Chapter 2 Outline

Legal System

The legal system of a country refers to the rules, or laws, that regulate behavior along with the processes by which the laws are enforced and through which redress for grievances is obtained. The legal system of a country is of immense importance to international business. A country's laws regulate business practice, define the manner in which business transactions are to be executed, and set down the rights and obligations of those involved in business transactions. The legal environments of countries differ in significant ways. As we shall see, differences in legal systems can affect the attractiveness of a country as an investment site and/or market.

Like the economic system of a country, the legal system is influenced by the prevailing political system. The government of a country defines the legal framework within which firms do business-and often the laws that regulate business reflect the rulers' dominant political ideology. For example, collectivist-inclined totalitarian states tend to enact laws that severely restrict private enterprise, while the laws enacted by governments in democratic states where individualism is the dominant political philosophy tend to be pro-private enterprise and pro-consumer.

The variances in the structure of law among countries is a massive topic that warrants its own textbook. We do not attempt to give a full description of the variations; rather, we will focus on three issues that illustrate how legal systems can vary-and how such variations can affect international business. First, we look at the laws governing property rights with particular reference to patents, copyrights, and trademarks. Second, we look at laws covering product safety and product liability. Third, we look at country differences in contract law.

Property Rights

In a legal sense the term property refers to a resource over which an individual or business holds a legal title; that is, a resource that they own. Property rights refer to the bundle of legal rights over the use to which a resource is put and over the use made of any income that may be derived from that resource.¹² Countries differ significantly in the extent to which their legal system protects property rights. Although almost all countries have laws on their books that protect property rights, the reality is that in many countries these laws are not well enforced by the authorities and property rights are routinely violated. Property rights can be violated in two ways-through private action and through public action.

Private Action

Private action refers to theft, piracy, blackmail, and the like by private individuals or groups. While theft occurs in all countries, in some countries a weak legal system allows for a much higher level of criminal action than in others. An example much in the news of late is Russia where the chaotic legal system of the post-Communist era, coupled with a weak police force and judicial system, offers both domestic and foreign businesses scant protection from blackmail by the "Russian mafia." Often successful business owners in Russia must pay "protection money" to the Mafia or face violent retribution, including bombings and assassinations (there were around 500 contract killings of businessmen in 1995 and again in 1996).¹³ In one example, Ivan Kivelidi, a banker and founder of the Russian Business Roundtable, was murdered by poison applied to the rim of his coffee cup. In another, Vladislav Listiev, the head of Channel 1, Russia's largest nationwide TV network, announced in 1996 that he was going to remove unsavory elements (i.e., Mafia) from the network. Soon afterward he was gunned down by professional assassins outside of his apartment building.¹⁴ And in perhaps the most disturbing case, American businessman Paul Tatum was assassinated in late 1996 after a Moscow hotel joint venture that he was involved in turned sour.¹⁵

Of course, Russia is not alone in having Mafia problems. The Mafia has a long history in the United States. In Japan, the local version of the Mafia, known as the yakuza, runs protection rackets, particularly in the food and entertainment industries.¹⁶ However, there is an enormous difference between the magnitude of such activity in Russia and its limited impact in Japan and the United States. This difference arises because the legal enforcement apparatus, such as the police and court system, is so weak in Russia. Many other countries have problems similar to or even greater than those currently being experienced by Russia. In Somalia during 1993 - 1994, for example, the breakdown of law and order was so complete that even United Nations food relief convoys proceeding to famine areas under armed guard were held up by bandits.

Public Action

Public action to violate property rights occurs when public officials, such as politicians and government bureaucrats, extort income or resources from property holders. This can be done through a number of mechanisms including levying excessive taxation, requiring expensive licenses or permits from property holders, taking assets into state ownership without compensating the owners (as occurred to the assets of numerous US firms in Iran after the 1979 Iranian revolution), or by demanding bribes from businesses in return for the rights to operate in a country, industry, or location.¹⁷ For example, the government of the late Ferdinand Marcos in the Philippines was famous for demanding bribes from foreign businesses wishing to set up operations in that country.¹⁸

Another example of such activity surfaced in mid-February 1994 when the British paper The Sunday Times ran an article that alleged a 1 billion sterling ($750 million) sale of defense equipment by British companies to Malaysia was secured only after bribes had been paid to Malaysian government officials and after the British Overseas Development Administration (ODA) had agreed to approve a 234 million sterling grant to the Malaysian government for a hydroelectric dam of (according to The Sunday Times) dubious economic value. The clear implication was that UK officials, in their enthusiasm to see British companies win a large defense contract, had yielded to pressures from "corrupt" Malaysian officials for bribes-both personal and in the form of the development grant.¹⁹

The Protection of Intellectual Property

Intellectual property refers to property, such as computer software, a screenplay, a music score, or the chemical formula for a new drug, that is the product of intellectual activity. It is possible to establish ownership rights over intellectual property through patents, copyrights, and trademarks. A patent grants the inventor of a new product or process exclusive rights to the manufacture, use, or sale of that invention. Copyrights are the exclusive legal rights of authors, composers, playwrights, artists, and publishers to publish and disperse their work as they see fit. Trademarks are designs and names, often officially registered, by which merchants or manufacturers designate and differentiate their products (e.g., Christian Dior clothes).

The philosophy behind intellectual property laws is to reward the originator of a new invention, book, musical record, clothes design, restaurant chain, and the like, for his or her idea and effort. Such laws are a very important stimulus to innovation and creative work. They provide an incentive for people to search for novel ways of doing things and they reward creativity. For example, consider innovation in the pharmaceutical industry. A patent will grant the inventor of a new drug a 17-year monopoly in production of that drug. This gives pharmaceutical firms an incentive to undertake the expensive, difficult, and time-consuming basic research required to generate new drugs (on average it costs $150 million in R&D and takes 12 years to get a new drug on the market). Without the guarantees provided by patents, it is unlikely that companies would commit themselves to extensive basic research.²⁰

The protection of intellectual property rights differs greatly from country to country. While many countries have stringent intellectual property regulations on their books, the enforcement of these regulations has often been lax. This has been the case even among some countries that have signed important international agreements to protect intellectual property, such as the Paris Convention for the Protection of Industrial Property, which 96 countries are party to. Weak enforcement encourages the piracy of intellectual property. China and Thailand have recently been among the worst offenders in Asia. Local bookstores in China commonly maintain a section that is off-limits to foreigners; it ostensibly is reserved for sensitive political literature, but it more often displays illegally copied textbooks. Pirated computer software is also widely available in China. Similarly, the streets of Bangkok, the capital of Thailand, are lined with stands selling pirated copies of Rolex watches, Levi blue jeans, videotapes, and computer software.

The computer software industry suffers more than most from lax enforcement of intellectual property rights. Estimates suggest that violations of intellectual property rights cost computer software companies revenues equal to $12.3 billion in 1994, $13.3 billion in 1995, and $11.2 billion in 1996.²¹ According to the Business Software Alliance, a software industry association, in 1996 43 percent of all software applications used in the world were pirated. The worst region was Eastern Europe, where the piracy rate was 80 percent. This was followed by piracy rates of 79 percent in the Middle East, 68 percent in Latin America, 55 percent in Asia, 43 percent in Western Europe, and 28 percent in North America. One of the worst countries was China, where the piracy rate in 1996 ran 96 percent and cost the industry $704 million in lost sales, up from $444 million in 1995.²²

Music recordings represent another area where piracy is rampant. According to one estimate, nearly 200 million illegal compact disks are stamped each year, almost 60 percent of them in China. The International Federation of the Phonographic Industry claims that its members lose $2.2 billion annually to pirates.²³

International businesses have a number of possible responses to such violations. Firms can lobby their respective governments to push for international agreements to ensure that intellectual property rights are protected and that the law is enforced. An example of such lobbying is given in the next Management Focus, which looks at how Microsoft prompted the US government to start insisting that other countries abide by stricter intellectual property laws.

(Management Focus - see text)

Partly as a result of such actions, international laws are being strengthened. As we shall see in Chapter 5, the most recent world trade agreement, which was signed in 1994 by 117 countries, for the first time extends the scope of the General Agreement on Tariffs and Trade (GATT) to cover intellectual property. Under the new agreement, as of 1995 a council of the newly created World Trade Organization (WTO) is overseeing enforcement of much stricter intellectual property regulations. These regulations oblige WTO members to grant and enforce patents lasting at least 20 years and copyrights lasting 50 years. Rich countries had to comply with the rules within a year. Poor countries, in which such protection generally was much weaker, had 5 years' grace, and the very poorest have 10 years.²⁴ (For further details, see Chapter 5.)

One problem with these new regulations, however, is that the world's biggest violator--China--is not yet a member of the WTO and is therefore not obliged to adhere to the agreement. However, following pressure from the US government, which included the threat of substantial trade sanctions, in 1996 the Chinese government agreed to enforce its existing intellectual property rights regulations (in China, as in many countries, the problem is not a lack of laws; the problem is that existing laws are not enforced). During 1996 Chinese officials closed 19 counterfeit CD-ROM factories with a capacity of 30 to 50 million units a year. Still, according to the Business Software Alliance, a further 21 counterfeit CD-ROM factories were operating in China as of late 1996.²⁵

In addition to lobbying their governments, firms may want to stay out of countries where intellectual property laws are lax, rather than risk having their ideas stolen by local entrepreneurs (such reasoning partly underlay decisions by Coca-Cola and IBM to pull out of India in the early 1970s). Firms also need to be on the alert to ensure that pirated copies of their products produced in countries where intellectual property laws are lax do not turn up in their home market or in third countries. The US computer software giant Microsoft, for example, discovered that pirated Microsoft software, produced illegally in Thailand, was being sold worldwide as the real thing (including in the United States). In addition, Microsoft has encountered significant problems with pirated software in China, the details of which are discussed in the Management Focus.

Product Safety and Product Liability

Product safety laws set certain safety standards to which a product must adhere. Product liability involves holding a firm and its officers responsible when a product causes injury, death, or damage. Product liability can be much greater if a product does not conform to required safety standards. There are both civil and criminal product liability laws. Civil laws call for payment and money damages. Criminal liability laws result in fines or imprisonment. Both civil and criminal liability laws are probably more extensive in the United States than in any other country, although many other Western nations also have comprehensive liability laws. Liability laws are typically least extensive in less developed nations.

In the United States a boom in product liability suits and awards resulted in a dramatic increase in the cost of liability insurance. In turn, many business executives argue that the high costs of liability insurance are making American businesses less competitive in the global marketplace. This view was supported by the Bush administration. Former Vice President Dan Quayle once argued that the United States has too many lawyers and that product liability awards are too large. According to Quayle, the result is that product liability insurance rates are typically much lower overseas, thereby giving foreign firms a competitive advantage. In the United States, tort costs amount to about 2.4 percent of gross national product (GNP), three times as much as in any other industrialized country. So the cost of lawsuits does seem to put America at a competitive disadvantage.²⁶

In addition to the competitiveness issue, country differences in product safety and liability laws raise an important ethical issue for firms doing business abroad. When product safety laws are tougher in a firm's home country than in a foreign country and/or when liability laws are more lax, should a firm doing business in that foreign country follow the more relaxed local standards or should it adhere to the standards of its home country? While the ethical thing to do is undoubtedly to adhere to home-country standards, firms have been known to take advantage of lax safety and liability laws to do business in a manner that would not be allowed back home.

Contract Law

A contract is a document that specifies the conditions under which an exchange is to take place and details the rights and obligations of the parties involved. Many business transactions are regulated by some form of contract. Contract law is the body of law that governs contract enforcement. The parties to an agreement normally resort to contract law when one party feels the other has violated either the letter or the spirit of an agreement.

Contract law can differ significantly across countries, and as such it affects the kind of contracts an international business will want to use to safeguard its position should a contract dispute arise. The main differences can be traced to differences in legal tradition. Two main legal traditions are found in the world today--the common law system and the civil law system. The common law system evolved in England over hundreds of years. It is now found in most of Britain's former colonies, including the United States. Common law is based on tradition, precedent, and custom. When law courts interpret common law, they do so with regard to these characteristics. Civil law is based on a very detailed set of laws organized into codes. Among other things, these codes define the laws that govern business transactions. When law courts interpret civil law, they do so with regard to these codes. Over 80 countries, including Germany, France, Japan, and Russia, operate with a civil law system. Since common law tends to be relatively ill-specified, contracts drafted under a common law framework tend to be very detailed with all contingencies spelled out. In civil law systems, however, contracts tend to be much shorter and less specific, because many of the issues typically covered in a common law contract are already covered in a civil code.