Special report: legal risk
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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

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