Since the nineteenth century, writers on English contract law have emphasised the enforceability of contracts and have tended to marginalise the instances in which contracts have been set aside for unfairness. In dealing with consideration it has been common to point out that inadequacy of consideration is not, in itself, a defence to contractual obligation, and from this it has been inferred that, if there is sufficient consideration to meet the test of contract formation, the contract must be enforceable. Sir Frederick Pollock in his first edition (1876) wrote that it was:

Sir William Anson (1879) followed the same line, and made the point more forcefully:

The extent to which similar principles applied to loan transactions which fell outside the ambit of the usury laws, under the guise of unconscionability and related doctrines, was a question of great importance from the late seventeenth century.

The usury laws: the changing face of statutory regulation

John Baxton described usury as ‘lending for gaine’, the ‘gaine’ meaning the additional sum paid to the lender above the amount of the loan. His definition pre-dated the seventeenth century. It was derived from the canon law applied by the ecclesiastical courts, which had largely policed these transactions in the Middle Ages. In canon law, usury, any usury, was totally prohibited. Money lending continued unabated but those who wanted to avoid the risk of religious sanction were required to go to the trouble of disguising the true nature of the transaction.

By the late sixteenth century the old consensus was starting to collapse. In Thomas Wilson's A Discourse Upon Usury, published in 1572, a preacher, a lawyer, a merchant and a doctor of civil law debate the merits of usury. In the eyes of the preacher, usurers were little better than common criminals:

Freedom of contract: from the form to the substance

‘Conceptualising unconscionability in Europe’ means also conceptualising the relationship between freedom of contract and protection from unconscionable contracts. Freedom of contract and protection of vulnerable parties in contract law have traditionally been understood as antagonistic, conflicting principles. Legislative rules or doctrines providing remedies against unconscionable contracts are mostly seen as exceptions to the principle of freedom of contract. The high rank of this principle, which relies on the liberty and autonomy of private individuals vis-à-vis public powers, leads to the assumption that exceptions to freedom of contract should possibly be avoided, or, at least, restricted to a minimum.

Scholars who see freedom of contract and weaker party's protection as conflicting principles tend to challenge the predominance of freedom of contract, if they share a concern for social justice in contract law. For example, the Social Justice Manifesto criticised the European Commission's approach according to which in the Common Frame of Reference for a European contract law (CFR) exceptions to freedom of contract could only be admitted if justified by good reasons. The Manifesto raised the provoking question: ‘Why should the principle of freedom of contract have such a privileged position …? Why not reverse the burden of proof so that those who wish to deregulate market transactions should have the burden of explaining the potential advantages to be gained by the parties to these transactions from the absence of mandatory rules?

Introduction

What is the proper way to justify the doctrine of unconscionability? Should we understand the doctrine as a device by which the state bails people out of poor and uninformed choices they make in their agreements with each other? As a device against some forms of exploitation and in support of individual autonomy? As a redistributive device? As a means for improving efficiency? These perspectives may occasionally overlap in practice, but they are sufficiently distinct in principle. The choice among them will determine not just how the argument in favour of the doctrine ought to be made, but also the range of objections that this argument will need to meet. The aim of this chapter is to explain why making that choice has been a difficult task for contract theory and to offer an alternative justification of the doctrine of unconscionability, which I believe merits independent consideration.

Some threshold difficulties

Compared to the notions of ‘duress’, ‘undue influence’ or ‘misrepresentation’, the notion of ‘unconscionability’ is harder to unpack. Whereas the former notions give us some immediate glimpse of what is wrong with enforcing an undertaking, e.g. that one party to that undertaking has been put under some sort of illegitimate pressure or has been misled into agreeing, the notion of unconscionability tells us considerably less. On the face of it, all it signifies is that it would be ‘against conscience’ to insist on enforcing a certain undertaking or, from the point of view of our institutions, to actually enforce it.

Introduction

This collection of essays is concerned with the protection of the vulnerable in financial transactions, and specifically examines the role of unconscionability in those transactions. We should understand ‘financial transactions’ in a broad sense, as any contract involving valuable assets and requiring significant expertise in assessing the wisdom of entering into it. We should understand vulnerability in a broad sense too. A clear picture of this is presented by the Australian doctrine of unconscionable dealing which makes much use of the concept of ‘special disadvantage’, described by Kitto J in Blomley v. Ryan as ‘illness, ignorance, inexperience, impaired faculties, financial need or other circumstances’ that affect a person's ability to conserve their own interests. Unconscionability in this context and other contexts relevant to this chapter consists of taking unfair advantage of vulnerability.

This chapter will examine the grounds upon which the common law may be prepared to rescind or grant other relief to a vulnerable contracting party because of some occurrence in making the contract. These grounds are commonly referred to as ‘vitiating factors’. Five are commonly recognised – mistake, misrepresentation, duress, undue influence, and unconscionable dealing. In turn these can be sub-divided into two classes – mistake and unfair influence. Mistake contains the vitiating factor of ‘mistake’ itself as well as misrepresentation as a form of induced mistake. Unfair influence consists of all the others.

Introduction

The classic situation in which unconscionable bargains and the wider doctrine of oppressive and unconscionable terms developed was where an impecunious borrower took a loan to ease his plight. Originally it was an heir to a landed estate who mortgaged his expectant interest to secure that loan, but it is now the domestic borrower who mortgages his or her home to fund either a loan for its purchase or to secure other liabilities. It is in this latter context that this chapter will consider the current statutory protections that have overshadowed the original equitable jurisdiction and introduced new notions of unconscionability to English law.

The idea of the statutory protection in this context is not new. Laws against usury, which initially outlawed and later controlled interest rates, date from the Middle Ages and were only abolished in the mid-nineteenth century. Statutory protection continued to control moneylenders but, as credit has become part of everyday life, there has been an overhaul of the statutory landscape governing the supply and control of credit to domestic borrowers. This legislation has abandoned the broad discretionary jurisdiction that justified intervention on the grounds of unconscionability and in its place has developed a complex web of statutory provisions and regulatory responsibilities, which protect the impecunious borrower as a consumer. It is not intended in this chapter to examine each of these measures in detail but to look to the broad sweep of this new statutory landscape.

Unconscionability, embracing both procedural and substantive unconscionability, is a multi-dimensional legal concept. It evolved at common law, where traditional doctrines such as fraud, duress and mistake did not cover every situation in which a contract might be oppressive. Thus, the concept of unconscionability was developed to achieve justice in cases of unconscionable dealing, inequality in bargaining power and special disadvantage. However, application of this doctrine differs substantially even in the common law jurisdictions. Moreover, in the civil law jurisdictions, while a comprehensive concept of unconscionability may not exist, there are a number of legal doctrines and instruments that ensure fairness in contract law and, inter alia, in financial transactions; they all define unconscionability largo sensu.

The harmonised regulation of unconscionability in financial transactions would provide both parties with greater legal certainty since the validity of the contract or its terms would not depend on the peculiarities of the applicable national law. The regulation of unconscionability is closely linked to the free movement of capital and consumer protection and, therefore, it is especially important in the EU.

In this chapter, taking Lithuania as an example, I will investigate some issues relating to the harmonisation of the legal rules that deal with unconscionability largo sensu in financial transactions and attempt to evaluate the pros and cons of such harmonisation. I will demonstrate that Lithuania has transplanted the major rules on unconscionability from the UNIDROIT Principles of International Commercial Contracts (1994) and the Principles of European Contract Law.

Introduction

The first global financial crisis of the twenty-first century has fuelled extensive debate about the regulation of financial markets and transactions. Although much of this debate so far has focused on the inter-firm and intra-group dealings among financial firms that the crisis has exposed as sites of systemic risk, the catalytic effects of the insecurities and vulnerabilities experienced by sub-prime borrowers in the US and by Northern Rock savers in the UK has given new prominence to the regulation and governance of personal financial transactions. Responding to the urgency of the perceived need to strengthen consumer confidence in banks, European jurisdictions moved swiftly to shore up depositor compensation funds, increase coverage limits and eliminate co-insurance requirements, apparently with little regard to the moral hazard consequences of such measures.

Other consumer-oriented proposals for the new regulatory order include financial product safety regulation, additional information sharing and disclosure measures, further development of responsible lending standards, and the activation of the self-protective capacities of financial consumers through financial education and advice and, where possible, carefully crafted default rules.

Many such proposals build on the regulatory foundation that has been laid by the Financial Services Authority (FSA), the UK's main market regulator of consumer financial markets and products. Despite operating for most of its short life in an environment that celebrated ‘light-touch’ regulation, the FSA has nonetheless created an innovative model of fair dealing in consumer financial transactions.

Introduction

Financial contracts are mainly characterised by inherent risks undertaken by both parties. Investors in particular should never expect that contracts for the purchase of bonds or other financial titles would be subject to the rule (if any) of ‘adequacy of consideration’. Although issues like ‘contractual unconscionability’ are rarely discussed in relation to these types of contract, the economic balance of a financial contract might become a relevant issue for a court when the ‘consideration’ exchanged is striking in its unfairness. This was demonstrated in a case of ‘bad loans’ tendered by a Southern Italian bank: the transaction concerned loans subject to the purchase of ‘atypic’ titles – those which are expressly created and issued by the bank and unknown to the financial market – as well as the purchase of shares in mutual funds. The consideration for the loan charged to investors consisted of a 6.8 per cent interest rate. The overall economic aim of the financial transaction consisted of inducing investors to borrow money from the bank in order to purchase ‘atypic’ titles (named: ‘4 you’) issued by the lending bank itself; the loan would have a high interest rate (6.8 per cent per year), exceeding the titles' output. Once the titles proved to be false in their face value, investors sued for damages and the judge struck down the loan agreement on the basis of its ‘total failure of consideration’.

Introducing fairness

‘Fairness’ is at the heart of many requirements placed on suppliers when dealing with their consumers. Some measures use the term ‘fair’, while others use similar expressions like ‘reasonable’. Frequently the requirements are placed on all sectors; sometimes they are more limited. They may have their basis in statute, in the common law, in regulatory guidance or in codes of practice. Traders wishing to comply with their obligations must negotiate a complex web of requirements.

The requirement to be fair plays a particularly prominent role in the regulation of financial services firms' (hereafter ‘firms’) dealings with their consumers. An examination of this subject is particularly apt for a number of reasons. First, the Financial Services Authority (FSA) has recently set much store by its ‘Treating Customers Fairly’ (TCF) Initiative. TCF forms an important part of the FSA's efforts to place more emphasis on ‘principles-based regulation’. Secondly, recent statutory developments have imposed new fairness obligations on firms when dealing with consumers. These initiatives increase the already complex and fragmented regulatory framework in the UK.

The purpose of this chapter is to consider the meaning(s) of fairness in the context of the relationship between firms and consumers. It begins by examining the principal general statutory provisions on fairness, and then moves on to those provisions dealing specifically with financial services. Next, the main part of the chapter examines the key elements of fairness.

Introduction

The purpose of this chapter is to examine the legal position of the borrower under a loan agreement entered into with a bank. As Polish financial and capital markets develop, a growing amount of banking products have become available. This is particularly evident with respect to bank loans, which have become increasingly affordable.

Despite the fact that many banks are present on the market, the competition to secure a client base does not always guarantee that contracts equally protect the interests of the client and the bank. Apart from including abusive clauses and burdening the borrower with onerous duties, banks assume that the borrower is aware of the legal effects of creating security for the loan. However, in practice, the borrower does not comprehend the effect this has on his legal position. Moreover, this position entails legal effects not only for the borrower during his lifetime, but also for his heirs upon his death.

Poland's accession to the European Union must be viewed as having had a positive influence on the development of banking practice and consumer protection in the field of bank loans. Directives such as the Consumer Credit Directive, Door-Step Selling Directive, e-Commerce Directive, Distance Marketing Directive, and the Unfair Terms Directive are aimed at increasing the safety and transparency of transactions, with particular attention paid to the protection of consumers.

Introduction

The Unfair Commercial Practices Directive (UCPD) was adopted in 2005 and requires Member States to empower bodies to take preventive action against unfair business-to-consumer practices. This has been implemented in the UK by the Consumer Protection from Unfair Trading Regulations (CPUTR) 2008, which define such practices as forms of ‘Community infringement’ under the Enterprise Act (EA), thereby providing enforcement authorities with the powers to seek enforcement orders against such practices. This now coexists with the pre-existing powers to seek enforcement orders against other practices that represent ‘Community infringements’ and those that represent ‘domestic infringements’.

This chapter considers the concept of unfairness in the CPUTR, in particular what it adds to regulatory ideas of unfairness in the financial services sector.

The regime clearly catches financial service transactions, covering commercial transactions in relation to ‘any goods or service including immovable property, rights and obligations’. Indeed, financial services transactions are given special treatment, in that they are excluded from the ‘internal market clause’, which, when applicable, will prevent Member States from exceeding the level of protection provided for in the Directive. It is expressly provided by Article 3 (9) that in relation to ‘financial services’:

Coverage, regulatory context and the general notion of unfairness

The UCPD unfairness concept is of particular importance because of the sheer range of activities it regulates within any given transaction.

Introduction

The aim of this project has been to explore particular conceptions of, and responses to, unconscionability and similar notions, with specific reference to financial transactions across Europe. Such an endeavour is difficult for at least five reasons.

First, the process can be obscured by the nuances of emphasis and language both within jurisdictions and at a pan-European level. Secondly, as the chapter by Waddams suggests, particular jurisdictions may choose, to varying degrees, to respond (sometimes indirectly) to unconscionability issues through a variety of devices rather than through an independent doctrine of unconscionability. Thirdly, as we have suggested elsewhere, conceptions of, and responses to, unconscionability may be shaped by, for example, the social security and insolvency regimes within a particular jurisdiction. Fourthly, as Capper demonstrates, conceptions of unconscionability may be dependent on context and, as Swain and Fairweather clearly demonstrate, may vary over time. Indeed a week after the conference upon which this collection of essays is based, Lehman Brothers collapsed and the landscape of financial transactions and many of the assumptions underlying traditional approaches to the protection of the vulnerable in financial transactions was radically challenged; our perception of risk, attitudes towards regulation and understandings of risk may never be the same again. As Capper demonstrates, even within particular jurisdictions conceptions of unconscionability can be contested. Indeed Waddams thought-provokingly suggests that unconscionability ‘has had multiple dimensions, and that it has not been confined to a single conceptual category’.

Outline

In this chapter, we discuss problems related to kickback payments in financial transactions. After a short introduction into the nature of kickback payments, we identify these problems and briefly address solutions that have been discussed under German law (section 2). We then turn to EC legislation, in particular Directive 2004/39/EC on Markets in Financial Instruments (the MiFID Directive) and subsequent instruments that are meant to elaborate this Directive and demonstrate the way in which the Directive addresses kickback payments as ‘inducements’ (section 3). While the new rules have been the subject of heated debate between the banks and consumer groups, the German implementation of EC legislation is, at first glance, scandalously bank-friendly (section 4). In contrast, we propose to use findings from research on behavioural finance to interpret the law correctly and to propose a stricter reading of the EC rules on inducement and implementing legislation (section 5). We also discuss whether more stringent national rules on kickback payments are still allowed following the adoption of the MiFID Directive (section 6). Finally, we return to the general issue of deciding between procedural and substantive mechanisms to protect customers of investment services against unconscionable transactions (section 7).

Kickback payments in financial transactions and related problems

Kickback payments

First of all, what are kickback payments? Here we are looking at investors who use a bank or any other investment firm (for simplicity's sake, we will refer to banks) to get advice with regard to investment decisions – such as the purchase of stocks, shares in investment funds or other investment instruments.

Introduction

The doctrine of unconscionability has been widely adopted in the law of contract by many jurisdictions. It is a legal redress for a party who makes an unfair contract. In general, a contract is held to be unconscionable when the court believes that it contains one or more contractual terms which are substantially unfair to one party. A typical example is an add-on clause in a consumer credit sale which provides that all of the goods previously purchased by the buyer from the seller will be used as security for the debts incurred with the current purchase, and that a single default by the buyer could permit the seller to repossess all of the goods. Such a contractual term may be unenforceable in both the UK and the US, although the legal rules are based upon different grounds. In the US it contravenes Section 2–302 of the Uniform Commercial Code (UCC) and is treated as an unconscionable term. In the UK there is no doctrine of unconscionability in general contract law, but the legal consequence is the same for a different reason; the term violates Regulation 8 of the Unfair Terms in Consumer Contracts Regulations 1999. The same result can probably be reached in Germany for a breach of Article 138 of the German Civil Code (BGB).

Unconscionability is not a simple, easily defined concept. While unconscionability even within the common law is essentially contested, in Europe unconscionability or its equivalents is an even broader concept which is to be found in a plurality of sources; it is therefore perhaps best described as a multi-dimensional concept taking its place in a polycontextual environment of national contract laws and instruments aimed at protecting the vulnerable in a variety of contexts: arising variously in consumer, family or non-professional transactions. Traditionally, in some private law systems, unconscionability may only be resorted to sparingly, as an exception to the fundamental principle of freedom of contract; in others it may be resorted to more widely as an instrument of ensuring ideas of fairness or solidarity between contracting parties. Similarly, the concept may involve stringent procedural or more invasive substantive approaches; and the effective level of protection produced by either of these approaches may vary considerably. In yet other legal orders and within those orders in specific fields of law unconscionability may be delivered indirectly through the intervention of substantive constitutional law (fundamental rights) or, alternatively, and less spectacularly, through property law principles. Some form of unconscionability or its equivalent may thus be found in all European legal orders.

This book represents the results drawn and developed from the conference ‘Conceptualising Unconscionability in Europe’, an event held at Durham Castle on 8–9 September 2008.

Introduction

This chapter examines the compatibility of the common law concept of unconscionability with various categories in civil law, with particular reference to Spanish legislation, which has no general principle that corresponds directly to that of unconscionability, at least to the extent that this term exists in common law systems. Yet, Spanish law, in Article 1255 of the nineteenth-century Spanish Civil Code (hereafter CC), also provides a number of disparate tools that limit the basic principles of freedom of contract and free will, thereby offering similar remedies to those available in common law. The chapter focuses on the interpretation of the general good faith clauses contained in Articles 1258 CC and 116–7 of the Catalan Civil Code (hereafter CCCat) as a general remedy in a nineteenth-century liberal Civil Code, as well as additional prohibitions such as pactum commissorium. It then analyses an unusual text in the Spanish system that seeks to counter the imbalance between parties: the 1908 Act for the Repression of Usury. Finally, I conclude by turning my attention to the present-day situation which defends the rights of the weaker parties in consumer law and, in particular, to unfair contract terms (UCT).

Freedom of contract and the interpretation of the good faith clause in the Spanish Civil Code of 1889

The nineteenth-century Spanish Civil Code was founded on the basis of liberal doctrine and, as such, freedom of contract was placed at the heart of its contractual regulations.