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The Harmonization of Contract Law


through European Rules: a Law

and Economics Perspective










Fernando Gómez Pomar
School of Law

Universitat Pompeu Fabra


















BARCELONA, APRIL 2008

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Fernando Gómez

Abstract*

This paper aims to present some preliminary ideas about the potential benefits and costs arising from the
process of European Contract Law harmonization for the functioning of the existing national Contract
Laws, and in the end, for the welfare of European societies. Some of those benefits and costs will essentially
be illustrations of some relevant generic features of a legal harmonization process abstractly considered,
whereas others will apply specifically to the current process under way in Europe and affecting European
Contract Law. Section 1 serves as introduction, Section 2 would first present and then examine the
potential benefits of the harmonization process, while Section 3 will deal with the reverse side, that is, with
some of the potential risks, broadly understood, of the harmonization endeavor. Section 4 briefly concludes.

Title: The Harmonization of Contract Law through European Rules: a Law and Economics Perspective
Título: La harmonización del derecho europeo de contratos desde la perspectiva del análisis económico del derecho

Keywords: European Contract Law; Harmonization; Law and Economics
Palabras clave: Derecho europeo de contratos; harmonización; análisis económico del derecho



Summary

1. Introduction
2. Some plausible benefits from adopting harmonizing instruments of European Contract Law


2.1. Efficiency in economic relationships


2.2. Reducing transaction costs in cross-border trade


2.3. Economies of scale in legal reform
3. The potential costs of adopting harmonizing instruments on European Contract Law


3.1. Heterogeneity of preferences and economic conditions


3.2. Process goes beyond mere codification, for better and for worse


3.3. A complex game in which legislator interacts with contracting parties and Courts


3.4. The lack of clear behavioral models on contracting behavior


3.5. The insufficient use of empirical knowledge on contracting behavior
4. Conclusions
References





* I am grateful to participants at seminars on the role of (internationally) mandatory rules in a multi-level
European system of private law at the University of Amsterdam, and on the future of European contract law –the
Draft Common Frame of Reference- at ERA for helpful comments and suggestions. All remaining errors are, of
course, my own.

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1. Introduction

One of the most visible developments of Private Law, and specially Contract Law, in recent
years, has been the emergence of different processes focused on an increased Europeanization of
the substantive rules and principles, well beyond the more traditional –albeit still important-
issues of choice of Law and enforcement of judicial and arbitral decisions against one contracting
party situated in a different jurisdiction. Obviously, the legislative activity of the EU, most
notably with respect to important transactions involving consumers, has played an important
role in providing additional focus, impetus and concreteness to those processes. The Commission
Communication on European Contract Law and the revision of the Acquis1 has formalized, to
some extent at least, the existing plethora of initiatives and developments. In addition to the
evaluation, review, and reformulation of significant portions of the consumer Acquis, the process
has been focused around the formulation of a Common Frame of Reference (CFR) that would
condense principles, rules, and terms to organize and give coherence to the legal materials –the
Acquis among them, but not exclusively- in the field of contracts. It would also serve to inspire
the interpretation and application of existing Law, including national Laws of the European
countries, and eventually give rise to a new body of Law in the field of contracts, most likely as a
non-binding instrument.

The existing process, thus, seems to be one of creation of the framework for a more or less distant
stage of legislative decision-making. And whatever the legal nature of the final outcome of the
process, possibly in the form of a new piece of legislation (even if optional or non-binding as a
legal instrument), it seems undeniable that the set of principles and rules contained in the CFR
involves a general approach to the legal regulation of contracts in Europe, containing both
mandatory and default rules that aspire to constitute at least an important part of the legal
environment of contracting in economic and social environment of contemporary Europe.

The present paper tries to present some preliminary ideas about the potential benefits and costs
arising from this process for the functioning of the existing Contract Laws in the different
European countries, and in the end, for the welfare of European societies. Some of those benefits
and costs will essentially be illustrations of some relevant generic features of a legal
harmonization process in abstractly considered, whereas others will apply specifically to the
current process under way in Europe and affecting European Contract Law. Section 2 would first
present and briefly examine the potential benefits, while Section 3 will deal with the reverse side,
that is, with some of the potential risks, broadly understood, of the harmonization endeavor.
Section 4 briefly concludes.





1 Communication from the Commission to the European Parliament and the Council of 11 October 2004, on
European Contract Law and the revision of the acquis: the way forward, COM (2004) 651.

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2. Some plausible benefits from adopting harmonizing instruments on European
Contract Law

I do not purport to examine exhaustively the potential benefits of the current process set in
motion to prepare and adopt new bodies of Law in Europe affecting the area of contractual
activity of firms and individuals. Nor I will examine in detail the draft CFR to comment on the
advantages of the specific normative solutions proposed. I will limit myself to briefly review the
beneficial effects that, in theory, may ensue from a process such as the existing one, without
committing to a normative evaluation about the already available outcomes –even if still in draft
form- of the current enterprise, and whether it has exploited all available opportunities to
maximize those potentially positive effects. I will mention three of these: To improve the way in
which the existing Contract Law is affecting the efficiency of contractual interactions, to reduce
transaction costs from diversity in the legal regulation of contracts, and to achieve economics of
scale in legal reform. I do not include here any kind of redistributive ideal, given that the broad
scope of application of Contract Law (not just B2C, but also B2B, or C2C), and the broad
differences across countries in the factors affecting the outcomes of such policies, in all likelihood
prevent the pursuit of consistent redistributive policies at this level of generality2.


2 The statement in the text does not imply either of the following propositions. On the one hand, that distributive
concerns are not relevant for the design and operation of rules of Private Law. On the other, that at lower levels of
generality in the scope of Contract Law rules, distributive policies constitute a general appealing alternative for
legal policy in Private Law, in terms of being both normatively convincing and feasible as an overarching goal. I
think both assertions generally tend to be wrong. On the first, see Juan José GANUZA and Fernando GÓMEZ,
“Realistic Standards: Optimal Negligence with Limited Liability”, Journal of Legal Studies (2008) forthcoming,
showing how distributive questions –levels of wealth, and distribution thereof- are relevant for the optimal
design of Tort liability. On the second, showing how distributive policies face important informational and other
problems in design when one tries to adequately pursue them in consumer markets, or in areas of voluntary
interactions in which parties may react to policies by rearranging the terms of trade: Fernando GÓMEZ, “The
Unfair Commercial Practices Directive: A Law and Economics Perspective”, European Review of Contract Law
(2006), p. 9; Fernando GÓMEZ, “Contract Law and Economic Welfare: A View from Law and Economics”, Stefan
GRUNDMANN (ed.), Constitutional Values and European Contract Law, Kluwer (2008) (forthcoming). Again, the latter
proposition does not constitute a kind of impossibility theorem showing that redistribution through Contract
Law rules will always be moot, in the way that some prominent scholars think: See, Louis KAPLOW and Steven
SHAVELL, “Why the Legal System is Less Efficient Than the Income Tax in Redistributing Income”, 23 Journal of
Legal Studies (1994), p. 667; Louis KAPLOW and Steven SHAVELL, “Should Legal Rules Favor the Poor? Clarifying
the Role of Legal Rules and the Income Tax in Redistributing Income”, 29 Journal of Legal Studies (2000), p. 821.

There are, in fact, environments in which a particular Contract Law rule can have desirable efficiency properties
and, at the same time, induce desirable redistribution of welfare in favor of consumers: See, Alexander
STREMITZER, “Opportunistic Termination”, Working Paper, University of Bonn, Department of Economics (2007),
available at SSRN: http://ssrn.com/abstract=989557 in the case of termination rights for consumers when sellers
have market power. The proposition I advance is just one of scepticism about the feasibility of general and global
redistribution policies through Contract Law rules, given the complexity of factors that influence the efficiency
and the distributive effects of those rules, that do not seem amenable to an across-the-board policy for a wide
variety of environments. In fact, this is what makes things complicated for Contract Law: if redistribution were
always impossible or undesirable, or if it were an easy task, life would be much simpler for those devoted to the
academic analysis of Contract Law.

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2.1 Efficiency in economic relationships

From a Law and Economics perspective, it seems logical to start with efficiency as a plausible
advantage of a process of legal reform in the area of contracts. Contractual interactions are one of
the major sources of economic and social development, as they provide the main channel for
cooperation among individuals and for exploiting the undeniable benefits of division of labor,
and trade among agents with divergent valuations. In complex and developed societies as the
European ones, the Law, and specifically the Law of Contracts, provides one of the most
important mechanisms to foster the adequate functioning of contracting through the creation of
incentives for cooperative behavior inside contractual relationships, and the removal of
incentives for non-cooperative attitudes.

The Law, however, may not get its task right, and may not contain the legal solutions that
actually maximize the joint welfare of the contracting parties, by creating the wrong incentives,
or by interfering with the incentive mechanisms set out by the interested parties themselves in
their arrangements. Contract Law scholars have for centuries, and Law and Economics scholars
for decades, criticized inadequate solutions adopted by Contract Law to achieve the desirable
outcomes in a given set of contractual circumstances.

It is true that Contract Law is not the only force working towards efficiency -that the surplus
from the voluntary interaction becomes as large as technologically or otherwise materially
feasible, that the surplus is maximized, to use the mathematical jargon economists tend to favour.
Competition in the markets for goods and services seems at least as important for achieving this
goal. But not even the most devout believers in the benefits of competitive markets think that
competitive equilibrium will happen without some help from legal rules, and also from Contract
Law rules.

First, because many contractual interactions in real life take place outside the realm of
environments that can become competitive markets: the problems of information and
incompleteness of the terms of the interaction are so relevant that we cannot expect something
remotely similar to a competitive market. And then, general rules in Contract law sanctioning
duress, fraud and other informational deficiencies, and regulating contract enforcement and
remedies for breach of contract have to take the lead.

Second, because in areas in which competitive markets are feasible, the problems that may afflict
them (informational problems, for instance) are common with contractual environments, and
thus may be subject to rules and regulatory measures that resemble those in Contract Law –a sort
of leading role of contractual solutions in areas of market regulation.

European Laws probably differ widely on how they perform in these respects. It is also safe to
assume that even the most refined Contract Law system, the one working most effectively
towards improving the contractual surplus of the parties, avoiding at the same time negative
external effects, is still not working optimally and presents shortcomings, maybe even significant
ones.

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Is it possible that legal reform may be able to unearth existing deficiencies and offer
improvements in legal rules, institutional arrangements, and strategies for legal decision-makers
that can enhance the welfare of contracting parties? The answer is, naturally, yes, it is possible. Is
it also possible that such legal reform is set in motion and carried out substantially at the
European level, that is, at a level that in terms of abstraction and geographical scope lies beyond
the current systems of Contract Law, that to this day remain mainly national in their design and
scope? Again, the answer is yes. It is possible to improve the efficiency of the existing
performance of Contract Law national systems through reform measures, even comprehensive
ones, which can take place at the European level.

The core issue, of course, is how to do it properly. To design and apply an optimal system of
Contract Law that improves matters and, at the same time, does not interfere with the healthy
effects of competitive markets, and with the appropriate incentives of the existing rules and
institutions, is not an easy task. For instance, how comprehensive the European led outcomes
should be? How much variation should we allow in the solutions and outcomes, due to the
unquestionable fact that still the single Member States are, all in all, more homogeneous in terms
of preferences and relevant factors affecting the legal solutions, than the European ensemble?
What level of detail do we think optimal for the legislative solutions, and what role do we leave
to Courts and other adjudicators to develop more specific measures?

Just the type of questions that are not readily answerable in this respect are good indications of
the magnitude of the task of optimal law-making at this European level and on contractual
matters. The theoretical point remains, however: it may be possible to enhance the efficiency of
Contract Law as a working legal instrument in Europe, but if we do not think we can do it at the
European level, better not waste resources in a process that will not improve the welfare situation
of the individuals and firms that are subject to Contract Law in their economic and other
interactions.

An additional source of concern about the success in this difficult task lies in the set of incentives
that the leading actors in the European process would face to get things right. May be the experts
and the politicians that may endorse the outcomes of the drafting efforts share a common and
powerful concern for the well-being of European societies, and this provides sufficient incentives.
From an economic perspective, one should be prima facie alert at the expression of pure other-
regarding interests and preferences. Typically, politicians, but also other agents, public and
private, act for a variety of motivating factors, combining the own interest with genuine altruistic
and other-regarding preferences. Taken as granted a given level of social welfare interest in
European politicians, the more they will be politically and immediately rewarded or punished by
their decisions and choices, the more incentives they have for getting things right, that is, for
satisfying the preferences of their constituents. At the European level, this set of incentives based
on political rewards and punishments works less effectively, and with substantially less
immediacy, that at the local and national levels. Therefore, one would expect, all things being
equal, less successful outcomes in terms of responding to the preferences of European citizens.

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The current process, it is true, has been up to now substantially dominated by the academic legal
experts. And these, for better and for worse, do not face the political incentives that politicians,
even at the more distant European sphere, have to live with. How this affects the overall set of
incentives for the task would require further analysis, but it is clear that they do not look, at least
initially, necessarily more promising than at the level of the individual Member State.

2.2. Reducing transaction costs in cross-border trade

The language of removing barriers that hamper the smooth functioning of the internal market in
goods and services, looms large in the reasons provided by European legislation to justify the
introduction of common or harmonized rules in very different areas, consumer Law and Contract
Law among them. The idea that harmonized rules in Contract Law serves to promote the
European internal market can be understood as comprising two different elements or
perspectives. One refers to the reduction for firms of the costs of doing business in various
national markets: If a firm plans to launch a product in several Member States, the costs of
compliance with legal constraints are obviously higher, may be even much higher, in the
presence of different legal requirements than with a single set of legal conditions for the business
campaign. For instance, this dimension of reducing to firm’s costs of doing business, associated
with harmonization has been underlined with respect to several Directives in the field of
consumer Law.3

It can be cogently argued, however, that legal and regulatory diversity will not disappear as a
consequence of a harmonizing legal body in Contract Law, let alone common notions and
principles. The reason would lie primarily in the fact that even if the Law in the books may
become the same in the different Member States, the Law in action would still definitely differ
widely: Courts and other adjudicators, legal procedure, legal culture and environment in general
will remain national, and thus would not allow a dramatic reduction in diversity costs for firms
doing business Europe-wide. Moreover, the need to adapt to local market conditions will always
impose costs on cross-border activities by firms, and thus the extra cost of more complex legal
compliance in various jurisdictions would be close to negligible.

The second element in the picture, often with unappreciated relevance, has to do with the
consumer. In fact, some argue that consumer perceptions about legal and other uncertainties and
shortcomings of transacting over the national borders are the key building blocks of the barriers
to cross-border trade, and thus the crucial factor affecting the implementation of the internal
market through regulatory and legal harmonization4. The crucial obstacles to trade and
contracting across the boundaries of legal and regulatory jurisdictions would thus essentially be

3 See, Stefan GRUNDMANN, “European Contract Law of What Colour?”, (2005) 2 European Review of Contract Law, p.
184; Karl RIESENHUBER, “System and Principles of EC Contract Law”, (2005) 3 European Review of Contract Law, p.
303.

4 See, Hugh COLLINS, “EC Regulation of Unfair Commercial Practices”, in Hugh COLLINS (ed.), The Forthcoming EC
Directive on Unfair Commercial Practices, Kluwer (2003), p. 3.

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demand-driven, that is, those that consumers view, perhaps mistakenly, as negatively
influencing their decision to contract cross-border.

In any case, it seems hard to deny that legal complexity and variety entail some level of
transaction costs for firms contemplating commercial activities in the different areas covered by
the diverse legal and regulatory regimes, and for consumers who could become customers of
those goods and services. Lawyers primarily, but also other legal experts, are specialized
professionals who obtain quasi-rents from, among others, the task of assessing, managing and
minimizing the risks associated with such diversity. The phenomenon is observable even within
national borders, in federal systems in which the individual regional entities have substantial
powers to design and impose their own Laws. Whether this diversity is an important obstacle to
the formation and flourishing of a vigorous unified market is a different matter, and one which
can receive different answers from a theoretical perspective, and should addressed essentially as
a contingent and empirical issue.

In all likelihood, harmonized rules in Contract Law would contribute to produce a reduction in
complexity and disparity, and this, in turn, would produce some gains for the internal market,
and thus for the participants in it –the European consumers as the ultimate beneficiaries. These
gains would reveal themselves both in a static and in a dynamic way. Thanks to the pioneering
contribution of Ronald COASE5 on transaction costs we know that transaction costs are real and
important costs that prevent economic agents from taking the most efficient actions, and reaching
the socially desirable outcomes. In many settings, that they are not subordinate in importance to
technological or other more tangible costs. If a given measure brings about a decrease, greater or
smaller, in the existing level of transaction costs involved in cross-border contracting, that
measure actually entails a reduction of real costs for the economy and society, which implies a
direct and tangible social benefit. These benefits may be difficult to assess and quantify, and their
true extent may never be accurately determined, but the benefits would be real nonetheless. Also,
who would, in the end, benefit more from this reduction in transaction costs depends upon
market structure and the elasticity of demand for the different goods and services experiencing
the diminution in transaction costs.

Moreover, this reduction of transaction costs of cross-border contracting between firms and
consumers is very likely to produce also additional dynamic gains. Transaction costs created by
legal heterogeneity erect barriers to entry in national markets for foreign firms, so a decrease in
the former imply an enhanced chance of entry, and thus, increased competition within each of
the national markets facing entry of foreign firms. And, as is well-known from standard
economic theory, most gains from increased competition finally accrue to consumers.

The perspective of consumers is of course important, and not just for the reason that many of the
static and dynamic gains of reducing costs for firms in engaging in cross-border transactions and
activities ultimately result in the benefit of the consuming public. Consumers also face

5 See, for a summary of his contributions and thinking in this field, Ronald COASE, The Firm, the Market and the
Law, University of Chicago Press (1990).

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transaction costs in cross-border trade, and these are also real economic costs, whose reduction
would also bring both static and dynamic gains. The additional problem here is that the
perceptions of consumers on the real importance of diversity, and the extent of the reduction
brought about by the harmonized rules are, with high likelihood, less accurate than those of
firms. Hence, even if a real reduction in legal diversity –and legal uncertainty associated with the
legal diversity- in cross-border transactions has taken place, if consumers are slow, or myopic, in
evaluating the new situation, purely perceived or imaginary –but effective nonetheless, here-
transaction costs would remain at the previous high level, and little would be gained by the
adoption of harmonized rules.

In short, in order to exploit the advantages –real ones, not imaginary- of harmonized rules in
Contract Law, the reduction in diversity and the enhanced certainty needs to be internalised by
the agents subject to the rules, by the potential contracting parties. Otherwise, transaction costs
may persist, even when the basis for them has now largely evaporated.

2.3. Economies of scale in legal reform

The third potential benefit of a European process of producing a new body of Law in the field of
contracts is of a different nature. It has to do mainly with the costs of Law-making. Careful,
knowledgeable, and effective law-making is by no means an inexpensive activity. Let’s imagine a
benevolent Law-maker desiring to improve the welfare of those concerned by a given set of Laws
and regulations. In order to aptly carry out this goal, our Law-maker would need:
(i)
to collect reliable evidence on the actual state of the events one desires to regulate;
(ii)
to consider some range of alternatives for each issue under consideration;
(iii)
to estimate the likely impact of the regulatory alternatives on the position of the
relevant individuals and groups;
(iv)
to draft the Law, and legal drafting may be costly depending on the kind and length
of the exercise;
(v)
to invest political capital to convince the relevant public of the virtues of the new
legislation, and to overcome opposition from the interest group who may be harmed
by the legal reform, even when overall it enhances social welfare.

All those preparatory activities for the legal reform to be designed, drafted and passed –and I am
abstracting here from implementation and enforcement issues- are costly. And a significant
fraction of those costs are invariant to the number of individuals and firms that will benefit from
the new legal regime. Part from those costs would not vary much if the Law will be adopted in a
jurisdiction with a population of 1 million, or in another with a population of 100 million. That is,
there are important monetary and non-monetary fixed –in the sense of population-invariant-
costs of Law-making.

And fixed costs allow for economies of scale, meaning that if production is concentrated to serve
a larger population, the per-capita costs of production decrease. Thus, a legal reform that may not
be cost-effective if needed to be adopted separately by each Member State, may be cost-effective
if adopted at the European level, given that for the same –assumedly, at least- level of benefit in

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terms of increased social welfare, the costs of adopting the measure are now lower due to the
increased scale that produces significant savings.

This gain of European law-making may be even stronger if one thinks of a large and complex
body of the Law, such as Contract Law. The breadth and complexity of the subject matter
probably make those costs of Law-making (think of political capital, for instance) grow more than
proportionately.


3. The potential costs of adopting harmonizing instruments on European Contract
Law

From an economics perspective, the common theme in debates about legal, regulatory or
institutional harmonization is the issue of regulatory competition as a competitive alternative to
top-down harmonization or rule-setting. In the most naïve version of this model, Contract Law
(or Law and regulations in general) is a public good, and the beneficiaries (the main ones being
the contracting parties in our case) would move (not necessarily in physical terms, it can be
virtually by opt-in or choice of Law clauses) towards the most desirable set of rules providing the
maximum available welfare for themselves. Governments, wishing to attract more parties to their
own jurisdiction, would strive to achieve the best possible set of rules in order to maximize entry
–and presumably revenue- by users of their sets of legal rules and regulations. Of course, top-
down harmonization would interfere with the process that allows this desirable competitive
equilibrium to emerge. The most familiar example of this kind of competitive process that the
believers in the practical relevance of the regulatory competition model usually pose as an
example, is that of Corporate Law evolution in the US. This body of Private Law is characterized
and described by many as the product of healthy competition by different US states offering
menus of default rules of Corporate Law that would induce firms to incorporate in that state, and
thus increase the tax revenue from incoming firms6.

The regulatory competition models do not lack merit in general, and one should derive lessons
from them, specially for the allocation of powers in multi-level governance scenarios, such as
federal states, or the European Union7. A different matter is to trust that it can explain the

6 See, Roberta ROMANO, “Law as a Product: Some Pieces of the Incorporation Puzzle”, Journal of Law, Economics &
Organization (1985), p. 225. Many do not share the idea that such a competitive market exists: Marcel KAHAN and
Ehud KAMAR, “The Myth of State Competition in Corporate Law”, Stanford Law Review (2002), p. 679. Mark ROE,
“Delaware Competition”, Harvard Law Review (2003), p. 588.

7 See, Robert COOTER, The Strategic Constitution, Princeton University Press (2000), p. 130. For instance, and
important implication –also for legal rule-making, and applicable to Contract Law- is that if there are competitive
forces in provision of a public good, if mobility cannot affect one of the providers (for instance, the federal
Government, in a Federal State, or the European institutions, in the European Union), because it is located at a
higher level than the rest, that player should not enter the race of providing it competitively –it may supplement,
or replace other kinds of provision, or encourage the adoption of common standards or model rules- with respect
to the others, because this will lead to overprovision (in the case of Law-making, too much, and too expensive,
Law). This may be an initial theoretical reason to not to favor an optional –in competition with existing national
Laws- general instrument on European Contract Law, although the specifics of the context in which this

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