If I am not sure of the customer, I will not enter the contract simply because it is enforceable. It does not give me comfort. My comfort will be more in building up a good relationship with a good customer than with a bad customer with full legal protection. If this guy goes wrong, I will sue him, recover my money, what do I gain? (p 9) (Continued)

Hybrids: Private–Public Governance Regimes

121

Table 21: (Continued) Interview

No

Original passage/paraphrase

IND-VII

191

If the other company takes away ten people of mine, I may not even bother. I am not too concerned. I would terminate the relationship, without going to court. (p 10)

HYBRIDS: PRIVATE–PUBLIC GOVERNANCE REGIMES

Thus, analysis of the empirical data from the third scenario (Figure 6) establishes that Indian companies that supply foreign customers with software applications do not place great significance on the enforcement mechanism of state contract law. The results of the third scenario show, however, that, in contrast to the two previous scenarios, Indian companies do sometimes use legal means to safeguard the contractual performance of their German customers (Table 22, nos 192, 194, 195, 197). In contrast to their German, Bulgarian and Romanian counterparts, Indian companies do not exclusively rely on spontaneous and informal forms of economic governance; in a few cases they also use formally organised governance provisions of third parties when conducting cross-border transactions. The empirical findings specifically show that the Indian providers use the support of privately established arbitration courts in order to enforce particularly risky contractual clauses, like the ban on the wooing away of staff, vis-a-vis their German customers (nos 195, 196, 197, 198). The following example illustrates this point: In the case that the other company takes away my entire capability in terms of people, I am very much bothered. If that thing happens, it is a good reason to terminate the contract. One of our major partnerships has extensively dealt with non-solicitation. In the contract it is defined what happens in case the other company hires my employees, for example a compensation for each employee or a compensation for all the investments that I have done. We do believe in the enforceability of these contractual agreements as an Indian company going to Europe. First, we give him a notice, telling him, ’You have done this and I am entitled to do this’. Then, if he does not pay the compensation, we normally enforce it in an arbitration court. (IND-VII, 10, 11)

However, it would also be an exaggeration to state that a fully developed, autonomous private governance regime exists in this case. Private arbitration courts neither apply a lex informatica established by the market participants themselves to software development contracts3 nor organise the sanctioning of those parties in breach of contract, as is the case, for

3

Instead usually the law of clients’ states are applied See for this point also: Voigt, 2008, 1f.

122 Indian Contracts with OECD Countries instance, in the global trade of diamonds. However, in the Member States of the UN Convention on the Recognition and Enforcement of Foreign Arbitral Awards,4 the possibility exists that the judgments of privately established arbitration courts can be enforced with the help of state enforcement bodies. Nevertheless, it remains unclear whether private arbitration courts have to rely on the state enforcement of their judgments in order to function as a governance mechanism. In principle, the fear of reputation loss seems to be sufficient to ensure the acceptance of an arbitration ruling by the losing party. Therefore, privately established arbitration courts would seem to be more an element of the reputational networks than part of a state-guaranteed legal order. On the other hand, private arbitration courts usually apply state law to software development contracts, resulting in this mechanism of economic governance showing a strong public component, independent of the enforcement of arbitration rulings. More specifically, private and state elements of economic governance merge into a hybrid mechanism, which cannot easily be squared with the taxonomy of economic governance outlined above. This mechanism is referred to herein as a private–public governance regime because, in these instances, private arbitration courts (private component) come to their rulings on the basis of state law (state component), which are then enforced either with the help of the reputational mechanism (private component) or of state enforcement bodies (state component).5 Table 22: The significance of private governance regimes for generating transactional security from an Indian point of view Interview

No

Original passage/paraphrase

IND-II

192

You could steal my employees. Those are the things I need to lay down in the contract. If you start stealing my employees, ten people, twenty people, even if it takes five years, I have to go to court. The risk is higher than 20,000 euros. (p 15) (Continued)

4 The United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards, in short: ‘New York Convention’, was signed on 10 June 1958 and came into force 7 June 1959. Bulgaria, Romania, India and Germany are members to the New York Convention See: United Nations Commission on International Trade law, 1958— Convention on the Recognition and Enforcement of Foreign Arbitral Awards—the ‘New York’ Convention, available at: www.uncitral.org/uncitral/en/uncitral_ texts/arbitration/ NYConvention.html, last accessed 17 January 2008. 5 See: Dietz and Nieswandt, 2009, 90f.

Hybrids: Private–Public Governance Regimes

123

Table 22: (Continued) Interview

No

Original passage/paraphrase

IND-V

193

Both of us know, if I don’t honour the contract, there are chances that you can take me to court, and you can sue me. In reality, what happens is that there are a lot of things that are there in the contract when we actually sit down and execute the project. There are certain parts of the contract which we just overlook because we are doing it in good faith to each other. But it’s there, we know that it’s there, there is a binding to it and both parties tend to honour it. (p 6)

IND-VII

194

In the case that the other company takes away my entire capability in terms of people, I am very much bothered. If that thing happens, it is good reason to terminate the contract. One of our major partnerships has extensively dealt with non-solicitation. In the contract, it is defined what happens in the case that the other company hires my employees. For example, a compensation for each employee or a compensation for all the investments that I have done. We do believe in the enforceability of these contractual agreements as an Indian company going to Europe. First, we give him a notice, telling him, ‘You have done this and I am entitled to do this’. Then if he does not pay the compensations, we normally enforce it in an arbitration court. (p 10–11)

IND-II

195

We are first providing for the international arbitration which are internationally accepted principles of resolving disputes, which most of our lawyers also know. So we resolve to use arbitration, which is quicker. (p 15)

IND-IV

196

We had a small issue in France, six months back. It was not a problem of non-delivery or non-payments: one of the agents I hired in Germany did not perform the job and therefore I fired him, and he said, ‘No, you cannot fire me, you have to give me another 90 days’. I told him, ‘You had one year, you had to do 2 million euros’. One year later, he had done 0.75 million euros, much below the mark, so I fired him. Now he says, ‘If you had given me another three months, I would have done the thing’. I said, ‘No, I told you one year and you haven’t performed. And if you had performed 1. 8 million instead of 2, I’d accept. You have performed 0.75 million, how can the next three months make a difference’. But he said ‘no’ and went to court. And the court of jurisdiction was (Continued)

124 Indian Contracts with OECD Countries Table 22: (Continued) Interview

No

Original passage/paraphrase international arbitration held in France, in Toulouse, not in a French court but in an arbitration. And the French language. I spent some money—unfortunately I spent 130,000 euros, but, because, you know, again the same problem: he gives his documentation in French in order to understand it, I spent money to do it, I had to hire a French lawyer, and French lawyers definitely are expensive, and the case, even so it was an international arbitration, it took nearly six and a half months, However, at the end of the day, I got my justice. They ruled, and, including 50% of the legal costs, they had to pay us back because the ruling was in our favour. (p 9)

IND-V

197

The contract is for the international chamber of commerce in Paris and the place of arbitration is something fairly mutual. More often than not it is in the country where the company is based. Say, if it is a UK-based company, then arbitration would be held in the UK. Conflicts are not resolved by state courts but by arbitration courts. (p 4)

IND-IX

198

In the contract, we have arbitration clauses. If there is an issue, we go to arbitration (p 10)

PRIVATE CONTRACT ENFORCEMENT INSTITUTIONS

In addition to the private arbitration courts, Indian companies also rely on the informal and spontaneous contract enforcement institutions identified as significant in the other case studies when they supply software applications to customers abroad. For example, interview IND-IV highlights that complex and risky transactions are, indeed, conducted on the basis of self-enforcing contracts, which provide no way for a company to force a business partner to fulfil a contractual agreement: I went to Jordan, and definitely the Jordanian aircraft company found out that I have the capabilities to deliver a software-solution for aircrafts. Then the contracts came and I said, ‘No, I am not interested’, because I was not happy about the fact that it was drafted under the jurisdiction of Jordan. I told them that I want the court outside of Jordan, but they said no, and they said, ‘OK, if you do not accept this, forget it’. So I was confused because also for me it was a very good contract. So I talked to Australians the Jordan company worked with before. And asked: how did you guys accept? And they said: we took a calculated risk, but for the last eight months we feel we have made a mistake.

Private Contract Enforcement Institutions

125

Nothing severe has happened, there were some small delays in the payments, not that they will not honour, only some delays. Then again I weighed the consequences and I said, ‘OK, it is very unlikely that I go wrong on this delivery. There is reasonable cushioning delivery and a reasonable contractual phase to payments’. And then I found out in the negotiation that they badly needed us. Therefore I told them that I wanted 25% payment in advance in every phase. They said no, but I said, ‘It is a give and take. I will not agree on the land of the laws. I am coming down, so you must come down to me’. And finally we did. (IND-IV, 10, 11)

Initiation of Contractual Relationships Like the companies in the earlier scenarios, Indian companies who supply software applications to customers abroad scrutinise potential business partners extensively before transactions take place (Table 23, nos 200, 205, 206). They take great care to choose as business partners only companies that pose a relatively small risk of breach of contract. Indian companies, from the outset, reject potential business partners who appear unreliable: If the risk is very obvious that we are not going to get paid, or if that particular client has been identified as a chronic defaulter, then we will skip that client. (IND-I, 1)

When assessing the reliability of a German customer, Indian providers pay particular attention to two aspects of the potential transaction. First, the Indian companies try to establish whether a German customer is actually interested in a transaction or whether his approach has other, potentially opportunistic, aims, like the wooing away of qualified staff. Therefore, they initially enquire about the customer’s background and motivation in participating in the project: What is the German company doing? What is his objective, what are his plans, what is he trying to do by giving me work, what am I actually doing for him and how much, what does he gain if he breaches? What is his track record? (IND-VII, 12)

The Indian providers also try to assess whether a potential German customer is actually interested in developing a business relationship: [Are they] sitting with us in video conferences in Germany and India, [are they] flying down, [are they] coming here, booking hotels, staying here for an evening or for a week and doing workshops with us? (IND-II, 26)

Second, Indian providers pay attention to the financial stability of a potential business partner in order to avoid the risk of non-payment. Thus, they examine the business model of the foreign company extensively: How long has the company existed? What is its customer base? What is its

126 Indian Contracts with OECD Countries Table 23: Assessing the reliability of German customers from an Indian point of view Interview

No

Original passage/paraphrase

IND-II

199

See, today our view is not to do point projects. That is, you do a project and keep quiet. Outsourcing does not work that way. Our business model is that it is a relationship. Unless the customer on the other side has a long term view, it really does not pay off. India is cheap, let me go and do it. That is the wrong thing, because the investments are more into the relationship and the whole outsourcing effort. So, unless you have a long term view of why you want to do it, it is difficult and it fails. And we have taken baby steps in terms of getting to know—it is a long process—especially for German customers. (p 1)

IND-II

200

See, we do what is called ‘lead qualification’. So, tomorrow you come and say that you are so and so. So we go to independent reports, information that is available as far as you are concerned. For example, this customer of ours happens to be a DAX1-listed company. This means we have a lot of information about them and their business. So from publicly available material, we will have that in our sort of report files basically answering the same questions: How long have they been in business? Are they funded well? What is their market position? What is their reputation? Are they good customers? Who are their customers: who depends on them? Is it a business that is going around for some time? So these are things we try to assimilate from that list. (p 5)

IND-II

201

We draw on the source of public information. Other there is a website, and each will have their own website. Also, they will publish their information about their customers, who they are dealing with, finances, etc. (p 6)

IND-II

202

There is a big difference between DAX-listed companies and small companies with regard to the trustfulness of the information. Because what we feel is that anybody who is listed, his information is publicly available, number one. And it conforms to certain standards, so they will publish according to international accounting standards. Also, the liability is quite high as compared to a privately held company where not much of information is made public. So we need to get the relevant information, whether they are making profits, whether they have the money to fund this whole thing, and how they look at their business going forward, is there stability, growth? (p 6) (Continued)

Private Contract Enforcement Institutions

127

Table 23: (Continued)

1

Interview

No

Original passage/paraphrase

IND-II

203

The amount of money, investment I am ready to run the risk for, differs on the kind of opportunity that we see and the level of comfort that we will have, for the kind of things I described to you in terms of ‘I am not comfortable with all the funding’ and ‘I do not think this business plan is very clear, I do not even want euros’. But if you say that ‘tomorrow Deutsche Bank is coming, they want to do business with us’. I would invest. If there is only one programmer talking to me, I do not know whether he will be there or not. Deutsche Bank will be there. That will be big. (p 9)

IND-II

204

We have finished with our qualification process, and we are sure that this is a reasonably good company. And the client is also investing because their people are investing time. And they are sitting with us in video conferences in Germany or India, they are flying down, they are coming here, booking hotels, staying here for an evening or week, and do workshops with us. And we are sitting and discussing, saying: ‘This is what we will do’. (p 26)

IND-VII

205

There is the due diligence of the client. This would involve a financial check and an overall check of the client: How is the client, what is his track record? (p 2)

IND-VII

206

You start evaluating a person or a corporation step by step. If you look at non-solicitation, is he going to take away my other customers? What business is he engaged in? What is he doing? What is his objective? What are his plans? What is he trying to do by giving me work? What is my engagement with that customer? What am I actually doing for him and how much? What does he gain, if he breaches? If I start asking those questions and get those answers discretely, which I will wage, it will give comfort that I will be dealing with a company who will not do this. (p 12)

IND-I

207

When there is a new client coming, depending on services that we offer, there is an advance payment clause. That is something that we normally do not negotiate. We expect a certain percentage of up-front payment. (p 1)

IND-II

208

I do not count on the enforceability of state law for these 20,000 euros. I will take the risk for 20,000 euros with Deutsche Bank. But if it is somebody xyz, I ask for an advance payment. (p 13)

Deutscher Aktien Index (German share index).

128 Indian Contracts with OECD Countries market position? Who are its creditors? What is its turnover and does the company generate profits? (nos 201, 202, 205) This information is relevant to establishing whether a customer is, indeed, able to finance software development services. As the following example taken from interview IND-II indicates, Indian companies also examine the webpages of their foreign customers in order to obtain such information: There are websites. And each company will have their own website. There they publish the information about their customers, who are they dealing with, finances, etc. (IND-II, 5)

In summary, once the Indian provider establishes that a potential customer (1) can show plausibly why he wants to purchase software development services in India, (2) is willing to invest extensively in establishing a business relationship, and (3) demonstrates a stable financial background, the prerequisites are met for a collaboration based on private governance mechanisms. One additional selection criteria for the Indian providers, like Bulgarian and Romanian companies, to determine the reliability of a potential transaction partner is the distinction between larger globally known and smaller unknown companies (nos 202, 203, 208). Indian companies especially assume that working with a company listed on the German stock index bears a low risk of a contractual breach. After all, listed companies regularly have to publish their key figures according to internationally recognised standards. This establishes significant transparency with regard to the financial situation of a potential customer (nos 200, 202). Furthermore, as the Indian case study shows, the larger companies are seen to exhibit a robust business model and, hence, to have sufficient financial power to actually pay for the services of the Indian providers (no 203). In contrast, if the potential customer is a smaller, little-known company, Indian providers, like Bulgarian and Romanian companies, try to arrange advance payment before they begin to program a software application (nos 221, 222). The Indian case study therefore also confirms the picture that large multinational corporations are, in principle, seen as reliable business partners by the global software industry.

The Enforcement of Relational Contracts As Table 24 indicates, Indian companies, like their German, Bulgarian and Romanian counterparts, emphasise the particular significance of organising business relationships into different milestone phases in order to safeguard software development contracts against opportunistic behaviour (nos 209, 210, 211, 212, 213, 214, 215, 216). Indian providers are also able

Private Contract Enforcement Institutions

129

to control the behaviour of their foreign transaction partners by stopping the programming of a software application if the transaction partner does not provide the agreed milestone payment: ‘To make sure that the client will pay us, there is a tracking system available—milestones. You cannot wait until the end of the project. It is very unlikely that something would happen.’6 Moreover, Indian software producers, like Bulgarian and Romanian companies, know that their offshore customers depend on their knowledge in the course of the business relationship: Dependency is the key point of our business. If I am able to work on a certain system or an application, I gain a certain amount of knowledge. That creates dependency, dependency is in terms of time, not that somebody else cannot learn it and do it. But having learned it, it is easier for him to let me do that work. So that becomes a continuous kind of a dependency situation. (IND-II, 14)

Thus, the Indian company that supplies a software application to an OECD country relies on the increasing effectiveness of the mechanism of the self-enforcing contract during the course of the business relationship (no 214). Table 24: The significance of the self-enforcing contract for generating transactional security from an Indian point of view Interview

No

Original passage/paraphrase

IND-II

209

If you really end up going to the court, it might take three years, five years, and it comes with certain costs. Now, how do we reduce this uncertainty to a risk without going to court? So, if I am doing a project for 200,000 euros a year, I do not wait for the last month to know whether you are going to pay me or not. I limit my liability to maximum 20,000 euros. How do I do that? You pay me every month, so my risk is only 20,000 euros. Those are the risk mitigation steps that we will take. (pp. 12, 13)

IND-III

210

We are also investing from our side in the whole process without getting any result. In that way, we are taking a big risk because we really invest until something is developed. And then the customer is going to accept this only if it is successful: until that point we are taking the whole risk. So, naturally, they also understand. They usually agree to pay a kind of milestone payment. (p 5) (Continued)

6

IND-V, 12.

130 Indian Contracts with OECD Countries Table 24: (Continued) Interview

No

Original passage/paraphrase

IND-II

211

The arrangement is that we get paid after we delivered, but what we do then is that, against each deliverable, we ask for a payment. There will be different work products that happen. For example, a detailed specification, as we understand the scope of the software development, this document is a deliverable. So, against that, we ask for payment. Then, when we complete the whole design, then finally, once we complete the development here and have our independent quality department test the product, we ask for another payment. Then, there will maybe be 20–25% pending when they take their testing. (p 5)

IND III

212

The problem of being fooled is mitigated by the scheduled payment and those kinds of things. At one point of time it is not interested anymore, what we are losing is only the last step of what we have done. (p 15)

IND-IV

213

Actually, every time we go to a prospect we want to make him a customer. That is always an approach of give and take. At the technical level, there will be a very reasonable understanding: this was the expectation and you people haven’t met it. They will explain what is wrong. And we have an obligation to meet it. Therefore, invariably, even if I wrongly interpreted the expectation and I need to put in more efforts for which I may not be paid for the difference, I will ensure the job is done and give it to them. Because, at best, I can require the money for this project, but our relationship will not exist. We will ensure that we can tell him, ‘See, we interpreted this as this, but it seems to be different, however we will do the job, and because of this we have taken extra efforts of x per cent, if you want to pay for it, you can pay, if not, it’s OK’. And invariably, even if they are not able to pay me on that job, they understand and say, ‘OK, we will bill it in the next one’. (p 8)

IND-V

214

I do not think that the vendor and the cooperation partner are opportunistic because there is so much interdependency on both sides. (pp 12, 13)

IND-IX

215

Milestones reduce the financial risks. (p 7)

IND-X

216

We define deliverables in the contract, and the client has to pay on a milestone basis. We do not wait until the last phase. (p 18)

Key Findings

131

KEY FINDINGS

In summary, comparable to their counterparts in the first two scenarios, when they supply software applications to customers abroad, Indian companies do not rely on enforcing contractual claims with the help of state enforcement bodies. State contract law does not create transactional security. Although Indian suppliers can, in principle, enforce contracts with the help of courts in countries like Germany, as with the Bulgarian and Romanian software companies, the lack of knowledge of foreign legal systems prevents Indian companies, in the end, from using the court system as a governance mechanism. Moreover, the findings of the Indian case study indicate that state contract law does not just fail to reduce, but, rather, increases the uncertainty of cross-border transactions. The third case study, however, demonstrates that Indian providers do not exclusively rely on the informal and spontaneous forms of economic governance—as is primarily the case for German offshore customers— they also accept the help of private arbitration courts in some cases. This enforcement system merges state and private elements of economic governance into a hybrid mechanism (private–public governance regime). However, state courts are consistently avoided. In the end, the mechanism of the self-enforcing contract is of decisive significance in the Indian case study, similar to the Bulgarian–Romanian case study. Figure 6 summarises the findings of the third case study. SelfEnforcing Contracts

Reputational Networks

Private Governance Regimes

State Contract Law

High Significance

Medium Significance

Low Significance

Scenario 3 India

Figure 6: Overall results of scenario 3

8 How Contracts between German Buyers and Suppliers from Bulgaria and Romania are Enforced after Bulgaria and Romania Entered the EU METHODOLOGICAL CHANGES

I

F WE LOOK at the figures that summarise the empirical results of each scenario, it is clear that the parties in cross-border transactions do not rely on state-provided contract enforcement institutions because the contracting companies do not consider such enforcement mechanisms as capable of effectively supporting cross-border business transactions. Instead, the results of the first three scenarios demonstrate that the market actors themselves create private, informal institutions—mostly in the form of self-enforcing contracts and reputational networks—to safeguard their transactions against fraud and opportunism. In this chapter, these results are compared to a fourth scenario that adds a dynamic perspective to the book. The literature on law and economic development has often noted that private-order institutions are limited in size and that, therefore, expansion in markets usually leads to a transition to formal state-enforced institutions.1 These transition processes can also be observed in cross-border transactions, namely, in cases where nation states start to cooperate in the field of private international law in order to overcome the fragmentation problems of global legal orders. It will be explained below that, over the last few years, the EU in particular has made significant progress in this realm. What are the practical implications of these efforts by nation states to adapt their legal systems to the demands of a globalised economy? Does international cooperation in the field of private international law in fact lead to significant changes in the usage of private and public-order 1

See ch 2.

Methodological Changes

133

contract enforcement institutions in cross-border transactions? Or, more abstractly, will the spontaneous evolution of informal private governance structures on global markets—as observed above—indeed, be transformed into a formal, state-backed order when nation states start to develop supranational enforcement institutions as a legal framework for cross-border transactions? Scenario 4 is particularly designed to find an answer to these questions. In terms of methodology, scenario 4 follows the first three scenarios. This means that, again, qualitative expert interviews were conducted in the software industry in which the following points were raised: (1) risks of the transaction, (2) significance of state contract law, and (3) significance of private contract enforcement institutions. Again, only transactions that took place between companies that had not yet established a long-term business relationship nor were linked under property law (impersonal exchange) were examined. Due to the specific research question, however, the criteria to select an appropriate case differed in scenario 4 in two critical aspects. First, in contrast to the first three, the fourth scenario investigates cross-border contracts that take place between companies within the European Union (EU). Significant progress has been made within the EU in the last few decades with respect to both the enforcement of foreign court rulings and the harmonisation of substantive contract law. The enforcement of contracts in the EU is increasingly governed by uniform European law rather than fragmented national private law. No other international organisation has gone as far as the EU to create a supranational enforcement structure for cross-border transactions. So, if the empirical findings of this scenario lead to the conclusion that, even in this situation, private mechanisms prevail over public-order contract enforcement institutions, one can assume that such a condition would also hold true for less-integrated markets. Thus, this finding would reinforce the findings of the first three scenarios. On the other hand, if the results show that, within the EU, public contract enforcement institutions gain importance, it can be assumed that a cooperative international policy in the field of private international law can indeed lead to the result that states are capable of providing crossborder markets with a workable legal infrastructure. These results would contravene the findings of the first three scenarios, leaving an interesting question for further research to determine the conditions and requirements that would need to be met in order to create such a supranational order. The second aspect in which this scenario differed from the previous three is the dynamic character of the study. The best strategy for understanding how the design of a supranational legal order changes the significance of public and private contract enforcement institutions is to use a time series analysis. That is why the two countries of Bulgaria and Romania were selected in both the 2005 and the 2010 studies. Bulgaria and Romania were not members of the EU during the time the first empirical

134 German Contracts with New EU Member States Bulgaria and Romania study was conducted, while they are now EU Member States. The results from the study of the new scenario would add scientific value precisely because all methodical aspects of the study were the same as with the previous scenarios, while the study was conducted at a different point in time—namely, after Bulgaria and Romania joined the EU. In this way, it becomes possible to examine, in a methodically controlled fashion, how the process of European integration affects the ability of state contract law to effectively enforce contracts. A renewed study of cross-border business relations in the software industry between German customers and suppliers from Bulgaria and Romania provides a unique research possibility to understand how a cooperative international private law policy affects the significance of private and public contract enforcement institutions on international markets. However, the findings of scenario 4 go beyond this purely qualitative analysis. The results are compared to the statistical results of the so-called Heidelberg Report.2 This scientific report of 2008 was conducted on behalf of the European Commission in order to evaluate the practical application of the so-called Brussels I Regulation (EC) No 44/2001 which—building on the 1968 Brussels Convention—entered into force on 1 January 2002 and is regarded as the most important legal tool of an emerging European enforcement order. Comparing the results of the qualitative empirical study in the software industry with the broader statistical data of the Heidelberg Report significantly enhances the analytical basis of this book. But, before the findings of the second study are outlined in detail, the process of European integration into the field of private international law is briefly presented in order to make clear the ways in which the legal environment for cross-border contracts has changed since Bulgaria and Romania entered the EU in 2007. EUROPEAN INTEGRATION OF PRIVATE INTERNATIONAL LAW

Scholars of private international law widely acknowledge that state contract law cannot fulfil its function to safeguard the performance of contractual obligations in today’s globalised markets with the same reliability as it can in domestic markets. Every state has its own contract law, which is in force within its territory. Therefore, national legal systems could potentially collide once an economic transaction transcends national borders. From the perspective of actors interested in economic exchange, the territorial fragmentation of law leads to three major problems. First, uncertainty may emerge regarding the obligations of the contractual

2

Hess, Pfeiffer and Schlosser, 2008.

European Integration of Private International Law

135

parties, as they can be assessed differently according to the applicable law. Second, it is unclear where the place of jurisdiction lies for the solution of conflicts. And third it is often doubtful whether judgments of one state will actually be enforced in another. One might assume that the collision norms of private international law might ease this situation of legal uncertainty. But, private international law is also national law and, therefore, is affected by the territorial fragmentation of national legal systems in the same way as are other legal fields. Without international coordination, private international law hardly seems capable of providing an efficient legal enforcement structure to support cross-border contracts. Being aware of these fragmentation obstacles to global trade, many nation states have started to negotiate international agreements in order to facilitate bilateral recognition and enforcement of foreign judgments. However, most of these efforts have, at best, led to only slight improvements. Up to the present, nation states have turned out to be very reluctant to open up their enforcement systems to foreign court decisions, tending, instead, to control these processes by very restrictive legal procedures, which are rather inefficient in enforcing cross-border contracts. Nevertheless, compared to relatively un-advanced global legal development, the Member States of the EU have progressed remarkably in the last few decades in integrating their national private-law systems. One of the EU’s greatest achievements is the development of the internal market. Restrictions between Member States have gradually been eliminated in order to enhance free trade and competition. This economic integration has also lead to significant coordination processes in the field of private international law. In 1957, the founding members of the European Community committed themselves to the simplification of the formalities governing the reciprocal recognition and execution of judicial decisions and of arbitral awards. A first step in this direction was taken 11 years later, when the then-six EC Member States agreed upon the Convention on Jurisdiction and the Enforcement of Judgments in Civil and Commercial Matters (the ‘Brussels Convention’). More than 30 years later, this international treaty was turned into the ‘Council Regulation on Jurisdiction and the Recognition and Enforcement of Judgments in Civil and Commercial Matters’ and, hence, into secondary Community law (EC No 44/2001, Brussels I Regulation). The Regulation established a uniform law concerning the recognition of judgments from other Member States that is immediately applicable in all Member States, except Denmark. The Regulation thereby abrogated the complicated and time-consuming exequatur procedure for the recognition of a judgment in the enforcing state.3

3

McKendrick, 2004; Vogenauer and Weatherill, 2006.

136 German Contracts with New EU Member States Bulgaria and Romania In addition to procedural law, the substantive private law was also harmonised in the EU. The 1980 Rome Convention on the Law Applicable to Contractual Obligations was extended in 2008 and turned into secondary EU law. The so-called ROM I Regulation provides uniform rules of conflict-of-law throughout the Member States, except Denmark. Thus, the classic dichotomy between national and international law no longer exists in the EU, because European law steps in between the law of the individual member states. Moreover, in the area of private law the EU coordinates the national policies of its Member States.4 Many scholars who study processes of legal harmonisation in the EU stress that the regulations outlined above are highly effective instruments, since such processes facilitate the settling of cross-border cases with the help of efficient judicial cooperation.5 Whether this is true or not, no other international form of cooperation is characterised by such far-reaching integration in the field of private international law as the European Union, so it will be interesting to find out in what way this supranational legal integration changes both the significance and usage of public and private contract enforcement institutions in the case of cross-border transactions in the software industry between German clients and suppliers from Bulgaria and Romania.

STATE-ENFORCED CONTRACT LAW STILL LIMITED

The first two scenarios revealed that neither German customers nor Bulgarian and Romanian suppliers relied much on state courts and enforcement authorities to secure their cross-border software contracts against fraud and opportunistic behaviour. Interestingly, the fourth scenario establishes that both the passage of five years and the fact that Bulgaria and Romania had become members of the EU in 2007 has not significantly changed the overall picture. Indeed, the most striking result is that, despite the fact that the Brussels I Regulation entered into force in Bulgaria and Romania on 1 January 2007, all company experts—both German customers and suppliers from Bulgaria and Romania—at the end of 2010 declared that they had still never used state courts to enforce their contractual claims with international clients (Table 25, nos 218, 221, 222, 227, 229, 231, 234, 237, 239, 240, 241). One might be inclined to think that no conflicts arise in the software industry that would drive the parties to go to the courts. But this is not the case. In particular, the Bulgarian

4 5

McKendrick, 2004; Vogenauer and Weatherill, 2006. Berglund, 2009; Hess, Pfeiffer and Schlosser, 2008.

State-enforced Contract Law Still Limited

137

and Romanian interviews contain ample evidence of clear contractual breaches—for example, the non-payment of developing efforts—that are not followed by legal actions (nos 224, 230, 233, 241). Indeed, according to one interviewee, the Eastern European suppliers explicitly consider the use of local courts to enforce outstanding payments with domestic clients but do not consider the use of foreign courts for the same purpose with international clients (no 227). The companies clearly perceive the nation states as accommodating the demand for legal support in domestic contexts but not in international trade: The biggest risk is that the customer is not willing to pay. But for local Bulgarian clients the risk is low, because for local companies we can use the Bulgarian law. But with a foreign client we have to go to international courts and that is always a stopper. We do not rely on this mechanism to enforce contracts. (EU-BR-I, 1)

The follow-up study also shows no change regarding the companies’ choice of law for the contracts. Five years later, the contracts are still drafted under the law of the client’s state, which guarantees the clients easy access to the courts. However, despite the fact that the clients, in theory, have easy access to state legal institutions, according to the German interviews, they do not rely on this mechanism, in practice, to actually enforce their contractual claims across borders in real conflicts. The German customers still perceive the legal systems in Bulgaria and Romania as not capable of enforcing foreign court judgments efficiently (nos 217, 218, 219, 221, 223, 226). Consequently, the foreign clients also do not attach much importance to the courts and state authorities to safeguard their cross-border business relations against fraud and economic behaviour (nos 218, 221, 222). Notwithstanding the above, two interview statements seem to disagree with this general picture of the vast insignificance of state contract law. In statements 232 and 235 the experts clearly mention the fact that companies carefully negotiate contracts and try to avoid the risk of nonpayment by putting a clause in the contract that delays the transfer of the intellectual property rights of the designed software to the client until after full payment is received by the supplier. At first glance, these statements seem to indicate a major change that, in contrast to the 2005 study, formally defined and legally enforced property rights—at least from the suppliers’ perspective—might now play an important role in facilitating cross-border transactions in the software industry. However, a closer look at the Eastern European companies’ strategies for actually enforcing these rights in real conflict situations makes clear that these clauses are again part of a bi- and tri-lateral private- rather than public-order governance structure. These clauses enable the suppliers to hold back the source codes of the software until full payment is received. Under this practice, the Bulgarian

138 German Contracts with New EU Member States Bulgaria and Romania and Romanian suppliers only deliver a testable program (executable) to their clients, without including the underlying source codes. The suppliers thereby hold a powerful hostage in order to control the risk of nonpayment by their clients on a bilateral level because, without possessing the source codes, the clients are not able to update, maintain, or modify the software program in the slightest way (self-enforcing contract). Without the source codes, the software becomes rather useless: In terms of intellectual property rights the results always belong to the client. But, as a matter of fact, the source codes can be held back until the last milestone is paid. Each time a milestone is done, only the executables are delivered. These can also be used for testing. But the source codes are not delivered. Contractually the source codes can be held back, until the last payment is made. As an intermediary result the executable is delivered. However for the client the executable is almost useless because he cannot change the software in the slightest way without the source codes and they are delivered not before the end. (EU-G-I, 3)

The German clients understand that holding back the source codes shifts significant parts of the contractual risks to their side. That is why, in most cases, they embed the transaction in virtual organisational structures. As discussed later in this chapter, the follow-up study shows that, nowadays, in comparison to 2005, the foreign clients have even intensified their use of Web-based systems of close monitoring to control the work of their suppliers. This monitoring arrangement usually includes procedural standards that stipulate that, on a daily basis, the suppliers must save the programmed source codes on a server to which both contractual parties have access. Of course, the implementation of these procedural standards means that the enforcement mechanism of holding back the source codes to ensure timely payment is taken away from the suppliers. However, losing this ‘hostage’ enforcement structure does not leave the Bulgarian and Romanian suppliers with no options other than suing their clients in state courts to enforce the contractual clause that intellectual property rights are not transferred until full payment is received. The interview data shows that when real payment problems occur, the Bulgarian and Romanian suppliers can implement trilateral reputational effects. Usually, the European companies who purchase software products in Bulgaria and Romania have clients to which they, themselves, sell. In most cases, the Eastern European suppliers know about the end-clients of their customers, and this knowledge provides them with a starting point for reputational effects. For instance, an Eastern European supplier could threaten to inform his German company-customer’s end-client that the end-client would not be able to use the software that they purchased from the customer because the intellectual property rights had not yet been

State-enforced Contract Law Still Limited

139

transferred from the supplier to the customer pending the settlement of all outstanding bills: What can be a problem and which was our problem with a UK company was that they were not the end customer but partner that provided software for another company. So in this case when there was noise in the channel that they do not want to pay us, you simply tell them that you will inform the end customer, that the end customer actually does not have the right to use what they paid to the intermediary company. (EU-BR-V, 3)

It is easy to imagine how, in a business environment where reputation counts most, this threat to inform the end-client about outstanding payments would pose a serious danger to the future business of the foreign customers who are not willing to live up to the contractual agreements with their Eastern European suppliers. The end-clients would surely not be interested in buying software products that come with unclear and disputable intellectual property rights. So, when, on the bilateral level, the Bulgarian and Romanian suppliers do not maintain the possibility of holding back the source codes, they may still use reputational effects to enforce the payment of outstanding bills; they would almost never consider turning to the public legal system to enforce their contractual claims (nos 227, 228, 231, 234, 237, 239, 240, 241). Thus, according to the analysis of the interview data from the follow-up study, the fact that Bulgaria and Romania now belong to the EU did not have a significant impact on the specific governance structure of cross-border contracts in the software industry. The results show that, just as in 2005, even now when companies draft careful contracts, these contracts are still embedded in a private, rather than public, institutional infrastructure.

Table 25: The significance of state contract law Interview

No

Interview passage/paraphrase

EU-G-I

217

The Romanian court system is practically non-existent. (p 1)

EU-G-I

218

One cannot rely on the mechanism of enforcing a German judgment in Romania according to EU law. (p 1)

EU-G-I

219

In Romania, you have a lot of rights, which are then factually not guaranteed by the Romanian State. (p 1)

EU-G-II

220

Small and medium-sized companies do not use the possibility to go to court. (p 2)

EU-G-II

221

Jurisdiction is, of course, in Germany, but I have never used the German courts so far. (p 2) (Continued)

140 German Contracts with New EU Member States Bulgaria and Romania Table 25: (Continued) Interview

No

Interview passage/paraphrase

EU-G-III

222

I have never sued a foreign business partner. (p 2)

EU-G-IV

223

Cross-border enforcement does not happen often. At some point, the enforcement gets stuck. Although there is a title, the enforcement is not prosecuted. (p 2)

EU-G-IV

224

In order to enforce their outstanding payments from the last milestones, the Bulgarian companies need to employ a German lawyer. But, because they don’t do so, the German companies take advantage of this and don’t pay. (p 3)

EU-G-IV

225

The Bulgarians still have great inhibitions to use legal advice. For the Bulgarians, legal advice is almost impossible to comprehend. (p 3)

EU-G-IV

226

Over and over again, we get absurd judgments in Bulgaria that clearly violate EU law. (p 4)

EU-BR-I

227

The biggest risk is that the customer is not willing to pay. But for local Bulgarian clients the risk is low, because for local companies we can use Bulgarian law. But with a foreign client you have to go to some international court and that is always a stopper. We do not rely on this mechanism to enforce contracts. (p 1)

EU-BR-1

228

We do not have any experience dealing in cases with foreign clients in international courts. (p 1)

EU-BR-I

229

We used local courts to sue local clients, but we never went to court with international customers. (p 2)

EU-BR-II

230

With the French companies that did not pay the last milestones we are just sending a letter by our lawyer, and we are registering this letter. And this is the maximum you can do. (p 4)

EU-BR-II

231

I never went to court to sue a foreign client, not in normal court and not in an arbitration court. We have to take care that the loss is small, and then it makes no sense to go to court. (p 4)

EU-BR-III

232

We make sure that the IP over the product is transferred when the payment is done. (p 1)

EU-BR-III

233

We had just a few cases of customers who did not pay us, both with European customers, and we did not do enough to get our money. (p 3) (Continued)

Insignificance of State-provided Contract Law in the EU

141

Table 25: (Continued) Interview

No

Interview passage/paraphrase

EU-BR-III

234

We never start work without a contract. And we are usually quite careful about what we sign. Especially with bigger companies we spend a lot of time on the contract. But then nobody ever mentions the contract again. We do not use the contracts in front of courts and also our customers have never used the contracts to sue us. (p 4)

EU-BR-III

235

When it comes to protecting our business it is more important to have clauses that say that intellectual property rights are not transferred until we receive the payment, because clauses like that mean that, in the worst case scenario, we end up with a new product. (p 4)

EU-BR-III

236

It should be a very serious break on the side of customer that makes us consider legal action. If somebody purchases software from us and does not pay for development and then makes 10 million euros business, I am obviously going to sue him. But this has not happened so far. (p 4)

EU-BR-V

237

Seventy per cent of our business is with companies outside Bulgaria, fifty per cent with EU countries. Till now, we have not been engaged in court fights at all. (pp 3–4)

EU-BR-VI

238

For a loss of 50,000 euros it makes absolutely no sense to enforce your right in Europe. (p 1)

EU-BR-VI

239

I have never really sued anybody and nobody has sued me. (p 1)

EU-BR-VI

240

I do not have any experiences in cross-border enforcement of contracts. (p 1)

EU-BR-VI

241

In Western Europe when you deal with big companies, the last thing I am thinking of is how to enforce my rights. I would rather cut costs and move on. (p 2)

REASONS FOR THE INSIGNIFICANCE OF STATE-PROVIDED CONTRACT LAW IN THE EU

The empirical results presented in the last few paragraphs raise the question of why, even after Bulgaria and Romania entered the EU in 2007, the significance of state-enforced contract law still remains low. Why does the far-reaching supranational integration in the field of contract law in the EU not lead to a workable legal infrastructure on which market actors

142 German Contracts with New EU Member States Bulgaria and Romania actually rely when they safeguard their transactions against fraud and opportunistic behaviour? The answer that emerges from the empirical data in Table 26 is straightforward: The significance of state contract law remains low because the fact that the transactions are now embedded in a supranational European contract-law order does not significantly change the reasons that were crucial for not using the courts and state enforcement authorities in the 2005 study. The Bulgarian and Romanian suppliers explain that their clients still insist on having the jurisdiction in their country. Consequently, even now the suppliers have to go to a foreign jurisdiction when they want to get access to state support for enforcing their contracts. Again, the point is not that the Eastern European suppliers expect to be treated unfairly in a trial abroad. Principally, the suppliers still believe in the reliability and efficiency of Western European courts and enforcement authorities. However, the point is that the interviewed Bulgarian and Romanian suppliers, even after their countries entered the EU in 2007, invariably consider the use of foreign courts as too expensive. According to statement no 261, the costs of employing foreign lawyers in Western Europe are up to fifteen times higher than the cost of a lawyer in Bulgaria. Furthermore, there are typical costs for foreign plaintiffs, such as translation and travel expenses, which make it as financially impossible for small companies to effectively sue their foreign clients abroad today as in 2005. For bigger, better-financed suppliers, the situation is different. These companies are principally ‘not afraid of’ using foreign courts, but the decision to actually do so is based on a cost–benefit analysis that, in almost all cases, results in the conclusion that the relative costs of a foreign court trial—even within the EU—still exceed its possible gains. Taking all this into account, plus the fact that private institutions can alternatively be used to safeguard transactions against opportunism, it becomes clear why, according to statement 251, the Eastern European suppliers even now generally refrain from seeking comprehensive legal advice when they enter into a contract with foreign clients. It simply does not make sense to plan for legal action when using the law to enforce contractual claims in real conflicts is not cost-effective. The interview data shows that European integration in the field of contract law has not changed this result of the earlier 2005 study. Furthermore, the foreign clients still insist on drafting the contracts under their state’s law. The time series analysis shows that the foreign clients still do not trust the legal systems in Eastern Europe and that it is still important for them not to expose their companies to the risk of getting involved in a lawsuit abroad. In addition, by using this practice, the foreign clients, in effect, prevent the suppliers from having easy access to the courts when severe conflicts arise. However, with this arrangement, the foreign clients face their own set of problems when they actually want to have a court judgment enforced abroad.

Insignificance of State-provided Contract Law in the EU

143

For example, the follow-up study, like the original case study, contains ample evidence that foreign judgments are still not enforced reliably in Bulgaria and Romania. One problem that is articulated in the follow-up study interviews even more clearly than in the first two scenarios is corruption. The expert in interview EU-G-I stated that, ‘If the company owner knows the district attorney or he has connections to the police, then he can delay the enforcement in a ‘Romanian way’ pretty easily’.6 But, the problem considered most serious by the interviewees is the fact that Bulgarian and Romanian judges still do not reliably apply the new EU laws that were drafted in order to make it more efficient to enforce contracts across borders: The German judgment has to be recognised in Bulgaria. The problem is that the judges do not yet know the new EU laws. For instance, now there exists the possibility to immediately enforce uncontested claims in a foreign EU Member State without any further proceedings. However, in Bulgaria this practice is still completely unknown. Nobody even talks about this. (EU-G-IV, 1)

And: The judges in Bulgaria decide according to what they know. Sometimes we try enforcement according to EU Law, but most of the time we adapt ourselves to the situation and leave it to the judges to decide according to the new or the old way. Unfortunately, it is like this. And I would not dare to insist that there is a new EU regulation although they of course had to apply it. (EU-G-IV, 2)

In particular, these two statements make clear that it is one thing to draft a supranational order for contract enforcement ‘on paper’ and another thing to make it actually work in practice. When attempting to enforce a judgment abroad, it is uncertain for the German clients whether the judges in Bulgaria and Romania actually obey the new European rules or still make decisions according to old familiar procedures. In the latter case, the German clients face the risk of additional costs such as high legal expenses, high costs for translations, apostilles, and the employment of local lawyers—costs they would not incur if the new EU rules had been applied correctly. Thus, foreign clients still do not attribute much significance to state law to secure their contracts against fraud and economic behaviour, first, because non-transparency and corruption renders uncertain whether a foreign judgment will be enforced at all, and, second, because of the uncertainty regarding which procedures the judges will actually follow makes it is very hard for the clients to predict the final costs of enforcing a judgment abroad. Together, unclear chances of success and uncertainty about costs render state-enforced contract law generally ineffective for foreign clients in Bulgaria and Romania. 6

EU-G-I, 1.

144 German Contracts with New EU Member States Bulgaria and Romania Table 26: Reasons for the insignificance of state contract law Interview

No

Interview passage/paraphrase

EU-G-I

242

The judges in Romania do not know a thing, and legal proceedings take five years. Of course, Germans are frightened. Where could they find a Romanian lawyer? How could they sue in front of a Romanian court? (p 1)

EU-G-I

243

If the company owner knows the district attorney or he has connections to the police, then he can delay enforcement in a ‘Romanian way’ pretty easily. (p 1)

EU-G-I

244

Germans have the feeling, that in legal terms. Romania is still a ‘Banana Republic’. (p 1)

EU-G-IV

245

I am of the opinion that, meanwhile, the state legal system in Bulgaria has developed positively. The reason is that, by now, better legal practitioners are employed, because the salaries have risen. But, nonetheless, it is still a matter of luck to find a judge who decides well. It may happen that we end up again in a court where a judge who will retire soon does not feel responsible for the decision any more. And, in these cases, it is also possible to influence the court by payments. (p 1)

EU-G-IV

246

The German judgment has to be recognised in Bulgaria. The problem is that the judges do not yet know the new EU laws. For instance, now there exists the possibility to immediately enforce uncontested claims in a foreign EU member state without any further proceedings. However, in Bulgaria this practice is still completely unknown. Nobody even talks about this. (p 1)

EU-G-IV

247

Judges in Bulgaria decide according to what they know. Sometimes we try enforcement according to EU law, but, most times we adapt ourselves to the situation and leave it to the judges to decide according to the new or the old way. Unfortunately it is like this. And I would not dare to insist that there is a new EU regulation although they, of course, have to apply it. (p 2)

EU-G-IV

248

Nonetheless, we could enforce a German judgement in Bulgaria. Only the inhibitions on the German side to actually go through with this are very high. It involves much formal work: apostilles, translations, appendix and then a lawyer has to be consulted. And this causes high costs. (p 3)

EU-G-IV

249

When the enforcement of a judgement is requested in Bulgaria, rather high court fees have to be paid and these costs are lost anyway. (p 3) (Continued)

Insignificance of State-provided Contract Law in the EU

145

Table 26: (Continued) Interview

No

Interview passage/paraphrase

EU-G-IV

250

In order to enforce their outstanding payments from the last milestones, the Bulgarian companies need to employ a German lawyer. But, because they don’t do so, the German companies take advantage of this and don’t pay. In the construction business, we have exactly the same situation. We have many Bulgarian subcontractors that work here in Germany and the last milestones are not paid, and that is by very well-known German construction companies. (p 3)

EU-G-IV

251

The Bulgarians have inhibitions to see legal advice as a precaution. There is no developed legal culture. Very slowly, there are some Bulgarian executives who have maybe studied abroad and have had different experiences and now start to seek preventive legal advice. But there are very few. Bulgarians do not want to pay for legal advice. For Bulgarians, legal advice is not comprehensible. (p 3)

EU-G-IV

252

Bulgarians do not go to court in Germany because of the foreign language and because it is expensive. There are only a few lawyers in Germany who speak Bulgarian. If they take a German lawyer, they must hire a translator. But, in the end this is the same all over the world. (p 3)

EU-G-IV

253

Both the Bulgarian trade association and the industrial association have arbitration courts, and they are really good. (p 4)

EU-G-IV

254

Of course, Bulgarian law was heavily influenced by EU law: the law of taxation, commercial law, consumer protection etc. However the law is one thing. The other thing is whether the civil servants, the tax collectors or the judges also know and apply these laws. Failing this, we face these absurd judgments that, again, clearly violate EU law. (p 4)

EU-BR-I

255

We do not have expertise in dealing with such cases in international courts and it will be extremely expensive since we have to look for some international law companies, local lawyers cannot do this. (p 1)

EU-BR-I

256

Going to court with international clients is going to bring extra expenses for both parties. If you have a lawyer here in Bulgaria, you have Bulgarian law, and you know how the business works here. But, if you go to an international court you need a lawyer who has experience in this field and this is expensive. We are not afraid of doing this, but we always try to avoid this. (p 3) (Continued)

146 German Contracts with New EU Member States Bulgaria and Romania Table 26: (Continued) Interview

No

Interview passage/paraphrase

EU-BR-II

257

If someone from the UK or France goes to court with me in Romania, we meet in five or ten years again to discuss, because this is the time the court needs to decide. And, for me, going to court in Europe is also very difficult. Many times the customers say, ‘In Munich we will manage everything fast’. Yes, if two German companies are involved, maybe. But, for a German and a Bulgarian company, that will really be difficult. We tried once, but, the costs were much too high and we stopped this. (p 2)

EU-BR-III

258

We usually include arbitration clauses in the contract. It will be less expensive and disputes are easier to settle. Customers also find it easier, especially given that it is their law in the arbitration. (p 4)

EU-BR-III

259

The legal costs to enforce a contract are expensive because we typically sign the contract under the law of the customer. (p 4)

EU-BR-V

260

The court systems of the foreign clients in Europe work drastically more efficiently and more quickly than in Bulgaria. But having something like this, the price is definitely higher than the price of fighting in a Bulgarian court. Till now, we have not been engaged in such types of exercises at all. (pp 3–4)

EU-BR-VI

261

We have been working with a French company, for quite some time, with really high volumes and when they went bankrupt, we could do absolutely nothing to enforce our rights, because the expenses were much too high. (p 1)

EU-BR-VI

262

The costs for lawyers to enforce your rights in Western Europe are 10–15 times higher than in Bulgaria. (p 1)

EXCURSUS: STATISTICAL DATA ON THE APPLICATION OF THE BRUSSELS I REGULATION

It is also instructive to compare the qualitative data from this study to the results of another empirical study in the field. Article 73 of the Brussels I Regulation obliged the European Commission to present a report (hereafter the Heidelberg Report) on the regulation’s practical performance within five years of its implementation. In order to prepare this report, the European Commission asked three German professors to conduct a comparative study on the application of the Brussels I Regulation in all Member States. The results were presented to the EU Commission in

Application of the Brussels I Regulation

147

autumn of 2007. The study is based on (a) statistical data about the actual use of the Brussels I Regulation, (b) interviews with professionals in the legal field carried out on the basis of three questionnaires, and (c) a legal, doctrinal analysis. The Heidelberg Report uses two different approaches to analyse the practical performance of the Brussels I Regulation. The first approach is similar to the one used in this book, since the European Commission wanted to find out to what extent the Brussels I Regulation is actually used in practice. However, for the second approach, instead of conducting qualitative interviews with businessmen in a specific industry, the Heidelberg Report gathered broad statistical material about (a) the number of cases in which the Regulation was applied in the Member States in a specific year and (b) the number of recognitions of foreign judgments under Article 32 f. of the Brussels I Regulation made by courts in the Member States. The second approach aims to scrutinise the legal performance of the Brussels I Regulation. The European Commission wanted to determine the place of the Regulation in the present European law. It wanted to find out about the specific legal and doctrinal problems that result from the application of the Regulation, and it wanted to know in which ways the Regulation could be improved in order to avoid future legal, doctrinal conflicts in Member States. Since this book, in general, has no broad interest in analysing the doctrinal consequences of the Brussels I Regulation but wants to assess the Regulation’s empirical significance in European cross-border exchange, the following paragraphs particularly focus on the statistical data provided by the Heidelberg Report, which is systematically summarised in Table 27.7 Although the collection of statistical data proved very difficult for the Report gatherers due to the fact that many Member States do not maintain comprehensive databases about the use of the Brussels I Regulation in courts, Table 27 still makes it possible to draw some very interesting conclusions.

7 All figures in Table 27 are taken from the Heidelberg Report. I have not added any data. According to the authors of the Heidelberg Report the collection of data proved difficult. They write on page 11: The answers received from the national reporters to the first questionnaire asking about statistical data were full of gaps. In the end, none of the national reporters were able to react comprehensively to the set of questions. It is a matter of fact that the member states do not comprehensively collect data on the Judgement Regulation [Brussels I Regulation]. Nevertheless, it was possible to assemble some reliable information … While it is still impossible to draw general conclusions from these investigations, the results add up to a general picture, which combines specific data, rough estimations and individual research. (Hess, Pfeiffer and Schlosser, 2008, 11).

148 German Contracts with New EU Member States Bulgaria and Romania Table 27: Statistical data provided by the Heidelberg Report on the use of the Brussels I Regulation (EC) No 44/2001 in European Union Member States Member State

Application of Total number Brussels I in courts of civil and commercial cases

Application of Brussels I as percentage of all cases

Austria

2003: 12,907 (11.114 from Germany)

2003: 828,472

1.5

England

2004–05: fewer than 50

2004–05: more 0.8 than 6000

Estonia

2006: 17

Recognition of foreign judgments under Art 32 ff Brussels I

2004–06: (England and Wales) 163 2005–06: 1271

France Finland

20–30 per year

Germany

2005: LG2 Passau: 129 LG München: 518 LG Traunstein: 609 LG Karlsruhe: 25–30 LG Kleve: 25–30

0.75 2005: LG Passau: 1404 LG München: 16,876 LG Traunstein: 3684

Greece3

2005: LG Karlsruhe, Freiburg, Kleve: 20–40 LG Frankfurt: 40–60 LG München: 173 Landgericht Traunstein: 301 2004–05: 35

Hungary4

2004–05: 71

Ireland

2006: 20

2006: 200,000

0.035

2004–06: CRC5 of Buda: 17, LC6 of Györ: 10 = 27 in total

less than 17

2003–04: 86

Italy

2003–04: CA Milano: 85 CA Bolzano 74

Latvia

2004–07: 5

Poland

2004–06: 2,500

Malta

2004: 1

2004–06: 7,300,000

0.034

2003–04: Estimation of 430–900 (Continued)

Application of the Brussels I Regulation

149

Table 27: (Continued) Member State

Application of Brussels I in courts

Lithunia

2004–06: 5

Total number of civil and commercial cases

Application of Brussels I as percentage of all cases

Recognition of foreign judgments under Art 32 ff Brussels I

Luxemburg

2004: 420

Portugal

2004: 10

Slovenia

2004–06: 20–30

1

In 2005 the Tribunal de Grande Instance de Paris granted 92 declarations of enforceability, in 2006 (January–July) 30 declarations of enforceability were granted, while the Tribunal de Grande Instance de Versailles granted only 5 declarations of enforceability (January–July 2006): According to the Heidelberg Report the proceedings of enforcing a foreign judgment in France are concentrated in these two specific courts. 2 LG = Landgericht. 3 In Greece the First instance court of Athens and Thessalonica granted about 35 decisions of enforceability in 2003/2004. According to the Heidelberg Report the proceedings of enforcing a foreign judgment in France are concentrated in these two specific courts. 4 According to the Heidelberg Report the proceedings of enforcing a foreign judgment in Hungary are concentrated in the two specific courts mentioned in this line of the table. 5 CRC = Central Regional Court. 6 LC = Local Court. 7 Hess, Pfeiffer and Schlosser, 2008, 12.

The most striking information gleaned from this data is the fact that, although the legal professionals that work with the Brussels I Regulation generally appreciate this new European instrument, its practical relevance turns out to be rather insignificant. The authors of the Heidelberg Report summarise the situation as follows: In the course of the research the reporters got a clear answer from an overwhelming majority of persons interviewed on the Judgement Regulation. They clearly expressed the opinion that this Community instrument is performing well. It was even lauded as a masterpiece of Community legislation. Although some provisions of the Regulation and the case law of the European court of Justice have been criticised by the interviewed persons, the overwhelming majority appreciated the current state of affairs as being satisfactory. However, the satisfaction of stakeholders dealing with the European instrument is somewhat contradictory to its practical application as the percentage of cases where the Judgement Regulation is applied is relatively low.8

8

Ibid, 1.

150 German Contracts with New EU Member States Bulgaria and Romania A detailed look at Table 27 shows that the expression ‘relatively low’ at the end of this quotation understates the fact that this supranational European legal tool is almost insignificant as a legal infrastructure for cross-border trade among EU Member States. The second column of Table 27 contains the numbers of cases in which the Judgment Regulation has been applied in the Member States. Remarkably, in most of the countries mentioned in Table 27 these numbers lean towards zero, for example: Malta 1 (2004), Lithuania 5 (2004–06), Latvia 5 (2004–07), Estonia 17 (2004–05), Finland 20–30, (per year), Slovenia 20–30 (2004–06), Hungary 71 (2005), Ireland 86 (2003–04). One possible explanation for the low number of cases in which the Brussels I Regulation is actually applied in these states is the fact that each one of these is a small country that is legally unimportant because their jurisdictions are typically not selected in cross-border contracts in Europe. In other words, the jurisdiction simply lay in another country. However, apart from the fact, that in this case the number of recognitions of foreign judgments had to be significantly higher in these countries,9 this explanation would not apply to a busy jurisdiction like England. According to another empirical study conducted at the University of Oxford, England is one of the most favoured places for European lawyers to select as a forum for jurisdiction for cross-border contracts.10 Consequently, one would expect higher statistics from the English jurisdiction regarding the application of the Judgment Regulation for cross-border trade in Europe. However, as we can see in Table 27, even in England, the number of cases involving at least one party from a foreign Member State is almost insignificant. According to the LAWTEL database, in more than 6,000 commercial cases over a two-year timespan (2004–05), the Brussels I Regulation was applied fewer than 50 times, which amounts to almost never. There exists no comprehensive data about the application of the Brussels I Regulation in German courts. The reporters therefore turned to single courts to count the cases involving at least one party from a foreign Member State: The numbers are slightly higher than for the other states listed above. For example the Landgericht München counted 518 cases in 2004. For two other of the bigger Member States, namely Italy and France, the Heidelberg Report unfortunately does not provide data about the application of the Brussels I Regulation. One has to draw on the number of recognitions of foreign judgments under the Brussels I Regulation to get an idea about the practical relevance of this supranational European legal tool in those countries. Again, these numbers were very low: 127 recognitions were counted in France and 159 in Italy.

9 10

This is not the case according to the numbers for Hungary. See: Vogenauer and Hodges, 2008.

Application of the Brussels I Regulation

151

When one integrates economic figures with the statistical data about the application of the Brussels I Regulation in these countries, one sees just how insignificant this EU legal instrument really is. Table 28: Foreign trade ratio EU and application of the Brussels I Regulation Member State

Gross Domestic Product/in millions of euros1

Ex- and imports with other EU member states/ in millions of euros2

Foreign Trade Ratio EU in percentage

Year Application of Brussels I in percentage of all cases

Austria

223,453

99,125

44.3

1.5

2003

England3

1,948,518

501,263

25.7

0.8

2006

Germany

2,178,200

875,357

39.6

0.75

2004

Hungary

89,798

91,239

101.6

0.035

2006

Poland

160,273

143,506

53.7

0.034

2006

1 These

numbers are taken from Eurostat, see: Eurostat, 2011b. numbers are taken from Eurostat, see: Eurostat, 2011a. 3 Data is for the United Kingdom. 2 These

The Heidelberg Report provides data about the share of court cases involving at least one party of another EU Member State in the total number of civil and commercial cases for five countries (Table 28). Here, these numbers are compared to the Foreign Trade Ratio EU, which is defined as the share of foreign trade of a specific country with other EU Member States with regard to its Gross Domestic Product (GDP). In contrast to the general Foreign Trade Ratio, the Foreign Trade Ratio EU specifically measures how intensively a country trades with other EU Member States. The data speaks for itself. Germany’s exports and imports with other EU Member States, for example, totalled 875 billion euros in 2004, which equates to a share of 39.6 per cent of the German GDP in the same year. The numbers for Austria (44.3%), Hungary (101%), and Poland (53.7%) exceed that of Germany, while England’s number (25.7%) lies below that of Germany and the others. Thus, every year, all five countries trade goods and services worth thousands of millions of euros with other EU Member States. Clearly, their economies are deeply integrated into the European internal market. When, however, the focus turns to legal statistics, the data points exactly in the opposite direction. Drawing again on the example of Germany, the table shows that, although Germany traded goods and services worth 875 billion euros in 2004 in European markets, the share of court cases involving at least one foreign party was only 0.75 per cent, which means that 99.25 per cent involved exclusively domestic parties. Poland and Hungary

152 German Contracts with New EU Member States Bulgaria and Romania show numbers that are even below 0.1 per cent, while Austria shows 1.5 per cent and England 0.8 per cent. These statistics lead to the conclusion that, although all five countries’ economies are heavily engaged in international trade with other EU Member States, their legal systems remain almost completely national. The Brussels I Regulation is surely not the legal infrastructure that facilitates cross-border trade in Europe. In addition to these conspicuous findings, one other model can be applied to scrutinise the importance of the state courts and the Brussels I Regulation for European trade. This model, which has been created in this book, is called the legal-economic performance rate. Unfortunately, the data of the Heidelberg Report only allows this model to be applied to Austria and Germany and, even in these cases, the data is limited.11 However, even this small sample significantly enhances our understanding of the legal environment of cross-border contracts in the EU.

Domestic Legal-Economic Performance Rate The concept is very simple. The starting point is again the GDP12 of a specific country. However, this time the country’s exports13 are subtracted from it. In so doing, we get an idea of how much economic value creation derives from purely domestic transactions. Regarding Austria this operation would be: 223 billion GDP minus 79 billion exports = 144 billion domestic value creation (DVC). This number is then divided by the total number of domestic court cases involving exclusively Austrian parties. This number is roughly calculated by subtracting the number of court cases involving at least one foreign European party from the total number of cases.14

11 For Austria the report indicates the following numbers. In total, there were 12,907 cases in civil and commercial matters (not including social security) involving parties from one of the EU Member States. Given these numbers, however, it is unclear exactly what civil and commercial cases mean. In the following it is assumed that it includes those kinds of court cases which fall into the scope of the Brussels I Regulation. The same is assumed for the total number of civil and commercial cases, which for Austria was 828,472 according to the Heidelberg Report. See: Hess, Pfeiffer and Schlosser, 2008, 12. 12 This number and all following numbers are taken from Eurostat: See: Eurostat, 2011a, Eurostat, 2011b. 13 Only the exports are subtracted because in calculating the GDP imports are already subtracted. 14 This is just a rough number because there are also foreign cases involving parties of non-EU Member States. Ideally, these cases should also be subtracted to get the real number of purely domestic cases. However, given the high percentage of Austrian exports in other EU Member States this number is assumed to be not very large, and, therefore, as not having an important impact on this model.

Application of the Brussels I Regulation

153

Both numbers are again taken from the Heidelberg Report. The numbers for 2003 are: 828,472 total civil and commercial cases minus 12,907 cases involving at least one party of another Member State (CIAMS) = 815,565 cases involving domestic parties (CIDP). With the help of these two numbers, we can determine how important the domestic Austrian courts are for the domestic Austrian economy. We simply need to divide domestic value creation (DVC) by the number of domestic court cases (CIDP). For Austria the numbers are: 144 billion (DVC) divided by 815,565 (CIDP) = 176,832. This means that, on average, in Austria, one court case corresponds to an economic value creation of 176,832 euros. The domestic legal economic performance rate (DLEPR) for Austria in 2003 is 1/176,832.

European Legal-Economic Performance Rate The model proceeds by comparing the domestic legal economic performance rate to the so-called European legal economic performance rate (ELEPR). To calculate the latter, one takes the total number of Austria’s imports and exports with other EU Member States (EVC) in order to get an idea of the amount of economic value creation that stems from trade with other EU Member States. The number of exports plus imports in 2003 = 99 billion euros This number is now divided by the number of court cases involving at least one foreign European party (12,907), multiplied by two (CIAMS).15 The idea is now to determine how important the Austrian courts are for Austria’s foreign trade within the European Single Market. The numbers are: 99 billion (EVC) divided by 25,814 multiplied by 2 (CIAMS) = 3,839,970. This means that, in the European context, one Austrian court case corresponds to an economic value creation of 3,839,970 euros. The European legal economic performance rate for Austria is thus 1/3,839,970.

Domestic versus European Legal-Economic Performance Rate This model’s final step consists of comparing both results. If, in the case of Austria, the European legal economic performance rate is divided by the

15 By multiplying the number of court cases involving at least one foreign European Party, I control for the fact that Austrian parties, when engaged in cross-border European trade, could also use courts in another member state.

154 German Contracts with New EU Member States Bulgaria and Romania domestic legal economic performance rate, the result is 21.7. This number means that, on average, Austrian parties use state courts 21.7 times less in European cross-border trade than in the domestic contexts. Specifications At this point it should also be taken into account that of the 12,907 Austrian cases involving at least one foreign European party, 11,114 cases involve a German party. Of course, Austrian’s share of foreign trade with Germany is also very high, at about 30 per cent. Still, this number does not explain why about 86 per cent of all Austrian court cases involving a party from an EU Member State involve a German counterpart. If both Austria’s foreign trade with Germany and the number of court cases involving a German party are excluded from the model, then the European legal economic performance rate for Austria rises dramatically from 1/7,679,931 to 1/39,351,366. This result shows that, excluding Germany, Austrian parties use Austrian courts even 111.3 times less in the European foreign trade context than in the domestic context. Interestingly, the particularly high use of Austrian courts in Austria’s external trade with Germany also works the other way. The data provided by the Landgericht Traunstein, which is a regional court located at the Austrian–German border, shows that, at that court, there were a total of 3,684 civil and commercial cases in 2005 from which 609 cases—about 16 per cent—involved a foreign party. Yet, according to Table 28, the average percentage of court cases involving a foreign European party in all of Germany is about 0.7 per cent. Having recognised the particularly high number of cases involving Austrian parties, the authors of the Heidelberg Report extended their examination to other border regions, but it turned out that the findings for the Landgericht Traunstein are really unique. Neither the courts at the border with the Netherlands (Landgericht Kleve) nor the courts at the border with France (Landgericht Karlsruhe) show similar numbers. As can be seen in Table 27, these regions report very low numbers of cases involving a foreign European party. The Austrian– German border region is the only exceptional case. To summarise, the Heidelberg Report uses a much broader statistical approach than does the qualitative case study about cross-border contracts in the software industry, and it gets similar results. First, the Heidelberg Report clearly supports the view that the Brussels I Regulation and state courts are almost never used as a legal infrastructure in the new Eastern European Member States to facilitate cross-border exchange in the EU. This result agrees with the result determined from the Bulgarian and Romanian expert interviews presented in chapter six. It is even more interesting that the results do not differ significantly when applied to

Informal Private Ordering Still Evolving

155

the older Western European Member States, which are all well known for their reputable legal systems. All of these countries have undergone profound economic transformations in the last few decades, integrating their economies deeper and deeper into the European internal market. At the same time, however, their legal infrastructures have remained almost completely nationalised. Similar to the results obtained in the qualitative case study, the calculation of the legal economic performance rate for Austria makes clear that the courts can play a very active role for economic exchange, but only in domestic contexts. The fact that there is a huge difference in the usage of the courts for domestic transactions and cross-border transactions strongly supports the conclusion that national legal systems lose their effectiveness the moment a transaction crosses a nation’s border. The Brussels I Regulation only seems to play a more important role for foreign transactions taking place in the Austrian–German border region. This exception is not surprising, however, as the region builds on a centuries-old intensive trading history and, more importantly, the people of this region speak the same language, even the same dialect. So, one can conclude that the Brussels I Regulation might work, but only under very exceptional cultural and linguistic prerequisites which are absolutely not present in almost all cross-border trading contexts in Europe. In a nutshell: The so-called Brussels I Regulation, which regulates the recognition and enforcement of foreign judgments in civil and commercial matters in the European Union, is not actually used very often by the Member States of the EU. It surely is not the legal instrument that market actors rely on when they engage in transactions in European markets. This holds true for both the new Eastern European Member States and, more surprisingly, also for the older established Western European States. Although EU Member States have deeply integrated their economies into the European single market, their legal systems remain national. The Brussels I Regulation is not providing the institutional infrastructure that facilitates cross-border trade in Europe.

INFORMAL PRIVATE ORDERING STILL EVOLVING

Seeing these results, the question arises of which institutions market actors actually rely on when they engage in cross-border transactions in Europe. In other words, the focus turns again to the qualitative interview data and the significance of private-order contract enforcement institutions. The following examines whether the use of these mechanisms has changed significantly since the first two interview scenarios were conducted in 2005.

156 German Contracts with New EU Member States Bulgaria and Romania Generally, the results of the 2010 scenario match the empirical results of the 2005 scenarios. Five years later, the actors in the software industry, still mostly by themselves, create the institutional settings that enable them to engage in complex cross-border transactions. In the run up to a transaction, the actors thoroughly check the reliability of their potential business partners. After choosing a partner, they divide the transaction into milestone phases and the transactions are controlled by virtual systems of close monitoring. Furthermore, the transactions remain embedded in subordinated reputational networks in which relevant information is exchanged within the business community based on the reference system. Furthermore, a closer look at the qualitative interview data of the 2010 scenario reveals that these informal private-order contract enforcement institutions have improved their efficiency in the last five years. The most significant of these improvements involve increased application of virtual monitoring systems to control the business relation and the additional use of virtual social networks to spread and gather information about the reputation of potential business partners.

Virtual Systems of Close Monitoring The experts interviewed in the 2005 study reported that comprehensive technological interconnections of transaction partners significantly increase transparency. The German customers, in particular, benefited—by using such monitoring, they were able to immediately identify opportunistic behaviour of the foreign providers in the course of the contractual relationships and to react with appropriate sanctions, even before the end of the respective milestone phases. According to the qualitative interview data from the 2010 study, the use of these virtual monitoring systems has even increased in the last five years. In 2005, only 2 out of 10 Bulgarian and Romanian and only 1 out of 10 German experts explicitly referred to such technological monitoring; in the follow-up study all of the interviewed experts did so, including experts from smaller firms, which did not generally use this form of virtual transactional control five years ago (Table 29, nos 263–72). Indeed, in 2010, the interviewed experts explained the application and significance of virtual monitoring systems in much greater details than in 2005. As can be seen Table 29, in 2005, it was mostly the big and wellknown Indian firms that extensively used systems of close monitoring for the purpose of creating transactional security across borders. However, five years later, the same extensive use of virtual control systems can be observed in Bulgaria and Romania. Thus, it has become a routine practice

Informal Private Ordering Still Evolving

157

in even the countries with newly developing software industries to use virtual systems of close monitoring and to give the clients real-time access to these systems so that they can effectively control the contractual relation. The following interview passage further illustrates this point: In the case the customer is interested we also use a Web-based monitoring system, we use systems like Trac. This is a relatively new tool. You have tickets for each piece of the work. Both sides can see what is going on with the development, the quality etc. For larger projects the customer expects additional information to be put in. Yes, we use these systems of close monitoring and the customer usually wants to see what is going on. Trust is created by the fact that we are ready to give it. The fact that the customers have all necessary access to the information to drill down as deep as they want and see what is going on, this really creates trust. (EU-BR-V, 2)

Today, there exists a whole range of standard solutions for close monitoring efforts which can either be bought at the market for a reasonable price or downloaded for free as open source systems (nos 265, 271, 272). Five years earlier, these opportunities were not available to the Bulgarian and Romanian suppliers. Otherwise, it would not have been necessary for a smaller Bulgarian firm back then to spend the amount of 50,000 euros to develop its own virtual control systems (Table 13, no 77). Today, with mass circulation, the price of such virtual control systems seems to have fallen significantly, with the result that these systems have gained in efficiency and are thus applied more frequently than five years ago. Once again, it is not the states’ implementation of a working global legal infrastructure that meets the demand for effective institutions to back up cross-border exchange but the development, by private firms, of interorganisational control systems that make it possible to effectively monitor contractual relations, no matter where the contractual parties are located. The basis for these governance structures is not the state but, rather, the Internet and the World Wide Web. Table 29: The significance of virtual close monitoring systems

1

Interview

No

Interview passage/paraphrase

EU-G-I

263

We use servers to save the programming results on a daily basis. Everybody can see the progress of the software development. Actually, this is similar to an own employee who shows his results every day. (p 2)

EU-G-I

264

Besides, we work with ‘Wiki Enterprise’.1 This is used to administer testing results, meeting minutes, etc. (p 3)

This is a Web-based project management tool.

(Continued)

158 German Contracts with New EU Member States Bulgaria and Romania Table 29: (Continued) Interview

No

Interview passage/paraphrase

EU-G-I

265

The German clients bring their own control means. For example, there is a tool called ‘Tracer’ which makes it possible to delegate tasks, then it is recorded who has completed the task, and, when a failure (bug) occurs, the German clients can say that it needs to be corrected. Using these systems, the foreign supplier works for the German client as if he were his employee. The names of these control tools are Mantis or Gira. (pp 2–3)

EU-G-II

266

The whole project is captured by a tool, and the client can see exactly how far along the development of the software is, which steps have already been reached and even the source codes are deposited so that the client sees that the progress has not only been made in theory. And the client has time control This gives a good feeling. It is possible to see if the development actually meets the specification sheet. (p.1)

EU-G-III

267

We have a very strict process. All documents are upto-date, specifications, used cases. All documents are transferred to a portal, source codes included. I can see all this on the Internet, and the documents are always up-todate. (p 2)

EU-BR-I

268

We have a special system for task management. We monitor the general progress of the project. We use Webbased systems. The project manager on the other side has access to this system, so they can monitor as well, put in some tasks and commands. (p 2)

EU-BR-I

269

These monitoring systems are important for good relations with the client. Sometimes the virtual monitoring systems cause some trouble. Sometimes, some things may happen slower than expected by the customer, and this can be seen. But, overall, it is giving a good impression to the customer, because they feel in control of things. They can see a snapshot of the real situation: Even if they do not like it, it is useful for everybody. (p 2)

EU-BR-II

270

To control the software development process and for customer relations we use a ticketing system, we are registering issues and manage these issues. We also use the controlling modules for controlling the time that each employee spends for managing one task or issue. It is a Web-based system, so the client can also see parts of this information. (p 3) (Continued)

Informal Private Ordering Still Evolving

159

Table 29: (Continued) Interview

No

Interview passage/paraphrase

EU-BR-III

271

Four years ago, we purchased a system which is the best project and portfolio management system on the market according to Gardner. We use this for planning the projects and monitoring the projects. Some of our customers have direct access to this system, so that they can monitor the team’s work on a daily basis. This is one of the steps that help us to create credibility. The customer sees that we are serious company. We have invested a lot in our processes and in our IT systems and this is something the customers appreciate. The customer also appreciates the opportunity to monitor our progress. The fact that we are so transparent also helps our credibility. (p 4)

EU-BR-V

272

We use systems of close monitoring—CMMI Level 3. Each of the projects is under a quality and information system control, which is not only configuration management but a project management system. (p 2)

EU-BR-V

273

In the case the customer is interested we also use a Web-based monitoring system: we use systems like ‘Trac’, a relatively new tool, you have tickets for each piece of the work. Both sides can see what is going on with the development, what is the quality, etc. For more plan-oriented projects we use an MS project server for this purpose. For larger projects, the customer expects additional information to be put in. Yes, we use these systems of close monitoring, and the customer usually wants to see what is going on. This is in cases when the customers have appropriate personnel on their side to be able to significantly influence not only what will be delivered from a functional perspective but also how it will be delivered. When they have some additional teams on their side with which we integrate, then this information is valuable for them. Trust is created by the fact that we are ready to give it. The customer starts using it, and, after the first weeks of detailed checks, they see that things are controllable. And then they just do background checks from time to time to see the real situation. But the fact that we are so open really creates trust. The fact that the customers have all necessary access to the information to drill down as deep as they want, and see what is going on, this really creates trust. (p 2)

160 German Contracts with New EU Member States Bulgaria and Romania Reputation and Virtual Social Networks In the analysis of the 2005 study, it was explained in great detail that reputation is a crucial factor to enforce contracts in cross-border transactions in the software industry. We saw that the German customers, in particular, used references freely available on the Internet to investigate the transactional history of potential suppliers and exchanged information within networks consisting of companies, foreign trade chambers and trade associations. The Bulgarian and Romanian suppliers were aware of the fact that their potential clients exchanged information about them. Thus, if the suppliers were accused of a breach of contract they did not only fear losing their actual business partner but, against the backdrop of communicating reference networks, they also risked being excluded from future business opportunities. Comparing these five-year-old results to the 2010 findings, it becomes apparent that the impact of reputational networks has even increased. The main reason for this is that, currently, information about the past conduct of potential business partners is exchanged not only in the ways described above but also within business-oriented social networks, such as LinkedIn or XING (Table 30, nos 274–79). It is fair to say that, today, all managers involved in software business are members of at least one of these social networks.16 Therefore, it is very easy to locate one member within the virtual community and to see who her contacts are. Since social networks are usually divided into specialised sub-groups—for example, a particular group on outsourcing and software-development—it is almost certain that the actor who behaves opportunistically and the actor who is the victim of this behaviour have many contacts in common. So, if the actor who has been cheated communicates with his network, there is a high risk that information about the cheating manager will spread around: If your existing customers go away and become unhappy with your services this would be very drastic. Today with social networks I would expect that if your customer becomes unhappy that could close your business pretty fast because the community is small. Everybody is now on LinkedIn. There are a couple of systems where people are in the position to exchange opinions and to check everybody’s personal networks. (EU-BR-III, 3)

This quotation shows that the Eastern European suppliers know that their clients exchange information within social networks and that this practice could have severe consequences for their future business. Obviously, with social networks, it is impossible to control who gets in contact with whom and what information will spread around.

16

This most probably holds also true for other industries.

Informal Private Ordering Still Evolving

161

Furthermore, according to interview EU-G-1, it is possible that information originally generated in the network community spills over into the general World Wide Web (no 275). As a consequence, a simple Google search can reveal harmful information. So, actors behaving opportunistically are potentially exposing themselves to the risk of being known as ‘bad guys’ on the World Wide Web. Social networks have a second impact on the behaviour of actors in the global software industry. As a result of their organisational structure, the members of social networks are individuals, not companies. This makes an important difference in the reputational context, compared to the company-based reference system explained above in the 2005 study. Imagine a CEO of a software supplier who will leave the company soon for another company. In this situation, he might even be inclined to intentionally breach a contract with one of his clients because, in so doing he spoils his company’s reputation—the reputation of a company that, in the future, will be his competitor. But, being part of the personalised social network community of today changes the dynamics of such a situation. Nowadays, he faces the risk that not only his company’s reputation becomes spoiled but also his personal reputation. It is true that the information that this particular manager behaved in an opportunistic way could also have spread around within the business networks described in the 2005 scenarios, but as individual businessmen now communicate with each other within specialised social networks, the chances of being detected and personally exposed are much higher. Thus, the reputational networks of five years ago, consisting of the reference system, companies, trade associations and trade chambers, are currently very effectively supplemented by the use of social networks, which establish reputational mechanisms at the individual level. Table 30: The significance of social networks for reputation

1

Interview

No

Interview passage/paraphrase

EU-G-I

274

We use social networks to monitor and to check who is coming to us and his CV. In Germany, social networks are used less for direct acquisition but rather to check references. I check with the social networks: Who is he? Is he a real person and is he really the person he pretends to be? (p 2)

EU-G-I

275

With the Internet, I see the danger that I write an article about the Romanian company. I think, for example, articles in Xing1 can also be activated for Google so that everybody who is searching this company finds my article and I write in this article that this Romanian company cheated on me. This danger is everywhere. It is hard to get information out of the Web once it is there. Google is important. (p 2)

XING is one of the leading business oriented social networks in Europe.

(Continued)

162 German Contracts with New EU Member States Bulgaria and Romania Table 30: (Continued) Interview

No

Interview passage/paraphrase

EU-BR-II

276

We are looking at the information that is available in social networks or in newspapers and so on. We do Internet research. ‘Who is the manager, what is the company structure?’ Usually you get this information and you do not have to spend too much time. (p 2)

EU-BR-II

277

Sometimes you can find information about bad behaviour in the social networks. It’s a question mark, OK, you have to be aware. (p 2)

EU-BR-II

278

In these social networks are some groups, like technology groups around a certain technology, around off-shoring. People of this group receive information about you and you receive information about others. (p 4)

EU-BR-III

279

If your existing customers go away and become unhappy with your services, this would be very drastic. Today, with social networks, I would expect that, if your customer became unhappy, that could close your business pretty fast because the community is small. Everybody is now on LinkedIn. There are a couple of those systems where people are in the position to exchange opinions and to check everybody’s personal networks. (p 3)

Reputational Networks and the European Union According to the 2005 data, reputational networks worked mostly in favour of the German clients. Whether the Bulgarian and Romanian suppliers could also use reputational mechanisms to enforce their contractual claims was unclear. However, the results from 2010 indicate that the ability to activate reputational effects has increased significantly on the side of the Eastern European suppliers since both countries entered the EU in 2007. The Bulgarian and Romanian companies also show increased selfconfidence from five years ago when using trilateral reputational mechanisms to handle payment problems with their clients. The Bulgarian and Romanian business associations such as BASSCOM17 have also gained stature in the past five years as sources of reputational effects to enforce contractual claims across borders: I remember that one Bulgarian Company had a problem with a customer, our member asked us to help them because they did not receive their money

17 BASSCOM is the industry association of leading Bulgarian software development companies.

Key Findings

163

according to the contract. And we wrote to the foreign company, from our association we wrote them and we stressed them. We, as an association, we are a member of Pin-SME18, which is the pan-European network for small and medium sized enterprises in the IT-sector, and we said that we would make it known within the European association and after a month the Bulgarian company called us that everything was settled. The Bulgarian company even received some excuses and the foreign company said that it had some financial problems and that it could therefore did not deliver the money according to contract. We are a big network. We have an association here in Bulgaria, we have an association in the regional countries (Balkans), we keep contact with almost all of them. BASSCOM is a cofounder of this pan European association. They have an office in Brussels. The association was founded in December 2007. The idea came from the UEAPME.19 This is the biggest European organisation for small and medium-sized enterprises. The association includes members of all European Member States. (EU-BR-4, 1)

Indeed, there was no evidence that this same Bulgarian association was engaged in such activities when it was interviewed back in 2005. This example shows that Bulgaria’s entering the EU in 2007 led to the side effect that its business associations gained access to the wide networks of European business associations. New communication channels emerged that can now be used to represent the interests of Bulgarian companies. The foreign client that did not want to pay the Bulgarian supplier obviously did not care about the reputational consequences of its behaviour in Bulgaria. The foreign client most likely saw Bulgaria as only a small country and reasoned that, if it lost business there, it could still easily turn to other markets for future business. But, the fact that the Bulgarian association’s threat to spread this information around European networks finally induced the client to pay shows that, since Bulgaria entered the EU, its business associations benefit from network effects that they could not rely on five years ago, when the first empirical study was conducted. Today, Bulgarian companies are capable of using reputational network effects they could not use before their country entered the EU. Thus, the paradoxical result of Bulgaria joining the EU is not an increase in the significance of state courts and enforcement authorities to Bulgaria’s crossborder transactions, but the facilitation of the circulation of information within non-state reputational networks. KEY FINDINGS

The formation of an EU-wide supranational enforcement order which primarily rests on the so-called Brussels I Regulation does not seem to have a significant positive impact on the capability of states to reliably

18 19

For further information, see the homepage of this association: www.pin-sme.eu/. For further information, see the homepage of this association: www.ueapme.com/.

164 German Contracts with New EU Member States Bulgaria and Romania enforce contracts across borders. In 2005, at the time of the first interview series, Bulgaria and Romania were not yet Member States of the EU. Consequently, no supranational EU Regulations facilitated the enforcement of foreign court judgments for suppliers from these countries. One central conclusion that could be drawn from the results of scenarios 1 and 2 was that neither the German clients nor the Eastern European suppliers relied on state enforcement of contracts when engaged in cross-border economic transactions. Bulgaria and Romania entered the EU in 2007. Yet, according to the follow-up study, which was conducted in 2010, this situation has not changed. Nowadays, it is still true that neither German nor Bulgarian or Romanian companies rely on state-enforced contractual structures to safeguard cross-border transactions against fraud and opportunistic behaviour. Furthermore, the reasons for such non-use of state-provided contract law and enforcement authorities are the same now as they were in 2005: German companies still see the use of contract law as limited by unreliable local enforcement authorities in the two Eastern European countries. Bulgarian and Romanian companies still find it not feasible financially to take legal action in state courts in their client’s countries to enforce contracts across borders. However, it is not only the case that the Brussels I Regulation is very rarely applied in transactions that involve parties from the new emerging Eastern European Member States. A broader critical view on statistical data provided by the European Commission makes clear that state courts, in general, play a rather insignificant role in facilitating cross-border trade in the EU. Although the economies of the Member States of the European Union are deeply integrated into the single European market, their national legal systems remain highly national. The analysis of the case studies in this book clearly shows that, compared to the high volumes of European cross-border trade, the percentage of cases where the Brussels I Regulation is actually applied—even with regard to transactions between companies from the most advanced European Countries—is very low. The simple model of the legal-economic performance rate indicates that state courts do play very active roles in providing for a workable legal infrastructure for economic exchange, but only in domestic contexts. The huge difference between the usage of courts for domestic transactions and for cross-border transactions in the EU establishes that national legal systems, even for transactions within the EU, lose much of their effectiveness when transactions reach beyond the borders of the nation state. Economic exchange that takes place in the Austrian–German border region provides an interesting exception to this overall picture. According to the statistical numbers we have, both Austrian and German courts that are located near the border of these two states are used significantly more frequently to enforce European trade than other state courts in the

Key Findings

165

EU. Other border regions, for example the French–German region, do not display such high usage. The Austrian–German border region builds on a centuries-old intensive trading history, and the people living and conducting business in this region speak the same language. So, the fact that supranational enforcement orders are used more frequently in this region indicates that such orders only work under exceptional linguistic and cultural conditions, which are absent in most trading contexts. The empirical results of the 2010 study show that private contract enforcement institutions are still crucial to the software industry for safeguarding cross-border transactions against fraud and opportunistic behaviour across borders. The use of relational contracts and reputational networks has evolved due to recent technological developments. Relational contracts can be controlled even more efficiently nowadays thanks to new, cheaper, and more sophisticated virtual close monitoring systems. Furthermore, the results of the 2010 study have shown that the reputational networks that were described in the 2005 study are now effectively supplemented by social networks that make it possible to gather information relevant to the transaction not only on the firm level but also on the personal level. Recent technological developments have led to greater transparency of the global village. As a consequence, the significance of private contract enforcement institutions has also evolved. The general view of law and economic development scholars that private-order institutions are limited in size and that, as the market expands, a transition to formal state-enforced institutions takes place is not supported by the empirical data of either the 2005 or the 2010 study. Private institutions are still most important in facilitating economic exchange on international markets. Figure 7 illustrates this conclusion. SelfEnforcing Contracts

Reputational Networks

Private Governance Regimes

State Contract Law

High Significance

Medium Significance

Low Significance

Case study II EU

Figure 7: Overall results of scenario 4

9 Overall Results The contract is not worth the paper it is written on. (Statement from scenario 1)

T

HE EMPIRICAL STUDY covered in this book explored whether, in the course of economic globalisation, state contract law loses its capability to provide a workable legal infrastructure for cross-border exchange and is, therefore, replaced by private contract enforcement institutions. Cross-border software development contracts were selected as an especially suitable research object to investigate this question, and the study was subdivided into four scenarios. The first three scenarios, which were conducted in 2005 and 2006, scrutinised how German clients (scenario 1) and suppliers of software products from Bulgaria/Romania (scenario 2) and India (scenario 3) enforce contracts when they engage in complex and risky cross-border transactions in today’s globalised markets. The fourth scenario, conducted five years later, in 2010, compares some of the interview material of the first three scenarios to a methodologically similar follow-up study. Scenario 4 again looked at how customers from Germany and suppliers from Bulgaria and Romania enforce software development contracts but after the latter two countries had entered the EU in 2007. In addition, broader statistical data provided by the European Commission was integrated into the analysis. This chapter presents a systematic overview of the empirical study. INSIGNIFICANT STATE-ENFORCED CONTRACT LAW

In all four scenarios, the interviewed software industry experts made clear that they do not rely on state-provided contract law when they engage in complex transactions across borders. The results of the empirical study also suggest that the formation of an EU-wide supranational enforcement order, which primarily rests on the so-called Brussels I Regulation, does not seem to have a significant positive impact on the ability of states to reliably enforce contracts across borders. Indeed, analysis of both the qualitative interviews and the statistical data provided by the European Commission supports this conclusion.

Significant Private Contract Enforcement Institutions

167

The fact, that state contract law turns out to be incapable of safeguarding cross-border transactions against fraud and opportunistic behaviour, however, does not mean that the involved parties refrain from drafting detailed contracts. The interviews show that contracts do not just serve the purpose of enforcing cooperative behaviour. First and foremost, the interview material shows that contracts are used to communicate what both contractual parties expect from each other. The experts explain further that contracts regulate the companies’ relationships with third parties such as tax authorities and banks, which are not directly involved in the transaction. Finally, the interviews describe how contracts serve legitimisation purposes: managers who do not exhibit a valid contract run the risk of being blamed for negligent conduct by shareholders when the transaction goes wrong. Therefore, contracts are deemed to be necessary documents for taking part in modern business relations. They are drafted for various reasons even when they do not fulfil their original function to guarantee cooperative behaviour between the transacting parties.

SIGNIFICANT PRIVATE CONTRACT ENFORCEMENT INSTITUTIONS

If the mechanism of state contract law does not provide for a workable legal order across borders, what institutions, in the end, do enable the emergence of cross-border contracts? The empirical study about the global software industry provides the following answer. Self-enforcing contracts: Firms, on their own, create the institutional foundations that allow them to pursue cross-border transactions. More specifically, they inform themselves about a potential transaction partner in the run-up to a transaction and choose only partners with a relatively low risk of contractual violations. In this initiation phase, the customers, in particular, engage in thorough ex ante evaluations of their potential suppliers, paying attention to three aspects of those companies’ business: First, they check if the foreign supplier employs highly qualified employees capable of meeting the client’s standards. Second, they scrutinise the quality of the production processes and the production facilities of potential foreign business partners. Sometimes customers gain in-depth information about a potential supplier by sending a detailed questionnaire via the Internet. Third, after conducting these mostly online screening processes, the customers travel to the production facilities of their potential foreign suppliers. At this stage of the transaction it is, however, already clear that the foreign company fulfils all the criteria of a reliable partner. The initiation phase is followed by the transaction phase. According to the empirical results, both customers and suppliers of software products divide the process of exchange into so-called milestone phases

168 Overall Results whereby they turn the transaction from a simple prisoner’s dilemma into a repeated game. In this way, they take care that contractual agreements become self-enforcing. During these phases, the parties often apply systems of monitoring and reporting that enable the businesses—the customers, particularly—to follow the activities of their foreign transaction partners. In many cases, customers get direct access to the supplier’s computer systems via the Internet so that they can control, in real time, how the foreign company develops their software product (real-time monitoring). Due to this comprehensive virtual integration of the transaction partners, the customers are able to issue sanctions immediately if the foreign supplier does not fulfil its contractual obligation. These ICT-supported self-enforcing contractual structures evolve over time. Back in 2005/2006, when the interviews of the first three scenarios were conducted, only mostly big firms had established virtual systems of close monitoring. However, only five years later, this practice of relational, self-enforcing control has become standard in the global software industry. Today, virtual systems of close monitoring are even applied by very small companies because, due to rapid technological progress in the field of ICT, the production of these systems costs significantly less than five years ago. Reputational Networks: Cross-border software development contracts are embedded not only in the self-enforcing bilateral governance structures, but also in superordinate reputational networks in which transaction-relevant information about the past conduct of potential business partners is shared. Against the backdrop of communicating reference networks, firms have to be aware that cases of contractual breach could lead not only to the loss of the present transaction partner but also to complete exclusion from the market. In this way, modern ICT again plays a crucial role in facilitating the sharing of information in these networks. Furthermore, suppliers provide for transparency by publishing lists with information about customers with which they have worked in the past (reference-lists). This practice enables their customers, in turn, to gather information about the reputation of a potential foreign transaction partner extremely fast and at nearly no cost. Customers only need to consult the website of a foreign supplier of software products and click on the link ‘clients’ to promptly get detailed insight into the transaction history of their business partners. Another effective, albeit simple, way of evaluating a supplier’s reputation is to count the number of past transactions in which they have been involved and to check in how many they worked for well-established international enterprises. Of course, companies often feel it is necessary to cross-check some of the references by calling or directly emailing some of the supplier’s past customers. But since, through the

Significant Private Contract Enforcement Institutions

169

reference-lists, the companies can immediately identify former customers, this task can be accomplished very quickly and at low cost. These reputational networks have only gained in importance over the last five years. The Bulgarian and Romanian expert interviews make this finding particularly apparent. In 2005/2006, the interviewed Bulgarian and Romanian firms stated that, although they attempted to use reputational effects for enforcement purposes, they believed that the effects of reputation were limited since smaller Eastern European firms lacked the credibility to effectively spoil the reputation of bigger clients from already established market economies. The 2010 interviews demonstrate that this picture has changed. It seems to have become a common practice today for these suppliers to successfully threaten to inform wider business networks of their foreign clients when they refuse to pay them for their development efforts. In addition, paradoxically, instead of having a positive impact on contract law, the EU has had a positive impact on the efficacy of reputational effects. The European Union is not just a supranational organisation set up by nation states but has also triggered the integration of dense networks of civil society and business associations. After entering the EU, the Bulgarian and Romanian associations became part of these networks which, in turn, gave firms from these countries, as association members, a wider platform on which to rely for reputational effects. Finally, the empirical study shows that rapid technological progress in the field of ICT has improved reputational networks as well as other informal contract enforcement institutions. The 2005/2006 interview material proved the existence of very effective reputational networks that worked on the basis of virtual reference lists of the firms on a business level. In 2010, this form of reputational information sharing was still in full vigour. Yet, we now also observe the emergence of global reputational effects on the personal level, which are embedded in virtual networks such as LinkedIn or Xing. Today, managers and executives of companies perceive themselves as participants in universal professional digital communities in which the networks and transactional history of a potential business partner can be instantly tracked down. Naturally, in such a globally transparent environment, a company would be more likely to be successful if it is known as a reliable business partner rather than as a cheat who is likely to break a contract. It is noteworthy, however, that, throughout the empirical study, it turned out that no purely private governance regimes with exclusive rules, independent courts of arbitration or autonomous sanctioning opportunities have developed within the global software industry. The mechanism of the private governance regime thus has no significance for the generation of transactional security.

170 Overall Results Only a few Indian interviews indicated that Indian suppliers requested the support of international commercial courts in order to make sure that their foreign transaction partners fulfilled their contractual obligations. The results also show that, in all of these cases, the private arbitration courts apply the law of the customer’s home country to the contracts for software development. The use of state law by private courts of arbitration links public and private elements of contract enforcement into a hybrid. The empirical findings of these Indian interviews therefore do not easily fit into the taxonomy of private and public contract enforcement institutions and the mechanism of ‘the public-private governance regime’ must be added to the nomenclature. The important information, however, is that international commercial courts in general are still of only minor significance. Overall, it can therefore be stated that both types of informal and spontaneous contract enforcement institutions—self-enforcing contracts and reputational networks—are decisive for the generation of transactional security. This result is one again illustrated in Figure 8. SelfEnforcing Contracts

Reputational Networks

Private–Public Private State Governance Governance Contract Law Regimes Regimes

Scenario 1 Germany Scenario 2 Bulgaria Romania Scenario 3 India Scenario 4 EU

High Significance

Medium Significance

Low Significance

Figure 8: Overall synopsis of the empirical study

THE THEORETICAL PUZZLE

We can now turn to the study’s broader theoretical implications. If we contrast the study’s central findings with conventional institutional legal and economic theory about the role of contract enforcement institutions in economic development, a theoretical puzzle emerges.

The Theoretical Puzzle

171

It is not unusual behaviour for actors to use private-order contract enforcement institutions—even within modern market economies—to safeguard transactions against fraud and opportunism. The scholarly literature that has both empirically investigated and theoretically explained the significance of private ordering for economic exchange has been discussed in detail in chapter one. We know, however, that, though many business relations rest primarily on repeated interaction, reputation and relational norms, state-provided contract law and enforcement authorities still perform central functions. In the very moment a business relation threatens to fail, the contractual arrangement again moves into the centre of the relationship as the ‘norm of ultimate appeal’1 which had, up to then, hardly been of importance to both parties. The contract guarantees that the parties can appeal to courts for enforcement if the business dealings fail. Thus, business relations usually occur in the ’shadow of law’.2 Conventional institutional theory holds that, on their own, private-order contract enforcement institutions are insufficient to create an institutional framework that enables actors to reap the various exchange opportunities in modern market economies. Instead, state enforcement of contracts is essential to facilitate economic exchange in widespread modern markets. Informal contract enforcement institutions played crucial roles before the modern states came into existence, and they work well even today within small communities. However, the situation where contemporary economies are governed by dysfunctional contract law systems, meaning that market actors have no option but to rely on private enforcement mechanisms, is still seen as a clear indicator for economic underdevelopment. The vast literature on the economies of transition countries, in particular, raises this point again and again. According to conventional institutional theory, the evolution of modern market economies and the development of workable state-enforced contract laws are invariably interlinked processes. In contrast to conventional institutional theory, the empirical results presented above suggest that, for the current phase of global economic modernisation, this causal relation between formal law and markets needs to be subjected to a critical revision. The interviews tell a straightforward story—namely, that, in current cross-border competitive markets, complex exchange processes between anonymous actors develop even without the existence of a state-provided legal order that could guarantee transactional security. Furthermore, private arbitration courts and the new lex mercatoria, which are widely believed to merge into formal private–public governance regimes that are capable of replacing stateenforced contract law at the global level, are not very important. Instead,

1 2

Llewellyn, 1931. Mnookin and Kornhauser, 1979; Williamson, 1996, 57, 122.

172 Overall Results informal practices, such as the termination of a business relation or the exclusion of opportunistic actors from the community of market participants, are regarded as the most effective means of overcoming breaches of contract. The two spontaneous and informal contract enforcement institutions—self-enforcing contracts and reputational networks—have gained in importance to a degree that exceeds the imagination of conventional institutional theory. Today, informal mechanisms enable the emergence of economic exchange not only in narrowly confined transaction communities and long-term business relationships but also in broad competitive markets. The empirical study made clear that the private mechanisms based on bi- and tri-lateral social sanctions, especially, enable enterprises in the software industry to choose the most appropriate contender among a plethora of potential business partners on global markets. The still-prevailing opinion in institutional economics, which holds that processes of market expansion necessarily lead to a loss of importance of informal institutions, is, therefore, not supported by the empirical data on globalised processes of exchange. It is not the informal private mechanisms that lose their significance in the wake of market expansions of economic globalisation but the mechanism of state contract law that leaves a vacuum of transactional security, which is filled by spontaneous private ordering. As far as global markets are concerned, private order appears considerably more efficient than public order. The next part of the book aims to explain this theoretical puzzle. First, we explain further why stateprovided contract law turns out to be dysfunctional in the investigated cross-border transactions. Then, we learn why international commercial courts are much more limited in their capability to provide global order than widely believed. Finally, we analyse why it is possible that complex transactions between unknown persons on global markets take place on the basis of informal private contract enforcement institutions. In investigating these issues, we, once again, apply the results of the empirical study of the global software industry. However, other empirical data and a great amount of secondary literature will also be included into the analysis in order to draw a broader a picture about the contract enforcement institutions in action in today’s globalised markets.

10 Economic Globalisation and the Decline of State Contract Law

T

HIS CHAPTER FOCUSES on why companies do not rely on state enforcement to safeguard cross-border software development contracts against fraud and opportunistic behaviour and applies the answers to this question to help us to understand the shortcomings of state-provided contract law in today’s globalised markets in a more general way. COLLIDING NORMS AND DEFICIENT CONFLICT-OF-LAW RULES

When legal scholars examine the shortcomings of state contract law with respect to the enforcement of contracts in international trade, they usually focus on the issue of conflict-of-laws that occurs the moment that an economic transaction crosses the borders of nation states. When more than one national norm system applies to the transaction, different national contracts laws are likely to collide.1 In order to solve the normative uncertainties of colliding norms, states have created private international law. Private international law is, basically, a set of procedural rules that determines which national jurisdiction applies to a given cross-border dispute. However, scholars challenge the efficacy of this international private law. The following example illustrates the issues that arise from such a conflict-of-laws situation: Domestic contexts: When Firm A from Country X sues Firm B also from Country X, then jurisdiction is in Country X and the judge applies the law of Country X to decide the case. The judgment is enforced by the national authorities of Country X according to the law of Country X. The most important costs the parties have to incur are the litigation costs and the costs for local lawyers. Cross-border context: When, however, Firm A from Country X sues Firm B from Country Y, the whole situation gets significantly more complicated. Uncertainties can emerge about the place of jurisdiction and the 1

See, eg: Berger, 1999; Juenger, 1998; Stone Sweet, 2006.

176 Economic Globalisation and the Decline of State Contract Law applicable law. Ironically, the question can even arise of which country’s private international law has to be used in the first place in order to determine place of jurisdiction and applicable law. These decisions often lead to the result that place of jurisdiction and applicable law are different—for instance, the jurisdiction is with Country X whereas the law of Country Y applies. Moreover, before a judgment can be enforced, it has to be recognised by a court in Country Y. All of these extra procedural steps necessary in cross-border litigation are very likely to significantly curtail the performance of state-provided contract law. Additional legal costs and time are needed to clarify the place of jurisdiction and the applicable law. When the place of jurisdiction and applicable law are different, unpredictable court decisions may result because the judge may not be knowledgeable in foreign law, and the parties’ lawyers will usually need additional time to prepare drafts of legal opinions about foreign laws and to translate documents, all of which incur greater costs for the litigants. Additional legal costs and time are also needed to recognise the court decision of Country X in Country Y. Finally, the court of Country Y might refuse to recognise the foreign judgment of Country X because of inconsistencies with the local laws or simply because no treaty exists on recognition of court judgments between the country where the judgment is rendered and the country where the winning party seeks to collect. This illustration makes clear why, according to a survey conducted by Klaus Peter Berger, economic and legal practitioners refer to the existing private international law techniques as an ‘inveterate evil’, ’murky maze’, ‘creative chaos’, ‘alchemy’ or a ‘dismal swamp filled with quaking quagmires inhabited by learned but eccentric professors who theorize about mysterious matters in a strange and incomprehensible jargon’.2 Such flawed conflict-of-law rules are a crucial factor in explaining why companies in the global software industry do not rely on state-enforced contract law to safeguard their cross-border transactions against fraud and opportunistic behaviour. Statements referring to missing mutual enforcement agreements between states, uncertainties about jurisdiction and applicable law, judges who are incapable of deciding cases involving foreign parties and disproportionally high procedural costs in crossborder litigation were prominent in most of the case-study interviews to explain the non-use of state-enforced contract law. This data clearly supports the scholars’ view that private international law is incapable of efficiently coordinating colliding national norm systems. Present conflictof-law rules, indeed, lead to major legal uncertainties and high transaction costs which, in turn, significantly limit the performance of the mechanism of state-enforced contract law to provide a reliable legal infrastructure 2

Berger, 1999, 9–31.

Unreliable National Courts and Enforcement Authorities

177

for global commerce. Deficient private international law thus presents a first crucial reason to understand why companies do not rely on state enforcement of contracts when they engage in cross-border transactions in today’s globalised markets. UNRELIABLE NATIONAL COURTS AND ENFORCEMENT AUTHORITIES

However, a closer look at the empirical study on the global software industry shows that colliding norms and deficient conflict-of-law rules are not the only factors that limit the performance of state-enforced contract law across borders. Most significantly, the German interviews in scenarios 1 and 4 outlined that, although it is possible for the German companies to successfully sue their foreign suppliers for contractual performance in Germany, the subsequent enforcement of the ruling is not guaranteed in either India or Eastern Europe. Thus, even if German courts decide in favour of a German company, the judgment may not actually be enforced as it would be in a nation state equipped with a working legal system. The authority of the German state ends at its borders, which means that German companies have to rely on foreign judicial authorities to effectively enforce a judgment abroad. However, according to the German experts, because the courts and enforcement bodies do not work reliably in India and the studied Eastern European countries, this avenue of enforcement remains blocked and the foreign transaction partner can thereby avoid legal sanctions. From the outset, therefore, the mechanism of state contract law is not available to the actors involved in a cross-border transaction. Although the mechanism of state contract law works effectively within the territorial borders of states, it loses its effectiveness in globalised exchange processes, at least if the transaction partner comes from a country with a non-functioning or unreliable legal system. Nevertheless, unmitigated collision problems present only one obstacle to a workable state-based legal infrastructure. A global legal system that is composed of territorially fragmented national legal systems also faces the problem that it invariably integrates unreliable or inefficient units into its operation. As a matter of legal principle, private international law does not interfere with territorial sovereignty of nation states. Thus, national courts and enforcement authorities are responsible for enforcing judgments on their respective territories, but this task is clearly not fulfilled in every state with the same reliability.3 Forum shopping and choice-of-law clauses partly allow parties to circumvent inefficient norms in international trade. However, when it comes to the stage of enforcement, companies have no choice but

3

For the differences in reliability see: World Bank Group, 2011.

178 Economic Globalisation and the Decline of State Contract Law to depend on the local courts and authorities. Technically, this means that the overall performance of such a global legal system is a function of the efficiency of each of these units taken together. Whenever an unreliable legal unit is involved in the process of enforcing cross-border contracts, the performance of the mechanisms of state-enforced contract law will be reduced. To be sure, in many constellations, trade takes place between companies from states with sufficiently reliable legal systems. However, other situations, including newly developing markets, involve cross-border transactions with companies from states like China, Brazil, India and many other smaller emerging market economies that still possess rather inefficient legal systems according to various comparative governance reports. A statebased legal system that is built on the principle of territorial sovereignty of nation states cannot avoid involving these deficient or poorly performing legal units in its operation. Territorial fragmentation, thus, leads not only to the problem that the separated legal units are in need of coordination but to the inclusion of unreliable legal units in many important regions that today play vibrant roles in world trade, presenting a second crucial reason for the limited use of contract law in today’s globalised markets.4 BEING EXPOSED TO FOREIGN NATIONAL NORM SYSTEMS

The territorial fragmentation of national legal systems causes a third problem. In order to understand, consider the following empirical results of the study on the global software industry which look at the reasons for the non-use of state contract law from the perspective of the suppliers. At first sight, it seems positive that, in contrast to their German clients, the problem of cross-border non-enforceability of court decisions introduced in the last section does not apply to them. As the empirical results prove, cross-border software development contracts are usually drafted according to the law of the customer’s home country. The same applies to the place of jurisdiction, which is according to the respective agreement usually situated in the country of the customer. Foreign suppliers of software applications can therefore take legal action before a German court under German law. If a German customer were held liable, the judgment would reliably be enforced in Germany. Thus, for the foreign providers, there is no difference in the enforceability of state court decisions against a German customer between domestic and cross-border transactions. This means that the mechanism of state transaction law is, in principle, at the disposal of Romanian, Bulgarian and Indian companies when they supply a software application to Germany. In this context, the mechanism of state transaction law retains its effectiveness. 4 See: World Bank Group, 2010. This report by the World Bank also includes an overview of other available reports.

Being Exposed to Foreign National Norm Systems

179

As the findings of the empirical study show, however, a different problem arises for foreign companies out of the fact that German law is usually applied to cross-border software development contracts. The Bulgarian, Romanian and Indian companies are not familiar with the application of German law. They see German law as a rather overly complex system of rules that, additionally, is drafted in a language incomprehensible to them.5 Unlike their German business partners, foreign actors are not used to dealing with German law. The German companies, as part of a specific German legal culture, possess more legal knowledge than their foreign transaction partners—knowledge that they could use at any time to further their economic interests to the disadvantage of their foreign transaction partners. Thus, German law becomes a source of uncertainty for foreign providers. In principle, the foreign providers could hire an internationally operating or German law firm to look after the drafting of the software development contracts to thereby significantly reduce the uncertainty associated with German law as the legal framework. However, as the results of the empirical study show, none of the Indian, Bulgarian and Romanian providers are usually willing to bear the cost of comprehensive legal protection of their economic interests. Although they use local legal services, the relatively small Eastern European companies lack the financial resources to afford expensive, internationally operating law firms with the necessary expertise. Even the large Indian providers, who certainly have sufficient financial means to pay for qualified lawyers, refrain from a comprehensive legal protection of their economic interests, because incurring such costs appears inefficient compared to the profits which can be made in software development. For foreign suppliers, who are, themselves, remunerated at prices that are far below the average of OECD countries (that is the reason that they take part in globalisation), it is not economical to use legal services at the price level of a German or international law firm. The extreme disparity in cost levels between Western ‘high-wage countries’ and Asian or Eastern European ‘low-wage countries’ prevents foreign suppliers of a software application from turning to the mechanism of state contract law in order to ensure that their German customers fulfil their contracts. The basic problem behind these conflicts is that national legal systems build the operating units of a state-based global legal system. In the absence of a cosmopolitan, transnational legal system, cross-border contracts need to be attached to one of the existing national jurisdictions. This, in turn, invariably leads to the negative consequence that one party has to perform its contractual obligations under foreign, unfamiliar law. Once more it becomes clear that the territorial fragmentation of law causes deeper problems than previously assumed. Domestically,

5

See for this point: Mankowski, 2003, 7.

180 Economic Globalisation and the Decline of State Contract Law contract law and contract law politics tend to reduce the imbalances between contractual parties and create transactional security for both sides. Internationally, the law not only fails in this task but also markedly increases the imbalances between the contractual parties. Paradoxically, in cross-border exchange, state law is not part of the solution but part of the problem of transactional and legal uncertainty. In summary, whenever a party engaged in international trade manages to choose familiar national law to govern a cross-border transaction, it saves legal information costs and thereby achieves a strategic advantage over its contractual partner, who has to incur the higher costs of seeking legal advice in a foreign legal system.6 Consequently, companies that conduct their transactions under foreign law are less likely to rely on state enforcement of contracts and are more likely to rely on alternative private mechanisms. Furthermore, according to the results from the empirical study of the global software industry, legal imbalances caused by the territorial fragmentation of national law lead to particularly severe problems for companies from emerging markets. They seem to be very unlikely to take legal action in front of a court in an established market economy because pursuing this strategy is too expensive, either absolutely or relatively, compared to the potential gains from the underlying transaction. WHY DOES THE EU NOT MAKE A DIFFERENCE?

The shortcomings of state-enforced contract law also help to explain why, even within the EU, state courts and enforcement authorities turn out to be rather insignificant to cross-border transaction disputes. Up to now, the process of European integration in the field of private law has focused on the collision problem of territorially fragmented legal orders. The Brussels I Regulation establishes common procedures of recognising and enforcing foreign judgments, and the Rome I Regulation unifies national conflict-of-law rules. These regulations may be a necessary but are not a sufficient step towards creating a workable supranational infrastructure for cross-border commerce. Unifying conflict-of-law rules might improve the performance of the system to determine applicable law and place of jurisdiction for a given dispute, and they might reduce time and costs for parties to enforce contracts across borders. Yet, these improvements have no significant impact on the other fundamental shortcomings of stateenforced contract law in situations of cross-border exchange. Recall that, both before and after Bulgaria and Romania entered the EU, the interviewed German clients perceived the legal systems of those countries as corrupt, slow, and ineffective. Consequently, they still insist on stipulating German law and jurisdiction in software development 6

Ibid.

Why Does the EU Not Make a Difference?

181

contracts involving these countries. Just because a state joins a union that is governed by an international contract that unifies parts of its private laws does not mean that the local courts and enforcement authorities of that state work any more reliably in practice than they did before falling under the jurisdiction of that international contract. Consequently, the application of the Brussels I Regulation to the cross-border contract does not change the fact that, even after Bulgaria and Romania entered the EU German companies still do not rely on the mechanism of state-enforced contract law because they still do not trust the local courts and enforcement authorities in these countries to reliably enforce foreign judgments. Inasmuch as national jurisdictions have significantly different qualities across the EU, it is not a surprise that foreign contract partners trust some national courts and enforcement authorities more than others. Indeed, it is likely that if a company, such as a German customer, perceives the courts of Bulgaria and Romania to be unreliable, it may apply that distrust to courts in many other, particularly new, Eastern European EU Member States. This may help explain why, according to the Heidelberg Report, the Brussels I Regulation is almost never applied in either the new Eastern European Member States or other legally and economically less-advanced states. Furthermore, the EU’s attempt to provide unifying conflict-of-law rules to its members also does not seem to change the practice of one party choosing familiar national contract laws and jurisdictions when making cross-border contracts. Consequently, even within the EU, many parties face very high legal transaction costs, since they are forced to perform their contractual obligations under foreign law. This practice, like the perception of unreliability, turns out to be particularly problematic for companies from structurally less-advanced emerging markets. The empirical data established that, both before and after their countries’ entry into the EU, suppliers from Bulgaria and Romania refrained from taking legal action in a foreign court—even in one of the established EU Member States—because of prohibitive legal costs. European law does not change the fact that companies from less-advanced countries with lower price levels still lack sufficient financial and legal resources to take legal action in the courts of their clients’ countries. Taking into account the limitations of the EU’s attempt to create a workable supranational order for the enforcement of cross-border contracts, it is interesting to speculate about the effects of further legal reforms. On 11 October 2011, the European Commission published its proposal for a regulation on a Common European Sales Law (CESL). All empirical evidence suggests that, when it is actually established, this new legal regime will have little to no practical relevance. Indeed, there already exist transnational contract laws, such as the United Nations Convention on Contracts for the International Sale of Goods (CISG), that were introduced as alternative sales law regimes to national laws. In practice, these alterna-

182 Economic Globalisation and the Decline of State Contract Law tive law regimes are almost never chosen and, rather, are often explicitly excluded from contracts. When a unified economic sphere operates in an environment of territorially fragmented legal systems and this incongruity between economic and legal spheres causes various uncertainties and high transaction costs, initially it might seem to be a logical step to also unify the legal systems. However, introducing a common norm system does not automatically create a legal framework with which market actors are familiar or comfortable. In fact, the opposite is true. Even when the rules are common, they are still new and therefore unfamiliar to all market participants. We already know that unfamiliarity with legal norms is one of the main reasons for not choosing a particular norm system to govern contracts.7 We can thus conclude that the practical relevance of a new unified European sales law is very likely to turn out to be rather low because real demand for such a law is missing.8 Parties that have managed to stipulate their familiar home laws as part of their contracts in the past will presumably continue this successful practice in the future. Thus, different national laws would still apply to cross-border contracts in Europe, and the legal inefficiencies caused by the territorial fragmentation of national legal systems will not be effectively addressed by an alternative 28th European contract law regime that supplements the already existing 27 national contract laws. This book therefore predicts that even when a new European sales law is introduced into the law of the Member States, the current low importance placed on state courts and enforcement authorities to provide the legal infrastructure for cross-border trade in the EU will not significantly change. The last step in analysing the widespread problems that need to be overcome in order to establish a workable European contract law regime uses a framework that goes beyond that which hitherto guided this analysis. According to the Heidelberg Report, the doctrinal quality of the Brussels I Regulation is considered very high. However, proof for its practical significance could only be found in one very specific context, namely Austrian–German cross-border trade, to which very specific linguistic and cultural conditions apply.9 Precisely because Austrian–German trade presents a unique case suggests that legal norm systems are very deeply rooted in their respective cultures and that common legal practices only develop when these cultures match. Put more abstractly, different legal cultures among European Member States lead to far-reaching path dependencies and lock-in effects that block the designed creation of a workable supranational enforcement order. This finding leads us to the conclusion 7 See Vogenauer, 2013, He systematically summarises the empirical and theoretical literature to this point. 8 For this point see the advice by the Scottish Law Commission which draws the same conclusions: Scottish Law Commission, 2011, 11–15. 9 Hess, Pfeiffer and Schlosser, 2008, 12–38.

Key Results and Methodological Limitations

183

that the territorial fragmentation of national legal orders reaches deeper than assumed so far by legal scholars. In order to be effective, legal systems might require being embedded in corresponding cultural and linguistic practices that cannot be designed by supranational legal unification processes. Regardless of how far the EU pushes the unification process of national contract laws, the practical implications will be very insignificant unless a genuine common European legal culture can coevolve and sustain this process. KEY RESULTS AND METHODOLOGICAL LIMITATIONS

This chapter has been set up to determine central factors that limit the performance of state-enforced contract law to provide a workable legal infrastructure for cross-border commerce. One overarching principle that guides this discussion is that the shortcomings of state contract law in situations of cross-border exchange derive from the same source: the territorial fragmentation of national legal systems. First, the territorial fragmentation of national legal systems leads to colliding norms which are not efficiently coordinated by present conflictof-law rules. The consequences are legal uncertainty and very high legal transaction costs. Second, a global legal system that is composed of territorially fragmented sovereign national legal systems invariably integrates unreliable or inefficient legal units into its operation. Each time a crossborder contract involves a company from a country with such a legal system, the mechanism of state enforcement becomes dysfunctional. Third, a global legal system that accepts only state-made law as an operating unit invariably requires contracts to be attached to one of the existing laws and jurisdictions. Consequently, one of the parties is very likely to perform its contractual obligations under foreign, unfamiliar law which, in turn, leads to increasing uncertainty, high legal costs, and, ultimately, rising imbalances between the contractual partners. State-enforced contract law thus does not only fall short of providing a workable legal infrastructure but also markedly increases uncertainty and transaction costs in international trade. Being exposed to the risks of an unfamiliar foreign national contract law is particularly problematic for companies from emerging markets and developing countries. For these companies, using state law is too expensive, either absolutely or relatively, to the potential gains from the underlying transaction. Since the actual EU unification process of national contract laws seems to be incapable of overcoming most of the identified legal fragmentation problems, the practical relevance of state courts and enforcement authorities remains rather insignificant in the EU. However, since, by definition, case-study approaches, such as the one used in this book, choose a particular example in order to shed light on wider theoretical questions, they have an inherent tendency to over-

184 Economic Globalisation and the Decline of State Contract Law generalise results. It is important to recognise, then, that this study is methodically limited in drawing general conclusions about the significance of state-enforced contract in international trade. Although the software industry represents a very good example for the study of problems of contract enforcement in global exchange processes, one cannot be sure that a selection of different industries and countries would not lead to very different findings. One could argue that, in cross-border contractual relations outside of the software industry, state-enforced contract law might play a considerably more important role. This hypothesis is surely plausible, and, in a strict methodological sense, it cannot be disproved here. On the other hand, if we look again at the three main reasons for the ineffectiveness of state courts and enforcement authorities to provide a workable legal infrastructure for globalised exchange, we see that they are hardly industry specific. There is no logic to the argument that flawed conflict-of-law rules, unreliable legal systems in states that play pivotal roles in international trade or unfamiliar national norm systems would affect only the global software industry. In fact, it is much more plausible to assume that these shortcomings reflect general shortcomings of state-enforced contracts in cross-border exchange. Furthermore, it could be argued that state-enforced contract law could play a more vibrant role in different country constellations. Again this claim cannot be disproved. But we can, at least, argue that this is unlikely. Arguably, the conditions for relying on state-enforced contracts in cross-border transactions are in no alternative country constellation comparatively better than within the EU. The fact that state courts and enforcement authorities turn out to be rather weak mechanisms within the EU thus provides strong evidence that state-enforced contract law, indeed, plays a rather insignificant role for international trade, in general, independent from the country constellation.10 However, all of this analysis still does not completely preclude the possibility of relying on this mechanism to safeguard cross-border transactions against fraud and opportunistic behaviour. State law might still be significant for some cross-border transactions. But, because it is also clear that in many other cross-border transactions companies do face legal situations in which it is either ineffective or too expensive to rely on state-enforced contract law, one can hardly conclude that the rapid emergence of globalised markets over the last decades has been enabled by a state provided legal infrastructure that features such fundamental signs of dysfunction. A global, borderless economy seems unlikely to evolve on the basis of a territorially fragmented legal order.

10 This view is also confirmed by the very few studies that focus on the question of contract enforcement in international trade: See: Cavusgil, Deligonul and Zhang, 2004.

11 The Limits of International Commercial Arbitration

T

HE RESULTS OF the last chapter surely do not present a surprise to scholars of transnational law and international commercial arbitration. From their perspective, it is clear that in the absence of a workable state-provided order, a private global legal order develops with international commercial courts in its centre.1 Scholars in the field typically highlight the importance of international commercial arbitration as a mechanism to provide an efficient infrastructure for cross-border exchange: At the conclusion of any transaction, the possibility of disputes is unavoidable… To preserve international trade, efficient means of resolving such disputes is … of the essence. For well over a century, jurists as well as businessmen have been aware of the shortcomings of national courts to provide satisfactory means of dispute resolution. In the absence of any permanent international forum, the gap has been filled by international arbitration, which now plays a pivotal role in international trade as do the banking and insurance industries.2

The evolving number of cases filed at international arbitration courts is practical proof of this phenomenon. Dezalay and Garth, for example, acknowledge the growth trend of international arbitration by noting the fact that the International Chamber of Commerce (ICC)—the biggest and oldest arbitration house—dealt with 333 cases in 1991, 337 cases in 1992 and 352 in 1993.3 More generally, Walter Mattli states that the caseload of major arbitration houses, which, in addition to the ICC, include the London Court of International Arbitration (LCIA) and the Stockholm Chamber of Commerce (SCC), has doubled between the 1970s and the 1990s;4 and Alec Stone Sweet points out that traders filed about 3,000 disputes during the 70-year period from 1920 to 1980, whereas, during the 10-year period of the 1990s alone, they filed more than 3,500 disputes. These numbers have continued to soar: 5,250 disputes were filed at the ICC between 1996 and 2005.5 1 See, eg: Arksen, 1990; Blackaby, Partisides, Redfern and Hunter, 2009; Craig, Park and Paulsson, 2000; Redfern and Hunter, 2004; Maurer and Hoffmann, 2010. 2 Uff, 1997, 15. 3 Dezalay and Garth, 1996, 6, fn 4. 4 Mattli, 2001, 920. 5 Stone Sweet, 2006, 636.

186 The Limits of International Commercial Arbitration Table 31, which provides a very detailed picture of the international commercial court activities of the seven most important courts,6 confirms this trend of a rising caseload between 2003 and 2010. We see a rise from 2,197 cases in 2003 to 3,039 in 2009, representing a growth of around 38 per cent. Table 31: Arbitration requests filed at the ICC, LCIA and SCC between 2000 and 20101 Court/Year

2003

2004

2005

2006

2007

2008

2009

2010

ICC2

580

561

521

593

599

663

817

793

LCIA3

99

83

110

130

127

163

272

246

SCC4

82

50

56

74

87

85

96

91

AAA/ICDR5

646

614

580

586

621

703

836

801

HKIAC6

287

280

281

394

448

602

429

401

CIETAC7

422

462

427

442

429

548

559

531

DIS8

81

76

72

75

100

122

156

176

Total

2197

2126

2047

2294

2411

2886

3065

3039

8-year average 2508 1

The numbers are taken from the homepages of the eight major international commercial arbitration courts. 2 International Court of Arbitration. 3 London Court of International Arbitration. 4 Arbitration Institute of the Stockholm Chamber of Commerce. 5 American Arbitration Association/International Centre for Dispute Resolution. 6 Hong Kong International Arbitration Centre. 7 China International Economic and Trade Arbitration. 8 German Institute of Arbitration.

However, the results of the empirical study of the global software industry undertaken for this book do not support the widely shared view that international commercial arbitration courts provide the most important institutions to decide disputes and enforce contracts across borders in today’s globalised markets. According to the results of that study, international arbitration, at best, plays a minor role in global commerce, and even this was limited to the Indian scenario. Both the German and the

6 The seven major courts handle around 85 per cent of the total global caseload. This can be concluded from a comprehensive worldwide list of international commercial courts and their caseload is provided by an international Arbitration Study published by the School of International Arbitration of Queen Mary University London in cooperation with PriceWaterhouseCoopers. See: www.arbitrationonline.org/research/ Corpattitempirical/2008.

The Caseload of International Commercial Arbitration

187

Bulgarian–Romanian scenarios provide no evidence of the significance of international arbitration courts in cross-border trade. This raises the question of why the results of the empirical study about the global software industry differ so significantly from the widely supported view that international commercial arbitration plays a pivotal role for providing the legal infrastructure for globalised exchange. At first glance, the most plausible answer to this puzzle seems to attribute the deviant results to the research design of the study. Various factors could have had an impact on the results: The interviewed experts might have wanted to keep the use of these institutions confidential. The software industry might be an exceptional case where arbitration courts, in general, tend to play a minor role, or the surprising result of a non-use of international arbitration courts could be attributed to the small amount of companies that were interviewed in the qualitative study. However, a closer and critical look at the statistical figures of international commercial arbitration shows these factors to be irrelevant. Instead, the following makes clear that the results of the expert study about transactional security in the software industry, in fact, represent an adequate picture about the significance of private arbitration courts in international trade whereas the general view about this subject is vastly exaggerated. THE CASELOAD OF INTERNATIONAL COMMERCIAL ARBITRATION: LESS THAN MEETS THE EYE

Three of the major arbitration courts, the ICC, LCIA and SCC, publish detailed annual reports about their activity on their websites. In addition to the caseload numbers, which are shown in Table 31, these reports include information about the parties that actually used these arbitration courts. Since the empirical study about cross-border software contracts focused on companies from the countries of Germany, Bulgaria–Romania and India, we look, first, at the number of parties involved in international arbitration based in these countries. The ICC statistics for 2005, the year in which the first three scenarios of the empirical study were conducted, show the involvement of a total of 102 German parties, 42 Indian parties, 7 Bulgarian parties and 6 Romanian parties.7 For the same year, the SCC reports the involvement of just 11 German parties and no parties from India, Bulgaria and Romania.8 To be clear, these numbers do not represent just software companies but

7 See the statistics provided by the ICC: www.iccwbo.org/court/arbitration/id5531/ index.html. 8 See the statistics provides by the SCC: www.chamber.se/?id=23700.

188 The Limits of International Commercial Arbitration all companies from all industries existing in these four countries that were involved in international commercial arbitration. Rather than providing the specific numbers of participants, the LCIA provides data about the involved parties in percentages. The figures for 2005 show a share of 4.75 per cent German parties, 4 per cent for Indian parties, and 1.5 per cent for Eastern European parties excluding Russia.9 If we apply these percentages to the total number of 110 cases handled by the LCIA in 2005,10 it becomes apparent that the numbers of parties that are based in the four countries of the empirical study are also very small. Indeed, in the cases of Germany and India, the numbers are much smaller than the numbers reported by the ICC. What can be concluded from these figures? Most importantly, the insignificance of international commercial arbitration cannot be ascribed to the research design of the empirical study. It is fair to assume that hundreds of thousands of German, Indian, Bulgarian Romanian, and Indian companies from all different kinds of industries are engaged in cross-border trade on global markets in any year. Yet, compared to these numbers, the number of companies from the four countries of the empirical study that are actually engaged in cross-border arbitration is marginal. A further look at the statistics shows that this result can even be generalised. In all three courts’ statistics (ICC, LCIA, SCC),11 Germany is among the countries with the highest number of parties involved in international commercial arbitration worldwide. Only the USA features slightly higher numbers.12 India exhibits the highest number of party involvement in Asia.13 Romania and Bulgaria lie in the middle range of their region— Eastern and South-Eastern Europe.14 As a matter of fact, there are no countries with significantly higher party involvements than those investigated in the empirical study about the global software industry. The marginal use of international commercial arbitration is therefore not a country-specific phenomenon but can be ascribed to international trade in general. Against the background of very large numbers of companies that are engaged in international trade, the caseload of international arbitration courts appears to be very small. 9

See the 2005 report of the LCIA: www.lcia.org/LCIA/Casework_Report.aspx. See Table 31. 11 See nn 7–9 above. 12 In 2005, for example, 164 parties from the USA were involved in ICC arbitration procedures, compared to 102 companies from Germany. See: www.iccwbo.org/court/arbitration/id5531/index.html. 13 This means that even more Indian companies use international arbitration courts than companies from China. Looking again at the ICC caseload statistics for 2005, we see that only 34 companies from China were involved in arbitration, compared to 42 companies from India. 14 With 34 parties, the ICC statistics show Turkey as the country from this region with the highest party involvement at the ICC in 2005. 10

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189

A look at the following example makes this point even clearer. The USA shows the highest absolute numbers of companies involved in international commercial arbitration. According to the ICC statistics, in 2009, 10 per cent of the parties involved in international arbitration at that court were based in the USA.15 Unfortunately, most arbitration courts do not provide detailed statistics about the country of origin of the parties. But, applying the ICC statistics to the rest of the world and erring on the side of overstatement, let us assume that around 15 per cent of all worldwide arbitration cases involve a party from the USA. Consulting Table 31, which contains the caseload tallies for the seven major arbitration courts, we then assume (again, erring on the high side) a total number of international commercial arbitration cases of 4,000 for the year 2009. Taking 15 per cent of the 4,000 total cases leaves us with approximately 600 US parties involved in international commercial arbitration cases in 2009. The US Department of Commerce identified that, in 2009, 285,843 US companies exported goods or services across borders.16 If we take this number and divide it by 600—the estimated number of US parties that were involved in international commercial arbitration court cases—we see that, in 2009, only 1 out of 476 companies or about 0.2 per cent of all exporting US companies were involved in international commercial arbitration. Extrapolating this number and applying it to a broader period of time results in the conclusion that, over a 10-year period, not more than two per cent of all American exporters are involved in an international arbitration court case. Clearly, this number is very insignificant. At this point one might argue that raw numbers of court usage are not an adequate indicator to determine the real impact of legal systems. Sometimes, courts function like peace armies that do not need to take real action in order to have a strong bearing on individual behaviour. For example, if companies on global markets believed that international commercial arbitration courts were effective, they would believe that cheating in contractual relations would lead to sanctions and, thus, to undesired outcomes. Since rational contractual parties aim to avoid undesired outcomes, they would not cheat, which, in turn, would mean that fewer court cases would occur. The problem is that the number of cases filed at international commercial arbitration courts is just too marginal to reflect this effect. A brief comparison of the caseload of international commercial courts with the caseload of German commercial courts makes this point very clear. If we look again at Table 31, we see that, on average, 2,508 annual cases were filed

15

See: www.iccwbo.org/court/arbitration/id5531/index.html. See the numbers provided by the US Department for Commerce: www.census.gov/ foreign-trade/Press-Release/edb/2009/edbrel.pdf. 16

190 The Limits of International Commercial Arbitration at the seven major international commercial courts in the years 2003–10.17 But, throughout the same period (2003–10) each year the German commercial courts (Kammern für Handelssachen) handled an average case load of about 50,000 domestic cases.18 In comparison, according to Gary Born, the American Arbitration Association, under its commercial rules, handles about 12,000 domestic cases yearly.19 Economic exchange invariably involves disputes among contractual parties and, as workable legal infrastructures exist, a significant number of these disputes will end up in courts, be they arbitration or state courts. However, what applies to domestic contexts does not obviously apply to the same degree to international contexts. World trade has grown tremendously in the last few decades. In 2010, world exports amounted to a sum of 15,235 trillion USD,20 which is about 4.6 times the German GDP. It is significant, therefore, that the involvement of international commercial arbitration courts nowhere near corresponds with these economic figures. To further illustrate this point we present the following simple model: First, the German GDP for 2010 (3.3 trillion USD21) is divided by the number of domestic commercial cases (around 50,000). 22 The result is around 66 million, which means that, on average, one German commercial court case corresponds to a German economic value creation of 66 million USD. Second, we divide the volume of world exports for 2010 (15.2 trillion USD) by the number of international commercial cases filed in 2010 at the seven major courts (3,039). The result is around 5 billion, which means that one case in international commercial arbitration corresponds to an international economic value creation of 5 billion USD. If we now divide 5 billion by 66 million, the result is 76, which means that, if international arbitration courts were to play a similar role for the international economy as the German commercial courts play for the German economy, their caseload would have to be 76 times higher—in other words, 266,000 annual cases instead of around 3,500 annual cases. 17 Please also note that each year usually around 20% of these total cases are withdrawn again and that around 15% of the cases involve exclusively domestic parties and are thus not linked to international trade. In other words: The real number of international commercial arbitration cases is even significantly lower than suggested in Table 31. 18 Statistisches Bundesamt, Fachserie 10, Reihe 2.1, Rechtspflege Zivilgerichte korrigierte Ergebnisse, 2009: published online: www.destatis.de/jetspeed/portal/cms/Sites/destatis/ Internet/DE/Content/Publikationen/ Fachver-oeffentlichungen/Rechtspflege/GerichtePersonal/Zivilgerichte2100210097004, property=file.pdf., See also: Maurer and Hoffmann, 2010. 19 See: Born, 2009, 162. 20 See the numbers provided by the International Monetary Fund, available at: www.imf. org/external/pubs/ft/weo/2010/01/weodata/index.aspx. 21 See the numbers provided by the International Monetary Fund, available at: www.imf. org/external/pubs/ft/weo/2010/01/weodata/weorept.aspx?sy=2008&ey=2010&scsm=1 &ssd=1&sort=country&ds=.&br=1&c=134&s=NGDPD&grp=0&a=&pr.x=41&pr.y=8. 22 3.3 trillion USD/50 thousand.

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Although international commercial arbitration courts have grown by more than 40 per cent in the last seven years, they started from such a low level that these growth rates do not relevantly reflect their significance as a legal support structure for global exchange. Although much more empirical research is needed to determine the exact scope of international commercial arbitration, the numbers above suggest that the predominant portion of companies engaged in international trade does not rely on international commercial arbitration courts to resolve conflicts and to enforce contracts. Compared to the role domestic courts play for domestic markets, the role of international commercial arbitration courts for global markets is marginal. In essence, it is highly unlikely that international arbitration courts play a pivotal role in providing the workable legal infrastructure for global exchange as is so often claimed in the pertinent literature.

STATE LEGAL SYSTEMS CONSTRAINING INTERNATIONAL COMMERCIAL ARBITRATION

Presented with these limits, the questions remains: What are the major factors that constrain international commercial courts from evolving into an efficient private global legal system? In attempting to find an answer to this question it is useful to first introduce a second type of international commercial arbitration court that has so far been neglected.

Private Governance Regimes versus Hybrid International Arbitration Up to now our analysis has focused on what we call ‘universal or non-specialised international commercial arbitration’. All courts listed in Table 31 have jurisdiction to accept cases from all kinds of different companies and industries engaged in international commercial transactions. From these courts, we can distinguish a small number of so-called ‘specialised international arbitration courts’,23 which are provided, for members only, by international trade associations specialising in particular business sectors. Berkowitz et al have identified three international trade associations offering arbitration services to their members: The Grain and Feed Trade Association (GAFTA), the Federation of Cocoa Commerce (FCC) and the Liverpool Cotton Association (LCA).24 Other examples

23 24

Regarding this differentiation, see: Drahozal, 2009, 1045. Berkowitz, Moenius and Pistor, 2005.

192 The Limits of International Commercial Arbitration of such organisations are the London Metal Exchange (LME)25 and the international diamond industry, described by Lisa Bernstein as a federation of commercial associations using industry specific arbitration courts to adjudicate disputes and enforce contracts.26 In contrast to the universal type, specialised international commercial arbitration courts, indeed, seem capable of providing a workable legal infrastructure for cross-border exchange within their particular areas of trade. A good example of this synergy is found in the diamond industry. The international diamond trade is organised into a federation of 29 worldwide diamond bourses.27 To take part in this organised worldwide diamond market, one has to be a member of one of these bourses. Each member can trade at each bourse worldwide, and each bourse is governed by a local arbitration court. The New York Diamond Dealers Club (DDC), the exchange on which Lisa Bernstein mainly focuses, is one of these 29 bourses. In 1992, Bernstein counted a total of 150 cases submitted to the DDC’s arbitration systems.28 Arbitration courts in the diamond industry do not make their caseload public, so it is impossible to directly assess the significance of these courts to the industry. However, given the fact that diamonds are traded internationally in 29 bourses, of which the DDC is only one, and that each of these bourses provides its own arbitration court, it is obvious that arbitration courts play a much more vibrant role in this particular business sector than in international trade in general. From a theoretical private ordering perspective, it is crucial to understand that specialised arbitration courts, such as those in the diamond industry, are embedded in private governance regimes, as these structures have been defined in chapter one. Private governance regimes consist of three constitutive elements: private rules, private arbitration courts and private sanctions. Universal arbitration courts do not qualify as private governance regimes but as hybrid systems. Although the universal courts are private, both the norms that these courts apply and the sanctions on which they rely to enforce their judgments are usually state-provided. In chapter ten, it was explained that the territorial fragmentation of law significantly limits the capability of the state legal systems to enforce contracts in cross-border exchange. In the following section, we learn that, because of their close links to state legal systems, universal international commercial courts suffer from the same problem. In contrast to specialised arbitration courts, which are embedded in completely borderless private governance regimes, the territorial fragmentation of state legal systems

25 26 27 28

See: www.lme.com/. Bernstein, 1992. It was 20 bourses in 1992 when Bernstein published her article, see: ibid, 121. Ibid, 124.

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constrains the ability of international commercial arbitration courts to create efficient cross-border formal contract enforcement institutions.

National Contract Laws and lex mercatoria in International Arbitration Procedural rules determine the organisational details of how an arbitration court works, whereas substantive rules guide a court’s decisions in a given dispute. Trade associations and bourses that provide their members with specialised arbitration services have set up both distinct procedural and substantive rules to guide the work of their particular arbitral bodies. Table 32 gives an overview of when the various trade associations mentioned above formalised their private legal systems. Table 32: The age of private governance regimes in international trade Organisation

Date of formulation

FCC Rules

1936

LME Rules

1882

DDC By-laws

1932

ICA By-laws

1864

GAFTA Rules

1877

FCC = Federation of Cocoa Commerce LME = London Metal Exchange DDC = Diamond Dealers Club ICA = International Cotton Association GAFTA = Grain and Feed Trade Association

Table 32 shows us that these formalisation processes took place roughly between the last 30 years of the nineteenth and the first 30 years of the twentieth centuries. However, most of the trading associations and bourses have been involved in much longer trading histories than are covered by these periods. The formalisation of rules at the end of nineteenth and the beginning of the twentieth century was merely an act of writing down the traditional practices and trade customs that merchants in these particular branches had been using continuously for centuries. In contrast to specialised arbitration courts, universal arbitration courts only define the broad framework of their arbitral work. Otherwise, the parties are free to choose the procedural and substantive rules that will govern their disputes. This practice allows for the choice of both national laws and private transnational law codifications like, for example, the UNIDROIT Principles of International Commercial Courts. Many scholars

194 The Limits of International Commercial Arbitration of international commercial arbitration—including both supporters and critics—assume that the extensive choice of law possibilities provided in international arbitration would trigger a frequent application of transnational commercial laws to international contracts. Supporters claim that transnational commercial law is based on customary norms and generated by the merchants themselves and that, therefore, this private body of laws is far better adapted to the demands of the global trading community than national laws which are created by rent-seeking national governments. Critics argue that transnational law enables parties to use a business friendly law in order to circumvent state regulations that protect the interests of third parties. Either way, transnational commercial law is conceptualised as a system that works in favour of contracting global business parties. Consequently, it is widely expected that parties choose transnational commercial law in their contracts. However, according to Christopher R Drahozal, who, in 2005, summarised the then-available empirical data about choice of law in international commercial arbitration, this expectation is not met. In fact, parties to international contracts very rarely use the possibility to refer to transnational private codifications and almost exclusively choose national laws to govern their contracts.29 This picture is confirmed by a recent study done at Queen Mary University London which involved online questionnaires comprising 78 questions which were completed by 136 respondents from February to August 2010. The respondents were mostly legal councils or heads of legal departments of large or medium-sized international companies from all kinds of different industries and regions. In addition, this same group of respondents participated in 68 qualitative interviews. The study differentiates between four different categories of transnational commercial law: first, unwritten international principles (eg, broad concepts fairness and equity, determination ex aequo et bono); second, international treaties and conventions (eg, the United Nations Convention on Contracts for the International Sale of Goods (CISG); third, commercial law rules relating to trade and international contracts (eg, UNIDROIT Principles of International Commercial Contracts 2004 (UNIDROIT Principles) and INCOTERMS); fourth, other international rules (eg, Uniform Customs and Practice for Documentary Credits (UCP). Overall, the vast majority of interviewees stated that they never or only sometimes refer to one of the four categories of transnational commercial law. The study also makes clear that even when parties do rely on transnational commercial law they do so to supplement, rather than to displace, national law. In sum, this study found that transnational commercial law is used in international contracts considerably less frequently than is often assumed. 29

Drahozal, 2005, 526.

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It has been argued that the benefits of transnational law come at the price of certainty. General principles that characterise this type of law may on occasion, be useful to fill a gap but in essence they are too elementary to permit detached evaluation of conflicting interests, the specifically legal appreciations of the implications of a given situation. National laws are thus preferred over transnational laws because they provide for better predictability and legal certainty. A second reason that transnational law is seemingly avoided could be that the more powerful parties to an international contract are not interested in creating a level playing field by choosing a neutral transnational law but, rather, insist on choosing a national law with which they are familiar and their contractual partners are unfamiliar. By so doing, the stronger party puts itself in an even better strategic position in case conflicts should arise. From a rational choice point of view, it is clear that parties do not choose the law that is most efficient for both parties but the law that best suits their own interests. There is also a third reason to explain the low significance of transnational commercial law in international contracts that is more complex. Transnational commercial law is usually perceived as a system of norms that evolves spontaneously in the global trading community without being designed by governments. Its origins are traced back to the medieval ages, roughly between the tenth and thirteenth centuries. Commonly it is claimed that the medieval lex mercatoria provided universal norms and general legal principles that were applied and enforced by the merchants themselves to solve their disputes in trade relations that reached beyond local borders. The new lex mercatoria is thus presented as a descendant of the medieval lex mercatoria. Historians have questioned the accuracy of this account, particularly the universal nature of the medieval lex mercatoria. Certainly, mercantile guilds provided rules for its members, but these rules differed between guilds and thus no general trade law existed. This explains why merchants found it almost impossible to engage in transactions with traders outside their guilds. Historians argue, therefore, that guilds were important, not because of their legislative activities but because they provided effective networks-based enforcement mechanisms which were non-existent outside of these medieval private regimes. Other critics do not target the historical existence of a medieval lex mercatoria but question its relevance for contemporary legal debates. Under this viewpoint, reference to an old lex mercatoria that might or might not have existed in the Middle Ages is of little help to understand the theoretical and practical consequences of a transnational legal system that emerges in the twenty-first century. This point is crucial. Even scholars who support the existence of a medieval lex mercatoria acknowledge that this privately organised legal system was abolished by states at the latest in the eighteenth century. It is also a matter of fact that in the subsequent nineteenth and twentieth centuries, societies went through

196 The Limits of International Commercial Arbitration fundamental modernisation processes. Modernisation, among many other developments, led to a functional differentiation of economic and legal spheres. Once economies had modernised, the merchants, themselves, no longer had a role to play in setting up the legal infrastructure for commerce. This task was delegated to states and specialised legal professionals. As a consequence, the merchants were able to focus on the tasks in which they specialised—namely, doing business. What does this short excursus into modern history teach us about the concept of transnational commercial law at the beginning of the twentyfirst century? At first this perspective makes clear that there exists no continuous legal process in which one generation of merchants passed on customary lex mercatoria rules to the next generation. The practice whereby merchant organisations, themselves, were involved in creating private legal regimes for their transactions has survived only in a few particular industries that have been mentioned above. In general, these traditional practices were abolished and replaced by modern contracts that are governed by modern contract law. Second, history teaches us that the legal professionals who took over the function of creating and operating the institutional framework for economic exchange in modern market economies developed their professional skills during a socioeconomic development that was determined by rising nation states. Being a lawyer in the nineteenth and twentieth centuries involved studying national law plus, in exceptional cases, the laws of other nation states in a comparative fashion. The use of any kind of transnational law beyond the legal framework of nation states was not part of this cognitive framework. In sum, the medieval lex mercatoria did not survive as an applied legal practice in either the economic system or the legal system but became extinct in the course of societal modernisation and nationalisation. Moreover, in the period of classical national modernity, the possibility of a transnational law beyond statehood even ceased to exist as an intellectual idea. When the rapid rise of international trade in the first phase of globalisation towards the end of the nineteenth century led to new legal challenges, the creation of a worldwide private law system was exclusively discussed as a project on the basis of international treaty law between nation states. No alternative, a-national ideas about a global legal system were part of that discussion. However, after two world wars and a devastating outburst of nationalism in the first half of the twentieth century, the idea emerged again of a global commercial legal system that could serve the slowly recovering international trading community as a common legal infrastructure. In the late 1950s and early 1960s legal scholars like Berthold Goldman and Clive Schmitthoff postulated a resurgence of the lex mercatoria within the institutional framework of international commercial arbitration. In doing so, they conceptualised transnational commercial law as a third category

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of law—beyond the traditional dichotomy of national and international law—that is based on common legal principles and the customs of the international commercial community. They argued that its application, interpretation, and development should, therefore, be delegated to international commercial arbitration courts. Since then, thousands of volumes have contributed to the debate about the legal existence, normative quality, legal status and legitimacy of transnational commercial law. The debate about the rise of a new lex mercatoria has increased exponentially over the last two decades. New specialised law journals on transnational law have been founded, new research centres on the subject have been established and a growing number of law schools around the world have recently set up particular graduate programmes in the field of international commercial arbitration and transnational law. One should not underestimate the impact of these academic efforts. The more articles that are published, the more graduate programmes that are opened up and the more research centres that are started, the more transnational commercial law enters the cognitive legal framework of lawyers, which, over the last few centuries has been almost exclusively dominated by links to the modern nation state. It may well turn out that, in the near future, transnational commercial law becomes a routine practice and a regularly applied legal tool to guide the conduct of cross-border transactions. However, the currently available empirical data makes clear that, for the time being, transnational law has not achieved this status. Up to now, transnational commercial law has played only a minor role in transnational commercial arbitration. Thus, international commercial arbitration so far has not evolved into a common transnational law that would be capable of establishing a balanced legal playing field for companies engaged in global trade. The vast majority of cross-border contracts, even when they contain arbitration clauses, are still governed by national laws because these laws still determine the cognitive framework of legal professionals. The fact that international commercial arbitration courts predominantly apply national laws to solve disputes in cross-border exchange has a negative impact on the efficiency of these institutions. In chapter ten, it was explained that the territorial fragmentation of national legal systems leads to structural problems for state courts and enforcement in cross-border transactions. A global legal system that accepts only state-made law as an operating unit generates the need for contracts to be attached to existing laws and jurisdictions. Consequently, one of the parties is very likely to perform its contractual obligations under a foreign, unfamiliar law which, in turn, leads to increasing uncertainty, high legal costs and legal imbalances between the contractual partners. In theory, international commercial arbitration courts could solve this fragmentation problem because,

198 The Limits of International Commercial Arbitration in contrast to state courts, these private courts extend the freedom of the choice of law to transnational bodies of law. Yet, in practice, transnational commercial laws are rarely chosen by the contracting parties. Because of this behaviour, international commercial arbitration courts, like national courts, operate on the basis of a normative system that is shaped by fragmented national private laws. Thus, parties in international commercial arbitration also perform their contractual obligations under foreign, unfamiliar law face uncertainty and high legal costs. As a consequence, they are unlikely to turn to international commercial arbitration in order to enforce a contract, preferring to rely on alternative mechanisms. In sum, the significant role of fragmented national laws in international commercial arbitration limits the effectiveness of these private courts, which, as a result, end up with relatively small caseloads in relation to the immense growth of international trade.

Private Sanctions and State Enforcement in International Arbitration The international trade associations and bourses that are listed in Table 33 not only provide private norms that operate independently from territorially fragmented state law but also set up their own systems of sanctions to enforce the awards of their specialised arbitration courts. When, for example, it comes to sanctioning a defaulting party in the international diamond industry, the bylaws of the diamond bourses provide that [a]ll decisions of arbitration panels … which are not complied with within 10 working days, together with the picture of the non-complying member, shall be posted in a conspicuous room in the Club rooms.30

This information is communicated to all bourses in the world federation. Membership in the federation requires each bourse to enforce the judgments of all member bourses worldwide. Since most dealers frequently transact in foreign bourses, this reciprocity of enforcement greatly increases the penalty for failing to voluntarily comply with arbitration judgments. The local bourses usually exclude the non-complying party from the trading floor.31 Bernstein defines this enforcement structure as an ‘information intermediary regime’32 in which technology and markets link the rapid and low cost dissemination of information and reputation. Similar to the diamond bourses’ arbitration courts, the other four specialised international commercial arbitration courts are also embedded 30 31 32

Cited in: Bernstein, 1992, 128. Ibid, 128. Ibid, 116.

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in organised reputational systems. As can be seen in Figure 33, GAFTA and LME arbitration courts are entitled to inform their members about a party that refuses to carry out an arbitral award. The LCA goes even farther. Its directors might pass the name of the defaulting party not only to members but also to: Registered Firms, Associate Members, Member Associations of the Committee for International Co-operation between Cotton Associations (CICCA) or any other organisation or person by any method it chooses, including the listing of the name of the defaulter and appropriate details in the publicly accessible area of the Association‘s website.33

Similarly, the FCC publishes the names of defaulting parties that have failed to comply with an arbitration award on a website34 with unlimited access. At the time this book was written, this list contained a total of 17 parties.35 By contrast, universal arbitration courts have no role to play in the enforcement of their decisions. They are limited in the powers they can exercise. Legally, their service ends when the award is rendered. At that moment, the arbitral tribunal is functus officio.36 Universal international commercial arbitration courts are not linked to an organised system of private sanctions that gives immediate effect to arbitral awards. Instead, the ultimate sanction for non-compliance in international commercial arbitration is enforcement by proceedings in national courts.37 Table 33: Private enforcement in specialised international commercial arbitration Business Association

Reputation based sanctioning system

LME

If the Secretary has not, within 14 days of receipt of the notice of application […] received from both (a) the party in whose favour the award was made and (b) the party against whom the award was made, a notice of confirmation in writing that payment of all amounts due under the award have been made in full, the Secretary shall communicate to Members such failure to make payment.1 (Continued)

33 Bylaws and Rules of The International Cotton Association, available at: www.ica-ltd. org/media/layout/documents/rulebooks/rulebook_english_jan11.pdf, 36. 34 It should be noted that international business associations also obviously make use of the Internet to organise their reputational networks. Given this, the threat that noncompliance with an arbitral award will lead to exclusion from further business opportunities for the defaulting party clearly becomes more credible. 35 The blacklist of the FCC can be seen at: www.cocoafederation.com/arbitration/defaulters.jsp. 36 Blackaby, Partisides, Redfern and Hunter, 2009, 622. 37 Ibid, 622.

200 The Limits of International Commercial Arbitration Table 33: (Continued)

1

Business Association

Reputation based sanctioning system

FCC

The FCC only makes its arbitration and appeals rules available to members. However, it is clear that a similar private sanctioning system exists because on their homepage the Federation publishes a default list with parties that have not complied with arbitral awards.2

ICA

If the Association receives written advice from a party to an Award, (‘the Reporting party’) or from their representative that an Award has not been complied with by the other party to the Award (‘the alleged defaulter’), the Directors are to be informed. […] The Directors may pass on the name of the defaulting party to Full Members, Registered Firms, Associate Members, Member Associations of the Committee for International Cooperation between Cotton Associations (CICCA) or any other organisation or person by any method it chooses, including the listing of the name of the defaulter and appropriate details in the publicly accessible area of the Association‘s website. If the Directors so decide, this information and any other appropriate information will be circulated on a list of unfulfilled Awards, to be known as the ‘ICA List of Unfulfilled Awards’. The Directors may also at any time circulate to Full Members, Registered Firms, and Associate Members, and Member Associations of the Committee for International Co-operation between Cotton Associations (CICCA), an Advisory Notice advising them of any entity which appears to be related to, or utilised by a defaulter. Such Advisory Notice shall also be displayed in that area of the Association’s website restricted to Full Members, Registered Firms and Associate Members.3

GAFTA

In the event of any party to an arbitration or an appeal held under these rules neglecting or refusing to carry out or abide by final award of the tribunal or board of appeal made under these Rules, the Council of GAFTA may post on the GAFTA Notice Board, Web-site and/or circulate amongst Members in any way thought fit notification to that effect. The parties to any such arbitration or appeal shall be deemed to have consented to the Council taking such action as aforesaid.4

Arbitration Regulation of the LME, available at: www.lme.com/downloads/PT8_ Arbitration _Rules_14.12.09.pdf, 11. 2 See: www.cocoafederation.com/arbitration/defaulters.jsp. 3 Bylaws and Rules of The International Cotton Association, available at: www.ica-ltd.org/ media/layout/documents/rulebooks/rulebook_english_jan11.pdf, 36. 4 Cited in: Blackaby, Partisides, Redfern and Hunter, 2009, 624.

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Legal scholars normally do not perceive the enforcement of foreign arbitral awards as a problem that exerts a negative impact on the performance of non-specialised international commercial arbitration courts. Instead, they refer to a number of international conventions that facilitate the recognition and enforcement of foreign arbitral awards.38 In particular, one of the most widely adopted conventions—the 1958 United Nations New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards39 to which almost 150 nations are signatories—is usually presented as a successful piece of international law and thus a driving force for the emergence of private international arbitration in the last decades.40 However, upon a closer look one recognises that this view is based on a simple comparison, which unfolds as follows. Due to the New York Convention, the enforcement of foreign arbitral awards is far better regulated than the enforcement of foreign judgments rendered by state courts. Regarding the latter, similar multilateral agreements are still missing. Consequently, the New York Convention gives foreign arbitral awards a far better chance of becoming successfully enforced across borders than judgments by state courts. This advantage, in turn, induces companies engaged in international trade to favour international commercial arbitration over state courts. The New York Convention therefore triggers the rise of international commercial arbitration as the most important contract-enforcement institution in international trade.41 This line of argument appears plausible, except for the final conclusion. It is not useful to conclude that companies engaged in international trade rely predominantly on international commercial arbitration courts in order to enforce contracts across borders only because these private courts perform better than state courts, which do not work at all. Outperforming state courts is only one aspect of comparison, and it does not necessarily ensure that enforcing arbitral awards according to the New York Convention is also efficient. Indeed, quite the opposite seems true. Although, in contrast to judgments rendered by state courts, the

38

See, eg: ibid, 631. The Convention on the Recognition and Enforcement of Foreign Arbitral Awards, in short: ‘New York Convention’, was signed on 10 July 1958 was signed and it entered into force on 7 June 1959. See: United Nations Commission on International Trade law, 1958— Convention on the Recognition and Enforcement of Foreign Arbitral Awards—the ‘New York’ Convention available at: www.uncitral.org/uncitral/en/uncitral_texts/arbitration/ NYConvention.html, last accessed 17 January 2008. 40 See, eg: Born, 2009, 209; Redfern and Hunter, 2004, 69. 41 See, eg: Blackaby, Partisides, Redfern and Hunter, 2009, 631. 39

202 The Limits of International Commercial Arbitration New York Convention significantly facilitates the enforcement of foreign arbitral awards, this procedure still has various shortcomings, particularly when compared to private enforcement practices within private governance regimes. In comparing the efficiency of different enforcement mechanisms, two factors are of major importance: enforcement costs and unreliable national legal systems, which in the end need to enforce foreign arbitral awards. Enforcement Costs: At first glance, the New York Convention keeps the formalities of recognising and enforcing foreign arbitral awards at national courts rather simple. The enforcing party is merely required to produce for the court the original award (or a copy thereof) and the original arbitration agreement (or a copy thereof).42 The New York Convention also restricts the possibilities for national courts to refuse the recognition and enforcement of arbitral awards. The role of the national court is not to review the substantial rules of the decision.43 Rather the court’s function is simply to decide whether the hearings and procedures that led to the arbitral award were in accordance with basic procedural principles like the equality of treatment and the right of each party to have a proper opportunity to present its case.44 However, even though the New York Convention requirements for enforcement are relatively simple, these procedures still cause additional efforts for the enforcing party. For example, if the arbitral award is written in a different language from the enforcing state, local laws usually require a translation that has to comply with high formal standards like the attestation of a consulate in the country of origin. In addition to the translation costs, the local courts charge the enforcing party for the enforcement of the arbitral award, and the enforcing party incurs the costs for the advice of local lawyers. Furthermore, apart from the extra costs, the entire procedure takes time, in addition to the time it took to receive the arbitral award in the first place. Admittedly, compared to the costs of enforcing a state court’s judgment across national borders, these efforts are comparatively small. But there are still cost and time factors involved in enforcing arbitral awards under the New York Convention which are absent from effective private governance regimes.

42 Art IV, 1 of the New York Convention, available at: www.uncitral.org/uncitral/en/ uncitral_texts/arbitration/NYConvention.html. 43 Art V of the New York Convention, available at: www.uncitral.org/uncitral/en/uncitral_texts/ arbitration/NYConvention.html. 44 Art V of the New York Convention, available at: www.uncitral.org/uncitral/en/uncitral_texts/arbitration/NYConvention.html.

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In all five regimes mentioned above, the losing party has to fulfil the arbitral award within a short period of time (10–14 days) or it will be expelled from further trading by worldwide reputation mechanisms. Enforcing arbitral awards by means of spreading information about a non-compliant party among the members of a reputation network, or even the market in general, does not involve any costs for the winning party and is very fast. Specialised arbitration courts that are embedded in private governance regimes are thus considerably more efficient than universal arbitration courts. They do not require additional costly and timeconsuming court procedures to render their arbitral awards effective. In this context, it is very interesting to look at another empirical study by Queen Mary University London conducted in 2006. The study is based on data from 82 questionnaires and 47 interviews with major companies. The results show that the majority of the interviewed organisations did not proceed to the enforcement stage after the award was rendered but, rather, negotiated new post-award settlements with the losing party. In these negotiations, the winning party usually accepts reduced payments. When asked why companies employ this strategy, the main answer was that they wanted to avoid the costs and time of the enforcement procedure. Thus, winning parties would rather accept substantial reductions of original awards than incur the costly and time-consuming procedures to actually enforce the award under the New York Convention.45 So, even when the New York Convention keeps the formalities of enforcement rather simple, post-arbitration, the winning party still has to pass through additional costly and time-consuming procedures in front of a state court. From an efficiency point of view, additional costs and time present crucial factors which might well deter companies from relying on international commercial arbitration courts as their mechanism of choice to enforce contracts across borders. Unreliable National Legal Systems: In addition to the extra costs of postarbitration enforcement, unreliable national legal systems present further limitations to the efficiency of enforcing arbitral awards across national borders. It has been explained in chapter ten that, as a matter of principle, private international law does not interfere with territorial sovereignty of nation states. Thus, it is always the courts and enforcement authorities of nation states who have the final responsibility of enforcing foreign judgments on parties from their respective territories. This task is clearly not fulfilled in

45 Arbitration Study published by the School of International Arbitration of Queen Mary University London in cooperation with PriceWaterhouseCoopers. See: www.arbitrationonline.org/research/Corpattitempirical/2008, 8–10.

204 The Limits of International Commercial Arbitration every state with the same reliability.46 Corrupt, slow, expensive, or even non-existent state legal systems thus unavoidably restrict the use of state enforceable contracts in international trade. Scholars of international commercial arbitration tend to overlook the fact that this problem also applies to the enforcement of foreign arbitral awards. The widely shared notion that arbitral awards are reliably enforceable just because a state has become a member of the New York Convention is rather naïve. The behaviour of the Indonesian courts provides a good example to illustrate this point. The country became a party to the New York Convention in 1981. However, according to Robert N Hornick, even afterwards it was practically impossible to successfully enforce a foreign arbitral award in Indonesia.47 It took the Indonesian government almost 10 years to promulgate the underlying regulations to implement the New York Convention. Throughout this transition period, the Indonesian courts refused to enforce arbitral awards falling under the New York Convention, on the ground that the Convention’s implementation regulations were not issued by the relevant Indonesian authorities. But, even when the necessary regulations finally entered into force, the local courts refused to enforce arbitral awards. In every case, the courts found that there were unclear legal matters that inhibited prompt enforcement unless further guidance would be provided by superior courts or state authorities. At the time that Hornick published his article in 1991, not a single foreign arbitral award was successfully enforced in Indonesia, eleven years after the country became a member of the New York Convention.48 In contrast to specialised arbitration courts, universal international commercial arbitration courts do not impose private sanctions to enforce their arbitral awards but rely ultimately on state enforcement. This means that, at the end of the legal chain, international commercial arbitration courts are also limited by corrupt, slow or expensive national enforcement procedures in many regions of world trade.49 The 2006 study of Queen Mary University is again very helpful to illustrate this point. When asked about the recognition and enforcement of foreign arbitral awards, companies reported experiencing a range of difficulties. Unsurprisingly, the

46

See, eg: World Bank Group, 2011. Hornick, 1991. 48 Ibid. 49 Wai, 2002, 267: International commercial arbitration still very much relies on the support of national legal systems. The ultimate authority for arbitration procedures is that they are recognized and supported by national legislative and judicial processes. Without the power of state legal systems behind them, a party who expects to do poorly in the arbitration will have no incentive to comply … Consequently, international commercial arbitration operates very much in the ‘shadow of the law’ and national laws continue to impose important limits. 47

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main difficulty (46 per cent) was hostility to foreign arbitral awards in the place of enforcement. When further asked what kind of difficulties they had experienced at the place of enforcement, 56 per cent of company lawyers cited local recognition of the awards and problematic enforcement/ execution procedures. The majority of company lawyers linked both of these problems with the attitudes of the local bureaucrats and courts. Ten per cent of the interviewees reported difficulties with corruption at local courts. When asked about particular countries, the most cited regions where difficulties were likely to appear in enforcement or execution proceedings were Central America, South America (including Brazil), and Africa. In addition, China, India and Russia were considered potentially problematic territories.50 These results show that, despite the New York Convention, international commercial arbitration in its universal form lacks an efficacious worldwide enforcement system. Without efficacious enforcement, a legal institution has no bearing on human behaviour. Even more than the possibility of extra costs, the fact that foreign arbitral rewards cannot reliably be enforced in many parts of the world which are today deeply integrated into the world market severely constrains the capability of international commercial arbitration courts to provide for a workable legal infrastructure for global exchange. Being aware of the fact that they might ultimately be unable to enforce foreign arbitral awards, companies will be reluctant to rely on this mechanism and will look for alternative safeguards to secure their contractual risks. MARITIME ARBITRATION: A DEVIANT CASE

A short excursus into the field of Maritime Arbitration is helpful to further support the argument that legal systems only gain practical relevance when they provide effective enforcement systems. International commercial arbitration courts are very active, particularly in the area of charter business.51 In maritime trade, the most important arbitration courts are the London Maritime Arbitrators Association (LMAA) and the Society of Maritime Arbitrators in New York (SMA). Together, these two courts handle around 90 per cent of the worldwide caseload.52 Both the LMAA and the SMA accept only maritime cases for arbitration. However, with around 4,500 requests in 2009,53 these courts handle a 50 The Arbitration Study was published by the School of International Arbitration of Queen Mary University London in cooperation with PriceWaterhouseCoopers. See: www. arbitrationonline.org/research/Corpattitempirical/2008, 10–12. 51 See Maurer and Beckers, 2009; Maurer, 2012. 52 See Maurer, 2012. 53 For detailed statistical numbers on maritime arbitration see: Hoffmann and Maurer, 2010, Maurer, 2012.

206 The Limits of International Commercial Arbitration significantly higher caseload than all universal arbitration courts together, although the universal courts, which accept cases from all industries involved in global trade, operate in a potentially far greater market.54 These numbers, indeed, support the claim that the maritime trade sector is more effectively governed by specific industry rules and powerful private arbitration courts than is international trade in general. The interesting point is that maritime arbitration does not qualify as a complete private governance regime. Like universal international commercial arbitration courts, maritime arbitration courts lack private sanctioning powers. The ultimate sanction in maritime arbitration, as with universal arbitration, is enforcement in national courts.55 However, if maritime arbitration courts are not embedded in effective reputational systems, how can we then explain the vibrant role these courts play in supporting maritime trade? In order to give an answer to this question, we first need to understand a peculiarity of maritime law—the so-called ship or vessel arrest. To be clear, a ship arrest is a legal procedure administered by state courts and state enforcement authorities and cannot directly be ordered by maritime arbitration courts.56 The most important facet of a ship arrest is the following: if a party has a certain type of claim relating to a vessel, then that party can issue proceedings directly against that vessel or, usually, also a sister vessel belonging to same owner. The party can have the vessel arrested until the claim is settled. If the debtor is unable to settle the claim, the courts can be directed to sell the vessel under certain legal procedures.57 Ship arrests are part of national laws. Hence legal details vary from state to state. However, a substantial number of coastal states are party to the 1952 International Convention for Unification of Certain Rules Relating to the Arrest of Sea-Going Ships (Arrest Convention). The Arrest Convention particularly sets out a list of maritime claims for which a vessel may be arrested. Generally speaking, this list includes all possible claims related to using, renting, selling, buying or financing sea ships.58 In order to understand how this particular state-backed enforcement tool supports the work of private arbitration courts in the maritime sector, consider the following two scenarios.

54

Maurer, 2012. Andreas Maurer identifies some minor black-listing possibilities in maritime trade. However, these practices are very rarely used. Maurer therefore concluded that they are unimportant for enforcement. See: Maurer, 2012. 56 Zekos, 2008, 380–83. 57 Ibid, 382. 58 The text of the convention is available at: http://treaties.un.org/doc/publication/ mtdsg/volume ii/chapter xii/xii 8.en.pdf, see also: Lynn, 2001, 453–85. 55

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Imagine a Greek ship-owner engaged in a dispute over a charter contract with a Chinese shipping company that withholds payments.59 The case is filed at the LMAA in London. The arbitration court decides in favour of the Greek shipowner, but the Chinese company refuses to comply with the award. How can the Greek shipowner enforce the award? Scenario 1: The first step in attempting to collect the maritime claim consists of locating the vessels that belong to the Chinese shipping company (charter and ownership). If one of these vessels happens to anchor in a UK port, the enforcement procedure is very simple. UK courts immediately recognise arbitral awards rendered in the UK without further recognition procedures.60 Consequently, the Greek shipowner merely needs to produce to the UK enforcement authorities the arbitral award of the LMAA in order to get the Chinese ship arrested. In this way, the Greek shipowner is capable of collecting his debts from the foreign Chinese company without incurring the time and expenses of having the arbitral award recognised and enforced in China. Since the Chinese ship resides in Britain, a very costly and tedious enforcement procedure is turned into a simple and cost-effective domestic case. The whole enforcement procedure does not transcend national borders, meaning that all problems that limit cross-border contract enforcement of arbitral awards are absent. Scenario 2: Even if no Chinese ships anchor in Britain, the enforcement procedure is rather straightforward. The shipowner simply needs to locate a ship of the Chinese company in a port that is based in a state whose jurisdiction is capable of handling such cases efficiently, for example, the Netherlands in Europe or Singapore in Asia.61 Clearly, in the second scenario the Greek shipowner has to incur the cost and time of recognising the foreign arbitral award in the state of enforcement, meaning that the enforcement procedures are no longer domestic. But the Greek shipowner still circumvents the costly, tedious and unreliable enforcement procedures in China.62

59 This scenario was reported by the Financial Times (24 August 2011) p 1. The Greek shipowner is George Economou, who, according to the Financial Times, is ‘one of Greece’s highest-profile shipowners’, and the Chinese shipping company is Cosco, who, according to the Financial Times, is ‘the largest operator of dry bulk ships’. 60 See: Blackaby, Partisides, Redfern and Hunter, 2009, 626. 61 Maurer, 2012. 62 He could, for example, try to enforce the claim in Singapore where enforcement is comparatively efficient. According to a leading law firm in maritime law: Arbitration tribunals have full powers to give directions for security for claim and costs, disclosure of information, preservation of property, subject matter and evidence, interim injunctions, and other interim orders. Where there is no occasion for the arbitral tribunal to

208 The Limits of International Commercial Arbitration Sooner or later, a vessel of the Chinese shipping company will have to enter a port with an efficient jurisdiction because no shipping company can afford to run ships that are unable to call at some of the most economically important harbours in world trade. Thus, for the Chinese company, the incentives to pay the debt to the Greek shipowner are very strong. As discussed earlier in this chapter, enforcing universal arbitral awards leads to two major problems: First, it involves considerable costs and time; second, enforcement is unreliable in many regions that today play a vibrant role in world trade. In maritime arbitration, both problems are either absent (scenario 1) or significantly less severe (scenario 2). In contrast to universal arbitration courts, ship arrest provides maritime arbitration with a cost-effective enforcement system, which explains why, in this particular business sector, international arbitration courts play a much more significant role in providing for a workable legal infrastructure than universal arbitration courts do for world trade in general. Clearly, maritime arbitrators are great experts in their fields, and maritime arbitration courts provide well-proven procedures to settle disputes. However, without an underlying power structure, these advantages could not be utilised by shipping companies and maritime traders. This analysis, once again, supports the conclusion that arbitration courts will only be used in large numbers when they are embedded in efficient enforcement structures. However, besides a few private governance regimes and the maritime trade, such enforcement structures are absent at global markets. Therefore, deficient enforcement structures provide a second reason why the importance of universal arbitration courts remains smaller than often assumed. THE CARTELISATION OF INTERNATIONAL COMMERCIAL ARBITRATION

There is a third reason, which is widely neglected by the pertinent literature, to explain the relatively small caseload of universal international commercial arbitration courts. This reason is not connected to the close links of commercial arbitration to state legal systems but results from the internal structures of these courts, themselves. International commercial arbitration and the new lex mercatoria are widely considered as an emerging legal field that is not designed top-down by state-made politics but evolves gradually and bottom-up according to the legal demands and

act effectively, the Singapore court has power to make orders in support of the arbitration and can do so even if the juridical seat of the arbitration is outside Singapore. See: www.rodyk.com/usermedia/documents/Rodyk_Guide _To_Maritime_Arbitration_ In_Singapore.pdf, last accessed 24 November 2011.

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interests of companies and other organisations engaged in international trade.63 The following quotation illustrates this point: The short description of the elements of the modern Lex Mercatoria has shown that, at present, businesses are able to spontaneously develop institutions that offer a reliable institutional framework for border-crossing transactions.64

However, this view is only partly right. International commercial arbitration does evolve bottom-up according to the interests of private actors. But, companies and other organisations that are engaged in international trade are not the main driving forces. The picture of a legal system that is driven by the legal needs of ‘businesses’ in order to create a simple and reliable legal infrastructure might have fitted international commercial arbitration when it first emerged in the eleventh century. At that time, it was indeed the merchants who developed their own courts, provided the judges, applied their own rules to decide cases and enforced these decisions by multilateral boycott.65 However, after it virtually disappeared in the eighteenth century, international commercial arbitration returned as a different system at the end of the nineteenth century. One must not forget the fundamental processes of social and economic modernisation in the nineteenth and twentieth centuries.66 In modern societies, legal professionals provide the legal infrastructure for economic exchange; economic actors no longer play a role in performing this function.67 Today, society is moving on from state-centred to global modernisation.68 As a consequence, we observe the emergence of new legal professionals. However, globalisation does not bring ‘businesses’, themselves, back into the operation of the legal system. Up until the time of its second revival, after the Second World War in the 1950s, international commercial arbitration was shaped by its major legal actors, namely international commercial arbitrators and lawyers. These actors built an elite class that still performs dispute resolution services for a few elite clients. Our empirical knowledge is still too fragmented to understand whether it is because of pure interests or a lack of organisational capability, but, as will be shown in the following, international commercial arbitration courts have never been turned into broad, low-cost, cross-border contract 63 See, eg: Benson, 1989; Mattli, 2001; Stone Sweet, 2006, Cutler, 2003, Calliess and Zumbansen, 2010, Schmitthoff, 1987. 64 Volckart and Mangels, 1999, 433. 65 See Bruce Benson, 1989, 648, who argues that during the Middle Ages a private-order institution, that of the law merchant, enabled ‘thousands of traders who travelled to fairs and markets all over Europe exchanging goods which they knew little about with people they knew little about’. See also: Berman, 1983, 333; Volckart and Mangels, 1999, 437–39. 66 Modernisation processes have best been described by classical sociological writers like Max Weber and Emile Durkheim: See: Weber, 1980; Durkheim, 1992. 67 See: Luhmann, 1993. 68 Beck, 2000.

210 The Limits of International Commercial Arbitration enforcement institutions that serve the international trading community in general. After the end of the Second World War, in the 1950s, a small, intimate group of very distinguished European legal experts—often referred to as the ‘grand old men’ or ‘grand notables’—endeavoured to resurrect the project of creating a legal infrastructure for an emerging international trading community. The founding figures of international commercial arbitration were not arbitration professionals. They came from outstanding national and international careers as legal professors, judges or lawyers, which already guaranteed them high incomes and prestige. The members of the club of ‘grand old men’ became the chairmen and presidents of the most important arbitral institutions and began to shape the legal culture of international commercial arbitration. What emerged was a judicial system based on flexible procedures and universal lex mercatoria principles rather than formal law—a system that, in order to ensure its informality and flexibility, laid the main parts of the decision-making power in the hands of the grand old arbitrators themselves. The strategy worked out. The combination of informal procedures and flexible norms in the hands of outstanding legal professionals provided the crucial ingredient for the initial success of international commercial arbitration. Step by step, this legal system established a reputation for relying on excellent legal artisans to provide fast, confidential and cost-effective decisions on complex cross-border business disputes. In the decades following the 1950s, the club of ‘grand old men’ controlled the system of international commercial arbitration. In fact, the members of this club enjoyed a quasimonopoly in this legal market.69 Since the 1970s, the closed club of international commercial arbitrators has been expanded by mainly two groups. Dezalay and Garth call the first group the ‘technocrats’70—ie a younger generation of arbitrators who made their careers not outside the system like the ‘grand old men’ but within the expanding institutions of international commercial arbitration. The second group, which exerted a far greater influence on the system, were large American law firms, which mostly served American-based multinational companies.71 As these enterprises became increasingly involved in big cross-border merger and acquisition deals in the 1980s, the American law firms began to use the international commercial courts as one possible venue for related litigation processes.72 Naturally, such powerful players as the large American law firms did not accept the situation of performing their legal services in an institutional 69 70 71 72

For a detailed view see: Dezalay and Garth, 1996, ch 3. Ibid, 34. Ibid, 51. Werner, 1998; Helmer, 2004; Dezalay and Garth, 1996, 34–37.

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environment that was entirely controlled by others. Inevitably, conflict arose with the traditional club of the ‘grand old men’, through which the powerful newcomers pushed for transparency and formality in order to facilitate access for outsiders.73 Moreover, American law firms, who were unfamiliar with the principle-based, informal lex mercatoria procedures traditionally employed in international commercial arbitration, fell back on their home-grown ‘court-like’ practices. As a consequence, international commercial arbitration became, in many respects, as formal, costly and time-consuming as litigation in state courts. Today, international commercial arbitration is a much more formally organised legal institution than in the 1970s. However, according to Catherine R Rogers, who has studied recent institutional developments in international commercial arbitration, this system remains largely cartelised. Except for the powerful elite group of American mega law firms, it still seems difficult for newcomers to enter the world of arbitration. The majority of important procedures are still arbitrated by an astonishingly small number of recurring arbitrators: While the number of arbitrators has expanded, two major factors impede the development of competitive and open market for arbitration. First, even with expansion, the field continuous to be dominated by an elite group of insiders … [T]he market for international arbitrators operates as a relatively closed system that is difficult for newcomers to penetrate.74

Even today, the group of international commercial arbitrators is usually referred to as a caste or a mafia.75 From an efficiency perspective, the important point is that international commercial arbitration, since its beginning, has been organised as a supply market. It started after the Second World War with a small group of elite legal personalities that might have been inspired by the idea of developing a universal and global legal system to underpin the economic integration of the world. However, the informal, club-based structures that emerged were not, over time, able to be transformed into an effective modern system that would be capable of performing this function in the age of economic globalisation. Modern legal systems, as they developed within nation states in the nineteenth and twentieth centuries, consist of a variety of different legal institutions and—most importantly—rely on huge numbers of legal professionals. It is no coincidence that, in Western nation states, the emergence of modern legal systems was accompanied by the rise of modern universities and law schools which follow widely standardised educational

73 74 75

Dezalay and Garth, 1996, 51, 57. Rodgers, 2005, 968. Michaels, 2011, 11.

212 The Limits of International Commercial Arbitration models in order to cover the high demand for legal professionals. Yet, even now we do not see international commercial arbitration triggering similar processes. International commercial arbitration is still not part of the core curriculum of higher legal education, and there are still no standardised career paths to becoming an international arbitrator. International commercial arbitration can be compared to a cartel because its main actors control two crucial aspects of the system: first, they assign each other either as arbitrators or lawyers and, second, they hamper the professional process of becoming an arbitrator or lawyer in the field. Access to international commercial arbitration is still dependent on very close personal relations. Like in medieval guilds, the taskmaster chooses his pupil and promotes him to an international commercial arbitrator after a considerable time of learning.76 As a result of all of this, international commercial arbitration has never reached the organisational capability to function as a rational, universal private law system for modern global markets. Outside forces were needed to transform international commercial arbitration. The most successful group of actors that entered the system were lawyers of large American law firms. However, this group did not follow a public policy approach and turn arbitration into a low-cost and efficient globally available contract enforcement arbitration. On the contrary, even more than the club of the ‘grand old men’, American lawyers followed a business approach to international arbitration. The excessive American influence introduced into the system involves practices followed in US courts, like the prehearing production of documents and motion practice at the expense of speed, efficiency and low cost of arbitral proceedings. Over the last few decades, international commercial arbitration has become increasingly formalised. The formalisation, however, has not had the effect of turning international commercial arbitration into an open, universal legal system. Today, international commercial arbitration is still a closed system that is increasingly losing the informal structures which, in the past, enabled the system to provide straightforward and relatively low-cost dispute resolution services for enterprises engaged in complex cross-border contracts. In sum, international commercial arbitration has not been shaped by the legal needs of the global business community but rather by the interests of powerful elite legal actors.77 Over the last few 76

See: ibid, 11–12. The very high amounts of money that are involved in most arbitral cases are another fact that suggests that international commercial arbitration is not emerging as a universal contract enforcement institution for the vast majority of contracts and firms but as specialised legal business that is protected from competition in order to enjoy the monopoly rents of providing extremely expensive services to an elite class of multinational companies and other rich players in international trade like states that can afford using international commercial arbitration. 77

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decades, international commercial arbitration has been turned into both a cartelised and expensive legal service, and this provides a third factor to explain the low caseload of international commercial arbitration courts in comparison to the tremendous growth rates of international trade.

KEY RESULTS

The empirical study presented in Part II established that companies in the global software industry very rarely rely on international commercial arbitration to enforce contracts across borders. Given the widely shared notion that international commercial arbitration courts stand at the centre of an evolving global legal order, at first it seemed plausible to ascribe this finding to the idiosyncratic conditions in the global software industry. However, upon a broader examination of the available empirical data on the activity of international commercial courts, it turns out that the practical relevance of international commercial arbitration courts is vastly overestimated. When the caseload of international commercial arbitration courts like the ICC, LCIA and SCC is compared to economic figures, it becomes especially clear that these courts are still too small to be capable of providing the legal infrastructure for the immense growth of cross-border exchange and global markets that has occurred over the last few decades. Arbitration courts like the ICC, LCIA or SCC are universal in that they principally accept cases from all kinds of different industries and companies. From this universal type, we can distinguish a small group of specialised arbitration courts, which only exist within particular industries, like, for example, the global diamond industry. Specialised arbitration courts are embedded in international business associations that provide the norms that are applied by these courts as well as systems of private sanctions to enforce their arbitral awards. Specialised arbitration courts are thus part of fully developed private governance regimes. In contrast, universal arbitration courts are embedded in state-provided norm and enforcement structures. They are therefore best characterised as hybrid systems. A central conclusion of this chapter is that these close links to state legal systems markedly reduce the potential efficiency of international commercial arbitration courts. In chapter ten, it was explained that, because of the territorial fragmentation of legal systems, nation states turn out to be incapable of providing a working legal infrastructure for global commerce. Three major problems were identified: (A) colliding norms that are not efficiently coordinated by present conflict-of-law rules; (B) the inclusion of unreliable or inefficient legal units that exist in many parts of the world into the operation of the overall systems; (C) strategic imbalances

214 The Limits of International Commercial Arbitration between parties, emanating from the fact that, in many cases, one party can use its familiar national home law while the other party is forced to perform its contractual relations under unfamiliar foreign law. Arbitration courts seem to be well equipped to overcome problem A. Even when the contract is unclear about applicable law, arbitration courts usually provide simple and fast guidance for solving these ambiguities. In drawing on international arbitration courts, parties avoid uncertainties about place of jurisdiction and applicable law. Since international arbitrators are used to dealing with many different national legal systems, their legal knowledge is far better adapted to handling cross-border disputes than the legal knowledge of national judges who routinely apply their national laws but often lack experience in applying foreign norms. In this respect, international commercial arbitration is capable of transcending systematic fragmentation differences among national legal systems.78 However, according to this chapter’s analysis, different pictures emerge with regard to problems B and C. Although the last two decades, especially, saw an exponential increase of academic efforts to present transnational commercial law as a legitimate and efficient third category of law beyond national and international law, the available empirical data suggests that it has not yet become routine practice in cross-border contracts. Arbitration clauses in international contracts are usually combined with references to national contract laws. The negative effect of this practice is that, in the end, international arbitration courts, like national courts, factually operate on the basis of a territorially fragmented state-based norm system. Problem C is thus not solved. Also, when arbitration clauses are in place, many parties perform their contractual obligations under unfamiliar, foreign national norms. Unfamiliar norms lead to high legal costs which, in turn, render it less likely that these parties will rely on international commercial courts in order to enforce their contracts when conflicts arise. In contrast to specialised arbitration courts, universal arbitration courts do not provide systems of private sanctions. Instead, the ultimate sanction of arbitral awards is enforcement in a state court. This link to state legal systems leads to two major shortcomings. First, even when the New York Convention keeps the formalities of enforcement rather simple, after arbitration, the winning party has to pass through an additional costly and time-consuming procedure in front of a state court, which might well deter companies from relying on international commercial arbitration as their preferred cross-border contract enforcement institution. Second, and considerably more important, the dependence on state enforcement means that, similar to national courts, international commercial

78

See also: Leeson, 2008, 65.

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arbitration courts are constrained by corrupt, slow or expensive national enforcement procedures existing in many states that today play vibrant roles in international trade. Thus, problem B continues to exist, too. International commercial courts in their present form cannot avoid the inclusion of inefficient legal systems into their legal operations. Clearly, companies engaged in cross-border transactions are well aware of this fact. They know that, in many circumstances, they might end up with foreign arbitral awards that they cannot enforce. Consequently, they do not rely on this mechanism to safeguard their cross-border contracts against fraud and opportunistic behaviour but, instead, tend to choose alternative mechanisms. In this context, maritime arbitration presents a very interesting exception. Although maritime arbitration courts are specialised, they are not embedded in complete private governance regimes. Maritime arbitration courts rely on state enforcement. Nevertheless, their caseload is significantly higher than the caseload of universal arbitration courts in general. Maritime arbitration courts are more effective than universal arbitration courts because they are supported by a special enforcement tool: ship arrest. Profitable ships that carry goods and passengers around the globe sooner or later need to call at a harbour with a reliable and cost-effective jurisdiction. Given this, the winning party in a maritime arbitration can avoid problem B. In maritime arbitration, it is indeed possible to exclude inefficient or unreliable national legal units from the operation of the arbitral system, which reinforces the argument that the performance of arbitration courts crucially depends on effective enforcement structures. When such structures are absent, as is the case in general international commercial arbitration, considerably fewer companies will rely on these arbitration services. A further reason that helps us to understand the low caseload of universal international commercial courts like the ICC, LCIA or SCC is not connected to the close links of commercial arbitration to state legal systems but results from the internal structures of the courts themselves. Students of international commercial arbitration often claim that the evolution of commercial arbitration is driven by the legal needs of companies that are engaged in global business. However, one must not forget the interests of the major actors of these courts. After the Second World War, international commercial arbitration was revived by the European ‘club of grand old men’. In the decades following the 1950s, this informal club enjoyed a quasi-monopoly in the legal market for arbitration. Although this system was opened up later, with the exception of the powerful elite group of American mega law firms, it still seems difficult for newcomers to enter the world of arbitration. International commercial arbitration is, thus, still organised as a cartel that is interested in providing highly expensive legal services to elite clients but has never reached the organisational

216 The Limits of International Commercial Arbitration capacity to provide a cost-effective legal infrastructure for international trade in general. To be clear, despite the critical points set forth in this chapter, it is still true that international commercial arbitration has become the accepted method of dispute resolution in international trade. International commercial courts are surely better equipped to deal with cross-border contracts than state courts. Yet, the fact that international commercial courts are more efficient than state courts does not imply that these courts also provide low-cost and effective formal contract enforcement institutions for global trade. This chapter made clear that, in many cases, companies using international commercial courts face legal situations in which it is either ineffective or too expensive to rely on these institutions. It therefore seems unlikely that international commercial arbitration courts have, indeed, provided the necessary contract enforcement institutions that have enabled global markets to grow with such a rapid pace over the last few decades. These private courts, like state courts, still have significant shortcomings that render their legal services inefficient. These results shed a critical light on modern theories of transnational law as they have been developed most prominently by Gunther Teubner.79 Teubner associates globalisation with the emergence of a new, fundamental phase of modern society. In the age of the nation state, the centre of law-making was politically positioned in the legislative and judicial institutions of the state. Other social sub-systems, like the economy or science, were suppressed by the state in their law-producing activities. Globalisation, however, generates the need for a change of hitherto statedominated law-making processes. Nation states have developed legal orders that regulate an exclusive territory with coercive power. National law is thus territorially fragmented and thereby limited in its capacity to create a workable legal order for an increasingly borderless global society.80 The Kantian solution to this problem—the formation of a political world federation of nation states under a republican constitution—is also not in sight. Despite the growing importance of international politics and law, a comprehensive legalisation of world politics has not taken place. In sum, globalisation undermines the law-making capacity of state political and legal institutions. The development of global law takes a path fundamentally different from Kantian ideas. Globalisation dramatically changes the evolutionary relationship between state-centred political institutions and other social systems. The economy and other sectors of society, like technology, science, the mass media, medicine, education and transport, become

79 80

Fischer-Lescano and Teubner, 2004; Teubner, 1997. Teubner, 2006.

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globalised, while the centre of politics and law remains institutionalised at the territorial level of the nation state. As a consequence, the other social sectors have ‘overtaken politics and law on the road to globalization and are founding their global villages, independently from politics’.81 From a legal perspective, this means that, in the era of globalisation, the production of law is less linked to national politics and jurisdictions than to a multitude of global social subsystems. In Teubner’s words, [t]he focus of law-making is shifting to private regimes, that is, to agreements among global players, to private market regulation through multinational enterprises, internal rulemaking within international organizations, interorganizational negotiating systems, and world-wide standardization processes … All in all, in globalization dominant law-making is shifting from the centers of law which been politically institutionalized in the nation state (legislature and judiciary) to the peripheries of law, to the boundaries of law and the other globalised social sectors.82

Globalising social sectors of all kinds create a large demand for norms that cannot be produced anymore by nation states. In the absence of stateprovided law, private legal regimes take over the function of creating highly specialised norms in their special fields of activity. These regimes do produce not only substantive rules but also secondary norms, like procedural norms on law-making, law recognition, sanctions and conflict resolution. In doing so, they turn into what is defined as ‘self-contained regimes’. Teubner regards the new lex mercatoria as the most successful example of such a global law without a state. In his view, the global economy produces its own law of economic transaction largely independent from state legal structures. Model contracts and international arbitration houses deciding on conflicts between disputing contractual parties most crucially drive the legal evolution of the lex mercatoria into the dominant transnational law of cross-border economic transactions. If we now, after this brief digression, turn back to the results of this chapter, we recognise both the strengths and shortcomings of Teubner’s theory. Teubner’s assumptions about the territoriality of national legal systems and resultant structural limitations regarding the capacity of state legal systems to provide a workable global order for global commerce are correct. The law-in-action study about the global software industry clearly confirms this observation. The norms, conflict-resolution mechanisms and sanctions provided by states cannot satisfy the demand of transnational markets for a reliable legal infrastructure. However, Teubner’s further observations are problematic. He argues that the production of law changes from a territorial to a functional

81 82

Teubner, 1997, 3. Teubner, 2004, 3.

218 The Limits of International Commercial Arbitration foundation. As an autonomous global social system, the economy is evolving its own global private independence from national politics. The boundaries of this emerging law are not formed anymore by maintaining a ‘core territory’83 but by ‘invisible markets and branches’84 that operate on a global scale. However, these functional boundaries are not the only boundaries of the new lex mercatoria. According to analyses presented in this book, we need to take into account at least two more boundaries that significantly shape the scope of the new lex mercatoria. First, power: before globalisation, the centre of law-making, including the making of contract law, was located in the political system. Welfareoriented contract law politics aimed at granting economically weak parties access to the justice system, for example, by regulating litigation costs. These political efforts have been far from perfect—the ‘haves’ still maintained considerable advantages in litigation85—yet, the change in coupling of contract law from politics to economics in the course of globalisation dramatically worsens access to justice. Arbitration is private business; it is not organised as a public good. Arbitrators are not interested in promoting fair and inclusive market conditions. They want to make profits and, because of market failures, Adam Smith’s invisible hand, which would suggest that self-interested arbitrators as a by-product create the public good of legal certainty and workable contract enforcement institutions for global trade, does not function. Most importantly, the cartel of arbitrators charges arbitration fees that smaller companies—especially those from emerging market economies and developing countries—are unable to bear. These actors are factually excluded from international arbitration. The law-in-action perspective taken on in this book shows that the real new lex mercatoria supports only a few economically powerful actors. Teubner’s macro-sociological perspective on global social systems is not capable of grasping the socio-economic fragmentations of a global legal system that is predominantly driven by private interests. International arbitration is not generating an inclusive private legal regime for the entire social system of the global economy but actually contributes to the lawlessness of transnational transactions by excluding large parts of the global economy from its legal services. It is inherent to systems theory to overlook such kinds of social differentiations on the actor level. Second, territoriality: Like many other scholars of international arbitration, Teubner exaggerates the private nature of this legal regime. International arbitration is not a private but a hybrid mechanism. In particular, the arbitral awards enforcement sanctions remain state-provided.

83 84 85

Teubner, 1997, 5. Ibid, 5. Galanter, 1974.

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As Teubner rightly observes, state law is territorially fragmented and therefore limited in operating on a global scale. However, he overlooks that, due to its hybrid character, international arbitration is not operating independently from inefficient territorially fragmented national legal orders. Enforcement of arbitral awards still has to be conducted by national courts and authorities that control exclusive territories. The results of the empirical study have shown that different qualities of national legal systems significantly influence the performance of international arbitration. Whenever the enforcement of an arbitral award involves an inefficient legal system, such as that of India, China, or Brazil, the performance of international arbitration is significantly impeded. Businesses do not expect reliable enforcement of arbitral awards in countries with ineffective legal systems and therefore turn to alternative informal, non-legal mechanisms. Contrary to Teubner’s view, international arbitration and the new lex mercatoria do not a form a global law completely outside of a state mechanism that would be able to overcome all fragmentation problems of national legal orders. Functional differentiation has not replaced territorial differentiation entirely. The territorial differentiation of law still hampers the evolution of international arbitration and the new lex mercatoria into effective globally operating private legal regimes. Overall, this chapter’s analysis contends that significant parts of cross-border trade take place not only beyond state law but also beyond Teubner’s private legal regimes. The literature on transnational law has, so far, widely overlooked the crucial importance of ICT-supported informal governance mechanisms. We analyse these further in the next chapter.

12 ICT and the Rise of Informal Contract Enforcement Institutions in Global Markets

M

OVING ON FROM looking at why both states and international commercial arbitration courts fail to produce a workable formal legal order across borders, this chapter focuses on the rise of relational contracts and reputational networks. We demonstrate that informal private ordering has significantly increased in efficiency due to the introduction of modern ICT. As a result, both relational contracts and reputational networks are today capable of providing the institutional underpinning for complex global exchange.1 How modern ICT enhances the performance of informal contract enforcement institutions will be outlined in detail, both for self-enforcing relational contracts and for reputational networks. RELATIONAL CONTRACTS 2.0

The empirical study about the global software industry presented in Part II made clear that companies engage in complex cross-border transactions by initiating, monitoring and sanctioning self-enforcing contractual relationships. The fact that economic agents react to a dysfunctional public order by creating informal bilateral exchange structures is not unusual at all. However, institutional economists usually consider such behaviour an indicator of economic underdevelopment. The reasons for this were presented in Part I. When companies cannot rely on a state-provided legal order, they have to use their own resources to safeguard transactions against fraud and opportunism. The transaction costs of this strategy are low when the group of traders is restricted to a small number of agents who know each other well. Under this condition, no information asymmetries between the exchange partners exist. Relational contracts operate almost cost-free. But, when processes of economic modernisation lead to 1

Mann, 2001, 1627f.

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increasing geographical distances between and rising numbers of market participants, information asymmetries swell. Under these conditions, the costs of organising transactions as self-enforcing contracts are considered prohibitive. The next section will make clear that this line of argument was certainly plausible in the past. However, today we need to take into account the profound impact of modern ICT on relational contracting.

The Insignificance of Geographical Distances As indicated in the previous section, conventional institutional economists consider geographical distance between potential trading partners as one crucial reason for the inability of self-enforcing contractual relations to facilitate transactions in modern market economies. The costs of initiating and monitoring business relationships are explicitly assumed to increase with the geographic distance of the market participants.2 Under this theory, therefore, distance and efficiency of self-enforcing contractual relations are correlated: the larger the distance between the exchange partners becomes, the more expensive it is to initiate and monitor stable business relationships. However, if we look at the initiating and monitoring practices described in the empirical study about the global software industry, we recognise that, with the arrival of modern ICT, this picture changes dramatically. Because of virtual initiation and monitoring techniques applied today, geographical distances are hardly significant anymore.3 When agents mainly draw on the Internet as a source of information to conduct risk analysis about potential business partners in the run-up phase of a transaction, it is obviously no longer important whether the evaluated company is located in the same building or a distant country. Regardless of where the other company resides—far away or nearby—in both cases, the information about the reliability of a potential supplier reaches the customers at the same time and at the same cost. The same effect applies to monitoring contractual parties. When companies are able to control the actions of their foreign providers with the help of Web-based monitoring instruments in real time from any place on earth, then it makes no difference where the business partner resides. This conclusion is also confirmed by other studies in the field: Offshore providers … have developed sophisticated Internet-based tracking systems that allow their clients to track the progress of their projects as well as

2

See ch 3. That geographical distances lose their importance for social relations has best been described by Anthony Giddens, see: Giddens, 1990, 28–53. 3

222 ICT and Informal Contract Enforcement in Global Markets the quality of the output of agents working offshore … The use of Internet-based distributed monitoring systems has allowed firms to source services globally that were hitherto thought of as being too risky or complex to execute offshore. These systems enable buyers of such services (clients) to monitor the execution of processes in real time and exert a degree of managerial control over information workers of another firm located in a distant region.4

In sum, even over long distances, today there are only very low costs to assessing the reliability of a potential transaction partner and to monitoring the course of a business relationship. The hitherto-assumed correlation between the distance between the exchange partners and the costs of establishing and monitoring self-enforcing relationships has been nullified by the invention of modern ICT. Today, the transaction costs of relational contracts remain low even across wide distances.

Institutional Economy-of-Scale Effects Conventional institutional theory assumes that self-enforcing contractual relations lose their efficiency not only when the distances between the exchange partners grow but also when the number of actors increases at competitive markets. This argument is based on the assumption that bilateral structures can be set up with low fixed costs, because such structures require no high-cost higher-level institutions to be established first but cause extremely high marginal costs, which, in large competitive markets, quickly reach a prohibitive level and thus prevent further exchange.5 Under this theory, the costs that a company invests in the initiation and monitoring of a business relationship are sunk, as they generate no benefit for establishing a further business relationship. Every business relationship needs to be initiated, enforced and monitored individually, and each of these activities causes specific costs that add up to such an extent that the transaction costs exceed the potential trade gains when the number of market participants gets too high.6 Consider now, for example, the practice of companies developing detailed questionnaires in the initiation phase of a transaction, which are then sent out by email in order to select only those offshore providers that pose a low risk of a breach of contract. This digital approach in gathering information about the reliability of potential trading partners leads to a fundamental change in the cost structure of self-enforcing contracts. Note that this practice can only work today because of huge investments in the

4 5 6

Aron, Jayanty and Pathak, 2007, 1 and 3. See ch 2. See ch 2.

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development of a functioning global communication network. But, with this worldwide communication infrastructure in place, the practice of using online questionnaires in large quantities to gather important information about potential trading partners causes only very small additional costs. Today, modern ICT makes it possible to check the reliability of great numbers of potential trading partners at very low costs. The positive impact of modern ICT on the cost structure of selfenforcing contracts becomes even more obvious when we turn to the monitoring of foreign suppliers. It has already been mentioned that the foreign providers establish so-called Web-based monitoring systems that allow their customers to control their actions, even in real time, from any point on Earth, if an Internet connection is available. To set up such control systems involves costs and time. This means that companies have to first make an investment in order to enable digital monitoring processes. But, again, these investments pay off eventually, when the number of customers of the foreign software companies increases at globalised markets. Then, the established electronic control system can also be used to control many further business relationships without significant additional costs. The marginal costs of monitoring a business relationship therefore remain low. Overall, it should be noted that, before the existence of modern ICT, the transaction costs of assessing and controlling potential business partners limited both the geographical distribution and the number of potential business relations. In the past, relational contracts were set up and controlled primarily through manual processes, with networks of idiosyncratic personal relationships. Investments made in personal relationships are sunk. They cannot be transferred from one business relation to another.7 Certainly, engaging in today’s ICT-enabled practices of relational contracting requires investments in computers and telecommunication equipment. However, these investments are rarely relation-specific and are therefore not sunk. Once modern communication structures are in place the costs of organising transactions as self-enforcing contracts decrease significantly, even for transactions occurring over long distances. Moreover, the information exchange systems that are applied to initiate and control inter-company relations can be transferred to further exchange relations at low costs. As a result, unlike in the past, actors today are able to sustain large numbers of bilateral business relations even when the distances between transactors are on a global scale.8

7 8

See for this point: Clemons and Row, 1992. See ibid; Malone, Yates and Benjamin, 1987.

224 ICT and Informal Contract Enforcement in Global Markets REPUTATIONAL NETWORKS 2.0

In addition to relational contracts, relational networks turned out to be significant in the empirical study about the global software industry. Like the relational contracts, these trilateral contract enforcement institutions also benefit largely from modern ICT. In order to make this point clear, it is helpful first to survey the extensive literature that, since the mid-1990s, has dealt with the functioning of so-called virtual marketplaces, such as eBay. The causal connection underlying the hypothesis that there is a close connection between the development of modern ICT and the increased efficiency of reputational networks has been discussed in detail in this context.

Organised Virtual Reputational Networks Virtual marketplaces are platforms on the Internet, at which buyers and sellers meet in order to exchange goods and services. Just as in the real world, however, profitable exchange occurs only if there is a sufficient degree of transactional security. Establishing reliable contract enforcement institutions at virtual marketplaces is considered to be particularly difficult for two principle reasons. First, even in this field, state-enforceable contracts do not represent an adequate means of safeguarding the exchange processes against opportunistic behaviour, because Internet trading often involves different and unclear jurisdictions and laws. Second, the actors in virtual marketplaces usually neither interact repeatedly with each other nor belong to a narrowly confined transaction community in which group members know each other personally. In short, at virtual marketplaces there is no state-guaranteed transactional security, while there is also anonymity—a combination that actually does not promote trade.9 The operator-companies of virtual marketplaces have, for a long time, recognised that missing transactional security poses a problem for the success of their Internet market platforms. In order to overcome this problem, they started to develop their own governance mechanisms. Despite all the differences in the details, these governance mechanisms are generally based on the same principle as those in the cross-border transaction setting. With the help of modern ICTs, the operators of the marketplace store large amounts of data regarding the transactional behaviour of their participants and ensure transparency by making these data available

9

See: Resnick, Zeckhauser, Friedmann and Kuwabara, 2000, 45–48.

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online to all potential market participants.10 The relevant literature refers to this form of contract enforcement as a Web-based, multilateral reputational system or, in short, an electronic feedback system.11 Specifically, the economic governance of virtual marketplaces works as follows: After completion of the transaction, both buyer and seller are asked to share the experiences they had with a transaction partner with all other market participants. The evaluation of a transaction partner is done directly on the website of the marketplace operator by using a simple numerical scale, which may range, for example, from plus five (excellent rating) to minus five (very poor rating).12 Usually this numerical evaluation is supplemented by brief personal comments. All potential market participants have access to the past evaluations of a buyer or seller, including the submitted comments. From the set of evaluations submitted, an aggregated measure is finally calculated for the ‘reputation’ of a market participant, which is shown with the platform identity of an actor.13 The relevant literature concludes that reputational systems have acquired a new quality due to the existing opportunities to organise the information flow between market participants through the Internet, which they would have been unable to achieve without the invention of modern ICT.14 Nowadays, electronic feedback systems ensure that opportunistic behaviour is first revealed and then disseminated as information among all potential market participants, even if the transaction partners do not interact with each other repeatedly or do not belong to a narrowly defined transaction community: The Internet offers vast new opportunities to interact with total strangers … Prior to the Internet, such questions [questions, whether the transaction partner can be trusted] were answered, in part, through personal and corporate reputations. Vendors provided references, Better Business Bureaus tallied complaints, and past personal experience and person-to-person gossip told you on whom you could rely and on whom you could not. Participants’ standing in their communities, including their roles in church and civic organizations served as valuable hostage. Internet services operate on a vastly larger scale than Main Street and permit virtually anonymous interactions. Nevertheless reputations still play a major role. Systems are emerging that respect anonymity and

10 See: Diekmann and Wyder, 2002, 674f; Ockenfels, 2003, 295–96; Resnick, Zeckhauser, Friedmann and Kuwabara, 2000, 46. 11 Resnick, Zeckhauser, Friedmann and Kuwabara, 2000, 46. 12 This example refers to the virtual marketplace ‘Half.com’. 13 Diekmann and Wyder, 2002, 675–76; Ockenfels, 2003, 297, Resnick, Zeckhauser, Friedmann and Kuwabara, 2000, 47. 14 For example, Peter Kollock writes to this point: ‘the economics of online interaction mean that the costs of collecting and distributing information can be extremely low. Making possible reputation and evaluation systems that could otherwise not be supported.’ Kollock, 1999, 3–4.

226 ICT and Informal Contract Enforcement in Global Markets operate on the internet’s scale. A reputation system collects, distributes and aggregates feedback about participants’ past behaviour. Through few producers or consumers these systems help people decide, whom to trust, encourage trustworthy behaviour, and deter participation by those who are unskilled or dishonest … At eBay, for example a stream of buyers interacts with the same seller. They may never buy an item from the seller again, but by sharing their opinions about the seller via the Feedback Forum, they construct a meaningful history of the seller. Future buyers, lacking personal histories with particular sellers may still base their buying decisions on a sufficiently extensive public history. If buyers do behave this way the sellers’ reputation will affect their future sales. Hence, they seek to accumulate as many positive points and comments as possible and avoid negative feedback. Through the mediation of a reputation system—assuming buyers provide and rely on feedback—isolated interactions take the attributes of long term relationships. In terms of building trust, a boost in the quantity of information compensates for a significant reduction in its quality.15

Thanks to the invention of modern ICT, today it is very inexpensive to feed an electronic feedback system with the necessary information about the business conduct of a transaction partner after a transaction took place. Then, modern ICT makes it very easy and cost-effective to save these data sets about the past behaviour of an actor and to disseminate this information to any number of market participants at any location around the globe. Modern ICT thus promotes a new mode of sharing reputational information. In the online world, market actors create meaningful histories about each other without incurring the costs of establishing offline contacts.

Spontaneous Virtual Reputational Networks As discussed above, ICT-based reputational systems can be organised and designed by operator-companies of virtual marketplaces. This practice is already well documented and understood in actual institutional theory. However, if we take a look back at the respective sections of the empirical study about the significance of reputational networks, we recognise that ICT-based reputational networks can also emerge spontaneously without being organised by third parties. Three empirical results are particularly relevant to this conclusion. First, according to the interview data, it is a common practice today that software companies ensure transparency by publishing lists of former business partners on their websites. These reference lists, in turn,

15

Resnick, Zeckhauser, Friedmann and Kuwabara, 2000, 45–47.

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allow potential clients to inform themselves quickly and at low cost about the reputation of a particular company. They only have to open the company’s website and click on the menu item ‘clients’ in order to get a comprehensive overview of the transactional history of a potential business partner. In general, it can be said that the more jobs a foreign supplier completed, and the better known the companies are with which a foreign supplier collaborated in the past, the higher its reputation is rated. To ensure that the information given is accurate, however, it is necessary for the evaluating company to verify some important references through personal checks. But, due to the fact that the online reference lists state the former customers of a potential foreign business partner, this task is dealt with quickly and inexpensively in the form of a phone call or an email. Starting with these lists, a spontaneous global exchange of information develops that allows any software company to contact any other software company in the world in a very short time in order to get the relevant information to reconstruct the transactional history of a potential business partner. Second, the interview data made clear that nowadays all businessmen in the global software industry are members of business-oriented social networks such as XING or LinkedIn and that it is common practice to join the virtual networks of a potential exchange partner’s counterparts in the run-up phase to a transaction. In doing so, the two contractual parties become part of common communicative structure which makes it very easy to inform other network participants about a particular manager when he or she turns out to breach a contractual agreement in an opportunistic way. Third, in order to broadcast or learn about others’ opportunistic behaviour, contractual parties can also turn to various online platforms, for example, specific blocks or forums provided by business associations. This information usually spills over into the general World Wide Web where it is detected by companies conducting Internet research about potential future business partners. If we now compare these three ICT-facilitated ways of exchanging reputational information with the way reputational information used to be exchanged within conventional reputational networks as described in chapter one, we recognise significant differences. Consider agent A, who is satisfied with the contractual performance of his business partner, agent B. At the outset, this experience is private information. Other agents possess no knowledge about this contractual relationship. Imagine, in addition, a world without the Internet and modern computers. Under these circumstances, the information about the reliability of agent B might be communicated to the personal networks of agent A. The network members may belong to the same family

228 ICT and Informal Contract Enforcement in Global Markets or ethnic group, they may be part of the same religious community, they may live and conduct business in the same local area, or they may be members of the same industry association. Yet, in all cases, the circle of other agents that might benefit from this information in order to find a reliable business partner is constrained to small numbers. In the offline world there simply exists no communicative structure beyond personal networks that would give market participants fast and cheap access to information about the transactional history of company B. However, with the arrival of modern ICT, this picture changes dramatically. Subsequent to the transaction, agent B will ask agent A for permission to add the company’s name to the reference list. The reference list is displayed online. Since Internet access is ubiquitous, this practice leads to the effect that all agents can retrieve the information about the past contractual relationship between agents A and B instantly and at no cost. Given contemporary ICT-based communication structures, the information about the reliability of agent B potentially benefits every agent in the world who regards agent B as a possible cooperation partner. Reputational information is thus turned from private into public information. Virtual reference systems differ from electronic feedback systems in one significant respect. Electronic feedback systems do not allow the transactors any control over their ratings. Therefore, transactors cannot avoid negative reports. In contrast, the virtual reference systems enable agents to hide harmful information. Agent B could cheat on agent A and then not add agent B to the reference list. In this case, information would potentially remain private. However, beyond the reference system, further virtual communication structures exist that facilitate the circulation of a negative reputation. For example, agent A might publish a short report about agent B’s cheating on specific blogs or online forums, which can then easily be found on the World Wide Web by other potential future business partners of agent B. Even more effectively, the deceived agent A can draw on the virtual business contacts of agent B and inform them, at almost no cost, about the behaviour of agent B. It is impossible for the cheating agent B to control this flow of information across different virtual business networks. He is therefore very likely to become known as a ‘bad guy’ in the online community. Peter Kollock illustrates this point in the following way: There is little satisfaction in suffering silently. Having experienced a bad trade, the common reaction is to complain publicly, perhaps in the hope that it might motivate one’s trading partner to make restitution or at least in order to warn others to watch out for this person in future trades. In our ‘offline world’, we might complain to our friends or business colleagues, or to an agency such as the Better Business Bureau in the case of the commercial enterprise. But on the Internet, we can complain to the world, and at almost no cost. The Internet has

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radically reduced the costs of distributing information to a global audience. Thus, it is no surprise that individuals take advantage of these extraordinary low distribution costs at their grievances.16

Consequently, with ICT-based communicative structures in place, both positive and negative reputational information becomes public information, which can easily be accessed on a global scale. The Internet thus leads to a new form of information pooling. Agents can reconstruct meaningful transactional histories of potential trading partners without having prior dealings with that company or having to rely solely on information available in its personal networks. The Internet thus provides for an interaction-free and, therefore, very cost-effective way of exchanging reputational information. Reputational information spreads quickly throughout globally linked markets, and firms know that their behaviour is open to public assessment on a global scale. Modern ITC thus promotes transparency, which, in turn, incentivises market actors to cooperate and to fulfil their contractual obligations because it is only in this way that they can ensure success at global markets in the long term. It is a well-documented fact that informal reputational networks play significant roles in safeguarding economic transactions against fraud and opportunism. Most of the relevant literature regarding these institutions has been discussed in the first chapter of this book. What this chapter adds to the discussion is the fact that, following the revolutionary developments in the field of ICT, new and considerably more efficient forms of virtual reputational networks have emerged. So far, institutional theory has fallen short in understanding the effects of this development. It is still widely believed that informal reputational networks require the existence of social groups whose members are tied to each other by common social bonds. Conventional reputational networks require narrow economic or social structures that already had to exist prior to the transaction. But, today, this picture changes dramatically. Nowadays, we see countless transactions between business partners from different countries who are not part of the same close-knit community. In fact, these actors are strangers when they start to interact but nevertheless work together on the basis of reputational networks. The structures that enable market actors to rely on virtual reputational networks differ significantly from the structures of conventional informal private ordering. Virtual reputational networks do not rely on the pre-existence of social ties but can be activated ad hoc in the very moment, allowing unrelated companies to engage in an exchange relation. Instead of real social structures, virtual

16

Kollock, 1999, 6.

230 ICT and Informal Contract Enforcement in Global Markets networks rely on technological structures. The flow of information that is needed to govern transactions by means of reputational networks is provided by fast processing computers and virtual networks on the World Wide Web that potentially connects all market actors that engage in global trade. In pre-modern times, we lived in villages; in postmodern times, we live in the global village. Analysing the contract enforcement institutions of pre-modern societies, Douglass C North writes: The most likely and indeed empirically observable state in which contracts are self-enforcing is that in which the parties have a great deal of knowledge about each other and are involved in repeat dealings with tribal and primitive societies and with small communities. Under these conditions, it simply pays to live up to agreements. In such a world, the measured costs of transacting are very low because of dense social networks interaction. Cheating, shirking, opportunism, all problems of modern industrial organization, are limited or indeed absent because they do not pay.17

Asked about the contract enforcement institutions in place in today’s global markets, experts give the following typical answers: We think that if we try to give a commitment to the customer and the chances are that we may not be able to meet, then in the long term this causes big problems. It is a network society and word will easily go around. (IND-III, 4)

And: If your existing customers go away and become unhappy of your services this would be very drastic. Today with social networks I would expect that if your customers become unhappy that could close your business pretty fast because the community is small. Everybody is now on LinkedIn. There are a couple of those systems where people are in the position to exchange opinions and to check everybody’s personal networks. (EU-BR-III, 3)

Thus, although pre-modern and contemporary globalising economies are fundamentally different in all relevant aspects, the degree of transparency that has been achieved today is very similar to pre-modern times. Of course, in contrast to pre-modern villages, not everyone knows everybody else on a personal level in the global village. But in contemporary global markets, contracts can still be governed by informal contract enforcement institutions because parties have a great deal of knowledge about each other. Therefore, actors in contemporary global markets live up to agreements because they fear that opportunistic behaviour will be known to the global business community which is linked together by worldwide virtual information networks.

17

North, 1990, 55.

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From the point of view of efficiency, modern ICT resolves the limitations of reputational networks that previously rendered it impossible for these contract enforcement institutions to operate in widespread anonymous modern market economies. Without modern ICT, the more actors that become part of a reputational network the more expensive it becomes to disseminate reliable information about defaulting parties. Conventional reputational networks are limited to small groups. Beyond small groups, information costs exceed possible gains from exchange so that no further trade takes place. The running costs of information dissemination in conventional networks are too high to enable anonymous change on widespread modern markets. Modern ICT changes this logic. Building up a worldwide technological infrastructure for fast global communication surely requires incurring very high fixed costs—by both states that are responsible for building this infrastructure and single companies who need to equip themselves with modern computers and IT-systems. However, once these investments are made, the running costs of disseminating information in reputational networks decreases dramatically. This is precisely the reason why reputational effects work today in global markets between companies who have never even known each other previously. In 1990, David Charny published his seminal article about non-legal sanctions. He wrote the following about the significance of reputational networks as contract enforcement institutions in modern market economies: One key to effective reputational controls is a system for transmitting relevant information to market participants … Collective reputational enforcement should work well … in markets limited to small numbers, homogenous groups of individuals who are in frequent contact and thus can share relevant information. These markets are, of course, relatively rare. Conversely mass markets based on reputational bonds are feasible only with technology that conveys information cheaply to a large group of transactors, such as computers.18

His statement about reputational networks is not flawed. In 1990, computers were already part of business organisations, but ICT was still far away from providing the high-speed world-wide virtual communication system we experience today. Charny was therefore right in pointing to the limited efficiency of reputational networks. Nevertheless, Charny already anticipated that progress in the field of communication technologies could have a significant impact on the efficiency of reputational networks. He understood that, if information technologies existed that could convey information cheaply to a large group of transactors, then mass markets could also be based on reputational bonds. In 1990, the extreme

18

Charny, 1990, 373.

232 ICT and Informal Contract Enforcement in Global Markets technological progress that would follow in the field of modern ICT was beyond prediction. But, today, technologies exist that are capable of conveying information cheaply to large groups of transactors around the globe. In the absence of a workable formal legal order, reputational networks thus present an institutional framework on which companies can rely when they engage in complex and risky transactions across borders. Back in 1980, before the invention of the Internet and modern computers, Ian Macneil began his seminal book on relational contract theory with the following passage: Society. We shall start at the beginning. In the beginning was society … [C] ontract without social structure and stability is—quite literally—rationally unthinkable. The fundamental root, the base of contract, is society.19

Relational contract theory 2.0, as developed in this paper, still subscribes to this general assumption about society. The expert interviews presented in this book leave no doubt that contractual relations are still embedded in significant social structures. The crucial point, however, is that the social structures that constitute contemporary society have, in some ways, fundamentally changed over the last decades. Traditional relational contract theory highlights the role of substantial ties that develop through repeat interaction and face-to-face contact. Firms become familiar with each other by engaging in long-lasting business relations or being located in the same area. Businessmen might know each other well for a long time; they might belong to the same ethnic or religious group. They can be one family or part of common business communities with the same educational, cultural and professional backgrounds.20 In essence, all of these traditional relationships are multiplex. They focus not only on exchange but also on both commercial and social dimensions.21 Actors might share common meals; they might visit the same sporting events, meet at the same bars, or go to the same church. In short, they personally and physically belong to the same social group.22 In traditional relational contract theory, the governance structures of inter-firm relations are a direct function of the substantial social structures just described. However, the empirically investigated relations between companies from different countries in the global software industry obviously do not fit into this picture. As a matter of fact, actors who operate in today’s globalised markets often do not share common social

19

Macneil, 1980, 1. Ben-Porath, 1980; Granovetter, 1973; Granovetter, 1985; Greif, 2006; Landa, 1981; Uzzi, 1996, 1997, 1999. Many more possible connections between exchange partners are imaginable. 21 Bernstein, 1992; Richman, 2004. 22 Uzzi, 1999. 20

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structures in the traditional sense. Both the extensive reliability checks and the thorough monitoring practices furnish evidence that the investigated inter-firm relations are not embedded in already existing high-trust social ties that provide for stable governance structures ex ante to the transaction. The involved actors, rather, are uncertain about their potential business partners and feel at risk of becoming exploited by them. But, even in the absence of substantial social ties, the involved exchange partners are not totally unrelated. The interviews clearly illustrate that modern market participants are integrated into global ICT-based communicative structures. In contrast to substantial ties, virtual ties do not exist as social facts ex ante to the transaction but can be purposely set up by the transaction partners before and during the transaction process. After the exchange is completed, these virtual ties may well become deactivated again. ICT-based global communicative structures provide the technical infrastructure for developing virtual interconnections with almost every company in the world at very high speed and low costs. These virtual structures do not provide the high-trust social ties that are central to traditional relational contract theory, but they considerably reduce information asymmetries between the transaction partners and facilitate the evolution of almost unrestricted virtual reputational networks. Virtual ties therefore render it possible to replace the trust inherent in traditional social ties with ICT-based transparency controls, and sanctioning mechanisms. In sum, the evolution of an information society promotes the evolution of new virtual relational contracts. METHODOLOGICAL LIMITATIONS

It is has already been explained that case study research is generally prone to overgeneralisations. One could therefore argue at this point that, outside of the software industry, digital forms of private ordering are significantly less practised. Again in a strict methodological sense, this possibility cannot be disproved here. However, we can again argue that it is unlikely. Students of strategic management and business organisation have produced volumes of literature over the last two decades that highlight the enormous potential of new communication technologies to leverage more efficient forms of economic organisation.23 A great deal of this work focuses on ICT-driven changes within firms. Moreover, we also find ample research regarding the impact of ICT on the organisation of exchange between companies. In essence, this research analyses how

23

For a very good overview of this literature see: Ruey-Jer, 2007.

234 ICT and Informal Contract Enforcement in Global Markets ICT supports inter-firm coordination by facilitating inter-organisational communication. Various forms of ICT-based information sharing across companies are described and analysed. Companies might use tools such as email, private chat rooms and user groups in combination with videoand tele-conferencing to facilitate intensive communication among managers and staff. Beyond that, they might even build advanced electronic partnerships. In the latter case, inter-organisational information systems, such as EDI, lead to fully integrated supply chains in which all information sharing is automatic and standardised. For the purpose of this study, it not necessary to go into further details here. The important point is that, according to this literature, the software industry is not exceptional at all. Similar and more extreme practices of ICT-enabled information exchange are found today in companies of all sizes and in all kinds of different industries.24 Given this, it seems very likely that both ICT-enabled practices of relational contracting and virtual reputation systems have not only emerged in the global software industry but also play significant roles for a much wider range of cross-border transactions. Intensive use of ICT is not industry specific but applies today for the world economy in general. CONCLUSION: GLOBAL ORDER BEYOND LAW

In essence, this chapter has shown that, due to revolutionary progress in ICT, the efficiency of both self-enforcing contracts and reputational networks has increased to such an extent that these two mechanisms are no longer restricted to working within narrowly confined transaction communities and long-term relationships but are also able to allow complex exchange between a plethora of unacquainted actors within big competitive markets. Informal contract enforcement institutions are thus capable of following the economy into the global realm. This feature differentiates them from state-enforced contract law, which is territorially fragmented and therefore inefficient across borders. In addition, international commercial arbitration courts are also not yet in the position to provide effective and lost-cost contract enforcement institutions for international trade. We therefore need to refer to ICTenabled informal institutions in order to understand how, in today’s globalised markets, companies safeguard complex cross-border transactions against fraud and opportunistic behaviour. Figure 9, which is

24

Chatterjee, Segars and Warson, 2006.

Conclusion: Global Order beyond Law

235

linked to Figure 2 at the end of Part I, illustrates this point once more very clearly: Transaction Costs

Curve 1

Turning Point 2a

Turning Point 1

Curve 2

Curve 3

Turning Point 2b

Economic Modernisation Transition from nation-state to globalised modernity

Figure 9: The impact of globalisation and technological progress on the efficiency of public and private economic governance

According to conventional institutional theory as presented in Part II, the efficiency of informal contract enforcement institutions initially is considered to have decreased in the course of the eighteenth and nineteenth centuries (classical nation-state modernity) while the efficiency of state contract law grew in the emerging national domestic markets (Curve 1 and 2). Eventually, a point was reached at which it was more efficient to replace the private-order mechanisms dating back to the pre-modern period with state contract law (Turning point 1). Modern exchange economies could only develop further where actors had a functioning state contract law at their disposal. This process of increasing nationalisation of economic governance, however, peaked during the transition from nation state to globalised modernity in the second half of the twentieth century (transition from nation state to globalised modernity). Since this point, the significance of state contract law has been in decline while the previously inefficient informal contract enforcement institutions have continuously gained efficiency due to the revolutionary developments in the information and communications technologies. Informal private ordering has become more significant than state contract law (Turning point 2a). Relational contracts, together with reputational networks—and not state law— nowadays constitute the institutional foundation for the development of globalised competitive markets. Figure 9 shows a third curve (Curve 3), which represents the development of international commercial arbitration courts. As noted above, similar to informal institutions in general, the effectiveness of interna-

236 ICT and Informal Contract Enforcement in Global Markets tional commercial courts also declined in the course of the eighteenth and nineteenth centuries but started to rise again with economic globalisation. However, in comparison to informal mechanisms, their rise is rather modest. International commercial arbitration courts are surely more efficient than state courts in global markets (Turning point 2b). Beyond that, we need to take into account that their caseload has been increasing over the last few decades so that, in the future, these institutions might well evolve into effective universal legal systems. However, for the time being, it is crucial to acknowledge that, apart from special branches such as the maritime trade or the diamond industry, international commercial courts have not yet reached this position. Extrapolating the reasoning of Douglass C North, I would like to make the following concluding remarks.25 State contract law, alone, is not sufficient for realising the opportunities for complex exchange in globalised markets. Neither are international commercial courts and lex mercatoria. Formal systems of law therefore do not constitute the end point in the evolution of efficient contract enforcement institutions; rather, in the course of economic globalisation and the development of modern information and communications technologies, a new form of ICT-enabled exchange has emerged, which could be defined as impersonal exchange on the basis of digital private ordering.26 The productivity of the modern global society is essentially based on universal communications technology, which provides transparency beyond national borders and thereby fosters cooperative behaviour. In contrast, the fragmented national contract laws seem to be a curb on the welfare-increasing integration of the world economy. 25 Remember that North, 1990, 58, describes two historical stages of institutions and economic development: The more complex the exchange in time and space, the more complex and costly are the institutions necessary to realize cooperative outcomes. Quite complex exchange can be realised by creating third party enforcement via voluntary institutions that lower information costs about the other party; ultimately, however, viable exchange that would realize the gains from trade inherent in technologies of modern interdependent economies requires institutions that can enforce agreements by the threat of coercion. 26 Other authors also see a connection between the advent of modern ICT and both the rise of private ordering and the decline of state contract law. See, eg: Ronald J Mann who writes: If we believe that commercial enterprises in the longer run generally design their transactions so as to minimize the cost of such information problems, then the parties to those transactions generally should select the mechanisms that best resolve the information problems at the lowest cost. Thus, two features of the current environment suggest that the current set of institutions is unstable. The first of those is a general rise in the cost of legal sanctions, reflecting in the increasing pecuniary cost of litigation as well as slowing rates of resolution of civil disputes to the courts. The second is the general decrease in the cost of acquiring, processing and analyzing information. Taken together those two effects presage a significant shift in the balance of institutions away from legal sanctions—which are becoming more expensive and less effective—to non legal sanctions—which become more and more effective as information related cost continue to fall. (Mann, 2001, 2–3)

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Index anonymous transactions, 51–52, 56, 171, 231 cross-border software development contracts, 55–56 arbitration, 44–45, 95 international courts of arbitration, 44–45 new lex mercatoria, 47 private arbitration courts, 34, 43, 121, 171–72 India, 121–22, 124, 131 see also international commercial arbitration; maritime arbitration arm’s-length transactions, see anonymous transactions Axelrod, Robert, 14 Belloc, Marianna, 45 Berger, Klaus Peter, 176 Berkowitz, Daniel, 191 Bernstein, Lisa, 3, 192, 198 Bretton Woods, 39 Brussels Convention, 135 Brussels I Regulation, 134, 135, 163–64, 166 application, 146–55, 181 Heidelberg Report, 146–49, 151–52, 181, 182 legal-economic performance rate: comparing domestic and European rates, 153–53 domestic, 152–53 European, 153 specifications, 154–55 procedures, 180–81 scrutiny: Heidelberg Report, 147 Bulgaria-Romania, 2, 58–60, 62–65 enforcement of contracts, 99, 115–16 post-EU membership contracts with Germany, 132–65 application of Brussels I Regulation, 146–55 scenarios, 132–34 state-enforced contract law, 136–46 private contract enforcement institutions, 107 enforcement of relational contracts, 109–11 initiation of contractual relationships, 108–09 reputational networks, 112–15 state-enforced contract law, 99–100, 106–07

generating transactional security, 100–06 transactional risks, 99 ‘cartelisation’ of international commercial arbitration, 208–13 Charny, David, 231–32 choice-of-law clauses, 177 Coase, Ronald H, 24 Common European Sales Law (CESL), 181 complex transactions, 2, 45–46, 52–54, 172 cross-border software development contracts, 56, 60, 166 simple transactions distinguished, 52–53 conflict of law, 3–4, 5, 43, 147, 175–77 harmonisation, 180–83 ineffective rules, 175–77, 184 Rome I Regulation, 136, 180 contract enforcement institutions, 2–4, 13, 230 arbitration, 44–45 breach of contract, 2, 13 cooperation, 11–13, 45–46 function, 13 informal: new generation contract enforcement agencies, 220–33 reputational networks, 7, 15–17, 168–69 self-enforcing contracts, 7, 13–15, 167–68 new generation contract enforcement agencies: limitations, 233–34 relational contracts, 220–23 reputational networks, 224–33 private governance regimes, 7, 18–21 private institutions, 2, 5–6, 7 public v private ordering, 24–25 quality, 2 reputational networks, 7, 15–17, 168–69 sanctions, 2, 4, 7, 13, 16–17, 32–33 self-enforcing contracts, 7, 13–15, 167–68 state-enforced contract law, 7, 21–22, 23–38 globalisation and, 39–47 taxonomy, 22 technological developments, 27, 169–70 transaction costs, 24 types, 7 private governance regimes, 7, 18–21 reputational networks, 7, 15–17, 168–69

248 Index self-enforcing contracts, 7, 13–15, 167–68 state-enforced contract law, 7, 21–22 see also private contract enforcement institutions; state-enforced contract law contracts: communication: Bulgaria-Romania, 102 Germany, 77–78 defining legal relationships, 76 monitoring relationships, 84–85 necessity, 76–78 relational contracts: enforcement, 82–83 limitations, 88 Convention on Jurisdiction and the Enforcement of Judgments in Civil and Commercial Matters, 135 Council Regulation on Jurisdiction and the Recognition and Enforcement of Judgments in Civil and Commercial Matters, 135 Dezalay, Yves, 185, 210 division of labour, 11–12, 24, 28, 41 Dixit, Avinash K, 13 Drahozal, Christopher R, 194 Durkheim, Emile, 28 economic globalisation: cross-border software development contracts, 56–57 decline of state-enforced contract law, 175 conflict of laws, 175–77 emergence of private international law, 175–77 enforcement agencies, 177–78 unreliable national courts, 177–78 free trade, 39 impact on capability of state contract law, 42 liberalism, 27, 28, 38, 39 protectionism, 39 trade barriers, 40–42 economic governance, 6, 21–22, 25, 29, 36–38, 115 nationalisation, 234–36 private mechanisms, 13, 25, 36–37, 115, 180 spontaneous and informal mechanisms, 7, 21, 29–30, 34, 121, 131, 172 virtual marketplaces, 225 economic trends, 38–42 complex transactions, 2, 3–4, 52–54 cross-border transactions, 2, 41–42 focus on core business, 1–2 social interactions, 2 electronic feedback systems, 225–26, 228–29

Ellickson, Robert C, 3, 15, 17 European Economic Community, 40 European Union (EU), 3, 40, 58–60 enforcement of rulings, 46–47 harmonisation of laws, 47, 133, 136 integration of private international law, 134–36 reputational networks, 162–63 state-provided contract law: insignificance, 141–46, 180–83 Federation of Cocoa Commerce (FCC), 191, 199 formal contract enforcement, see private governance regimes; state contract law forum shopping, 177 Garth, Bryant G, 185, 210 General Agreement on Tariffs and Trade (GATT), 39–40 Germany, 58–60 contracts with post-EU membership Bulgaria-Romania, 132–65 application of Brussels I Regulation, 146–55 scenarios, 132–34 state-enforced contract law, 136–46 enforcement of contracts: limitations, 88 post-EU membership BulgariaRomania, 132–65 transactional risks, 67–68 international commercial arbitration, 189–90 interpretation of contracts, 76–78 defining legal relationships, 76 private contract enforcement institutions, 78 enforcement of relational contracts, 82–84 initiation of contractual relationships, 78–82 monitoring of contractual relationships, 84–87 reliability tests, 79–81 reputational networks, 88–97 self-enforcing relational contracts, 88 reliability tests, 79–81 reputational networks, 88–93 private governance regimes and, 93–97 self-enforcing relational contracts: limitations, 88 state-enforced contract law: interpretation of contracts, 76–78 significance for transactional security, 69–76 software development contracts, 68–69 transactional risks:

Index bad quality goods, 67 interpretation of contracts, 76–78 non-delivery of product, 67 producer obtains sensitive data, 68 re-sale of same product, 67 significance for transactional security, 69–76 software development contracts, 68–69 Glaser, Barney, 61 global competition, 60 focus on core business, 1–2 globalisation, 3, 6–7, 54 economic globalisation, 39–42, 175–84 state contract law and, 39–47, 216–17 see also economic globalisation globalised exchange, 4–5, 184, 187 emergence, 46 enforcing contracts, 58–59, 61 state contract law and, 177 Goldman, Berthold, 196 Grain and Feed Trade Association (GAFTA), 191, 199 ‘grand notables’, 210–11, 212, 215 ‘grand old men’, 210–11, 212, 215 Great Depression, 39 Greif, Avner, 16 Heidelberg Report, 134, 146–54, 181 analysis of Brussels I performance, 147–49, 182 hybrid governance regimes, 131, 170, 213 India, 121–24 international arbitration, 218–19 private governance regimes distinguished, 191–93 INCOTERMS, 194 India, 58–60 enforcement of contracts, 117 hybrid governance regimes, 121–24 private arbitration courts, 121–22 private contract enforcement institutions, 124–25 enforcement of relational contracts, 128–31 initiation of contraction relationships, 125–28 state-enforced contract law, 117–21 transactional risks, 117 informal contract enforcement institutions, 6 enhancement of performance: ICT role, 220 ICT and, 220, 234–35 limitations, 233–34 positive impact 223 new generation relational contracts, 220–21 economies of scale, 222–23

249

insignificance of geographical distances, 221–22 relational contracts 2.0, 220–24, 232 reputational networks 2.0, 224, 229–32 organised virtual reputational networks, 224–26 spontaneous virtual reputational networks, 226–33 see also reputational networks; self-enforcing contracts intellectual property rights, 67, 69, 71–72, 137–39 international arbitration courts, 5, 6, 235–36 economic limitations, 5–6 national laws and, 197–98 specialised international arbitration courts, 191 universal arbitration court distinguished, 192 structure, 215–16 ‘cartelisation’, 208–13 see also international commercial arbitration; specialised international arbitration courts International Chamber of Commerce (ICC), 185, 187–88, 213 international commercial arbitration: ‘cartelisation’, 208–13 caseloads, 187–91, 208, 213 choice of law, 194 enforcement of awards, 201 enforcement costs, 202–03 unreliable national legal systems, 203–05 formalisation, 212–13 Germany, 189–90 hybrid international arbitration, 191–93 universal arbitration courts, 192 limitations, 185–87, 213–19 national legal systems, 191–205 organised reputational systems, 199 sanctions, 200 procedural rules, 193 sanctions, 198–205 specialised international arbitration courts, 191 universal arbitration court distinguished, 192 state enforcement: private sanctions, 198–205 trends, 185 universal arbitration courts, 192 limitations, 199, 214–15 US, 189 see also international arbitration courts; specialised international arbitration courts International Monetary Fund (IMF), 39

250 Index Kollock, Peter, 228–29 lex mercatoria, 195–96 transnational commercial law and, 196 see also new lex mercatoria law-in-action approach, 3, 217–18 legal-economic performance rate: comparing domestic and European rates, 153–53 domestic, 152–53 European, 153 specifications, 154–55 Liverpool Cotton Association (LCA), 191, 199 London Court of International Arbitration (LCIA), 185–88, 213, 215 London Maritime Arbitrators Association (LMAA), 205, 207 London Metal Exchange (LME), 192, 199 Macaulay, Stewart, 3, 4 McMillan, John, 32 Macneil, Ian R, 4, 232 Maine, Henry S, 28 maritime arbitration, 205–06 enforcement tools, 206–08 sanctioning powers, 206 ship arrest, 206–07, 215 Marshall Plan, 39 Mattli, Walter, 185 Mayring, Phillip, 61–62 Milgrom, Peter, 30 Moenius, Johannes, 191 national legal systems, 3, 4, 36, 42, 47 exposure to foreign norm systems, 178–80 international commercial arbitration and, 191–205 reliability, 177–78, 203–05 territorial fragmentation, 5, 6, 178, 183 emerging uncertainties, 42–44 negotiation, 4, 76, 135, 137, 203 new lex mercatoria, 4, 5, 43–44, 46–47, 98, 171–72, 197, 208 global law, as, 217 post-war nationalism and, 196 power, 218 territoriality, 218–19 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards, 44, 201–05, 214–15 New York Diamond Dealers Club (DDC), 18, 20–21, 182–84, 192 norm systems, 43, 214 conflict of laws, 175–77 exposure to foreign systems, 178–80 North, Douglass, 35, 38, 230, 236

Pistor, Katharina, 191 private governance regimes, 7, 18–21, 169–70 control mechanisms, 25 costs, 34–35 definition, 18 examples, 20 hybrid international arbitration distinguished, 191–93 maritime arbitration, 206, 215 monitoring, 25 origins, 19 reputational networks and, 93–95 sanctions, 18–19 collective punishment of opportunism, 19–20, 21 international commercial arbitration, 198–205 significance, 30 taxonomy of contract enforcement institutions, 22 private international law: emergence, 175–77 EU integration, 134–36 private contract enforcement institutions, 2, 171 cross-border transactions in Europe, 155–63, 165 capability as a legal framework, 166 Bulgaria-Romania, 107 enforcement of relational contracts, 109–11 initiation of contractual relationships, 108–09 reputational networks, 112–15 Germany, 78 enforcement of relational contracts, 82–84 initiation of contractual relationships, 78–82 monitoring of contractual relationships, 84–87, 97 reliability tests, 79–81 reputational networks, 88–97, 98 self-enforcing relational contracts, 88 India: enforcement of relational contracts, 128–31 initiation of contraction relationships, 125–28 reliability tests, 79–81 significance, 167–70 virtual close monitoring systems, 156–60 see also private governance regimes; reputational networks; self-enforcing contracts public-order contract enforcement, see state contract law

Index public-private governance schemes, see hybrid governance regimes relational contracts, see self-enforcing contracts reputational networks, 7, 15–17 Bulgaria-Romania, 112–15 European Union, 162–63 Germany, 88–97, 98 informal contracts traditional trade habits, 17 unwritten rules, 17 information exchange, 15 new generation reputational networks, 224 organised virtual reputational networks, 224–26 spontaneous virtual reputational networks, 226–33 reputational networks 2.0, 224 organised virtual reputational networks, 224–26 spontaneous virtual reputational networks, 226–33 structure, 16 use of social sanctions, 16–17, 198–99 virtual social networks, 160–62, 224–33 research design: case selection, 51–54 anonymous transactions, 51–52 complex transactions, 52–54 globality, 54 cross-border software development contracts, 54–58 anonymous transactions, 55–56 complex transactions, 56 globality, 57–58 law-in-action approach, 3, 217–18 methodology, 60–62 interviews, 62–66 scenarios, 58–60 Rogers, Catherine R, 211 Rome I Regulation, 180 sanctions, 2, 4, 7, 13, 32 international commercial arbitration, 198–205 organised reputational systems, 200 private governance regimes, 18–19 collective punishment of opportunism, 19–20, 21 international commercial arbitration, 198–205 reputational networks: use of social sanctions, 16–17, 198–99 state-enforced contract law, 33

251

international arbitration courts, 198–205 private sanctions, 198–205 Schmitthoff, Clive, 196 self-enforcing contracts, 7, 13–15 contract enforcement, 14 game theory, 13–14 Middle Ages, 34–35 new generation relational contracts, 220–21 personal relationships, 14–15 relational contracts 2.0, 220–24 Shirley, Mary M, 25 Smith, Adam, 11, 218 self-regulation: reputational networks, 18 self-enforcing contracts, 17, 18 societal evolution, 25–28 economic liberalism, 27, 28, 38 impact on state-enforced contract law, 27–28 industrialisation, 27–28, 37 institutional developments, 27–28 technological developments, 27–28, 41, 165, 229–30 ICT, 85, 98, 156–57, 168–69, 231–232, 235–36 Society of Maritime Arbitrators in New York (SMA), 205 specialised international arbitration courts, 191, 196–99 trade associations, 193 universal arbitration court distinguished, 192, 193–94, 203–04 state legal systems, see national legal systems state-enforced contract law, 7, 21–22 arbitration, 44 Bulgaria-Romania, 99–100, 106–07 generating transactional security, 100–06 capability as a legal framework in cross-border exchange, 166 costs, 32–37 impact of societal evolution, 35–36 initiation costs, 32 monitoring costs, 32–33 private governance regimes distinguished, 34, 36–37 reputation networks distinguished, 33–34 development of modern market economies, 23–38 rise of state-enforced contract law, 28–37 societal evolution, 25–28 economic globalisation, 39–42 economic relevance, 7–8

252 Index efficacy, 29–32 private governance regimes distinguished, 30–31 efficiency, 23–24 transaction costs, 24 evolution, 28–37 Germany: interpretation of contracts, 76–78 significance for transactional security, 69–76 software development contracts, 68–69 globalisation and, 39–47 India, 117–21 international arbitration courts, 44, 198–205 limitations, 183–84 territorial fragmentation, 183 private governance regimes distinguished, 30–31, 34, 36–37 sanctions, 33 international arbitration courts, 198–205 significance, 166–67 state-provided contract enforcement institutions, 2 Stockholm Chamber of Commerce (SCC), 185, 187–88, 213 Stone Sweet, Alec, 185 Strauss, Anslem, 61 technological developments, 27, 169–70 see also virtual close monitoring systems; virtual social networks Teubner, Gunther, 217–19 third party contract enforcement, see private governance regimes; state contract law Tonnies, Ferdinand, 28 trade associations, 191–92 trade barriers, 39–42 transactional risks: Bulgaria-Romania, 99 Germany, 67–68 India, 117 transnational commercial law, 5, 6

categories: commercial law rules, 194 international treaties and conventions, 194 other international rules, 194 unwritten international principles, 194 global commerce, 3 national legal systems versus, 194–95 UN Convention on Contracts for the International Sale of Goods (CISG), 181–82, 194 UN Convention on the Recognition and Enforcement of Foreign Arbitral Awards, 122 UNIDROIT Principles of International Commerce, 43, 193–94 Uniform Customs and practice for Documentary Credits (UCP), 194 United States (US): international commercial arbitration, 188–89 impact of large law firms, 210–12, 215 Van Damme, Eric, 33 virtual close monitoring systems: German contracts with new EU members, 156–60 virtual social networks, 156 organised virtual reputational networks, 224–26 reputation and, 160–62 spontaneous virtual reputational networks, 226–33 Weber, Max, 31 Weingast, Barry, 30 Woodruff, Christopher, 32 World Bank, 39 World War II, 39, 41 international commercial arbitration, 209–11, 215 market restrictions, 56