to arbitrate or to litigate: that is the question

Ž .European Journal of Law and Economics, 8:91]151 1999Q 1999 Kluwer Academic Publishers. Manufactured in The Netherlands.

To Arbitrate or To Litigate: That Is the QuestionBRUCE L. BENSON [email protected] Moore Distinguished Research Professor, Department of Economics, Florida State Uni ersity,Tallahassee, Florida 32306, USA

Abstract

The benefits of interjurisdictional competition, particularly with a customary law option, are discussed.Arbitration can be a mechanism for choosing among systems of substantive law if effective sanctionsback arbitration. Powerful groups capture wealth by manipulating monopolized law, however, andarbitrators’ decisions must correspond with expectations about how they will be viewed under review if acoercive monopoly provides sanctions, so conditions necessary for establishing alternative sanctions areexplored. Finally, historical efforts to eliminate or absorb customary commercial law are discussed inlight of the analysis of interjurisdictional competition, and the potential for encouraging such competi-tion in emerging markets is considered.

Keywords: arbitration, interjurisdictional competition, customary law, commercial law, lex mercatoria,private sanctions

JEL Classification: JEL Subject Categories: K4, K1, N4

Ž .Friedman 1987, p. 173 explains that, for the most part, ‘‘the economic analysis ofŽ .law involves three distinct but related enterprises’’: 1 prediction of the effects of

Ž .legal rules, 2 determination of the efficiency of legal rules, usually in order toŽ .recommend what the rules ought to be, and 3 prediction of what the legal rules

Ž .will be. In this regard, however, Fuller 1964, p. 106 defines law as ‘‘the enterpriseof subjecting human conduct to the governance of rules.’’ That is, law is not simplya set of rules.1 For rules to be part of a legal system they generally must beaccompanied by institutions of governance. Such institutions may be required inorder to induce individuals to recognize the rules, for instance, as well as to clarifythe rules when disputes over their application arise and to change the rules as

Ž .circumstances change, as suggested by Hart 1961 . Furthermore, both the effectsof rules, including the likelihood of enhanced efficiency, and the nature of therules that will arise, are determined, at least in part, by the governance institutionsthat accompany the rules. Thus, in contrast to much of the law-and-economicsliterature’s focus on rules, an economic analysis of law often should includeconsideration of the institutions and processes of governance.2 To illustrate this,the following presentation considers one potential characteristic of governance:interjurisdictional competition. It does so by focusing on commercial law and thefact that internationally, and domestically in many countries, private arbitration is

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Ž .an alternative dispute resolution mechanism to litigation in public i.e., statecourts.

To the degree that arbitration might be considered in the law and economicsliterature it is typically treated as a procedural choice for resolution of contract

w Ž .xdisputes e.g., Brunet 1987 , and it clearly is true that arbitration may be chosenfor any of a number of procedural reasons. The following presentation focuses onanother potential function of arbitration, however: arbitration may also provide amechanism for assuring that the contracting parties’ preferred substantive law isapplied. To illustrate this, Section 1 provides a brief discussion of modern interna-tional commercial arbitration and its role as a mechanism for jurisdictional choice.The fact that arbitrators can be instructed to turn to a specific source for itssubstantive rules does not prove that such a jurisdictional choice has any realsignificance, of course. At least two other conditions must hold.

First, there must be differences in the substantive rules of law across jurisdic-tions, and from the perspective of the parties to the dispute, the rules enforcedthrough litigation must both differ from and be less desirable than the rulesapplied through arbitration.3 Section 2 suggests why this might be the case in thecontext of a general discussion of the benefits of interjurisdictional competition. In

Ž .particular: 1 specialization in law across multiple legal jurisdictions and competi-tion between them are desirable due the degree of complexity and diversity that

Ž . Ž .exists in commerce and in many other aspects of life , 2 interjurisdictionalcompetition facilitates the evaluation of rules and the acceptance of ‘‘good’’ rules,

Ž .and stimulates the production of new rules when the need arises, and 3 interjuris-dictional competition constrains the ability of those with political power to use lawas a transfer mechanism. Compared to legal systems that involve legislated rulesimposed through coercive institutions, the processes of customary law are muchless likely to produce or maintain biased substantive rules or institutions ofgovernance that can transfer wealth, as explained in Section 3 where the generalcharacteristics of spontaneously evolving customary law are also discussed. Thisexplains the observation in Section 1 that customary law is particularly attractive ininternational trade relationships.

A second condition may also be necessary for arbitration to serve as a mecha-nism for real jurisdictional choice. Since a party that expects to lose in anarbitrated dispute might refuse to honor a contractual promise to arbitrate, and aparty that does lose may refuse to comply, some means of inducing parties toaccept arbitration may be necessary. If the relevant sanctions are provided bynational governments, as many observers contend, then the individuals employed in

Žthe relevant governance institutions of the nation backing the arbitration e.g.,.judges may require that arbitration rulings be consistent with the nation’s substan-

tive rules. In this case, arbitrators’ decisions will have to correspond, at least to asubstantial degree, with expectations about how the decision will be viewed underreview. An alternative source of sanctions may, therefore, be required in order toimplement true jurisdictional choice. The potential role of sanctions and the

TO ARBITRATE OR TO LITIGATE 93

conditions necessary for establishing an alternative customary law jurisdiction incommercial law are also considered in Section 3.

Domestic merchants also may wish to choose customary law over a nationalsystem of law, if the national law is expected to be biased or costly to apply. Forinstance, the law-making consequences of commercial arbitration led WooldridgeŽ .1970, p. 104 to suggest that its substantial growth in the United States is a ‘‘silentdisplacement of not only the judiciary but even the legislature.’’ If particular

Žpolitically powerful groups e.g., interest groups, bureaucrats, individuals who have.specialized in understanding and manipulating the politicized legal system capture

considerable wealth through the national system of law, these benefactors havestrong incentives to reduce and even prevent jurisdictional choice, however, soefforts to either eliminate or absorb alternative jurisdictions can be anticipated.Even if not completely successful, such efforts can raise the transactions costs ofturning to alternative jurisdictions. The history of commercial law and arbitrationprovides illustrations of both efforts to eliminate and to absorb customary lawjurisdictions, and examples of each are discussed in Sections 4 and 5. Section 6considers the potential sources commercial law and arbitration in the emergingmarkets of Eastern Europe and Asia in light of the analysis of interjurisdictionalcompetition.

1. Arbitration and Jurisdiction Choices In Modern International Commerce4

Almost all international trade contracts have clauses that expressly exclude litiga-tion by the national courts of the trading parties and refer any dispute that cannot

Ž .be resolved through negotiation perhaps with the aid of a mediator to arbitrationŽ .Berman and Dasser 1990, p. 33 . Around eighty percent of these contracts had

Ž .arbitration clauses at the time of Lew’s 1978, p. 589 study, for example, and hew xsuggests that over time, ‘‘more and more international traders . . . turn to arbitra-

Ž .tion.’’ More recent studies confirm Lew’s prediction: Casella 1992, p. 1 , BergerŽ .1994, p. 12 and others report that about 90 percent of all international tradecontracts contained arbitration clauses in the early 1990s.

Not surprisingly, given this reliance on arbitration, there are many potentialsources of arbitration for international business disputes. A large number ofinternational trade associations have their own conflict resolution procedures,using arbitrators with special expertise in trade matters of concern to association

w Ž .members over three decades ago, for example, Lazarus, et al. 1965 discussedxmore than 120 such tribunals . Other traders rely on the International Chamber of

Ž .Commerce ICC and its arbitration institution. ICC arbitrators are experts ininternational commerce, and are typically chosen from a different national originthan those of the parties in the dispute. In addition, arbitration of internationaltrade disputes can be carried out by arbitrators from nation-specific organizations

w Ž .around the world e.g., the American Arbitration Association AAA , the Hungar-x Žian Chamber of Commerce . Ad hoc arbitration is also widely used Bockstiegal¨

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.1984, p. 21 , and in this regard, there is a rapidly growing market in private disputeresolution services provided by for-profit firms, at least in the United StatesŽ .Benson 1990, pp. 223]224, 1998d, 1998g, pp. 113]116; Ray 1992 .

International arbitration is attractive for a number of procedural reasons.ŽSpecialization by arbiters selected for their expertise and reputation Ashenfelter

.1987 means that arbitration typically is a faster, less formal, and less expensiveprocedure than litigation, in part because the parties do not have to provide asmuch information to the arbitrator to avoid an error in judgement as they would to

Ž .a non-specialized judge or jury Benson 1989, forthcoming-a . Another benefitarises when court time is allocated by waiting, since delay often can be devastatingto a business and arbitration services can be purchased in a market or provided by

Ž .a trade association without such delay Benson 1989, 1995a . Other potentiallyimportant procedural benefits include the facts that, if desired, privacy can be

Ž .maintained Brunet 1987; Bernstein 1992 , and that arbitration is generally lessŽ .‘‘adversarial’’ than ‘‘transaction-rupturing’’ Williamson 1979, p. 250 litigation, so

it is more likely to allow continuation of mutually-beneficial repeated-dealingŽ .relationships Benson 1989, 1995a . Any dispute is ‘‘adversarial’’ of course, but the

use of arbitration is generally motivated by relatively positive economic incentives,as explained below.

Arbitration is also attractive because it provides a means of supporting theŽ .contracting parties’ choice of legal jurisdiction Bockstiegal 1984, p. 23 : ‘‘When, in¨

relation to arbitration, judges, arbitrators or authors speak of the ‘applicable law’they do not always mean the same thing. The term is sometimes used ratherindifferently with regard to three separate questions: What is the applicableprocedural law? What are the applicable conflict of law rules? What is theapplicable substantive law? All three of these questions have their definitiverelevance in any kind of international commercial arbitration.’’ Essentially, the

Žchoice of an arbitration institution involves a choice of procedural rules Bockstiegal¨.1984, p. 23 , but the contract can also specify the choice of substantive law and

conflict of law rules which an arbitrator is expected to apply. For instance,international contracts can specify that a dispute be resolved under a particularnation’s law. In doing so, however, it is likely that the law chosen will not be from

Ž .the nation of either of the contracting parties. As Bockstiegal 1984, p. 19 suggests,¨even if there is ‘‘a certain preference for one’s own jurisdiction which one knowsand with which one feels comfortable’’ the other contractual party also is likely tohave a similar preference for a preferred jurisdiction, so unless the bargainingpower of one party is much stronger than the other, ‘‘the compromise most oftenreached is to submit to international arbitration which is neutral and does not givean advantage to either side in case of a dispute.’’ The argument also applies to the

Ž .choice of an arbitration forum Bockstiegal 1984, pp. 17]18 . Arbitration selection¨processes are designed to guarantee that impartial arbitrators are likely to be

Ž .chosen Ashenfelter 1987 , as explained below, so if either party fears that anarbitrator from the other party’s nation will be biased, the contract is likely to

Žspecify that an arbitrator must come from another nation e.g., this is typically the


.case with ICC arbitration, for instance . Indeed, even state owned enterprises aregenerally forced to agree to private arbitration if they want to enter into interna-

Ž . 5tional contracts Bockstiegal 1984, pp. 17]19 . International contracts between¨state owned enterprises from two different nations almost always have arbitrationclauses since neither wants the other enterprise’s national courts to resolvedisputes. This was even true of enterprises from the countries of Eastern Europeunder communism, for whom arbitration was the ‘‘exclusive method of disputesettlement in business relations with other socialist countries and also the standard

Žmethod in contracts with business partners in non-socialist countries’’ Bockstiegal¨.1984, p. 15 .

One substantive law option is to choose the law and conflict-of-law rules of theseat of arbitration, but this is not necessary. Instead, the ‘‘usual way’’ of determin-ing the relevant substantive law for international commercial arbitration is todecide cases ‘‘exclusively on the interpretation of contracts and the relevance of

w xtrade usages so that very little depends on the question of the applicable nationalŽ . 6 Ž .law’’ Bockstiegal 1984, pp. 27, 23 . Lew’s 1978, p. 581 detailed analysis of¨

w Ž . Ž .xavailable records also see Trakman 1983 and Draetta et al. 1992 reveals that inprinciple, ‘‘The answer to every dispute is to be found prima facie in the contractitself. What did the parties intend, what did they agree and what did they expect?’’When arbitrators cannot discover the parties’ intent in the contract, however,which is likely to be the case since a dispute has arisen, they must decide what theparties expected or should have expected, and in this regard, international arbitra-tors generally intentionally ‘‘denationalize’’ their awards and attempt to make themacceptable by showing their consistency with accepted traditional rules of the

Ž .relevant business community Lew 1978, pp. 582]585 . Contracts might explicitlyŽstate that the practices and usages of a particular commercial community e.g., a

.trade association should be applied, or this may simply be understood. PracticesŽ .and usage business custom provide the default rule, at any rate, as arbitrators

apply the customary rules which are commonly recognized within the ‘‘privateŽ .international law systems from which the parties come’’ Lew 1978, p. 585 , unless a

particular nation’s substantive law has been specified in the contract. In fact, eventhough many national governments may be unable to agree on common rules fortrade between their citizens, relative international uniformity in rules within

Žparticular international commercial communities e.g., formal trade associations,.informal trading groups is established as businessmen use arbitrators rather than

state courts, thereby replacing conflicting state laws with accepted business customŽ .David 1985, p. 138 : ‘‘Owing no allegiance to any sovereign State, internationalcommercial arbitration has a special responsibility to develop and apply the law of

Ž .international trade’’ Lew 1978, p. 589 . The law that dominates international tradeŽthrough the use of arbitration, increasingly referred to as lex mercatoria De Ly

.1992, p. 1 , is customary law, as explained below. But why might customary law bepreferred over other sources of substantive rules? In order to answer this, let usfirst consider the benefits of interjurisdictional competition.

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2. Interjurisdictional Competition versus a Monopoly in Law7

Many legal scholars believe that there should be a single centralized legal systemŽ .within a large geographic jurisdiction. Drobnig 1996, p. 6 finds it ‘‘amazing,’’ for

instance, that ‘‘the EEC Treaty did not and does not envisage any positive actionwith a view to unify or at least harmonize commercial law.’’ Similarly, FeldbruggeŽ .1996, p. 571 , in writing about law in Russia and the other newly independentstates following the breakup of the Soviet Union, suggests that ‘‘the still prevailinglegal uniformity is one of the few positive survivals of the Soviet era,’’ and IoffeŽ .1996, p. 80 contends that ‘‘legislative activities in the realm of civil law must nowbe comprehensive. Such a necessity results not only from the emergence of gaps inthe law, but also from the restructuring of the former Soviet economy which

Ž .requires new legal regulation.’’ Ioffe 1996, p. 95 also maintains that ‘‘Thecodification which will be implemented in the independent states must lead to thedevelopment of two codes}civil and commercial . . . . But the commercial code, nottaken literally, must encompass all forms of economic activity, both in production

Žand trade.’’ Why is a monopoly in law seen as desirable? Landes and Posner 1979,.p. 239 put the case as clearly as any: ‘‘there would appear to be tremendous

w xeconomies of standardization in law , akin to those that have given us standarddimensions for electrical sockets and railroad gauges. While many industries haveachieved standardization without monopoly, it is unclear how the requisite stan-

w xdardization of commonality could be achieved in the law without a single sourcew xfor law }without, that is to say, a monopoly.’’ There are at least three flaws in

such arguments, however.

2.1. Complexity, Di ersity, and the Benefits of Specialization In Law

First, the wide variety of activities and relationships that exist in a modern worldmean that many rules that are effective for one type of transaction or one groupmay not be effective for another. Within commerce, for instance, the diamond

Ž .traders discussed by Bernstein 1992 may prefer a very different set of rules andŽ .institutions than those adopted by the oil traders discussed by Trakman 1983 . The

products being traded are very different, of course, suggesting that very differentcontractual issues are likely to be relevant, but the trading communities are alsovery different. Diamond merchants share common ethnic and religious back-

Žgrounds, creating an environment of mutual understanding e.g., of common trade.practices and usage and trust, for instance, thus reducing the need for highly

technical and specific contracts, while oil traders display much greater ethnic andŽreligious diversity as well as differences in motivations a number of oil producing

states have nationalized production, for instance, so political considerations can.have major impacts of decision-making , possibly reducing the level of common


understanding and undermining trust relationships, thus dictating much morespecific and complex contracts. Certainly, these two commercial groups are likelyto share many of the same rules, but they are also likely to be some importantdifferences in traditions and practices. Imposition of the diamond merchants’ ruleson the oil traders would, therefore, lead to higher transactions costs for thesetraders, including more contract disputes, and imposition of the oil traders’ ruleson the diamond merchants would add unnecessary costs to their contractingprocess. Combining all of the rules from each group into a single legal system

Ž .would create unnecessary complexity for both groups. As Cooter 1994, p. 216explains, more decentralized lawmaking is desirable in the increasingly complexinternational economy. In other words, the economies of standardization are notnearly as significant as they might appear to be, and they are probably shrinkingrather than expanding, while the benefits of specialization are relatively large andgrowing.

2.2. E¨aluating Rules and De¨eloping Alternati es

A second but closely related point is that a monopoly in law will have undesirableresults in a dynamic uncertain world. For instance, given the potential for ‘‘bad’’

Ž .rules e.g., biased or transactions-cost-increasing rules to be produced and main-Žtained no matter what size the legal system is a potential that can increase

dramatically as the size of the decision-making group falls relative to the size of the.community affected by the decision, as suggested below , the effects of such laws

are less severe in a decentralized or polycentric system of legal jurisdictions. AsŽ .Osterfield notes 1989, p. 152 , in the case of a ‘‘good’’ rule, it often does not

matter how extensive the legal system is, as good rules tend to be emulated,especially if there is competition for members and freedom to choose amongjurisdictions. In the case of a bad rule, however, the extent of the legal systemclearly matters, particularly if there are institutional factors that make elimination

Ž .of such rules difficult see the discussion of endogenous transactions costs below .There is an even more fundamental issue involved. In the absence of alterna-

tives, it may not be possible to evaluate the ‘‘goodness’’ or ‘‘badness’’ of a rule. Arule imposed in an over-arching legal system may produce undesirable unintendedconsequences that another rule would not produce, but this may not be recognized.On the other hand, as individuals in parallel legal systems experiment withalternatives, the relative impacts of different rules can be observed and moreeffectively evaluated. Good rules can spread as one group emulates those rules thatprove effective in another group, and if individuals can exit, the groups which fail

Žto adopt good rules will loose subjects who move to the other group or form a new.one, adopting the best set of rules that have been observed elsewhere . In law, as in

markets, competition is an important determinant of the outcome. Indeed, thebenefits of competition go beyond the enhanced abilities to evaluate and chooseamong rules. Competition actually stimulates legal innovation and sophistication,

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Ž .as Berman 1983, p. 10 explains:

It is this plurality of jurisdictions and legal systems that makes the supremacy oflaw both necessary and possible . . . . The very complexity of a common legalorder containing diverse legal systems contributes to legal sophistication. Whichcourt has jurisdiction? Which law is applicable? How are legal differences to bereconciled? Behind the technical questions lay important political and economicconsiderations . . . . The pluralism of . . . law, . . . has been, or once was, a source ofdevelopment, or growth}legal growth as well as political and economic growth.

Berman includes the ‘‘or once was’’ phrase in recognition of the fact that throughmuch of history diverse legal systems have been subjugated and centralized under

Žthe authority of coercive state governments and today, multi-national organiza-. 8tions such as the EEC, WTO and UN .

2.3. Law As a Transfer Mechanism

ŽTo understand the third flaw in arguments for a monopoly in law and to reinforce.the arguments made above about the potential for biased and costly rules , the

Ž .potential functions of legal rules must be recognized. As Coase 1960 emphasized,one motivation for creating rules is to eliminate externalities and facilitate volun-

Ž .tary interaction. Coase 1960 also explains that rules and institutions determinethe distribution of bargaining power and therefore the distribution of wealth,however, and while he did not focus on this issue, these distributional conse-quences also create incentives to make and alter rules. Indeed, as OppenheimerŽ .1908, pp. 24]25 observes, an understanding of the formation and development ofthe institutions of the state requires recognition of the fact that

There are two fundamentally opposed means whereby man, requiring suste-nance, is impelled to obtain the necessary means for satisfying his desires. Theseare work and robbery, one’s own labor and the forceful appropriation of the

w xlabor of others . . . . T he warriors’ trade . . . is only organized mass robbery . . .Both because of this, and also on account of the need for having, in the furtherdevelopment of this study, terse, clear, sharply opposing terms for these veryimportant contrasts, I propose . . . to call one’s own labor and the equivalentexchange of one’s own labor for the labor of others, the ‘‘economic means’’ forthe satisfaction of needs, while the unrequited appropriation of the labor ofothers will be called the ‘‘political means.’’

Rules can be institutionalized to facilitate the pursuit of either the economic or thepolitical means of personal wealth enhancement. In fact, ‘‘law,’’ the enterprise ofsubjecting human conduct to the governance of rules, almost always involves oftenconflicting efforts to achieve both objectives. The existence of the political process


raises the transactions costs of the economic process, as explained below, and theŽeconomic process is necessary for the survival of the political process wealth must

.be created to be transferred , so an understanding of law requires recognition ofthe resulting conflict between incentives to pursue wealth through both economic

Ž .and political processes Benson 1997, 1999, forthcoming-b .Since property rights dictate the distribution of wealth, involuntary wealth

transfers involve the involuntary attenuation andror reassignment of propertyŽ .rights Benson 1984 . Unlike voluntary exchange which tends to increase wealth,

involuntary wealth transfers through enforcement of legislated rules, whether theyare established by kings, dictators, ‘‘representative’’ parliaments, or courts, tend toreduce wealth for at least four reasons. First, comparative static analysis of a

Žtransfer e.g., through a tax andror subsidy, or through granting of a monopoly.franchise points to a deadweight loss. Second, while many observers suggest that

these deadweight losses are small and that institutions should evolve to minimizew Ž .x Ž .them e.g., Becker 1983 , Tullock 1967 explains that the resources consumed in

the competition for such transfers also have opportunity costs. These rent-seekingcosts can be very large since individuals and groups have incentives to invest timeand resources in an effort to gain wealth through the political process. Victims ofthe transfer process have incentives to defend their property rights, of course, andpart of these defense costs are rent-avoidance costs arising through investments inpolitical information and influence. Exit is another option, however, whether bymoving to an alternative political jurisdiction, or by hiding economic activity and

Ž .wealth e.g., moving transactions ‘‘underground’’ into black markets . Therefore, inorder to induce compliance with discriminatory transfer rules, the rule makers will

Žgenerally have to rely on an enforcement bureaucracy, both to prevent exit e.g.,.establish a monopoly in law and to execute the rules. These enforcement costs are

a third source of opportunity costs that accompany a wealth transfer process. EvenŽrules that facilitate voluntary production and exchange e.g., private property

.rights require some enforcement costs, of course, but the level of these costsincreases dramatically when laws are also imposed in order to generate involuntarywealth transfers. But adding rent-seeking, rent-avoidance, and relatively-high en-forcement costs to the deadweight loss still under-estimates the full opportunitycost of an ongoing transfer process. The dynamic consequences are likely to beeven more significant: faced with the probability of involuntary transfers, produc-tive individuals’ property rights to their resources, wealth, and income flow areperceived to be relatively insecure, so their incentives to invest in maintenance ofand improvements to their assets, and their incentives to earn income and producenew wealth that might be appropriated, are relatively weak. Indeed, if transfers areexpected to be large, frequent, and arbitrary, most wealth production may have to

Ž .be motivated by threats e.g., as under slavery or totalitarian socialism , makingenforcement costs even higher. Such threats are imperfect, however, so production

Ž .will be low and wealth expansion economic growth will be slow compared to asituation wherein property rights are relatively secure.

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A legal system that is performing significant transfer functions actually must alsosupport wealth creation, of course. After all, wealth must be produced for it to betransferred. Therefore, rule makers face a trade off, as large levels of transfers inthe short term reduce productivity, wealth creation, and the potential for transfersover the long run. The actual degree of transfers in any period, therefore, depends

Žin part on the ruler makers’ time horizons Levi 1988, pp. 13, 32]33; Holcombe.1994, p. 112; Benson 1999 . In an effort to reduce enforcement costs and increase

wealth production, efforts to legitimize political activities and divert oppositionw Ž .xshould arise. The legitimization effort can involve many tactics see Benson 1999 ,

but one focus will be on establishing a claim that there is only one legitimatesource of law. Indeed, stifling interjurisdictional competition is necessary in orderto generate wealth transfers. After all, the ability for those subject to the law to optfor a different jurisdiction sharply limits such transfer opportunities. Rule makerswith reasonable time horizons may, therefore, attempt to provide a comprehensivesystem of rules and governance institutions. Many rule makers also should recog-nize, however, that selectively supporting rules which originated within wealth-pro-ducing communities that have been subjugated, provides a low cost mechanisms forfacilitating cooperation in the creation of wealth that can then be expropriated.Therefore, legislation may explicitly codify many of the customary norms that have

Ževolved to support voluntary interaction see the discussion of this evolutionary.process below . In such an environment, ‘‘law’’ simultaneously serves many func-

tions, some of which are widely seen as legitimate, and some of which are widelydespised. The law protects some private interests and destroys others, it serves tointegrate ‘‘society’’ through force while disintegrating many of the groups thatmake up ‘‘civil society,’’ it fosters the production of wealth by some and the taking

Žof wealth by others, it defines crimes and is used to commit crimes involuntary and. Ž . Žuncompensated takings . Law in a positive sense and justice in a normative

.sense are clearly not synonymous.Another significant component of the legitimization effort involves actions that

raise transactions costs for potential political opposition or for the maintenance ofŽalternative jurisdictions recognizing and offering to enforce customary norms also

.reduces the benefits of maintaining an alternative jurisdiction . That is, instead ofwtrying to minimize total transactions costs as some have contended e.g., Stigler

Ž .x1992 , those with political power want to reallocate them, lowering their own andraising those that potential opponents or resisters must overcome. For instance, as

Ž . w xLevi 1988, p. 67 explains, ‘‘rulers are most successful at legitimization . . . whenthere is uncertainty.’’ Therefore, tactics of misrepresentation and falsification of

Ž .information are common in political institutions Breton and Wintrobe 1982, p. 39 ,as they raise the transactions costs for those who might attempt oppose the rules iftrue information was available. Uncertainty does not necessarily require outrightfalsification, of course. It can be increased by making ‘‘rules’’ very complex anddifficult for most people to understand, and given the expected payoff for individu-als from trying to understand the laws that they are not likely to be able to changeanyway, rational ignorance implies that such a tactic may disguise the underlying


Ž .transfer implications. Levi 1988 also suggests that quasi-voluntary compliancemay increase if people believe that everyone is sharing the burdens imposed onthem. Therefore, one tactic may be to establish complex rules that appear to applyto everyone, but then selectively enforce them.

The development of specialists with considerable discretion in regulating, polic-ing, collections, and rule interpretation within a complex system of laws that serveto both support wealth production and transfer wealth, also creates transactionscosts. These individuals are essentially acting as agents of those with rule-makingpower or influence, but severe principle-agent problems arise as the specialists willbe in a position to skim relatively large shares of the wealth being transferredandror accept bribes to selectively enforce the rules in ways that differ fromlegislative intent. This creates incentives for rule makers to limit the power ofindividuals and subgroups within their bureaucratic organizations, and a number ofmonitoring and control processes are inevitably introduced. Control is incomplete,however, so bureaucrats are generally in a position to manipulate the process inorder to capture some of the wealth in the form of discretionary budgets, bribes,

Ž .andror other perquisites Breton and Wintrobe 1982; Benson 1995b . This manip-ulation includes efforts to raise transactions costs for those outside the bureauŽ .both legislators and political interest groups who may want to monitor androrcontrol the bureau’s activities. After all, individuals who depend for their livelihoodon a particular institutional arrangement have incentives to increase transactionscosts associated with both eliminating the arrangement and finding alternativeŽ .competitive arrangements that might more effectively achieve the same objectivesw Ž . Ž . Ž .xfor instance, see Breton and Wintrobe 1982 , Gambetta 1983 , Benson 1995b .Competitors in any environment have incentives to raise their rivals’ costs, ofcourse, but those operating within institutions that have coercive powers are inparticularly strong positions to influence the level and distribution of transactions

Ž .costs Twight 1988; Crew and Twight 1990 .Individuals facing large potential losses due to the discretionary application of

complex rules will want to avoid the negative consequences of such rules, sospecialists in interpreting rules and avoiding their consequences are likely to offer

Žtheir services to such individuals. Like bureaucrats, these specialists e.g., lawyers,.tax consultants also rely on the process and its complexity for their livelihood, so

they have incentives to organize and gain political influence in order to resistchanges in the system that might reduce the demand for their services, and todemand stronger barriers to exit from the jurisdiction in which they have developedspecialized expertise. In other words, transactions costs are, at least to a degree,endogenous: transactions costs influence the evolution of rules and institutions, butthe rules and institutions also determine at least some of the transactions costs,and the distribution of those costs.

Perhaps a monopoly in law will not necessarily produce biased rules for theŽpurpose of transferring wealth rules that will also undermine incentives to be

.productive , but it is clear that a necessary prerequisite for such law is strongbarriers to exit for those who expect to lose wealth through transfers.9 Interjuris-

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dictional competition can occur between legal systems attempting to monopolizelaw making and enforcement, and to the degree that wealth can escape one tomove to another, the potential for using law as a transfer mechanism is limited.This is another obvious benefit of interjurisdictional competition, and importantly,there is another source of competition as well: customary law.

3. Customary Law10

ŽCustomary norms appear to have a ‘‘community’’ basis, but as Fuller 1981, pp..227]228 explains,

Where customary law does in fact spread we must not be mislead as to theprocess by which this extension takes place. It has sometimes been thought of asif it involved a kind of inarticulate expression of group will . . . This kind ofexplanation abstracts from the interactional process underlying customary lawand ignores their ever-present communicative aspect.

The original source of widely accepted customs are often not known, but in alllikelihood, they started as a convention11 or a contractual promise12 for someindividual and then spread through the community. Indeed, a key distinguishingcharacteristic of customary norms is that a rule of obligation is initiated by anindividual’s decision to behave in particular ways under particular circumstances,but then numerous individuals who interact with one another observe each others’behavioral patterns, emulating those that appear desirable so that some behavior

Ž .spreads Mises 1957, p. 192 . In other words, customary norms evolve sponta-neously from the bottom up rather than being intentionally designed by a legislatorŽ .or court , and they are voluntarily accepted rather than being imposed, eventhough there never has been an explicit statement declaring that they are relevant.Adopting such behavior creates expectations and accompanying obligations for

Ž .everyone in the relevant community Hayek 1973, pp. 96]97 : ‘‘the binding powerŽ .of custom is the security of expectations’’ Commons 1924, p. 301 .

For an obligation to achieves the status of a ‘‘customary law’’ it must be widelyrecognized and accepted by the individuals in the affected group. The result is

Ž .analogous to a unanimity or consensus rule for collective decision-making. Ifsome individuals choose not to adopt all of the rules, they will not be members ofthat customary community. A unanimity rule implies that if individuals expect arule to be biased against them, to fail to support decisions that will enhance theirchances for wealth production, or to generate greater personal costs than personalbenefits, it is not adopted. Indeed, customary law tends to be quite conservative inthe sense that it guards against mistakes. Of course, unanimity could also meanthat many unbiased rules that could enhance allocative efficiency are not adopted.

Ž .The view of custom frequently traced to Sir Henry Maine 1864, p. 74 but sharedw Ž . Ž . Ž .xby many e.g., Hart 1961 , Landes and Posner 1979 , Brunet 1987 , is that it is


static, or at least very slow to change, making it an ‘‘inefficient’’ process fordeveloping new rules in a dynamic environment. The fact is, however, that

Žflexibility and change often characterize customary law systems Commons 1924,pp. 301]302; Trakman 1983; Mitchell 1904; Berman 1983; Pospisil 1971; Benson

.1988b, 1989, 1992, 1998c, 1998d, 1998e . The mistaken perception that customarylaw is slow to change may arise from the belief that there is only one mechanismfor initiating change: an individual must begin behaving in a particular way undercertain circumstances, others must observe the behavior, come to expect it, andthen adopt similar behavior under similar circumstances, creating similar obliga-tions for everyone in the community.13 Certainly, this process can be a very

wimportant mechanism for creating new custom it has characterized the transmis-sion of commercial customs among expanding networks of traders, for instanceŽTrakman 1983, p. 11; Mitchell 1904, pp. 7]9; Bewes 1923, p. 138; Benson 1989,

.x1998c, 1998e . However, when that process proves to be too slow, there are othermechanisms for initiating change in customary law.

If conditions change and a set of individuals decide that, for their purposes,behavior that was attractive in the past has ceased to be useful, they can voluntarilydevise a new contract stipulating any behavior that they wish. Through negotiationand contracting, existing custom can be quickly replaced by a new rule of obliga-tion toward certain other individuals without prior consent of or simultaneousrecognition by everyone in the group. Individuals entering into contracts with theseparties are informed of the contractual innovation, andror others outside thecontract observe the results of a new contractual stipulation, so if it provides amore desirable behavior rule than older custom, it can be rapidly emulated.Indeed, many contracts spread quickly as ‘‘standard forms’’ throughout the relevant

Žcommunity, serving as ‘‘powerful norms’’ with obvious ‘‘legal character’’ Rubin. 141995, p. 115 . Contracting may actually be the most important source of new rules

Ž .in a dynamic system of customary law Commons 1924, p. 301; Fuller 1981, p. 157 ,and in fact, many innovations in commercial law have been initiated in contracts

wand dispersed quickly through the relevant merchant community e.g., see MitchellŽ . Ž . Ž .1904, p. 12 , Berman 1983, pp. 349]355 , Benson 1989, 1998c, 1998e , Draetta et

Ž .xal. 1992 .Alternatively, as conditions change, the inadequacy of existing customary rules

can be revealed when a dispute arises. Negotiation is probably the primary meansof dispute resolution for members of a close-knit customary law community,reinforcing the contention that contracting is a primary mechanisms for initiating

Žrapid change in customary law. If direct negotiation perhaps facilitated by a.mediator fails, however, the parties to a dispute within a customary enterprise of

law often turn to a third party for arbitration. This is clearly the case withinmodern international commercial communities, as noted above, but it is also true

Ž .for primitive societies Pospisil 1971; Benson 1988b, 1991a , and for many domesticŽ .commercial communities Bernstein 1992; Benson 1995a . Since a dispute suggests

that existing rules are unclear or insufficient, new customary rules can be and oftenŽare initiated as arbitrators resolve the disputes Fuller 1981, pp. 90, 110]111; Lew

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.1978, pp. 584]589; Wooldridge 1970, p. 104; Benson 1988b, 1989, 1998c, 1998e .Unlike public court precedent, such dispute resolutions only apply to the parties inthe dispute, of course, but if the resolution suggests a rule that appears to be moreeffective at facilitating interactions than previously existing customary rules havebeen, the rule can spread rapidly through the community.

In contrast to the claim that private arbitration can be an important source ofŽ .new rules of behavior, Landes and Posner 1979, pp. 238]239, 245 argue that

arbitrators seeking to maximize profits actually have incentives not to clarify rulesbecause doing so will reduce the number of disputes to be resolved, and theyconclude that arbitration in the commercial area is ‘‘not a source of rules or

Ž .precedents.’’ Similarly, Brunet 1987, p. 19 contends that substantive law producedas precedents by common law judges is a ‘‘public good’’ which is not going to beproduced at efficient levels by private arbitrators. He emphasizes that arbitrationresults are ‘‘internal’’ to the parties involved, as noted above, and that the secrecythat characterizes much of modern arbitration means that others will not be able

Žto learn about the outcome of any particular dispute anyway Brunet 1987, pp.. Ž14]15 . Such arguments fail to recognize that when external benefits e.g., produc-

.ing new customary law are significant, strong incentives exist to develop institu-tions that can internalize them. This can be an important source of incentivesunderlying the formation of trade associations and other commercial groups, for

Ž .instance Benson 1995a, 1998c, forthcoming-a , and within such an organization,institutional arrangements easily can create incentives to minimize disputes by

w Ž . xmaking clear rulings as Landes and Posner 1979 recognize . Furthermore,Ž .Ashenfelter 1987, pp. 342]343 explains that since disputants typically have veto

Ž .power in arbitrator selection see the discussion of selection processes below ,arbitrators competing for business have incentives to develop expertise and a

Žreputation for rendering clear and unbiased decisions. Similarly, Lew 1978, pp..584]585 contends that arbitrators have strong incentives to demonstrate that a

ruling is consistent with expectations arising from existing practices and usage asŽ .well as with other arbitration rulings. Thus, Fuller 1981, pp. 110]111 maintains

that arbitrators’ incentives are exactly the opposite of those suggested by LandesŽ . Ž .and Posner 1979 and Brunet 1987 : when an arbitrator must be concerned with

the acceptability of his decisions to more than just the parties involved, there areŽ .strong incentives to get the facts and relevant law custom right and to justify the

ruling in the context of those facts and existing law. This clearly appears to be thecase in customary law communities where public acceptance of an arbitrator’sruling is important. In many primitive societies, for instance, third-party disputeresolution is a highly ritualized public display wherein the arbitrator loudly explains

Ž .the evidence and the reasons for his decision Pospisil 1971; Benson 1988b, 1991a .But what of modern commercial arbitration and its emphasis on privacy or secrecy?

Ž .Consider Bernstein’s 1992 examination of the systematic rejection of state-created law by the diamond industry in favor of its own internal rules and

winstitutions including both mediation and arbitration institutions and privatelyxproduced sanctions such as those discussed below wherein she explains that the


diamond merchants’ Boards of Arbitrators resolve disputes on the basis of industry‘‘trade custom and usage.’’ But she also finds that within some diamond tradingclubs the outcome of arbitration is ‘‘officially kept secret’’ as long as the ruling is

Ž .complied with Bernstein 1992, p. 124 , perhaps supporting the view that prece-dents are not produced? Such ‘‘official’’ secrecy does not mean that new rules arenot created or spread, however, or even that too few customary rules exist, for at

Ž . Ž .least four reasons Benson forthcoming-a : 1 parties to the dispute will considerthe outcome in future dealings and contracts under similar circumstances even

Ž . Ž .with different trading partners Benson 1998c, forthcoming-a ; 2 there is aŽ .tremendous ‘‘unofficial’’ flow of information through word of mouth gossip within

Ž .and between diamond trading clubs Bernstein 1992, p. 121 , a process that alsow Ž .xcharacterizes other trade groups e.g., see McMillan and Woodruff 1998 , so that

Ž . Ž .arbitration results do ‘‘become known through gossip’’ Bernstein 1992, p. 126 ; 3there are import mechanisms for initiating new customary rules in addition to

Ž .arbitration Benson 1998c, 1998e , as indicated above, so even when a particulararbitration process does not appear to clarify existing or produce new customaryrules, it may just be that third-party dispute resolution is a relatively unimportant

Ž .source of legal change for the relevant group; and 4 arbitration mechanisms arevery flexible so if external benefits become attractive, a group can change its

Ž .dispute resolution procedures to capture them Benson 1998c, forthcoming-a . InŽ .regard to this last point, for instance, Bernstein 1992, p. 150 notes that diamond

dealers have begun to recognize that their secrecy practices create uncertainty, andmany trading clubs have changed their institutions. Some of their arbitrators nowpublish written announcements of the principles applied in novel cases whilekeeping the parties and identifying facts secret.

3.1. Sanctions under Customary Law

A potential contradiction to the contentions that arbitration can be a source ofnew substantive rules andror involve a jurisdictional choice is the frequently madeclaim that in order to induce acceptance of arbitration a plaintiff must be willingand able to seek enforcement by some coercive power. For example, WilloughbyŽ . Ž . Ž .1929, p. 56 , Lazarus, et al. 1965, pp. 31, 125 , Landes and Posner 1979, p. 247 ,

Ž . Ž .Domke 1984, p. 27 , and Shavell 1995, p. 3 all suggest that domestic arbitrationin the United States must be backed by a threat to litigate. If litigation provides therelevant threat then arbitration’s potential as a jurisdictional choice may beundermined even if judges never directly interpret most of the rules that areapplied. After all, a credible threat to litigate requires that arbitration rulings willbe acceptable to judges, and therefore arbitrators’ decisions will have to corre-spond, at least to a degree, with expectations about how the decision will be viewedunder judicial review. A similar claim is made by some who see sanctions under the1958 New York Convention on the Recognition and Enforcement of ArbitralAwards and other similar international agreements between states to recognize

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Žand enforce arbitration rulings e.g., 1961 European Convention on International.Commercial Arbitration as the major reason for widespread acceptance of arbitra-

Ž .tion. Butler 1996, p. 509 suggests, for instance, that for the independent states ofŽthe former USSR which are not parties to the New York Convention all of them

.except Belarus, Latvia, Russia, and Ukraine , ‘‘the result is a legal vacuum ofastonishing proportions. Foreign investors are in most Independent States left with

Ž .no alternative but local courts and local law.’’ Bockstiegal 1984, p. 49 explains¨that such arguments tend ‘‘to overestimate the question of enforcement . . . . Everyresearch into the practice of international arbitration shows that by far the greatmajority of arbitration awards is fulfilled without the need for enforcement.’’ This

Ž .is also true for most domestic arbitration rulings Benson 1995a , but Bockstiegal¨Ž .1984, p. 49 qualifies his observation, suggesting that ‘‘On the other hand, ofcourse, it may be said that this is so only because the losing parties know thatotherwise the award could be enforced, especially due to the New York Conven-tion. Thus, no doubt, the possibility of enforcement has an indirect influence onthe voluntary fulfillment of arbitration awards.’’ This qualifier is much too strong,however.

Most arguments about the inability of private parties to cooperate are explicitlyor implicit prisoners’ dilemma arguments. For instance, suppose a contract arises inan isolated and discrete one-shot transaction and a dispute arises over interpreta-tion of that contract. Voluntary acceptance of an unbiased dispute resolution suchas one provided by arbitration and based on customary law is not likely to occur.Instead, the party that expects to lose in such a decision will renege on thecontractual promise to arbitrate. Even if arbitration does occur, the party that losesis likely to refuse to comply with the decision. Therefore, the application ofcustomary law through arbitration will have to be backed by a threatened sanction,and arguments such as those made above assume that coercive governments arethe source of such threats. There are three problems with these arguments. First, ifone party in this prisoners’ dilemma can employ the coercive powers of the state toforce another party to accept a particular forum, it does not follow that the forumchosen will be unbiased. Biased rulings can only arise when one party can force

Ž .another or get some institution with coercive power to force another to accept aparticular dispute resolution forum, after all. When this is possible, then in thecontext of a one-time transaction, the party who expects to benefit from a biasedruling will use the available force to opt for the biased forum. Indeed, in order to

Žinduce acceptance of an alternative forum e.g., another biased forum or an.unbiased forum applying customary law , the other party must be able make a

counter threat against the party preferring the biased tribunal. Otherwise, the mostlikely outcome is probably a decision biased in favor of the party backed bycoercive power. Second, recognized governments are not the only sources ofpotential threats that can induce acceptance of a particular dispute resolution

wforum. Private organizations can also employ such threats e.g., see Gambetta’sŽ . Ž .1993 examination of the Sicilian Mafia, Pejovich’s 1995 discussion of the

Ž .‘‘Mafia’’ in post-communist Russia, and McMillan and Woodruff’s 1998 evidence


xregarding debt collection by ‘‘private agencies’’ in Vietnam , for instance, andindividuals can employ ‘‘self-help’’ procedures. Third and most important, theone-shot prisoners’ dilemma analogy does not characterize most kinds of commer-cial interactions. In reality, communities of traders form wherein individualsinteract with others that they know either personally through repeated dealings, or

Ž .by reputation. In this context, Charny 1990, pp. 409]412 explains that ‘‘nonlegalsanctions’’ will induce the members of a ‘‘community of transactors’’ to acceptarbitration and comply with the arbitrator’s judgement. These nonlegal sanctionsare essentially the ‘‘private’’ sanctions discussed in the large economics literatureexplaining that bond-posting or hostage-taking, including the potential loss ofreputation, provide powerful sources of credibility in many bilateral relationships.

3.2. Trust and Hostages: Reciprocities and Reputations

Contracts generally do not involve simultaneous performance, so some a prioriŽ .basis for trust is actually often implied by the contract itself Rubin 1994, p. 4 .

Moreover, most businessmen expect to be active for a long time, and perhaps to beinvolved in interactions with a particular transactor over and over. Under thesecircumstances, each individual may recognize that the long-term benefits of re-maining on good terms with the other party, by behaving cooperatively even when adispute arises, are likely to be greater than the immediate benefits of not cooperat-

Žing i.e., refusing to accept an arbitration process or ruling, appealing instead to the.public courts . Repeated dealings create an environment conducive to the develop-

ment of trust and create incentives to employ cooperative strategies. Such reciproc-Ž .ities do not guarantee cooperation, of course Tullock 1985 . A rational individual

Žwill still compare the expected benefits of cooperation the discounted stream of.benefits from the long-term set of repeated dealings to the expected benefits of

Ž .non-cooperation the immediate benefits of refusing the arbitrated ruling . Thus,transactors’ time horizons and discount rates are important determinants of theincentives to cooperate when cooperation incentives arise from repeated dealings,and these factors may be significantly influenced by the institutional environmentŽ .see the discussion which follows .

Repeated dealings actually produce weaker incentives for businessmen to coop-Žerate than those which exist in many business communities, however Tullock 1985;

.Benson 1989, 1992, 1998c, 1999; Klein 1997 . In particular, each individual entersinto several different dealings with different trading partners. Thus, refusal toarbitrate within one transaction can affect the person’s reputation and limit hisability to enter into other transactions to the extent that reputation travels fromone transaction to another. When transactors choose trading partners based ontheir reputations for living up to promises, the potential benefits associated withrefusing to cooperate in resolving a single dispute will have to be very large for aparty to damage an established reputation by reneging on a promise to accept

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arbitration. Essentially, anyone who chooses a non-cooperative strategy in onetransaction will have difficulty finding a partner for any future transactionsŽ .Tullock 1985, pp. 1075]1076 . Therefore, in order to maintain a reputation for

Ždealing under recognized rules of behavior i.e., for fair and ethical dealings,.including amicable acceptance of ‘‘fair’’ non-violent dispute resolution , each

transactor’s dominant strategy is likely to be to cooperate throughout each transac-tion that he is involved in, whether it is a repeated or a one shot deal. In essence,‘‘reputation’’ andror the benefits of repeated dealings can be the transaction-specific investments that motivates trilateral governance as discussed by WilliamsonŽ .1979 . Because each individual has made an investment in establishing himself aspart of the relevant transacting community, that investment can be ‘‘held hostage’’

Ž .by the business group, a la Williamson 1983 , in order to insure that thecommitment to cooperate by arbitrating disputes and accepting arbitration rulings

Ž .is credible Charny 1990 . Indeed, a valuable reputation may be the ideal hostage.After all, a good hostage is something that the hostage-giver values highly and thatthe hostage-taker values little, so the giver has strong incentives to live up topromises and the receiver does not have incentives to appropriate the hostage.15

3.3. Pri ate Organizations: Communication, Credible Sanctions,and Arbitration Arrangements

Repeated dealings and reputation effects may not be sufficient to induce coopera-Ž .tion in dispute resolution e.g., acceptance of arbitration even when time horizons

Ž .are long Williamson 1991, p. 168 . Given a long time horizon, for instance, thedamaged party may find that withdrawing from all future interaction with the party

Žrefusing arbitration is actually more costly than simply acquiescing forgiveness and.‘‘lumping it’’ . Furthermore, frictions in communication may prevent passing infor-

mation about the non-cooperative action to the rest of the relevant businesspopulation, so that the reputation threat is not credible. However, both arbitrationcommitments and reputation threats can be made more credible, in many in-stances, if individuals with mutual interests in long-term interaction form ‘‘con-tractual’’ groups or organizations such as trade associations to institutionalize theirtrilateral governance process. Depending on the requirements for membershipŽ .e.g., the strength of threats of automatic private sanctions , an affiliation with such

Ža group can be information generating in that it can imply a bond or assurance a.credible signal of reputable behavior . Furthermore, the group can provide a

formal mechanism to overcome frictions in communication, as Milgrom, et al.Ž .1990 stress, insuring that information about any individual’s non-cooperative

Žbehavior will be transmitted to others in the relevant business community Rubin.1994, p. 24 . Then group membership can include a contractual obligation to

boycott anyone who reneges on a promise to arbitrate or accept an arbitrationruling: specifically, any party refusing arbitration will be automatically expelled

Ž .from the organization Rubin 1994, p. 24 . Such automatic penalties make the


Ž .reputation threat much more credible Williamson 1991, p. 168 . These groups canalso lower the transactions costs by establishing their own unbiased arbitration

Ž .arrangements Bernstein 1992; Benson 1995a, 1998a, 1998f .

3.4. Assurances of Unbiased Dispute Resolution

Many critics of arbitration contend that these private alternatives to litigation willactually be biased. The proposed reasons for such bias vary, however. Somecontend that arbitrators are easily corruptible, so the bias is in favor of thedisputant with the most financial resources: ‘‘If the rendering of verdicts is to beindependent of the relative wealth of the litigants, then the provision of judicialservices naturally requires separation of the decision-makers gain from that of eachlitigant. This fact either requires heavy regulation or it requires public provision of

Ž .the judge directly’’ Mabry et al. 1977, p. 83 . A different bias is seen by Landes andŽ .Posner 1979, p. 254 who contend that ‘‘ . . . it might seem that competition would

lead to an optimal set of substantive rules and procedural safeguards. But this isincorrect. The competition would be for plaintiffs, since it is the plaintiff whodetermines the choice among courts having concurrent jurisdiction of his claim.The competing courts would offer not a set of rules designed to optimize disputeresolution but a set designed to favor plaintiffs regardless of efficiency.’’ BrunetŽ .1987, pp. 31]40 simply concludes that arbitration’s procedures are biased awayfrom ‘‘accurate’’ results because they do not incorporate as much information aslitigation does. He sees arbitration procedures as too ‘‘informal, ambiguous, andnot administered in a managerial fashion’’ and lacking effective discovery processesŽ .Brunet 1987, 31]33 .

All such arguments reflect a failure to recognize the potential for creating anarbitrator selection process to avoid such biases. Indeed, as Bloom and CavanaghŽ .1986, p. 409 explain, ‘‘one of the most important characteristics of arbitrationsystems is that they may be designed in different ways.’’ Not surprisingly, arbitra-tion selection mechanisms actually vary widely. For example, within some organiza-tions a single arbitrator or panel is chosen for a set period to arbitrate all disputesbetween members. Thus, prescreening occurs as these arbitrators are chosen froma competitive pool by the association through its membership approved selectionprocess. For instance, in the diamond industry, arbitrators are elected from the

Ž .organization’s membership for two year terms Bernstein 1992, pp. 124]125 .Ž .Those selected are likely to have considerable standing reputation within the

community, and they have strong incentives to maintain their own reputation forfairness, so they are not likely to be biased or corruptible. Another selectionalternative involves a preapproved list of professional arbitrators determined by thecontracting parties or their trade organization, so if a dispute arises, an arbitrator is

Žchosen from the list by some preset mechanism e.g., random selection, rotating.selection, selection by a third party such as a governing board of the association .

Selection of the preapproved list is based on the reputation of the arbitrators for

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Žimpartiality and expertise in contractual matters that might arise Ashenfelter.1987; Bloom and Cavanagh 1986 . Whether arbitrators are chosen from the

membership of a trade group or from a pool that have expertise in the area ofŽ .commerce under consideration, Brunet’s 1987, pp. 31]40 contention that ‘‘accu-

rate’’ results are unlikely can be discounted. A knowledgeable specialist can rendera decision more quickly and with less information transfer from, and therefore less

Žcosts incurred by, the disputants, and is less likely to make an error rule.incorrectly given the facts, rule in a way that is inconsistent with expectations than

Ž .a judge or jury with no such expertise Benson forthcoming-a . Parties to litigationoften must spend considerable time and effort simply informing the judge or juryabout the facts, issues, and relevant rules, while an arbitrator is likely to beselected in part because of prior knowledge of some or all of these factors.Furthermore, while arbitration of commercial disputes is certainly ‘‘adversarial’’ ittends to be much less so that litigation often is, as both parties have incentives tomaintain their reputations for cooperative behavior and perhaps even to return toan ongoing trade relationship with the other party, so they are probably much lesslikely to try to hide or distort the facts than litigants are. Therefore, the lack offormality and of discovery procedures need not produce less accurate rulings thanlitigation would.

Yet another common selection system gives the parties to a dispute the resumesŽof an odd numbered list of arbitrators from a larger preselected group e.g.,

preselected by a trade association, or provided by an organization like the ICC or.AAA , with each party having the power to successively veto names until one

remains. Thus, a second level of screening is added at the disputant level,contributing ‘‘to the legitimacy of the arbitrator and his award in the eyes of the

Ž .parties’’ Bloom and Cavanagh 1986, p. 409 . Since the parties are given thearbitrator’s resumes, they have information about experience, training, the natureof awards given in the past, and so on. A similar practice, the subject of Bloom and

Ž .Cavanagh’s 1986 empirical study of labor arbitration, is also common: the partiesare given a list and resumes of an odd number of potential arbitrators from apreapproved list, with the power to veto one less than half and rank the othersŽe.g., a list of seven with each party being able to veto three and rank the other

.four , and the arbitrator who is not vetoed by either party and has the highestcombined rank is chosen. Another common practice is for both sides of the disputeto provide a list of a fixed number of arbitrators, and each can then veto any or allof the names on the other party’s list; if all names are vetoed each provides

Žanother list and the process is repeated clearly, this procedure requires that both.parties want to arbitrate, so they do not continue to provide unacceptable names .

All such systems guarantee the appointment of an arbitrator without requiringexplicit agreement by the two parties while still allowing for prescreening, andpossibly more than one level of screening, of the potential arbitrators.

In light of the fact that selection mechanisms allow prescreening andror veto,each party might be expected to support at least some candidates that are reputedto be unbiased. In fact, it is widely recognized that arbitrators are chosen for their


expertise, reflected by their experience, knowledge, and training, as well as forwtheir impartiality and consistency in deciding cases solely on their merits e.g., see

Ž .Bloom and Cavanagh 1986 who provide statistical evidence from labor arbitrationxto verify this . Indeed, the arbitrators available for a particular dispute, whether

they are predetermined by a trade association or proposed by the parties to thedispute through one of the processes described above, tend to be quite similar, and

Ž .as Ashenfelter 1987 explains, this is precisely what should be expected: arbitratordecisions should be statistically ‘‘exchangeable,’’ a prediction born out in a numberof empirical studies.16 Biased rulings are not likely in a competitive environment

Žwhere potential arbitrators are chosen before hand by the trading community e.g.,.as in the diamond traders associations or where both parties have the power to

reject judges proposed by the other party.

3.5. The Scope of Sanctions

Some scholars who recognize the potential for the spontaneous evolution ofcustomary law still argue that the resulting legal system is likely to be inefficiently

w Ž .x Ž .small e.g., Hayek 1973, p. 47 . In this same vein, Rubin 1994, p. 4 suggests that‘‘Private Parties can use many available mechanisms to make agreements self-en-

w x w xforcing . . . but the law of a post-communist governments of Eastern Europe canw xfacilitate the use of these mechanisms . . . by enforcing arbitration clauses in

Ž .contracts if parties insert such clauses.’’ Rubin 1994 recognizes the potential roleof private sanctions but also correctly notes that these sanctions will not besufficient to induce compliance with arbitration in every case. For instance, manytransactors may see relatively small benefits arising with group formation. Theymay not expect to face a dispute that cannot be resolved bilaterally throughnegotiation, for instance, perhaps because they expect to be able to unilaterallymake strong threats of private sanctions without the support of a group. Alterna-tively, however, they may face collective action problems that make the transac-tions costs of organizing very high. Therefore, such transactors are only bilaterallyorganized through contract.

The formation of mutual support groups is not a necessary requirement forcooperative dispute resolution. Disputes may be settled through direct negotiationsupported by repeated dealing reciprocities, or perhaps backed by unilateral

Ž .threats e.g., of violence or litigation , and arbitration is readily available outsideŽthe trade associations e.g., through organizations such as the ICC or the AAA, or

.from private firms selling such services , but perhaps at a higher cost than whatwwould arise within an organization like a trade association belonging to such an

organization can entail costs too, of course, including dues, time devoted tomeetings and official duties, perhaps including direct participation in mediationandror arbitration for others, as in the diamond industry’s arbitration boardsŽ .Bernstein 1992 , and so on, so decisions not to join may be quite rational under

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xmany circumstances, even though dispute resolution costs might be higher . Forsome of these bilaterally organized transactors, private sanctions may not becredible inducements to negotiate or arbitrate, in part because communicationschannels are informal and relatively ineffective, and in part because of the lack ofautomatic sanctioning mechanisms that trade associations develop. The transac-tions may even involve one-time contracts, or finite repeated exchanges, althoughentering such contracts in the first place is clearly less likely. Recognition of such

Ž .transactions costs led Rubin 1994 to conclude that to facilitate the achievementof efficient short-run decisions and efficient long-run precedents, the governmentsin the former communist countries of Eastern European should announce thatthey will honor and enforce arbitration agreements. In order to evaluate such a

Ž .suggestion or any other suggestion about expanding the use of coercive power ,however, all of the potential benefits and costs of such legal sanctions must beconsidered in the context of a system of interjurisdictional competition. After all,even if a customary law system is inefficiently small relative to what might beproduced by an idealized benevolent government with coercive power, the costs ofexpanding the legal system and counting on such benevolence may be far greaterthan the benefits of extending the legal system. In fact, customary law system

Žjurisdictions may be limited e.g., some merchants may not choose customary law.and arbitration because of the transactions costs produced by an overlapping or

parallel legal system’s wealth transfer activities.

3.6. Time Horizons and Transfer Institutions

The incentives to invest in building a reputation and to weigh the potential benefitsof repeated deals are significantly weakened when the decision maker’s timehorizon is short. Therefore, high levels of uncertainty, such as that which character-izes most post-communist and many other ‘‘developing’’ or ‘‘third-world’’ economiestoday, tend to undermine the potential for non-violent private sanctions in the

Žform of threats to reputations and to long-term reciprocities. As Rubin 1994, p..32 explains, much of this uncertainty is due to political instability. When property

Žrights are insecure due to the potential opportunistic behavior by government e.g.,changes in tax policy to capture the quasi-rents that arise with investments in

.reputation , or by other private parties because of the governments’ inability orunwillingness to prevent counterfeiting and trademark infringements, incentives toinvest in reputation or to count on future dealings are weak and the kinds ofprivate sanctions discussed here are likely to be relatively weak. Thus, the ability to

wchoose a customary law jurisdiction may be relatively limited the large ‘‘informal’’sector that develops in such economies typically establishes and enforces its own

Ž .rules de Soto 1989 but the size of this ‘‘economy’’ is clearly limited relative towhat it would be if the state was not a threat to the property rights that are

xestablished and the wealth that is generated .


A government can also raise the costs, and therefore, undermine the ability ofgroups to use private sanctions. For instance, in Paramount Lasky Corporation ¨ .

Ž .United States, 282 U.S. 30 1930 , an explicit agreement to boycott designed to backan arbitration system was struck down by the United States Supreme Court. Agroup of motion picture producers agreed to place an arbitration clause in allcontracts with motion picture exhibitors, and to boycott any exhibitor who refusedarbitration or refused to accept an arbitration ruling. This boycott agreement washeld to be illegal despite the fact that there was no evidence that the purpose of

Žthe agreement was anything other than to make arbitration effective e.g., it was. 17not an attempt to police a cartel .

3.7. Bounded Rationality: Limited Knowledge, Subjecti e E¨aluationsUnder Uncertainty, and Principle-agent Problems

Rational individuals are not able to use conscious reason to evaluate e¨eryŽ . Žparticular action Hayek 1937 . The required knowledge is too costly to obtain the

.transactions costs are simply too high . Thus, given perfect knowledge of options,an individual might prefer customary law and arbitration, but limited knowledgeleads to litigation before the potentially biased courts of a legal system with asubstantial transfer function. Some businessmen are almost never in a dispute that

Žthey cannot resolve through direct negotiation or exit i.e., their low cost solutionmay be to simply lump-it and get on with business with some other party because

.the gains from salvaging the relationship are less than the costs , for instance, andthey may not belong to an organization wherein they can observe arbitrationbetween other parties. Therefore, they may not be familiar with the arbitrationoption at all, or at least, they may not understand it. If an unanticipated andapparently unsolvable dispute should arise for such a person, the lack of knowledgeregarding arbitration andror uncertainty about the process may lead the individualto the relatively more familiar public courts. Of course, the high costs of litigationmay induce some parties to look for an alternative, perhaps by seeking advise fromsomeone perceived to be an expert on dispute resolution. The most likely source ofsuch information is a lawyer, however, and due to asymmetric information, the factthat the lawyer has probably invested most of his or her time and effort in gainingexpertise about a particular nation’s legal system rather than about commercialcustom, and the interests that the lawyer may have in litigating rather than

Ž .arbitrating Ashe 1983 , a principal-agent problem arises and litigation may bechosen, as explained below.

Ž .North 1990, pp. 22]24 stresses that results such as this are not simply due toincomplete information. Different people also have ‘‘subjective perceptions ofreality’’ that play major roles in determining the choices that they make. Institu-

Ž .tions that involve impersonal repetitive actions habits, traditions, etc. reduceuncertainty and reduce individuals’ need to make choices based on their subjective

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perceptions. Other institutions involve interactions that are much less repetitiveand impersonal, so uncertainty is greater, and personal perceptions of reality havegreater impacts. Clearly, for most people, dispute resolution is a relatively infre-quent and relatively personal issue about which they have relatively little knowl-edge. So some subset of the business world may perceive litigation to be the lowcost means of dispute resolution, particularly in domestic trade. After all, govern-ments tend to claim to be the exclusive source of law, including commercial lawŽ .Benson 1989, 1999 , and to the degree that a government is successful inlegitimizing its claims to sovereignty, the result is a perception of a single source of

Ž .law, including dispute resolution. Fuller 1981, pp. 156]157 suggested that suchlegitimization has been so successful that ‘‘instead of being perceived as distinctive

w xinteractional processes, law is seen as unidirectional exercises of . . . power. Con-tract is perceived, not as a source of ‘law’ or social ordering in itself, but ofsomething that derives its whole significance from the fact that the courts of thew xauthority stand ready to enforce it.’’ Thus, individuals who are not familiar witharbitration may believe that litigation is their only option.

Of course, some businessmen may actually prefer to litigate rather than arbi-trate, at least with contractual parties with whom the businessmen do not expect to

Ždeal repeatedly. If litigation takes more time e.g., due to delay as court time isrationed by first-come-first-serve, andror due to the requirements for presenting

.more evidence in order to educate an uniformed jury or judge and more expensesŽ .due to the need for lawyers as discussed below , or if the outcome is less certaindue to the potential for judicial error or bias andror the complexity of the nationallaw, then a party that expects to lose through arbitration may be able to threaten

Žlitigation either by refusing to arbitrate or by appealing an arbitration ruling, as.discussed below and induce the other party to settle for less than would be gained

Ž .through arbitration Neely 1982, p. 108 . If the other party cannot make sufficientlystrong reputation or reciprocity threats, for reasons such as those suggested above,

Ž .then the choice is between settlement perhaps for nothing and litigation. Indeed,many businessmen may prefer a legal system with a transfer function because theyhave political power to influence the creation or application of those laws.

3.8. Polycentric Go¨ernance

Any legal system that is larger than what would spontaneously evolve throughindividual interaction will, by definition, require some concentration of coercive

Žpower in a centralized authority customary law may require institutions to imposesanctions too, as noted above, but they do not have to be applied by a centralized

.authority with coercive power . Such power might be used to simply extend thescope of basic customary rules, perhaps by unconditionally enforcing arbitrationagreements, but it is also likely to be used to alter at least some those rules toproduce wealth transfers, thereby offsetting many if not all of the gains from an


expanded legal system. Perhaps more to the point, however, it took privatelyproduced and adjudicated medieval lex mercatoria discussed below to oërcome thelimitations of political boundaries and localized protectionism during the medievalperiod, thus paving the way for the commercial revolution and development of

Ž .international trade Benson 1989, 1998e . In other words, where the ‘‘tremendousŽ .economies of standardization in law’’ that Landes and Posner 1979; p. 239 allude

to exist, a customary system is likely to be better able to take advantage of them.Territorial governments typically cannot because of the artificial constraints of

Žgeographic boundaries a customary legal system’s jurisdiction may reflect a.functional rather than a geographical boundary, after all . Indeed, there is abso-

lutely no reason to believe that any particular national government is of the idealsize to take full advantage of the economies of standardization in law. However,since customary law can be geographically extensive and functionally decentralizedŽ .i.e., specialized , in contrast to the law of geographically defined states which tendsto be functionally centralized and geographically constrained, customary law canhave different sized jurisdictions for different functions. In some areas of law,economies may be considerably more limited than any state, so existing political

wentities are too large geographically e.g., this applies for many aspects of criminalŽ .xlaw Benson 1998g; Rasmussen and Benson 1994, pp. 177]206 or functionally

we.g., many aspects of domestic commerce may be most effectively governed byxdiverse trade associations rather than by the state . In other areas of law, such as

international commerce, some of these economies appear to be greater in geo-graphic scope than any existing nation can encompass, although many also arenarrower in functional scope, as international trade associations may be the mostefficient source of rules and governance for many groups of traders. A customarysystem of polycentric law would appear to be much more likely to generate

Ž .efficient sized ‘‘geographic market areas’’ jurisdictions for the various legalcommunities involved}perhaps many smaller than most nations, with others

Žencompassing many of today’s political jurisdictions e.g., as international commer-.cial law does today . The existence of economies of standardization really proïdes

an argument against state proïsion of adjudication and law then, in order to breakaway from the inefficient artificial political restrictions that exist. Thus, BernsteinŽ .1992, p. 117 concludes that ‘‘The private regime must be Pareto superior to theestablished legal regime in order to survive.’’

Furthermore, the relatively limited jurisdictions of some customary communitiesare not as constraining as they might appear to be. Individuals often are membersof several different communities, so being outside one community does notpreclude dealing with people in it on some dimensions. A person may belong to atrade association, a homeowners association, a religious group, a fraternal organi-zation, and so on, for instance, each with its own rules and governance institutions.The membership of all of these communities can differ, although considerableoverlap may also occur, so individuals may deal with other individuals on somedimensions but not on all dimensions.

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3.9. Polycentric Go¨ernance and Economic Acti ity

Every individual is likely to be constrained by a complex web of rules emanatingfrom a variety of institutional environments. A person may simultaneously belongto many groups that have well established customs, and be subject to the com-

Žmands of several rule-making authorities e.g., as in a formal federalist system of.government . Furthermore, the various types of rules clearly do not involve

mutually exclusive jurisdictions. Many rules that first evolve as customs within acommunity can become codified. Codification of custom may simply be an effort toclarify unarticulated custom in order to better facilitate coordination within agroup, so codes need not be discriminatory. However, even codified custom can bediscriminatory if the norms from one group are imposed upon individuals who arenot members of the original community. Codes can also explicitly contradictcustom, of course. Coercively imposed discriminatory laws also drive many activi-ties underground, as noted above, and the resulting ‘‘informal’’ sector often relieson customs, including rules encouraging violation of rules mandated by thecoercive legal institutions.

Resistance to efforts to transfer wealth is likely to be most effective where theŽbenefits generated through voluntary interaction are very large so the costs of

.submission are large andror the relevant group members’ wealth is mobile so theycan interact across the jurisdictions of different authorities and inter-jurisdictionalcompetition to attract that wealth occurs. The international merchant communitiesof modern trade discussed above are examples of such groups. Indeed, the choiceof customary commercial law’s jurisdiction is becoming increasingly importantduring the twentieth century, for the reasons suggested above. First, customary lawcan be very decentralized, allowing for different rules and institutions to meet theneeds of diverse specialized business communities. In contrast, national systemstend to produce homogenized law that limits the potential for specialization, andthe development of international economic and political ‘‘blocks’’ made up of

Ž .several nations e.g., the EEC implies an increasing likelihood of even morecentralized and homogenized state-backed commercial law. Second, while much ofthe commercial law that has been codified or recognized as precedent in nationallegal systems actually derives from custom, traders generally assume that national

Žcourts will not enforce obligations derived solely from contracts and custom Chen.1992, p. 100 , choosing instead to apply the nation’s statute or precedent law where

Ž .a conflict with custom arises. And third, as Lew 1978, p. 589 emphasizes,international businessmen are increasingly uncertain about politicized nationalcourts’ impartiality and abilities to appropriately resolve disputes with a domestic

Ž .trader. Gardner 1958, pp. 17]18 makes the same point, explaining that interna-tional traders avoid nationalized legal systems, in part because these legal systemsare frequently less concerned with fairness and justice than with political power. Incontrast, arbitration selection processes can be and are structured to avoid biases.

Domestic merchants are also likely to have incentives to choose the jurisdictionof customary law if a nation’s law is expected to be biased or to apply rules that are


relatively costly to employ. And as explained below, arbitration is a major source ofwdispute resolution for domestic commerce within many countries e.g., see Bern-

Ž . Ž .xstein 1992 , Benson 1995a, 1998g . Domestic commercial activities may be lesslikely to be able to avoid the application a nation’s law, of course. Indeed, the stateis frequently called upon to establish and enforce rules having to do with domesticeconomic activity, and often by the same merchants who are able to enforce theirown rules in international trade and within their trade associations. This politicalinfluence is not surprising, both because domestic merchants might be targets forwealth transfers, and because members of the merchant community have incentives

Ž .to seek wealth transfers. As Adam Smith 1776, p. 144 observed:

People of the same trade seldom meet together, even for merriment and di-version, but the conversation ends in a conspiracy against the public, or in somecontrivance to raise prices. It is impossible indeed to prevent such meetings, byany law which either could be executed, or would be consistent with liberty andjustice. But though the law cannot hinder people of the same trade fromsometimes assembling together, it ought to do nothing to facilitate such assem-blies; much less to render them necessary.

The first sentence in this quote is often cited, of course, but the last one rarely is.Since the transfer process requires that wealth be created so it can be transferred,

Ž .however, and capital is relatively mobile able to exit , political rule makers actuallyhave strong incentives to create mechanisms through which various businesscommunities’ political interests can be determined and facilitated. By granting

Ž .selected merchants special privileges i.e., transferring wealth to the merchants inexchange for their willingness to invest within the political jurisdiction, rents ariseas wealth is produced by relatively immobile resources that are inputs to orcomplements of the merchants’ enterprises, and those can be appropriated by themerchants and others who have sufficient political power, including many who areemployed within the state’s governing institutions. Not surprisingly, merchants haveactively sought and willingly accepted wealth transfers within political jurisdictions.Domestically, medieval mercantilism was a system dominated by merchants dealingwith kings to restrict competition in favor of domestic monopolies and guildsŽ .Ekelund and Tollison 1980 , and that system has a firm hold within many

Ž .twentieth century economies de Soto 1989 . In fact, in every ‘‘market economy’’with a significant political sector, economic regulations limit competition and

Ž .generate rents for businesses Stigler 1971 . With this in mind, let us turn to thehistorical evolution of commercial law in Europe, and then in the United States, inorder to illustrate the importance of interjurisdictional competition, and some ofthe consequences of efforts to monopolize commercial law within the geographicjurisdictions of nation-states.

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4. Historical Underpinnings of Europe’s International Commercial Law18

From the sixth to the tenth centuries commercial trade was almost nonexistent inEurope relative to what had occurred before in the Roman Empire and what wouldcome after. However, rapid expansion in agricultural productivity during theeleventh and twelfth centuries meant that less labor was needed to producesufficient food and clothing to sustain the population, trade was stimulated, andpopulation began to move into towns, many of which rapidly became cities. Oneconsequence of, and simultaneously, one impetus for these developments was theemergence of a class of professional merchants to trade in agricultural commodi-

Ž .ties and in the products of the new urban centers Berman 1983, p. 335 . Law,Žessentially to facilitate or substitute for trust, was also required Benson 1989,

.1998e , and it was during this period ‘‘that the basic concepts and institutions ofŽ .modern Western mercantile law}lex mercatoria ‘‘the law merchant’’ }were

formed, and, even more important, it was then that mercantile law in the West firstŽcame to be viewed as an integrated, developing system, a body of law’’ Berman

.1983, p. 333 . In fact, the commercial revolution could not have occurred withoutŽ .the rapid development of this system of law Berman 1983, p. 336 . This legal

system evolved spontaneously within the decentralized merchant community, how-ever, rather than being produced by centralized state government.

Naturally, the Law Merchant did not spring from a void. Parts of it trace toŽ .Roman commercial law Berman 1983, p. 339 which was predominantly customary

law. Parts also trace to Lex Rhodia, the customary commercial law of the Mediter-Ž .ranean identified in the third century Trakman 1983, p. 8 , and to the middle east

where commercial interactions arose earlier and persisted longer than in much ofŽ .Europe. Indeed, Bewes 1923, p. 11 suggests that ‘‘Europe may be indebted to the

East for the earliest form of shipping documents, as well as for the law merchantgenerally.’’ However, from these foundations, the continued evolution of rules andlegal institutions in European commercial society was spontaneous and unde-signed. This ‘‘customary nature of the Law Merchant was by far the most decisivefactor in its development: it made the law eminently a practical law adapted to therequirements of commerce; and as trade expanded and new forms of commercialactivity arose}negotiable paper, insurance, etc.}custom everywhere fashioned

Ž .and framed the broad general principles of the new law’’ Mitchell 1904, p. 12 .As merchants began to transact business across political, cultural and geographic

boundaries they learned about foreign trade practices. Since similar circumstancescreate similar legal problems, they are likely to be resolved similarly, so many trade

Žpractices in different localities were found to have much in common Bewes 1923,.p. 9 . But where conflicts arose or where innovative trade practices were developed,

those practices which proved to be the most effective at facilitating commercialŽinteraction tended to supplant those which were less effective Trakman 1983, p.

.11 . After all, merchants had incentives to adopt those rules which minimized theirexpected transactions costs. By the end of the twelfth century all important

Žprinciples of commercial law were international in character Mitchell 1904, pp.


.7]9; Bewes 1923, p. 138; Berman 1983, pp. 350]355 , providing alien merchantswith substantial protection against potential discrimination under local laws, in-

Ž .cluding local customs Berman 1983, p. 342 , and by the early thirteenth centuryvarious communities of traders could turn to the Law Merchant as an integratedsystem of principles, concepts, rules and procedures. The rapid evolution of theLaw Merchant continued through the thirteenth, fourteenth, and fifteenth cen-turies so that as commercial opportunities expanded, commercial law became evenmore objective, precise, uniform and integrated, and its dispute resolution proce-

Ž .dures became more regularized Berman 1983, p. 350 .Merchants established their own participatory courts for several reasons. For

one thing, merchants needed their own courts so they could be sure that their ownŽ .rules would be enforced Trakman 1983, p. 15 . The fact is that royal judges simply

would not or could not adapt and change as fast as the rapidly changing commer-Ž .cial system required Bewes 1923, p. 19; Trakman 1983 . Furthermore, foreign

Ž .traders feared that local courts royal courts, and later, some urban courts wouldbe biased against them while courts of the merchant community were less likely to

Ž .be biased indeed, such courts frequently included foreign merchants as judges .Commercial disputes also could involve consideration of highly technical issues.Merchant court judges were merchants chosen from the relevant merchant com-

Ž .munity fair or market , and when technical issues were involved, merchant expertsin the relevant area of commerce could be chosen as judges. Lawyers and royaljudges often had no knowledge of such issues, so the risk of judicial error was lowerin a merchant court. Perhaps the most widely cited characteristics of the merchant

Ž .courts were their speed and informality Berman 1983, p. 347 . This characteristicwas in response to the needs of merchants, and another reason for participatory

Ž .merchant courts Mitchell 1904, p. 13; Bewes 1923, p. 19 . Merchants of the timehad to complete their transactions in one market or fair and quickly move to thenext, so a dispute had to be settled quickly to minimize disruption of businessaffairs. This speed and informality could not have been equitably achieved withoutthe use of judges knowledgeable of commercial issues, whose judgments would berespected by the merchant community at large. In this same light, appeals were

Žforbidden in order to avoid undue delay and disruption of commerce Trakman.1983, p. 16 . Similarly, rules of evidence and procedures were kept simple and

Ž .informal Trakman 1983, p. 14 .The rules that came to dominate the Law Merchant ‘‘commanded merchants to

Ž .do that which they themselves had promised to do’’ Trakman 1983, p. 18 . TheŽagreement was the overriding force in regulating business conduct Trakman 1983,

.p. 10 . Thus, many rules developed about and through contracting, and much of theŽmerchant courts’ business was focused on contract issues. Berman 1983, pp.

.349]355 discusses significant Law Merchant developments relating to negotiableinstruments, bankruptcy, business associations such as joint ventures, and insur-

w Ž .x Ž .ance, for instance also see Mitchell 1904 . Nonetheless, Mitchell 1904, p. 16 ,Ž . Ž .Berman 1983, p. 343 , and Trakman 1983, p. 12 also stress the Law Merchant

requirements of ‘‘equity.’’ When it is recognized that individuals had to ¨oluntarily

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adopt a certain practice before it could become common usage it becomes clearwhy commercial law had to be objective and impartial. Reciprocity in the sense ofmutual benefits and costs is the very essence of trade, but the legal principle ofreciprocity of rights, as it was developed in the late eleventh and early twelfthcenturies and still is understood today, involves more than mutual exchange. It

Žinvolves an element of fairness in exchange Mitchell 1904, p. 16; Trakman 1983, p..12 :‘‘Substantively, even an exchange which is entered into willingly and knowingly

must not impose on either side costs that are excessively disproportionate to thebenefits to be obtained; nor may such exchange be unduly disadvantageous to third

Ž .parties or to society generally’’ Berman 1983, p. 344 . Fairness was required underthe Law Merchant, of course, precisely because its recognition arose voluntarily in

Ž . 19recognition of mutual benefits Benson 1989 .

4.1. Royal Law ¨ersus the Law Merchant

Around the twelfth century, some European kings began systematically collectingŽ .and codifying the customary rules of the Law Merchant Berman 1983, p. 341 .

Kings were asserting claims to legal authority in competition with other claimantsŽ . Ž .such as the Roman Church canon law , and the powerful aristocracy manor law ,

and they clearly wanted to claim authority over commercial matters as well. Afterall, commerce was an increasingly important source of wealth expansion, andcontrol of its rules might allow kings to capture part of that wealth. Earlycodifications did not substantially alter the customary underpinnings of commercial

Ž .law, however Mitchell 1904, p. 11 . In England, for example, the Statute of theStaples of 1353 declared that ‘‘merchant strangers’’ were to be given protection inthe fourteen major trading centers for ‘‘staple’’ products}mainly wool, leather andlead. The statute actually dictated that disputes involving these foreign merchantswould be settled under merchant law, rather than royal law. Significantly, however,appeals could be taken to the chancellor and the king’s council. By givingmerchants access to royal appeal the appearance of royal backing of the LawMerchant was created, while simultaneously a roll for the royal courts in enforce-ment of commercial law was established. And even more importantly, by creatingthe possibility of appeal, the Law Merchant was made to appear to be less decisivelaw. The implication was that royal law was superior law, with final authority overcommercial matters. The Statute of Staples was also an early step toward focusingand concentrating foreign trade flows so they would be easier to monitor and taxby the state. Most foreign trade was compelled to pass through a few importanttowns in the fourteenth century, and special courts were created in these ‘‘staple’’

Ž .towns to administer the Law Merchant Mitchell 1904, p. 72 . The makeup of thesecourts was dictated to consist of the mayor of the town, two constables and twomerchants, and it was from these staple courts that appeal could occur. Fairs andmarkets still held their own merchant courts, however. In fact, merchants actuallyhad several legal systems to choose from.


Merchants could and did take some types of disputes to ecclesiastical courts.Ž .After all, the Church was a major trader Bewes 1923, p. 9 , and in addition, many

of the major fairs were held at important priories and abbeys, so it was clearly inthe interests of the church’s leaders to remain on good terms with the merchantcommunity by offering them a source of dispute resolution that would recognizetheir customs and practices, at least when they did not conflict with canon law.Similarly, merchants naturally used the urban courts which evolved from the earliermarket courts, and which merchants continued to dominate. The availability ofnumerous alternative dispute resolution forums, including the merchant courts ofthe fairs and markets, meant that the Law Merchant remained a source of

Ž .protection against the growing centralized power of kings Berman 1983, p. 343 .Ž .Indeed, as Hayek 1973, pp. 81]82 explains, ‘‘The growth of the purpose-indepen-

dent rules of conduct which can produce a spontaneous order will . . . often havetaken place in conflict with the aims of the rulers who tended to try to turn theirdomain into an organization proper. It is in the ius gentium, the law merchant, andthe practices of the ports and fairs that we must chiefly seek the steps in theevolution of law which ultimately made an open society possible.’’ Even as royalcourts gained increasing numbers of merchant disputes they generally had to grantmerchants similar safeguards and privileges to those provided in merchant, urban,and ecclesiastical courts in order to attract commercial disputes away from theircompetitors. Thus, early codifications and interjurisdictional competition meantthat the customary laws of the Law Merchant provided the foundation upon which

Ž .government enforced commercial law would evolve Bewes 1923, p. 19 . However,in some jurisdictions, the Law Merchant was ultimately altered and at leastpartially absorbed. Consider England.

4.2. Interjurisdictional Competition in England

Ž .When royal law in England including common law was emerging as a recognizedsystem of law, it had to contend with the cannon law of the Roman Church, the

Ž .evolving Law Merchant and subsequently, the law of the urban centers , theŽmanor law of the barons, and the local customary law of the hundreds Berman

.1983; Baker 1971; Rowley 1989 . Furthermore, competition was intense even withinthe evolving system of royal law. By the middle of the thirteenth century the king’shigh courts were quickly moving toward institutional structure that would last intothe late nineteenth century. The Court of the King’s Bench, the Court of CommonPleas, and the Court of the Exchequer had become identifiable entities withidentifiable jurisdictions. The Courts of Common Pleas supposedly had exclusivejurisdiction over all cases between private citizens unless a crime had occurred, inwhich case the King’s Bench and Court of Common Pleas had concurrent jurisdic-

Ž .tions. However Lyon 1980, p. 443 ,

through fictitious legal means the king’s bench stole much legal business fromthe court of common pleas. This is principally explained by the desire of the

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justices of the bench for more legal business; each case meant fees, from whichthe justices derived much of their living. Competition between the courts forlegal business became very bitter with the result that jurisdictions became muchless definite. The judges resorted to any subterfuge to attract cases into theircourts.

Competition between the three common-law courts was intense, in part becausejudges’ income came from fees and therefore depended on the numbers of cases

Ž .they tried Landes and Posner 1979, p. 258 , and perhaps as a consequence, by thefourteenth century the king’s power over these courts had been substantiallyreduced. In reaction to this increasing independence from the crown, variousspecialty courts also began evolving from the King’s Council. These ‘‘conciliarcourts’’ or ‘‘prerogative courts’’ included the Court of the Admiralty, the Court of

Ž .Chivalry, the Court of the Chancery or equity , the Star Chamber, and the Courtof Requests. The Chancery became particularly important since common lawrulings could be appealed to it on equity grounds.

The availability of alternative legal jurisdictions for dispute resolution processestends to push all judges toward unbiased dispute resolutions, just as it does forarbitrators competing for business. If a forum is expected to favor one party, andthe other can demand the use of or appeal to an alternative, they will tend tocompromise on the forum that will be least biased and therefore most fair. Thus, as

Ž .Rowley 1989, p. 371 explains, ‘‘The competitive nature of early common lawevolution provided a powerful impulse for the law to reflect the interests oflitigants and, in this sense, to be efficient . . . . The royal courts succeeded byproviding the best available justice, reflecting not least the preferences of mer-chants and money lenders attracted to England by the development of foreigntrade. The law of property and the early law of contract undoubtedly benefittedfrom the efficiency impulses thus provided.’’ The common law courts ultimately

Ž .triumphed over most of their competition in England Baker 1971 , however, andeventually, the competing common law courts were also combined. The entire storycannot be explored here, but some of its implications can be seen by consideringpart of the competitive process.

The functional separation of the organs of government toward the end of thefourteenth century intensified the competition between the powers represented inParliament, the king with his prerogative courts, and the common law courts. Somecommon-law judges felt that the common-law courts should be the supreme sourceof law rather than either the king or the Parliament, but they clearly did not havesufficient power to achieve this goal. Most common-law judges recognized that theyhad to pick sides, and over time their interests tended to become more aligned with

Ž .Parliament Ekelund and Tollison 1980, p. 584 , in part because many common-lawŽ .lawyers and judges were members of Parliament Holdsworth 1903, pp. 210]211 .

Therefore, common-law judges began characterizing Parliament as simply a com-mon-law court, supreme in that it could overturn other common-law court deci-sions, legislate jurisdictional boundaries, and dictate other characteristics of the


courts, but also dependant on the other common law courts to facilitate theimplementation of the law. In light of the common-law courts’ alignment withparliament, Henry VIII supported the prerogative courts’ in aggression againstcommon-law jurisdictions and encouraged application of Continental civil lawrather than common law. However, the common-law courts had gained superiority

Ž .over the ‘‘weaker’’ competitors e.g., ecclesiastical, manor, and hundred courts bythe later part of Elizabeth’s reign, so they also attacked the jurisdiction of the

Ž .prerogative courts Holdsworth 1903, p. 414 .Asserting the Parliamentary and common-law courts’ claim as the supreme

source of law was accomplished, in part, by attacking all other sources of law. Forinstance, the great common law jurist and parliamentarian, Sir Edward Coke, whowas intimately involved in the struggle between parliamentary and royal authority,ruled that decisions of merchant courts could be reversed by common law judges,claiming that the merchant courts’ purpose was to find a suitable compromise

Ž w xwhile judges ruled on the legal merits of the case Vynior ’s Case 1609 4 Eng Rep.302 . In essence, Coke asserted that the Law Merchant was not a separate

identifiable system of law, but rather that is was ‘‘part of the law of this realm’’Ž .Trakman 1983, p. 26 . Thus, merchant court rulings could be appealed to commonlaw courts, and in essence, be treated as a never-before-tried dispute. FollowingCoke’s ruling, the use of traditional Law Merchant courts in England declined, and

Ž .they continue to function only in a few places Gross 1974, p. xix . After all, if theirrulings were not expected to be final, and if litigation expenses were likely to ariseanyway, parties had incentives to litigate directly rather than arbitrate first.

Ž .Furthermore and perhaps significantly but see Section 5 below , arbitrationclauses in contracts were declared to be revocable by common law courts. Thisprecedent was viewed to be binding for the next two and one half centuries inEngland and even longer in parts of the United States. In fact, while this rulingoccurred before the common law doctrine of binding contracts was fully formed, ascommon law courts began enforcing all contracts to which parties intended to bindthemselves, arbitration clauses remained revocable.

The development of royal and parliamentaryrcommon-law influences in com-mercial law was not just motivated by those wishing to monopolize the supply oflaw, however. Powerful members of England’s merchant ‘‘community’’ also sawadvantages in having royal and later parliamentary authority established over

Ž .commercial matters Ogilvie 1984, p. 115; Benson 1989 . In this context, one earlydevelopment in the gradual process of absorption of the Law merchant wascooperation by royal authorities in applying sanctions to back the Law MerchantŽ .Berman 1983, p. 343 . This does not imply that the merchants could not enforce

Ž .their own laws through boycott sanctions Benson 1989 , but some merchantsclearly found it beneficial to shift the burden of enforcement. Another result of thegrowing political power of some domestic merchants was a more significant factorleading toward more royal and then parliamentary influence over commercialmatters, however. A merchant who wants to become wealthy in an unregulated

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competitive market must be concerned primarily with maintaining a reputation forfair dealings, because other merchants and consumers can always choose to buyfrom someone else. Similarly, an unbiased legal system is vital in order to createthe incentives to cooperate in trade for everyone’s mutual benefit. But theincreasing centralization of power offered an alternative. Developing economicregulation involved domestic merchants trading support and money to kings orparliament in exchange for special privileges such as royal grants of monopolyrights within the empire, and the power to form exclusive guilds protected by entry

Ž .restrictions Ekelund and Tollison 1980 . In this context, the English Parliamentalso passed acts of trade and navigation throughout the seventeenth century in aneffort to make its empire self-sufficient by having the colonies supply raw materialsexclusively to England and purchase only British goods, all on British ships.International trade was much less important for England than it was for most otherEuropean nations without large colonial empires, so the incentives to maintain theLaw Merchant were relatively weak.

The full development of monopolization through economic regulation and theassociated incentives that tended to undermine recognition of the Law Merchantdid not occur, however. Indeed, it could not, in part because of the ongoingcompetition for authority within the kingdom and the continued importance ofinternational trade in many areas of commerce. Furthermore, by the time parlia-ment and the common law courts could be secure in their victory over competitors,

Ž .‘‘much of the common law was already hardened and set’’ Rowley 1989, p. 371 .Ž .This was particularly true of contract law as well as property, but not tort law . As

Ž .Commons 1924, p. 301 explains, ‘‘The law of business, as thus developed, is asdifferent from the old common law as is a going business from an acre of land, apromise from a horse. Yet, . . . by fiction, the old slid into the new so easily thatthere was no serious break except at the points in the seventeenth century whenthe revolutions . . . subjected the officials of the monarchy to the same courts and tosimilar rules of law as the private citizens. The power of the courts, especially onthe equity side, thereupon unfolded to meet the unfolding conditions ofbusiness . . . as feudalism was confronted by business.’’ The competition betweenthe common law courts probably also reduced the impact of subjugation of the LawMerchant somewhat even after most of the prerogative courts and other alterna-tives were eliminated as effective competition. Common law judges refused torecognize the Law Merchant as a distinct branch of law, however, in contrast toother European countries, and they rejection some of its important principles.

Ž .Indeed, as Commons 1924, p. 303 suggests, ‘‘The capitalist system has been builtw xup, as we have seen, on the enforcement and negotiability of contracts, but it was

. . . difficult . . . for the lawyers of the Sixteenth and Seventeenth Centuries toauthorize the custom of merchant in enforcing promises and buying and sellingthem.’’ Civil law countries like France were more receptive to the Law Merchant

Ž .than was English common law Trakman 1983, p. 24 because trade between thesecountries continued to be relatively important. In this environment, Trakman


Ž .1983, p. 27 argues that the Law Merchant suffered:

By restricting the dynamic use of trade custom in various ways, the Englishcommon law courts precluded resort to the pliable framework of the LawMerchant. Either they refused to admit custom into the legal system in any formwhatever, or custom was required to satisfy onerous tests of admissibility beforeit was received into English law . . . custom had to comply with the rules ofpositive law. It had to be truly ‘‘ancient’’ in its origins in order to be admitted inlaw, and it had to be consistently practiced, notwithstanding the changingenvironment of business itself . . . . In this way, the Law Merchant became rigidas post-medieval English judges sought to integrate the Law Merchant into theestablished confines of a centralized common law.

It appears that with the growth of the empire and its accompanying trademonopolies, and the demise of the prerogative and merchant courts, the intensityof competition was significantly reduced, and the subsequent evolution of contract

Žlaw was clearly altered in England from what it might have been Trakman 1983, p..30 . Still, sufficient similarity remained between England’s common law of com-

merce and the law applied in France’s commercial courts to imply that thecustomary Law Merchant was an underlying source of much of England’s commer-

Ž .cial law Bewes 1923, p. 14 .Political pressure on Parliament to alter common law treatment of arbitration

also emerged during the later part of the seventeenth century, and the ArbitrationAct of 1698 mandated that once an arbitration award is made, the common-law courts should not overturn the award, either for an error in law or an error offact. In other words, the English courts were directed to let arbitration awardsstand unless they were made under fraudulent or otherwise unfair procedures.Common-law courts could determine what was ‘‘unfair,’’ of course, and further-more, the doctrine of revocability was not overturned by the statute. Indeed, it was

Žw x .justified and reinforced in Kill ¨ . Hollister 1746 1 Wilson 129 explicitly becausecontracts to arbitrate ‘‘oust courts of their jurisdiction.’’ Thus, early judicialdefenders of the revocability doctrine spoke of the courts’ interests, suggesting thatthe common-law judges of England saw arbitration as an undesirable threat totheir control of dispute resolution. Still, arbitration remained an option if mer-chants were willing and able to apply reputation sanctions.

The late seventeenth century, particularly with Sir John Holt, and the eighteenthcentury with Lord Mansfield, did see common law decisions once again explicitlydrawing upon customs and usages of English merchants as a source of changes in

Ž .English common law Mitchell 1904, pp. 77]78 . Mansfield even instituted the useŽ .merchant juries to consider commercial disputes Draetta et al. 1992, 11 . While

Mansfield’s role in the revival of customary sources of legal change in common lawwwas particularly important there also were political motivations behind Mansfield’s

Ž .xefforts Ogilvie 1984, p. 116 , a significant impetus for once again recognizingmerchant’s evolving custom, appears to be the fact that as international trade

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became relatively more significant, common law courts were forced to competeŽwith foreign courts and legal systems to regulate international commerce Trakman

.1983, p. 28 . Increasing resistance to its trade and navigation acts arose in parts ofthe colonial empire, after all, and ultimately England began to lose its hold on thecolonies. Thus, facing the potential loss of captured markets and an increasinglyinternational competitive environment, the common law courts were increasinglyforced to explicitly recognize evolving business practices as a source of law. Still,substantial differences between civil law and common law in commercial mattersremain, in part perhaps because of the influence that the common law had overevolving business practices in England during the period when the civil law wasmore receptive to the Law Merchant. For instance, common law turns to moneydamages first when a breach of contract occurs, while the civil law relies much

Ž .more heavily on specific performance Ebke 1987, p. 612 . This is not surprisinggiven the incentives of common law judges of the period, since determination of a

Ž .damage award often must be done by a third party e.g., a judge , generating morejudicial fees, while recognition that a court will order specific performance maydeter more breaches andror encourage negotiation to get out of an inefficientcontract.

Demands for a unified court system increased in England, particularly during theŽ .nineteenth century, and ultimately in 1875 the three common law courts were

merged under a single Supreme Court. However, competition from commercialarbitration intensified in England during the same period that saw mounting

Ž .pressure to centralize the common law Benson 1989, 1998f . Following Holt andMansfield, English courts were increasingly willing to enforce contracts as busi-nessmen wanted them to be enforced. In this light, they also began pulling back

Ž Ž ..from the doctrine of revocability in Scott ¨ . A¨ery 5 H.L. Cas. 811 1855 , holdingthat contracts to arbitrate specific future disputes were binding although contractsto arbitrate ‘‘any disagreement arising under the terms of the contract’’ were

Žrevocable. In Scotland the doctrine was explicitly rejected in Drew ¨ . Drew 2Ž ..Macqueen’s Cases on Appeal 1855 , as it was recognized to be in direct conflict

with the general common law doctrine of binding contracts.The passage of the Arbitration Act of 1698 recognizing the standing of arbitra-

tion awards and essentially offering legal enforcement of arbitration rulings, andthe demise of the common law doctrine of revocability, thereby implying that thecourts will enforce arbitration clauses as well, may suggest that similar rules are

wdesirable elsewhere e.g., in the former communist countries of Eastern Europe, asŽ .xsuggested by Rubin 1994 . The use of both arbitration clauses and arbitration

expanded rapidly shortly after these 1855 rulings, after all. This court backing ofarbitration was probably not the most important stimulus for the rapid spread ofarbitration, however. The naval blockade of the South during the American CivilWar resulted in tremendous court congestion in England due to contractclaims}claims that would have taken years for the courts to untangle. Thecontracts in question were in regard to the purchase, delivery and sale of cotton,primarily to British markets. Many ship owners became unwilling to run the


blockade, and a lot of those who tried had their vessels sunk. Prices fluctuatedunpredictably. Further complications arose due to British neutrality, and contra-band-of-war laws. Insurance was either unavailable, or carried new and extremelycomplex provisions developed in light of the tremendous uncertainty. These provi-sions required reinterpretation with each new contingency. Because of all thesedifficulties and uncertainties associated with the blockade, and the resulting publiccourt backlog, the Liverpool Cotton Association agreed to insert arbitrationclauses in their contracts. Liverpool merchants were handling the majority of thecotton trade at the time so a majority of the disputes involved members of thatassociation. ‘‘Arbitration proved so successful in adjusting differences without theexpense, inconvenience, and hard feelings of suits that other Liverpool commercialassociations took up the device, first the Corn Trade Association and then the

Ž .General Brokers Association’’ Wooldridge 1970, p. 99 . The success of arbitrationin Liverpool led to its adoption by other trade groups in other locations, including

ŽLondon, within a short period of time. The large commodity dealers corn, oil seed,.cotton and coffee adopted arbitration clauses first, followed by stock dealers and

produce merchants. Then professional associations of architects, engineers, estateagents and auctioneers took up the practice, regularly putting arbitration clauses inall contracts to guarantee that disputes over transactions would not go intogovernment courts. ‘‘By 1883 a correspondent of the London Times could writethat ’whole trades and professions have virtually turned their back on the courts’ . . .Once ‘private courts’ were tried their advantages quickly became apparent’’Ž .Wooldridge 1970, p. 99 .

The timing of common-law changes in the treatment of arbitration clauses, andthe rapid spread of such clauses does suggest a potential causal connection, ofcourse. This could in turn imply that mandating that courts recognize arbitrationawards and enforce arbitration clauses is desirable, unless they have some sort ofadverse effects. Do they? Since statutes of this kind have been passed in virtuallyevery state in the United States since 1920, as well as by the United States federalgovernment, an examination of their consequences can suggest an answer.

5. Commercial Arbitration in the United States: Litigation Threatsand Transactions Cost20

Ž . Ž .Prior to the passage by New York 1920 , New Jersey 1923 , the federal govern-Ž . Ž . Ž . Ž .ment 1925 , Oregon 1925 , Massachusetts 1925 , Pennsylvania 1927 and Cali-Ž .fornia 1927 , of statutes commanding their common law courts to enforce arbitra-

tion agreements and rulings, agreements to arbitrate were generally not consideredbinding under U.S. common law, and at least for a portion of U.S. history prior tothe 1920s, hostile judges felt free to overturn arbitration decisions if one of theparties chose to litigate.21 Nonetheless, an examination of newspapers, merchantletters, and the records of organizations providing arbitration services, such as theNew York Chamber of Commerce, clearly demonstrates that commercial arbitra-

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tion actually was in widespread use in each of the British Colonies almost threecenturies before modern arbitration statutes were passed, and that after therevolution, arbitration remained in wide use in the all of the states.22 The use ofcommercial arbitration developed during the colonial and post-revolutionary peri-ods in spite of judicial hostility. Later in the nineteenth century, a trend toward less

Žhostility can be detected in several state courts MacNeil 1992; Benson 1995a,.1998f , but arbitration continued to evolve both in states where the courts were

Ž .relatively receptive and states where they were not Benson 1995a, 1998f . Forinstance, as New York merchants organized into various associations and ex-changes, provisions were always made for the arbitration of disputes among

Ž .members Jones 1956, p. 214 , despite New York’s maintenance of the doctrine ofrevocability until 1920.

The volume of evidence regarding the widespread and growing use of arbitrationŽis particularly heavy for the last four decades of the nineteenth century Jones

1956, pp. 214]215; Wooldridge 1970, p. 101; Auerbach 1983; MacNeil 1992;.Benson 1995a, 1998f . Indeed, these developments suggest that arbitration was

wbeing substituted for litigation for both procedural reasons rising litigation costsŽ .xdue to court congestion and trial delay Benson 1995a, 1998f and jurisdictional

reasons reflecting increasing uncertainty as ‘‘the growth of the regulatory stateunsettled advocates of commercial autonomy who turned to arbitration as a shield

Ž .against government intrusion’’ Auerbach 1983, p. 101 . Incentives to establishŽcontractual arrangements and organizations e.g., trade associations, commercial

.exchanges to govern the process of dispute resolution and insure against litigationŽ .e.g., arbitration clauses, arbitration institutions, institutionalized private sanctionswere clearly increasing, so that by the end of World War I, arbitration had madethe courts irrelevant for contract disputes in large segments of the business

Ž .community in the United States Wooldridge 1970, p. 101 .Still, states began passing arbitration statutes in the 1920s, mandating that the

courts back arbitration rulings. Why? The primary political impetus behind arbitra-Ž .tion statutes came from Bar Associations Auerbach 1983 as lawyers saw the

growing use of arbitration without lawyers as a threat to their control over contractŽ .writing and dispute resolution Benson 1995a, 1998f . This may seem surprising

since lawyers had virtually no role in arbitration at the time. Indeed, arbitration, asit was developing, not only avoided the use of lawyers, but it was hostile toward thelegal profession. The feelings that many trade associations had regarding lawyerinvolvement in their arbitration processes is suggested by an officer of the SilkAssociation who argued that businessmen can settle their disputes better thanlawyers because a lawyer ‘‘is going to dominate the situation and bind the thing upwith technicalities and precedents’’ rather than yield to business expertise and an

Ž‘‘ordinary understanding of what is right and what is wrong’’ Auerbach 1983, p..108 .

While many lawyers may have preferred to squelch the competitive threat posedby arbitration, others apparently recognized that its rapid development andwidespread use suggested that its elimination was not possible.23 Moreover, if they


could establish a lucrative role for themselves in arbitration, then elimination ofarbitration in favor of litigation was not as important as it had been for commonlaw judges in the seventeenth century. Therefore, if an alternative forum to thepublic courts was to be used, trial lawyers wanted that forum to be one that theymight be able to influence and perhaps even dominate. An obvious hypothesisfollows: lawyers hoped to initiate arbitration statutes written in a way that wouldlead to a role for lawyers in the arbitration process, and they sought such statutesby lobbying through their Bar Association. This hypothesis might be questionedbecause many and perhaps most lawyers in Bar Associations are probably neverinvolved in litigation. This does not mean that arbitration did not pose at leastsome indirect threat to many of them, however. For instance, carefully draftedcontracts and dispute resolution procedures are substitutable, at least to a degree.If the cross elasticity is of any consequence, commercial lawyers who draftcontracts might also perceive arbitration as a threat, just as trial lawyers specializ-ing in business disputes would. After all, as noted above, trade associationsdemonstrated considerable animosity toward lawyers in general, and the availabil-ity of their internal arbitration arrangements may have allowed association mem-bers to avoid some expenses for contract-drafting lawyers as well as for trial

Ž .lawyers. In fact, as Charny 1990, pp. 388, 403]405 explains, when legal sanctionsare available, the demands placed on formal contract writing are increased. Whenprivate sanctions alone apply, particularly within narrowly focused commercialorganizations, less formality in contracting is required because the parties areintimately familiar with business practice and custom in their particular area oftransactions; they understand what a general statement in a contract means, andthey can choose an arbitrator with similar intimate understanding. However, ajudge is much less likely to have such an understanding, so a contract that may facejudicial scrutiny will have to be much more specific and formal in order to avoid a

Ž .high probability of judicial error Charny 1990, pp. 385, 404 . Thus, the growth ofarbitration was probably a threat to contract writing lawyers as well as trial lawyers.Furthermore, since arbitration also allows the possibilty of greater reliance oncustomary law in commerce, the potential for appeal might force the businesscommunity to consider the statutes and public court precedents which providelawyers with their legal frame of reference. Lawyers specialized expertise is of littlevalue if people can opt for an alternative jurisdiction.

5.1. Principal-agent Problems

Ž .Cohen 1921, p. 150 observed, shortly after the New York Arbitration Act’spassage in 1920, that this statute ‘‘establishes legal machinery for protecting,safeguarding and super ising commercial arbitration. Instead of narrowing thejurisdiction of the Supreme Court it broadens it . . . . Instead of being ousted ofjurisdiction over arbitration, the courts are given jurisdiction over them, and . . . the

Ž .party aggrieved has his ready recourse to the courts’’ emphasis added . Prior to the

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statute’s passage, credibility for arbitration agreements in New York came fromprivate sanctions, often imposed by formal and informal business groups. Thestatute essentially asserted that the state was the source of authority and sanctionsfor such agreements. As a result, an enormous number of court cases were filed asbusinessmen tried to determine what characteristics of arbitration would be consid-

w Ž .xered ‘‘legal’’ by the public courts see Sturges 1930 . Cases involved such issues asthe appropriate way to select arbitrators, whether lawyers had to be presentŽindeed, as explained below, many lawyers became active in arbitration because ofthese statutes, just as they presumably intended when they advocated their pas-

.sage , whether stenographic notes of the proceedings should be taken, and so on.As similar statutes were passed elsewhere arbitration litigation mounted. Casesover jurisdictional issues involved courts from and appeals in multiple statesŽ .Auerbach 1983, p. 110 . Businesses, forced to pay attention to the prospect ofjudicial review, had to make their arbitration processes compatible with statute andprecedent law including public court procedure. In order to do so, they had toconsult lawyers and involve lawyers in arbitration. A Harvard business law profes-sor who observed the period immediately following passage of the 1920s statutes,wrote ‘‘There is irony in the fate of one who takes precautions to avoid litigation bysubmitting to arbitration, and who, as a reward for his pain, finds himself in court

w xfighting not on the merits of his case but on the merits of arbitration . . . Thiswmonumental tragicomedy . . . demonstrates the success of the common law legal

x Žprocess at thwarting legitimate efforts to escape its tortuous procedure’’ Isaacs.1930, pp. 149]151 . Litigation over arbitrated rulings has continued, and the early

1980s were still witnessing a ‘‘growing number of court challenges to arbitrationŽ .awards’’ Ashe 1983, p. 42 . This appears to reflect that fact that the statutes and

the increasing complexity of precedent law forced some businesses to involvelawyers in their contracting and arbitration in an effort to insure that the arbitra-tion process itself will stand up to judicial scrutiny, and this in turn has created aprincipal-agent problem. Lawyers are in a position to extract rents by influencing

Ž .business decisions regarding dispute resolution, and as Ashe 1983, p. 42 con-cludes, the increase in appeals reflects the increasing use of lawyers in arbitration:losing attorneys have a stronger tendency to circumvent the arbitrator’s decisionthan there is for the losing party who, in the absence of legal ‘‘advice,’’ would tendto have greater ‘‘allegiance to the system of arbitration itself.’’ The growing level oflitigation of arbitration rulings is certainly correlated with the increasing involve-

Ž . 24ment of lawyers in the process Ashe 1983, p. 42 , supporting this hypothesis.

5.2. Moral Hazard

There may be other transactions costs associated with the statutes and resultinginvolvement of lawyers that reduce arbitration’s attractiveness. For instance,

Ž .Mentschikoff’s 1961, p. 14 seminal research on arbitration using AAA recordsas well as personal observations, concludes that ‘‘in the great majority of


cases . . . lawyer participation not only failed to facilitate decisions, but . . . materiallyw x w xlengthen ed and complicate d the presentation of the cases.’’ Mentschikoff also

finds that lawyers do not understand businesses usages and practices that typicallyare relevant to business disputes, and that is one reason for AAA proceedingsbecoming unduly technical and creating unnecessary delays. Similarly, Lazarus et

Ž .al. 1965, p. 95 conclude, on the basis of an arbitrator questionnaire, that lawyerstend to be less than adequately prepared to represent clients in arbitrationhearings, and that they are ‘‘reluctant to abandon practices condoned and valuedin the courtroom.’’ Essentially, a moral hazard appears to have been created: inpart due to the incentives to encourage appeals after arbitration, lawyers may haverelatively strong incentives to shirk during arbitration, which they may perceive as aprocedural stage of legal dispute resolution rather than an alternative to litigation.

Lawyers apparently also have incentives to make arbitration like litigation.Ž .Lazarus et al. 1965, p. 102 stress that arbitration’s ‘‘strongest points lie in those

areas where it most widely differs from courts,’’ for instance, but note thatarbitration proceedings by the AAA have ‘‘been altered to accommodate lawyers’’

Ž .making them more like court proceedings as a result. Ashe 1983, p. 42 similarlyargues that with more and more lawyers used in AAA arbitration, ‘‘as arbitrationbecomes more like a court proceeding, the benefit to the participants for whom itwas designed diminishes. Such a development is destructive of the process, not onlybecause of the increased time and cost that accompanies it, but because itencourages the process to be viewed by the courts as only one more step in thealready lengthy litigation process.’’ Thus, some of the most attractive aspects of thearbitration alternative can be substantially reduced as a direct result of thestatutory legalization of the process and lawyer involvement, suggesting that thestatutes have significantly increased the cost of arbitration and reduced its attrac-

Ž .tiveness Auerbach 1983; Ashe 1983 . Indeed, arbitration is less expensive thanlitigation only if ‘‘parties do not take advantage of certain states’ statutes allowingthem to resort to court prior to arbitration or to demand review of the arbitrators’

Ž .award through appeal’’ Lazarus et al. 1965, p. 106; Charny 1990, p. 427 . Theincentives to insert arbitration clauses into contracts appear to be undermined, atleast to a degree.

5.3. Legal Sanctions and the Distribution of Transactions Costs for Arbitration

How widespread and important these increased transactions costs might be isactually difficult to determine, although the U.S. experience provides some in-sights. The AAA is the most well known and studied source of arbitration in theUnited States, and many writers apparently assume that the characteristics of itsarbitration are representative of arbitration in general. Mentschikoff’s conclusionthat lawyers fail to facilitate decisions, and actually materially lengthen and

Ž .complicate cases 1961, p. 14 arises in the context of her focus on AAA arbitra-tion, for example, and many subsequent writers tend to attribute the characteristics

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w Ž .she observed to arbitration in general for example, see Auerbach 1983 , AsheŽ . Ž . Ž .1983 , and to a degree, Lazarus et al. 1965 , but also see Willoughby 1929, p. 58

xfor similar arguments made prior to Mentschikoff’s article . Lawyer participation inAAA arbitration as council rose from 36 percent in 1927 to 70 percent in 1938, 84

Ž .percent in 1942, and 91 percent in 1947 Auerbach 1983, p. 111; Kellor 1948, p. 26 ,Ž . Ž .and it probably is near 100 percent today. Auerbach 1983 , Ashe 1983 and others

cited above may put too much emphasis on the success lawyers have in influencingthe AAA as evidence of a virtually complete ‘‘legalization’’ of commercial arbitra-tion in general, however. Judges and lawyers joined the AAA in strength, they havea significant presence in the AAA as members of the Board of Directors and ofvarious committees, and they have a substantial influence over AAA policies and

Ž .procedures Kellor 1948, p. 18 , thus opening ‘‘to lawyers a general practice that isŽ .lucrative to them’’ Kellor 1948, p. 69 . The AAA is not the only source of

arbitration, however, and it does not appear to be typical of arbitration from otherforums. Indeed, the ‘‘business community’’ may be divisible into three groups forthe purpose of considering the consequences of legal sanctions backing arbitration.

First, a large portion of the business community apparently can enforce contractswithout legal sanctions and use private sanctions to induce their members not touse lawyers or appeal arbitration rulings to common law courts. Trade associationsand exchanges have already overcome the collective action problem and organizeda natural reciprocal support arrangement, so it has been relatively easy for them toestablish their own specialized arbitration systems, information transmission mech-anisms, andror automatic sanctions that make arbitration promises credible. Thus,the statutes providing legal backing for arbitration probably have had little impacton these businesses. They can still use arbitration as a mechanism for jurisdictionalchoice as well as for its procedural advantages. While 91 percent of AAA

Ž .arbitration involved lawyers by 1947, Mentschikoff 1961, p. 857 reports that about40 percent of the nation’s trade associations explicitly forbad attorney representa-tion in arbitration in the 1950s, for instance, while attorney involvement in theother roughly 60 percent was ‘‘highly unlikely.’’ Furthermore, the AAA provided

Žonly an estimated 27 percent of all commercial arbitration Mentschikoff 1961, p.. Ž .857 . Similarly, Lazarus et al. 1965, p. 92 surveyed 1,673 trade associations in

1965, and all respondents indicated that none of them encouraged legal represen-Žtation lawyers were either forbidden, permitted with limitations, or permitted but

.‘‘not encouraged’’ . In contrast, the AAA ‘‘openly encourages lawyer participationat all steps of the arbitration procedure, from the drafting of arbitration clauses in

Ž .contracts to the hearing itself’’ Lazarus, et al. 1965, p. 92 , contending that lawyersŽ .are essential to the process AAA 1964, pp. 6]7 . Therefore, it is not at all clear

that the characteristics of AAA arbitration apply for the majority of commercialarbitration in the United States, let alone internationally. Still, some trade associa-tions may also have to pay attention to the prospect of judicial review and adjust

25 Žtheir procedures accordingly they may be relatively affective at using privatesanctions to discourage appeals, however, thereby alleviating this concern some-

.what .


Second, some businesses may not have ready access to such established proce-dures for reasons discussed above, but they can still attempt to avoid the slow andcostly public courts by using the arbitration specialists provided by lawyer-dominated

Žorganizations such as the AAA e.g., by including standard arbitration clauses in.contracts, or by agreeing to arbitrate after the fact . Indeed, it may well be that for

Ž .some many? of those in the business community who turn to such unaffiliatedsources of arbitration, a legal sanction is the primary source of credibility backingtheir commitments to arbitrate. This may in turn means that because privatesanctions are relatively weak, appeal is more likely and therefore that there is astrong incentive to involve lawyers in all disputes from the outset, even if they arearbitrated. Such implications do not deny the points made above about therelatively high costs that arise with lawyer involvement, the inadequate preparationof lawyers involved, and so on. Indeed, it reinforces the suggestion that there maywell be principal-agent and moral hazard problems for those transactors whocannot employ strong private sanctions. Asymmetric information about legal issuesmeans that the lawyers may be in a position to behave opportunistically, even tothe point of encouraging relatively more appeals to the courts than might occur ina full-information world, thus explaining the large number of appeals that dooccur, as well as the behavior and consequences observed by Mentschikoff, Lazaruset al., Auerbach, and Ashe. Nonetheless, lawyer involvement in such proceedingsmay be the low cost alternative given the role that legal sanctions play for thoseinvolved in such disputes: these costs are relatively high, only when compared to an

Žunobtainable alternative unobtainable due to the lack of an effective private.sanction . They are relatively low as compared to the real alternative: the expected

costs of litigation in public courts. Under these circumstances, arbitration isprobably much less relevant as a mechanism for jurisdictional choice, however, atleast for domestic traders, in part because the level of lawyer involvement willmitigate against application of business practice and custom as lawyers turn to thesources of rules that are more familiar to them. After all, transactors must be morecareful and formal in writing their contracts in order to make sure that anuninformed judge will not make a mistake, so lawyers become more important asinputs to contract writing too, reducing the likelihood that business practice andusage will be considered. Under these circumstances, when arbitration is chosen, itis probably for its procedural advantages. Note that this is consistent with thewidespread view among U.S. legal scholars who see arbitration as a proceduralrather than a jurisdictional choice. AAA arbitration has been the most visible andmost studied of all the arbitration arrangements in the U.S., and if the argumentsmade here are correct, this source of arbitration is predominantly a proceduraloption. Arbitration within trade associations has rarely been studied, on the otherhand, and it is this source of arbitration that is most likely to involve a jurisdic-

Ž .tional choice. Berstein’s 1992 study of the diamond traders organization isparticularly relevant in this context, as she emphasizes that customary law isapplied rather than state law.

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Private sanctions can be very powerful outside of formal associations andinformal groups, of course, so it also does not follow that all of the disputes takenbefore third parties such as AAA arbitrators require legal sanctions for backing.That is, a third group may lie between those with strong and weak private sanctionsŽindeed, a continuum may be more appropriate than the three discrete groupings

.suggested here . Private sanctions may be relatively weak in the third groupcompared to the first group, but still sufficiently strong to induce compliance witharbitration under most circumstances in the absence of legal sanctions. However,with the advent of legal sanctions and the potential for appeal, the transactionscosts associated with arbitration rise due to the reasons suggested above. Howmany businesses are actually worse off because they have been forced to includelawyers and consider the implications of appeal? There is really no way to tell, inpart because the statutes themselves may significantly diverted the path of arbitra-tion’s evolution. Indeed, and importantly, these groups should not be considered in

Ž .a static sense as exogenously determined. As Charny 1990, p. 428 explains, theexistence of legal sanctions may stifle the development of trust relationships fromwhich private sanctioning mechanisms often spring, because the honoring of anycommitment may often be perceived to arise primarily because of the deterrenteffect of legal sanctions. That is, the incentives to develop private sanctions may beundermined by such statutes and this in turn adds to the size of this third grouprelative to what it would be without the statutes. Thus, it reduces the potential forarbitration to serve as a jurisdictional option.

5.4. Undermining Incenti es to Arbitrate and to Contract

Ž .Charny 1990, p. 428 also notes that the prospect of court intervention to enforcecommitments that parties would prefer to have enforced by private sanctions may‘‘chill’’ commitment-making in general. Similarly, in discussing contract enforce-

Ž . Ž .ment internal to an organization, Williamson 1991, p. 164 explains that ‘‘ 1parties to an internal dispute have deep knowledge}both about the circumstancessurrounding a dispute as well as the efficiency properties of alternative

Ž .solutions}that can be communicated to the court only at great cost; and 2permitting internal disputes to be appealed to the court would undermine theefficacy and integrity of the hierarchy.’’ Williamson applies this argument tohierarchical organizations in comparing them to markets, but he also notes that

Ž .‘‘hybrids’’ between markets and hierarchies abound 1991, pp. 165]166 . Clearly,trade associations, commercial exchanges, and other ‘‘organizations of businessorganizations’’ are examples of such hybrids, and the arguments Williamson raisesabout internal dispute resolution applies to them as well. As Willoughby notesŽ .1229, p. 64 , for instance, even though the statutes ostensibly established judicialbacking for properly made arbitration awards, they may not actually have thateffect ‘‘because the awards were not deemed to be final but were subject torevision by the courts; and because inadequate provision was made for arbitrators


securing from the courts rulings upon points of law.’’ The possibility of appeal tothe public courts implies that rulings from arbitrated commercial disputes may

Žbecame less decisive than they had been Benson 1989, 1995a, 1998f, 1999; Ashe.1983, p. 42 }the efficacy and integrity of this non-adversarial dispute resolution

process are undermined. This implies weaker incentives to abide by arbitratedŽ .settlements. As Rudden 1996, p. 43 suggests, ‘‘paradoxically . . . The promises that

are not legally binding are the ones you have to keep.’’ The weakened incentives toarbitrate can in turn stifle the development of trust relationships and the institu-

Ž .tions that foster them e.g., trade associations as the honoring of any commitmentwill be perceived to arise because of the deterrent effect of legal sanctions. Thus,‘‘the prospect of legal intervention to enforce commitments that parties wish to

w xkeep legally unenforceable i.e., that have been enforced by private sanctions may‘chill’ commitment-making. If transactors fear that they will not be able to avoidthe costs and potential over deterrence of legal enforcement, they may not make

Ž .commitments at all’’ Charny 1990, p. 428 . Thus, in the absence of modernarbitration statutes and the AAA, it does not follow that the level of arbitrationwould be dramatically less in the United States than it is today. Lawyers would beless prevalent, and there would be fewer appeals, but because of stronger incen-tives would exist to develop mechanisms for the imposition of private sanctions,arbitration would still be flourishing, even outside existing associations and ex-changes. On net then, it may well be that the aggregate transactions costs ofcontract dispute resolution are higher in the United States with the statutes thanthey would be without them. Given the long history of arbitration in the U.S.Ž .Benson 1995a, 1998f , there does not appear to be sufficient evidence to supportthe opposite conclusion, at any rate, and there certainly is little basis for a generalclaim that arbitration is made ‘‘more efficient by giving it legislative sanction’’Ž .Domke 1984, p. 27 . While arbitration may be chosen by some people because ofthese statutes, it is probably chosen for its procedural advantages, and the statutesappear to undermine incentives to organize into groups that can impose their ownsanctions, making it less likely that customary law is available as a jurisdictionaloption. This issue is particularly relevant today as Eastern Europeans and Asiansattempt to develop market economies and become competitive in the globalmarketplace.

6. Conclusions: Should Legal Sanctions be Created to SupportArbitration in an Emerging Market Economy?

The emergence of market economies in parts of Eastern Europe, Asia, andelsewhere clearly is not occurring as rapidly as many domestic politicians and

Žforeign observers would like indeed, in some places, it appears that these economies.are stagnant or declining . While ‘‘experts’’ point to many factors, a growing

number of political, economic, and legal consultants and academics recognize thatthe slow pace of development is a function of the institutional environment. In

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particular, the legal systems in these countries often do not support privateproperty rights or enforce contracts. Thus, many of these consultants and aca-demics contend that the states must step up their efforts to establish commerciallaw. These arguments ranges from sweeping proposals to write all-encompassing

Ž .commercial codes Ioffe 1996 , perhaps by copying the codes that exist elsewhereŽ .Izdebski 1996 , to focusing on the ‘‘core tasks of liberal governance’’ such asprotection of property rights along with clarification and uniform application of

Ž .contract law Dempsey and Lukas 1998, p. 472 , to explicit state recognition andŽ .enforcement of existing international norms Boguslavskii 1996, p. 421 , to more

modest calls for legislation andror international agreements mandating that statecourts recognize and enforce arbitration rulings so that these private institutionscan serve as a substitute for the ineffective andror corrupt state legal systemŽ .Rubin 1994; Butler 1996 . In reality, however, less state involvement in commer-

Žcial law is called for at this stage of market development, not more Rudden 1996,.p. 44; McMillan and Woodruff 1998; Pejovich 1995, 1997; Benson 1998b .

One reason for suggesting that the states in these emerging market economiesdo less in the area of commercial law rather than more is simply that these statesare probably not capable of doing the things that various commentators suggestthat they should do. After all, legislators, bureaucrats, and judges in places likeRussia, Poland, Ukraine, Belarus, Vietnam, China, and so on, are even less likelyto understand the important underpinnings of a successful market system wellenough to provide effective support for them than Western European and NorthAmerican judges, bureaucrats, and politicians who frequently seem to make

Ž .decisions that undermine rather than support market processes Pejovich 1997 .Ž .More fundamentally, as Feldbrugge 1996: 568]569 notes in an understated way,

The construction of a totalitarian system entailed the systematic destruction ofthe civil society and the free market system; the end of totalitarianism raises thequestion whether the road can also be traversed in the opposite direction. In acountry like Russia, the historical tradition, the instincts of the leaders, theurgency of the problems all suggest a positive answer: the political leadership,the government, is considered to be responsible for reintroducing a free marketeconomy and laying the foundation for the emergence of a civil society . . . .There is some reason to look critically at such a view . . . . There is somethingincongruous about the planned approach to the abolition of the plannedeconomy and its replacement by another economic system. It presupposes afairly detailed view of the society of the future, and is this possible or desirable?

The fact is that the beliefs andror objectives of those in authority in many of theseeconomies are generally not compatible with the kinds of changes that would haveto be made in state law to effectively support a strong market economy. Feldbruggesuggests, for instance, the ‘‘instincts of the leaders’’ is that they can guide the

Ž .development of a market economy. Similarly, Simons 1996, pp. 251, 254 , indiscussing corporate law in Russia, notes that ‘‘the system is changed but state


Žcontrol is not,’’ in part because of ‘‘the mere tradition of state control especially as.concerned the foreign, non-state sector in the Soviet Union .’’ He goes on to

explain that while there has been some very visible reductions of state control insome areas, such as privatization of state enterprises, ‘‘the state has to date

w xseemingly been unable to adequately define its role regarding . . . the importantŽ .requirement . . . of market -type economies that parties enjoy basic freedom of

contract . . . . Rather, the role of the state at present is as yet an ill-defined one andwhere it takes shape it often appears to favor too much control when less isrequired . . . . And it is precisely this ill-defined role of the state}not as the ownerof all the ‘‘means of production’’ as was previously the case in the Soviet era but asa regulator of economic activity in the transition period}which is a serious

Žimpediment to significant progress in the transition process’’ Simons 1996, pp..256]257 .

Similar impediments exist when it comes to adoption of international norms.Ž .Ginsburgs 1996, pp. 463]464 points out that in Russia, ‘‘the will and desire to

harmonize international law and national law certainly seemed to be there now,but the blueprints for the machinery to fit the pieces together into a coherentwhole continued to languish on a welter of drawing-boards. The logistical dilemmaafflicted both the matter of which international law norms called for priority

Ž .injection into the domestic bloodstream and the topic of what office s wouldperform the job of directing in-bound traffic and monitoring the operation toensure maximum compatibility between respective strands.’’ Furthermore, theselection of international norms that the Russian Constitutional Committee islikely to adopt is biased by the persistent beliefs among Russian leaders that thestate must be the source of rules that facilitate the transition to a market economy.In this context that results in a focus on those international norms which have beenestablished or recognized in formal treaties and agreements. This focus has been

Ž .criticized, as Ginsburgs 1996, p. 489 notes: ‘‘the habit evinced in this genre ofŽ .instructions of zeroing in on the treaties agreements to which the Russian

Federation is a party has attracted valid criticism on the grounds that it would bemore correct here to talk about international law as a whole inasmuch as custom-ary norms, too, might be relevant in this context.’’ But the bias, blamed on‘‘long-standing predilection among the law-makers of the USSR, and then Russia,to consider international law to be represented only by treaties,’’ has persisted.Legislation requires the regulation of international treaty norms and in Russiancourts, the ‘‘standard tendency . . . to treat international customs as something‘‘tertiary,’’ to be consulted only where national and international normative acts

Žsupply no answer to the question brought up before the court’’ Ginsburgs 1996, p..489 . This general view that custom is relevant only when state-made law does not

cover the situation under consideration is reinforced by the draft Russian Federa-tion Civil Code submitted in April 1993 where it ‘‘is envisaged that the form offoreign economic transactions entered into by Russian juridical persons andcitizens, independently of the place where the transaction is entered into, is

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Ždetermined by the legislation of the Russian Federation’’ Boguslavskii 1996, pp..425]426 . This document does state that the terms of a contract are determined by

the law of the place where it was entered into unless otherwise provided by theagreement, so it is really in the absence of a choice of law that Russian substantivelaw is expected to rule. This is in stark contrast to arbitrated internationalcommercial law, of course, since commercial custom is applied if no contractualchoice of law is made, but it is consistent with the general attitude toward customthat is apparently prevalent among Russian law makers and judges.

In light of the continued belief in Russia that the state must be the source of therules that shape the economy, it should not be surprising that a ‘‘jungle of statecontrol’’ still exists there, ‘‘parading under the banners of reform or democracy’’Ž .Simons 1996, p. 263 . The same is true to a greater lesser degree in many of theformer communist block countries and many other countries around the world.When the state is expected to produce law, of course, the resulting law inevitablehas conflicting objectives, as explained above. Certainly, law makers in severalEastern European and Asian countries are under considerable pressure to createan environment conducive to market activity, but they are also under pressure to

Ž .do many other things. As a consequence, Rudden 1996, p. 44 sees a ‘‘tendency toconstitutionalize the civil law, that is to insist that its ordering of private legalrelations comply with certain public virtues’’ in Russia, for instance, and HazardŽ .1996, p. 78 notes that ‘‘Continuing debate within the Congress of Deputies of theRussian Republic suggests that there . . . remain ideological restraints in civil law,although it cannot be determined what their origin really is}socialist or primor-dial?’’ Ideology regarding ‘‘public virtue’’ may explain the evolution of law in thesesituations, of course, but most of the issues being debated have to do with thedistribution of wealth.

A fundamental purpose of law emanating through legislation often is to preservethe political system, but this can be in direct conflict with the effort to create amarket system. Furthermore, for many people involved, the reasons are much moresinister than ‘‘ideological’’ pursuits of perceived ‘‘public virtues.’’ For instance, avast array of complex rules enforced by bureaucrats with a great deal of discre-tionary power creates an environment that can be very lucrative for public officials

Ž .who are willing to accept bribes Benson 1988a, 1990, pp. 159]175 . After all, asŽ .Pejovich 1995, p. 18 notes, ‘‘A predictable consequence of the arbitrary state is

the emergence of black markets, underground economies, and grey economies.’’Ž .Schelling 1971 contends that organized crime is really monopolized crime, but in

Ž . Ž .this regard, Rubin 1979 and Anderson 1979 both point out that criminal firmspossess market power because there are economies of scale in buying corruptionfrom governmental officials. These arguments clearly apply in Russia and much ofthe rest of the world where markets are attempting to emerge, and not surprisingly,

Ž .as Dempsey and Lukas 1998: 471 suggest, ‘‘The Russian government’s reluctanceto give up further economic control is the single greatest catalyst to organizedcrime.’’ Organized crime in Eastern Europe traces back to the communist era


when widespread underground markets developed, often to supply governmentofficials with consumer goods and services, since they were among the few whocould command the financial resources to purchase such goods. The end of thetotalitarian regimes did not bring an end to organized crime, however, or togovernment ties to it, because of the strong controls that the government attemptsto maintain over economic activities. Indeed, the power of organized crime in

w Ž .xRussia and elsewhere Benson 1988b still emanates from government, andgenerally to the substantial benefit of those in government. In Russia, for instance,much of organized crime is not involved in the drug, prostitution, or gamblingmarkets that are the primary focus of such groups in the United States andWestern Europe. Instead, many ‘‘mafia’’ are serving as middlemen to facilitate theillegal sale by bureaucrats of state-owned enterprises and resources, and anothermajor function is to coordinate the payment of bribes by businesses in their effortsto expedite the regulatory process which involves ‘‘a daunting array of license,

Žpermit, and fee requirements on normal business activity’’ Dempsey and Lukas.1998, p. 471 . The still substantial customs procedures and high taxes also stimulate

a tremendous amount of smuggling and black market trade in all kinds ofconsumer goods, and bribery of police, customs officials, and probably judges, playsa major role in these activities.

Even if the national governments of the Eastern European and Asian countriesdiscussed here were exclusively focused on making and enforcing rules that would

Žfacilitate the development of market economies rather than on wealth transfer.issues and rent extraction by corrupt officials , it does not follow that they would be

the best source of those rules and governance institutions. If we look to WesternEurope and North America for models of how market economies emerge, then wemust recognize that markets were well established and governed by customary lawlong before the states got involved in the making and enforcing of rules ofcommerce, and that even when the states did so, they generally started byrecognizing established custom. Furthermore, in many places the institutions of

Ž .customary law merchant courts, arbitration have survived as an ongoing source ofcompetition for the state, helping to constrain its activities. As the FeldbruggeŽ .1996, p. 568 quote above states, of course, ‘‘the construction of a totalitariansystem entailed the systematic destruction of the civil society and the free marketsystem,’’ so the emerging markets of formerly-communist Eastern Europe andstill-communist Asia are not able to start with the types of trade associations andother private organizations that have provided the foundation for customarycommercial law in the U.S. and in much of Western Europe. Western Europe didnot have them either, however, until they became desirable. The evolution of theprivate institutions of commercial law and of market institutions themselves has

Ž .always been simultaneous rather than sequential Benson 1989 . As the conditionsof commerce change, legal institutions evolve, and this in turn leads to morecommercial developments and more legal evolution. And in this regard, it is notsurprising to find that informal and even formal groups of trading partners are

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developing quite rapidly in places like Poland, Hungary, the Czech Republic, andŽ .even Vietnam Pejovich 1995, McMillan and Woodruff 1998 , much as they did in

North America during the colonial period and western expansion when the statewas unable to provide protection for property rights and unwilling to enforce

Ž .contracts Benson 1991b, 1995a .Many entrepreneurs have turned to private protection services that secure their

Žproperty and enforce their contracts Pejovich 1995; Dempsey and Lukas 1998, p..470 , much as medieval merchants had to do as they began to trade across political

Ž .boundaries during the formative period of the Law Merchant Benson 1998e .There are roughly 10,000 private security firms registered in Russia today, forinstance, and experts suggest that there are actually as many as 30,000 such firms.26

Perhaps more significantly in terms of the development of customary law, repeateddealings and reputation effects are being used to support trade among themembers of these groups, although during the early stages of their formation theymay not develop arbitration arrangements, relying instead on negotiation and

Ž .threatened sanctions to resolve disputes McMillan and Woodruff 1998 . But thefact is that it takes time for the private institutions to evolve.

One reason for weak private sanctions tends to be the existence of a predatorygovernment. If the quasi-rents associated with developing reputations and repeateddealings can be appropriated by the state, the ability to develop effective non-vio-lent private sanctions are weak. A similar result occurs if the state is simply ineptor inefficient in performing the legal functions it claims to monopolize. Forinstance, if the state is ineffective at enforcing property rights to trademarks, brandnames, and other manifestations of reputation, the quasi-rents can be appropriatedby others, and once again, private sanctions to back arbitration are less likely to

Ž .develop. As Pejovich 1995, p. 17 notes, ‘‘The arbitrary state undermines thestability and credibility of institutions, reduces their ability to predict the behaviorof interacting individuals, raises the cost of activities that have long-run conse-

w xquences, and creates conflicts with the prevailing informal customary rules . . .w x Ž .M ost countries in Eastern Europe are arbitrary states.’’ Rubin 1994 clearlyrecognizes that these types of government failure are a primary source of theinability of Eastern European traders to develop effective private sanctions to backarbitration, and suggests that under these circumstances, legal sanctions may beimportant inducements to arbitrate. However, this suggestion presumes that agovernment which is too corrupt andror inefficient to create stable property rightsis still sufficiently trustworthy andror efficient to create effective contract enforce-ment.27 If this is not the case, then legal backing of arbitration may have very littlebeneficial impact, and substantial negative consequences. Of course, such statutescould stimulate a greater use of arbitration in the short run, but to the degree thatarbitration statutes ordering public courts to enforce arbitration clauses andrulings are relevant, meaning that arbitration rulings can be subject to judicialreview so lawyers are involved in more arbitration than they otherwise would be,the potential for arbitration to be a mechanism for making a jurisdictional choice


28 Ž .are probably reduced. Furthermore, as Charny 1990, p. 428 suggests, theexistence of such legal sanctions is likely to inhibit the development of the kinds of

Ž .relationships e.g., commercial groups, trade associations from which privatesanctioning mechanisms generally arise, because the honoring of any commitmentmay often be perceived to arise primarily because of the deterrent effect of legalsanctions. Thus, the potential for developing effective jurisdictional options arereduced, and the potential benefits of interjurisdictional competition are diverted.Beyond that, if it is corruption rather than ineptitude that leads to the governmentfailure, creating an environment that gives potentially corrupt judges explicitauthority over arbitration may actually undermine the incentives to use it. Andimportantly, it appears that at least in some places, institutions are beginning todevelop that can back arbitration without state sanctions, so if such sanctions dosignificantly affect such incentives, their long-run costs could be considerable.After all, entrepreneurs from these emerging market economies who enter interna-tional markets are being introduced to the modern Law Merchant’s customary

Žcommercial law and its institutions for governance private arbitration, information.channels and ostracism, etc. . In fact, many may already be familiar with interna-

tional arbitration, as it was regularly employed under the communist regimes byŽ .state owned enterprises involved in international trade Bockstiegal 1984, p. 15¨

walthough their perception of the benefits of arbitration might be colored if this isthe source of their experience: arbitration with a state-owned enterprise tends to

Žbe ‘‘very slow moving’’ and perhaps less likely to be enforceable Bockstiegal 1984,¨.29 xpp. 22]23, 49]50 . International traders who see the benefits of such arrange-

ments can attempt to emulate them in their domestic dealings. And indeed, partiesto domestic contracts in some of the emerging economies are beginning to turn toarbitration when disputes arise, even when they have to find arbitrators outsidetheir own countries to do so.30 Thus, even the level of state involvement withcommercial law associated with providing legal sanction to arbitration could meanthat Eastern European and Asian merchants may never develop the kinds ofpractices and usages that are necessary to support its use.

Reliance on the state for rules andror legal sanctions at this early stage maymean that the future evolution of commercial law will be along a very differentpath than the one taken in the economies of Western Europe and North America,where the state did not claim jurisdiction until long after the evolutionary process

Ž .was under way. As Rudden 1996, p. 44 explains, the state simply must shrink as‘‘Many of its functions are to be taken over by persons, human and corporate, ofprivate law, and it will go hard with them if they are not permitted in good faith toset aside the application of the standard legal patterns.’’ The withdrawal of thestate from any efforts to influence commerce is likely to do more to stimulatecommercial activity than any proactive efforts by the state to speed up the process.Laissez faire appears to be the best policy for emerging economies in the area ofarbitration and contract law enforcement as well as in economic policy itselfŽ .Benson 1998b .

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Acknowledgments

This paper is part of a larger project on law and legal institutions which has beensupported by two Earhart Foundation Fellowships, research grants from theInstitute for Humane Studies and the Carthage Foundation, and a book contractfrom the Independent Institute. I wish to thank two anonymous referees, PaulRubin, and participants in a Florida State University Political Economy Seminarfor helpful comments and suggestions on earlier versions of this paper, as wellPeter Newman, Barry Hirsch, Steve Ware, Lisa Bernstein, and participants in theNinth Egon-Sohmen-Foundation Symposium on ‘‘The Merits of Markets}CriticalIssues of the Open Society’’ for valuable comments on the various papers from

Žwhich this one evolved Benson 1998a, 1998c, 1998d, 1998e, 1998f, forthcoming-a,.forthcoming-b .

Notes

1. ‘‘Rules’’ are behavioral patterns that other individuals expect a person to adopt and follow in thecontext of various interdependent activities and actions. The rules one individual is expected tofollow influence the choices made by other individuals: like prices, rules coordinate and motivateinterdependent behavior. Furthermore, rules are generally not necessary if there are no conflicts to

Ž .resolve, and as David Hume 1751 emphasized almost two and a half centuries ago, the primarysource of conflict between individuals is scarcity. Thus, the incentives created by scarcity lead to the

Ž .rationing processes that economists study, and they also underlie the evolution of many all? rulesŽ .and institutions Commons 1924, p. 138; Benson 1994, 1998a, 1998b . Rules to coordinate competi-

Žtion over the allocation of scarce resources and the wealth produced by them e.g., to createincentives to compete through markets or through political institutions rather than through

.violence establish the obligations that underlie the property rights to those resources and theirproducts, as well as the procedures through which such property rights can be created, attenuated,and transferred. Scarcity is not the ‘‘necessary’’ condition for creating rules, however. After all,

Ž .Coase 1960 illustrates that in the absence of transactions costs, rules and institutions do notmatter from an efficiency perspective, as individuals will always bargain to achieve the most efficientallocation of resources. Of course, when transactions cost stand in the way of bargaining, theefficient allocation of resources need not arise, and since transactions costs are always positive,

Ž .rules can influence allocative efficiency if they lower or raise transactions costs.2. Note that the term ‘‘institution’’ is used in a variety of ways. For instance, Vanberg and Kerber

Ž .1994 explain that it often means a ‘‘configuration of interconnected rules,’’ or equivalently, theproperty rights arrangements established by these rules. In the presentation which follows, however,it is important to distinguish between different parts of such an ‘‘institution.’’ In particular, theprimary rules of conduct will be distinguished from the procedural rules of governance. Proceduralrules establish the mechanisms or processes that motivate individuals to recognize primary rules, as

Žwell as the means by which primary rules of conduct can be clarified perhaps through dispute.resolution and changed. Thus, the procedural rules establish the institutions of multi-party

Žgovernance. Therefore, in the following discussion, terms like ‘‘rules’’ as well as ‘‘conventions,’’.‘‘norms,’’ ‘‘customs,’’ ‘‘laws,’’ and ‘‘codes’’ will refer to primary rules while ‘‘institutions’’ will

typically refer to the process constituted by the procedural rules of governance.3. In this context, the law and economics literature on contracts and contract enforcement has focused

Ž .almost exclusively on judicial adjudication Rubin 1995, p. 113 , despite the facts that the vast


majority of contract disputes are settled through negotiation, perhaps with a mediator’s assistance,and that unsuccessful negotiation generally leads to arbitration rather than adjudication. This focus

Žmight be appropriate if court precedents and statutes as interpreted by the state’s courts as well as.court interpreted trade agreements between nations were the exclusive sources of law shaping

contracts. As explained below, however, this is not the case, at least in the area of commercialŽ .contracting Rubin 1995; Benson 1989, 1998b, 1998d, forthcoming-a .

Ž .4. Parts of this section are drawn from Benson 1998e .5. There are exceptions, however. Some state-owned enterprises are prevented by various state laws

Ž .from accepting arbitration. Thus, in his 1984 study, Bockstiegal 1984, p. 18 finds that stateënterprises in Belgium, Canada, and Denmark, Argentina, Brazil, Morocco, and Turkey seldomagree to arbitrate at the time of his study, for instance, but this may severely hinder their ability toenter into international trade. Furthermore, state enterprises do tend to press harder for using thecourts of their home state: ‘‘The position of the state enterprises seems to be a certain extentinfluenced by the position taken by the states themselves when they, for reasons of sovereignty and

Ž .national prestige, consider they should not accept foreign jurisdictions’’ Bockstiegal 1984, p. 17 .Änd when a dispute does arise, state enterprises tend to be less likely to be able to negotiate, so

Ž .third party dispute resolution becomes relatively more likely Bockstiegal 1984, p. 22 :¨

The fact that very often an amicable settlement might be more favorable in view of the expenseof a prolonged arbitration and also in view of the unknown outcome of an arbitration procedureseems to be overridden by the problems of personal responsibility within public entities be theythemselves involved in the arbitration or the controlling state enterprise. Quite often theindividuals in charge in state administration may prove less ready to take responsibility fordecisions than one might in private enterprise. The civil servants may consider it as less risky forhis own position to have to accept the final decision of an arbitral tribunal than taking uponhimself the responsibility for a certain amicable compromise and the need to convince the rest of

wthat state administration that this was a good choice . . . . Furthermore, the persons withx Žauthority to make decisions are often not fully informed by those in charge of the case whether.public officials or lawyers . The latter are tempted to give biased accounts of the arbitration

proceedings in order to protect their responsibility or to overestimate their own forensicactivities.

However, state enterprises are also slow at making the advanced payments required for arbitration tostart, they tend to slow the arbitration process itself, and they appear to be less likely to fulfill

Žarbitration awards they are clearly slower in fulfilling awards, possibly because of the morecomplicated and slower decision-making process in such enterprises or because they must get

.approval from state authorities , claiming immunity in territories outside their own state or that theyshould be excused because authorities in the state have interfered with fulfillment of the contract or

Ž .forced a breach Bockstiegal 1924, pp. 22]23, 37, 49]50 . The transactions costs of dealing with stateënterprises appear to be relatively high, suggesting that even if they can be competitive in terms of

Ž .price whether because they are technologically efficient or because they are subsidized , they are notlikely to be attractive trading partners.

6. The national legal system of the state-owned enterprises discussed in the previous endnote may bespecified in their contracts more frequently than such law is chosen in contracts between privateenterprises, since these entities tend to have stronger preferences for such law and they may also

Žhave more bargaining power than private enterprises typically do Bockstiegal 1984, pp. 17, 19, 28,¨.30 .

Ž .7. This section draws upon and extends material from Benson forthcoming-b .8. The availability of competition still varies across legal issues, however, and therefore, the character-

istics of the law should also vary. Kings and their courts have claimed the exclusive right to trycriminal cases for centuries, for instance, and modern states have retained this claim of exclusive

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enforcement. As a consequence, the criminal law process appears to be very inefficient, and manyŽof the rules applied in criminal law appear to produce very large costs relative to benefits Benson

.1998e; Rasmussen and Benson 1994 , but such rules are difficult to change once they are in placefor reasons explained below. In the area of commercial contract law, on the other hand, the

Ž .availability of alternative forums e.g., arbitration has tended to produce a much more flexible anddynamic law.

Ž .9. In this context, Oppenheimer 1908 contends that the earliest states arose as nomadic huntingandror herding communities from the relatively unfertile mountains, deserts, or sea coasts, invadedand subjugated those who had settled in fertile valleys, setting up a ‘‘protection racket’’ to extractwealth from the subjugated communities and transfer it to group with military power. Many other

Žhistorians and political theorists also characterize early states as protection rackets. See Levi 1988,. Ž . Ž .p. 110 and Benson 1999 for references. Carneiro 1970 agrees with this historical description of

early state formation but adds that successful creation of relatively permanent states of this typeoccurred where exit by those being subjugated was very difficult due to the surrounding hostile

Ž . Ž .environment e.g., deserts, mountains, other hostile communities . Also see Commons 1924, p. 136Žwho explains that the rules against which revolts arise e.g., in seventeenth and eighteenth century

.Europe and North American ‘‘originated from the principles of prerogative based on conquest,whereas the working rules . . . proposed to substitute under such names as reason, natural law,natural order and so on, had originated from the principles of custom and habit.’’

Ž10. This section draws together and expands upon material from Benson 1998a, 1998c, 1998d, 1998e,.forthcoming-a, forthcoming-b .

11. One source of customary rules can be habits or conventions developed by an individual andemulated by others. Such rules often arise as an individual attempts to economize on time and

Ž .effort required in calculating tradeoffs in similar circumstances, for instance Hayek 1973 . Theindividual chooses to use a fixed ‘‘rule-of-thumb’’ for a particular type of recurring decision. Manyof these habits or conventions are repeatedly observed by others who begin to anticipate the samebehavioral pattern under similar circumstances, and take these expectations into account in variousdecisions. Thus, the convention serves to coordinate and motivate. If this is the case, the convention

Žhas become a ‘‘rule’’ as defined in endnote 1 behavioral patterns that an individual is expected to.follow , but only for the individual who voluntarily adopts the behavior. Such rules are generally

Žself-enforced since they are adopted to achieve some particular desired end e.g., reduce decision-.making costs . An unexpected change in an individual’s conventional behavior may disappoint other

people’s expectations, of course, creating uncertainty and reducing their incentives to interact withthe individual, so there may also be some negative consequences to violating such a rule imposed byothers. These consequences are not likely to be institutionalized, however, unless the conventionhas been emulated by others so they are also expected to follow it. In this way a convention canbecome a widely followed rule of customary law for everyone in the relevant group.

12. Rules can be explicitly and voluntarily created through negotiation. However, since rules refer toŽ .expected i.e., future behavior, the implication is that rules only arise through negotiations if the

Žresulting bargain produce an explicit or implicit contract e.g., the bargain does not simply lead to.an immediate exchange with no future obligations . The resulting contractual rules only apply for

the negotiating parties and for the term of the contract. Others may voluntarily emulate thebehavior by adopting the same contract, of course, but the scope of these rules is limited by theterms of the contracts. When the contractual rule has become standard for a community, however,it is part of the group’s customary laws.

13. Another reason is that customary law is often equated to primitive law, and anthropological studiesŽ .of primitive societies often do not depict a dynamic changing law. However, as Pospisil 1971

explains, this reflects the facts that most anthropological studies of law look at a short period oftime rather than at a long history, and that most anthropologists have not been interested in theissue of legal change. In reality, legal evolution occurs even in primitive societies and it can be

Ž .detected if the researcher looks for it Pospisil 1971, Benson 1988b . However, legal change is not


necessary when conditions are not changing, and since conditions that might demand new rules orextensions of old rules arise relatively slowly and infrequently in most primitive societies, theevolution of custom also appears to be slow. One must look to a dynamic changing environmentruled by customary law, such as modern international trade, to see rapid changes in that law.

Ž .14. While customary law and contract law are typically sharply differentiated, Fuller 1981, p. 176explains that this is inappropriate. He notes, for instance, that if contingencies arise which were notexplicitly anticipated in a contract, they will generally be resolved by asking what ‘‘standardpractice’’ is with respect to similar issues. Are the parties subject to customary law, or did theytacitly agree to incorporated standard practice into the terms of the contract? Actually, contract andcustomary law often are simply different terms for the source of a particular behavioral obligation.

Ž .Indeed, Commons 1924, p. 301 correctly notes that ‘‘contracts are themselves customs.’’ Further-more, a contract may be implied entirely from the conduct of the parties, because they conductedthemselves in such a way that a tacit exchange of promises occurred. Also note that while the rulecreating roles of dispute resolution, as discussed below, and of contracting in the evolution ofcustomary law are treated separately here, they are actually tightly intertwined. For instance,contracts can be used to expand voluntary interactions beyond a close-knit group bound by strongtrust relationships, but that means that disputes requiring third party assistance may become moreprevalent. Through contracts, parties can specify that arbitration will be employed rather than more

Ž .adversarial adjudication processes i.e., public courts .15. It must be emphasized, however, that the positive incentives associated with reputation building

andror relation-specific reciprocities that arises in repeated dealings are the primary reasons forŽ .acceptance of arbitration Trakman 1983, p. 10 . Negative incentives in the form of threatened

sanctions are only relevant on those occasions when one party’s perception of the costs of anunbiased ruling are greater than these positive benefits. Of course, in another sense, reciprocitiesand reputations are valuable assets which can be threatened, and therefore, part of the privatesanctions arsenal. That is, the relative roles of the positive and negative incentives associated withreciprocities and reputations cannot be delineated.

16. A number of independent empirical studies from labor arbitration tend to verify this exchangeabil-Ž .ity hypothesis}see Benson forthcoming-a for a review and references.

17. What may appear to be a liberalization of the Paramount Lasky ruling was rendered in Sil er ¨ .Ž Ž ..New York Stock Exchange 373 U.S. 341 1963 . Enforcement of stock exchange rules by boycott was

not held to be in violation of the antitrust laws, given adequate procedural safeguards existed in theexchange’s procedures. ‘‘Yet before Sil er it was generally assumed that the antitrust laws had no

Žapplication to the private self-government scheme of the regulated exchanges’’ Landes and Posner.1979, p. 257 . The courts were granted authority to supervise arbitration by statute. They clearly

maintain the power to make rulings which could undercut an effort to supplant their authority, atleast to a degree. How successful such an effort would be depends on the transactions cost ofenforcing limits on nonlegal sanctions and the relative benefits of arbitration, given such efforts.

Ž .Arbitration developed in the U.S.. when courts were quite hostile Benson 1995a, 1998f , however,and given the high cost of using U.S. public courts today, even an outright ban on arbitration mightnot raise the price of arbitration enough to bring all business disputes into the courts.

Ž .18. This section combines and expands upon material from Benson 1998d, forthcoming-b .19. The incentives to recognize rules of obligation arose, in part, from the mutual gains generated by

Ždeveloping repeated exchange relationships within international merchant ‘‘communities’’ Benson. Ž .1989 . Furthermore, each merchant had dealings entered into many games with different mer-

chants. The spread of information, primarily through word of mouth, about fraud, or other breachesof widely held rules of conduct within one exchange could affect a merchant’s reputation and limit

Ž .his ability to enter into other exchanges Benson 1989, 1998e; Milgrom et al. 1990 . Thus, the LawMerchant was ultimately backed by the threat of ostracism by the relevant merchant community.

ŽNevertheless, this boycott sanction, while a real threat, was not often required Trakman 1983, p..10 : ‘‘Good faith was the essence of the mercantile agreement. Reciprocity and the threat of

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business sanctions compelled performance. The ordinary undertakings of merchants were bindingbecause they were ‘intended’ to be binding, not because any law compelled such performance.’’

Ž20. Parts of this section draw together and expand upon material from Benson 1995a, 1998a, 1998f,.forthcoming-a .

Ž .21. See Benson 1995a, 1998f for evidence and references.Ž .22. See Benson 1995a, 1998f for evidence and references.

23. Many lawyers clearly recognized that they would benefit if the incentives to use arbitration weresomehow reduced, for instance, so that commercial disputes could be shifted back to the publiccourts, just as English kings and judges had benefitted centuries earlier. The 1919 meeting of theNew York Bar Association involved a vigorous debate over general arbitration clauses, for example,with many lawyers arguing that such clauses should be illegal, supposedly because they requiredbusinessmen to sign away their right to a fair trial. The real fear, that arbitration clausessignificantly reduced lawyer’s business, was explicitly stated by many Association members, however,

Ž .and ‘‘echoed throughout the arbitration debate’’ Auerbach 1983, pp. 105]106 .Ž .24. Also see Bernstein 1992, p. 156 for related discussion about the growing use of lawyers in diamond

industry arbitration.Ž .25. See Bernstein 1992, p. 156 , for instance.

26. One reason for this is the threat to businessmen posed by organized crime in Russia, of course, asŽ .Dempsey and Lukas 1998, p. 471 suggest. However, organized crime can also be a source of

Ž .contract enforcement and protection of property rights Pejovich 1995 . In this regard, PejovichŽ .1995, p. 24 even suggests that ‘‘the mafia might end up doing more for Russian people than theircurrent government.’’ This may not be incorrect since one of the major threats to business can be

Ž .the state, and the mafia can be seen as a competitive alternative to the state Gambetta 1983 . Thus,for instance, many Russian businesses turn to mafia groups to evade excessively high taxes and

Ž .overly restrictive regulations Dempsey and Lukas 1998, p. 471 .27. In the United States, for instance, it appears that the increased uncertainty about the way the

government might treat the property rights and contractual promises of businessmen in the lateŽnineteenth century actually stimulated more rapid expansion in the use of arbitration Auerbach

.1983; Benson 1995a, 1998f .28. The Hungarian Chamber of Commerce now offers domestic arbitration services by either domestic

or foreign arbitrators, for instance, and such arbitration is proving to be attractive for proceduralreasons as it is substantially faster and easier than litigation in the Hungarian courts, and it can be

Ž .private Jankovich 1996, p. 539 . This formal arrangement reflects the fact that a recent amendmentto the Hungarian civil code sanctions arbitration for disputes between Hungarian citizens. Prior to

Žthis, only arbitration involving foreigners were sanctioned Hungary is a party to the 1958 New York.Convention and the 1961 European Convention , and only for ‘‘disputes arising out of legal

relationships, whether contractual or otherwise, which are considered to be ‘commercial’ underŽ .xHungarian law’’ Jankovich 1996, pp. 538]539 . Hungarian law also defined some procedural rules

for arbitration, however. In this light, such sanctions and procedural requirements could producethe same sorts of impacts on HCC arbitration as have occurred with AAA arbitration in the UnitedStates: involvement of lawyers, and relatively high levels of appeal. Such arbitration may prove to bean attractive procedural option, and therefore generate considerable benefits over the short term.To the degree that judges and legislators are in a position to mandate that rulings comply with thestate’s substantive rules because they are providing relevant sanctions, however, arbitration will notserve as a mechanism for jurisdictional choice. Perhaps because of these factors, some groups inHungary apparently have agreed to take all disputes to an international arbitration tribunal in

ŽGeneva this information was related to me by a researcher who had recently spent several months.in Hungary observing the activities of such informal groups .

29. See endnotes 5 and 6.30. See endnote 28.


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to arbitrate or to litigate: that is the question

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