Allen & Overy's Response To The Publication Of The Results Of The EU Feasibility Study

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Allen & Overy LLP's response to the publication on 2 May 2011 of the results of the feasibility study carried out by the Expert Group on European contract law for stakeholders' and legal practitioners' feedback (the feasibility study)

Introduction

In this response we refer to the draft code at annex IV of the feasibility study as the OI (for "optional instrument") or draft code. The Bürgerliches Gesetzbuch (or German Civil Code) is referred to as the BGB and the Code Civil de la République Français (or French Civil Code) is referred to simply as the Code Civil. In Section One, we summarise our general comments on the draft code. In Section Two, we set out more detailed observations on various Articles in the draft code and our responses to specific questions posed in the feasibility study.

The Commission has justified this project on the grounds that a uniform contract law will encourage cross border trade, particularly online trade, throughout Europe. As set out in our response to the Green Paper on European contract law dated January 2011, the Commission has not demonstrated that the absence of such a law is in fact a real obstacle to trade. Indeed, at least in the online sector, evidence suggests that other factors, such as concerns about payment security and shipping costs, are a far greater deterrent to cross border trade than an absence of a uniform governing law.1 Whilst we support the Commission's aim of promoting the internal market, we have serious reservations as to whether the proposed draft code will achieve its stated objective. Indeed, as discussed below, the introduction of the draft code in the form annexed to the feasibility study risks creating legal uncertainty and undermines freedom of contract and thus is unlikely to be attractive to business.2

This response is submitted by our London office but it contains views from our practitioners elsewhere in Europe. In particular, we record views expressed by practitioners in our Frankfurt office, Amsterdam office and Paris office. It is difficult to review a legislative proposal in the abstract and we have found it helpful to do so by reference to national law. In producing this response, we have therefore sought to compare the OI with existing commercial rules in three major European jurisdictions (England, France and Germany). Unsurprisingly, not all practitioners agree on all issues and, where appropriate, we record differing views on the issues under consideration.

Our client base is predominantly corporates and financial institutions, very often operating on a global basis. In submitting our response, we seek to highlight issues of concern about the OI from the perspective of these businesses. In summary, businesses should not be compelled to contract under the OI. Further, on the text of the OI itself, there are two particular concerns expressed by commercial parties – first, worries about the legal uncertainty that the OI creates and secondly, the draft code's perceived encroachment on parties' freedom of contract.

Section One – Overview

1. No legal basis. The Commission has provisionally identified Article 114 (ex 95) of the Treaty on the Functioning of the European Union (TFEU) as the legal basis for its proposal to introduce the OI. We are concerned that the Commission has not fully demonstrated that it satisfies the necessary legal requirements3 to introduce the OI under Article 114. Self evidently, establishing the proper legal basis for this draft code is an important precondition to progressing this initiative: Europe's law-makers must comply with and respect (and be seen to comply with and respect) European law. We note in this context that in their 2007 report on the Legal Basis for an Optional Instrument on European Contract, Hesselink et al4 concluded: "It is not clear that an optional instrument, especially a mere opt-in instrument which is limited to cross-border contracts, would amount to a measure for the approximation of the laws of the Member States, as required by Articles 94 and 95 EC. Moreover, many of the subjects contained in the forthcoming draft CFR would almost certainly not pass the Tobacco test, as they are not directly relevant to the Internal Market."

2. Risk of legal challenge to OI. Related to (1) is the practical risk that a continued failure by the Commission to resolve the fundamental issue of the legal basis for the proposal means that a legal challenge to the draft code is likely. Such a legal challenge may throw into chaos the contracts which businesses and consumers will have concluded under the new code, as well as any legal actions to be determined under the new code which may be pending in member state courts. This would be an unhappy outcome for European citizens, businesses and the institutions of the European Union. It also risks damaging Europe's reputation as a global trading partner. We would therefore urge the Commission and the European Parliament to address this issue as a matter of urgency and to do so openly, with the results of any expert's report on this issue published.

3. Legal uncertainty. In addition to the uncertainty created by the doubt over the legal basis of the draft code, we are concerned that should the draft code be applied in the commercial context, it would introduce elements of uncertainty into business dealings which, at least as far as English law is concerned, did not previously exist. We set out below a few examples:

   (i) As a general point the various member states have very different legal, cultural and historic traditions. This means that each member state court is likely to interpret and enforce the OI differently. This point is illustrated by reference to the State of Louisiana, U.S. which, with its civil law background, has enforced the Uniform Commercial Code in a very different manner to the other (common law) states. It will be many years before the ECJ is able to give any substantial body of guidance on many of the issues that are likely to give rise to dispute.

   (ii) Some provisions of the new code are unclear and many are unsuitable for business contracts. For example, Article 48 provides that a party may avoid a contract if, at the time of the conclusion of the contract, it "was in economic distress or had urgent needs, was improvident, ignorant, inexperienced or lacking in bargaining skill" and the other party "knew or could be expected to have known this" and "exploited the first party's situation by taking an excessive benefit or unfair advantage". In the commercial context such a provision provides enormous scope for businesses to try and escape the consequences of what might have turned out to be a bad bargain, or a deal that has proved less profitable or more onerous to perform than had been anticipated. Numerous terms are ripe for litigation. For example, what is meant by "urgent needs" in the business context? Could this be interpreted as widely as a company having a requirement for a product or service because of a related contractual arrangement or is in financial difficulties? When is a business "ignorant" or "improvident"? In any event, why should a business be allowed to set aside a contract on this ground? What is an "excessive benefit" under a contract? Is a profit of more than 5% "excessive"? Overall, many of the provisions create a great deal of uncertainty in the business context and increase the risk of litigation.

   (iii) The draft code provides new rules by which member state courts are to interpret contracts. Under 'interpretation' it provides: "... the contract is to be interpreted according to the meaning which a reasonable person would give to it in the circumstances." (Article 56(3)). From a common lawyer's perspective (and also a Dutch perspective) this introduces more uncertainty into business dealings, as parties cannot rely with confidence (at least as a starting point) on the natural and ordinary meaning of the provisions of their written contract.

   (iv) The draft code also provides that when interpreting a contract regard may be had to "(a) ... the preliminary negotiations; (b) the conduct of the parties, even subsequent to the conclusion of the contract; (c) the interpretation which has already been given by the parties to expressions which are similar to those used in the contract; (d) practices which the parties have established between themselves; (e) the meaning commonly given to expressions in the branch of activity concerned... (g) usages; and (f) good faith and fair dealing." (Article 57). In the commercial context, this provision is likely to give rise to difficulties because parties will be unable to ascertain with any certainty whether the terms recorded in their contracts might be vulnerable to being rewritten or interpreted in a different way following a lengthy and expensive trial involving (amongst other things) an examination of evidence of the motives of the contractual parties. It may also lengthen trials, at least in England, where the general position is that pre-contractual conduct is largely irrelevant to the objective interpretation of the contract and evidence of such conduct is usually inadmissible. We anticipate this provision will give rise to litigation, as parties seek to introduce evidence to persuade the court that the words in the contract do not mean what they say.

   (v) Two concepts underpin the OI - good faith and reasonableness. As we note below, there is a divergence of understanding as to what these terms mean, depending on whether you come from a civil or common law background. It does seem likely that there will be litigation about the precise application of these terms in the commercial context. Further, since the OI is to be given an autonomous meaning, there would be no case law by which parties, their advisers or member state courts could interpret these terms (parties/courts are expressly told at Article 1(2) not to refer to national...