Comparing Legal and Alternative Institutions in Commerce Franklin Allen Jun “QJ” Qian

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Comparing Legal and Alternative Institutions in Commerce*

Franklin Allen Jun “QJ” Qian

Finance Department Finance Department

The Wharton School Carroll School of Management

University of Pennsylvania Boston College

May 11, 2008

First draft, comments welcome


The extraordinary economic performance of China and India in recent decades raises questions about the conventional wisdom of using the legal system as the basis of commerce. Despite many well-known advantages, the legal system can be captured by interest groups and become a barrier to change. We argue that one way to solve this problem is not to use the law as the basis for commerce but instead to use alternative mechanisms outside the legal system. Our prior work on China and India suggests that these alternative mechanisms can be quite effective. In the context of a fast-growing economy such as China or India, there is an additional advantage that this type of system can adapt and change much more quickly than when the law is used. In particular, competition can ensure the most efficient mechanism prevails and this process does not require persuading the legislature and the electorate to revise the law when circumstances change.

Keywords: Dispute resolution, institutions, law, legislature, competition.
JEL Classifications: O0; H0; P5.

I. Introduction

The economic achievements of China in the past three decades have been remarkable. Its economic growth and transition from a central-planning to a market-based economy represent one of the greatest economic transformations in history. India has also been very successful in terms of economic growth during the past two decades. At the end of 2007, China and India together accounted for 40% of the world population and about 20% of the world GDP in Purchasing Power Parity terms (see Table 1 below for more details). With growth rates among the highest of all countries, these two countries will play an increasingly more important role in the world economy for years to come.

The conventional wisdom is that to be successful in terms of long-run economic growth a country needs good institutions. In particular, it needs a good legal system that enforces contracts and resolves disputes, and a good financial system including financial markets and a banking sector to fund firm growth. In earlier work (Allen, Qian, and Qian, AQQ 2005; Allen, Chakrabarti, De, Qian, and Qian; ACDQQ 2007) we have documented that China and India do not have these. In fact, the governments of these countries are notoriously corrupt, the legal systems are ineffective and the financial markets and banks are small relative to their economies and inefficient.

Most observers would characterize the economic performance in China and India as ‘successful despite the lack of western-style institutions.’ By contrast, we argue in this paper that these economies have been successful because of this lack of western-style institutions – in that conducting business outside the legal system in fast-growing economies such as China and India can actually be superior to using the law as the basis for commerce. Our focus is on dispute resolution and contract enforcement mechanisms based on law and courts vs. alternative mechanisms operating outside the legal system.

We advance our main thesis by first describing a number of examples on how alternative mechanisms work and on the problems with using the law and legal system in commerce. A good example of how alternative mechanisms ‘substitute’ for legal mechanisms is the practice of corporate sectors in China and India. Based on earlier work we demonstrate that despite the differences in their history of developing laws and formal institutions, firms in these countries operate in an underdeveloped legal system (China) or a sophisticated legal system on paper but of limited use in practice (India). To a large extent firms conduct business outside the legal system and do not rely on formal financing channels from financial markets or banks for most of their financing needs. Instead, they use nonlegal methods based on reputation, relationships and trust to settle disputes and enforce contracts, and rely on alternative financing channels such as trade credits and funds from family and friends, backed by the nonlegal mechanisms, to finance their growth.

To highlight the problems of using the law and legal system as the basis for commerce, we focus on examples in developed countries such as the U.S. The reason for this choice is obvious. If there are deficiencies in using the legal system in countries with the most developed institutions, these deficiencies will be magnified in developing countries with underdeveloped institutions.

A frequently talked about and controversial topic is intellectual property rights including patents and copyrights. The practice of enforcing intellectual property rights by courts is much more vigilant and prevalent in developed countries than in developing countries. There is a widespread belief in developed countries that such protection is essential but this belief is not shared in the developing world. What is the empirical evidence? An extensive literature in industrial organization in economics has found mixed results on the relationship between patent/copyright protection and the pace of innovations. On the one hand, exclusive property rights provide strong incentives for innovations and do lead to more innovations in some industries such as chemicals and pharmaceuticals. On the other hand, such positive relationship between protection and pace of innovations is not observed in many other industries; instead, excessive protection deters competition, which is another important factor in spurring innovations. One of the problems with the patent/copyright and litigation systems is that they induce rent-seeking behaviors by vested interest groups and individuals. With abundant resources they can undertake various measures and use the legal system to block competition and innovations from other individuals or smaller companies, and this type of behavior reduces social welfare.

Another potential problem of using the law lies in the legal system capacity and fixed costs associated with revising the law as required by changes in commerce. In democracies, the legislature must approve any revisions in the law before corporations and investors can freely implement new techniques in their activities and transactions in practice. However, in any given period politicians have limited time and effort to devote to one area of the law, implying a fixed cost in revising the law. A good example illustrating such limited capacity and fixed costs is the U.S. payment system. At the beginning of the 21st Century the U.S. had a 19th Century system, relying mostly on checks and the mail, and significantly lagging behind other developed nations. Checks had to be physically transported from where they were deposited to a central operations center, then to the clearer and then back to the banks they were drawn on. This process significantly delayed business transactions as compared to electronic methods.

Despite repeated calls for changes from the banks and businesses, it appeared that the U.S Congress was not interested in solving this seemingly simple yet costly problem, until September 11, 2001. After the terrorist attack all commercial flights in the U.S. were grounded for several days, completely halting the check clearing process. The Check Clearing for the 21st Century Act was signed in October 2003, allowing electronic images to be a substitute for the original checks, and thus the clearing process is no longer dependent on the mail and transportation system.

In a final set of examples we show that alternative mechanisms can handle disputes from complicated transactions. The diamond industry has historically operated outside the legal system (of any one country) and flourished worldwide despite the lack of transparency of most of its dispute resolutions. Another industry that has relied on out-of-court mediations and arbitrations to settle disputes is reinsurance. In recent years it appears that selecting objective arbitrators has become a lengthy process that significantly delays the arbitration process, particularly in large scale transactions, and the industry has been revising the traditional procedure in order to expedite the process without losing sight of fairness.

These examples motivate our analysis on the advantages and disadvantages of legal institutions and alternative institutions. The use of legal systems as the basis of commerce has many well-known advantages. The legal system from a democracy allows equal and full access by all and fairness in trials and settlements. With powerful enforcement mechanisms including civil and criminal penalties, disputing agents and firms have strong incentives to follow the resolutions backed by the legal system and government, which in turn provides long-term stability on how things should be done in practice. By using the entire legal operator and system, the marginal enforcement costs can be very low and this improves overall efficiency.

However, there are also disadvantages in using the legal institutions. First, recent research on political economy factors, and in particular, work by Rajan and Zingales (2003a,b) argues that rent-seeking behaviors by vested interest groups can turn legal institutions into barriers to changes. We expect these problems to be much more severe in developing countries and the costs of building good institutions can be enormous in these countries. We argue that one way to solve this problem is not to use the law as the basis for commerce but instead to use alternative mechanisms. Second, as shown by the example of U.S. payment system reform, legal system capacity can impose significant fixed costs in revising the law and thus delaying the pace of innovations. These fixed costs can further increase if the people in charge of revising the law (e.g., politicians and judges) lack the expertise of business transactions. In addition, interest groups with more resources may receive more protection than individuals and this asymmetric protection system induces more rent-seeking behaviors and further deters innovations.

In the context of a fast growing economy, such as that of China or India, characterized by frequent fundamental changes in commerce and the economy, the disadvantages of using the legal system can overshadow its advantages, and it may be better to conduct commerce not using the law and legal system. In addition to minimizing the political economy costs of using the legal institutions, using alternative mechanisms has the advantage that they can adapt and change much more quickly than when the law is used. In particular, competition among different mechanisms and networks can often ensure the most efficient prevails and it is not necessary to persuade the legislature and the electorate that the law needs to be revised when circumstances change.

There are also limitations to alternative mechanisms. By design these mechanisms often exist within a network (or networks) of firms and investors, and may be inaccessible to outsiders and the limited access can come with the price of biases favoring insiders. With frequent changes and limited enforcement (since penalties cannot be imposed with authority), these systems generate instability and hence weak long-term incentives. While in a fast-growing economy profit-sharing in the long run and reputation-based mechanisms can ensure ‘good’ (cooperative) behavior, these mechanisms may be insufficient to induce such behavior in environments with limited long-term profits. On the other hand, in such static environments with infrequent changes to the fundamentals, the fixed costs of using the legal system are relatively small (especially in large transactions) and hence the law and legal system become superior to the alternative mechanisms.

Overall, we conclude that while legal mechanisms are an important part of developed economies’ institutions, alternative mechanisms play a much more prominent role in emerging economies, and can be superior to legal mechanisms in supporting business transactions in certain industries or entire economies. Therefore, our main policy implication is that in emerging economies alternative dispute resolution and contract enforcement mechanisms should be encouraged and developed alongside the development of legal and other formal institutions. The coexistence of and competition between alternative and legal mechanisms can also exert positive impact on the development of legal institutions, so that they are less likely to be captured by interest groups and become more efficient in adapting to changes.

The rest of the paper is organized as follows. In Section II, we present a series of examples demonstrating how alternative mechanisms work and illustrating the problems with using the law and legal system as the basis for commerce. In Section III we compare and contrast the advantages and disadvantages of alternative and legal mechanisms and discuss policy implications. Finally, Section V concludes.

II. Examples on Alternative Mechanisms and Problems with the Legal System

In this section we first provide descriptions on legal protection of investors in practice and how alternative mechanisms work and substitute for legal mechanisms among corporate sectors in China and India. We then present examples that illustrate potential problems with using the law and legal system as basis for commerce. As indicated earlier, we focus on examples in developed countries such as the U.S. in order to emphasize the nature of the inefficiencies of legal institutions.

II.1 Alternative Mechanisms in China and India

Table 1 presents information from IMF on GDP based on simple exchange rates, GDP based on purchasing power parity (PPP), growth rate in GDP and GDP per capita in constant prices during 1990-2007 for the top twenty countries in each category. China is leading the chart in terms of growth rates of GDP and per capita GDP, while India’s growth rates are the third (GDP) and fifth highest (per capita GDP) in the world during the period 1990-2007. At the end of 2007, China’s PPP-adjusted GDP is the second largest and India’s PPP-adjusted GDP is the third largest in the world. If current growth rates persist, China’s economy (PPP-adjusted) will overtake the U.S. to become the largest economy in the world in 2010, and double the size of US economy by 2020.1 With 40% of the world’s population and the status as the two largest and fastest growing emerging markets in the world, China and India are expected to play an increasingly important role in the global economy for years to come.

The remarkable economic performance of China and India also presents significant counterexamples to existing literature on law, institutions, finance, and growth. The conventional wisdom is that a necessary condition for long-run economic growth is good institutions, including a legal system that enforces contracts and resolves disputes, a financial system with efficient financial markets and a banking sector, and a democratic and benign government. However, AQQ (2005) and ACDQQ (2007) document that both China and India have weak and underdeveloped institutions. In particular, the legal systems are ineffective, the markets and banks are small relative to the economies and have played a limited role in allocating resources to most efficient uses, and the governments are among the most corrupt in the world.

These two countries also present distinctly different cases in their histories of developing western-style legal and other formal institutions. Transiting from a socialist system to a market-based system, China had no formal commercial legal system and associated institutions in place when its economy began to take off in the 1980s. However, historically China had highly commercialized societies without the development of western institutions. India, on the other hand, has a long history of Western legal institutions and financial markets due to its colonial ties to the U.K., and inherited a set of rich institutions. Based on the British judicial system, India’s formal legal system dates back more than two centuries. The State Bank of India, the largest commercial bank in the country in terms of deposits as well as assets, is over two hundred years old and thriving. The Bombay Stock Exchange (BSE), at 130 years, is the oldest in Asia. Yet, Indian firms, like Chinese firms, generally conduct business outside the legal system.

There are notable alternative views to the law and finance literature. For example, Rajan and Zingales (2003a; 2003b) suggest that development of formal financial system may trigger political economy costs, causing a disconnection between the level of financial market activity and economic development. Similarly, Acemoglu and Johnson (2005) find that while “contracting institutions,” or laws protecting contracts between individual parties, do not affect long-term growth, “property rights institutions,” or laws and regulations restraining powerful elites and the government, do affect economic growth. We argue that a common theme from the experience in China and India is that by using alternative mechanisms the political economy costs of using the legal institutions can be minimized.

What economic lessons can be learned from the remarkable performance of China and India? Are they simply applying the conventional wisdom, or are they doing something fundamentally different that (Western) economists have yet to fully understand? While most scholars would characterize the economic achievements in China and India as ‘successful in spite of their lack of western-style institutions,’ we argue that they have been successful because they have not relied on western-style institutions to develop commerce.

In this regard, China presents the extreme example. In the West, we take it for granted that finance and commerce should be undertaken using the law as the basis for contracts. Many would agree that the same should be applied for China:
The modern corporation on a Western model would be the essential vehicle for private economic development.”
Interestingly, this was not written today but rather was the view of China’s first Company Law in 1904 (Gongsilü), drafted by the newly created Ministry of Commerce (Shangbu) of the waning Qing government aimed at promoting China’s industrial development. Several subsequent versions of the Company Law (1904-1946) have tried to promote the development of share-holding firms with limited liabilities, but despite these attempts the model of western-style corporations was never taken up in China. An important factor is that the philosophy of having a disperse ownership including outsiders and insiders runs directly against China’s traditional business model of keeping business ‘within the family.’ Indeed, most family-based firms’ fear of incorporation stemmed from their distrust of government and unwillingness of letting strangers to gain partial control of the firm. An example was the Nanyang Brothers’ Tobacco Company, a large and successful company competing with British counterparts in coastal China. As one of the very few registered firms using the new corporate model, they chose the share-holding ownership structure as the last resort to raising equity capital, and tried their best to minimize the control stakes of anyone outside of the founder’s family.2

Historically, China did not use the legal system in commerce, but it had a highly commercialized society. The earliest form of capitalism can be traced back to the late Ming Dynasty (17th century), with commerce initiated in the Zhejiang-Jiangsu area and further developed during the Qing Dynasty (17th century to early 20th century). The Opium War (1840s) between China and Great Britain ruined China’s sovereignty, but it brought Western-style legal and capital systems into China’s coastal areas (until 1949). During this period, foreign systems and the Chinese system co-existed and commerce boomed. Despite the entrance and development of Western-style courts in Shanghai and other major coastal cities, most business-related disputes were resolved outside courts. Since the Qing Dynasty, dispute resolution by guilds (merchant coalitions), families, and local notables based on the detailed regulations of guilds, family traditions, and customs was commonplace. Chinese firms on the mainland (pre-1949) and later in Taiwan (after 1949) did not use the provisions of the law but again conducted commerce outside the legal system. Modern equivalents of these dispute and contract enforcing mechanisms are arguably behind the success of Chinese firms in the 1980s and 1990s.

The development of China’s financial system from the late nineteenth century to the early twentieth century was highlighted by the emergence of Shanghai as the financial center of China and Asia. Shanghai transformed from an agricultural-based trading hub for surrounding areas into an industrialized center linked to international goods and financial markets. With thriving entrepreneurial and trading activities, financial institutions proliferated and financial innovations surged. For example, the number of Chinese lending institutions (qianzhuang) exceeded 105 in 1875; five of China’s first modern banks were founded between 1897 and 1908; and by 1936, there were 28 major foreign banks that had set up branches in Shanghai. Merchants used up to eleven currencies in their transactions, some of which were printed by local banks; the exchange rate of local currency saw wide fluctuations; many unregistered local banks (diaotang) engaged in high-leverage credit transactions with little capital reserves and defaulted frequently. At the same time, merchants’ fear of risk spawned an active insurance industry, which was first introduced by the British. Insurance on real estate, ships, and goods became routine, with collateral and personal guarantors accompanying large transactions to reduce the risk of non-payments; to alleviate the problems of asymmetric information, foreign merchants hired Chinese middlemen (and guarantors) to select Chinese merchants. Chinese and foreign merchants also devised the “commission indent system,” an early form of trade credit allowing firms and institutions to operate with minimum financial resources. The stock exchange in Shanghai was the largest in Asia for most of the 1920s and 1930s. It is worth mentioning again that most of the development of the sophisticated financial system coincided with one of the most volatile periods in Chinese history characterized by political turmoil and (civil and foreign) wars.

A review and comparison of India’s corporate sectors also provide an example of the effectiveness of alternative mechanisms and problems with formal institutions. The Indian economy is unbalanced relative to other emerging economies in that 52% of output is from services, 26% is from manufacturing and 22% is from agriculture (67% of workforce). Manufacturing industries have not done well perhaps because they are constrained by unions and traditional political economy factors including corruption and bureaucracy in the government and legal system. New industries like software have done much better because they are not constrained by political economy factors and rely more on alternative mechanisms. ACDQQ (2008) have conducted detailed surveys of more than 200 firms from the Small- and Medium Enterprises (SMEs) sector in India, and the results clearly favor alternative mechanisms over the law and legal system.

For example, when asked about their preferred actions if they face defaults, breaches of contract and dispute initiated by their business partners or customers, over 80% of surveyed firms say they do not use the legal system at all. Informal, out-of-courts channels of dispute resolution play a far more important role for these firms. About 50% of the firms surveyed do not have a regular legal adviser; among the other half that does, less than 50% of these firms have “legal advisors” with a law degree or a license to practice law. When pressed for a reason, 63% of respondents who did not have legal advisors claimed they did not need lawyers as they knew all their business partners and could deal with them fairly. Clearly, the formal legal system takes a back seat while reputation, trust and informal personal relationships are the driving factors in screening counter-parties to do business with.3

The inverse of reliance on law that determines whether a firm seeks legal recourse to redress a breach of contract and other disputes is concern for legal deterrence that may prevent it from perpetrating similar breaches itself. To this end the survey findings indicate that legal sanctions are far less important than the demands and responsibilities of the informal networks within which they exist and function. For instance, in the case of default, late payment and a breach of contract, the primary concern is loss of future business opportunities or reputation; the fear of legal consequences (adverse court sentence or jail term) is the least important concern, below even threat to personal safety.

Overall, the picture that emerges of the SME sector in India clearly indicates that the sector has little confidence in the legal system. It relies little on the courts in settling disputes and enforcing contracts and is also not much concerned about legal consequences of infractions. Non-legal sanctions, on the other hand, are far more effective. This is also the finding of the Chinese corporate sectors today. One common theme of China and India is that by operating outside the legal system, corporate sectors, especially small and medium nonlisted firms and their investors and customers can minimize the costs of using institutions such as financial markets and banks. In Section III below we compare more carefully the alternative mechanisms, such as reputation, connections and networks and positive financial incentives, with legal mechanisms, in terms of assuring performance and other ‘good’ behaviors.

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