The Chronicles of a Capitalist Lawyer: Contract Law

Showing posts with label Contract Law. Show all posts

Today, I attended a very interesting Law and Economics Workshop at the University of Chicago Law School on Market for Gem. In his paper, the author argued that the Market for Gem is an reversal of the Market for Lemon. Market for Lemon is a market where, due to information asymmetry between buyers and sellers where sellers have better information than the buyer, the high quality products will be driven out from the market, leaving the market only with low quality products. A good example of this type of market is the market for used cars.

On the other hand, according to the author, the Market for Gem can be described as a market where, due to information asymmetry between buyers and sellers where buyers have better information than the seller, the low quality products will be driven out from the market, leaving the market only with high quality products. At a glance, this seems odd, won't an efficient market produce the same thing, i.e. low quality products will be kicked out from the competition by better products? Apparently not. The Market for Gem is applicable to a situation where low price products that can actually be purchased by certain type of buyers are not being sold because the seller does not know the quality of his own products and therefore he does not have incentives to sell the good products.

The author provides a nice model to show his argument. But that would be too complicated to be described in a blog, so instead, let me show you a simple example. Suppose you have three bracelets, one from pure gold, and two are fake golds. Let us assume that each of them is crafted masterfully so that unless you are an expert, you are completely unable to differentiate the bracelets. Suppose that the market price of the pure gold bracelet is US$5,000, while the fake gold bracelet is US$50. What would be your selling strategy?

You can sell each of the bracelets by using the average price, i.e. US$1,700. But once you disclose the fact to the buyer that two of the bracelets are fake, inexperienced buyers who wish only to buy the fake bracelet will refuse to buy since they only expect to pay around US$50. Meanwhile, experienced buyers will choose to buy only the pure gold bracelet since the price is lower than the market price. But in that case, you will lose money, since you sell a US$5,000 product with a price of US$1,700 and you will be left with the fake bracelets.

In the end, you will only have two strategies, either you sell the bracelets as a bundle, meaning that the buyers must buy all of the bracelets (denying the chance of buyers of fake gold bracelets to buy the cheaper products). Or you will price each of the bracelets using the price of the pure gold bracelet, hoping that an expert buyer will come and buy it. According to the author, there is a social loss in this case, since people are being deprived from their rights to buy the products with the lower price.

The author then provides some ideas on how the law can help to solve this issue, such as by imposing a mandatory disclosure rule for buyers who have the expertise on matters related to the products so that the seller can make an informed decision. Unfortunately, I believe this become the downfall of the paper. The basic problem of this paper is because the author tried so hard in his model to show that Market of Gem is truly an inverse version of the Market for Lemon. While it is true that the basic problem in both markets is same, i.e. information asymmetry, the causes are completely different.

The information asymmetry in the Market for Lemon is mainly caused by usage of the products, while the information asymmetry in the Market for Gem is caused by difference of level of expertise, meaning that buyers in such market are having an informational advantage because of their own expertise gained from investment of their own time and money. To the extent that the buyers gain such expertise without any illegal measures, requiring them to disclose their advantages would be similar to punish people for their own good efforts. This would give bad incentives for people who have worked hard for acquiring such expertise.

A good example would be insider trading cases in capital market transaction where buyers of shares would only be punished if it can be proven that they gained their insider information through illegal measures, e.g. breach of confidentiality duty, abuse of power/authorities, etc. But for buyers who gained their material information from their own research and perseverance, there would be no reason to punish them if they fail to disclose such information to the seller and gain a considerable amount of profit that can be enjoyed by the seller if only the seller knew the existence of such information.

Furthermore, in the Market for Lemon, we do not want people who know that there are defects in their good to sell their products without disclosing such information to the buyer because it would not be efficient if people are being asked to accept bad products without having any recourse to the sellers. In simple mathematical formula, the buyer values the products in P, the seller knew exactly that the value is actually P - x. Of course it would not be fair for the buyer to pay P for a product whose value is less than P.

Meanwhile, in the Market for Gem, the Seller's valuation of the product is P, and the Buyer's valuation is P + x. From any point of view, it is an efficient transaction. In fact in any case, buyers only buy a product from the sellers because the buyer value the products more than the seller. If not, there would be no transaction in the first place. The actual problem with the Market for Gem is that we have to admit now that there should be an objective valuation outside the valuation of sellers and buyers over an asset in order to help the seller in making the right decision. I think this is ridiculous.

I would be very careful in using legal solution in solving the problem of the Market for Gem. After all, we encourage people to do their own research in order to reduce the information asymmetry and therefore we hope that a better and more efficient market can be created. If the problem is on the level of expertise, rather than asking the buyer to inform their knowledge to the seller, why don’t we instead give incentives to the seller to gain the necessary expertise? Returning to the basic principle that we desire good quality products in the market, if the seller does not even know the quality of his own product, he should not try to sell his products in the first place.

Moreover, we also need to assess the actual damages caused by the existence of Market for Gem to the welfare of the society. If the products involved within such market are trivial, maybe we don't need any new duty or obligation. In fact, basic contract law have already provided a solution for this problem. While the buyer does not have any legal obligation to disclose what he really knows about the relevant product, the seller can always ask the buyer to give a representation that he does not know at all about the product. If it turns out that the buyer lied, the seller can simply bringing a suit for breach of representation by the buyer. If the buyer refuses to give the representation, that can be used as a signal by the seller that the buyer really knows something that the seller doesn't know. In any way, it is still a very interesting paper and hopefully we can see the updated version of this idea soon.

I have discussed Law No. 24/2009 on National Flag, Language, Emblem and Anthem ("Law 24/2009”) in my post dated 27 August 2009. However, I feel that my analysis on the issues related to this Law 24/2009 is not complete, I am not satisfied with the legal analysis in my previous post and in practice, the impact of this Law is greater than I've ever thought to be. Thus, I believe that I must revisit the issues on Law 24/2009 and provide a deeper analysis in this blog.

Our main issue revolves around Article 31 of Law 24/2009. The first paragraph of this Article requires the use of Indonesian language in agreements involving state institutions, Indonesian government authorities, Indonesian private institutions or Indonesian individuals. The elucidation of Article 31 paragraph 1 states that an agreement in this context includes international agreements made within the framework of public international law.

Article 31 paragraph 2 of Law 24/2009 further states that if the agreements involve foreign parties, the national language of those foreign parties and/or the English language can also be used. Furthermore, the elucidation of Article 31 paragraph 2 states that if agreements are executed in multiple languages, i.e.: Indonesian language, the national language of the foreign party and/or English language, each version is equally original.

Although the above provisions look simple, they have triggered significant legal problems, i.e.:

whether Indonesian companies are obliged to use Indonesian language in their commercial contracts since Article 31 paragraph 1 and its elucidation are not particularly clear on whether (i) the term “Indonesian private institutions” includes Indonesian companies or Indonesian branches of foreign companies; and (ii) the term “agreements” includes private commercial contracts;
suppose they are obliged to use Indonesian languages, what would be the legal impact for any failure to do so? Is this is a mandatory obligation or merely an administrative requirement?
with respect to dual languages contracts, whether “equally original” means that each contract must be executed as original (not merely translation) and if yes, whether the parties to such contract can choose non-Indonesian language as the governing language.

In practice, the impacts are disastrous, especially in relation to commercial contracts made between Indonesian and foreign parties. Most foreign parties fear that the failure of using Indonesian language in their contracts might cause the contracts to be annulled by operation of law due to breach of mandatory legal obligation. As a result, they act conservatively and request that the contracts must be executed in dual languages. Not only that this choice of action significantly delays the transactions completion and increases the parties’ costs, it also imposes unnecessary risks and liabilities, particularly because certain complicated contracts such as Indenture, Trust Deed and EPC Contracts are too technical to be perfectly translated into Indonesian language (which is a very young language compared to English). As a result of this and without any definitive meaning on the concept of “equally original,” parties are running the risk of executing a contract with misleading or incorrect terms and conditions.

While the fear is understandable, in my opinion, acting conservatively does not solve the problems and there are better ways to solve them rather than executing all contracts in dual languages format. First, we should refer to Article 40 of Law 24/2009 which stipulates that the use of Indonesian language will be further stipulated in Presidential Regulations. I appreciate the fact that the provisions of Law 24/2009 are still valid even without those Presidential Regulations. However, it also indicates that the provisions of this Law is not yet complete, which in fact is true. As a matter of Indonesian legal principle, when the text of the law is not clear, parties to a contract should not interpret the law for the detriment of any of the parties. If a party tries to annul a contract due to failure of using Indonesian language where each party to that contract is aware that having such Indonesian version would most probably cause adverse effect, it shows that such party has bad faiths and in my opinion the court should not grant the claim. After all, why forcing the parties to use Indonesian language if it does not give any clear benefit to them?

Second, Law 24/2009 does not provide for any sanction for failure to comply with the above requirements, and it is arguable under the general Indonesian legal principle that when a law provision does not have any sanction (or the sanctions are merely administrative), the failure of performing such provision cannot affect the validity of a legal act, i.e. the contract. This has been made clear in a famous landmark case where the Supreme Court decided that the failure of submitting a report on foreign loan (which is an administrative requirement under Bank Indonesia regulations) cannot be used as a valid reason to annul a credit agreement made between an Indonesian debtor and foreign creditors. While I understand that there is a previous case on the similar matter where the credit agreement was annulled, the latter precedent should prevail since it is in accordance with the correct interpretation of law and is closer to fairness, i.e. it is completely ridiculous and unfair to the creditors to invalidate a credit agreement due to the failure of the debtor to submit some administrative reports.

Therefore, I would suggest that in case a contract involves Indonesian and foreign parties, the parties should not execute a dual languages contract without first performing a complete analysis on the advantages and risks of having such format. Suppose they conclude that having a dual languages contract is not a viable option, I would suggest them to insert a clause stating that they have agreed to execute the contract in non-Indonesian language and that they will execute an Indonesian language version of the contract when the implementing regulations clearly oblige them to do so. This mechanic would be useful to prevent any party having bad faiths from trying to annul the contract.

On the "equally original" phrase, my suggestion is that the Parties involved must also insert a clause concerning governing language. It is indeed unclear on whether the equally original means that each language should be deemed as applicable. However, when in doubt, the Parties should not use an interpretation that harms them. In addition, why don't we refer to the freedom of contract principle? The Parties should be able to agree on the governing language of the contract, and therefore eliminating any risks to have misleading or incorrect terms. However, the main question would be: if the Parties execute the Indonesian language contract for the sake of complying with Law 24/2009 and the governing language of such Contract is non-Indonesian, what is the purpose of having an Indonesian version in the first place? Is not this a waste of time and money? The Government should answer this big question.

In the end, we can conclude that the existence of Law 24/2009 brings more problems than benefits in practice, particularly in relation to the use of Indonesian language. While, we can argue and use several solutions to solve the issues brought by Law 24/2009, it should be noted that there are no bullet proof mechanisms here. The courts could always have a different interpretation. So, let us hope that the Government can give us a better solution through the implementing regulations and the courts can decide based on the correct and fair interpretation of the law while we are waiting for the implementing regulations.

To certain extent, the answer would be yes. Why? See here (it is in Indonesian language, but no worries, we will only discuss one article and I'll provide the translation below). On 9 July 2009, the Indonesian Government issued Law No. 24/2009 on the Flag, the Language, the National Emblem, and the National Anthem. The title says it all, so I don't expect to provide a summary of this Law in my blog. While I don't see the necessity to have this kind of regulation, I can understand that the Government is trying to increase Indonesia's profile, particularly the use of Indonesian language.

Now, onward with the main theme for today, I have some concerns with the application of Article 31 Paragraph (1) of this Law, which states (unofficially translated):

"The Indonesian Language must be used in any memorandum of understanding or agreements which involve state institutions, Indonesian government agencies, Indonesian private institutions, and Indonesian individuals"

This is a provision that I would call as inefficient and unreasonable. Why oblige parties to use Indonesian language in their contracts? There are many reasons for Indonesian companies to use foreign languages (notably English) for their contracts with another Indonesian parties, such as: (i) the relevant Indonesian company has several foreign creditors and therefore most of its contracts were made in English so it would be easier for its creditors to review such contracts (if necessary); or (ii) the relevant Indonesian company usually enters into contracts with foreign parties and therefore its standard contracts were mostly made in English. We need to understand that the costs for drafting Indonesian version of the contracts are not always cheap, so I'm asking once again, why force them to use Indonesian language and penalize them with unnecessary costs? If the parties need to use Indonesian language for the best interest of both parties, they would do so without having to be forced by this Law. Having this kind of provision is indeed an exaggeration.

In addition, forcing Indonesian parties to draft all of their agreements in Indonesian language may cause unnecessary risk (due to its ambiguity), i.e. Indonesian parties with bad faith (of course, supported by their lawyers) may claim that contracts made with another Indonesian parties are invalid and should be annulled by operation of law simply because such contracts were not made in Indonesian language. That would be horrendous! What should be considered as an administrative breach can now be deemed as a major breach of law which could cause a contract to be annulled, all because of an ambiguous provision which shouldn't even exist in the first place.

Of course as a lawyer, I would love this provision since it will create additional job for lawyers, i.e. translating standard English contracts into Indonesian language. Sure it's a boring stuff, but it can generate some nice incomes :).