Ebook Contracting in the Shadow of the Law
A rapidly growing empirical literature in Comparative Law and Economics documents an important variation between Common Law and Civil Law countries of several economic indicators. These findings have typically been explained by arguing that different legal systems differently regulate the economy (e.g. Djankov et al. 2003). Yet, this explanation is at odds with the law and finance literature, which shows that the Common Law fosters various aspects of financial development (e.g. Levine 2004).
Although Civil Law systems are characterized by regulations reducing the protection of investors against management (La Porta et al. 1998), it is unclear why such regulations should be binding, given that in many countries entrepreneurs and investors can contractually opt out of them (Easterbrook and Fischel 1991). More broadly, the view that the law affects the economy by directly regulating economic activities is challenged by Coase’s (1960) proposition that if — as it is most likely in financial transactions parties can freely contract, then the law becomes irrelevant. Why, then, does the law matter?
The law and finance evidence becomes less puzzling after one realizes that Coase’s argument crucially relies on proper contract enforcement. Parties can only get around the law if courts are able and willing to enforce their contracts, but generally not otherwise. As a result, the law may affect the economy via a ”contractual channel”, i.e. by shaping contractual litigation and enforcement. Recent evidence supports this view by showing that a country’s legal system affects financial contracting (e.g. Lerner and Schoar 2005, Qian and Strahan 2004) and the quality of contractual litigation (La Porta et al. 2003, 2005). Yet, the impact of different legal systems on contracting has not received much theoretical attention. In this paper, I present a model of the ”contractual channel” where the law shapes courts’ enforcement behavior. In line with legal scholars (Damaska 1986, Posner 2004a), who view the degree of discretion as a key determinant of court behavior, I compare two legal regimes, one where judges wield discretion, another where they follow a code.
My analysis relies on two assumptions. First, I assume that in contractual disputes courts may be biased in favor of certain litigants and against others. Under judicial discretion, bias comes from judges’ personal beliefs about what is just or efficient and reflects the social, economic and political background of the judge. As stressed by the legal realists (e.g. Frank 1949), bias may lead judges to favor employers or employees, insurance companies or accident victims, managers or shareholders.
The evidence confirms the importance of judges’ beliefs for rulings on politically sensitive issues (see Pinello 1999), and on contractual disputes regarding workers’ compensation (Beiser and Silberman 1971), insurance coverage (Chesler et al. 1986), firms’ bankruptcies (Morrison 2003). But bias does not only arise under discretion. Hayek (1960) and Posner (1992) warn that codes are likely to favor the sovereign or special interests. Hence, also under codification courts are biased if the code itself is biased. Examples abound. Black (2001) and Enriques (2002) show the pro-management bias in Korean disclosure rules and Italian self-dealing regulation, respectively, while Kittner and Kohler (2000) show the pro-worker bias of “fair dismissal” requirements in Germany.
Second, I assume that factual and interpretive ambiguities plague contract enforcement. Crucially, such ambiguities offer biased courts leeway to distort contract enforcement. This is especially true for contracts regulating complex transactions, when judges are called upon to verify and enforce intricate clauses and interpret broad and ambiguous language. Frank (1949) and Posner (2004a) stress that fact-finding gives judges enormous possibilities for subverting contracts in complex and uncertain cases such as when courts need to verify the parties’ ”good faith”, ”intent” or ”negligence” and evidence is in conflict.
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