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Contract law: some background

19 January, 2016 - 12:53

Before we launch into the main body of the unit, we will begin by thinking about contract law and its role in the market economy.

Contracts are at the core of the market economy. The reason for this is clear: business transactions are premised upon contractual relationships. The enforceability of contracts is a key to economic development. The market economy mechanism relies on the combined usage of capital and credit. The implementation of credit sales is effected by the contract law system. The fact that contracts are enforceable in a court of law makes credit sales possible. This unit will examine the background of the contract law system. One aspect we will not cover, however, is how different kinds of contractual arrangements affect transaction costs. This is a topic for the economists, and is out of the scope of this course.

As we think about the significance of contract law, it may be useful to consult the work of some well-known scholars. The first of these is the sociologist Max Weber.

Figure 1.1 Max Weber

According to Weber, one of the major characteristics of modern society is the process of rationalization. In other words, a task is achieved through a process broken down into a number of distinct and highly specialized rules. These rules are measured in terms of precise figures. Abstract adjectives such as ‘basic’ or ‘good’ are not helpful to rationalization.

To take an example, in modern accounting there is a process of breaking down accounts into balance sheets as well as profit and loss accounts. As a result of this process, the financial status of an enterprise can be expressed in terms of its assets and liabilities as well as profitability. This process is analogous to the use of contracts. Contracts are a rational means for managing future events. The breaking down of information into detailed clauses in a contract enables large-scale transactions to be made. 

This explains why contracts occupy a prominent role as the infrastructure for the development of modern market economy. Some economists (for example, Cheung 1983) view the institution of ‘company’ or ‘corporation’ as a series of contractual arrangements.

By now, you may be under the impression that in modern society, commercial transactions are all based on contracts. Have contractual arrangements replaced the system of relationships based on personal connections and trust?

To answer this question, let’s turn to another scholar, Stewart Macaulay. Macaulay, an American jurist, reminds us that the reality may be more complicated. In his essay, ‘Non-contractual relations in business: a preliminary study’, he reveals that in the 1950s, many business activities carried out in the US were non-contractually based. At that time, 75% of commercial disputes in the US were resolved through arbitration settlements (Bruce 1989, 644–61).

Later, Macneil, another American jurist, also pointed out in his work The New Social Contract (1981) that a majority of US commercial transactions were not transacted through discrete contracts between strangers, but rather through established relationships. He referred to these relationships as ‘relational contracts.’

Avner Greif, an economist, made a historical study of the pre-modern European economy. He found that in the absence of a contract enforcement system, there was inter-community, impersonal exchange from as early as the 12th century in Europe, under an institution called the Community Responsibility System. Under this system, traders would belong to particular groups based on their social affiliation. Within these groups, contracts were often made and signed in the presence of witnesses. These groups also had the ability to impose sanctions on individual members. This guaranteed the fulfilment of the contractual obligations and promoted the economic development of credit transactions.

As we examine the findings of the scholars mentioned above, one thing is clear. In any society, interpersonal relationships are an important factor in commercial practice. In a long-term cooperative relationship between two commercial entities, if one party commits a breach, the other party may not hastily opt to resolve the dispute through litigation. The use of contracts is premised on the assumption that the other side is not completely reliable, for otherwise the contract becomes irrelevant in the commercial transaction.

Activity 1.1

Imagine that you own a company and so does John, your friend. Your company has a long business relationship with John’s company and both companies just carry out their respective obligations without entering into any contract. This time, you intend to make a transaction with John’s company involving a large sum of money, and you wish to make a contract. In response, John says that it is a waste of time to draft any contract, as all along the parties have been dealing with each other based on personal trust and relationship. How would you respond to John’s proposal?

Let’s now take a brief look through history at the strategies used for resolving business disputes in the past. This can help us understand the evolution of contract law. We will have a more thorough study of the historical development of contract law in the next section.

In the early stages of Western legal history, business disputes were resolved through specialized tribunals for merchants, and there was a time when courts of law competed with these tribunals. In England, the historical origin of many legal principles applicable to the sale of goods and negotiable instruments was ‘the law merchant’ (or lex mercatoria, to give it its Latin name). Towards the end of the Middle Ages, Italian merchants were influential, and the rules based on mercantile usage were better developed than those in England, which was relatively backward in terms of developing the legal framework for regulating commercial activities. The primary objective of the merchant rules developed in continental Europe was to ensure commercial disputes could be resolved expeditiously. In the early days of English trade, only smaller local commercial disputes were submitted to local courts in England, which dealt with them largely within the framework of the common law (Goode 2004, 5). Disputes involving transactions of a larger scale were submitted to the central courts, which were prepared to give decisions in accordance with the law merchant. In the early 17th century, common law judges gradually borrowed rules developed in the law merchant and integrated them into the common law as they became more experienced in handling such cases. By the 19th century, the law merchant was almost fully absorbed into the common law.

In the US, merchants had tried to avoid the time-consuming court procedures for resolving commercial disputes until the end of the 18th century. Similar to the situation in England, the outcome of the competition between courts of law and merchants’ tribunals was that the customs of merchants were absorbed by judges and integrated into the common law.

The experience in Western jurisdictions shows that merchants’ concern about their goodwill and long-term reputation, rather than the effectiveness of the court system, is probably the biggest driving force behind the enforceability of contracts. In China, however, business ethics have yet to be cultivated. The deterrent force of peer pressure on contract breakers remains to be seen. Coupled with the immature system of the enforcement of court judgments, it is hardly surprising that many commercial disputes in China are resolved by non-legal means.

In the next section of the unit, you will find out more about the key milestones in the historical development of Chinese contract law.