Private commercial law in the cotton industry: creating cooperation through rules, norms, and institutions.

• Author: Bernstein, Lisa

The cotton industry has almost entirely opted out of the public legal system, replacing it with one of the oldest and most complex systems of private commercial law. (1) Most contracts for the purchase and sale of domestic cotton, between merchants or between merchants and mills, are neither consummated under the Uniform Commercial Code ("Code") nor interpreted and enforced in court when disputes arise. Rather, most such contracts are concluded under one of several privately drafted sets of contract default rules and are subject to arbitration in one of several merchant tribunals. Similarly, most international sales of cotton are governed neither by state-supplied legal rules nor by the Convention on the International Sale of Goods, but rather by the rules of the Liverpool Cotton Association. (2)

The institutions that create and administer the industry's private legal system work extraordinarily well. The trade rules are periodically revised to respond to technological advancements, market changes, and ambiguities revealed during disputes. Their content is known and understood by most market participants. The arbitration tribunals that resolve disputes do so expeditiously and inexpensively. Their decisions, which are recorded in written opinions, reveal a distinctive and coherent jurisprudential approach. Within the industry, arbitration awards are widely respected and complied with promptly. In short, the industry has succeeded in creating and maintaining a private legal system ("PLS") in which transactions costs, error costs, legal system costs, and collection costs are low. This system has endured since the mid-1800s, surviving widespread social change, years of extreme price volatility, and substantial changes in the background public legal regime.

This Article draws on a detailed case study of contractual relations in the cotton industry to examine the ways that the rules, norms, and institutions that constitute the industry's PLS create value for transactors. Part I describes the formal operation of the PLS and discusses the ways that its substantive rules, adjudicative approaches, and arbitral procedures improve on those provided by the Code and the public legal system. Part II describes the many steps taken by cotton industry institutions to strengthen the social and informational infrastructures of trade. It discusses how these efforts combine to make reputation-based nonlegal sanctions a powerful force in the industry and explores how the availability of these sanctions makes important features of the PLS work better than they would in their absence. It also suggests that the availability of such sanctions may enable transactors to create value-enhancing contract governance structures that might be either unavailable or prohibitively expensive if their transactions were governed by the public legal system. Part III takes a step back and explores how the industry's efforts to support the legal and extralegal aspects of contracting relationships, together with certain other features of cotton institutions, have succeeded in creating conditions that are conducive to the creation, maintenance, and restoration of cooperative contracting relationships. Part IV concludes by suggesting that understanding how the cotton industry's institutions create value for transactors may help identify other industries and other contexts in which private institutions can play a positive role in supporting trade.

1. THE PRIVATE LEGAL SYSTEM

   1. The Formal Operation of the Private Legal System

      There are numerous sources of private commercial law in the domestic cash markets for the purchase and sale of cotton. (3) Most merchant-to-mill transactions are governed by the Southern Mill Rules ("SMRs"), (4) a set of trade rules that is jointly adopted by the American Cotton Shippers Association ("ACSA"), (5) a trade association representing merchants, and the American Textile Manufacturers Institute ("ATMI"), (6) a trade association representing mills. (7) Most merchant-to-merchant transactions are governed by the trade rules of one of four regional cotton shippers' associations, all of which are members of ACSA, (8) or by the rules of the Memphis Cotton Exchange ("MCE"), whose ninety member firms typically "handle about 75 percent of the U.S. cotton trade and about 35 percent of the world's cotton trade." (9)

      Both shippers' associations and regional exchanges provide arbitration services. (10) Most require members to arbitrate disputes with other members as a condition of membership. (11) In addition, the ACSA and the ATMI have created a joint arbitration tribunal, the Board of Appeals ("BOA"), (12) to arbitrate contract disputes that arise under the SMRs. (13) They have also created a separate tribunal, the Cotton States Arbitration Board ("CSAB"), to make binding quality determinations. (14) Although merchants and mills are not required to contract under the SMRs, or to arbitrate disputes with one another as a condition of membership in their respective trade associations, most merchant-to-mill contracts nevertheless provide for BoA arbitration. (15)

      The formal operation of the cotton industry's PLS can best be understood by looking at the procedural rules, substantive rules, adjudicative approaches, and judgment enforcement mechanisms that have been adopted by the two most important private commercial law institutions in the domestic cash cotton trade: (16) the BoA, which resolves disputes between merchants and mills, and the MCE arbitration tribunal, (17) which resolves disputes primarily between merchants.

      1. Procedural Rules

         The BoA is composed of one arbitrator appointed by the president of the ATMI and one appointed by the president of the ACSA. (18) Arbitrators are selected for their "experience in their respective industry and their reputation for integrity and fairness." (19) The BoA does not hold hearings. It decides cases solely on the basis of briefs and documentary evidence, most commonly: verified copies of confirmations, correspondence, mail receipts, telephone logs, weight slips, quality determination reports, and affidavits from lawyers and employees who played roles in the questioned transaction. All evidence has the names of the parties redacted.

         The MCE arbitration tribunal is composed of seven arbitrators, appointed annually by the Exchange's board of directors. It holds oral hearings, (20) complete with the calling of witnesses and cross-examination. (21)

         Neither the BoA nor the MCE's arbitration tribunal permit unconstrained party-initiated discovery, though both permit the arbitrators to request additional information. (22) The SMRs do not contain a general limitations period, but they do contain rules specifying the proper time frame for raising certain types of objections. (23) The MCE trading rules provide that all claims are to be reported to the arbitration committee "within thirty days after the matter in controversy arises," (24) and also specify time frames for raising particular types of objections. (25)

         Both tribunals produce written opinions. Most opinions include a statement of the facts, a short discussion of the rule to be applied, a few paragraphs discussing the arbitrators' reasoning, and an award. (26) Some opinions, however, simply state the outcome of the case. (27) BoA opinions are circulated to all ACSA and ATMI members. (28) The names of the parties are redacted, (29) but the names of the arbitrators are given. MCE opinions contain the names of both the parties and the arbitrators, but they are not made public. Neither tribunal formally accords prior decisions precedential authority. (30)

         The BoA's awards are final judgments, but the MCE tribunal gives parties the right to appeal to a three-person appeals board in cases where the decision of the original panel was not unanimous. (31) At the BoA, the rules require the time from filing to the close of evidence to be between fifteen and thirty days. Decisions are rendered as soon thereafter as possible. (32) At the MCE, the length of time from filing to disposition varies but is typically just over a month. (33) Both the BoA and the MCE require prompt payment of awards. (34)

      2. Substantive Rules

         The BoA decides contract disputes by applying the SMRs, (35) a comprehensive set of bright-line contract default rules (36) that cover contract formation, performance, quality, delay, payment, repudiation, excuse, and damages, and include numerous industry-specific definitions of terms like "prompt," (37) "raingrown," (38) and "long staple." (39) The MCE decides cases on the basis of the Exchange's own Trading Rules, (40) which also define numerous industry-specific terms and contain primarily bright-line provisions. Although most SMRs and MCE Trading Rules would be enforceable under the Code if included in a contract, (41) they nonetheless differ from the Code in fundamental ways.

         First, the industry-drafted trade rules do not, for the most part, include the types of standard-like words, such as "reasonable," (42) "seasonable," and "without objection in the trade," that permeate the Code. Rather, they contain primarily clear, bright-line rules.

         Second, the types of damage measures available in the private system differ in important ways from the measures used in the public system. The Code's damage measures are designed to protect the expectancy interest by putting the "aggrieved party ... in as good a position as if the other party had fully performed." (43) In contrast, the damage measures in the SMRs and the MCE Trading Rules tend to be undercompensatory. (44) Under the SMRs, the aggrieved party is entitled only to market difference damages plus a one-half cent per pound penalty (a penalty that is trivial given contemporary cotton prices). (45) The recovery of consequential damages is not permitted, although the SMRs do impose fixed fines for certain types of misbehavior. (46) The MCE uses the same measure for breach of...