Contractual Obligations (PIL)

From Max-EuP 2012

by Giesela Rühl

1. Introduction

International contracts belong to the most important instruments of international trade. In light of the increasing integration of markets their significance has steadily increased in the 20th century. Since they create numerous problems unknown to domestic contracts, most legal orders and international instruments make particular provision for their regulation.

a) Basic problems of international contracts

International contracts are different from domestic contracts in that they have relationships to multiple, differently calibrated legal orders. Unlike domestic contracts, international contracts are therefore exposed to a particular form of uncertainty which can lead rational actors to eschew their formation. Empirical studies, which have multiplied in recent years, confirm these considerations: they show—with variations in detail—that the volume of trade declines dramatically at national borders. Economists usually attribute this so-called ‘border effect’ to government-imposed import tariffs, quantitative or qualitative trade restrictions, differences in consumer preferences, regulatory asymmetries or technical barriers. However, for various reasons these factors do not explain the ‘border effect’ entirely. Most importantly, they do not explain why the volume of trade also declines substantially between countries such as the United States and Canada, ie countries that have liberalized their trade and that are mostly homogenous in view of both culture and language. Some economists therefore argue that the ‘border effect’ should be attributed to ‘institutional and jurisdictional discontinuities’. More specifically, they argue that the diversity of institutional and legal arrangements, ie the differences in legal systems, impede international contracts significantly more than any other factor. The conclusion of international contracts is, according to this view, subject to higher transaction costs than domestic contracts, with the result that parties regularly decline to enter international contracts. That this is the case even when the conclusion of an international contract would ordinarily be advantageous for both parties is the primary problem of international contracts: it can be called the international transaction dilemma.

b) Strategies to overcome these problems

The failure of international contracts in a connected and integrated world is an undesirable phenomenon. The important questions, therefore, are: can the international transaction dilemma be overcome? And if so, how? The answer to the first question is straightforward. It flows from the development of the worldwide trade volume, which in the last 70 years has increased from US$20 billion to US$9000 billion. Apparently, the co-existence of various legal orders does not exclude the conclusion of international contracts, it merely discourages them to the extent of the border effect. The second question is more difficult to answer: how is the international transaction dilemma overcome? Different strategies of public regulation (public ordering) and private regulation (private ordering) seem to complement each other. The strategies which fall into the first category, public ordering, are promulgated by a central regulator, especially a domestic or international legislature, and imposed on the relevant private actors (‘top down strategies’). Strategies belonging to the second category, private ordering, are created and implemented by the private actors themselves (‘bottom up strategies’) (private rule-making and codes of conduct).

2. Private international law of contracts

The most important strategy for solving the international transaction dilemma on the level of public ordering is the private international law of contracts. It is part of private international law (PIL) and determines which law is applicable to a contract that has connections to several legal orders. Its legal basis is—despite its international subject—for the most part to be found in domestic law. However, the number of international frameworks has increased in the last decade. The Member States of the European Community, for example, ratified the Rome Convention in 1980 and the Rome I Regulation on the law applicable to contractual obligations in 2008 (Reg 593/ 2008). The latter is now in force in most Member States and has replaced the Rome Convention. Only Denmark still adheres to the Rome Convention. Insofar as the Regulation is applicable, it excludes recourse to the national conflict rules of the Member States and in fact does so with respect to both pure Union cases and cases involving third states.

Outside of Europe, international frameworks can be found in South America. Here, Mexico and Venezuela have enacted the 1994 Mexico Convention on the law applicable to international contracts. It has been signed but not yet implemented by Bolivia, Brazil and Uruguay. No international basis for the private international law of contracts exists in the United States. The relevant choice of law rules are rather to be found in the laws of the 50 US states. Nevertheless, the American Law Institute’s Restatement (Second) of Conflict of Laws (restatements) and the Uniform Commercial Code designed by the National Conference of Commissioners on Uniform State Law have had profound standardizing effects. Admittedly, both sets of rules have no direct application and are not binding. However, most US states have—partly or totally—implemented the Restatement and the UCC into their state laws.

a) Choice of law

The overwhelming majority of legal orders as well as international legal instruments submit international contracts to the principle of party autonomy. The parties can therefore freely choose the law applicable to their contract (choice of law by the parties). In Europe, this follows from Art 3 Rome Convention and Art 3 Rome I. In the United States, freedom to choose the law is enshrined in § 187 Restatement (Second) of Conflict of Laws and in § 1-301 (a) UCC. In South America, it is granted highest priority in Art 7 Mexico Convention and in Japan it is enshrined in Art 7 of the recently adopted Law on the Application of Laws. The reason why the principle of party autonomy has emerged as the globally leading connecting factor (connecting factors) in the private international law of contracts is straightforward: choice of law helps solve the international transaction dilemma because it allows the parties to subject their contract to a single legal order. It thus creates certainty and reduces the costs of determining the applicable law. In connection with the parties’ right to choose the competent forum, choice of law, therefore, allows parties to regulate international contracts in a fashion similar to contracts made in a purely domestic setting.

b) Applicable law in the absence of a choice of law

Which law applies if parties have not agreed on a particular law is not uniformly regulated around the globe. The traditional connecting factors are the place of contracting, the place of performance and the hypothetical will of the parties. These factors have long dominated the discussion and are still applicable today in many countries. However, in Europe, the United States and some other countries, all three connecting factors have been replaced by the principle of the closest connection (most significant relationship, proper law of the contract, principe de proximité). In Europe, the principle of the closest connection is to be found in Art 4 Rome Convention and Art 4 Rome I. However, Art 4 Rome I is less clear than Art 4 Rome Convention. Whilst Art 4(1) Rome Convention expressly states that contracts are subject to the law of the state to which they have the closest connection, Rome I refers to the closest connection only in the escape clauses of Art 4(3) and (4). The reason for this seemingly lower ranking of the closest connection principle is the structure of the Rome I provision, which is dissimilar to Art 4 Rome Convention. Whereas Art 4(2)–(4) Rome Convention merely provide for rebuttable presumptions as to which state has the closest connection to a contract, Art 4(1) and (2) Rome I set up strict rules to determine the applicable law. An express reference to the principle of the closest connection is, therefore, unnecessary. However, as Art 4(3) and (4) Rome I allow application of the law of the closest connection where Art 4(1) and (2) do not apply or where the contract has a closer connection to the law of another country, the basic principle remains unaltered. This can also be derived from the fact that the strict rules laid down in Art 4(1) and (2) Rome I for the most part correspond to the presumptions enshrined in Art 4(2)–(4) Rome Convention, including the relevant case law. In particular, Art 4(2) Rome I and Art 4(2) Rome Convention set out that contracts have the closest connection to the state where the party effecting the characteristic performance has her habitual residence or seat. By the same token, Art 4(1) Rome I follows the case law on Art 4(2) Rome Convention and provides that a sales contract is subject to the law of the seller, a service contract to the law of the service provider, a real estate contract to the location of the real estate, a short-term rental contract of immovable property located abroad to the common habitual residence of the parties, and a franchise contract to the law of the franchisee.

In the United States the principle of the closest connection follows from § 188 Restatement (Second) of Conflict of Laws. After the Restatement (First) of Conflict of Laws had linked contracts to the place of contracting or the place of performance, § 188 Restatement (Second) expressly mandates that contracts are subject to the law of the most significant relationship. As in Art 4 Rome Convention and Art 4 Rome I the principle of the closest connection is substantiated in §§ 189–197 of the Second Restatement. Consequently, the relevant provisions provide for rebuttable presumptions as to which law has the closest connection to a contract. However, in practice the presumptions very often point in directions different from both Art 4 Rome Convention and Art 4 Rome I. For example, § 191 Restatement (Second) presumes that contracts for the sale of goods have the most significant relationship to the state where the goods are to be delivered which is very often the buyer’s and not the seller’s place of habitual residence. Similarly, § 196 Restatement (Second) presumes that service contracts are most closely connected to the place where the service is provided.

Against this background, whether and to what extent the principle of closest connection contributes to the solution of the international transaction dilemma is difficult to say. Even though European and US law are in and of themselves consistent and comprehensible, parties have no chance to know which law will apply to their contract before a suit has been filed. As a result, even though the principle of the closest connection can claim greater flexibility than the place of contracting or the place of performance, it fails to provide the legal certainty and foreseeability parties need in the context of international contracts. This holds even more true if the principle of the closest connection is not substantiated at all, as, for example, in the framework of the Mexico Convention. In the absence of a choice of law, Art 9(1) submits international contracts to the law of the closest connection. However, the provision gives no further indication as to what this means for particular types of contracts. Instead, Art 9(2) Mexico Convention sets out that the judge must determine the law of the closest connection on a case-by-case basis in consideration of all objective and subjective elements. It is almost inconceivable that this provision fosters the legal certainty and foreseeability which parties need against the background of the international transaction dilemma.

c) Special rules for certain contracts

Most legal orders provide for special choice of law rules where a contracting party is deemed to be in need of protection. As a forerunner, Arts 5 and 6 Rome Convention and Arts 6 and 8 Rome I can be mentioned. They limit the effects of a choice of law in consumer and employment contracts and apply the law of the perceived weaker party (consumer contracts (PIL); employment contracts, individual (PIL)). In addition, Arts 5 and 7 Rome I limit the selection of laws in contracts for the carriage of goods and passengers as well as insurance contracts (insurance contract law (international)). In the United States, similar results are achieved with the general and very flexible fundamental public policy doctrine (choice of law by the parties).

3. Unified and harmonized contract law

Next to the private international law of contracts, which assigns international contracts to one of the many parallel existing legal orders, unification and harmonization of substantive contract law are the most important strategies to solve the international transaction dilemma on the level of public ordering. Both are aimed at subjugating international contracts to the same—or to similar—rules of substantive contract law. More specifically, they attempt to abolish the parallel existence of differently calibrated legal orders and thereby remedy the discontinuity between legal orders and the legal uncertainty which causes the international transaction dilemma. However, their impact is different: unification aims at creating globally—or regionally—unified rules of substantive contract law in the form of ‘true’ or ‘false’ uniform law. ‘True’ uniform law contains uniform substantive rules for international and national contracts. It is promulgated in Europe through regulations and on the international level through international conventions. Since it entirely removes differences between national and international legal orders, it attacks the problem of international contracts at its core. Something similar applies to ‘false’ uniform law. However, unlike ‘true’ unified law, it offers unified substantive rules only for international contracts and leaves the regulation of domestic contracts to national law. A prominent example of ‘false’ unified contract law is the UN Convention on Contracts for the International Sale of Goods (CISG). According to Art 1(1) it applies to international sales contracts (sale of goods, international (conflicts of laws)) and thus removes the discontinuity between neighbouring and differently calibrated systems at least for contracts which could fall prey to the international transaction dilemma.

Harmonization of substantive contract law, in contrast to unification of contract law, does not aim at creating globally—or regionally—unified rules of substantive contract law. It does not intend to remove differences between national legal systems entirely, but merely serves to cause convergence. The corresponding laws, namely the directives of the European Union, do not take the place of national regulations, but make provisions for their calibration. Since individual legal orders and their differences remain, harmonization, unlike unification, cannot entirely resolve the international transaction dilemma, but merely reduces its impact.

4. Privatized contract law

In addition to the various forms of public ordering, various strategies of private ordering contribute to the solution of the international transaction dilemma (private rule-making and codes of conduct). The most important autonomous private regulation mechanisms, which are described as ‘privatized contract law’, ‘self-made business law’, ‘autonomous law of world trade’ or simply lex mercatoria, are specifically tailored strategies for the solution of the problems of world trade. They contribute to the solution of the international transaction dilemma in that they provide incentives to keep contractual promises. They do this in two different ways: first, they increase the chance of short-term or direct losses in the event of disorderly conduct. Secondly, they increase the chance of long-term or indirect losses. There are numerous examples of both forms in practice. An example for the first form, the increase of short-term or direct losses, is the preparation of collaterals in the form of bank guarantees on first request. According to such guarantees, a bank promises to stand in for a party’s obligations, independent of the underlying contractual relationship and without scrutinizing the justification. Bank guarantees thus ensure the secured party that the bank will put them in the position they would have held in the event of regular performance of the contract. With respect to the second form, the increase of long-term or indirect losses, we can use the example of the build-up of long-term business relationships and the introduction of information services. In the first case, anonymous market transactions are gradually replaced by repeated dealings with the same business partner. A lack of cooperation, therefore, can destroy the entire business relationship and bring future losses. In the second case, information about the previous conduct of the parties is made available. In practice, chambers of commerce and industry, foreign trade chambers, as well as credit reference and rating agencies (rating agency) take over the collection and distribution of the relevant information. Recently, such institutions have become more significant for consumers given the practice of placing information about other consumers and potential contracting partners on the internet.

Next to these specifically tailored strategies, standardization of contracts represents a method of overcoming the international transaction dilemma. Like standardization and harmonization, it attacks the dilemma at its roots in that it subjects international contracts to special rules which consciously distance themselves from national contract laws. Similar to the above strategies, there are countless examples of this method of combating the international transaction dilemma. Here, it is worth mentioning general contract terms, standard contracts and model contracts compiled by industry organizations and developed over years of practical experience. Further, mention can be made of the frameworks set up by international organizations or committees: in particular, the INCOTERMS of the International Chamber of Commerce have gained worldwide significance. Recently, in the area of electronic consumer contracts, international frameworks have been created by institutions such as ICANN, but also by large internet companies like eBay and Amazon, which can be categorized as standardizations of international consumer contracts. In connection with the above described specific strategies, standardization regularly helps to overcome the international transaction dilemma without recourse to means of public ordering.

Literature

Ole Lando, ‘Contracts’ in IECL III/2 (1976) ch 24; Anthony Kronman, ‘Contract Law and the State of Nature’ (1978) 1 JLS 5; Oliver Williamson, ‘Credible Commitments: Using Hostages to Support Exchange’ (1983) 73 Am Econ Rev 519; Hans-Jörg Schmidt-Trenz, Außenhandel und Territorialität des Rechts (1990); Dieter Schmidtchen, ‘Territorialität des Rechts, Internationales Privatrecht und die privatautonome Regelung internationaler Sachverhalte’ (1995) 59 RabelsZ 56; Mathias Reimann, ‘Savigny’s Triumph? Choice of Law in Contracts Cases at the Close of the Twentieth Century’ (1999) 39 Va J Int’l L 571; Dani Rodrik, ‘Globalization and Growth—Looking in the Wrong Places’ (2004) 26 J Pol Mod 513; Jürgen Basedow, ‘Lex Mercatoria and the Private International Law of Contracts in Economic Perspective’ in Jürgen Basedow and Toshiyuki Kono (eds), An Economic Analysis of Private International Law (2006) 57; Richard Plender and Michael Wilderspin, The European Private International Law of Obligations (3rd edn, 2009); Giesela Rühl, ‘Effizienzprobleme bei grenzüberschreitenden Rechtsstreitigkeiten’ in Reinhard Bork, Thomas Eger and Hans-Bernd Schäfer (eds), Ökonomische Analyse des Verfahrensrechts (2009) 336; Christoph Reithmann and Dieter Martiny (eds), Internationales Vertragsrecht (7th edn, 2010).

Retrieved from Contractual Obligations (PIL) – Max-EuP 2012 on 06 December 2022.

Terms of Use

The Max Planck Encyclopedia of European Private Law, published as a print work in 2012, has been made freely available in 2021 as an online edition at <max-eup2012.mpipriv.de>.

The materials published here are subject to exclusive rights of use as held by the Max Planck Institute for Comparative and International Private Law and the publisher Oxford University Press; they may only be used for non-commercial purposes. Users may download, print, and make copies of the text files being made freely available to the public. Further, users may translate excerpts of the entries and cite them in the context of academic work, provided that the following requirements are met:

  • Use for non-commercial purposes
  • The textual integrity of each entry and its elements is maintained
  • Citation of the online reference according to academic standards, indicating the author, keyword title, work name, and date of retrieval (see Suggested Citation Style).