Special report: legal risk
Top
ten legal risks | Keep
your company on side with the law | The
regulators: who's who | NatWest
Three: could you be next? | What's
my liability as a company director? | Get
ready to be raided | Defective
documentation | Survive
an FSA investigation | Employers
watch out
English law places a high value on certainty, and this tends to be reflected
in the approach to commercial and financial documents. We owe the stability
and success of our financial markets in no small part to this.
But the management of such risk is not to be taken for granted. Imagine, for
example, how much worse the fallout from the “credit crunch” will be if the
complex documentation used to sell on (and thus spread) the risks around the
market are found not to “work” legally.
The seriousness of this kind of risk getting out of hand preoccupies
regulators and participants in the financial markets sufficiently to keep
thousands of lawyers churning out very expensive chargeable hours in London,
New York and other centres. But the risk is not confined to financial market
activity. It can arise in the most basic commercial transactions.
Why does legal documentation sometimes not function properly? Here are some
examples. Some of them may seem basic. But don’t think it couldn’t happen to
you.
1. Entering into a contract “by accident”
It happens more often than you might think. Very few kinds of contract need to
be in writing in order to be valid and fewer still need any kind of
formality of language. A contract can be entered into over the phone, by
exchange of letters and even by email.
Many lawyers will have had experience of clients sending them “instructions”
to draw up a contract for, say, the sale of a business: “The deal is
described in the letters between me and the buyer. Can you just get the
paperwork done?” It may well be that those letters do fact constitute a
binding contract, unless they are clearly marked “subject to contract” or
otherwise expressed in provisional terms. In such cases the correct advice
may have to be: “I’m sorry, but you have already agreed to sell your
business”. This may be catastrophic (from either party’s point of view) if
the letters in question do not contain all the commercial terms that were
being contemplated.
Obviously, if neither party is happy with the letters being the totality of
the deal, the lawyer will be asked to draw up “proper documentation” anyway,
but it may well be that one party sees an advantage in sticking with the
letters as they are (perhaps because they contain none of the usual
warranties).
2. Not entering into a contract when you think you have
Imagine: two businesses “agree” to buy and sell a consignment of widgets. Each
emails the other confirming quantity, price, delivery date and the rest and
they each say “subject to our standard terms and conditions”. But the two
sets of standard terms are not consistent with each other. The buyer’s terms
impose a higher quality requirement than the seller’s. Whose terms apply?
Answer: neither’s. There is no contract. English law requires that, for a
contract to come into existence, there must be some form of offer and
acceptance of the same terms: an agreement, in other words.
Surprisingly, perhaps, this kind of misunderstanding as to whose terms apply
occurs quite frequently. It provides an easy get-out clause, in effect, for
the party who has second thoughts about the deal.
Another, similar trap is the “agreement to agree”. If you leave too much of
your deal “to be agreed” at some later point (with no mechanism for
resolving any impasse) you may find that you have no deal at all.
3. It’s a perfectly drafted document, but one of the parties did not
validly enter into it
As mentioned above, companies and individuals in the UK can enter into binding
contracts with minimal formality. But certain kinds of institutions and
especially entities based in other countries may have to follow more
elaborate procedures and/or be bound by other requirements than would apply
to an ordinary UK business.
In the global economy, contracting with an overseas business is no longer an
exotic or unusual experience, but it does bring with it a need to check the
legal rules that apply in the country of the trading partner as regards
entering into the contract in question.
This is so even when the contract is put under English law (a desirable
precaution for an English-based business). So if your Ruritanian supplier
needs to initial every page of the contract or have its signature specially
witnessed by an official of some kind for the contract to be valid, make
sure that this is done. It’s also worth checking that the Ruritanian courts
would enforce all the provisions of the contract (and respect English law as
the governing law) if you find in the future that you have to go to that
country to get an effective remedy for your supplier’s breach of contact.
4. It’s not fair!
Fairness has little or no place in ordinary English commercial contract law. A
deal is a deal and you should not complain afterwards if you feel it is
unfair. But the fairness concept has, thanks to consumer protection laws,
assumed towering proportions in contracts involving consumers and can result
in provisions being deemed invalid.
It also has much more importance in continental (civil law) systems, which may
come into play if you are dealing with a counterparty based abroad.
Gradually, it seems to be gaining a foothold in English law, albeit in
specific areas. The Financial Services Authority, for example, has an
overriding requirement that businesses regulated by it must treat their
customers fairly. Breach of this rule can result in swingeing fines.
5. Recharacterisation
At this point we start to get more technical. Recharacterisation is the name
that lawyers give to a court decision that judges that the parties’
description of a transaction is not, as a matter of law, the correct one. It
can occur in a range of contexts. Supposing, for example, you agree to
deliver a consignment of widgets to a customer on credit and, to protect
yourself against the risk of the buyer going bust, you specify that title to
those widgets will remain yours until you have been paid. You might even
insist that the widgets are labelled as yours and stored separately until
title passes to the buyer (in other words, after you have been paid).
Such “retention of title” clauses have generated a great deal of controversy
over the years. If the buyer does go bust its other creditors may complain
of unfairness and argue that your transaction — which clearly involved
credit — as actually one in which you took a security interest over the
widgets for your “loan” and that you should have registered it in the public
register that is kept for this purpose.
In other words, you did not merely “retain title” (which is what your
documents say); you took a grant of a charge over the widgets and this
should have been registered if it was to have any standing in the buyer’s
liquidation.
The case law on such arrangements is complex. Some provisions have been upheld
and some have been struck down. Much depends on whether or not the widgets
get mixed up with, or turned into, other products, losing their original
identity (generally a fatal flaw for retention of title arrangements).
Fortunately, as a matter of English law, recharacterisation is encountered
only rarely; the courts are loath to accept “form over substance” arguments,
except in tax cases. The same may not, however, be true in Ruritania . . .
Roger McCormick is director of the Law and Financial Markets Project at the
London School of Economics and the author of Legal Risk in the Financial
Markets
