September 06, 2012
My colleague, Alan Morrison (pictured), is keeping us up-to-date on the news from the world of the cotton trade. We posted on Monday about a Wall Street Journal article about an epidemic of broken contracts affecting the cotton trade. On Tuesday, the WSJ published this follow-up story.
In our last post on the subject, we suggested that it was irrational for parties to breach the contracts at issue because contracts law damages are created to eliminate any economic incentive to do so. We noted that the best explanation for why parties might nonetheless breach is a faulty enforcement mechanism. In this case, the problem is that the arbitral body associated with the International Cotton Association (ICA) is unable to enforce its awards in all cases.
On Tuesday, the WSJ reported that the ICA is now cracking down on parties that do not pay the arbitral body's judgments. Currently, such parties are placed on a "default list," warning other parties that these are entities that may not abide by their contractual obligations. However, the default list has been ineffective because a lot of entities in the trade continue to do business with entities on the default list. In addition, entities evade the consequences of their prior defaults by reorganizing their businesses or renaming them.
According to the WSJ, the ICA has set up a task force of investigators to try to establish connections between entities on the default list and new entities that are carrying on the defaulters' businesses under new names. Other possible solutions include new insurance vehicles to protect traders in the event of defaults or increased transparency in the arbitration process. Currently (and rather shockingly), the ICA provides only aggregate data about the number of cases and total awards. It also discloses default lists.
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"In our last post on the subject, we suggested that it was irrational for parties to breach the contracts at issue because contracts law damages are created to eliminate any economic incentive to do so. We noted that the best explanation for why parties might nonetheless breach is a faulty enforcement mechanism."
Another hypothesis: if the cotton market is hot (and it sure looks to be), buyers may be less willing to sue (and alienate) sellers because (1) they need to buy from them again [the second article says that some cotton buyers are knowingly doing business with blacklisted sellers] and (2) they can get a better rate of return by moving forward and doing more cotton business than by investing in litigation. Lawyers ain't cheap, and this of course distorts the incentive effects of contract damages. Even where losers pay the winners legal costs, the plaintiff has to take an initial risky investment in litigation.
Posted by: Tom Joo | Sep 7, 2012 8:48:26 AM
All excellent points, Tom. Still, if parties value their long-term relationships more than their contract prices, why do they enter into fixed-price contracts rather than contracts providing that buyer will pay the market price at the time of sale?
Posted by: Jeremy Telman | Sep 8, 2012 8:42:44 AM