Are contracts necessary?

03/04/2010

By Henar Dyson, Senior Associate in Corporate & Commercial. Featured in Kent on Saturday.

Are contracts necessary?

A recent article in The Times newspaper has considered whether trust between contracting parties is an effective substitute for a contract. The reality is that the law will imply contractual terms into any business arrangement, whether or not there is a written document. There are also circumstances where a written contract is a legal requirement. The question, then, is whether parties can dispense with a fully negotiated contract, where there is mutual trust.

Even lawyers will agree that contracts can take on a life of their own and become unwieldy.  Word processing technology, an explosion of regulation in some areas and an increasingly litigious business environment have been largely responsible for this. Yet, is a negotiated contract such a bad thing? There are good reasons for having one:

• it records what the parties have agreed, helping to avoid future argument

• it apportions risk, making clear who pays if something goes wrong

• it will iron out the uncertainties of the general law position.

This said, there are obvious downsides to an overly prescriptive contract. The costs of negotiation and dispute resolution can be huge. No contract can legislate for every eventuality and this can lead to an unexpected result in court if an argument arises over circumstances that are not catered for in the contract. International contracts present additional difficulties, where lawyers from different legal cultures try to devise a universal legal language. Also, the process of negotiation, if extensive, can result in a loss of trust between the parties.

Why contracts are still necessary

Undoubtedly, no business arrangement can succeed without the parties trusting each other.  In most cases, nor will it without a contract. There are many reasons for this:

• the basic reasons for negotiating a contract are still valid.  This is not a question of lack of trust, but of practicality
• it takes time to build up the necessary degree of trust, far more time than it takes to negotiate a balanced contract
• where the power of the parties is mismatched, a negotiated contract will help the weaker party
• high level management does not have the time or necessarily the ability to resolve all disputes
• shareholders would be unlikely to support the company if they knew how potentially exposed it was.

Whilst contracts are still necessary, the level of detail in them is not always beneficial and there are circumstances where this can and should be controlled.  For regular arrangements, between the same parties, contracts can set out general principles, but need not be overly prescriptive.  It is not uncommon for businesses to operate in this way.  For one-off arrangements or very high value transactions, this is simply not appropriate.  The risks and the 'unknowns' are too high and too many.  Consider also a smaller organisation, where management knows and trusts its own staff.  In those organisations, there may well be scope for trust to replace a negotiated contract.  In larger organisations, this is not commercially feasible.

The production of an effective contract need not be time-consuming if clients agree terms before engaging lawyers and set a sensible timetable for concluding negotiations. There is no substitute for a well-negotiated contract - the mark of a well-negotiated contract is that everyone sleeps well and the contract lives in a drawer, never to be seen again.