http://www.thehindubusinessline.com/2005/02/10/stories/2005021000300800.

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Contract enforcement Whither time value of money?

Thursday, Feb 10, 2005

R. Vaidyanathan Enforcing contracts is not easy. Considering the backlog at courts, private channels have become active especially for the Proprietorship and Partnership sector with relatively low financial flexibility. Unable to use the legal route, it resorts to the unconventional approach with its own consequences. R. Vaidyanathan suggests a speedy reform of the legal system, including introducing innovative approaches, if there is to be any sanctity to the time value of money. THE RISK premium on investment is a function of the type of instrument, the interest rate, forex fluctuations, inflation, etc. In our context there is an unstated but important risk that associated with enforcing any contract. It can be a contract between a landlord and tenant, a contract for services such as house construction, for purchase of vehicle in the second-hand market, between a lender and a borrower in the financial market, for such services as plumbing, electrical fitting, cooking etc, for long-distance travel (arranged tours), for undergoing major operations, and even a contract with lawyers to enforce these contracts; a phenomenal amount of time and cost is involved in trying to enforce any of these. A significant portion of the transactions are "relationship" and not "contract" based. Particularly the initiation of the deal is based only on referral, trust and "relationship". There may be a written contract but neither party takes it seriously. If there is no problem in the "informal" arrangement then things move in the right direction. But if the arrangement fails then the contract is invoked to settle the dispute. There in lies the rub. For, invariably the so-called contract is not worth the paper it is written on. It could take ages to go through the labyrinthine steps of judicial procedure. Using a simple cost of capital model one can derive an optimal solution in terms of using extra-legal processes to settle contracts. Hence, one of the major areas of concern in our economic system is the capability to enforce contracts in a timely fashion.

Table 1 gives an idea of the situation as prevailing in 2003-04. The numbers are mind-boggling. Of course, the proportion of civil cases varies in this, across States but it is anywhere from 30 per cent to 50 per cent. It is also interesting to note that total number of land related cases under litigation is only 16093 across all States (Lok Sabha unstarred question No: 984 dated 27/02/01).

The legal system fails to fully comprehend the concept of time value of money, which is the basis of functioning of the market system. Over three million cases are pending in just the 18 High Courts and more than 20,000 cases are pending in the Supreme Court for admission, interim relief or final hearing. This is not the full story since million more cases are pending at lower courts. The most protracted lawsuit ever recorded was in India (which has the dubious distinction of entering the Guinness Book of records). A `Mahant, or a keeper of a temple, filed a suit in Pune in 1205 A.D., and the case was decided in 1966 a full 766 years later. However, we can take consolation that this is not the average time taken by the Indian courts for deciding cases. It is estimated that on average a case can take from seven to fifteen years. Consider the experience elsewhere. For example, Nick Leeson of the Barings Bank saga of 1995. Not only has he been punished, he has even come out of jail after serving his time. Last heard, was about a book written by him, which was made in to a movie. In the case of Harshad Mehta (1992) scam, the complete disposal of all cases is yet to happen; of course, the Big Bull died a few years ago. Taking recourse to the legal system, it is difficult, nay impossible, for a tenant to be evicted by a landlord after the end of tenancy for a house property, for a creditor to collect his debts, for a lessor to repossess his leased assets from the lessee if there is a default, for a depositor to collect his principal and interest from the borrowing entity, for a bond-holder to redeem his instruments from the corporates. The system in practice does not accept asset ownership as natural and due to socialistic propaganda of more than fifty years considers default/illegal possession/occupation a natural right of the `underdog'. The right to the lessor to repossess the leased asset in the event of a default committed by the lessee was not very clear until the Bombay High Court clearly ruled that the "lessor has a right" to repossess the leased asset in the event of default by the lessee (Twentieth Century Finance Corporation vs. SLM Maneklal Industries Ltd). This `right' was upheld by the Supreme Court. In such a situation, the Proprietorship and Partnership (P&P) sector with relatively smaller financial flexibility suffers the most. It is not in a position to use the legal route and, hence, resorts to arm-twisting to press its `rights'. Use of `Collection/Re-possession agents' and other types of strong-arm tactics are becoming rampant in enforcing contracts. Press reports suggested that the infamous Romesh Sharma of Delhi (arrested for assorted crimes) was one of those whose services many used to enforce tenancy contracts by getting residential and business premises cleared of tenants. A report from Kochi spoke of the police initiating an inquiry into the operations of the `repossession teams' employed by finance and hire-purchase firms for recovering loans. This follows the arrest of two senior officials of a finance company and seven members of a `repossession gang' for their alleged role in the violence against a borrower, which led to the death of two individuals. Official sources said use of repossession teams by firms selling household appliances on hire-purchase basis is common knowledge. This points to an ominous trend developing in the system, wherein the affected parties take the law into their hands for enforcement of property rights. Even well-established multinational banks are said to engage "repossession/collection agents" with the police often turning a Nelson's eye. This has far reaching implications for the financial system. The reforms should have addressed this issue, since the maximum impact is felt by the P&P sector because unlike large corporates or the government, their financial flexibility is low and hence waiting time is crucial for their survival.

It is extremely important to recognise, and tap, the social capital we have accumulated in the form of community and family linkages; we need to think afresh instead of remaining boxed in by the Anglo-Saxon jurisprudence. We need to remember that we have less than 10,000 police stations in our country but more than two million places of worship. In other words by and large contract compliance is more due to fear of God than legal processes. One alternative worthy of serious consideration is to encourage community-based arbitration and recognise it by law as binding on both the parties. Such a system is prevalent, for instance, in stock exchanges wherein disputes among memberbrokers are settled by arbitration and the decision is binding on the members. The reforms of the legal system including introducing innovative ones, particularly at the lower levels of judiciary, has not been addressed as a basic issue since the government itself is one of the biggest litigants and for the Government there is no concept of Time or Value of Money leave alone Time Value of money. (The author is Professor of Finance and Control, Indian Institute of Management-Bangalore, and can be contacted at vaidya@iimb.ernet.in. The views are personal and do not reflect that of his organisation.)