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Risk allocation in treaty obligations

Mandatory and conscientious fulfillment of assumed contractual obligations is the aim of any transaction. However, the specificity of such relationship shows that at the stage of execution of the obligation against the will of any of the parties may be circumstances (events) leading to a breach of contractual obligations. The danger of different kinds of fortuitous circumstances / incidents traditionally defines as “risk”.
These events beyond the control of treaty obligations can lead to negative property and reputation results. It can mean the real damage (value of lost property, goods, impossibility of obtaining things entitled in the contract) and/or loss of reputation due to the inability to fulfill other obligations arising from existing (impossibility of subsequent delivery to another counterparty, finishing some production processes, etc.). A problem can be resolved by adapting the obligation to the changed conditions that requires fair negotiations. However, for many reasons the parties often are unable to reach a reasonable compromise that requires the intervention of law which prescribes certain rules of conduct. The right cannot eliminate or reduce the risks arising in civil (business) circulation, but it is able to limit the volume of risk assigned to one of the parties of the contract (mandatory control method) or to offer optimal risk allocation rules (dispositive control method).
It is well known that the main function of the contract and contract law is the legalization of the exchange of goods (services). This risk allocation rules promote the function of the civil (business) circulation. Increasing the intensity of the civil (business) circulation is achieved by both methods: reducing the fix costs that accompany transfer of material goods from one person to another and the development of some mechanisms to counter unfair behavior at the stage of signing the contract and its implementation. Some barriers on the way to the exchange cannot be resolved, such as fixing costs of signing the contract, collecting information about the product, market, price, counterparty (also called as “transaction costs”), the cost of monitoring the execution of the contract, as well as protection of violated rights in the court, costs of adverse changes in the environment (risk-bearing costs).
Typically, participants of transactions in their negotiation limit on the most important conditions, such as the subject, price, special order of performance. However, many conditions are not stipulated and parties rely on the general rule allowing to settle efficiently the majority of cases (custom, imperative norms of legislation, etc.), because the parties at the time of signing the agreement believe that occurrence of unforeseen circumstances is unlikely. At the same time, the volume and criticality of risks existing in transactions within one jurisdiction increase in the cross-border business activities due to the different legal systems in different countries, frequent legal conflicts, complexity and costliness of cross-border litigation, etc.
So, preliminary legal analysis of risks at the stage of pre-contractual and contractual work becomes extremely important tool to assess in advance some potential losses, to develop mechanisms to prevent or minimize such losses, to add the code of conduct for parties in the event of unforeseen circumstances. This cannot be limited by work with established risks in management practice, for example, the standard risk of accidental loss and damage of goods, such way of lawyer’s work does not lead to the main aim – to the formation of equality between parties in the transaction.
It’s not a secret that the vast majority of contracts set economic inequality of parties because of conditions of an agreement (for example, significant prepayment or, vice verse, the delivery of goods without prepayment) the strong side receives unjustified opportunity to shift all of its risks on the weak side of the agreement. After that, the weak side, having suffered material losses, is forced to bear more costs for protection their rights and interests, while the strong side takes a passive waiting position. However, in this case you should know that international courts and international arbitrations use the principle of economic efficiency in cases like this. It means that a greater risk belongs to the side of the contract that could prevent the onset of adverse effects or compensate it for the lower cost for risk management, at the cost of insurance as well. The possibility of prevention the onset of adverse effects by one of the party is the main condition to warrant the distribution of contractual risk, so only if none of parties of the contract can completely eliminate the risk, you should compare the costs of their risk management.
That is why every contract with every contractor, whoever he is, should be evaluated for the subject of risks minimization and negative consequences. It is better to entrust this kind of work to lawyers of the country of the counterparty in the case of cross-border agreements. This approach gives you better results, as local lawyers have much more experience in the right of their country and, as one of the option, they can check the reliability of the counterparty, its reputation and other things like this. This also leads to the minimization of risks. In any case, the fee for a preliminary legal examination of the deal will be much less than the potential loss if something goes wrong.

Author: Kydalov Igor


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Kydalov & Partners
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Publication Date: 03.08.2015
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