Peter Lewisch, Associate Professor of Constitutional and Criminal Law, University of Vienna
CONSTITUTIONAL ECONOMICS AND CHOICE OF LAW1
The concept of federal competition has proven a powerful analytical tool to explain the relations between and the development of alternative legal systems. Whereas legislators may enjoy, within the boundaries of their jurisdiction, a national or regional monopoly in the production and administration of legal rules, these regional monopolies find themselves in competition with each other provided for (free) entry and exit of the individuals/firms concerned: Being contestable to a "voting by feet" in a broad sense by these individuals/firms, it is in the self interest of nation states to modify and improve their legal institutions to ensure their attractiveness within this competitive process.
Despite the general interest in the literature for issues of federal competition, little attention has been devoted to an economic analysis of "Choice of Law". This paper attempts to provide such an analysis from a constitutional economics viewpoint. It discusses the choices of law which individuals perform when drafting a contract. This consensual choice of law concerns both the choice of contract law in international cross-border business and the choice of procedural law in national and international transactions.2 The paper, first (section II), explains the existing legal framework of these choices, proposes (section III) an interpretation of these contractual choices as an exchange of constraints and, in its main part (section IV), discusses the effects of these choices on the states as the national monopolies of law production and enforcement.
II. THE INSTITUTIONAL FRAMEWORK
1. Choice of contract law in international transactions
In a purely national context, the contracting parties are, by and large, limited to the national laws applicable at the specific geographical location. If A and B agree on the sale/purchase of A’s pen in Austria, Austrian contract law applies; if the same contract is performed in Virginia, the contract law of Virginia (US law) governs this agreement. Whereas the contracting parties may modify (or "fine tune") provisions of the thus determined national contract law by means of the specific contractual provisions agreed upon, the national law remains the relevant institutional framework for all contractual rights and obligations: On the one hand, the pertinent contract law supplements these agreements which, due to the cost involved in designing legal remedies for each and every contingency, are regularly incomplete. On the other hand, the national contract law regularly provides a set of "non derogable" constraints in terms of mandatory rules that individuals are, even by mutual consent, unable to modify.
Regarding international transactions, the institutional framework is different. The laws of conflict (i.e. the international private law) of practically all countries acknowledge the principle of free choice of contract law.3 This means: If the sale of the above mentioned pen is performed between an Austrian and a US (Virginia) resident, the contracting parties may choose the contract law either of Austria or of Virginia, or of any other third country; the parties may even agree to combine in their contract the laws of several different countries. This feasibility of free choice of law, and this is the crucial point, holds also true with respect to mandatory national contract law. Hence, if the contract law of either Austria or Virginia or even of both countries contained a mandatory provision banning a certain contractual arrangement, the parties would be free to choose the laws of a third country that would not provide for a similar constraint.
2. Choice of procedural law
Procedural law is commonly considered a part of a country’s "public law"; its character, hence, is mandatory. The parties have to accept the pertinent procedural laws as they exist in a certain jurisdiction without, again by and large, any modification of these legal rules being possible. Closer observation, however, reveals that choice of law still remains possible in some meaningful sense: On the one hand, the parties may choose the venue of their litigation and determine thereby, in an international context, also the applicable procedural law. On the other hand, the parties may, in most (also purely national) cases, submit to the jurisdiction of arbitrational tribunals. In doing so, the parties may choose among a variety of institutional arbitrational tribunals available. This choice depends on the relative attractiveness of the said tribunals. Moreover, most legal systems acknowledge the parties’ right to opt out of the regular court system and to submit their cases (both international and national) to an "ad hoc tribunal" to be established for the particular case: Since national laws provide only a very rough legal framework with respect to the operation of these ad hoc arbitrational tribunals, the parties are basically free to effectively determine, by their contractual arrangement, those procedural rules that govern the respective procedure.
III. CONTRACTUAL CHOICE OF LAW AS AN EXCHANGE OF CONSTRAINTS
In a constitutional economics perspective, any contract can be seen as an exchange of constraints4. Contractual obligations as such are a "bad", and the individual contracting party is unlikely to accept these constraints on her own side, unless the other side agrees to accept reciprocal (though not necessarily identical) contractual constraints in exchange. Whereas in the "classic" case of a barter exchange of apples and oranges individuals perform their choices on the "action level" under the already given framework of existing legal rules (regularly the applicable national contract law), the parties may modify and alter these legal rules (on the "rule level") when drafting an agreement. In doing so, the law itself becomes the object of choice in a twofold manner. First, when negotiating an agreement, individuals exchange constraints on the "contractual level", i.e. by trading rights and obligations in terms of contractual clauses. Second, in international transactions, choice of law is also feasible with respect to the legal "meta level" (the "constitutional level"), i.e. the level of the contract law itself: Individuals agree upon that legal framework under which they wish to enter into a contract. A similar choice of law is also feasible regarding the above mentioned aspects of procedural law. In the case of arbitration (more precisely the case of ad hoc arbitrational tribunals) the parties may even determine by their agreement (on the "meta level") the rules governing the procedure of their case.
A Coasian perspective, moreover, shows that the original assignment of contractual rights under the applicable legal framework (e.g. the provisions under the applicable national contract law, as determined by the pertinent international private law) does not alter outcomes: The contracting parties may either "trade away" liability clauses originally provided by the pertinent legislation or, in the inverse constellation (if some such clause is not provided by the applicable contract law) incorporate the clause in their agreement as a contractual provision. Similarly, in international transactions, individuals may end up with the same contract law, irrespective of whether the laws of country A or B have been initially assigned under the applicable rules of international private law.
One has to keep in mind this "contractual nature" of choice of law when we turn to issues of federal competition in the following section. Whereas individual choices in these competitive environments are commonly considered "autonomous" (the individual decisionmaker selects the most preferred institution environment out of a bundle of alternative legal systems), contractual choice of law is – by its very nature – consensual. The contracting parties agree on a certain law; these consensual choices, however, depend on the contracting parties’ evaluation of the institutional arrangements available.
IV. FEDERAL COMPETITION
1. The analytical starting point
a. The concept of "federal competition", originally developed to explain the loss of influence of the national state monopoly in terms of the power to tax, has been extended to all fields of regulatory policy.5 Whereas "institutional competition" understood in a broad sense has always been with us, its degree and effectiveness is not exogenously given, but depends on the pertinent constitutional infrastructure; an infrastructure which determines the relevant costs of "exit" and "entry" (see, e.g. the example of the European Union).6 The said institutional competition reduces the discretionary power of decision-makers (politicians) in terms of undesired heavy regulatory pressure and, in quite general terms, contributes to a convergence of the institutional environment with the preferences of the relevant population.7 Since countries can benefit economically from luring factors into their jurisdiction, these countries have a clear incentive to effectively utilize this potential by offering a superior institutional framework. Individuals may "vote by their feet" and move either themselves or capital to their most preferred jurisdiction. As a result, national legislators will, driven by their self interest, compete in offering favorable rules and institutions, i.e. an attractive legal infrastructure, to mobile factors.
b. With respect to genuine legal competition, contributions in the literature8 tend to offer explanations along similar lines: In the famous debate on competition in the area of US company law (the "Delaware case"), the underlying economic structure is such that, first, "the objective of states is revenue maximisation, which is thought to depend directly upon the volume of domestic incorporations".9 Second, the companies concerned also face a competitive pressure that forces them to choose what they consider the most efficient company law and to react to changes in the institutional arrangements available. The economic mechanism that makes this competition work is, hence, twofold: Selective incentives "to go for efficient legislation" exist both for the national law maker and for the management of the companies concerned.
Let us turn now to a discussion of the "choice of law" with respect to contract law and procedural law.
2. Choice of Contract Law
a. In international transactions the contracting parties may, as shown above, avoid the otherwise prevailing mandatory law by deliberate choice of the applicable contract law.10 What are the implications of this legal framework in terms of institutional competition? It is not that mandatory provisions lose their "non derogable" nature in international transactions, but it is the entire – otherwise applicable – national contract law that in itself becomes the object of choice. Since the contracting parties are free to choose among the contract laws of any country, they can effectively opt out of otherwise prevailing mandatory constraints. The parties may, therefore, pick their preferred contract law among the variety of possible contract laws, as offered by the respective national monopolies of law production. The possibility of this free choice of law, therefore, leads to a delegation of power downwards. The thus created institutional system is one of federal competition; or so it seems.
b. Closer analysis, however, reveals that the case of "choice of contract law" differs decisively from the above mentioned "classic" cases of legal competition. The driving force for institutional competition to work in the above cases is the co-existence of selective incentives both for the respective regional monopolies of power (i.e. the states) and for the individuals/firms concerned. In contrast, in the case of contract law selective incentives only exist for the contracting parties, not for the legislators.
Let us consider first the choice of contract law in the perspective of the contracting parties: Similarly to the above "competition cases", the contracting parties benefit from choosing the (in their own evaluation) best contract law. In this respect, national contract laws, as seen from the individuals’ perspective, are in competition with each other concerning the quality of their provisions (i.e. the rules that govern effectiveness, contractual remedies such as mistake or deceit, rules of interpretation and, in particular, the mandatory provisions contained therein). The contracting parties, therefore, face positive incentives to choose, by their consent, among this bundle of alternative legal arrangements their most preferred legal infrastructure. Insofar a delegation of power downwards actually takes place.
However, no selective incentives prevail for the legislators (i.e. the national law producers) in terms of the attractiveness of their national contract law vis-à-vis "competitors". Each national legislator, to be sure, has a self interest to provide for its territory a reliable and efficient legal infrastructure (embodying "social capital") without comparative disadvantages to alternative monopolies of law. Regularly, the national legislator derives benefits from this institutional competitiveness in terms of increased business on its territory (and, therefore, tax revenues). Quite in contrast, the national legislator does not derive selective benefits from being the preferred choice with respect to its contract law in international agreements. In particular, the national legislator is unable to collect revenues in any broad sense from such choice. In essence, a country’s contract law is a purely public good. Contract law, as provided by a national legislator, is non-rival in consumption: If, therefore, parties in an international contract choose the contract law of country X, this choice does not affect the choice of any other potential contract party. And once provided, exclusion of non-contributors is not feasible. Differently to the case of "registration" of companies under the laws of Delaware, countries are unable to attract "business" to their jurisdiction by offering a favorable contract law: With respect to the choice of contract law individuals need not migrate; nor is any other factor mobility required. Hence, countries cannot derive any particular monetary benefit (royalties, fees, etc.) from the fact that its laws are preferably chosen in international contracts. Consequently, no competitive pressure exits for a certain country with respect to international transactions to adapt and modify its own contract law in order to be an attractive candidate for the contractual parties’ choice of law.
3. Choice of Procedural Law
a. As regards procedural law, the underlying economic structure seems, at least at first glance, to match the standard formate of institutional competition: Whereas nation states hold a legal monopoly in the production and administration of (national) procedural law, the parties concerned may, by their deliberate choice of venue, opt out of these jurisdictions and submit their case to a court in some other country and, thereby, to a foreign procedural law. In this sense, litigants may vote with their feet. Moreover, selective incentives seem to exist both on the level of the parties concerned and the respective national legislators: In their choices, the parties will be guided by their self interest to submit their cases to the institutional umbrella of that procedural law which they consider efficient. Moreover, direct incentives seem also to exist on the side of the nation states: Since the parties have, for purposes of conducting a legal case, to physically "bring" this legal dispute to the jurisdiction chosen, the respective nation state may be in a position to derive direct economic benefits from such choice, say in terms of court fees collected.
b. Such conclusion, however, would be premature. Practically all western states effectively subsidize their civil court system and they do so in order to encourage litigation that produces, at private cost, the public good of court rulings that clarify previously ambiguous legal rules.11 It follows, however, that the litigants conducting a civil procedure before a state court pay court fees below the actual costs of the hearing or such a legal case. Provided for this "cost side of the coin", the states concerned do not have an incentive to lure in foreign "business" in terms of international litigation to their state courts if this business is unlikely to contribute to a clarification of previously ambiguous relevant legal rules: Such would be the case if two Japanese firms with no relation to Austria whatsoever submit their case to the jurisdiction of the commercial court in Vienna. Seen from the perspective of the Austrian legislator (tax payer), such litigation would simply loose money without providing any public good; it would, therefore, "free ride" on the national court system. Far from attracting "foreign litigation", nation states have, therefore, tried to "protect" themselves, by means of specific rules on "international jurisdiction", against a contractual choice of venue by foreign parties with no linkage whatsoever to the jurisdiction chosen.12
Second, and even worse: If foreigners would be free to submit their cases to the courts of any legal system, they could, by such choice, deteriorate the efficiency of such a court system. A given number of judges would have to deal with an increased number of cases. Consequently, law makers will be reluctant to see their national courts being congested by foreigners and will even implement legal devices to hinder or at least limit such procedural choice. This prediction is mirrored by the respective legal rules actually in operation in most western countries.13
c. The above analysis has illustrated that institutional competition would be, in principle, effective also in the realm of procedural law, but that nation states protect themselves by deliberately designed institutional devices against being the "preferred choice" in a potentially competitive environment. Since the economic reasons for this "protection" consists in the state subsidies for the national court system and the interests in avoiding congestion due to additional "international litigation", theory predicts that institutional competition is likely to work in the absence of these institutional properties. Let us, therefore, turn to legal competition among (international) institutional arbitrational tribunals (say, Chamber of Commerce/Paris, London, Stockholm, Vienna, Moscow). The situation regarding these arbitrational tribunals is just the opposite of state courts: Arbitrational tribunals, first, charge fees that do cover full costs plus a certain mark-up for the arbitrational centre itself. Second, due to the institutional reasons, no congestion of the arbitrational tribunal is possible: Each arbitrational centre maintains a "secretary general", which does neither hear nor decide individual cases. Instead, arbitrational tribunals are "demand dependent". Each tribunal is established by the secretary general, at the occasion of an individual complaint, for the particular event: There exist, therefore, as many individual tribunals as there are cases. As indicated by the above analysis, competition among these commercial arbitrational centres is real and effective: These centers regularly review their fees, and more interesting, their own procedural rules in comparison with those of alternative comparable centres in order to secure institutional attractiveness. This institutional legal competition has lead, again as predicted by theory, to a remarkable empirical convergence of the relevant procedural rules.14
d. Competition of arbitrational tribunals does also exist in a further respect: The "quality" of the particular tribunal is the result of two factors; first, as mentioned, of the relevant procedural rules, and second, of the quality of the judges (arbitrators) in charge. Arbitrational centres, to be sure, do have only a limited influence on these arbitrators: they are selected primarily by the parties themselves, who, by their deliberate choice, also influence the quality of the panel in charge. Still, the arbitrational centres do have a certain, albeit limited, role in the appointment of arbitrators: in around 1/10 of all cases, parties fail to nominate arbitrators or (in case of a panel of their arbitrators) the two arbitrators appointed by the parties fail to agree on their chairman. In such a case the secretary general of the arbitrational centre is competent to appoint the thus missing arbitrator from the "list of arbitrators" furnished by the arbitrational centre itself. This "list of arbitrations" is, hence, an important "business card" of each arbitrational centre and there exists, also empirically, a certain competitive pressure for an "attractive list"15.
This paper discusses the choice both of contract law in international cross-border transactions and of procedural law. The paper shows that, differently to the "classic" cases of federal competition, the competitive process is unlikely to work in the same manner in these two constellations. Whereas in the case of international choice of contract law the contracting parties face incentives to choose what they consider the most efficient contract law out of a bundle of alternative legal systems, no comparable incentives prevail for the national legislators to provide an efficient legislation for these choices: The provision of contract law is a public good and the respective nation state cannot derive any direct or indirect business from being the "first" choice of law in international contracts. As regards procedural law, the contracting parties would choose the most attractive venue of litigation. Since, however, nation states regularly subsidize their court system, they implement legal devices to hinder the access of foreign litigation to national courts; litigation that would both freeride on the national court system and congest it by additional litigation. In the area of arbitrational tribunals, these effects are not present: Competition among arbitrational tribunals is real and efficient and has contributed to a remarkable convergence of the respective procedural rules.
1I herewith extend my cordial birthday wishes to Prof. Buchanan from whom I have learned more about the legal and constitutional order than in many years at the law school. I am grateful for his support since my first visit to the Public Choice Center in 1990.
2For an economic discussion of some aspects of choice of contract law, see e.g. Ribstein, "Choosing Law by Contract", Journal of Corporation Law 18 (1993), 245 and Lewisch, "Choice of Law", in Essays in Law and Economics IV, eds Ott and von Wagenheim (1998), 271.
3If no explicit or implicit choice is made, the laws of conflict of most countries are governed by the principle that international contracts shall be governed by the laws of the side providing the "characteristic service".
4See in particular, Buchanan, "The limits of liberty" (1975); Brennan and Buchanan, "The Reason of Rules" (1985).
5See Tiebout, "Pure Theory of Local Expenditures", Journal of Political Economy 64 (1956), 416; Brennan and Buchanan, The Power to Tax (1980); For an extensive treatment of the subject, see now the contributions in Jahrbuch für Neue Politische Ökonomie 17, eds Schenk, Schmidtchen, Streit and Vanberg (1998).
6See e.g. Bureau and Champsaur, "European Economic Integration: Where do we stand?", American Economic Review, Papers and Proceedings 82 (1992), 88; further Frey and Eichenberger, "The New Democratic Federalism for Europe" (forthcoming).
7See in particular Vanberg, "Globalization, Democracy and Citizen Sovereignity: Can Competition among Governments Enhance Democracy? Paper presented at the 1999 Annual Meeting of the European Public Choice Society, Lisbon, 7.-10. April 1999.
8Romano, "Law as a Product: Some Pieces of the Incorporation Puzzle", Journal of Law, Economics, and Organisation 1 (1985), 225.
9Romano, op. cit., p. 228.
10See e.g. Kieninger, "Kommentar" zu "Grenzen des institutionellen Wettbewerbs", in Jahrbuch für Politische Ökonomie 17 (1998), p. 338.
11See e.g. Schäfer, "Kein Geld für die Justiz – Was ist uns der Rechtsfriede wert?", in eds Austrian Ministry of Justice, Lewisch and Rechberger, "100 Jahre ZPO" (1998), 251 and Lewisch, "Der Zivilprozeß: Soziales Übel oder soziale Wohltat?", op. cit., p 97.
12This has been, for example, the Austrian policy to block foreign litigation with no connection to Austria before Austrian courts that have enjoyed and still enjoy reputation of being efficient. Leading cases have been the mentioned Japanese lawsuits in Vienna. By now, this policy is – at least vis-á-vis "EU foreigners" - no more feasible"; the latter development is in line with the general economic analysis as provided by Buchanan and Congleton, Politics by Principle, not Interest (1998) p. 137.
13See footnote 12.
14For a comparison of these procedural rules as they currently exist, see Simpson/Thacher/Bartlett, (eds), A Chart Comparing International Commercial Arbitration Rules (1998).
15Competition also exists regarding the market for arbitrators itself: Their performance is guided, in the first place, by the intense competition among all those specialists offering their services as arbitrators. The same type of competition among arbitrators is also present in the area of purely national legal conflicts and ad hoc tribunals. For an economic perspective on private judges, see Cooter, "The Objectives of Public and Private Judges", Public Choice 41 (1983), 107.