BASIC RULES OF CONTRACT LAW: A LAW AND ECONOMICS PERSPECTIVE

1. The Basic Economics of cooperation and contract I. Introduction The first fundamental theorem of welfare economics confirms that if markets are competitive, all individuals are informed , then individual interaction through a complete set of markets produces Pareto efficiency (a social situation in which no improvement is possible without someone being worse-off). Modern economists think that the most interesting economic exchanges do not take place in perfect markets. What are the means to induce the adoption of cooperative actions in human relations, countering the impulse present in individuals to behave opportunistically and to pursue self-interest at the expense of the common welfare of all interacting parties?

II. Basic instruments to achieve cooperation Economists have identified 5 major mechanisms to achieve cooperation among humans. 1. Biological kin selection Biological selection favors genes with higher survival and reproductive payoffs, and reproductive success involves not just selfish behavior, but also cooperative, disinterested behavior. 2. Selfish teamwork Some human interactions are characterized by a structure of payoffs to participating parties by which it is in the self-interest of each participating party to take the action that is jointly preferable. In assurance games there is more than a Nash equilibrium. Although (Cooperate, Cooperate) is the pareto-optimal outcome, is not the only equilibrium. (Defect, Defect) is also a Nash equilibrium, because no player has an incentive to deviate if the other does not deviate. There are several ways to select a specific equilibrium, in particular, to select the pareto-optimal equilibrium. A formal and legally enforceable contract imposing legal obligations on both parties to execute the actions corresponding to the desired equilibrium is one option. Creating common expectations on the resulting equilibrium might do the trick. If each player is convinced that the other will cooperate, and each is convinced that the other is equally convinced of it, they will both choose to cooperate, and thus the Pareto-optimal equilibrium will be achieved.

Typically, long-term relationships can serve to effectively coordinate expectations of behavior by all involved parties. The Law can serve also to coordinate expectations around a focal point. The fact that a given conduct is labeled as illegal, or as less desirable by the legal system, makes the other option the focal point to coordinate the expectations on behavior by the parties. 3. Altruism (or fairness) Interacting agents might not only have self-regarding preferences, but other-regarding preferences as well, based on altruism or similar notions. 4. Reciprocity in long-term relationships Probably the most famous application of game theory outside economics is the prisoners’ dilemma. It’s a strategic structure that characterizes many interactions involving cooperation among two parties. Each player has a dominant strategy of defecting from cooperation. If the interaction is unique, or one-shot interaction, the unique strictly dominant strategy equilibrium is (Defect, Defect). One-shot dynamic interaction, such as the so-called trust game: not trust and betray are non-cooperative actions, whereas trust and honor are the cooperative actions. The game begins with a decision node for Player 1, who can choose either to Trust or Not Trust Player 2. If player 1 chooses Trust, then the game reaches a stage in which Player 2 can choose either to Honor or Betray Player 1’s Trust. If Player 1 chooses Not Trust, then the game ends. If Player 1 chooses not to establish a relationship, both players’ payoffs are zero. If Player 1 chooses to trust Player 2, however, then both players’ payoffs are one if Player 2 honors 1’s trust, but Player 1 receives -1 and Player 2 receives a pay-off of two if Player 2 betrays Player 1’s Trust. If player 2 gets to move then Player 2 can receive either a payoff of one by honoring Player 1’s trust, or a payoff of two by betraying Player 1’s trust. Since two exceeds one, Player 2 will betray Player 1’s trust if given the opportunity to do so. Knowing this, Player 1’s initial choice amounts to either not initiating the relationship (and so receiving a payoff of zero) or trusting Player 2 (and so receiving a payoff of -1, after Player 2 betrays Player 1’s trust). Since zero exceeds -1, Player 1 rationally prefers not to create the relationship. In a dynamic setting, cooperation in exchange cannot be sustained. Assume that the trust game is played in exactly the same terms as shown above, with the difference that it is played a very large number of periods, T. In the Tth period, Player 2 has no reason to honor the relationship, because he can obtain a higher pay-off by betraying than by honoring. Anticipating this, Player 1 will not enter the relationship in the last period, T. Then, the last possible effective period of the relationship is the T-1th period. Here, Player 2 knows it is the last period, and therefore he would behave accordingly. And so the dismal logic of the trust game unravels down to period 1, and both players find themselves exactly in the same position as in the one-shot interaction. Finite repetition does not improve cooperation in economic exchange. Cooperation remains unachievable when the parties know their

relationship will last for a fixed and known length of time (this result is known in game theory as the chain-store paradox). But the trust game can be repeated an infinite number of periods or, more realistically, that it can be played an unknown –by the parties– number of periods. In such a scenario it is possible to show that if the parties care enough about the future, reciprocity strategies can lead to cooperative outcomes. The two reciprocity strategies most used in the game-theoretic literature are the following:

The grim trigger strategy, that states for each player: - Choose a cooperative action until the other player deviates from

cooperation. - Once the other player has defected, play defect forever after.

The Tit-for-tat strategy, that states for each player: - Choose a cooperative action if the other player cooperated in the previous

period. - Defect if the other player defected the previous period.

This powerful result that reciprocity can achieve cooperation has been crucial to the relevance of long-term contracts in recent economic theory. If parties can write complete contracts specifying the Pareto-optimal actions, the short or long nature of the relationship, and the use or not of reciprocity strategies is of no importance: Contract Law can force cooperation through the use of the appropriate legal sanction. This is why economists have routinely assumed that contracts between the parties are incomplete. This makes the contract a relational contract: many of the relevant actions cannot be foreseen and specified when the contract is signed, and it is in the course of the ongoing relationship that the parties will adopt those actions. The relational contract can be based on information only at the disposal of the parties as it becomes available, maybe only as a result of a change of circumstances. Of course, a relational contract in this sense cannot be enforced by a Court or an arbiter. The quest in relational contracts is then the design of self-enforcing relational contracts, those in which the parties are induced to adopt the best available actions for the common good. 5. External enforcement mechanisms (notably legal) It is clear that society as a whole benefits from the fact that its members interact mostly in a cooperative way. This explains why societies have developed systems to enforce cooperative commitments by individuals. These enforcement systems may show a variable degree of formalization and State intervention. Take the trust game in figure 3. If we change from 2 to -1 the pay-off of Player 2 in case of betrayal, to reflect social disapproval by third parties of the non-cooperative behavior of that Player, then (Trust, Honor) becomes the only Nash equilibrium of the game. Social disapproval may be expressed by a social sanction in the form of ostracism, negative gossip, etc. It cannot be denied that in large and open societies the most powerful external mechanism to promote cooperation in economic exchange is the legal system. To operate as an enforcement instrument, legal systems require a set of rules determining cooperative

behavior in a given context, an external (to the parties) authority to enforce the rules, and a system to produce the relevant information in order to apply the rule of cooperation in a given situation. A crucial issue remains thus open concerning the role of Law and formal, enforceable contracts, in long-term relationships. Although Contract Law is a powerful instrument to create incentives for cooperative behavior in economic exchange, it is not certain whether contract Law generally improve or weaken the self-enforcing nature of relational contracts. In a positive way, contract Law reduces the likelihood of breaching a relational contract, by making non-cooperative behavior more costly and/or the gains from opportunistic behavior less important. In the unwelcome direction, it can be said that contract Law may reduce the effectiveness of the other self-enforcing mechanisms in relational contracts, thus reducing the costs of non-cooperative behavior. The big questions concerning the actual effects of contract Law on long-term contracts remain largely unanswered by economic theory in a fully convincing way. Legal rules and institutions in isolation do not capture the full picture of cooperation in relational contracts. An exclusive focus on the legal dimensions might induce a design of rules and legal instruments that interfere with the latter, with the undesired result of reducing the level of cooperation in economic exchange.

2. The basic economic theory of Contract Law I. Introduction: Complete Contract, Efficient Breach Complete contract. When individuals can write a contract that determines contractual behavior in the whole set of possible circumstances, and the factual basis and the agreed consequence for each and all contractual determinations can be verified by the legal enforcer, typically, a Court of Law, then we have a complete contract. Agreement by the parties is the basis of the contract, from both the economic and the legal view point. The most determinative element of a contract is that it consists of a voluntary agreement related to a set of future conducts which are enforceable through an external mechanism. The concept of contract from an economic point of view:

The economic concept of contract is characterized by voluntariness. Parties to the contract take part in it because their preferences are satisfied better by the contract than by any of the other mutually exclusive alternatives of conduct.

The contract establishes the future behavior of the contracting parties.

The aforementioned is based on an explicit or implicit characterization of several circumstances than can affect such behavior by contracting parties.

The economic concept and the legal concept differ in the following aspects:

The economic concept of contract involves less phenomena, less economic and social situations than the legal concept.

The economic concept of the contract stresses aspects such as future conducts and circumstances connected with the contract.

Concept of “complete contract” In economic analysis, the concept of “complete contract” is identified with the Pareto-optimum. A contract in which both parties agree to a complete specification of all contractual behavior by the parties in all possible and imaginable states of the world and future circumstances is Pareto-optimal by definition. In the real world, contracts are not complete in this sense. Contractual incompleteness is the rule and not the exception:

The prevalence of non-verifiable information concerning many relevant contractual behaviors.

The difficulties in measuring and evaluating the cooperativeness of contractual behaviors.

The advantage of internal motivators for cooperation over external mechanisms such as formal and legally enforceable contracts.

The parties may not foresee all the circumstances which shall occur in the future and which may in a way affect the contract.

There exists several obstacles which may prevent the parties from reaching an agreement: Transaction costs.

The notion of complete contract is a very useful conceptual benchmark, being optimal for the parties. The closer a given contractual mechanism brings us to the outcome under the complete contract, the more desirable that mechanism is. Legal theories have long recognized the existence of loopholes, of incompleteness in legally enforceable contracts. An incomplete contract in the economic sense may or not have legal loopholes. The economic point of view should be distinguished from the legal one: from the former view point, the contracts are classified in complete and incomplete, whereas from the latter one, we may find contracts with loopholes and contracts without them. Example: S and B are thinking of entering into a contract. The cost of performance for S is uncertain: it could be 50, with 60% of probability, 70, with 20%, and 150, with 20%. The value of performance by S to B is 100. In such a way, pursuant to the “complete contract”:

- With a cost of the contract for S of 50, S shall perform, since the purchaser values it in 100, and so a surplus of 50 shall be produced.

- Should the cost of production of the contract be 70, S shall perform, since there is still existing surplus, in this case of 30.

- On the other hand, if the cost of production is 150, according to the complete contract, S should not perform, since a cost of 150 is incurred in order to obtain a benefit of 100. The contractual surplus is negative. It is in the best for the common good of both parties that the contract is not performed. This is called the EFFICIENT BREACH.

Many prices within a range could enter into a complete contract, since, in any case, the complete contract shall be performed whenever it is desirable for both ex ante that it is performed. B could obviously prefer the lowest possible price, and S the highest possible one.

From the economic point of view, which is decisive is that the value is created, not the fact that any party may obtain more or less from the contractual surplus. What is a conclusive issue in order that a complete contract exists is that a surplus is created. If, e.g. a price of 60 is agreed, which post the parties in a better position than one not to enter the contract. The concept of complete contract pursues the joint interest and not the interest of only one of the parties: the optimal thing is that contract is entered into because a value of 30 is created, notwithstanding the fact that, later on, S looses 10. There exist certain circumstances which, even though they could be contractually foreseen and solved by both parties in an optimal way, they may not be verified by a third party who shall have to find a solution in respect of said contract.

3. Formation of contract One of the most relevant issues in Contract Law is the determination of the conditions for legally enforceable contracts to be formed.

I. Formalities required for contract formation The first problem to be analyzed is that of contractual formalities. Contract Law adopts a form-less approach to contract formation. “A contract need not be concluded or evidenced in writing nor is it subject to any other requirement as to form”. “Contracts shall be binding no matter the way in which the contract was formalized, provided that the essential conditions for its validity are met”. Freedom from formality seems to be a sensible general starting point from an economic perspective. Law should not erect barriers to prevent these welfare-enhancing interactions from taking place. In most legal systems some contracts require certain formalities. Corporations and limited liability companies and partnerships usually also require public deeds. Other agreements have to be made in writing. All these are traditional formalities, whose imposition does not depend on the quality and condition in which the contractual party acts. In modern Contract Law, many formalities are required only when one of the contracting parties is a consumer:

The requirement that the contract is made in writing with one copy for the consumer.

The requirement of a minimum content, informative of contractual rights of consumer.

The right of regret, thereby the consumer can walk away from the contract within a legally specified time from signing the contract.

Other contractual formalities try to prevent external effects to the legal machinery as a whole: formalities are required to provide proof as an element of constancy of the will of the parties, reducing in such way, the costs of administration of justice and the cost deriving from the uncertainty regarding the content of what has been agreed.

II. Silence as contractual assent For a valid contract to be formed, the positive expression of the contractual will is necessary. “Silence or inactivity does not in itself amount to acceptance”. The mere omission of conduct is not construed as an acceptance of the contract. In certain circumstances the silence may be deemed relevant to indicate contractual agreement. A simple game-theoretic model will show the economic logic behind this rule: We have two contracting parties or players, and each of them will act in contemplation of the other party’s conduct. The offering party (O) may make an offer or not make it. In case of lack of offer, the payment of the consideration is equivalent to (0,0). 1) First, assume that the general rule requires actual declaration (silence has no value as declaration of will). We also assume that the delivery of the response has a cost, then D (addressee of the offer) will never reject the offer since it is costly and he will obtain the same result by remaining silent. D will accept the proposal of O (offering party) if:

V-R-p>0 V= value of the subject matter of the contract for D R= cost of sending back a response to V p= contract price The above implies

p<V-R If this inequality is satisfied, D will accept the offer, since it will lead him to an increase in welfare. The maximum price that D would accept in this situation is p= V-R 2) Second, assume that the general rule is the positive value of silence (who remains silent, accepts): since remaining silent is tantamount to acceptance, D shall not waste the costs of responding, and thus D shall never take the option of expressly accepting.

V-p>-R

So D would remain silent, thereby accepting the offer, if the following inequality is satisfied:

p<V+R

The maximum price D would accept under this legal regime is p=V+R. The regime of silence with positive value has the advantage of not having costs in the formation of the contract. The problem with this rule is that it makes possible that D accepts offers that make hi worse-off. When one of these unwelcome offers arrive, D will be forced to accept the offer, since to reject it would be more costly than accept it, but accepting it may

imply paying above the maximum quantity he would be willing to pay for the contract (V<V+R), thus letting D in a worse situation. In some legal contexts, a determined value of silence is expressly granted or denied:

In the field of distance consumer sales, for instance, Spanish Law establishes that under no circumstances will silence be interpreted as assent. The risk of exploiting vulnerable addressees and using inefficient means of communication is relatively high, so a clear rule of negative value of silence seems preferable.

Courts sometimes grant positive value to silence, when the contract is entered into by companies which have regular business dealings, since it is understood that they would be made through an efficient means of communication, not existing in such case risk of choosing an inefficient means of communication. Between two parties holding long-term contractual relationships, the probability that the contract has positive value for both parties is substantially higher.

III. Perfection of contract The consent as basis of the contract is completed from the legal point of view with the concurrence of offer and acceptance. Although in many cases this concurrence is evident since both acts take place simultaneously, in certain cases there is a gap between the issuance of the offer and its reception by the addressee and between the issuance of the acceptance and its reception by the addressee. In contracts between persons being apart, the communication between them is produced ex intervallo temporis. There are several theoretical solutions to the problem of when a contract is formed: 1) THEORY OF ISSUANCE: the contract is perfected when the accepting party issues his declaration of acceptance. Firstly, this theory does not stress the receptive characteristic which shall be attributed to the contractual declarations. Secondly, it should be questioned whether it is fair or not that the offering party is considered involved with a contract performed as a consequence of a declaration of will of acceptance of which he has not been informed yet and which he therefore ignores. 2) THEORY OF COGNITION: is formulated as a result of the objections which were opposite to the theory of issuance, and it claims that the contract is not perfected and regularly formed when the accepting party issues a will declaration of acceptance, but when said declaration is known by the offering party. It is radically opposed to the latter. Should the accepting party have done everything which was under his control, as to communicate acceptance to the offering party, and yet the latter did not know of it. 3) THEORY OF EXPEDITION: in order for the contract to be formed, it is not only necessary that the accepting party issues a declaration of will of acceptance. While the declaration of will of acceptance is within the sphere of the accepting party, it should be not perfect the contract. The accepting party needs to release his declaration of will. From that moment, it is construed that the accepting party has done everything which was under his control to make his declaration of will known to the proposing party. If said declaration does not reach the offering party, the contract is nevertheless perfect. The contract shall be considered executed from the

moment in which the accepting party issues and addresses the declaration of will of acceptance. In American Contract Law this solution has been imposed and called the mail box rule. 4) THEORY OF RECEPTION: opposite to the theory of the expedition, the so called theory of the reception stresses the consequences to which the theory of the cognition may reach, since it derives from said theory. It is not necessary that the acceptance is known by the offering party in order for the contract to be considered perfected. It is not sufficient for the accepting party to issue a declaration of will and send it. The moment of perfection of the contracted is the moment the declaration of will of acceptance reaches the sphere of interests of the offering party, regardless of the fact that the offering party has effective knowledge of it or not. 5) COMBINATION OF RECEPTION AND EXPEDITION: VIENNA CONVENTION: the contracts are perfected when the acceptance reaches the offering party, but if there has been a revocation of the offer, the contract is perfected at the moment of dispatch of the acceptance. The conflict in Spanish Law Under the former version of section 54 Code of Commerce the contract is perfected when the offer is issued but also the revocation is perfected by issuance. Under the original version of Section 1262 CC, the contract is perfected when the acceptance is known or reaches the offering party and the revocation is known by the accepting party, in coincidence with the theory of the cognition or knowledge. Most of the legal authors have chosen the interpretation from the point of view of the theory of the reception, considering that the criterion of the law would let the actual knowledge be equivalent to the possibility of knowledge when the possibility was not caused by causes to be imputed to negligence or lack of diligence from the part of the issuer of the declaration. It is considered that there exists consent from the moment the offering party knows or is informed of the acceptance or from the moment in which it was delivered and it could not be ignored pursuant to the principle of good faith: Being in different places the offering party and the accepting one, there is consent from the moment the offering party knows about the acceptance or since having been delivered to the accepting party, he may not ignore it according to the good faith principle. The contract is assumed to be entered into in the place where the offer has been made. There exists a secondary rule for contracts executed by means of automatic devices: in contracts entered into by means of automatic devices there is consent at the moment the acceptance is expressed. General conclusions:

The rule which most anticipates the perfection of the contract is the so called “mailbox rule”. This rule implies a bigger risk for the offering party since from the moment he sends the offer he loses control. This rule offers the advantage that from the very beginning it lets the acceptant to invest on reliance, increasing the value of the contact. The risk for the offering party is not so serious as he controls that the offer arrives.

The issuance rule is an uncertain rule for both contracting parties: the offering party already knows that when the offer is issued.

The reception rule is more uncertain for the acceptant since although he had issued the acceptance, he does not know if there exists contract. From the offering party’s view point it is also an uncertain rule: the existence of a contract depends on the fact that the acceptance be known prior to the revocation.

IV. Defects in contractual consent

Contracts are based upon voluntary consent by the contractual parties. In order to guarantee that the expression of external consent corresponds with internal preferences of the contracting parties, most legal systems contemplate the possibility of the interference of different factors in the process of translating internal preferences into contractual consent. Most legal systems consider those anomalies under four headings: violence, intimidation (threat), fraud and mistake. When one of these anomalies is present, the contract is voidable and non-enforceable.

1. Violence

Considering the use of violent means to extract contractual consent a reason to void the contract perfectly matches the economic view of contracting. There is violence when irresistible force is used to extract contractual consent. It makes full sense for the contract to be voided due to violence, as the contract is based on voluntariness. When violence interferes in the decision-making process, voluntariness disappears by definition. Among the so-called vices of will (vicios de la voluntad) violence is one of the causes for voiding and therefore, it could be claimed within a four year term since violence ceases. The absolute nullity would not have any sense since it would be possible that, despite the existence of violence, the contract would improve the utility. The challenging of the contract is left to the contracting party. 2. Intimidation The intimidation makes the contract void if it exists, both when the threat comes from the other contracting party, and when it comes from a third party. “There is intimidation when one of the contracting parties is made to be subject to rational and founded fear of suffering serious and proximate harm in person or property, or in the person or property of spouse or kin”. It does not make much sense to limit the relevance of threat to actions by the other contracting party. The solution should be same, because identical are the underlying reasons, when the threat comes from the other contracting party, and when it comes from a third party. There are threats that use means that are not illegal by themselves but which may have powerful influence over the will of the person subject to blackmail. If said person is able

to proof that the opposing party has threatened him with disclosing and said information the contract may be declared voidable. But it must be said that pressure is an essential component of many business dealings and contractual negotiations. The criterion under several European legal systems distinguishes as follows:

If the threat is not wrongful and it is connected with the advantage which is being pretended: not a voidable contract since there is no intimidation.

If the threat being made is legal per se, but bears no connection with the contractual benefit obtained, the action is deemed wrongful: voidable contract due to intimidation.

From an economic point of view, there is a way of explaining why the blackmail is negative. The explanation is based on the fact that the potential benefit from blackmail gives incentives to obtain information concerning other people, but by the fact that the blackmail deal is accepted, that information is buried again. By making the blackmail deal a voidable contract, and moreover, by making blackmail a punishable crime, the Law prevents this misalignment of incentives. The illegality of blackmail does not benefit the blackmailed person: firstly, he benefits from having the option of choosing the information to be disclosed or not be disclosed, since if the blackmail were legal, the blackmailed person would prefer to reject it. If the blackmailer cannot blackmail the other contracting party, the blackmailed person would prefer to disclose the information. 3. Fraud and duties to disclose information 1. A party may void a contract when it has been led to conclude it by the other party’s fraudulent representation. 2. A party’s representation or non-disclosure is fraudulent if it was intended to deceive. 3. In determining whether good faith and fair dealing required that a party disclose particular information, regard should be had to all the circumstances, including: a. whether the party had special expertise b. the cost to it of acquiring the relevant information c. whether the other party could reasonably acquire the information for itself; and d. the apparent importance of the information to the other party. Fraud constitutes the legal expression of deception and cheating in contract formation. The contracts entered into because of fraud and deception are voidable, since there is no guarantee that the contract improves the joint welfare of both contracting parties. If contracts involving fraud were not annulled, there would be an incentive to engage in deceptive behavior. Deceptive behavior is socially undesirable and should be discouraged by Contract Law. a. Should the mere non-disclosure of information which has not been requested in the same way as an outright lie? In insurance contracts, there exists a special duty (uberrima fidei) to declare on the part of the insured party but not all information has to be disclosed.

With respect to this relationship between omitting to give information and cheating with false information, economic theory has developed a very striking theoretical result: “unraveling”. Example: A seller S has a closed box with a certain amount of items between 1 and 10. S knows that he cannot lie to purchaser P because if he does, fraud will be claimed and the contract shall be annulled. However, although S cannot lie, he can remain silent. The possible purchasers know that S knows exactly what is inside the box and as S knows that the conduct of lying shall be sanctioned, he will tell the truth. If S has 3 items in the box, will he tell the number of items in the box voluntarily? S cannot lie but he may no answer. It may be deduced that the person having the worse possible information remains silent, the rest will tell the truth in order that they are paid the actual content of the box. In this way, if S remains silent and has 9, P knows that he does not have 10 and therefore, he shall agree to pay the average price between 1 and 9 but never 9. If the fact that the information exists and one party possesses it is common knowledge, the information is verifiable ex post, and outright provision of false information is detected and adequately sanctioned, there are voluntary incentives to reveal information, so the need to define duties of disclosure is substantially weakened. Since if one of the parties knows for sure that the other has certain information, if he does not disclose it is because it is the worst possible information. Many times the sellers disclose information voluntarily even though it is not compulsory: as the seller who offer the best to their clients, they disclose it to them and the consumer knows it, the businessmen have the incentive to disclose it with no need to be obliged to do so. b) Should the Purchaser and the Seller be equally treated as far as duties to reveal information are concerned? From the different types of information that may affect a contractual relationship a distinction should be made between: 1. Information with social value: the one which can improve the use of the resources subject matter of the contract. 2. Information without social value: although it may benefit any of the parties, it does not lead to improve the resources subject matter of the contract. 1. Cases in which they type of information has no social value (2) The information may have a cost of acquisition, even a small one, as it has no social value; it is not worth promoting the search or production of such information. Thus, if S is not obliged to disclose the information to purchaser and said information is good, S does not remain silent since by disclosing it can obtain a better price. If the information is bad, S will not disclose it since P is not sure if S has it available. The legal rule capable of lessening the aforementioned effects is that which obliges to disclose the information which is available at the time of entering into a contract, in such a

way that, were the information not disclosed, the contract would be voided due to fraud or mistake. 2. Cases of types of information with social value (1) From S’s point of view, if he decides to invest money in obtaining information with social value, if the information is good, it can increase the price of what is being sold. On the contrary, if the information is bad and there exists no rule which obliges him to disclose the information, S will remain silent and P will give relevant value to the fact of not disposing of information about the thing. From P’s point of view, if he is not obliged to disclose information and, if the news is good, P will remain silent. If the new are bad he will disclose it to S, since that will lead to pay the price corresponding to the actual terms of the subject matter of the contract. Obliging S to disclose information when such has social value does not prevent him from having incentives to obtain it. In case of P, the incentives will disappear, since he has to acquire the resource to be able to enjoy the increase in value from the socially valuable information, so if he discloses the information he will pay a higher price to S. As far as imposing duties of disclosure goes, there should be a differentiated treatment for the buyer and the seller. The duties of disclosure for the party who has title to property must not be the same: while S may be imposed a severe duty to disclose information, P may only be imposed of this duty in cases in which the information does not increase the value of the contract. 4. Mistake 1. A party may avoid a contract for mistake of fact or law existing when the contract was concluded if: a. (i) the mistake was caused by information given by the other party (ii) the other party knew of the mistake and it was contrary to good faith and fair dealing to leave the mistaken party in error (iii) the other party made the same mistake b. the other party knew that the mistaken party, had it known the truth, would not have entered the contract. 2. However a party may not void the contract if a. in the circumstance its mistake was inexcusable, or b. the risk of mistake was assumed, or in the circumstances should be borne by it.” For a mistake to void a contract it must refer to the substance of the object of the contract. a) P and S agree the sale of a cow which they both believe it is sterile. At the time of delivery, S discovers that it is pregnant, and claims that the contract be annulled by mistake. The first case is one of bilateral mistake regarding an essential element of the contract. This case is one of the classic mistake cases in US Law. Most legal systems require, in order for a contract to be declared void, that the mistake is made in respect of an element of the

contract which clearly influences the decision to enter into it, or at least its fundamental terms. This is clear in our case, so the contract could be voided. In such a case of bilateral mistake, we have no grounds for presuming that the contract is welfare-enhancing. If P and S enter into a contract ignoring whether the cow is sterile or fertile and agree a price of 100: could S challenge the contract by mistake if the cow is sterile? S’s mistake may be an inexcusable mistake (given that the information concerning fertility of the cow is socially valuable, he should invest in obtaining it). In cases of bilateral mistake, the contract does not let us know if the exchange of considerations benefits any of the parties. If the inexcusable mistake is bilateral, one of the parties may declare the contract voidable by mistake, since nothing is lost then if one of the contracting parties gives more value to the product than the other one. b) P and S agree the sale of a picture that they both believe it is from a famous painter. Some years later, the greatest expert on the artist writes a work about him in which he does not include the picture acquired by the P. P claims the annulment of the contract by mistake. An Art Gallery in Barcelona (S) sold to a purchaser (P) what both parties believed was a picture of the famous modern painter Anglada Camarasa. Later on, it was proved that the picture was false and P tried to annul the contract by mistake. Different from case a), in this case SC did not annul it because it stated without sustain that there existed no evidence that the name of the painter was the essential element which induced P to buy. It is clear that in pictures authorship is the main element which provides the contract with value. Both case a) and b) are cases of identical bilateral mistake, and should be therefore, solved in the same way, since there exists no way of knowing which contract improves the position of both parties. In case a) the value of both contracting parties seems to increase but in fact, it is not the case, therefore, there is no motive to keep the contract in existence. On the other hand, if the mistake were unilateral, should it invalidate the contract? If the mistake is inexcusable for who suffers it, the contract is not declared voidable. The question is not so simple in case the mistake is excusable: at first, we could consider that the seller of a good shall be informed about his product, and even more if the purchaser has realized of the mistake. Should P be obliged to disclose his information? In respect of fertility of the cow, we are before the type of information which has social value as it affects the actual use of the resources. If P is obliged to disclose the information to S, P losses incentives to enter into the contract since S will increase the price. The contract should not be annulled. In the case of the picture, if P knows that it is false there is no possible problem as he consciously agrees to buy a false picture. If S knows it but there is no fraud on his part, it is not possible to invoke inexcusability of mistake since P is a professional and therefore, he should know the precise area of economic traffic in which he makes the transaction. In cases of authentic pictures with no sufficient value to constitute extreme cases, we are facing a case of information without social value. Therefore, the seller should be forced to disclose information since, on the contrary, he is promoted to make an omission of the bad information and disclose it only in cases in which said information is positive.

V. Standard form contracts From an economic perspective, the uses and abuses of standard form contracts essentially involve asymmetries of information between contracting parties. 1. A party may avoid a term which has not been individually negotiated if, contrary to the requirements of good faith and fair dealing, it causes a significant imbalance in the parties’ rights and obligations arising under the contract to the detriment of that party. 2. This article does not apply to: a. a tern which defines the main subject matter of the contract, provided the term is in plain and intelligible language, or b. the adequacy in value of one party’s obligation compared to the value of the obligations of the other party. But standard form contracts are heavily regulated in European legal systems. The standard terms of the contract are stipulations or clauses pre-established by one of the parties for all contracts of a given kind he intends to enter into. Some terms (special terms) are negotiated and adjusted to the individual contracting party. The drafter of the standard terms has superior information regarding the content of those terms. We are talking about terms which are not modified: they are identical clauses for all contracting parties. They confer economic advantages, e.g., they save transaction costs. However, the content of the contract is not the product of the joint preferences of both parties since by definition the standard terms are not subject to negotiation. The main problem arising is based on the different level of information between the parties. 1. The drafter is, generally, a company. 2. The client is another company or a final user / consumer. In situations in which asymmetric information exist, the market may fail. Possible solutions to the problem of market failure in case of asymmetry in the information There are certain mechanisms that can contribute to overcome the dismal result of the market for lemons: 1. A seller of products of high quality could convince the opposite party that the product he offers is one of good quality, through a warranty. This warranty can be voluntarily offered, or legally imposed. Since 1999, European Law has such a mandatory warranty which imposes a two year warranty. 2. The product quality could be searched, the good be tested, and the object be studied to see if it has a superior or inferior quality. However, investigating the quality of the product is limited by the nature of the good. 3. Legal rules could force disclosure of information regarding quality, obligations to disclose certain information to overcome the asymmetry in such a way. Does the idea of searching information about quality actually work= The simple reading of the general conditions should be sufficient. Rules mandating disclosure in order for the standard terms to be incorporated to the individual contract may be sufficient. All EU countries impose such requirements as: standard forms should be generally in writing, the client should

be given a copy of the standard terms at the signature of the contract. If the contract is not formalized in writing, it is then required that the standard terms be situated at a visible place, accessible by the client. It is intended that the drafter adopts measures to increase knowledge of the conditions by the client. We could question the efficacy if we consider that to invest time and effort in reading the terms is a relationship-specific investment by the client, which can be easily appropriated by the drafter, by simply setting a level of quality in terms that leaves the client indifferent between contracting and not. The contracting process involving standard terms does not by itself result in the level of quality in the bundle of rights and obligations of the parties that will be Pareto-optimal.

VI. Agreements of intentions and pre contractual liability MOU (Memorandum of Understanding), or “letter of intentions” is the document whereby the negotiation stage of a contract of acquisition of a company is structured. It consists of a standard document which gathers most of the clauses related to acquisitions of companies. There are two forms of producing this type of documents:

MOU, which is a joint document from both parties, including the signature of the parties at the bottom.

“Letter of intent” (or “carta de intenciones”), which is structured in a different way: it is a letter of a contracting party (X) to the other one (Y), in such a way that Y shall return it executed to X, from what it is deduced that Y agrees with its content.

Spanish law rather prefers to use formula 1 (MOU), which is more advisable. In the letters of intentions, the agreement is made by the one sending the letter. In the MOU, the parties have established a relationship in a prior stage, and although it is also possible that the letter has that same characteristic, the latter expresses a unilateral content that, even though they are not general conditions, it should consider the rule of construction: The construction of obscure clauses of a contract shall not favor the party who has caused her obscurity. The difference between the agreement of intentions and the letter of intentions is not a question of content but of the way the parties appear. The MOU usually establishes that certain clauses are not binding, therefore, the difference between promise and contract is not useful in the Spanish Law. MOU: Structure 1. Identification of the parties and, above the clauses, it is customary to include indications of prior deals: price, aspects which have existed up to the date thereof; intention on the parties of the Company. 2. Purpose: aim of the agreement of intentions which is to be executed. 3. Price to be paid. 4. Standard procedure of transactions of a company’s acquisition. Stages: a) Prior stage (conditions that should be complied with for the existence of the contract). Among the conditions which shall usually be imposed at this prior stage, it should be mentioned as follows: the requirement that a “due diligence” have been

made; that there had not been significant changes; that the boards authorize the extraordinary payments. b) Stage of the purchase agreement (in Spain, executed in a private document). In this stage, we find the essential clauses of the purchase agreement: the ones related to compensation, representations and warranties before tax, labor, regulatory and other contingencies. Y warranties a set of aspects to X: -Its title over the shares he sells. -The contingencies that could have been observed. -The price. -Other conditions (suspensive conditions): that there would not be a negative or substantial change in the conditions. c) Closing or ending (in Spain it is done by means of a public deed before notary public). If the prior conditions precedent are complied with, at the closing of the contract it shall be evidenced by means of a public deed; the assignment of shares be performed; and finally, the first term price be made. Frequent clauses in these contracts

The so referred to the temporal or interim term: they impose the seller to make the Company subject matter of the transaction works until the closing of the transaction. These clauses control the risk that after the due diligence the seller may carry out any act which can reduce the Company’s value. These clauses may foresee to put somebody trustful in the Board during this interim term.

Non-complete clauses: they start producing effects from the closing date and for a determined period of time. They prohibit competition with the acquiring Company and its subsidiaries.

Confidentiality clauses: it is a standard clause by which both parties agree not to inform or disclose the content of the transaction and also the fact that a negotiation stage is taking place.

Clauses of assignment to third parties (assignment).

Clauses referred to the term: they establish the temporal effects of the agreement of intentions and may foresee that the parties shall be released of any obligation undertaken in said agreement.

Clauses of exclusivity: they are operative during the validity of the letter of intentions: from its execution date until the moment a negotiation agreement is reached.

Substitution clause: as the agreement of intentions is an interim point between the parties’ negotiation, it substitutes all prior agreement.

Applicable law, competent jurisdiction: it is a standard clause, especially in cases where there is an international element in the transaction. Any dispute between the parties which may arise out of the agreement of intentions or the transactions may be subject to arbitration and it is so in almost a hundred per cent of the cases.

Rule of cost: normally, each party pays for his own expenses, although it is not unusual that the purchaser agrees to pay part of the seller’s costs, especially in cases in which negotiation will probably end successfully closed.

Binding and non binding clauses: it can be established in any final clause of the agreement which is the binding part and which of its parts are not. Normally, the so called “minor clauses” are binding, whereas the clauses referring to extreme aspects such as the purpose of the agreement, price and structure of the transaction are not binding, they do not give rise to contractual or pre contractual liability.

Although the MOU has no binding nature, it should be mentioned that the agreement of intentions opens a negotiation process and that under Spanish law the contacts are perfected as from the existence of consent with no need for a special form. If a conduct of a contracting party against good faith causes damage to the other party, there exists liability. The party suffering damage due to the bad faith of the other party shall proof that the waiving to enter into the contract before the execution date is opposite to the principle of good faith. What is the use of a clause such as the non binding one in the Spanish Law? Its relevance is based on moving the burden of the proof very clearly, while the preliminary deals already implies that the parties are bound, in a position in which they prefer not feeling bind until the date of purchase.

4. Breach of contract I. The legal situation of the breach in the Spanish legal system Concept of the breach according to the case law emerging from the Supreme Court: The concept of breach of contract pursuant to the Supreme Court is a result of a combination of two different elements:

Material breach or materiality of breach.

Imputation of breach to the conduct of one party. (i) Materiality of breach Under Spanish law, any breakdown between the conduct of the parties and the conduct which should be followed according to the terms of the contract constitutes a material breach. In order to determine the material breach of the contract, criteria external to the contract itself should not be estimated. The parties, an owner of a ship and some shipyards, entered into a contract whereby it was agreed that the latter would repair the ship of the other party. The particularity of the contract was that, in accordance with its terms, after the repair of the ship, the ship would not be useful for sealing. Since on estimating the possible breach of contract on the part of the shipyards, the Supreme Court considers there is no breach of contract as the shipyards had subjected to the terms of the contract. In another case, the constructor required tile maker tiles of two different batches. The problem arises since the color of one of the tile batches does not coincide, as it is nearly impossible to obtain the same tone in tiles which correspond to different cooking batches. Due to the difference in color and the impossibility of using them in the same floor, according to the purchaser, there is breach of contract, however, the Supreme Court does not agree with him

since it was him who requested two different batches of tiles and that was what he obtained. A different case would be, if it could be a breach of duty of the seller to inform the purchaser of the consequences of buying the tiles of two different batches. The determination of the existence of a breach of contract is a question of fact and therefore, to that respect, the trial Court (Tribunal de instancia) shall resolve, with no possibility of further review on the part of higher Courts. Who breaches a contract in the first place cannot request the contract to be rescinded and furthermore, this solution is only viewed by trial Courts (en primera instancia). (ii) Imputation of breach of contract to the conduct of one of the parties The imputation herein referred to supposes that the affection of the interests of one of the parties could be attributed to the breach of contract of the other party. As follows three criteria of imputation of breach of contract:

Contractual fraud: the fraud in the contractual sense appears in those situations in which the contract is voluntarily breached. Although it could result a bit weird, the Supreme Court does not require fraudulent intention to appreciate fraud in a contractual sense: only “spontaneous determination of will” is required in the “materiality” of breach. In a contract whereby the delivery of a good is agreed, the liability of the party who shall perform the delivery is limited to “x” Euros for each day of delay in the delivery. Let us also imagine that the party obliged to make the delivery voluntarily delays it. So if the other party can proof that the delay has caused him damage of “x+y”, the limit of “x” which has been mentioned before, shall have no validity. The fact that the breach is fraudulent also implies that there will not be moderation of the criminal clauses. The main tendency of the Spanish Courts of granting compensation in the cases of fraudulent breach instead of those cases where the breach of contract is negligent.

Fault or negligence: fault or negligence is appreciated in the sphere of breach of contract when the defaulting party has not subjected to the preventive measures required in the contracts. If fault is appreciated the consequences of fraud are not produced.

Strict liability: in strict liability, even though there is neither spontaneous determination or will nor negligence, there exists a legally relevant link between the breach of one of the parties, through which the breach may be imputed to said party.

Concerning an “act of God” or “force majeure” the objective liability may not be applied despite the relevant link between party and breach of contract. It should be noted that the Supreme Court has never considered the “act of God” or “force majeure” an event which occurred in the internal sphere of the organization of the company or of the businessman. During the lapse of a strike, the “roadmen” of SERVIPRENSA delivered the publication wrongly and in delay and moreover, they kept the money paid by the distribution stalls. Therefore, the SC considered that the strike should not be considered a case of “act of God” or “force majeure” so estimated the liability of the delivery company.

II. Remedies for breach of contract 1. Specific performance It is a very intuitive remedy for non-performance of contract. It simply consists of the right of the aggrieved party to require the performance of the contract which was not performed or the completion of the one which has been performed in part. In Spanish Law, specific performance has traditionally been considered a procedural matter: creditor may obtain the conduct prescribed in the contract with the help of the Courts and of the public force, which rules are and have been procedural. There are coercive fines if the party condemned to comply with his personal obligations under the contract refuses to comply or delays compliance. Specific performance might be an inadequate remedy in several circumstances, due to the inappropriate incentives that such a remedy would create for the parties. There was a contract by which the owner of a given plot of land leased it to a mine company in order that during 90 years the latter could use it as a deposit of the mine residues originated by its activity. After the expiration of the contractual term, the mining company was supposed to return the premises free from accumulated residues. However, when the restriction takes place, the premise are found in a condition which was not in accordance with the one agreed, so that the owner claims for the performance of the contractual obligation. The issue was based on the fact that the specific performance had a cost of 50,000,000 Ptas. while the premises had a value of 116,000 Ptas. The Court decided not to grant specific performance, but a compensation of 116,000 Ptas, that is to say, the market value of the premises. The owner was not satisfied with said compensation and appealed to the TC (Constitutional Court). However, the TC stated that what warrantees section 24 CE is a response according to law and that in this case the response had consisted in a concession of damages. The Spanish Supreme Court affirms that defendant may not oppose damages alleging that the specific performance constitutes a less detrimental remedy for him. Let us imagine that a realty company sells a defective house. The purchaser, on realizing so, gives notice of it to the seller which only repairs the defect in part. So the seller goes to court and the court confers a compensation for damages. Thus, although the seller alleges that it would be better for him to repair the defect in full and definitely, instead of paying compensation, said petition shall not be accepted. A couple of Spanish Supreme Court decisions have declared, on a theoretical level that specific performance is to be preferred to damages, at least with respect to obligations to do or to make. 2. Damages This remedy in case of breach of contract basically consists in the payment of a sum of money by the defaulting party to the aggrieved party to compensate the loss from breach of contract. “Those who in the performance of their obligations act with intent, fault or delay, or which otherwise breach the provisions thereof, are subject to paying damages for the harm caused”.

The amount of damages may vary, and not all measures to assess damages include the same elements or pursue the same compensatory goals. Two different types of damage measures exist: Compensation for the positive contractual interest or expectation damages (i) and compensation for the negative contractual interest or reliance damages (ii). (i) Compensation for the positive contractual interest (expectation damages) It is that compensation by which the defaulting party shall be obliged to compensate the other party in such a way that the latter is left in the same situation as the one he would have been in case of performance of the contract. Let us take the case of a person who due to a congenital malformation only has mobility of 50% in one of his hands, and a doctor promises that after being operated on he could reach 100% of mobility. After being operated on, not only does the expected result fail but also the mobility of the hand is reduced to 25%. If the doctor compensates the patient for damages according to this rule, then said compensation shall be equivalent to the difference between the utility for the patient to have mobility of 100% in the hand and the current utility resulting from only having a mobility of solely 25%. Under reliance damages, that whose aim is to leave the aggrieved party in the same position that he would have been if the contract had not been entered into, the compensation would only be the equivalent of the difference between utility involved in having mobility of 50%. “The general measure of damages is such sum as will put the aggrieved party as nearly as possible into the position in which it would have been if the contract had been duly performed. Such damages cover the loss which the aggrieved party has suffered and the gain of which it has been deprived”. Traditionally, it was understood that when the contract was rescinded, the contract was only entitled to a right of negative contractual interest. According to the current case law of the SC, on the contrary, the contractor suffering the breach and thus rescinding the contract may petition for compensation for the positive contractual interest. The SC also considers the compensation lawful when there is a breach of warranties of declarations emerging from the contract or from the publicity prior to the making of the contract. Another case in which the SC resolves for compensation for positive contractual interest is that of pre contractual fraud. This solution is not so accurate from the technical point of view, since with it the breach of contract and the pre contractual fraud seems to be identified.

The breaching party has to pay damages corresponding to the losses which were foreseen or were foreseeable at the time of undertaking the obligation and which are a consequence of its breach of contract. Intentional breach (“en caso de dolo”) the limitation does not work.

Those losses which the aggrieved party could have reasonably reduced will not be included in the damage award.

The breaching party is not liable for loss suffered by the aggrieved party to the extent that the latter contributed to the non-performance or its effects.

The calculation of the damages leads to some problems which explain the frequent lack of skill of the Courts in calculating them. Should the consideration not consist in a unique good and have substitutive ones in the market, then it is easy to estimate the damages, and damages are the most advisable remedy in case of breach. However, if we find ourselves before a unique good, then the estimation of damages is more complicated and so it is frequently more advisable to apply specific or forced performance. It also depends on the difficulty of the calculation of the compensation if the suffering party is a natural person or an artificial one. Whether it will be the case of a natural person, the estimation of the consideration is difficult to be determined and so specific performance is more advisable. On the other hand, if it is the case of an artificial person, it is easier to determine the estimation of certain consideration and, consequently, damages is more recommended. In Europe, excepted for Germany, the general remedy in case of breach of contract is the compensation for damages but with the following feature: the specific performance is preferred in contracts related to certain unique goods, for example, the realty. (ii) Compensation for negative contractual interest (reliance damages) This remedy in case of breach of contract has the goal of placing the aggrieved party in the same situation he would had been in case the contract had not been entered into. This compensation shall cover:

The expenses incurred by the contract which the aggrieved party had to bear.

The specific investments that the latter had made on reliance on the compliance of the contract.

The opportunity cost of having entered into the contract. Reliance damages can be claimed by the party who is victim to a defect in the formation of the contract under the following formula: “A party who avoids a contract under this Chapter may recover from the other party damages so as to put the avoiding party as nearly as possible into the same position as if it had not concluded the contract, provided that the other party knew or ought to have known of the mistake, fraud, threat or taking of excessive benefit or unfair advantage”. Under Spanish Law, the reliance measure of damages should be adopted in the following cases:

Annulment of the contract.

Pre contractual liability: the damages must be proved by the suffering party, they are not assumed by the mere breach of the other party. This states the problem of compensation of said alternative profit which could be obtained whether the contract had not been made.

3. Liquidated damages Liquidated damages constitute a remedy bearing a great resemblance with damages. Liquidated damages are not determined ex post by the Courts, but are agreed by the parties ex ante in providence of a breach of contract.

Liquidated damages generally take the form of payment of a stipulated amount of money to the aggrieved party. “(1) Where the contract provides that a party which fails to perform is to pay a specified sum to the aggrieved party for such non-performance, the aggrieved party shall be awarded that sum irrespective of its actual loss. (2) However, the specified sum may be reduced to a reasonable amount where it is grossly excessive in relation to the loss resulting from the non-performance and the other circumstances.” In the Spanish legal system there is no explicit obstacle for the conventional penalty to be larger than the damages that could be obtained judicially. If breach is partial and not fraudulent the Judge is forced to reduce the conventional penalty. And if the petitions do not comply with this provision, there is nothing to avoid the SC to modify the penalty. The problem is determining when breach is partial or irregular. According to the traditional position of the SC, if the breaching party, considering his overall conduct, has performed part of the consideration, then breach was already partial. The conventional penalty responds to an assumption of precise fact, and it is necessary to verify to what extent this assumption of specific fact foreseen in the conventional penalty has taken place or not so as to determine if the breach is partial or total. 4. Termination This remedy allows the aggrieved party to terminate the contract upon a qualified breach (“fundamental non-performance”) by the other party. It is important to point out that the breach allowing termination of the contract is not any breach, it must be a qualified breach: the rescission breach. Upon the effective existence of said breach, the party affected by the breach may rescind the contract and, except in cases of contracts to be performed over a given period of time, he may ask for the restitution of the consideration. The consequences of termination are the following:

The contract is left without force and effect.

Considerations must be returned.

Typically, the defaulting party must compensate the rescinding party for losses due to the breach of contract.

On the other hand, in Spanish Law, this rescission or termination can be carried out by the party affected by the breach without going to Court. Because of this, it is a remedy widely used in real contractual settings. “The case law deals fundamentally on cases of purchase and sale of realty. Another field in which case law is vast is in the rescission of distribution contracts, although in these cases they are somewhat different as to contracts of indefinite duration.” Case law of the SC can be summarized: 1. Not every breach permits rescission. 2. It must be a breach that affects a main obligation. 3. The breach must be permanent or with a vocation of permanence.

4. The SC demands as well a “plus of negative conduct” in the breaching party. The existence of a certain element of willingness to breach in a final manner, leaving the other party unsatisfied. If the circumstances aforementioned take place, the party affected by the breach of the other party may rescind. If both parties breach, then the last party to breach can rescind. The problem in the construction of the SC in respect of contract rescission is that it is thought for cases of purchase and sale realty, and because of that it puts too much stress on the importance of handing over and on previous breach in time.

III. Economic effects of the different remedies Breach remedies constitute the single most significant variable in the legal regulation of contracts. The list of economically relevant contractual decisions looks as follows: the decision to enter the contract; the decision to make specific investments relying upon the performance of the contract; the decision whether to perform or breach; the allocation of the inherent risk of non-performance; the decision to renegotiate the contract post-reliance investments and post-breach. S and P enter into a purchase agreement at a price of 65. The estimation of P of the contract is of 100 at last. The estimation of S of the contract is subject to variation: in 60% of the cases it is the price of 65 less some costs of 30 (35), in 20% of the cases it is a price of 65 less costs of 70 (-5) and in 20% of the cases it is a price of 65 less some costs of 150 (-85). It could be derived from this chart to perform the contract is socially inefficient in the third case. Thus, since the best of the remedies shall be said leading S to comply in the first two cases and breaches the third one. We shall analyze the effects that on the decision to perform or breach, as well as to invest in reliance or not, have the different remedies in case of breach. 1. Effects on the decision to perform or breach the contract 1.1. Specific performance Under a remedy of specific performance the seller will always perform because if he does not, the Courts will force him to do it anyway. Conclusion: the solution under specific performance deviates from the complete contract since performing the contract is not always more efficient than breaching it. Specific performance induces an inefficiently high level of compliance with the contract. 1.2. Damages Expectation damages: if S breaches and must compensate the positive contractual interest, this shall imply compensating P in an amount equal to what performing the contract would have meant to him. This supposes compensation equal to the value of performance to the buyer P (100) less the contract price (65):

Expectation damages = 100-65=35

S must consider so as determining if the decision to breach is efficient, that it shall have to compensate P with an amount of 35. Conclusion: expectation damages are able to replicate the outcome under the complete contract, that is, compliance in the first two cases and breach in the third party. Reliance damages: if S breaches and shall compensate the negative contractual interest, this will mean compensating P in such a way that it leaves P in the situation prior to entering into the contract. Thus, in a situation where P has not paid the price but has made an investment in reliance of 4, the compensation shall also be 4:

Reliance damages = 4 Thus, S shall consider, in order to determine the efficiency of the decision to breach, that he will have to compensate P with an amount of 4. Conclusion: reliance damages deviates from the complete contract in the sense that it induces too little performance and excessive breach. 1.3. Liquidated damages The optimal liquidated damage clause will be equivalent to the expectation damages measure. On the other hand, it shall not be efficient if it sets a compensation so high that it makes S comply in all cases or so low that S shall be induced to comply only in the first of the cases. 1.4. Termination If the remedy established upon breach is just termination of the contract, P may rescind the contract if S breaches, and the latter will have to return the payments received. Now, in the case that the price has not been paid and there are no reliance investments, S will not have to return anything and this will induce him to perform only in the first of the cases. Conclusion: termination as a sole remedy for breach of contract departs from the outcome under the complete contract, as it induces breaching in the second case when performing would be efficient. 2. Effects on the decision to invest in reliance Adding a new variable: P may make specific investments relying on the performance of the contract. Reliance investments positively affect the valuation of performance by P. If he invests 0*the valuation of the contract will be 50, if he invests 5 it raises up to 100, and if he invests another 25 it increases from 100 to 128. The investment is to be made before the uncertainty of S’s cost of production disappears. Starting from this information we will try to reason which is the optimum level of investment on trust by P and how the various remedies upon breach bring us close or separate us from this optimum level. 2.1. Optimal level of reliance investments The investment only produces an increase in value if the contract is in fact performed. It must be considered that according to the complete contract, S shall comply with the contract only

80% of the cases (when his costs are 30 or 70) and breach in 20% of the cases (when his costs are 150). So, the values of the consideration to P must be modified according to this probability, depending on the investment on trust of 50 (if he invests 0), 100 (if he invests 5), or 128 (if he invests 25) referred to. According to the valuation of the considerations at the different levels of investment in reliance, the following step is to calculate the increase in valuation that is produced at each new level of investment on trust. The desirable investment on trust is not necessarily the one that makes the nominal value of the considerations for P highest, the maximum available investment. If the contract is breached, the increase in value will not occur but, on the other hand, the cost of the investment will have been incurred. The investment that increases most the nominal value of the contract for P is 25, but it is not worthwhile investing 25 to obtain an increase in valuation, compared to the previous level, of only 22,4. On the other hand, it is clearly efficient to invest 5 in exchange of an increase in valuation of 40 as compared to the previous level. 2.2. Effects of the remedies upon breach at the optimal level of investment on trust 2.2.1. Damages Expectation damages: expectation damages tries to leave the aggrieved party in the same situation as if the contract had been properly performed. If S breaches he must compensate P with the quantity that latter expected to obtain from the contract. Conclusion: if the remedy upon breach is expectation damages, the level of investment in reliance chosen by the buyer will be the maximum. Under expectation damages the Buyer always receives the return of reliance investments, either through performance or through damages in case of breach. Thus the compensation of positive contractual interest induces excessive reliance by promises. Reliance damages: reliance damages purport to produce that S returns P to the situation prior to the contract. Assuming the contract price is to be paid upon performance, this means that P should receive back his reliance investment. Conclusion: if the remedy upon breach is reliance damages, again P will make the maximum investment as he will always be returned the amount invested. 2.2.2. Specific performance The contract will always be complied with, so the buyer runs no risk if he invests at maximum searching to obtain the maximum value possible. Conclusion: specific performance also departs from the optimal reliance decision under the complete contracts. 2.2.3. Termination If the remedy upon breach is solely termination, S will perform only when it is ex post profitable for him to do so. Just in 60% of the occasions, when his costs are 30 and the price he

receives is 65. This will make P invest only 5 and not 25 as in the previous cases because only an investment of 5 will be profitable, that is, the increase in valuation of the consideration that is achieved with it will be lower, considering that the contract is complied the 60% of the times. Conclusion: termination without compensation for damages leads in our example to the optimal level of reliance investment, but generally it induces a sub-optimal level of such specific investments. 2.2.4. Liquidated damages If the remedy upon breach is liquidated damages, it is the parties who set the compensation that is to be paid upon breach. In our example, the optimal liquidated damages clause is such which induces S to comply on 80% of the occasions, and P to limit his investment on trust to 5. Conclusion: if the liquidated damages clause is correctly set, it can replicate the outcomes of the complete contract regarding both efficient breach and optimal reliance investments.

LEGAL WARRANTY IN CONSUMER SALES DIRECTIVE 1999/44/EC 1. Economic rationales for warranties in consumer sales a. Insurance of losses resulting from product malfunctioning. b. Quality signaling by producers who have superior products. c. Incentives to invest in producing non-defective products.

2. Scope of application of legal warranty in European Law a. Sales from a professional to a consumer. b. Consumer goods, including second-hand goods. c. Contracts similar to sale.

3. Coverage of warranty a. Lack of conformity of good i. Does not fit description. ii. Does not fit accepted special use. iii. Does not satisfy normal quality and performance. iv. Contradicts public statements about good b. Not if consumer knew or should have known lack of conformity.

4. Remedies with legal warranty a. Repair or replacement, free of charge for consumer. b. The choice belongs to consumer unless one of the options is impossible or disproportionately costly to the seller. c. If repair and replacement are delayed, or inconvenient, consumer may choose between price reduction and rescission.

5. Time issues a. Warranty is binding for 2 years from delivery. b. If lack of conformity appears within 6 months from delivery, it will be assumed to have existed at time of delivery. c. For second-hand goods, the time may be reduced in the contract to a minimum of 1 year.

6. Mandatory nature of consumer rights a. The rights granted to the consumer may not be eliminated or negatively altered in the contract. b. Voluntary guarantees may expand these rights.

STANDARD FORM CONTRACTS IN THE EUROPEAN DIRECTIVE ON UNFAIR CONTRACT TERMS (DIRECTIVE 93/13/EEC) AND THE REGULATION PROPOSAL ON A COMMON EUROPEAN SALES LAW

The legal regime I. Notion of standard form terms 1. Contract terms drafted in advance by the seller or a third party, which the consumer agreed to without having the possibility of influencing their content. 2. The fact that the consumer had the possibility of influencing the content of certain aspects of a contract term or one specific term, shall not exclude the notion of standard terms to the rest of the contract.

II. Transparency requirements of contract terms 1. Contract terms shall be expressed in plain, intelligible language and be legible. 2. In the CESL (Common European Sales Law), contract terms shall be made available to the consumer in a manner which draws his attention to the non-negotiated terms.

III. General principles on the content of standard terms 1. Even when a term is not included in the “black list of prohibited terms”, the term should be considered as unfair if, contrary to the requirement of good faith, it causes a significant imbalance in the parties’ rights and obligations arising under the contract, to the detriment of the consumer. 2. The unfairness of a contract term shall be assessed at the time of the conclusion of the contract, to all the circumstances attending the conclusion and to all the other terms of the contract or of another contract on which the former is dependent. 3. The unfairness test shall not apply to the assessment of the main subject matter of the contract or to the adequacy of the remuneration foreseen for the trader’s main contractual obligation, provided that the terms are transparent.

IV. Black list of prohibited terms The CESL contains a list of contract terms that are considered unfair in all circumstances.

V. Grey list of prohibited terms Both directive 93/13 and CESL contain lists of contract terms that are presumed to be unfair.

VI. Interpretation of terms 1. Where there is doubt about the meaning of a term, the interpretation most favourable to the consumer shall prevail. 2. This Article shall not apply in the context of collective actions against allegedly unfair contract terms.

VII. Effects of unfair contract terms Contract terms which are unfair shall not be binding on the consumer. The contract shall continue to bind the parties if it can remain in force without the unfair terms.

Economic rationales for the legal regime of unfair contract terms

I. Transparency issues The proposed Directive on consumer rights and other legal documents insist on transparency requirements of standard form contracts, that is, that the consumer is informed and able to read the contract terms that will govern the transaction. There is evidence of various sorts that consumers, in e-transactions and in other forms of contracting relying on standard form terms do not commonly read the contract terms before entering into the contract, do not have the capacity, or the willingness, to read and understand the implications of standard contract terms. Moreover, there is also evidence that the opportunity to read the standard terms before signing the contract does not change the substantive content of the contract terms. So the available empirical evidence does not seem to give a clear indication that imposing duties to disclose standard contract terms and providing consumers with opportunities to read them actually improve the material situation of consumers in terms of the welfare they obtain from the transaction.

II. Content issues As for the content of the standard terms, the concern is real. The fact that consumers will rationally disregard becoming informed about the standard terms, means that for the consumer, to invest time and effort in reading the standard terms is a relationship-specific investment by the client, which can be easily appropriated by the drafter, by simply setting a level of quality in terms that leaves the client indifferent between contracting and not contracting. This makes rational for the client to remain ignorant of the clauses, as already documented. This strategy of the consumer can be easily anticipated by the seller, so the seller will provide the level of “quality” in the contract terms that it is most beneficial to him and not the level of quality in the terms that would be best for the joint welfare of the parties.

It is therefore extremely likely that the contracting process involving standard terms does not by itself result in the level of quality in the bundle of rights and obligations of the parties that will be best for both parties. The legal reaction to this failure of private ordering, as we have seen, is to mandate certain minimum levels of quality in standard terms, both by having a black list of prohibited terms and a general notion of an unfair term, if it prejudices consumers against the requirements of good faith. It is highly debatable that the European lawmaker would have the information to properly fix the threshold or floor of contractual rights and duties for consumers that would correspond to what most consumers in very different product markets, and in very diverse countries, would have chosen under conditions of symmetric information.

RIGHT OF WITHDRAWAL AND COOLING-OFF PERIODS IN THE CONSUMER RIGHTS DIRECTIVE

Directive 2011/83/EU on consumer right foresees in favor of consumers a right to withdraw in distance and off-premises contracts. In other Consumer Directives (timeshare, life insurance) a similar right is granted to the consumer. The right implies that the consumer shall have a period of fourteen days to withdraw from the contract, without giving any reason. The consumer rights Directive does not allow Member States from having more or less stringent provisions, departing from the level of protection set out in the Directive. It is a full harmonization Directive.

Legal regime I. Timing 1. 14 days period. 2. Starting from the date in which the consumer acquires physical possession of the goods. For services, the moment would be the conclusion of the contract. When the seller has failed to inform the consumer of the right of withdrawal, 12 months from the date in which it would have otherwise started, or 14 days after the information is granted, if it is provided within the 12 months period. 3. The deadline is met if the communication concerning the exercise of the right of withdrawal is sent by the consumer before the end of that deadline.

II. Exercise of right of withdrawal 1. A statement in his own words or a form prepared and given to him. 2. The seller may give the option to the consumer to electronically fill in and submit the standard withdrawal form on the trader’s website.

III. Effects of withdrawal 1. Seller shall reimburse any payment received from the consumer within 14 days from the date in which he receives the communication of withdrawal. Reimbursement should be made through same means of payment as used by consumer, unless otherwise agreed by the latter. 2. For sales contracts, the trader may withhold the reimbursement until he has received or collected the goods back. 3. When the consumer is in material possession of the goods, the consumer shall send back the goods or hand them over to the seller or to a person authorized by the seller within fourteen days from the day on which he communicates his withdrawal. 4. The consumer shall only be charged for the direct cost of returning the goods unless the seller agreed to bear that cost.

5. The consumer shall only be liable for any diminished value of the goods resulting from the handling other than what is necessary to ascertain the nature and functioning of the goods. 6. Any ancillary contracts shall be automatically terminated, without any costs for the consumer.

IV. Exceptions from the right of withdrawal Distance and off-premises contracts, the right of withdrawal shall not apply as regards the following: a. services where performance has begun before the end of the fourteen day period; b. the supply of goods or services for which the price is dependent on fluctuations in the financial market which cannot be controlled by the seller; c. the supply of goods made to the consumer’s specifications or clearly personalized or which are liable to deteriorate or expire rapidly; d. the supply of goods that given their nature are to be inseparably mixed with other goods after delivery; e. the supply of sealed audio or video recordings or computer software which were unsealed by the consumer; f. the supply of newspapers, periodicals and magazines; g. not suitable for return due to health or hygienic reasons; h. accommodation except for residential purposes, transport of goods, car rental, catering and leisure when the contract sets a specific date or period of performance; i. digital content without tangible medium when performance has started with the consumer’s express consent and knowledge of losing right to withdraw from the contract; j. contracts for the supply of foodstuffs, beverages or other goods intended for current consumption in the household; k. contracts for which the consumer, in order to respond to an immediate emergency, has requested the immediate performance of the contract; l. contracts for which the consumer has specifically requested a visit to his home.

V. Excluded contracts 1. The right of withdrawal shall not apply to: a. for the sale of immovable property or relating to other immovable property rights; b. concluded by means of automatic vending machines or automated commercial premises; c. concluded with telecommunications operators through public payphones for their use; d. for the supply of foodstuffs or beverages on frequent and regular rounds; e. for social services; f. for healthcare; g. for gambling; h. financial services; i. construction or renovation of buildings or rental of accommodation; j. where other withdrawal rights are provided, such as timeshare; k. auctions; l. contracts in which a notary intervenes;

m. package travel; n. automatic vending machines; 2. The right of withdrawal may be excluded by Member States for contracts under 50€.

Economic rationales for the right of withdrawal and its legal regime From an economic perspective, plausible rationales for a right of withdrawal lie in typical failures in the contracting process.

I. Correcting failures in the contracting process In certain settings of interaction between consumers and professional marketers and sellers, consumers may make suboptimal or irrational decisions due to:

- Unstable and peak preferences - Important impact of emotional factors - Inter-temporal choice inconsistencies - Pressing marketing tactics - Limited cognitive abilities in certain decision contexts

Certain market strategies or decisional environments created by firms may produce situational monopolies in which sellers may extract higher portions of surplus from consumers.

II. Information acquisition post-transaction Sometimes consumers cannot easily evaluate goods and services prior or at the time of buying. The value of the goods for the consumer may depend on how they look together with other goods, or the consumer may need to try their functioning. In other cases, the complexity of the contract may require extra time to fully understand and may get advice about the desirability of the contract.

III. Strategic use of right of withdrawal (moral hazard) The problem is that a generous and ample right of withdrawal may be strategically abused by the consumer, who uses the good at will during the cooling-off period, and then withdraws from the contract leaving a much depreciated good to the seller. If sellers can anticipate this, and given they cannot screen consumers through contract terms given the mandatory nature of the right to withdraw, the prices will go up, and some valuable consumer transactions will be lost. Of course this inefficiency would disappear if consumers had to pay for depreciation costs in case of the exercise of the right of withdrawal. The problem is that calculating the depreciation cost of the good in each case may be difficult and/or excessively costly with respect to the value of the goods. Thus, it probably would make sense to set a limit to the right to withdraw, even a short one, giving the high degree of depreciation of most goods. Sometimes, the exclusion makes

sense, given the immediate depreciation of some goods. It also makes sense to condition right of withdrawal on lack of use, if this is the triggering factor of depreciation and to make consumers bear the particularly high transportation and return costs of some goods.

GENERAL PROBLEMS OF ENFORCEMENT AND PRIVATE REDRESS IN CONSUMER LAW

1. I. The need for private redress In modern developed economies consumer goods and services tend to be produced and distributed in large amounts and to a large number of consumers. One single behavior by a firm is likely to affect in the same way a significant number of consumers similarly situated. When a problem arises with the product, the marketing campaign or the contract clause, substantive rules in European and national legal systems are likely to provide remedies to the affected consumers. These remedies are typically granted on an individual basis to the individual consumers and have to be pursued individually and on a case by case basis in front of the relevant adjudicator, traditionally a court of law, and in some areas, an ADR (Alternative Dispute Resolution) scheme such as an arbitration body, be it of private, quasi-governmental, or governmental nature. A main purpose of the legal remedies granted to the consumers is to deter firms from engaging in the kind of behavior that is deemed undesirable to the physical and financial well-being of consumers. In order to achieve this goal, the remedies need to be perceived by the firms engaged in business as effective, and truly applicable to each and every firm who is in the situation of making the choices that may impact consumer welfare. This means that the remedies have to be in practice able to be effectively pursued against the firm sanding behind the product, the campaign or the unfair contract term.

II. Incentive problems of individual redress Individual consumers face very serious obstacles and incentive problems that make optimal enforcement of consumer rights and remedies through individual legal action difficult. Infringement of Consumer Law and resulting damages may not be detected by the affected consumers, due to a wide variety of circumstances: firstly, long-tail effects may exist, meaning that a fraction, even a substantial one, of the adverse consequences of the infringement may manifest themselves only after a substantial period of time. Secondly, the negative effects of the firm decision may be only a low-probability event: such is the case with a pharmaceutical that has significant side effects only for small number of patients. Finally, the loss for the consumer may not be manifest to many consumers. This may be the case if an advertisement is misleading and manipulates the economic behavior of the consumer. Even if the infringement itself is detected by many or most consumers, they may not be adequately informed about the legal consequences of the infringement and the remedies provided to them. Due to these varied informational deficiencies the individual consumer does in many cases not have an actual and effective chance of legal action against the firm. In addition to these informational problems, even if the affected consumers are aware of the loss suffered as a consequence of the infringement of Consumer Law and are informed

about the legal rights and remedies applicable in the circumstances, these informed consumers may rationally decide to forego legal actions and the ensuing remedies. The reason would be that the costs of individual legal action outweigh the benefits of such legal action. Moreover, the private benefit of initiating legal proceedings is not certain, but probabilistic. The potential benefit needs to be discounted by the probability that the firm, in the end, is not found liable, due to factual or legal reasons. On the cost side, there are fixed cost of litigation, both monetary and non-monetary. The mode of individual action does not significantly alter the incentive problem of consumers. It may favorably influence, under some circumstance and to some decision to take legal action, but does not essentially and dramatically change the nature of the problem.

III. Threshold amounts for individual actions The costs of litigation therefore appear to lead to threshold amounts for individual action. A threshold amount for individual legal action is the minimum amount of loss that would make a consumer bring a problem with a product or service to court. The research confirms that the threshold amount for individual legal action differs by country and can be expected to be in the range of several hundred Euro to more than 10,000 €. The consequence of these thresholds is that from the different types of mass claims discussed above, remedies are likely to be not pursued individually for very low value claims, where the individual loss is lower than the threshold for both ADR and individual court action. And also for low to medium value claims rational consumers may refrain from taking individual action, depending on the circumstances of the case and the availability and accessibility of appropriate redress mechanisms. Individual action concerning mass claims seems to be more often pursued in the case of high value claims.

IV. Positive externalities of individual legal actions Legal action does not only provide benefits to the individual consumer who decides to bring an action. If successful, also serves to provide two types of non-rival and non-excludable benefits: a. The action creates a beneficial precedent favoring parties in similar circumstances; b. The action serves to enforce the substantive rules of Consumer Law by imposing costs in the form of adverse consequences on firms infringing their legal duties, thus providing incentives for that firm or other comparable firms, to “play by the rules”. These collective benefits in precedent and enforcement are not taken into account in the individual decision of consumers on whether to take legal action or not. This is a well-known failure, where suboptimal incentives exist for individual consumers to contribute to the provision of the collective good (the so called collective action failure). Are the problems of individual enforcement of Consumer Law affected by the number of individual consumers affected by a mass claim? Problems related to collective goods are likely to be more acute, and lead to a larger disparity with the socially desirable outcomes, when the size of the group of affected individuals increases. The rational reluctance of consumers to bring individual claims is also likely to be aggravated the higher the number of affected consumers is. The reason would lie in the fact that the costs for the consumer plaintiff to bring an action are not exogenous, but depend on the stakes of the case for the defendant.

And the larger the group of affected consumers, the more serious the consequences of losing the case for the firm, and thus, the more the latter would likely be willing to invest in the individual case in terms of better and more expensive lawyers. This would also potentially raise the costs for the consumer who may decide to file a suit. For a given level of damages, the balance will be even more titled towards refraining from legal action. One would expect that the more consumers are affected by the same problem the more information will be available for individual consumers, and public attention will be higher, both with respect to the underlying facts and to the legal consequences of the infringement of Consumer Law.

V. Incentive problems of collective redress Disperse individual actions by consumers are not likely to adequately enforce legal remedies for harm or loss incurred as a result of Consumer Law infringements by firms affecting a large number of consumers. To overcome this deficiency several European countries have introduced collective redress mechanisms for damages:

Group actions where individual actions are literally grouped into one procedure.

Representative actions where one individual or an organization represents a multitude of individuals.

Test case procedures, where a case brought by one or more persons leads to a judgment that forms the basis for other cases brought by persons with the same interest against the same defendant; and finally

Procedures for skimming-off profits, where a defendant who infringes the rules against unfair competition or unfair commercial practices is held liable to reimburse the illegally obtained profits.

These collective redress mechanisms often intend to exploit the significant economies of scale in the process of preparing and litigating a case. The economies of scale and also the public attention raised by a collective action also likely reduce the information costs for individual consumers who may decide to form or join a group of plaintiffs. Collective actions are therefore likely to shift the balance in favor of initiating legal action by forming or joining a group. In spite of that, the availability of collective redress in a given legal system will not entirely eliminate the rational disincentives for individual consumers to take part in collective litigation. This is even true for those collective redress mechanisms, where participating consumers do not bear any financial risk of litigation. Information costs and the transactions costs associated with the time and effort needed to join a collective action can be a significant deterrent to join an action, especially in very low and low value cases. Even if reduced compared to the alternative of individual legal action, the fraction of the cost of collective litigation that falls upon a given individual under these procedures may be higher than the expected benefit in terms of the per capita share of total damages awarded to the group. If this is the case, a consumer would rationally opt for not joining in the group of plaintiffs, and if a sufficient number of consumers behave similarly, the collective suit may become infeasible.

VI. Threshold amounts for collective actions From the evaluation of the existing collective redress mechanisms in the EU it appears that the threshold amount for collective action is lower than for individual litigation, but still significant. The existence of a threshold amount may lead to low participation rates of affected consumers in collective actions concerning very low and low value mass claims, also depending on the requirements of the collective redress mechanism, the related costs and time effort for the consumer. Although collective litigation is therefore capable of reducing the costs of coordination among consumers in order to jointly contribute to the provision of a public good for the group this is no guarantee of successful avoidance of the above mentioned problems of individual vs. collective interests. Also in other forms of collective redress action consumers may be tempted by the wait-and-see strategy in order to save the costs of sharing in the collective action, while being able to personally enjoy some of the public good elements of the action. The above considerations are not relevant for those collective redress mechanisms where consumers do not have to opt-in, or collective redress mechanisms that are not aimed at compensating individual consumers. But even in these cases other problems of collective actions still remain an issue. The fact that in many cases collective redress mechanisms shift the financial risks of litigation from the consumer to an intermediary creates new incentive problems. The inadmissibility of contingent fees in many European countries can make the financing of actions difficult, given that contingent fees are widely perceived as a way to finance legal action by potential plaintiffs, who may face liquidity constraints with respect to the cost of legal proceedings, especially in complex cases. 2. Immediate economic consequences of the obstacles to obtaining satisfactory redress for consumers Even if the aggregated loss of all consumers in a mass claim is very substantial, a rational consumer will not take action if his or her individual loss is lower than these threshold amounts, be it by bringing an individual legal action or by participating in a collective action. This indicates that there is a need to analyze the economic consequences of obstacles to obtaining satisfactory redress. I. Losses and inefficiencies for consumers caused by obstacles to obtaining satisfactory redress The following losses and inefficiencies can be identified as economic consequences of obstacles to obtaining satisfactory redress for consumers:

Consumers are subject to uncompensated loss

Economic behavior of consumers can be distorted

Efficiency gains of ADR for consumers are not fully exploited

Efficiency gains of collective redress mechanisms for consumers are not fully exploited.

Loss for consumers: uncompensated financial and other detriment When consumers cannot enjoy a sufficient level of redress against the infringing firms they will be subject to uncompensated loss, of varied nature depending on the character of the underlying Consumer Law violation. They may experience losses of various kinds:

Physical harm. In these cases there, depending on the degree and nature of the harm, individual action is more likely to be rationally pursued by consumers.

Financial losses due to excessive pricing or undue changes, unsatisfactory or uncompleted transactions. This would definitely reduce the overall well-being of consumers, perhaps in an important way if one considers the aggregate effect across a large number of affected consumers. In fact, it is plausible to expect that the smaller the per capita effect and the larger the number of consumers involved, the more serious the negative effect on consumer welfare will be.

These uncompensated losses do regularly occur in a situation where consumers are affected by a very low value mass claims. Loss for consumers: economic behavior can be distorted Obviously, the behavior of consumers in the future will be affected as a result of these uncompensated losses: consumers will anticipate, to some degree at least, the lack of redress and thus the smaller net welfare to be expected from the consumer transaction. These consumers’ perceptions about the lower net value for them of the goods and services they purchase in consumer markets, due to those losses that they anticipate will remain uncompensated, will reduce the willingness to pay the monetary price for those goods and services, to an extent that would be affected by the level of loss that consumers have to bear. Loss for consumers: efficiency gains of ADR for consumers are not fully exploited The level of the threshold is affected by obstacles such as the length of court proceedings, high lawyer fees etc., which directly increase the costs of litigation and/or the attractiveness of individual legal action. They may lead to increased consumer losses, as the participation rate for individual legal action can be expected to be reduced and the number of consumers that do not obtain satisfactory redress in mass claims will rise accordingly. ADR may provide significant efficiency advantages compared to individual redress, and this is reflected in lower threshold amounts: a rational consumer will rather participate in an ADR scheme than file an individual legal action, because the associated costs are lower. This may lead to reduced consumer losses and so would the level of deterrence associated with redress. However, in practice formal ADR schemes have significant limitations, both concerning their applicability for very low value mass claims, and concerning their applicability for high value mass claims involving complex questions of liability. ADR schemes seem to be most relevant for a subset of low to medium value mass claims where liability is relatively easy to establish.

Loss for consumers: efficiency gains of collective redress mechanisms for consumers are not fully exploited Collective redress mechanisms provide efficiency advantages compared to individual redress, and this is again reflected in lower threshold amounts. A rational consumer will rather participate in a collective action, because the associated overall costs for the consumer are lower. Efficiency gains of collective redress mainly result from the high fixed costs associated with enforcing legal rules through the court system. This implies the presence of economies of scale that can be exploited if the high fixed costs can be spread out over a large number of individual cases arising from the same set of factual circumstances even if affecting different individual consumers: the sharing of legal services by lawyers and other legal professionals, the sharing of judicial and experts’ time, the reduction in time taken by litigation from both claimants and defendants, bring down the costs per case and per euro of compensation, or per unit of increased deterrence of the undesirable behavior. Collective redress mechanisms can allow societies to attain a given degree of enforcement at lower costs, both to the parties involved and to the public. A number of obstacles for obtaining satisfactory redress are particularly relevant for collective redress mechanisms. These obstacles harm the efficiency gains that these mechanisms are able to provide to consumers. Efficiency gains for consumers from collective redress include:

Decrease of costs of gathering and disseminating information for consumers: the fact that a single organization is in charge of coordinating the claims of the individual consumers involved reduces the costs of transmitting information.

Reduction in litigation costs: collective redress mechanisms produce economies of scale in bringing and adjudicating claims by consumers against firms for infringing substantive rules in consumer protection legislation.

Higher level of loss compensation for consumers: on top of the direct effect on the cost amount for litigation, an indirect effect over the gross payment is also to be expected.

More settlement offers to be expected under collective action: claimants and defendants are typically both better-off if they settle their disputes before going to a full trial, and thus jointly save most of the costs associated with litigating or handling the claim till the end of the procedure.

Efficient risk bearing of failed litigation for individual consumers: a collective redress mechanism allows individual consumers to pool the risk of losing a case and then having to bear the costs of the defendant under the “loser pays” principle that govern civil litigation in most European legal systems: in case the collective action is possible, each consumer pays at maximum only an equal share of the total legal costs of the defendant.

If collective redress is not available, or seriously hampered, consumers are denied these efficiency gains of collective redress.

II. Benefits for consumers caused by obstacles to obtaining satisfactory redress These other redress mechanisms (collective redress and ADR) are not devoid of some inefficiencies. The unavailability of these redress mechanisms in a legal system, or the lack of effective use of these mechanisms, may prevent these inefficiencies from occurring and therefore theoretically also could result in benefits for customers. This concerns two potential benefits:

Enforcement costs do not occur if consumers do not seek redress

Potential inefficiencies of collective redress mechanisms can be avoided, if obstacles prevent their use.

Benefit for consumers: enforcement costs do not occur if consumers do not seek redress The shortcomings of individual action in the field of consumer protection were presented and discussed, leading among others to a threshold amount of loss under which it is unlikely that any individual redress action is to be expected. Although consumers would not find adequate redress no costs will be incurred by consumers in litigation or ADR related costs in the first place. In contrast, when collective redress mechanisms or ADR schemes are readily available, and are attractive enough for individual consumers to join in the action, the scenario may change substantially. The scattered claims that remained unfiled and unpursued may well find their way in litigation or arbitration. Albeit at a lower per capita cost than under individual enforcement, consumers may now face some costs in presenting and enforcing their claims within the collective redress mechanism or the ADR scheme. It may happen, however, that consumers will have to face these costs with little in return. If the recovery is very limited, the costs may well outweigh the benefits, even if we add the general or long term deterrence effect on firms of the threat of the collective redress action. Consumers may well still pursue their claims, even though they are incurring costs that may not be paid-off with the expected benefits of litigation or arbitration. There is at least the theoretical possibility that such a problem arises, due to the cost-reducing, and claim-facilitating properties of collective redress mechanisms, and of ADR mechanisms. Benefit for consumers: potential inefficiencies of collective redress mechanisms can be avoided if obstacles prevent their use Potential inefficiencies of collective redress mechanisms that can be avoided if obstacles prevent their use:

Less meritorious claims may be brought under collective redress. If claims can be effectively filed and pursued, and compensation can be obtained, and settlement offers can be extracted from the defendant, it is possible that also unmeritorious claims will be filed in the expectation of obtaining a positive settlement amount from the defendant.

Collective actions bring increased agency costs between consumers, on the one side, and lawyers and consumers’ organizations, on the other. In individual legal redress (and individual ADR), claimants enjoy an important degree of control over the process.

In collective redress schemes the degree of control of each individual consumer over the litigation is limited. The agency costs become then crucial, and may lead to a significant risk of disregard of the interests of the individual consumer in the entire process.

It is very difficult to obtain empirical confirmation concerning the potential impact of collective redress on the level and rate of success of unmeritorious claims, given that the true nature of the claim can be only very imperfectly guessed from the result of the litigation or the arbitration, not to say of the settlement, if that is how the action ends. However, under the “loser pays” principle it is already quite risky to bring to court unmeritorious claims, unless it is extremely easy to get away with unmeritorious suits.

THE UNFAIR COMMERCIAL PRACTICES DIRECTIVE: A LAW AND ECONOMICS PERSPECTIVE

1. Introduction Among the pieces of European legislation directly affecting how markets operate, we should count the recent Directive 2005/29/EC of the European Parliament and of the Council concerning unfair business-to-consumer commercial practices in the internal market. The confessed goal of the Directive is twofold, to harmonize the existing and diverging national rules on unfair commercial practices, so as to improve the smooth and unencumbered functioning of the European internal market in goods and services, and to achieve a high level of consumer protection vis-à-vis commercial practices by firms capable of harming the economic interests of consumers. The Directive is notably ambitious and far-reaching in this field.

2. The plausible goals and organizing principles in regulating commercial practices

I. Efficiency in b2c transactions From an economics perspective, it seems logical to start with efficiency as a plausible mission in the regulation of commercial practices in the business-to-consumer relationship. In a business-to-consumer interaction the desirable outcome is that the surplus from the voluntary interaction becomes as large as technologically or otherwise materially feasible, that the surplus is maximized. As simple economic theory shows, perfect competition ensures that all consumers who value a certain good or service at more than what it would cost for the society to produce the good or provide the service, will obtain it at the price which reflects the exact social cost. Competition forces firms to offer the most attractive combination of prices and qualities technologically available, and consumers are thus able to find the price/quality that best suits their preferences. Although consumers are able sometimes to discipline untrustworthy or otherwise undesirable firms through the simple mechanism of not buying again and taking business elsewhere, this is not always the case. Reputation and repeat sales may not deter fly-by-night or scam operators, and general rules and remedies in Contract law sanctioning duress, fraud, and breach of contract, and even rules in Criminal law may be often necessary. Still, the latter cannot adequately respond to instances of contract breach that are not verifiable in a Court of Law, or to behavior of firms that are entirely or almost, judgment-proof, and thus, undeterrable using ex-post monetary sanctions. In these circumstances, there is a role for regulatory duties and public enforcement mechanisms. From a pure efficiency perspective, there is space for the imposition of regulatory requirements on firm behavior towards consumers, affecting communication, advertising, sales promotion, contracting and pre-contracting conduct, and so on, in order to increase the surplus in the firm-consumer relationship. The core issue is how to design and apply an

optimal system of duties of information and behavior that covers the gaps that market forces are unable to check and does not interfere with those pressures of competitive markets. Of course, the various dimensions concerning the scope of the regulatory measures are crucial issues to consider. II. The redistributive deal A second plausible objective of regulating the practices of firms affecting consumers would be to benefit the latter at the expense of the former, that is, to redistribute welfare from producers to consumers. It is entirely sensible to think that the gains from trade and interaction between producers and consumers are unequally distributed among both groups. The real-world market structures actually are far from the perfectly competitive ideal, and that imperfect competition reigns, arising from the presence of a single producer or a group of producers acting like a single producer, monopoly and collusive behavior: when a monopolist restricts output to maximize profit, it causes a raise in price above the competitive level. This will bring about a shift in the ultimate beneficiary of the surplus of the market exchange. A fraction of this surplus will be transferred from consumers to producers, making the former worse-off and the latter better-off. In less than perfectly competitive market structures, it is therefore theoretically feasible to improve the lot of consumers at the expense of firms. The problem is that firms and consumers are in a contractual or otherwise voluntary situation. An increase in duties or rights that is not efficient, in the sense of increasing the surplus of the interaction, will imply a readjustment of the terms to the detriment of consumers that cannot be compensated by the increased consumer welfare due to a higher level of firms’ duties or consumers’ rights. Thus, a purely redistributive legal intervention –one that does not increase joint welfare apart from how this welfare is shared among the parties to the interaction –is very likely to become moot (discutible) due to the readjustment in price and / or other terms of the transaction. Such a redistributive goal would thus be largely self-defeating, and does not provide an appealing foundation for a set of rules as the ones contained in Directive 2005/29. III. The market manipulation theory A slightly different goal would be to prevent undue influence, or outright manipulation by firms –essentially through advertising, sales promotions, and other marketing techniques –of consumers’ preferences. In recent years, psychologists and behavioral economists have identified, described and experimentally analyzed several cognitive and behavioral biases in human beings, all of which imply a significant departure from the standard model of human behavior. People have shown to be bad statisticians and users of factual information and to have time-inconsistent and other-regarding preferences. Many, if not most commercial practices are but instrument in the hands of firms to manipulate those biases in their benefit: advertising, promotion, and price setting are ways to alter consumer preferences to the advantage of firms. The goal of opposing the manipulation of consumers’ tastes and choices by the producers, although containing some redistributive flavor, is conceptually different. Here the crucial issue is the formation of consumers’ preferences and how firms consciously interfere

with a fair process of choice by consumers. In some sense, there is a fairness flavor to it, pointing at the policy of using the Law to impose ethical constraints on the commercial practices of firms towards consumers. It is highly likely that such a fairness motivation against preference manipulation lies behind several rules in consumer protection Law generally, as well as in European consumer Law. Many of the practices contemplated as aggressive seem to be clear and obvious examples of the kind of preference manipulation that lies at the core of consumer protection under this goal. There are some problems with this approach. First, if we take the market manipulation argument at face value, then the regulation of commercial practices should restrict almost any of them. Commercial practices are primarily means of persuasion, not means of informing the consuming public. The end result is that no communication with consumers will ever take place. If the Law of commercial practices did in fact try to eliminate such well-internalized and widely-used marketing tactics as the ones just cited, or other to similar effect, the enforcement costs of the regulation would sky-rocket, because almost any marketing technique would be prohibited. The result of a marketplace with no advertising and marketing strategies seems bleaker than a marketplace with some preference manipulation and distortion. The second reason lies in the fact that the market manipulation story goes too far. Cognitive and behavioral biases by consumers are very real, for sure, but they do not make consumers mere puppets in the hands of firms. DELLA VIGNA and MALMENDIER: if consumers are sophisticated, and knowledgeable of their own shortcomings in terms of self-control, firms not only are unable to exploit consumers’ weaknesses, but in fact can help them so they are not harmed, in terms of welfare, by the lack of self-control. There is also substantial empirical evidence that consumers are not blindly fooled and persuaded by all communicative actions by firms. Consumers tend to think that communication by firms is relatively untrustworthy, although they are able to obtain valuable information from it concerning the relevant features of the product or service, or the projected transaction. All this implies that cognitive and behavioral biases per se do not impede that market forces can perform relatively well also if consumers are relatively impulsive, weak, or uninformed. If they are aware of where their biases lie, the chances of market manipulation diminish, and thus the need to introduce legal means to correct market outcomes. This does not imply that firms do not attempt to take advantage of the cognitive and behavioral biases affecting consumers. A third problem in adopting market manipulation avoidance as the overarching goal of regulating commercial practices lies in the fact the kind of legal intervention that, in all likelihood, would be required to achieve this goal, would entail most of the costs and negative argument against paternalism, to the unwanted side-effect of eliminating much valuable free choice, to the real dangers of regulatory capture by interest groups. IV. Removing barriers to trade with consumers across borders The objective of removing barriers that hamper the smooth functioning of the internal market in goods and services, looms large in the Directive. The internal market, or the harmonization

goal 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 carry out an advertising campaign covering several, not to say all Member States, the costs of compliance are much higher in the presence of different legal and regulatory requirements than with a single set of legal conditions for the campaign. It is in fact this dimension of harmonization the one underlined by many commentators of Directive 2005/29. Others downplay the importance and reach of the cost-reducing effect of the Directive, mainly due to the fact that regulatory diversity will not disappear as a consequence of a harmonizing Directive, because even if the Law in the books is the same in the different Member States, the Law in action will definitely differ widely, due to diverse enforcement strategies and views. The need to adapt to local market conditions will always impose costs on cross-border marketing activities by firms. Some argue that the perspective of reducing costs for firms is not the adequate one to make ground for cross-border trade. Consumer perceptions about legal and other uncertainties and shortcomings of transacting over the national borders would be 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 harmonization. It is hard to deny that regulatory complexity and variety entails some level of transaction costs for firms contemplating activities in the different areas covered by the diverse legal and regulatory regimes. Lawyers are specialized professionals who obtain quasi-rents from 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 regulations. Whether this diversity is a relevant obstacle to the formation and flourishing of a vigorous unified market is a different matter. A reduction in complexity and disparity would produce some gains. These gains are both static and dynamic in nature. Since COASE we know that transaction costs involved in cross-border commercial activity actually entails a reduction of real costs in the economy. Who will benefit more in the end of this cost reduction depends upon market structure and the elasticity of demand. There is also a dynamic gain resulting from this reduction of transaction costs of cross-border commercial relations between firms and consumers. Transaction costs created by regulatory 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, enhanced competition in each of the affected national markets. 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 transaction costs in cross-border trade, and these are also real economic costs, whose reduction would also bring both static and dynamic gains. 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. Even if a real reduction in regulatory diversity and legal uncertainty in cross-border transactions has taken place, if consumers are slow, transaction costs would remain at the previous high level. The biggest issue is that all the former considerations refer only to the benefit side of the necessary balance in order to evaluate harmonized rules as a desirable instrument to

implement the internal market. Harmonization also has its costs. In the current European context, it is far from clear that a uniform pan-European regulatory content would be optimal for the conditions of all national consumer markets. It is true that Directive 2005/29 as a total harmonization Directive, would not really mean that firms would be subject to exactly the same regulatory requirements in their commercial activities towards consumers everywhere in Europe. The rules present in the Directive are based on the use of standards and notions, which allow ample room for interpretation and judgment in accordance with the specific circumstances of the national and/or product market affected, and thus, permit a relatively wide variety of substantive outcomes. The enforcement of the provisions of Directive 2005/29 is largely left to Member States. It is almost axiomatic that uniformity of effective regulatory outcomes on commercial practices would increase as a result of the new Directive. And this uniformity would imply a reduction in the current levels of regulatory stringency in some countries: less information duties, less obligations to justify statements in commercial communications and so forth. If the existing levels were optimal given the conditions of markets and consumers, and the preferences of voters in each country, such a move towards uniformity would entail costs and losses to the affected parties and to the disinterested and representative voter. Whether these costs outweigh or not the benefits of more unencumbered cross-border trade, is something very difficult to establish. The general question concerning the cost-effectiveness of the harmonization effort in the field of commercial practices remains unresolved. III. The efficiency of the scope of Directive 2005/29 In terms of scope and intended reach, Directive 2005/29 is notoriously ambitious in its pretension to cover all commercial practices and all markets for goods and services. From an economic perspective, three of the drafters’ choices concerning the scope of the Directive seem particularly noteworthy. The first refers to the decision to restrict its reach to business-to-consumer commercial practices, without affecting “… the national laws on unfair commercial practices which harm only competitors’ economic interests or which relate to a transaction between traders”. There has been substantial debate concerning the appropriateness of this restriction, which departs from the tradition of most Member States to include in the legal regime of commercial practices also those affecting competitors or other professional participants in the market. From an economic perspective, it is not immediately clear whether the general regulation of unfair commercial practices should include both those addressed to consumers and those addressed to other firms. In economic terms, given the most relevant kind of practices and prohibitions contemplated in Directive 2005/29, there are enough important differences between the median consumer and the median professional market operators in those respects, as to make the diversified regime consumers/professionals a sensible choice. The second major choice in terms of regulatory coverage concerns the range of economic actions or activities affected by the rules in Directive 2005/29. The definition contained on ‘business-to-consumer commercial practices’ is broad and almost all-encompassing: “any act, omission, course of conduct or representation, commercial communication including advertising and marketing, by a trader, directly connected with the promotion, sale or supply of a product to consumers”. Such a ‘generalist’ approach to

regulating commercial practices, even if circumstances do matter much for the economic consequences, and the optimal way to regulate of different commercial actions in which firms engage to contact and interact with consumers. The same consumer acts very differently varies enormously from one market to another. Another crucial differential factor is the impact on consumer’s welfare of the relevant commercial practice. In some circumstances, the effect of an undue change in the behavior of the consumer as a result of a given practice by firms may be life-endangering while in other instances the effect is trivial. It seems that the drafters and promoters of Directive 2005/29 are confident in the use of general clauses. It is undeniably good to have general and abstract theories and analytical tools, capable of illuminating and helping to understand a wide variety of social phenomena. But legal rules are not instruments of knowledge, but direct and indirect motivators of human conduct. Nevertheless, provided that coverage under the Directive is desired to be market unspecific, the notion of commercial practice introduced seems adequate in its breadth. It would be pointless to try to subject all markets and then use a somehow restrictive notion of the subject matter in terms of the actions covered. Firms contact and address consumers to persuade them to buy. This is the essence not just of narrow marketing behavior but of all kinds of contact, direct or indirect, of firms with prospective customers. Transactional decision is “any decision taken by a consumer concerning whether, how, and on what terms to purchase, make payment in whole or in part for, retain or dispose of a product or to exercise a contractual right in relation to the product, whether the consumer decides to act or to refrain from acting”. The definition intends to cover the entire range of consumer’s behavior either before, during or after purchasing. A reference to contract would be appropriate here. If the intention is simply to state the obvious fact that the Directive should not be understood as substituting existing private law rules on contract, fair enough. It should be made clear that communication between the provisions of Directive 2005/29 and rules of contract law, specially European contract law would be active. A third important choice in terms of scope refers to the relevance or impact of the practice to be deemed unfair. The crucial notion here is that of materially distorting the economic behavior of consumers. Directive 2005/29 is concerned thus with commercial practices that do matter for the actual response and behavior of consumers. “Using a commercial practice to appreciably impair the consumer’s ability to make an informed decision, thereby causing the consumer to take a transactional decision that he would not have taken otherwise”. The starting point behind this idea is sensible: it makes sense to restrict and deter commercial practices vis-à-vis consumers only when they are harmful to them. The notion of material distortion of the economic behavior of consumers thus seems to serve as a proxy for the harmfulness of the practice. As a proxy for harm, however, some problems may appear with this notion. First, its core normative content is based upon an exercise in counterfactuals: the distortion exists if the observed decision taken by the consumer exposed to the commercial practice departs from what would otherwise have been his or her decision. Second, as a proxy for harm to consumers, the notion of material distortion of the economic behavior of consumers as it appears in Directive 2005/29, is too focused on the starting point of the commercial practice. As it stands, the commercial practice has to impair the consumer’s ability to make informed choices, so the shift from the baseline requires

some kind of behavior attributable to the firm engaging in the commercial activity. Pre-existing errors, misinformation or misrepresentation on the part of consumers, unless they can be linked to a previous statement or precise omission of the trader in question, cannot serve to build a result of unfairness in the underlying commercial practice. From a purely economic perspective, this linkage should not be a pre-requisite for imposing duties upon firms engaging in commercial communications or commercial practices generally. If these firms are well-placed to increase the information useful for consumers so they can make more informed choices, there is no economic reason not to require them to do so. That is, if firms can correct inadequate levels of information on the part of consumers, their practices should be deemed unfair if they do not engage in these educational or corrective actions. IV. Setting the test for unfairness As has been widely acknowledged by all commentators of the Directive and the Proposal, the finding of unfairness of a given commercial practice is organized in a complex way in Directive 2005/29. There are several different levels of analysis. The more general level is a general clause of unfairness, and expressed in a double requirement: violation of professional diligence, and material distortion of the economic behavior of the average consumer. The second level is made operational through the concepts of misleading and aggressive practices. Last, a black list of specific commercial practices, presumably having been found in real-world commercial experience, which are considered unfair, regardless of the verification of the presence or absence of the elements or factors on which either the general unfairness, determinations depend. The general unfairness clause receives meaning via a double test. First, professional diligence of traders has to be determined, and the actual commercial behavior of the individual trader has to be assessed against this standard. The violation of the standard is a pre-condition for a finding of unfairness. In Law and Economics terms, the Hand formula nicely explains how the negligence rule is to be understood from an economic perspective. In this case, if the standard of professional diligence of traders is adequately set, the commercial actions of firms would be the optimal ones. Setting optimal standards is no easy task in any realistically imaginable situation. Several factors can lead to think that this task would be particularly Herculean in this setting. These factors clearly point in the direction of expecting that it would be extremely unlikely that the determination of what constitutes professional diligence in the field of commercial practices will be just right in terms of the balance of costs and benefits. First, the mere heterogeneity of the agents involved increases dramatically the complexity of the task: the optimal standard of behavior should be perfectly tailored to the characteristics of the specific agents involved, and the more heterogeneous the agents, the harder is to tailor the standards. Firms engaging in commercial practices are extremely diverse. To determine the professional diligence standards for all of them on the basis of a general formulation seems almost chimerical. Second, the optimal determination of professional diligence standards in commercial b2c practices cannot be accomplished without looking at the harm resulting from the alternative feasible practices. Economically, no optimal standard can be determined without

having an estimate of the expected harm for each of the alternatives of conduct which may become the standard. Third, Directive 2005/29 does not give any hints at how to understand and construct the professional diligence standard crucial for the first level of determination of the unfairness test. The likelihood that legislators, regulators and Courts in the different Member States may have radically divergent views upon the role and content of such standard, particularly in view of the diverse contexts in which the standard has to apply, is very high, thus heavily questioning the plausibility of a coherent solution. In order to effectively govern the behavior of firms the likely results of the unfairness test applied to commercial practices have to be anticipated, so that firms actually can plan their commercial strategies in accordance with the required standards. Finally, standards of behavior in the commercial setting are notoriously difficult to establish. Legislators and Courts are no business experts, and this explains how in other areas of the Law, notably that of liability of managers, legal systems tend to use a hands-off approach, illustrated by the ‘business judgment doctrine’. The second part of the top-level test is the material distortion of the economic behavior of the average consumer whom the practice in question reaches, or to whom the practice is addressed. The material distortion notion corresponds, broadly speaking, to the idea of effective and relevant harm to the consumer. The ‘average consumer’ concept would provide the way to circumscribe the population against which to assess the existence and level of harm. The notion of ‘average consumer’ remains controversial. First, the notion is a composite, in the sense that it has no immediate real world correspondence. In reality there is no average consumer, just individual consumers each with his or her own endowment of information. Optimally, harm should be assessed also individually, taking into account the specification of each consumer. Using averages, however, requires a clear definition of the population or variable range from which the average is drawn. This is somewhat obscure in Directive 2005/29, because what is the relevant population needs to be defined. If a practice is likely to materially distort the economic behavior only of a clearly identifiable group of consumers who are particularly vulnerable to the practice of underlying product because of their mental or physical infirmity, age or credulity in a way which the trader could foresee, the practice should be assessed from the perspective of the average member of that group. If it is necessary to clarify that the targeted public is the relevant population in cases of vulnerable consumers, it is legitimate to think that otherwise the population is not defined as targeted audience or group. From a Law and Economics perspective, harm to consumers from a commercial practice should be evaluated for the purposes of a determination of fairness or unfairness of the practice against the benchmark of how consumers really are and act, not how they could or should act, based on some external normative criterion. The second level step distinguishes between misleading and aggressive practices. Within the first category Directive 2005/29 tackles in a differentiated way positive actions from firms, and omissions to inform. An action is misleading if it provides false information concerning some elements of the transaction, or is deceitful for the average consumer, even if factually correct, concerning those same elements. In both cases it is necessary that the

average consumer would take a regrettable transactional decision as a consequence of the exposure to the misleading practice. The idea that the literal meaning, and even the interpretation, of a communication from firms, should not determine a finding of deception, is one. That a communication should not be misleading if it does not generate beliefs in consumers, and that they act upon such beliefs in a manner detrimental to their own interests. The list of elements to determine falsity or misleading character seems to present serious problems. The idea of having a sole set of dimensions of the interaction between firm and consumer is unnecessarily rigid. Each market and each product can be very different in this respect. The list is exceedingly exhaustive and detailed, given its validity for the entire universe of markets. Some of the elements included can hardly play a major role in most markets for goods and services, and a shorter and non-closed list might have been a more attractive strategy. Finally, Directive 2005/29 displays a rule on the burden of proof on the truthfulness of factual claims made in commercial practices, or as it is usually called in the Law of misleading advertising, on the substantiation of claims in advertising. The rule forces Member States to confer power on Courts or regulatory agencies to require firms to provide evidence on the accuracy of factual claims in relation to a commercial practice. The efficiency goal of allocating the burden of proof in this matter is to minimize the harm from two types of errors. Type I errors (false positives) are errors caused by allowing as fair a claim that is factually false. Type II errors (false negatives) are errors caused by not allowing a claim that is factually true. The goal would be to minimize the sum of the negative consequences from both types of errors. In theory, none of them should be considered more or less serious than the other. The outcome depends on the harm resulting from each of them, and the prior probabilities of each kind of error. The idea of a misleading omission determining a finding of unfairness is more disturbing, in economic terms, than what happens with positive misleading actions. First, because it transpires some distrust on the appropriateness of the level of consumer information prevailing in consumer markets. In fact, we should not think that consumer markets are entirely dominated by imperfect information. Even if we abstract from legal constraints and requirements to this effect, the level of information provided by and at the disposal of market participants in consumer’s markets is by no means negligible. Consumers acquire information about relevant characteristics and variables affecting the transactions on goods and services by several means. Producers themselves are major providers of information in consumer’s markets. Advertising plays a key role in transmitting information on the existence, characteristics, prices and other determinants of market transactions. And not only the so-called ‘informative’ advertising has this positive informational role. Advertising, and the reputation that is usually with it, are extremely powerful market mechanisms to effectively signal consistent levels of quality to consumers, particularly in markets for experience goods. More surprisingly, market forces can, under some conditions, induce producers to disclose even unfavorable information to consumers or, more generally, to the other party in a prospective transaction. In what is one of the more striking results of the economics of information, it can be shown that, when the private information in possession of the seller is verifiable and the consumer knows that the seller has private information, the seller will

voluntarily reveal the information even if it is unfavorable. Sellers whose private information is best would voluntarily disclose it, and so would set in motion a continuous process of revelation by the decreasingly good-news sellers, until only that with the worst private information is left alone without disclosure. And consumers would actually observe that their expectations are met. A third important shortcoming lies in the fact that the Directive seems to have ignored the problems of information overload for consumers. Increasing the amount of information may in fact confuse consumers. The intrinsic limitations of space and time of the medium used to communicate with consumers should be taken into account in assessing where there was a misleading omission. These constraints should indeed play a role, because they affect directly firms’ costs in providing additional information. But it is not enough. Consumers’ constraints in processing the additional information should also be included in the cost-benefit analysis of adding to the informational content of the communications. Fourth, there does not seem to be awareness in the Directive’s provisions on omissions, that information in commercial communication is necessarily incomplete, and that attempting to reach complete informational content may well be counterproductive. All in all, the rules on misleading omissions appear to be too intrusive on the market forces at play in the provision of information in the marketplace, and too disdainful of the costs of completing information for consumers. The list of product and transaction features that are to be regarded as material when there is an invitation to purchase is also exceedingly exhaustive and detailed, given its universal reach for all goods and services. Aggressive practices. The general notion is based on preventing the use of harassment, coercion, physical force and undue influence in commercial actions, to the detriment of consumers. Harassing, coercive and violent behavior all seriously and obviously reduce social welfare and should be banned from commercial activities. “…exploiting a position of power in relation to the consumer as to apply pressure, even without using or threatening to use physical force, in a way which significantly limits the consumers’ ability to make an informed decision’. Although it is not entirely clear, there may be a suggestion here of the notion of inequality of bargaining power. Threatening or abusive language and behavior seem natural examples of the kind of conduct one would want to deter. The same happens by artificial situational monopolies such as creating onerous or disproportionate non-contractual barriers to exercise rights under the contract. It also seems economically undesirable to use general commercial practices that exploit situations of misfortune or exercise duress on consumers. The list of prohibited practices includes obviously inefficient practices, such as verifiable false statements, or abusive or harassing behavior, but it also brings in practices which would require a deeper consideration of costs and benefits.

INTRODUCTION TO THE LAW AND ECONOMICS OF INTELLECTUAL PROPERTY LAW

1. The role of economics in IP Law “The instability of economists to resolve the question of whether activity stimulated by patent or other forms of protection of intellectual property enhances or diminishes social welfare implies that economists can tell lawyers ultimately very little about how to enforce or interpret the law of intellectual property”. “As a consequence, I regret the influence of the economist on the law of intellectual property will always be limited”. Economic analysis is not the only valuable source of inspiration for lawyers in IP. It is not able to explain all IP Law. There is no underlying or overarching economic logic in IP Law.

2. The economic Problem(s) Underlying IP In legal terms, IP covers three basic distinct sets of rights: copyrights, patents and trademarks. The economic rationale for having copyright and patent on the one side, and trademarks on the other turns out to be very different. Copyright and patent are rights protecting interests in a commodity with some particular features: information or intellectual goods. And this particular type of commodity shows two important features (public-good characteristics).

Non-rivalry: the use I make from a piece of information or intellectual good does not decrease the possibility of use by others.

Non-excludability: without the intervention of the legal system, the producer of an intellectual good cannot prevent non-payers from consuming the good.

The combination of these two features leads to a significant incentive problem for the production of this type of commodity: severe problem of underproduction of informational goods. Granting IP rights: legal rights that allow the right holder to exclude competition from other sources of producing the informational good. This allows the right holder to charge a positive price for the good (above marginal cost). It is one possible way to alleviate the incentive problem in the production of intellectual goods. Trademarks: the economic problem is basically different. The names, images or symbols protected by trademarks do not constitute as such valuable informational goods, but derive their value from their use as communication devices with consumers. Through trademarks consumers associate the trademarked good with a certain brand or producer and therefore consumers search costs are reduced. This association in the mind of consumers gives producers of trademarked goods an incentive to keep consistent quality over time.

3. Social vs. Private Incentives to Produce Informational Goods Exclusive IP rights do not necessarily solve the problem of insufficient incentives to produce informational goods. Economic theory shows this with a simple model on the discrepancy between social and private incentives to invest in new information. We call this discrepancy the “replacement effect”: pure incentive to innovate regardless of strategic considerations of preemptive innovation, potential entry deterrence and so forth. It is not the whole picture. The model was created by Arrow.

4. Intellectual Property Rights vs. Rewards Economists have tried to compare two alternative organized systems to encourage innovation and production of new intellectual goods:

Intellectual Property Rights: legal monopoly or exclusive right to use the informational good. This system has 2 basic economic effects:

- Incentives generated by future monopoly profit are lower than the pure social incentive.

- Static deadweight loss due to monopoly pricing (price > marginal cost).

Public Rewards: the Government will pay the creator a prize or reward, and then the informational good would be free, and available through competitive production. Two claimed effects of this system:

- Deadweight loss due to price > marginal cost disappears by definition. - Incentive to create will be insufficient, exact or excessive depending on the

relationship between the reward and the pure social incentive. Comparative efficiency between the two Under the reward system there is no deadweight loss because the intellectual good is supplied competitively. The importance of this advantage of the reward system depends on the magnitude of that loss. Under the IPR system the incentive to innovate depends on the monopoly profit after the good is in the market. Under the reward system, the incentive to innovate is a constant and depends of the size of the reward. Even if we assume that the Government knows the expected social benefit from the innovation, and equates the reward to it, this doesn’t mean that the incentive will be optimal. Optional reward system The alternative system is a combination of the two: the inventor chooses whether to accept the reward or to get an IPR. The optimal reward system is strictly superior to the IPR system: given that the Government determines R, it can, at worst, fix it at a level in which no creator chooses the reward, and this is equivalent to the pure patent system. So fixing an R slightly over the minimum social benefit of the innovation, and the creator, if this turns out to be the case,

chooses the reward, which increases the incentives and, moreover, eliminates the deadweight loss. International requirements for the reward system In the model, the Government needs to know the density of the possible demand curves and the production cost. It is very unlikely that “ex ante” the Government will have this information. But the Government may be able to observe sales “ex post” and condition the reward on the demand curve. Moreover, this fact implies that the relevant comparison to calculate the relative informational advantages of the Government and the firm, is between the “ex ante” information of the firm and the “ex post” information of the Government. Drawbacks of the reward system 1. Assumption that the Government seeks to maximize social welfare. 2. Adverse selection in the optional reward system. 3. Global effects of innovation vs. national base of tax money. 4. Rent-seeking for derivative works and subsequent innovations. 5. Administrative costs.

5. Intellectual Property Rights and Property Rights in tangible objects A substantial number of recent IP legislative pieces in European IP Law increasingly try to ground their provisions in general propositions such as:

IP is essentially a form of property, and thus the positive consequences of legally protecting private property on tangible goods also extend to IP protection.

A high level of IP protection would appear as naturally desirable.

Directive 2001/29/EC on copyright and related rights in the information age, contains statements such as “Any harmonization of copyright and related rights must take as a basis a high level of protection. Their protection helps to ensure the maintenance and development of creativity in the interests of authors, performers, producers. Intellectual property has therefore been recognized as an integral part of property”.

These arguments come to complement other arguments, linked to the incentive rationale for IP: reward to induce the production of informational goods.

Directive 2001/29/EC: “A harmonized legal framework on copyright and related rights, through increased legal certainty and while providing for a high level of protection of intellectual property, will foster substantial investment in creativity and innovation.

Directive 2004/48/EC on the enforcement of intellectual property rights contains statements such as: “The protection of intellectual property is important not only for promoting innovation and creativity, but also for developing employment and improving competitiveness.

To ground IP protection upon its economic function as engine of R&D and innovation and as societal instruments to encourage desirable investments in production of informational goods is a positive development The first development based on a “pure proprietary” model of IP does not seem to be equally desirable:

Equating exclusive rights over informational goods with property over tangible assets is theoretically and empirically questionable.

The implications of this equation are also questionable, as it may induce losing sight of the true economic function of IP protection.

The desirability of high level of IP protection, similar to the level enjoyed by property over tangible assets, would flow almost unquestionably from the analogy.

Some Law and Economics scholars have strongly tries to challenge the idea that IP rights incorporate a different form of exclusive entitlement from ordinary property rights, and have argued that IP rights are not essentially different from ordinary property on tangible assets. Claims:

IP rights do not involve market power.

IP rights are just property rights, with a different subject matter: an informational good capable of many physical embodiments.

Counterarguments:

It is true that many IP rights do not confer significant market power.

But some IP rights do in fact confer market power: some patentees and copyright holders enjoy monopoly power.

The outcome of introducing IP in a given setting is seldom perfect, atomistic competition, and the opposite, pure monopoly, but somewhat closer to oligopolistic competition.

Theoretically it is often useful to model IP rights as involving decreasing demand, and it is justified because price of each use of informational good typically exceeds marginal cost.

The benefits from IP and from property rights on tangible assets are theoretically different:

- Both IP rights and property rights over tangible goods provide incentives to invest.

- Access and consumption of informational goods are non-rivalrous in many settings, and in IP the value of property rights to organize rivalrous uses in a more efficient way is typically absent in IP for many circumstances.

- Tangible property commonly gives good notice about the existence, scope and extension of rights. With IP, notice is commonly poor: existence, scope and extension of rights are difficult to determine prior to investing in R&D and considering a possible infringement.

Costs of property rights are different in the world of tangible goods and the world of informational goods:

- Costs of defining property rights are higher for IP rights: no physical boundaries.

- Costs of transacting over property rights are higher for IP.

- Costs of diversified property rights on the same asset: balance of costs and benefits changes.

- The lower costs of diversity: higher fragmentation of rights in IP with respect to the same asset, and affecting the same kind of use of the asset.

o Problem of anticommons: fragmentation leads to higher transaction costs, but worse, leads to underutilization of the asset, and to lower revenues for the right holder.

o Private transactions, and collective enforcement may alleviate, but rarely eliminate, such problems.

o Those problems are less frequent in case of various rights over tangible assets.

- Costs of rent-seeking to obtain property rights: overall, typically higher for IP.

- Costs of protecting and enforcing property rights: higher for IP

OVERVIEW OF THE EUROPEAN COPYRIGHT SYSTEM 1. There is no European copyright system as such, but a collection of national copyright Laws, each with its own rules and doctrines. 2. Given substantial European cooperation in the field of Copyright and since the early 90’s active EU legislative involvement, there are striking similarities between national copyright systems. 3. 3 big families of copyright regimes can be found in Europe:

Monistic systems (Germany and other central European countries): copyright is a unitary legal right arising in full from the personality of the creator requirements for copyright protection are the highest among European systems.

Dualistic systems (France, Italy, Spain): copyright is a combination of 2 distinct sets of rights, an economic right and moral rights, the latter arising from the personality of the creator requirements for copyright protection are intermediate among European systems.

Copyright systems in which moral rights are recent imports (UK, Ireland) requirements for copyright protection are the lowest among European systems.

4. All European regimes share the following basic structural features: Copyright Law is a set of rules that protect the creator of intellectual works displaying two features:

Originality. The creation of the work requires labor, skill and effort. It doesn’t mean nor imply a requirement of objective contribution to culture or society: doesn’t imply necessarily artistic merit. It is not copied or derived from a previous work: copyright doesn’t prevent independent creation or duplication.

Authorship. The work is the expression of an author, either individual or collective. In the wording of EU directives, it is the “author’s own intellectual creation”. But it can be a factual work or compilation, with little degree of creativity. Confers two sets of rights on the author or copyright holder.

Exclusive exploitation rights a. Reproduction rights: rights to produce copies, in whole or in part, by any means and in any form, of the work. b. Distribution rights: right of making copies available to the public. It is exhausted after the first consented sale of a copy within the EU. c. Communication to the public, including Performance and display rights: any communication to the public, even the mere make available to the members of the public is within the author’s rights. d. Transformation rights: right to adapt, translate, and make derivative works. e. Rental and lending rights: rights to authorize or prohibit rental and lending of work. f. Resale participation right or Droit de suite : right to participate in the proceeds of a future sale of a work. Exceptionally, this right is non-assignable and non-waivable. Moral rights

In all European countries are non-assignable, in most they are non-waivable and unalienable, and in after the end of the copyright term

Right of paternity (or attribution): the right to be credited as the author by any third party.

Right of integrity: the right to approve alterations of a work, and to oppose derogatory uses of the work.

In most countries also:

Right of disclosure: the right to publish or keep unpublished a work and decide mode of publication.

Right of withdrawal: right to take the work out of circulation. Subject matter Typically, subject matter is defined broadly, encompassing all literary, musical, artistic and scientific creations, regardless of mode of fixation, including, among others: books, speeches, musical compositions, dramatic works, cinematographic and other audiovisual works, painting, sculpture, drawing and prints, plants of architecture, maps and charts, photographic works, computer programs, databases. Copyright is not subject to formalities. Term of protection lasts the life of the author plus a variable amount of year (50 performers, 70 author). The Directive 93/98 extends the Berne Convention (life + 50 years), to life +70 years. 5. All European copyright Laws, beside author’s right recognize and enforce the so-called Related or Neighboring Rights Last 50 years: performers rights, phonogram producer rights, cinematographic producer rights, broadcasting organizations rights. And include the right of fixation, reproduction, distribution, communication to the public and rental and lending, but in the latter cases it can be transformed, under many circumstances, into a right to an equitable remuneration for some forms of communication, and rental and lending, and has to be exercised through collective societies. In several countries, performers also enjoy moral rights (attribution and integrity) for life+20 years.

THE LAW AND ECONOMICS OF TRADEMARKS IN EUROPE

1. The basic structure of European legal regulation of trademarks Trademark Law in Europe is multi-layered: i. National trademark systems, 2 important qualifications:

Registered trademark systems are very similar: they have been heavily harmonized at the EU level by the First Directive on Trademarks.

Most EU countries keep related areas of the Law that are less harmonized: unfair competition, passing off, misrepresentation, affecting the existence and exercise of trademarks.

ii. The European Union level: Councing Regulation 40/94 created a Community Trade Mark and a Community Trade Mark Office (OHIM, Office of Harmonization for the Internal Market), with a single procedure, unified rules, single right and unitary effects in and for all member States. Substantive rules of the Directive = substantive rules of the Regulation no contradiction between national trademark and Community trademark. ECJ (European Court of Justice) has developed an extensive and important set of precedents interpreting the Regulation and the Directive and also the internal market and competition dimensions of the exercise of trademark rights. iii. International level:

Paris Union provides for national treatment principle, protection for well-known marks even if unregistered, certain priority rights for prior foreign applications and registrations, but does not build a system of international applications and leaves national substantive rules and national offices untouched.

Madrid Agreement and Protocol: Create international application mechanisms, through which the WIPO (World Intellectual Property Organization) sends application to designated national TMO (Trade Mark Office), and if they do not object within a specified time, it is nationally registered.

The 1988 Directive contains the main rules common to all EU national TM systems, and also to the CTM. Directive sets the rules for registered TM, allowing States to keep non-registered TM protection, and also to regulate the procedural and economic aspects of TM. But the core of TM Law is subject to common rules. Requirements for TM protection: i. Registration: TM is granted to the first to file. ii. Sign that refers to or can be attached to goods or services. iii. Capable of graphical representation. iv. Distinctive. TM is excluded for absolute grounds: i. Signs with no distinctive character: evocative and suggestive signs are accepted, and descriptive elements if combined with non-descriptive ones.

ii. Signs indicative of the origin, quality, kind, value of product. iii. Customary or generic signs. iv. Functional signs: signs resulting from the nature of the good. v. Deceptive signs. vi. Contrary to public policy or of high symbolic value. vii. Bad-faith applications. TM is excluded for relative grounds. i. Identical to an existing TM for identical goods or services. ii. Similar to an existing TM for similar goods or services and with risk of association by consumers. iii. Identical or similar to an existing reputed TM and would tarnish the reputed TM or take unfair advantage of its reputation. iv. Conflict with earlier non TM rights. Rights conferred by the TM. TM owner has the right to authorize or prevent use in commerce of signs: i. Identical for identical goods or services. ii. Similar for similar goods or services, and with likelihood of confusion, including rsk of association by consumers. iii. Identical or similar, for any kind of good or service, if TM is a reputed TM. iv. No fixed term of protection? TM protection does not cover: i. Use of name and address. ii. Indications of quality, origin, kind or other characteristics of good or service. iii. Use of TM when necessary to indicate purpose of complementary product or service. iv. Tolerated infringing uses, covered by a trademark, lasting 5 consecutive years. TM protection is exhausted i. For goods voluntarily put on the EEA (European Economic Area) market. ii. No exhaustion of TM rights if put on the market outside the EEA. iii. Parallel imports involving repackaging from EEA can be opposed by TM except when it involves artificial partitioning of the internal market. TM right is subject to revocation: i. Non-use for 5 years after registration unless justified. ii. TM has become generic common term for product or service. iii. TM is likely to mislead consumers includes cases of assignment or license in gross in which the circumstances may be confused about quality or origin of product.

2. Economics of European trademark protection Characteristics of goods and services can be divided into: i. Search characteristics can be determined by prospective consumer before purchase. ii. Experience characteristics cannot be determined by prospective consumer before purchase; the good must be purchased and used before characteristics can be evaluated. iii. Credence characteristics cannot be determined by consumer before or after purchase and consumption of the good. Basic economics of TM protection. Exclusive TM rights have 2 major functions: i. Reduce search costs to consumers allow consumer to identify the producer of a given brand of good or service, and thus use in the search process the past experience with the same brand ii. Signal a consistent level of quality to consumers to benefit from the search reducing qualities of TM, producers have to maintain consistent quality, both along temporal and spatial dimensions. Moreover, if quality is not maintained, investments in making TM recognizable to consumers will be lost. If past and current consumption are not mutually consistent, TM loses its value. Consumers do not trust TM as a signal of future quality. Both economic functions require legal protection of an exclusive nature. If anyone could use the TM i. TM loses its search reducing properties. ii. TM loses quality signaling function. iii. Producers lack incentives to invest. Both basic economic roles of TM are mutually reinforcing i. the more consistent the quality, the less costly it is for a brand producer to back a strong and popular TM, so the more recognizable the TM and thus the greater the reduction in search costs. ii. the bigger the impact in search costs, the greater the potential effect of TM and thus the incentives to make it a signal of consistent quality and to back it with quality investments. There is some empirical evidence about the basic economic roles of TM. Use of TMarked brands is more likely i. The less verifiable quality before purchase ii. The less attractive and the more costly is personal search and testing by consumers. Apart from the basic economic functions, some mention also i. Incentive to create new words or symbols that enrich our vocabulary or our imagery. ii. Facilitate persuasive advertising through widely known and catchy terms as TM dubious in terms of social welfare. Clear correlation between use of TM and advertising: i. Advertising expenditures tend to act as signal of product quality. There is a level of advertising that the high-quality would find profitable and the low-quality would not, sending an implicit signal of high quality.

ii. Advertising to sales ratio depends

Positively on the advertising elasticity of demand. How responsive demand is to the level of advertising.

Negatively on price elasticity of demand. TM Law seems in general consistent with the basic economic function of TM: i. Requirements for TM protection emphasizing distinctiveness and ability to distinguish the goods and services from one brand from another. ii. Exclusion of generic and common terms, functional signs not necessary to communicate effectively with consumers, but increasing competitors costs to communicate iii. No fixed term of protection, no deadweight loss caused by TM protection. iv. Protects right holder only against acts that may cause confusion to consumers or may reduce the incentive to invest in high-quality. v. Some restrictions on transfer of TM preserving the incentive to invest in consistent quality and to reduce consumer’s costs. vi. Requirement to use TM. TM only play a positive role when effectively used to identify brand producer. vii. Revocation of TM when becomes generic, loses identification force and raises rivals’ costs. Acquired generic status is normally due to a previous patent belonging to TM holder.