For whatever they are worth, I've had some further thoughts on the question of governance versus contractual protections. At the meeting last week it seemed that there was an anticipation (not fulfilled) that approaching the needed protections for private investment in infrastructure projects in developing countries through "governance" would provide a means of avoiding some of the problems inherent in providing these needed protections through contractual risk allocation. I also sensed that there was a related frustration as the discussion at the meeting highlighted the fact that governance as a means of allocating risk can suffer the same complications and weaknesses as contracts which allocate risk.

Governance allocates risk through allocating responsibilities in the processes for decision making and execution in an organization. Some of the legal mechanisms for doing this, while not contractual in the narrow sense, are contractual in the broader sense that they are "private law" determined by the parties participating in the organization ( the provisions of by-laws, articles of incorporation, terms of reference etc.), of course within limits created by the public laws governing the organization. Other legal mechanisms that allocate responsibilities in organizations are the laws applicable to all such organizations. This allocation of responsibilities allocates risk because of the principle (universally applicable, I believe) that if a party with a responsibility fails to fulfill it or fulfills it improperly, that party bears the consequences. Not only is this the same principle that applies in the case of a contract, but as with a contract it takes an effective enforcement mechanism to give it force. Because of the complications and weaknesses with enforcement mechanisms where developing countries are involved, to this extent governance structures have the same weaknesses and complications as contractual risk allocation for infrastructure investments in developing countries .

But while governance does not eliminate the need for effective enforcement of other parties' obligations in protecting the interests of private investors in infrastructure projects it nonetheless provides advantages over (without eliminating the need for) contractual risk allocation. These advantages can be thought of as resulting from three interrelated effects.

First, and perhaps most important, the presentation and negotiation of the governance structure clarifies expectations in ways that contractual risk allocation cannot. Where an agency of the host government or an important local participant will be included in the legal entity which creates/controls the project, the necessity of being explicit about responsibilities within that entity leaves, in my view, much less room for the unspoken reservations that parties to any contractual risk allocation usually bring into and take out of the conference room where the deal is negotiated.

The main reason a more explicit negotiation is likely forced by a governance structure and the second reason it has advantages over having only contractual risk allocation is that the responsibilities a governance structure creates are in many ways inherently broader than contractual risk allocation. For example, the obligations of directors of a corporation (or their equivalents in other entities) in every legal system of which I am aware include putting the interests of the organization before the interests of any individual owner, even if the director is a representative of one particular owner. This is a very broad standard that can be more effective than contractual risk allocation in restraining self interested actions by a party involved in a project who also is an owner with the power to appoint a director (or director equivalent in other forms of organization).

Third, governance structures, by allocating risk through the creation of responsibilities, can also create additional venues and jurisdictions for the necessary (no matter how much lamented) enforcement of risk allocation. Although protection through ultimate enforcement of legal rights provides a weak support for investment, nonetheless in many cases the more effective enforcement mechanisms that are available the more likely that their potential will create the atmosphere for resolution of issues without resort to enforcement.

This entry is a reproduction of an email sent by a participant of the 2nd General Counsels' Roundtable to the Roundtable organizing committee.

Posted by rjorr at February 17, 2006 1:27 PM