Forum Selection in International Business Contracts: Home Bias Portfolio Puzzle and Managerial Moral Hazard

Abstract

We provide an economic analysis of forum selection in international business contracts. International business contracts or multi-state transactions within federally structured countries might be subject to more than one sovereign adjudication system. In case of conflict between the transacting parties, the appropriate tribunal must be identified. We examine the question of business firms' optimal choice of the forums to adjudicate future business disputes. We extend the investment model approach to litigation, by applying a Portfolio Theory type analysis. We show that firms that prefer higher expected income and lower income volatility are better off diversifying the forums under which they litigate business disputes. This stands in contrast to real-world business practice that consistently shows a clear preference to selecting the home court and legal system to settle international business disputes. In a fraction of the cases, both parties gain by selecting a certain forum, because of specialization for example, and it becomes optimal to ignore diversification. In most cases, however, the relevant factors that affect forum selection are zero sum and priced ex ante. Court bias, for example. Once priced, there is no incentive to disregard diversification. We hypothesize that several factors such as managerial moral hazard explain the real world behavior of firms: managers are less likely to be blamed, ex post, for choosing the home court. We suggest that, as international barriers decline and international trade grows, firms will diversify the forums in which they adjudicate international business disputes. Key Words: forum-selection, international-business transactions, contracts, portfolio diversification, home bias, managerial moral hazard, investment approach to litigation, managerial discretion