Enforcing contracts in dysfunctional legal systems: the close relationship between public and private orders.

• Author: Porat, Ariel
• Position: Response to article by John McMillan and Christopher Woodruff in this issue, p. 2421

A Reply to McMillan and Woodruff

1. INTRODUCTION

   When the public order is dysfunctional, a private order for enforcing contracts will develop. In the absence of courts, transactors will seek ways to secure performance without recourse to legal sanctions. Social and economic sanctions imposed on the party in breach, whether by the aggrieved party or by the economic and social community in which both parties operate, replace legal sanctions. These sanctions sometimes arise within a private order functioning spontaneously, as when ongoing contractual relationships prevail between the parties, or when a close-knit economic or social community exists in which information concerning breaches of contract flows freely. In other cases, sanctions will be enforced within an organized private order, in which market intermediaries and trade associations enable information to flow and thereby provide transactors with the security essential for entering contracts. John McMillan and Christopher Woodruff have examined the characteristics of the private order that emerges in response to a dysfunctional public order, and the private order's influence on transactors.(1) Their article relies mainly on empirical studies conducted by the authors in Vietnam and in several Eastern European countries. They start with the assertion that, for various reasons, the public order is dysfunctional in these countries, and legal sanctions enacted against the party in breach are therefore ineffective. They examine how private order arises in response to this purported deficiency, and analyze the interaction between public and private orders when both function concurrently. This paper responds to their work by focusing on some of the contours of the relationship between public and private orders.

   In the real world, one cannot draw a distinct line between countries where a public order operates and countries where a private one obtains -- both orders tend to function in every country, in varying degrees. This occurs because, when enforcing contracts, no public order is ever perfect to the point of making the private order redundant. Indeed, the public order need not be at the brink of collapse in order for a private order to materialize. A private order may emerge even when the public order is only partially dysfunctional, or when dysfunctionality is limited to specific types of transactions. The character of the private order, its scope, and its components, are inextricably related to the reasons leading to the emergence of a private order in the first place. Hence, a comprehensive theory about the emergence of a private order, whether as replacement for or complement to public order, needs to consider the various reasons for the dysfunctionality of the public order, which resulted in the creation of the private order in the first place.

   In Part II, I suggest reasons for the dysfunctionality of the public order, and show that dysfunctionality is usually partial. I then examine the relationship between the reasons for the dysfunctionality of the public order and the characteristics of the private order emerging in response; this may be considered a proposal for further empirical research aiming to examine the nature of this relationship.

   Since a private order always operates beside the public one, a question arises concerning the interaction between them.(2) In Part III, I examine how the content of the law operating within the public order might affect the concurrent private order. The law operating within the public order may support the private order, repress it, or, at times, acknowledge its existence but endorse a neutral attitude toward it. At the same time, the private order may also affect, through its own mechanisms, the character and content of the public order. In the course of discussing the interaction between the two orders, I also consider whether, when the court awards damages for breach of contract within the framework of the public order, it should deduct from it the value of the sanction imposed by the private order on the party in breach. I point out the advantages of such a deduction, particularly the efficient incentives it provides to the contractual parties.

   I touch briefly on the interaction between the public order and the social networks functioning within the private order in Part IV. I attempt to explain McMillan and Woodruff's finding that social networks constitute a substitute for the public order in the sense that, when the public order is stronger, reliance on social networks lessens.(3) Part V provides a brief conclusion.

2. REASONS FOR A DYSFUNCTIONAL PUBLIC ORDER AND THE RESPONSE OF THE PRIVATE ORDER

   Parties will consider a public order ideal if the courts (and the enforcers of the courts' decisions) enforce all contracts according to the substantive law preferred by the parties without incurring costs of litigation, with great speed and expertise, without bias, without mistakes, and without the parties incurring damages through litigation proceedings.

   No empirical studies seem required to determine that these conditions are never actually present to a perfect degree. Hence, parties to a contract will never view a public order as ideal, and potential transactors will naturally seek ways of overcoming the failings of the public order. Typically, their work takes place at two levels: to amend the flaws of the public order directly, and to develop a private order acting beside, or altogether replacing, the public order.

   The reaction of potential transactors depends on the character of the flaws affecting the public order and hindering its functioning. These flaws may be "generalized" -- that is, equally relevant to all potential transactors, such as when all judges in a system are corrupt. More frequently, however, at least in Western legal systems, flaws may be deemed "partial" -- that is, their harmful effects are context-bound or industry-specific. Thus, in a given industry, such as the diamond industry, where transactors may be particularly sensitive to the public exposure entailed by litigation, they may develop a private order to avoid the need for litigation in the courts.(4) In contrast, in an industry where the risk of exposure is lower (or nonexistent), transactors may not be as reluctant to resort to the courts. Similarly, another industry, such as the grain and feed industry,(5) may find dissatisfaction with the actual substantive law operating in the public order, and consequently traders may seek an alternative system applying a different law. This sense of dissatisfaction may not be shared by traders in another industry, with different characteristics, who are comfortable with the substantive law applied by the courts.

   In the following sections, I examine several typical flaws impairing the functioning of the public order. These flaws fall under three rubrics: flaws relating to judges, flaws relating to court decisions, and flaws relating to legal proceedings. The discussion will consider several possible responses to these flaws within both the public and the private orders. Note that several flaws may operate simultaneously, either as "generalized," or as "partial" flaws.

   1. Flaws Relating to Judges

      A potential and particularly serious reason for dysfunction in the public order relates to the corruption of the judges, their biases, or their lack of professionalism. In these cases, it may be assumed that plaintiffs who believe they will profit from these flaws will use legal proceedings, whereas those who fear they will lose because of these flaws will not. Plaintiffs who cannot foresee whether they will benefit or suffer from the corruption or the lack of professionalism may be deterred by the uncertainty and forego legal proceedings altogether. Others may forsake recourse to the public order because they are outraged by the corruption of the system, regardless of whether or not it works in their favor. Finally, since these disputes involve contracts, a party fearing unfair treatment in legal proceedings may attempt, ab initio, to preclude recourse to the public order.

      A private order may develop in all these cases, as private actors attempt to overcome the problems of a corrupt or unprofessional public order. If the problem is limited to the judges' lack of professionalism, without necessarily entailing general corruption in the public order, and provided that judgments are plausibly enforced, we may expect institutions of arbitration to develop, staffed by professional (and assumedly uncorrupt) arbitrators. As long as the public order provides a reasonable way of enforcing the arbitrators' rulings, the problem of unprofessional judges might be solved.

      If, however, corruption in the public order extends to enforcement, arbitration alone will not suffice because its effectiveness depends on a proper system of enforcement. A more extensive private order will develop. Potential transactors will seek ways of implementing non-legal economic and social sanctions, which will replace legal sanctions and which will be imposed by the aggrieved parties and by the community, either spontaneously or in organized fashion.(6)

   2. Flaws Relating to Court Decisions

      Enforcement of contracts by the public order may be impaired also because of flaws relating to court decisions. Three types of flaws may fall in this group: flaws resulting from information problems in the courts; flaws due to the application of a substantive law that the parties find unsatisfactory; and flaws due to courts' refusal to enforce certain agreements.

      1. Information Problems Impairing the Court's Ability to Enforce Contracts Effectively

         Courts sometimes lack information required to rule on contractual disputes, thus making it highly questionable whether their decisions can properly reflect the parties' rights and duties. For example, in the diamond industry, as we learn from Lisa Bernstein's study, it is extremely difficult for...