Self-Enforcing Contracts: A Good Tool for Tough Markets

1. Draft Your Contract for the Applicable Country

In How Not to be in China, we wrote about how companies are seeking to diversify their supply chains by moving some or all of their production to other countries. When entering into contracts in these new countries, the first question to ask is whether the new country in which you will be working has a legal system that provides effective contract enforcement. If the answer is yes, then your best strategy is to maximize the contract for effective enforcement in the local courts on the model that we have followed in China. See Drafting China Contracts that Work and note that the World Bank ranks China fifth in the entire world at enforcing contracts.

But what should you do when doing business in a country whose local court system is not well developed and where effective and efficient contract enforcement is unlikely or uncertain? As supply chains expand to new and untested countries, this is becoming a real issue. In the pursuit of lower prices, lower tariffs and new opportunities, more and more product buyers are finding themselves operating/manufacturing in less developed countries with less developed court systems.

2. Avoid These Three Common International Contract Mistakes.

So what is to be done when doing business in a country with an undeveloped or wildly corrupt legal system? The first thing to do is to avoid the following three standard mistakes:

– Mistake Number One: Assuming Arbitration in a Neutral Country is the Way to Go.

Drafting for arbitration in a neutral, third country is the most common mistake we see. When I was a young lawyer, drafting the contract to provide for arbitration in a neutral third country was the standard advice. But this advice was provided by lawyers and academics with little to no on-the-ground experience. What using arbitration neglects is what happens once an arbitration award is obtained. At that point, the award must be enforced in the home country of the defendant and in most countries where litigation will be difficult, it is nearly certain that enforcement of an arbitration award will be next to impossible. For that reason, arbitration is usually a waste of time and money. More important, it gives the buyer the illusion that it has a remedy when in fact there is none. This then leads to a failure in planning which can be a disaster.

– Mistake Number Two: Operating With no Contract at All.

Foreign parties often say that “If I cannot rely on a fair and open court system to enforce a contract, why bother with any contract at all. It is better to operate “naked” than to waste money and time on a contract that cannot be enforced.” This approach is a mistake; a written contract is a tool that can be used by a buyer in any situation. The key is to understand the situation and design the contract to provide maximum benefit in that situation. It is a mistake to discard a tool that can be used to achieve your basic goals.

– Mistake Number Three: Assuming Arbitration Does Not Make Sense.

Just assuming that arbitration never makes sense when sometimes it does is the third big mistake we see. I know I told you above that arbitration rarely makes sense, but there are a few countries with undeveloped legal systems that nonetheless have a history of actually enforcing arbitrations from specific countries and from specific arbitral bodies.

In other words, the biggest mistakes are not having a contract or choosing the wrong dispute resolution forum and rendering your contract  unenforceable in the country that matters most.

3. Best Practices: A Two-Stage Guide

The best practice operates in two stages.

First, enter into a country-centric contract. This usually (but not always) means enforcement in the home country of the foreign party, governed by home country law, and enforced in home country courts. This approach shows you are serious about enforcement. Arbitration, on the other hand, usually (but not always) shows you are either ignoring or do not understand how to get your contract enforced. Most businesses in less developed countries will view a contract calling for arbitration in a third country as giving them carte blanche to breach your contract.

Home country enforcement, on the other hand, shows that you are knowledgeable and serious about contract enforcement and it signals to your foreign counter-party that they ignore your contract at their peril. In most situations, the threat of litigation in the hometown of your foreign seller, joint venture partner, factory, distributor or licensee will allow you to apply legal and psychological pressure that simply is not available with a contract provides for third country arbitration. So even when it is certain that litigation will be difficult, a home country-centric contract is always the best practice because litigating will be more likely to achieve enforcement than arbitrating.

Second, draft your contract in a way that deals directly with the difficulty of court enforcement. A major weakness of arbitration-style contracts is often that the contract is entirely unrealistic. Normally, the arbitration style contract is written as if though it were a fully enforceable contract for resolution of a dispute between two advanced country litigants operating in an advanced country legal system. This approach distracts you from analyzing what disputes are likely to arise and how you should protect itself from damage arising from such disputes.

A complex contract with a third country arbitration provision can cause you to believe you have a strong contract when you don’t. But here in the real world of tough international business, you must quit dreaming, get realistic, and design your contract to actually (not theoretically) minimize your risks. The best practice is to write your contract with a system that works for you.

4. Self-Enforcing Contracts Are the Way to Go.

The best type of contract to use in countries with less developed legal systems will usually be a self-enforcing contract. In a self-enforcing contract, the transaction is designed so that if there is a default, the foreign party is in control and suffers minimal damage. The key is to design your transaction in a way that gives you the power to enforce your basic rights without needing to litigate. In the event of a dispute, it will usually be you, the foreign party that is required to take legal action, which puts you on the defensive. In the situation we are describing where the foreign legal system is weak or non-existent, the practical effect is that you are left with having to deal with the problem of an ineffective legal system. A self-enforcing contract can help prevent this situation.

In tomorrow’s post, I will describe how to write a self-enforcing contract that works.