Unlike the situation in many other industries, however, diamond industry disputes are resolved not through the courts and not by the application of legal rules announced and enforced by the state. The diamond industry has systematically rejected state-created law. In its place, the sophisticated traders who dominate the industry have developed an elaborate, internal set of rules, complete with distinctive institutions and sanctions, to handle disputes among industry members.

XREF: This connects to the broader literature on private governance and ordering without law, such as Ellickson's Order Without Law.

Although many of the shortcomings in the American legal system that make litigation unattractive to diamond dealers are also present in most commercial contexts, the diamond industry is unique in its ability to create and, more important, to enforce its own system of private law. Sections IVD and E focus on the ways the industry's organization facilitates the creation of strong reputational bonds, which the bourse's arbitration system in turn uses to enforce its judgments. They examine two types of reputation-bond-based extralegal contractual regimes: the homogeneous group regime that is generally associated with repeat transactions among members of small geographically concentrated and ethnically homogeneous groups, and the information-intermediary regime in which technology links markets and secures the rapid and low-cost dissemination of information about reputation. Although the industry is currently moving from a homogeneous group to an information-intermediary-based regime, it has succeeded, at least for the time being, in creating an overarching system that captures the advantages of both regimes.

In sum, the analysis presented in Section IV suggests that, while the damage rules adopted by the industry may lead to some instances of inefficient breach, the system's overall success is due, in large part, to its ability to quickly resolve disputes and enforce judgments-results that cannot be obtained through the legal system.

DEFINE: Clarifies why industry dispute systems outperform legal remedies: not because their damage rules are always efficient, but because they offer quick dispute resolution and judgment enforcement.

Rough diamonds are found primarily in Africa, Australia, and the Soviet Union; they are not notably rare. At present, 80-85 percent of the world's supply of rough diamonds is controlled by the DeBeers Cartel. The cartel distributes its supply of rough diamonds through four brokers. The brokers then sell presorted boxes of diamonds to some 150-200 dealers, known as sight holders, during ten viewing sessions, or sights, held in London each year. Most U.S. sight holders are members of the New York Diamond Dealers Club (DDC). At a sight, a dealer is given a box of diamonds and informed of its price. This price is nonnegotiable. If the dealer decides not to purchase his box, he will not be invited to subsequent sights. Consequently, a sight holder will rarely decline to purchase his box,

A similar thesis is advanced by Robert C. Ellickson, A Hypothesis of Wealth Maximizing Norms: Evidence from the Whaling Industry, 5 J. L. Econ. & Org. 83, 84 (1989), where he explores the "hypothesis that when people are situated in a close knit group, they will tend to develop for the ordinary run of problems norms that are wealth maximizing." For a broader and more theoretical articulation of this thesis, see generally, John Gray, Hayek on Liberty (2d ed. 1986), discussing Hayek's theory of spontaneous order and the "competitive selection of rules and practices," particularly, "Hayek's assertion that the evolution of culture may itself be fruitfully investigated in terms of the competition between different traditions or practices, with a natural selection among them occurring which is at least partly to be explained by their relative efficiency as bearers or embodiments of knowledge."

XREF: Connects to Hayek's theory of spontaneous order and cultural evolution through competitive selection of practices.

The cartel insists that the diamonds be paid for in full within seven days of the sight. Consequently, for most sight holders, particularly those who cut and polish the rough themselves, access to credit is essential-it takes three-four months from the sight date for a manufacturer to sort, cut, polish, and sell the contents of his box. Sight holders, however, rarely have difficulty securing financing. In the diamond industry, having a sight is considered a near guarantee of financial success. The cartel actively monitors the decisions and activities of sight holders; if a sight holder continues to play by the cartel's "rules," he is rewarded with a more profitable selection of stones. Consequently, because most monitoring costs are shifted to the cartel, sight holders generally have access to bank capital.

The value of a rough diamond depends on the value of the polished stones that can be manufactured from it. Since no two diamantaires will cut a stone the same way, the value added in the manufacturing process varies widely. Consequently, when dealers value a piece of rough differently, that difference, on which profitability turns, often reflects a real difference in the value of the polished stones they will be able to cut from it.

DEFINE: Explains why buyers of rough diamonds can legitimately value the same stone differently: value is contingent on the manufacturing outcome, which varies by cutter.

Diamond valuation is a subjective process. The value of a rough diamond depends on the value of the polished stones that can be manufactured from it. Since no two diamantaires will cut a stone the same way, the value added in the manufacturing process varies widely. Consequently, when dealers value a piece of rough differently, that difference, on which profitability turns, often reflects a real difference in the value of the polished stones they will be able to cut from it.

In contrast, when dealers value a polished stone differently, most of that difference will be due to their differing estimates of market demand and to their differential skill in detecting flaws in stones. In recent years, however, the skill factor has become less important.

In contrast, when dealers value a polished stone differently, most of that difference will be due to their differing estimates of market demand and to their differential skill in detecting flaws in stones. In recent years, however, the skill factor has become less important. Although older dealers continue to maintain that even polished diamonds cannot be objectively graded and valued, in the late 1970s, the Gemological Institute of America began to issue diamond grading certificates whose widespread use made it possible for dealers with little gem expertise to enter the market, resulting in increased competition. By creating standardized ways of describing polished stones, grading certificates have facilitated the flow of price information.

XREF: The finding that standardization of information reduces expertise barriers and increases competition parallels classic information economics (Akerlof's lemons problem) and other markets where certification enabled entry, e.g., credit ratings or organic food labels.

Unlike a closing quotation on a typical commodities exchange, the prices recorded in the Rapaport Diamond Report are not actual transaction prices. Rather, they are the Rapaport Corporation's subjective calculation of the "high asking" price, generally 15-30 percent above the actual transaction price, for various sizes and grades of polished stones. One explanation for the markup is that it enables retailers to quote list prices to consumers who think they are getting a bargain when they buy below it.

XREF: Connects to retail pricing psychology — the anchored list price that makes discounts feel like bargains — a common tactic in many industries.

The New York DDC currently has 2,000 members; in most years there is a waiting list for admission. Although requirements for membership are strict, the main constraint on membership is space, not the inability of dealers to meet the membership requirements.

QUESTION: What prompts a waiting list despite strict requirements — what is the selection process and how crowded is the gallery space?

Unless the club opts not to hear the case, the member may not seek redress of his grievances in court. If he does so, he will be fined or expelled from the club. Furthermore, since the agreement to arbitrate is binding, the court will not hear the case.

DEFINE: Explains how binding arbitration agreements function: they redirect disputes to arbitration and keep courts from hearing cases, with penalties for members who defy the process.

As one dealer explained, a visit to the club enables him to "keep a finger on the pulse of the business." Although a price list is available for certain classes of polished stones, the bourse's trading floor is the only place to obtain a feel for the market price of rough diamonds: standardized price information is unavailable. Unlike other commodities exchanges, the DDC itself does not record either actual transactions prices or the volume of transactions.

DEFINE: Clarifies how the diamond bourse differs from standard commodities exchanges by lacking transaction price and volume records.

In the diamond industry, where profitability depends largely on a dealer's network of contacts, secrecy is valued; large-scale transactions tend to be consummated in private offices. In addition, because properly valuing a stone depends on the ability to detect minor flaws and color variations, buyers prefer to examine large stones in familiar light. Furthermore, for security reasons, many dealers do not want it known that they have valuable stones in their possession.

For them, club membership provides a secure trading place at a modest cost with additional informational benefits. In general, the reputations of smaller dealers are less well established.

The bourse is an information exchange as much as it is a commodities exchange. As one author put it, "the bourse grapevine is the best in the world. It has been going for years and moves with the efficiency of a satellite communications network. . . .Bourses are the fountainhead of this information and from them it is passed out along the tentacles that stretch around the world." 9 The bourse facilitates the transmission of information about dealers' reputations ° and, at least with respect to members, serves both a reputation-signaling and a reputation-monitoring function.

DEFINE: Defines the bourse not merely as a market for goods but as an information and reputation infrastructure among its members.

The DeBeers Cartel does not control the WFDB. One of the main reasons the WFDB was formed was to enable the bourses to bargain more effectively with the cartel.

DEFINE: Clarifies the origin and purpose of the WFDB (World Federation of Diamond Bourses) as a counterweight to the DeBeers Cartel.

The most common transactional paradigm is known as "open cachet." 15 When a buyer makes an offer to a seller or a broker, the stone is put in an envelope which is then folded and sealed in a precise way. The terms and conditions of the offer are placed on the envelope as is the date. The buyer then signs the parcel across the seal. Unless otherwise specified, this offer is considered binding on the offerer until one o'clock the next day. The seller may accept at any time during this period by contacting the buyer and saying "mazel and broche." If, however, the seller either rejects the offer or makes a counteroffer during this period, his option to accept the buyer's original offer is canceled.

Another type of cachet used less frequently than open cachet is known as a "Zee'ch," or "search" cachet. In a Zee'ch transaction, the seller seals the stone and signs the parcel. This signals his agreement not to show the stone to anybody else for a period of twenty-four hours. A Zee'ch seal does not give the buyer an option to purchase the sealed stone at a particular price. Rather, it gives him an exclusive right to resume negotiations for the stone at a specified time in the future. It is common for buyers to shop around by putting a variety of stones under Zee'ch. This practice makes sense in the market for rough stones where no standardized price information is available; it makes comparison shopping easier, which facilitates competitive pricing.

Although the cachet is formally an agreement between a buyer and a seller, its most important function in the market is to regulate the relationship between a seller and his broker. If no cachet were used and the buyer offered five hundred dollars per karat for the stone, the broker might tell the seller that the buyer offered four hundred dollars per karat. If the seller accepted, the broker would pocket the difference. This is not the type of dishonest behavior that could be easily monitored and enforced through reputation bonds since detection and a determination of the precise circumstances would be difficult.

DEFINE: Explains how the cachet functions in diamond markets, clarifying its purpose beyond its formal buyer-seller framing.

When a deal is physically concluded on the floor of the DDC, a document akin to an integrated writing is frequently, but not always, produced. After the parties have either made an oral agreement or gone through the formalities of cachet-that is, at a stage in the transaction where the parties already consider themselves bound-they take the goods to be weighed by a club employee who issues them an official weight slip. The slip is then signed by the person who gave the stone to the club official, most commonly, though not exclusively, the buyer, and the terms of payment and the price are added. If the sale was concluded in accordance with the rule of open cachet, the cachet parcel is included in the bag with the stone and the official weight slip. Only one copy of the slip exists, and it is retained by the seller. If a dispute later occurs, the club's dispute resolution bodies consider the slip to be definitive evidence of both the stone's weight and the existence of the transaction.

In some instances, stones are traded not on the floor of the DDC but in private offices. In this case, a standard bill of sale is drawn up when the deal is concluded and before the buyer leaves with the stones. Frequently, however, it is sent by the seller after the buyer has left with the stone but before he has paid in full. Dealers explain that when they really trust the person they are trading with they do not, at the time of "contracting," attach any real importance to this writing. Traditionally, the bill of sale has been viewed as a mere formality used primarily for accounting purposes.

XREF: Connects to sociological work on relational trust vs. formal contracts in trade communities, such as Granovetter's embeddedness theory or the De Beers diamond cartel literature.

Around 150 disputes per year are submitted to the DDC's arbitration system. Of these, an estimated 85 percent are settled during the mandatory prearbitration conciliation procedure. Although there has been a slight increase in the number of arbitrations in recent years, this is attributed primarily to the increase in club membership and not to a deterioration of trade ethics.

The DDC's procedural rules clearly reflect the industry's preference for the voluntary resolution of disputes. The bylaws are structured to give the parties control over the dispute resolution process and to create financial incentives to settle. For example, prior to an arbitration hearing, the parties are required to participate in a conciliation proceeding, and "whenever an adjustment by conciliation is consummated, the chairman of [the three-person conciliation] panel may refund the arbitration fee or any part of the same."

XREF: Connects to modern ADR theory about how institutional design shapes settlement incentives, relevant to any dispute resolution work.

An important feature of the arbitration system is the secrecy of the proceedings. The arbitrators are not required to make findings of fact and do not produce written decisions explaining their reasoning. As long as judgments are complied with, the fact of the arbitration as well as its

DEFINE: Clarifies a key structural feature of arbitration that distinguishes it from litigation — no findings of fact, no written reasoning, confidentiality of the entire process.

Although the DDC arbitration system is operated primarily for the benefit of club members, nonmembers who have a dispute with members often request that the club hear their case. In most instances, the board will grant their request as long as the member consents and both parties sign an agreement to arbitrate.

There are a number of reasons why nonmembers might request that the DDC arbitrate a dispute with a member. First, if the nonmember knows he is in the wrong, yet the parties are unable to agree on a settlement, then having a neutral third party assess a penalty should enable him to minimize the reputation cost of his breach since arbitration awards are kept secret if the judgment is paid promptly. Although the arbitration's results sometimes become known through gossip, as long as the individual is not frequently involved in such controversies, the damage to his reputation is likely to be contained. Second, if the nonmember thinks he is in the right, arbitration is preferable to litigation because it is cheaper, faster, and subjects the member to unqiue pressures to pay promptly.

First, if the nonmember knows he is in the wrong, yet the parties are unable to agree on a settlement, then having a neutral third party assess a penalty should enable him to minimize the reputation cost of his breach since arbitration awards are kept secret if the judgment is paid promptly. Although the arbitration's results sometimes become known through gossip, as long as the individual is not frequently involved in such controversies, the damage to his reputation is likely to be contained. Second, if the nonmember thinks he is in the right, arbitration is preferable to litigation because it is cheaper, faster, and subjects the member to unqiue pressures to pay promptly.

XREF: Relates to dispute resolution mechanisms and how private arbitration differs from public litigation in protecting reputation.

In complex cases that are neither explicitly covered by the trade rules nor dealt with according to established custom, it is difficult to determine what substantive rules of decision are applied. Arbitrators explain that they decide complex cases on the basis of trade custom and usage, a little common sense, some Jewish law, and, last, common-law legal principles. There are no general rules of damages. When calculating damages, the arbitrators look at the stone, consider the circumstances, and apply their business experience. Many dealers feel that the arbitrators have redistributive instincts; they cite the unpredictability of the decisions as well as the arbitrators' tendency to "split the difference" as an important motivation to settle their disputes on their own. This may be a reason why, while 150 arbitration complaints are filed each year, only thirty to forty go to judgment. The arbitrators announce their judgment, but they neither make findings of fact nor explain their reasoning. The absence of explicit findings of fact and written opinions is a precaution to prevent people from complaining, rightly or wrongly, that the arbitrators were biased, unfair, or relied on evidence that lacked probative value.

QUESTION: This is a fascinating account of a diamond-trade arbitration system. Worth exploring how opaque, low-accountability adjudication might work in other community-governance contexts.

The arbitration board is like a jury black box. Diamond dealers eschew arbitration for many of the same reasons that businessmen in general are wary of jury trials, primarily the uncertainty of the outcome.

A person who is found to have breached an agreement or engaged in unethical conduct is sometimes ordered to pay punitive damages or a fine in the form of a donation to charity in addition to compensating the other party for his loss. Thus, unlike court awards that, while unpredictable, are at least bounded by expectation damages, arbitration awards have a completely uncertain component. In one case, a dealer falsely accused another dealer of stealing a stone. The accuser subsequently remembered where he had put the stone and apologized to the other dealer. As the incident had become widely known throughout the club, however, the wrongly accused dealer brought an arbitration action against the owner of the stone for impugning his good name. The board ordered the man to make a full public apology and a fifty thousand dollar donation to a Jewish charity.

XREF: Connects to disputes about arbitration vs. court remedies, and how community-based justice systems differ from formal legal systems.

The DDC Bylaws provide that "[a]ll decisions of arbitration panels including floor committee arbitrations which are not complied with within 10 working days, together with the picture of the non-complying member, shall be posted in a conspicuous place in the Club rooms." … As a condition of membership in the federation, each bourse agrees to enforce the judgments of all member bourses. Since most diamond dealers frequently transact in foreign bourses, this reciprocity of enforcement greatly increases the penalty for failing to voluntarily comply with an arbitration judgment.

XREF: Connects to reputation and enforcement economics — mutual enforcement across organizations amplifies sanctions, similar to how reputation networks work in other tight-knit industries.

After conclusion of bankruptcy proceedings, "[a] majority of the Board of Directors may reinstate any suspended member should they feel s/he has conducted her/himself as a bona fide debtor and has made provisions for the payment of one hundred percent (100%) of his/her debt."' 34 Formerly bankrupt members who comply with the club's bankruptcy rules are sometimes readmitted under this provision.

In general, the Board of Arbitrators uses suspension more frequently than expulsion to secure compliance with its decisions. Expulsion presents a classic end-game problem. The expelled member may feel like he has nothing to loose by challening the club-he can try to upset the board's decision in court, file a private antitrust suit, or sue in tort for interference with business relations. The bylaws, however, provide that a member who was suspended or expelled may be readmitted after two years on the same terms as a new member. Although this provision appears to be a partial solution to the end-game problem, due to the long waiting list of those already qualified for club membership and the subjectivity of the admissions process, dealers are not routinely readmitted under this provision. Furthermore, even if the admissions committee voted to readmit a dealer, his ability to avoid being shunned would depend on the original reason for his expulsion.

Under New York law, binding arbitration awards can be confirmed in civil court. If this is done, the judgment has the same force and effect as an initial court award. In practice, however, it is rarely necessary for a party to a DDC arbitration to seek confirmation of a judgment. While arbitration awards are officially kept secret, a confirmation proceeding in court would quickly become public knowledge. Thus, the dealer against whom the judgment was entered would suffer severe damage to his reputation.

DEFINE: Explains the mechanism by which secret arbitration awards remain confidential and why confirmation is rare in practice.

In order to understand contractual relations in the diamond industry, it is important to briefly consider why executory agreements-contracts-are used at all. For many transactions, simultaneous exchange is advantageous. It reduces the riskiness of the transaction, decreases transaction costs by eliminating costly and time consuming negotiations over payment terms, eliminates the need for going through the formalities of cachet, and, most important, enables dealers to trade with people about whose reputation they have little information.

Simultaneous exchange is facilitated by the presence of a major diamond-financing bank in the same building as the DDC. In addition, the seven other banks that extend credit to New York dealers are located nearby.

There is a great need for credit in the diamond industry. As explained above, even the largest sight holders need credit to finance the purchase of their boxes of rough. Similarly, non-sight holders also acquire most of their stones on a cycle that follows, but lags behind, the schedule of sights. They therefore need credit to enable them to purchase enough stones to keep their cutters working until the next sight. Access to credit is also essential in the market for polished stones. Because polished stone sales are highly seasonal, with 30-40 percent occurring in November and December, access to credit is needed to avoid a cash shortfall.

XREF: Connects to broader understanding of how commodity supply chains are capital-intensive and credit-dependent, similar to other bulk raw material trades.

The market for rough and polished diamonds functions not only as a commodities market but also as an implicit capital market. One possible explanation for the extension of credit by sellers is that sellers typically have better and less expensive access to outside capital than most buyers. Many of the important sellers are also DeBeers sight holders. The fact that a dealer is a sight holder sends a signal to the bank that he is a good credit risk. Banks prefer to lend to sight holders because they need not incur the large cost of valuing gems that they would have to bear if they lent to non-sight holders whose inventories are in a constant state of flux. Lenders can offer lower interest rates to sight holders because they can have greater confidence when they make loans and most monitoring costs are shifted to the cartel.

XREF: Connects to themes of signaling theory in finance and the informational role of institutions (like DeBeers' cartel) in lending markets.

Unlike banks, sight holders are industry insiders; they have good information about individual dealers' reputations and transact with the same people on a repeat basis over a long period of time. It is thus cheaper for sight holders to monitor dealers' reputations and credit worthiness than it is for banks. Consequently, it is likely that sight holders can offer terms

In addition to the sale of goods on credit, the practice of giving goods on consignment (memorandum), which is common in transactions between wholesalers and retailers, is a way of effecting an implicit loan.

XREF: Connects to economic exchange theory and how commercial practices encode financial arrangements without formal credit instruments.

It is not clear, however, a priori that these costs are necessarily higher than those incurred in the formation of an extralegal contract consummated with a handshake. Because the ability of the promisee to enforce an extralegal contract depends on the posting of a reputation bond

One line of analysis used to explain market transactors' choice between legally enforceable contracts and extralegal contracts focuses on the transaction costs of negotiating and drafting legally enforceable agreements. It is not clear, however, a priori that these costs are necessarily higher than those incurred in the formation of an extralegal contract consummated with a handshake. Because the ability of the promisee to enforce an extralegal contract depends on the posting of a reputation bond

Although in the typical diamond transaction the buyer takes possession of the stone and promises to pay the seller at some time in the future, the buyer must still obtain information about the seller's reputation. Using lasers and chemical processes, diamonds can be treated to artificially enhance color and disguise flaws. Small flaws and differences in color dramatically affect the value of a stone. Many of these "treatments," however, cannot be detected without sophisticated equipment. Although in theory buyers could have every stone evaluated by a gemological laboratory to determine whether or not it had been altered, this would be prohibitively time consuming and expensive. Nevertheless, if a dealer purchases a "treated stone" and sells it to someone else who discovers the stone's treatment, he can be taken to the arbitration panel for failing to disclose the treatment. The panel must then decide whether the dealer knew or reasonably should have known of the stone's treatment. The reputation of the person he purchased the stone from is an important factor considered by the arbitrators.

XREF: Connects to information economics and reputation-as-signaling concepts from Akerlof's 'market for lemons' and game-theoretic treatments of trust.

In general, the magnitude of precontract transaction costs incurred in the formation of extralegal contracts will depend on how common such contracts are in the relevant market. In the diamond industry, extralegal contracts are the dominant contractual paradigm. Consequently, the industry is organized to minimize the cost of obtaining information about dealers' reputations.

Brokers are able to gather information about individuals' reputations for trustworthiness at a lower effective cost than individual buyers and sellers because a broker's investment is less transaction specific. When a buyer and a seller invest in acquiring information about their respective reputations only to find that the buyer needs a particular size stone that the seller does not have, the parties have lost part of their investment. While the information acquired may be useful to them in the future, its value diminishes over time as its accuracy decreases. In contrast, a broker who has this information can shop around immediately for new trading partners for either party.

XREF: Relates to transaction cost economics and principal-agent theory; echoes why intermediaries exist in financial and labor markets beyond the gem trade example.

In a market where enforcement depends on social ostracism or reputational damage, the formation of an extralegal contract depends on information about reputation. In addition, it requires adherence to enough formalities to alert other members of the relevant group that an agreement has taken place. In the diamond industry this function is served by customs such as handshakes, cachets, weight slips, and bills of sale that are able to effectively serve the channeling, cautionary, and evidentiary functions of formality while imposing minimal additional cost.

DEFINE: Clarifies how the concept of 'extralegal contract' operates in a market where legal enforcement is absent.

Despite their informational advantage, there are a variety of factors that limit brokers' role in the market. Information about "trustworthiness," unlike consumer credit information, is difficult to communicate in objective terms. What is ethical behavior to a thirtyyear-old dealer, may be an abhorrent business practice to a sixty-year-old dealer. (One Israeli dealer explained that within the bourse there are small trading groups whose members trade primarily among themselves. The groups are defined by their standards of what constitutes fair and ethical trading.) In addition, even when they participate in brokered transactions, the individual buyer and seller still have to acquire some information about the broker's judgment and reputation. This task is cheaper, however, since it is less transaction specific. Once a dealer determines that a broker has good judgment, he has access to many other dealers whose reputations he need not inquire into directly.

The diamond industry's preference for an extralegal contractual regime cannot be explained by the transactions costs incurred in preserving an agreement in an integrated writing. Although the industry is organized to minimize the costs of using extralegal agreements, given the widespread use of weight slips, invoices, and bills of sale, the additional transaction costs of using legally enforceable standard-form contracts would not be significant. These agreements could be drafted to approach a complete contingent-state contract because most of the events that might disrupt a transaction are well known within the industry and are subject to wellestablished customs and usages within the trade. Nonetheless, the use of

The diamond industry's preference for an extralegal contractual regime cannot be explained by the transactions costs incurred in preserving an agreement in an integrated writing. Although the industry is organized to minimize the costs of using extralegal agreements, given the widespread use of weight slips, invoices, and bills of sale, the additional transaction costs of using legally enforceable standard-form contracts would not be significant. These agreements could be drafted to approach a complete contingent-state contract because most of the events that might disrupt a transaction are well known within the industry and are subject to wellestablished customs and usages within the trade.

XREF: Connects to Barak Richman's work on the diamond industry and the role of communal sanctions versus legal enforcement in trade networks.

In the diamond industry, even if fully specified legally enforceable contracts were widely used and could be inexpensively drafted, dealers would still incur many of the precontract transaction costs of entering into extralegal agreements. In general, as the cost of enforcing a contract in court increases relative to the expected benefit, even fully specified legally enforceable contracts contain an implicit and increasingly large extralegal component. This is also true when the expected value of the court-awarded remedy is insufficient to fully compensate the promisee. In the typical diamond transaction, litigation costs would be high relative to the amount that could be recovered, and the promisee would almost always be undercompensated under standard damage remedies. Therefore, even if legally enforceable contracts were used, diamond dealers would still need the benefit of the reputation bond posted in the formation of an extralegal agreement. And, consequently, dealers would still have to incur the transaction costs of inquiring into their trading partner's reputation and conforming to industry custom.

DEFINE: Introduces the 'extralegal component' concept — the implicit reliance on reputation and custom that persists even in formal contracts when court enforcement is disproportionately costly.

Given the well-established institutional premium on secrecy, parties are rarely willing to pay the reputational price of violating that norm simply to gain access to the courts. Historically, preserving the secrecy norm is one of the primary reasons that the industry uses extralegal agreements rather than legally enforceable contracts.

If commercial transactions in the industry were governed solely by explicit, legally enforceable contracts under which the promisee could recover expectation damages in the event of breach, the market would be characterized by frequent inefficient breach of contract. The sources of this inefficiency are the uncertainty of recovery, the way courts calculate damages, the length of time it takes to obtain a judgment, and, in some instances, the fact that many diamantaires do not have ready access to capital markets. In most settings, expectation damages, as enforced through the courts, do not achieve their stated theoretical objective of placing the promisee in the same position that he would have been in if the breach had never occurred; they neither make the promisee whole ex post, nor give the promisor sufficient incentive to perform the promise ex ante.

In most settings, expectation damages, as enforced through the courts, do not achieve their stated theoretical objective of placing the promisee in the same position that he would have been in if the breach had never occurred; they neither make the promisee whole ex post, nor give the promisor sufficient incentive to perform the promise ex ante.

In practice, courts are reluctant to award compensation for lost profit since in most instances it is considered speculative. In a diamond transaction, when a seller fails to deliver a stone, lost profit is extraordinarily difficult to calculate since it is highly idiosyncratic." A dealer's profit on a rough stone depends intimately on his network of contacts, his skill as a cutter, and his ability to choose a cut for which market demand is high. The same is true of polished stones, but to a lesser degree. Similarly, when a buyer breaches a promise to pay money, it is difficult, if not impossible, to determine the profit the promisee would have made subsequent to the breach had he been able to invest the money he was owedthe value of business opportunities forgone is inherently speculative. The longer it takes to obtain a judgment, which in New York court can take up to three years, the greater will be the uncompensated loss suffered by the promissee when his ability to enter into subsequent transactions is impaired due to lack of capital.

XREF: Connects to contract law remedies and the economics of damages, particularly how uncertain future profits are treated in common-law jurisdictions.

In calculating expectation damages, courts award interest to compensate the promisee for doing without the money during the pendency of the controversy. Interest will fully compensate the promisee only if the unavailability of funds did not affect his ability to enter into subsequent transactions, that is, if the promisee had access to credit on reasonable terms during the relevant time period. The typical diamond dealer does not have ready access to capital markets or excess cash on hand. For example, in a transaction between two non-sight holders, if the promisee is not paid, it is unlikely during the pendency of the dispute that he will be able to either borrow money or obtain access to the implicit capital market at the predispute implicit interest rate. If the amount owed is large, it is quite possible that he will have to suspend operations until he is paid.

XREF: Links to contract damages theory and the efficient breach discussion; the Diamond Dealers Club fiduciary regime is flagged as modifying this typical outcome.

Even the expert diamantaires who sit on the DDC's arbitration panel have difficulty accurately valuing lost profit and business opportunities forgone. They are allowed to award punitive damages, however, and usually err on the side of generously compensating the promisee for alleged lost profit. They render their decisions quickly so as to minimize the number of business opportunities the promisee will have to forgo when he is not paid.

A dealer's ability to obtain credit through the industry's implicit capital market will also be affected by the existence of a public dispute. Until a decision is rendered, the judgment enforced, and the dealer absolved of wrongdoing, other dealers will be either unwilling to sell to him on credit or will charge him a higher implicit interest rate on each transaction to compensate for the perceived increase in the risk of nonpayment and the depletion of his cash reserves. Thus, even if a court were to adjust its award of expectation damages by the correct interest rate, the promisee would still be undercompensated; until the controversy is resolved, the promisee will have to pay the higher implicit interest rate in every subsequent transaction, while the court will award him interest only on the amount of the original debt. Thus, the shortcomings in the expectation remedy are particularly acute in an implicit capital market.

Until a decision is rendered, the judgment enforced, and the dealer absolved of wrongdoing, other dealers will be either unwilling to sell to him on credit or will charge him a higher implicit interest rate on each transaction to compensate for the perceived increase in the risk of nonpayment and the depletion of his cash reserves. Thus, even if a court were to adjust its award of expectation damages by the correct interest rate, the promisee would still be undercompensated; until the controversy is resolved, the promisee will have to pay the higher implicit interest rate in every subsequent transaction, while the court will award him interest only on the amount of the original debt. Thus, the shortcomings in the expectation remedy are particularly acute in an implicit capital market.

Having a portion of his capital tied up for three years while a lawsuit progresses through the New York Courts could cause a dealer extensive financial harm that would not be taken into acocunt in the final calculation of damages. In addition, when the promisor's default causes the promisee to breach other contracts, the promisee will suffer long-term damage to his reputation for which he will not be compensated under standard damage measures.

In a diamond transaction, it would be particularly difficult to draft a liquidated damages clause that a court would view as a "good faith" attempt to preestimate damages. Often, at the time of contracting, the parties themselves are unable to accurately preestimate damages since the actual harm suffered by the promisee in the event of breach depends largely on business decisions made after entering into the contract. For example, even if at the time of contracting nonpayment would neither have bankrupted the promisee nor caused him to default on other obligations, if he subsequently made a large financial commitment in reliance on being paid and then was not, he might suffer tremendous financial and reputational harm, particularly if forced to go to court to obtain a judgment.

XREF: Connects to contract law doctrine on liquidated damages and the difficulty of predicting reasonable forecasts of harm.

In a diamond transaction, it would be particularly difficult to draft a liquidated damages clause that a court would view as a "good faith" attempt to preestimate damages. Often, at the time of contracting, the parties themselves are unable to accurately preestimate damages since the actual harm suffered by the promisee in the event of breach depends largely on business decisions made after entering into the contract. For example, even if at the time of contracting nonpayment would neither have bankrupted the promisee nor caused him to default on other obligations, if he subsequently made a large financial commitment in reliance on being paid and then was not, he might suffer tremendous financial and reputational harm, particularly if forced to go to court to obtain a judgment. Since at the time of contracting the magnitude of this harm could not have been predicted, liquidated damages clauses designed to compensate the promisee for this type of harm would run a serious risk of being invalidated as penalties.

What is unique about the diamond industry is not the importance of trust and reputation in commercial transactions, but rather the extent to which the industry is able to use reputation/social bonds at a cost low enough to create a system of private law enabling most transactions to be consummated and most contracts enforced completely outside the legal system.

XREF: Echoes research on private governance in other close-knit trading communities, and relates to the broader economics-of-trust literature on informal enforcement mechanisms.

The typical diamond transaction involves the posting of a reputation bond equal to the present value of the profit on future transactions that will not take place if the promisor breaches a contract, less his ability to cover.

DEFINE: This is a formal economic/legal definition of how reputation functions as a bonding mechanism in diamond dealing.

In the early 1980s the DDC Board of Directors exercised their authority to expel a member from the club for making public statements that tended to cast the industry in a negative light. They expelled Martin Rapaport for saying to the press, "diamonds, ethics, Feh! If the devil himself showed up they would sell to him." The real reason the club wanted to expel Rapaport, however, was that they were opposed to his price list. See note 4 supra. They also brought an antitrust suit against him for price-fixing and asked a Jewish court to issue an injunction barring him from any further participation in the Jewish community until he ceased publishing the list. The attention generated by the suit led the Federal Trade Commission (FTC) to initiate an investigation to determine if the club itself was in restraint of trade. Although the FTC instituted a full-scale investigation, it was later dropped. Rapaport challenged his expulsion in court but ultimately settled with the club on undisclosed terms and was readmitted as a member. Today Rapaport has a strong base of support at the club: he is a member of the board of arbitrators, and his price list is an accepted fixture in the international diamond trade. Rapaport was not expelled for breaching contracts or failing to meet his commercial obligations; consequently the club was unable to use its power to exclude him from the industry. The norms of the diamond industry only work when they capture information that the market values.

Charny has noted, however, that a reputation-bond-based, extralegal contractual regime will function even in large scale markets so long as "technology . . . such as computers used to monitor credit worthiness, or mass media used in advertising, [make it possible to] convey information cheaply to a large group of transactors . . . [that is] when a thick set of informational intermediaries" exists.

DEFINE: Clarifies the condition under which extralegal contractual regimes can scale to large markets: the presence of informational intermediaries that cheaply convey trustworthiness data.

In a given market, geographical concentration, ethnic homogeneity, and repeat dealing may be necessary preconditions to the emergence of a contractual regime based on reputation bonds. As the diamond industry illustrates, however, these conditions are not required for the maintenance of such a system, particularly when the system has already demonstrated itself to be preferable (Pareto preferred) to the established legal regime.

XREF: Connects to network effects and institutional path dependence — once a reputation system reaches critical mass and proves superior, it becomes sticky.

Jews have been involved in the diamond industry since the Middle Ages. The original reasons for their involvement were largely fortuitous: Jews happened to live in major cities on the diamond trade route. In two of these cities, Amsterdam and Antwerp, laws relating to Jewish employment were quite liberal and the governments allowed them to freely enter the diamond-cutting trade. The concentration of Jews in the industry accelerated in 1492 when Spain expelled its Jews and large numbers then fled to Amsterdam and Antwerp.

In the past, Jews formed a cohesive, geographically concentrated social group in the countries in which they lived. Jewish law provided detailed substantive rules of commercial behavior, and the Jewish community provided an array of extralegal dispute resolution institutions.

XREF: Connects to law-and-economics literature on private ordering and extralegal dispute resolution (Ostrom, Ellickson).

11 See Menachem Elon, ed., The Principles of Jewish Law 20-21 (1974) ("A striking expression of the religious and national character of Jewish law is to be found in the prohibition on litigation in the gentile courts ... to which the halakhic scholars and communal leaders attached the utmost importance .... any person transgressing the prohibition was deemed to have reviled and blasphemed and rebelled against the Torah").

DEFINE: Clarifies the halakhic prohibition on gentile courts and its serious theological significance.

Jewish arbitrators were given the authority to attempt to bring about conciliation (compromise) between parties prior to rendering their decision. … Just as the DDC arbitrators are not required to produce written opinions of their decisions, “according to talmudic halakhah [Jewish law], a party may require the regular court to submit written reasons for its judgments, but an arbitral body is not obligated to do so, even upon request." … According to Jewish law “any custom adopted by the local merchants as a mode of acquisition is valid . . . since it fulfills the principle that the purpose of the kinyan [any formal act of acquisition] is to bring about the decision of the parties to conclude the transaction .... some authorities even regard a handshake as the equivalent of an oath."

XREF: Parallels with the DDC (Distressed Debt Consortium?) arbitration procedures mentioned in the highlight, showing continuity in conciliation-based dispute resolution.

The similarity in the terms of the substantive law is also striking. According to Jewish law "any custom adopted by the local merchants as a mode of acquisition is valid . . . since it fulfills the principle that the purpose of the kinyan [any formal act of acquisition] is to bring about the decision of the parties to conclude the transaction .... some authorities even regard a handshake as the equivalent of an oath." Id. at 209. In addition, under Jewish law, "the decision of the parties to conclude a sale is finalized by the performance of one of the appropriate acts of kinyan ("acquistion") by one of the parties-generally the purchaser-that the other parties have expressed their agreement that this be done.

XREF: Connects to comparative legal history — a recurring thread in sources comparing religious and secular legal traditions.

Sugden developed a model of exchange that demonstrates how, under certain conditions, a market norm that normally results in cooperation can be a stable, though not unique, equilibrium-even when there appear to be incentives for individuals to be free riders and transactors occasionally make mistakes (breach unintentionally). The game is an adaptation of the classic prisoner's dilemma model in which the following conditions hold: the benefit to player 1 of player 2 refraining from defecting b must be greater than the cost to player I of refraining from defecting himself c; the same must also be true for player 2; k , the probability that a subsequent round will be played, must be greater than b/c, since, if this condition did not hold, the expected gain from defection will be greater than any gain from alternative strategies.

DEFINE: Sugden's model formalizes the conditions under which a cooperation norm becomes a stable equilibrium in an iterated prisoner's dilemma. XREF: Relates to classic game theory and the iterated prisoner's dilemma, such as Axelrod's work on reciprocal altruism.

In the context of the diamond market, these conditions seem to hold. The probability that the transactors will have occasion to deal with one another in the future, 4 , is quite high. In addition, many aspects of the industry suggest that the condition that b > c will hold. For example, a diamond dealer generally operates on a slim cash flow margin and has trouble getting access to capital. He routinely makes business decisions in reliance on receiving payment on a particular date. If he is not paid, the harm he suffers can be far greater than loss of the amount of money he is owed. Nonreceipt of payment might force him to breach a contract with another dealer, which will in turn damage his reputation. It might force him into insolvency and result in suspension from the club.

XREF: Connects to formal/relational contract theory and how reputation sustains cooperation in closed trading networks.

In the context of the diamond market, these conditions seem to hold. The probability that the transactors will have occasion to deal with one another in the future, 4 , is quite high. In addition, many aspects of the industry suggest that the condition that b > c will hold. For example, a diamond dealer generally operates on a slim cash flow margin and has trouble getting access to capital. He routinely makes business decisions in reliance on receiving payment on a particular date. If he is not paid, the harm he suffers can be far greater than loss of the amount of money he is owed. Nonreceipt of payment might force him to breach a contract with another dealer, which will in turn damage his reputation.

In essence, the game relies on the familiar strategy of tit-for-tat, in which one player (say an established dealer) agrees to comply with the rules of the game until the other side violates them but will punish that player by defecting from the cooperative solution if the other player has done so in the previous round. In general, the established dealer adopts a strategy that promises cooperation to those who cooperate and punishment to those who defect.

These organizations make it clear to new entrants, who are primarily manufacturers of small stones, that their ability to secure a steady flow of rough diamonds for their cutting centers is intimately linked to their willingness to play by the established rules-to organize bourses, set up arbitration systems, and submit claims filed against them to the Arbitration Board of the World Federation.

A bourse's ability to attract business depends largely on the aggregate reputation of its members for trustworthiness and fair dealing, and a bourse's economic viability depends, in large part, on its ability to attract foreign dealers to its trading halls.

Intrabourse reputation monitoring, induced by competition between bourses, is likely to be cheaper than increased monitoring by an umbrella organization such as the world federation. Within each bourse, there is a measure of social and ethnic homogeneity. Consequently, intrabourse monitoring can take advantage of preexisting social relationships and therefore be achieved at a lower cost than regulation by an outside body that cannot take advantage of these preexisting relationships.

XREF: Connects to economic sociology work on reputation and social capital, and to governance-by-community literature versus formal external regulation.

In general, the world federation's drive to create new bourses has succeeded in combating an additional problem associated with markets based on social networks among homogeneous groups, namely, that "these markets may become unstable because of free-riding potential, as outlying transactors may adopt the customs of the markets without bearing the costs of membership." … Although it may be true that, in the long run, "markets based upon social networks are unlikely to sustain themselves in the face of alternative markets based on sophisticated and potentially more extensive information systems,"" the diamond industry is currently in a state of transition; it has succeeded, at least for the time being, in creating a system that is designed to capture the benefits of both monitoring by small social groups (individual bourses) and monitoring achieved through information intermediaries (institutions such as the world federation and brokers).

Although trade practices and customs have remained largely unaffected by the shift from a homogeneous-group-based contractual regime toward one that is based increasingly on information technology, the change could radically affect the economic structure of the industry. In a homogeneous-group-based contractual regime, developing a reputation for trustworthiness and fair dealing takes time since reputation information is communicated solely by world of mouth and depends largely on personal contacts. This results in high barriers to entry.

XREF: Connects to the economics of reputation as a barrier to entry — parallels literature on group-based trust networks (e.g., ethnic trading networks) and how credentialing/technology lowers entry costs.

Although trade practices and customs have remained largely unaffected by the shift from a homogeneous-group-based contractual regime toward one that is based increasingly on information technology, the change could radically affect the economic structure of the industry.

It might be argued that an outsider with no established reputation could overcome reputation-related barriers to entry by offering to transact using legally enforceable contracts. If extralegal contracts are rationally preferred, however, a promisor offering a written agreement would have to offer a much higher price to compensate the promisee for the risk and imperfections of litigation-not only the actual cost and uncertainty of the litigation, but also the reputational damage of being involved in a court suit at all. More important, over a certain range of transaction values, a legally enforceable agreement is not of great value to a party. Even with larger transactions, the expected value of a legally enforceable contract in the absence of information about the other party's reputation might be less than the expected value of a legally unenforceable agreement with a person with a reputation for honesty and fair dealing.

Although, as the size of the transaction increases, the benefit of a legally enforceable contract increases relative to the transaction costs of litigation, the amount of capital that is tied up is greater, which in turn increases the opportunity cost of doing without the capital during the pendency of the litigation.

The use of reputation bonds to enforce contracts is sometimes said to be inefficient because there is no correlation between the damage suffered by the promisee and the cost of breach to the promisor. Because the cost of breach to the promisor is generally assumed to be large, reputation bonds are said to induce an inefficiently high level of contractual performance. The most common type of executory agreement in the diamond industry, however, is exchange of goods today for a promise to pay X dollars on a future date. Consequently, the most common type of breach is nonpayment. On the day payment is due and the buyer has to make the decision to perform or breach, the seller's expectancy is known with certainty; it is X dollars. Since only money is at stake, and it is of equal value to both parties, performance is always indicated; the extent of a payment obligation cannot be made to turn on either party's "need" for the money. Thus, even a legal rule that led to no breach of contract would be efficient in the context of these transactions. This is, in fact, close to what is observed in the market; breach of contract is rare.

Given the structure of the market for rough diamonds, however, if S sells to M I, it is unlikely that the stone will wind up in the hands of M2. Dealers keep their trading partners secret, particularly their sources of rough, since a dealer's ability to operate at a profit depends, in large part, on his network of contacts. After buying a stone that can be cut at a profit, most manufacturers do not want to incur the search cost of ensuring that the stone cannot be more profitably cut by another manufacturer, not do they want it known that they have a particular type of rough in their possession.

One major function of a broker is to conduct an effective search for the buyer willing to pay the highest price when the value of a stone is uncertain. If that uncertainty exists, the original owner has every incentive to hire the broker to search the market. If that has been done, then the first purchaser for use will rightly conclude that hiring a second broker has a very low rate of return, given the search already undertaken by the broker for the original owner.

There is another reason that a rule of automatic performance does not introduce major inefficiency in the market. The cartel has the ability to fix the price of the rough that it sells. It also has a standard practice of announcing the magnitude of the price increase at each sight. Together, these two controls keep the difference between the prices that two manufacturers are willing to pay small relative to the aggregate benefit of avoiding the deadweight cost of dispute resolution. As an additional benefit, a high level of contractual performance in the sale of rough promotes efficient reliance decisions such as hiring skilled diamond cutters in advance to cut and polish the rough. In aggregate, the magnitude of the inefficiencies introduced through a high level of contractual performance of executory promises to delivery rough stones is likely to be small, particularly since contracts for future delivery of a stone are uncommon and possession is typically transferred at the time of contracting. Thus, while it cannot be claimed that the rule of automatic performance in the sale of rough diamonds will always lead to the theoretically efficient outcome, the dynamics of the market suggest that the customary solution may well be the efficient solution when the imperfections brought on by positive transaction costs are taken into account.

In those situations where the first purchaser really does have superior connections for resale, he should enter the market as a middleman. This is observed: some of the largest manufacturers with the most extensive supply connections to sight holders, who often purchase rough stones in large parcels rather than individually, also run very active brokerage businesses.

62 Diamond cutters are independent contractors and are often paid by the stone. Consequently, after contracting to purchase a piece of rough, a dealer will contract with a cutter. If he does not obtain the stone and does not have other work for the cutter to do, he will still have to pay the cutter.

Diamond cutters are independent contractors and are often paid by the stone. Consequently, after contracting to purchase a piece of rough, a dealer will contract with a cutter. If he does not obtain the stone and does not have other work for the cutter to do, he will still have to pay the cutter. Furthermore, unlike many commercial contexts, at the time a diamond contract is made, the promisee typically is unable to estimate what is reliance expenditures will be; they will depend largely on the subsequent business opportunities that present themselves to the promisee.

DEFINE: Illustrates the concept of reliance expenditures that cannot be estimated at contract formation, using the diamond trade as a concrete example.

In the diamond industry, arbitration has important substantive and procedural advantages over adjudication. It enables parties to resolve disputes and enforce judgments quickly, inexpensively, and secretly, thereby containing damage to reputation and reducing the actual damage suffered by the promisee in event of breach.

Unlike courts, whose award of damages is limited by either expectation damages or a valid liquidated damages clause, the DDC bylaws allow arbitrators to award any measure of damages they think is appropriate, including punitive damages. They can also order one or both of the parties to pay a fine to a third-party beneficiary such as a charity. The authority to award punitive damages means that they can make the promisee whole, and the authority to order payment of a fine enables them to create a deterrent to breach contract. Since transactors know they may be forced to pay a penalty in the event of breach, their incentive to breach in the first place will be greatly reduced.

Although DDC arbitrators have industry expertise and sophisticated business judgment, they are not much better than courts at valuing lost profit or business opportunities forgone. Because arbitration hearings are held soon after the filing of the complaint, however, and because deci-

The bourse's ability to resolve disputes promptly is considered so important that even if a dealer fails to appear for an arbitration, the hearing is held and he is bound by the panel's decision.

In disputes other than breach of a promise to pay money or deliver a stone, which are dealt with in the bylaws or according to well-established custom, arbitrators' verdicts may be more accurate and predictable than those of a court since arbitrators possess industry expertise and are permitted to consider information that would be excluded in court under the rules of evidence. If a diamond dispute were decided by a court, the application of industry custom would be highly unpredictable: unlike a DDC arbitrator, who can apply his own knowledge of industry custom, a judge would have to determine the content of customary norms from the conflicting testimony of expert witnesses. The uncertainty introduced by a judge's need to resolve conflicting testimony would greatly reduce the expected benefit to the promisee of having a legally enforceable contract.

XREF: Relates to private-ordering and dispute-resolution literature; the arbitrator's informational advantage parallels theories of specialized adjudication.

Under the club's bylaws, the existence of a dispute and its resolution are kept secret so long as the arbitrators' judgment is paid promptly. Consequently, unlike filing a claim in court, initiating an arbitration does not affect the parties' ability to borrow or enter into implicit capital market transactions during the pendency of the dispute, which, in turn, minimizes the financial harm suffered by the promisee. The reputation damage suffered by the promisee is reduced by the practice of keeping disputes secret after a judgment is rendered since other transactors may view mere participation in an arbitration as a signal that a dealer was unwilling to renegotiate deals when unforeseen circumstances arose; they might demand additional protections or charge a higher price when dealing with him in the future.

The rapid enforcement of judgments is another advantage of DDC arbitration. Unlike a court, the DDC has the ability to bring unique pressures on the losing party to pay: it can put him out of business almost instantaneously by hanging his picture in the clubroom of every bourse in the world with a notice that he failed to pay his debt.

The rapid enforcement of judgments is another advantage of DDC arbitration. Unlike a court, the DDC has the ability to bring unique pressures on the losing party to pay: it can put him out of business almost instantaneously by hanging his picture in the clubroom of every bourse in the world with a notice that he failed to pay his debt. Thus, the threat of publicity and the practice of keeping disputes secret as long as judgments are paid gives the defendant an incentive to promptly comply with the arbitrators' judgment.

Although keeping this type of information about dealer behavior from a market that works largely on reputation may slightly impair the efficient operation of the market for reputation information, in the context of the diamond industry's institutional structure, there are sound reasons for this practice. … Furthermore, it may be that the information most important to the reputation market is not that a dealer has been involved in a dispute or even that he has breached a contract, but rather that he has been prepared to either settle disputes or abide by the judgments of the arbitral tribunal when a third-party adjudication was necessary.

QUESTION: This challenges the assumption that full transparency supports reputational efficiency. Worth exploring whether opacity in adjudication outcomes can preserve more valuable reputational signals.

Furthermore, it may be that the information most important to the reputation market is not that a dealer has been involved in a dispute or even that he has breached a contract, but rather that he has been prepared to either settle disputes or abide by the judgments of the arbitral tribunal when a third-party adjudication was necessary.

XREF: Connects to reputation economics literature (Milgrom/North on the Law Merchant) and signaling theory in information markets.

Requiring arbitration judgments to be made public without introducing additional changes in the system might result in the dissemination of information that would be difficult for the market to value accurately. If only the amount of the judgment were announced, a dealer who was ordered to pay a large judgment because there had been an honest misunderstanding in a large transaction would suffer more reputational damage than a dealer who had to pay a smaller judgment because of deliberate breach or theft. Consequently, the facts of the case would have to be released to accurately convey the relevant information to the market if judgments were made public. Arbitrators would have to make findings of fact and issue written opinions, which would lead to a demand for procedural protections such as rules of evidence and more extensive discovery. In time, the flexibility and informality of the system, essential to the rapid resolution of disputes, would begin to disintegrate.

The lack of written decisions and a tradition of stare decisis makes it difficult for market participants to make rational breach decisions and to determine in advance the type of sanctioned behavior. In order to increase predictability, many bourses in the world federation have relaxed the norm of complete secrecy. Arbitrators publish written announcements of the principles used to decide novel cases while keeping the parties and other identifying facts secret. The WFDB recently proposed compiling a computer data base of these statements of principle to promote worldwide uniformity of arbitrated judgments and to prevent "forum shopping."

If a dealer is a member of any one bourse in the world federation, he is automatically admitted to the trading floor of all of member bourses. Most diamond dealers frequently transact in foreign bourses. It would be wasteful for dealers to have to learn the trade rules of different bourses and be concerned with the technicalities of concluding legally enforceble agreements in different countries, particularly when many of these countries do not have well functioning judiciaries.

Some members of the DDC board of arbitrators are concerned that the lack of published opinions explaining the basis of decisions gives dealers the wrong signals about what type of behavior is sanctioned. Although cases are officially kept secret, the industry is "like a bunch of old ladies," and in new and unusual cases the result can rapidly become known.

DEFINE: The DDC's board arbitrates dealer disputes with unpublished opinions; the concern is that missing rationale undermines the deterrent/guidance function of case decisions.

A few years ago a case arose that revived the debate over the secrecy of judgments in the New York bourse. The Yehuda treatment is a way of altering a stone such that its flaws become invisible to the human eye unaided by special technology. The firm that developed this process and actually treats the stones requires those they deal with to sign an agreement requiring disclosure of the stone's treatment to any potential buyers. Soon after the treatment was introduced, but before it was widely known, a dealer sold a treated stone without disclosing the treatment. The buyer subsequently discovered the treatment and filed a claim against the seller. The seller defended on the grounds that he did not know or have reason to believe that the stone had been so treated. The board of arbitrators ordered recision of the deal and imposed a very small fine on the seller. One arbitrator wanted to write an opinion explaining that the only reason the judgment was so small was that the treatment was new and a dealer in exercise of ordinary care would not have been expected to ask whether or not the stone had undergone this treatment. By the time the arbitration was concluded, however, the treatment had become so well known that a similar defense of ordinary care would not prevail in the future and the arbitrators intended to impose extremely heavy fines in subsequent cases.

DEFINE: Introduces the 'Yehuda treatment,' a stone-altering process making flaws invisible, and the disclosure standard requiring sellers to reveal treatment. XREF: Connects to the broader book theme of secrecy/judgment in the diamond bourse, likely linking to norms of private arbitration and disclosure.

Diamond dealers consistently maintain that transactions between two club members, between two nonmembers, and between a member and a nonmember are conducted in exactly the same way. If the availability of the DDC's arbitration system and enforcement mechanisms were central to parties' ex ante decision making, the terms of the transaction (either substantive or price) should be different when at least one party is a nonmember. For example, a member seller who would sell a stone to another member on thirty-day terms would be expected to charge a nonmember a higher price (or perhaps demand cash on the spot) to compensate for the risk of nonpayment and the unavailability of arbitration. Dealers insist, however, that no such differences exist and that they decide who to deal with purely on the basis of the other party's reputation.

Diamond dealers consistently maintain that transactions between two club members, between two nonmembers, and between a member and a nonmember are conducted in exactly the same way. If the availability of the DDC's arbitration system and enforcement mechanisms were central to parties' ex ante decision making, the terms of the transaction (either substantive or price) should be different when at least one party is a nonmember. For example, a member seller who would sell a stone to another member on thirty-day terms would be expected to charge a nonmember a higher price (or perhaps demand cash on the spot) to compensate for the risk of nonpayment and the unavailability of arbitration. Dealers insist, however, that no such differences exist and that they decide who to deal with purely on the basis of the other party's reputation. … If reputation bonds are well functioning, this behavior is not surprising. In a transaction between a member and a nonmember, the nonmember has an incentive to keep the bargain if he wants to be admitted to the bourse in the future. The economic benefits of bourse membership make it actively sought after by most market participants. A member can not only spread the word about the nonmember's wrongdoing, but he can also object to his being accepted for club membership. In transactions between two nonmembers, both parties have reason to worry about their reputations. In order to obtain a steady supply of rough to run an efficient manufacturing business, a nonmember must have a reputation of being scrupulously trustworthy. Nonmembers know that their potential future trading partners will inquire more deeply into their reputation before transacting with them since they do not have the club's stamp of approval.

If dealers really did rely on arbitration to resolve most disputes, one would expect that if it were not available more disputes would go to court. This is not observed; litigation between two nonmembers is also infrequent. Similarly, if reputation bonds were not strong enough to enforce arbitration judgments, one would expect to see frequent recourse to the courts for judicial confirmation of arbitrated judgments. This is also not observed. Thus, it appears that the dispute resolution institutions in the diamond industry can fairly be called extralegal: it is primarily the fear of damage to reputation that maintains discipline in the diamond trade, not the bourse's board of arbitrators or the procedural right to appeal arbitrated decisions in court.

Models of suit and settlement65 suggest that the closer the plaintiff and defendant's estimates of the expected outcome of the litigation, the more likely they are to settle. Consequently, to the extent that the required prearbitration conciliation proceedings shed light on the strengths and weaknesses of the parties' arguments, they would be expected to lead to a high rate of settlement. This is, in fact, observed: 80-85 percent of the disputes submitted to arbitration are settled during the proceeding's mandatory conciliation phase.

XREF: Connects to negotiation theory about information asymmetry and settlement; the closer parties' estimates, the more likely settlement.

Since arbitrators neither make findings of fact nor render written opinions announcing their decisions, past decisions are a poor predictor of future outcomes. As a consequence of both parties'

When arbitrators opt to decide complex or novel cases, however, it is difficult for the parties to predict the rule of decision and/or the damage measure that arbitrators will apply. Since arbitrators neither make findings of fact nor render written opinions announcing their decisions, past decisions are a poor predictor of future outcomes.

One reason a relatively small number of banks are involved in the diamond industry is that evaluating the worth of a stone (often used as inventory collateral) in the absence of an objective and readily ascertainable market price requires an expertise in gemstones that bankers seldom have. Consequently, many loan decisions are really made on the basis of the bank's perception of the dealer's reputation in the marketplace.

Legally enforceable contracts are sometimes used in consignments because these transactions are often interpreted in the course of legal proceedings, and without them courts tend to interpret the meaning of an intraindustry consignment agreement in ways that are strongly at odds with industry custom and the intent of the original contracting parties.

Throughout its history, the diamond business has been largely selfregulating, operating outside the law of the state. Over the past thirty-five years, the private dispute-resolution mechanisms in the world's diamond bourses, combined with widespread adherence to the secrecy norm, have succeeded in maintaining a largely extralegal contractual regime where transactions are concluded on the basis of the dealers' reputations and the incidence of breach is low.

QUESTION: What happens when this reputation-based system fails, or when new entrants like lab-grown diamonds lack the same reputational constraints?

The Rapaport controversy has made the club much more reluctant to expel membersit is concerned not only about the expelled member bringing suit, but it also fears that too many expulsions will revive the Federal Trade Commission's interest in its activities. At present, a member is not expelled until the Board of Arbitrators first obtains a court order affirming its decision. Effective sanctions may still remain, however, since the member's picture, along with a description of the judgment that he refused to pay will still be hung in the club room and on the trading floor of every bourse in the world federation. … Although the DDC bylaws have always given the litigants the right to be represented by a lawyer, prior to the Rapaport case it was uncommon. Today, legal representation is the norm. The arbitrators feel that the presence of lawyers has, in some measure, altered the rules of decision they apply. The lawyers alert them to relevant parts of New York law, and, while this law still does not supply the rule of decision, the arbitrators are more conscious of the law and are increasingly reluctant to drastically depart from it, except in instances where the decisions are deeply rooted in custom or do not involve creating a new rule.

XREF: Connects to broader scholarship on how legal challenges and external pressure shape the behavior of private arbitration bodies and self-regulatory organizations.

Although the DDC bylaws have always given the litigants the right to be represented by a lawyer, prior to the Rapaport case it was uncommon. Today, legal representation is the norm. The arbitrators feel that the presence of lawyers has, in some measure, altered the rules of decision they apply. The lawyers alert them to relevant parts of New York law, and, while this law still does not supply the rule of decision, the arbitrators are more conscious of the law and are increasingly reluctant to drastically depart from it, except in instances where the decisions are deeply rooted in custom or do not involve creating a new rule.

QUESTION: Could explore how informal or customary justice systems change once lawyers professionalize them.

Although the Board of Arbitrators has traditionally declined jurisdiction in cases involving complex statutory rights or claims that are intertwined with pending litigation, in recent years, this has become a more common practice. The older arbitrators fear that legal interference in the diamond trade will one day destroy the traditional way of doing business.

This article has been largely devoted to offering explanations of why the diamond industry has long relied on the extralegal enforcement of its business norms. By a variety of reputational bonds, customary business practices, and arbitration proceedings, the diamond industry has developed a set of rules and institutions that its participants find clearly superior to the legal system. The industry, as it has been traditionally organized, is able to make and, more important, enforce its own rules. The market is organized to promote the low cost and rapid intraindustry dissemination of information about reputation, which enables it to use reputation bonds to create intraindustry norms that function as a deterrent to breach of contract and a private sanctioning system whose judgments can almost always be enforced completely outside the legal system.

XREF: Connects to theories of private ordering and Ostrom's work on self-governance of common-pool resources.

The customs and institutions in the diamond industry emerged for reasons wholly unrelated to shortcomings in the legal system; yet, even as the force of the old enforcement mechanisms of religion and secondary social bonds began to disintegrate, a network of trading clubs, designed to promote the dissemination of information about reputation and socialization among members, emerged to fill the gap. That generations of diamond dealers have clung to nearly identical intraindustry norms in countries with a wide variety of legal rules and institutions suggests that the traditional rules and institutions are likely to be efficient from the perspective of market insiders. In the United States, the traditional rules and institutions endured over time and demonstrated their superiority to the established legal regime.

DEFINE: Explains how informal reputation-based trading clubs emerged to replace disintegrating religion and social-bond enforcement mechanisms in the diamond industry.

The customs and institutions in the diamond industry emerged for reasons wholly unrelated to shortcomings in the legal system; yet, even as the force of the old enforcement mechanisms of religion and secondary social bonds began to disintegrate, a network of trading clubs, designed to promote the dissemination of information about reputation and socialization among members, emerged to fill the gap. That generations of diamond dealers have clung to nearly identical intraindustry norms in countries with a wide variety of legal rules and institutions suggests that the traditional rules and institutions are likely to be efficient from the perspective of market insiders.

XREF: Connects to institutional economics literature on private ordering and social norms as substitutes for formal law, as in Ellickson's work on order without law.