How to Write a Self-Enforcing Contract That Works

In part one of this series on self-enforcing contracts, Self-Enforcing Contracts: A Good Tool for Tough Markets, I wrote about how self-enforcing contracts can be so valuable when contracting with a company in a country with a less developed legal system. In this post, I will discuss how self-enforcing contracts work and the key provisions to put into such contracts.

How does a self enforcing contract work? Take a standard contract for purchase of goods as an example. In order to be self-enforcing, the key provisions are as follows:

 — No advance payments or deposits. Where an advance payment is absolutely required, limit the advance to the lowest percentage possible and apply the advance to a single purchase order. Do not make any advance payment that applies to multiple purchases. Assume that your advance payment is 100% at risk and in the event of a dispute or default, your advance payment will never be returned. By making this assumption, the foreign party will be pushed to reduce any advance payment to a minimum.

— Make payment only AFTER the product has been inspected and shipped. The best practice is to inspect your products at the factory before shipment. However, in less developed countries, this is often not possible. If inspection will be performed only after you receive your product, draft your contract so your payment is not due until you have received and inspected the product. If your overseas product seller is concerned about the security of your payment, make use of standard trade finance, such as a letter of credit or the equivalent. When I draft self-enforcing contracts, much of the work involves designing the letter of credit to protect the legitimate concerns of both parties. Where trade finance will not be used, one party usually takes all the risk of payment. In a self-enforcing contract, the seller assumes that risk. The seller will, of course, seek to dump all the risk onto the foreign buyer.

This system allows the foreign buyer to self-enforce against the major risks of an international product purchase agreement: a) if the product is shipped late, payment is adjusted to impose a late shipment penalty, b) if the product is defective, payment is adjusted to impose a product defect penalty, c) if the wrong SKU is shipped, payment is withheld until conforming product is delivered, and d) if product is never shipped or if a completely non-conforming product is shipped (bricks instead of fish, sand instead of granular fertilizer), the foreign buyer simply does not pay. In each of these cases the foreign buyer can enforce its contract without need to take the matter to a court.

— Do not make long term commitments that are enforced solely by denying the payment terms of your self-enforcing contract. Assume each of your orders is a unique event. If one conforming order is delivered, do not assume that a following order will be delivered in compliance with the contract terms. This is the required approach because there is no practical way to self-enforce to ensure long term commitment from your product seller. For example, it is not possible to create a self-enforcing contract that will cover the obligation of a foreign seller to provide a certain amount of goods at a specific price over an extended period of of time. This does not mean that a purchase contract cannot be written with the expectation that there will be a series of purchases that will be made over an extended period of time. But the extent of the penalty a buyer can impose on the seller in a self-executing contract setting is to withhold payment for a single purchase.

So what can be done to deal with long term commitments? The way to enforce a long term commitment is by using a stand by letter of credit or a similar payment guarantee contract. The LC then becomes the self-enforcement mechanism. However, as with the basic purchase contract, the buyer must be certain that the standby letter of credit is enforceable. That means the LC must be an irrevocable, confirmed LC drawn on a major independent foreign trade bank that is not located in the seller’s home country and that is independent of the seller’s home country.

Assuming a major financial commitment from both seller and buyer, the drafting of the LC is the major contracting drafting task. The risk is when the foreign buyer does not follow the basic LC rules and instead relies on a home country LC that will never be enforced, in the same way that a foreign arbitration award will never be enforced, as I discussed in part one of this series. For smaller scale transactions, LCs are often not practical.

The buyer should not rely on any long term commitment that cannot be self-enforced. The buyer makes long term commitments in its own country. Then the foreign seller defaults, but the buyer is fully liable to its own customers. This then is the worst of all possible worlds: the buyer can and will be sued by its own customers, but the buyer has no effective corresponding remedy against its foreign seller. The buyer should do whatever it can to avoid this bind.

As you can see, the key is to take a practical approach when you are contracting with a company in a country with a weak or uncertain legal system. Carefully consider the risk you are taking. Don’t abandon the contract process, but rather, design your contracts to be self-enforcing, placing the risks on the seller rather than on yourself. If the foreign party resists, explore the use of letters of credit and other trade finance mechanisms to fairly allocate the risks. If that is not possible, then assume that you are completely at risk and minimize your risk by reducing the size and the duration of your financial commitment.

In my next post, I will discuss ways the self-enforcing contract approach can be applied in other forms of international contracts.