The ability to make and enforce contracts and resolve disputes is fundamental if markets are to function properly. Good enforcement procedures enhance predictability in commercial relationships and reduce uncertainty by assuring investors that their contractual rights will be upheld promptly by local courts. When procedures for enforcing commercial transactions are bureaucratic and cumbersome or when contractual disputes cannot be resolved in a timely and cost-effective manner, economies rely on less efficient commercial practices.
A contract can be viewed as an agreement between two or more actors. These actors can be individuals, firms, non-profit organizations, or government agencies. This agreement pertains “to do, or to refrain from doing, a particular thing in exchange for something of value. If one side fails to live up to his/her/its part of the bargain, there’s a “breach” and certain remedies for solving the differences are available.”
Most commercial transactions, especially business-to-business transactions, take place via contracts. Indeed, commercial contracts can be viewed as the foundational pillars, the building blocks, for market-based exchanges.
Contract law includes the rules set and administered by the state that determines when an agreement is enforceable, the grounds on which a breach of the agreement will be found and the consequences. Contract enforcement is one of the pillars of the rule of law. Having a contract law on the books is not sufficient. What matters equally are the role and practices of the legal institutions that support the effective implementation of contract law. The legal institutions relate to the organization of courts, an independent and competent judiciary, the legal profession, the enforcement services and the process of lawmaking itself.
Their design is a crucial factor influencing equality of treatment between actors (e.g. small- and large-sized enterprises) and also bears the cost of enforcement and thus the reliance and confidence that investors have in the system of contract enforcement.
Alternative Dispute Resolution
Alternative dispute resolution systems seek to resolve differences between parties in a timely and fair manner. The main examples are arbitration, mediation, and conciliation hearings, often by industry bodies, specialized agencies or third party evaluators, conducted at the national or international level. Alternative dispute settlement processes often complement and sometimes supplement judicial contract enforcement procedures and can strengthen contractual commitment at lower cost.
The Importance of Enforcing Contracts
Contracts need to be monitored and enforced; otherwise, as Hobbes had observed, “Covenants without swords are mere words.” One pressing problem in developing countries is that contracts between commercial actors are costly to enforce.With the perception of poor or costly enforcement and the fear of being subjected to opportunistic exploitation, commercial actors tend to have fewer incentives to undertake long-term investments or to undertake transactions with actors outside their ethnic network.
This hurts commerce across time, space, and ethnicity. Actors cannot tap economies of scale. The end result is that economic development suffers. Policymakers should pay close attention to the contracting environment because it has an important implication for economic growth (Acemoglu and Johnson 2005). This is particularly important for developing countries which tend to have varying levels of contract enforcement. When enforcing contracts are expensive, market actors see their contracting costs increase and their profits dissipate. As North (1990) and others have pointed out, these costs are an important predictor of economic growth: lower the costs, higher the growth.
Any policy change that leads to the lowering of contracting costs should be beneficial for economic growth, a goal most policy scientists would agree is worth pursuing. We find evidence that FDI can serve as a useful agent in this regard. The implication is that policymakers should view the benefits and costs of integrating with the global economy not only in terms of the direct consequences but also in terms of the indirect consequences for domestic policy institutions.
Contracts can be enforced via a variety of mechanisms. Depending on their competencies, market actors are likely to vary in their preferences for the different modes of contract enforcement. Some actors might prefer enforcement via ethnic networks, others via the mafia, and yet others via the government.
Multinational corporations are less likely to rely on non-governmental networks to enforce commercial contracts simply because they are embedded in fewer numbers of such networks or do not have the social capital to mobilize these networks for contract enforcement. They behave as self-interested actors that seek to establish a low costs contracting environment to serve their own interests. What is important from a policy perspective is that in doing so, they can create positive externalities for other commercial actors as well.
This sort of contracting mode is not only suitable for multinationals but eventually for all actors that wish to participate in the modern economy. In sum, there are positive social consequences when multinationals pursue private interests in relation to the supply of low-cost contracting environment.
The concept of a rented chain (Baron 2000) is relevant here. FDI often stimulates the emergence of new domestic firms which supply materials and distribute its products. Michael Porter (1985) termed this as the value chain network. The political consequences of such value chain networks are significant. Thus, the presence of FDI’s rent chain networks may alter the political payoffs for governments to supply more efficient contracting institutions.
In recent years, institutions have become more prominent in the scholarly literature, among the factors that could determine growth and investment performance, (North, 1990; Rodrik, 2000; Shirley, 2008). Salient among the key institutions are those that protect investors from expropriation and those that determine how contracts are enforced.
The FDI had always been considered a hallmark of economic revival and positive trajectory for a country like Pakistan among other developing economies. Improving enforcement of contract plays into strengthening factors that support investment.
Various economic historians, including North (1990), have argued that the enforcement of contracts became more involved and consequential with increased specialization, larger numbers of trading partners, and geographic dislocation of transactions. With complex contracts, it became necessary to devise some form of third-party enforcement. In fact, in modern societies, the three forms of exchanges and enforcement arrangements (tacit, explicit-informal, and formal) co-exist, and even archaic and seemingly dysfunctional informal rules can have major impacts.
Impact on Investment
Analytically, weak enforcement of contracts has been argued to impact investment through a number of channels. For example, it could most directly influence the uncertainty surrounding a project, and therefore influence investors’ decisions by increasing the project’s costs, reducing its expected returns, causing both, or generally increasing the value of the “wait” option (Dixit & Pyndick, 1994).
Weak enforcement could act indirectly on agents’ willingness or ability to invest: it could induce them to choose less-efficient technologies, inhibit them from building relation-specific assets when those relations are dependent on contracts, or amplify the adverse effects of infrastructure or regulatory shortcomings.
All these could, in turn, affect a firm’s access to external financing, while capital markets and the banking industry might be more generally crippled by an environment of insecure contracts. Legal (sometimes called institutional) “reform” has specific meaning in that perspective: assuming a dominant influence of written norms and formal contracts over behaviors, reforms would consist of adding, removing, or modifying statutory provisions, or designing better contracts. This could account for some naiveté regarding measurement of quality of enforcement (which would just result from more stringent norms and/or more intense policing) and the unfounded preference for cross-country studies.
It is a fact that donors and governments do allocate financial, human, and political resources to improve the business environment, and in particular to trying to improve the enforcement of contracts. The WB is not the only institution promoting these reforms although it has had a leading role.
Other include the International Monetary Fund (IMF), the Organization for Economic Co-operation and Development (OECD), the UK’s DFID, the Swiss Agency for Development and Cooperation (SDC), and the United States Agency for International Development (USAID). They have supported or encouraged “rule of law” programs in different countries.
To illustrate their importance and expected results, consider the case of Rwanda. The country has been reforming its commercial laws and institutions since 2001, supported by the World Bank. It was named the top reformer in Doing Business 2010, for passing a number of legal reforms that largely amount to the importation of American-style code of contract based on common law.
In another example, USAID established a three-year “Contract Law Enforcement Program” in Kosovo in 2013, with the objective of “assisting Kosovo institutions to improve the enforcement of civil judgments while dramatically reducing the backlog of enforcement cases in the Kosovo court system, and … assisting Kosovo in developing and strengthening its contract and commercial law framework and systems, including mediation.”
Policy Practices & Criteria
Key issues in assessing the effectiveness of a country’s contract enforcement and dispute resolution system are how the contract enforcement system (i.e. contract law and supporting legal institutions) performs in terms of securing committal between transacting parties and enforcing contracts at a reasonable cost; as well as the accessibility to all investors and the options for, and cost-effectiveness of, alternative dispute settlement mechanisms. The following policy practices and criteria ought to be considered:
- The role of the rule of the law in the development and protection of contractual rights that includes: The jurisdiction for hearing contractual disputes is clearly defined in law and the existence of distinct laws that underpin and support self-enforcement mechanisms.
- The implementation of contract enforcement laws.
- The performance of the supporting legal institutions.
- The costs involved by a plaintiff to enforce a contract.
- Evaluating the cost and effectiveness of different contractual enforcement mechanisms in the reviewed country’s specific institutional context.
- Alternative dispute settlement systems.
Reliability & Resource
Based on the findings so far, one might conclude that institutional change that fosters reliability of contracts will be rewarded with greater additions to a society’s stock of capital. Improving contract enforcement could be a valuable objective in itself, to the extent that it is associated with fairness and the equality of citizens before the law.
Quite another thing is to advocate institutional reforms that will demand an investment of political capital and other resources, to improve the expediency and predictability of judicial rulings in the name of broad economic benefits that are not yet proven to exist.
Freedom of Contract
Freedom of contract and efficient contract enforcement matters to businesses. The exercise of freedom of contract by parties with similar negotiating power and good knowledge of market conditions promotes efficiency in the allocation of resources, maximizing individual welfare and spurring efficiency in the marketplace.
Efficient contract enforcement promotes investment by influencing the decisions of economic actors. By promoting investment, good judicial institutions can also contribute to economic growth and development. Indeed, an effective judiciary, by providing a structured, timely and orderly framework for resolving disputes, fosters economic stability and growth.
Efficient contract enforcement is essential to allow true freedom of contract. Even where the law allows extensive freedom of contract, the benefits of this can be greatly undermined if not matched by efficient contract enforcement. Without that, the predictability of the legal framework which is highly valued by firms operating in the market would be compromised.