Using Transnational Commercial Contracts to Regulate Business

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New research examines how such contracts can influence so-called soft-law policies.

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Over the past thirty years, the commercial contracts that make up global supply chains increasingly incorporate provisions regulating social, environmental, and safety standards, according to Penn Program on Regulation (PPR) fellow, Fabrizio Cafaggi. Such provisions transform contracts into “regulatory vehicles” and enable global supply chains to function as “transnational regulatory regime[s].”

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PPR Fellow Fabrizio Cafaggi

At a recent seminar sponsored by PPR, Cafaggi presented a paper which examines the allocation of transnational regulatory power through transnational commercial contracts. Drawing primarily on research of global food supply chains, Cafaggi focused on the incorporation by reference to transnational public and private regulatory regimes and on technical standards built into transnational sale contracts.

Cafaggi writes that although commercial contracts “have always had a regulatory dimension,” contractual obligations over safety and product quality were generally subject to interpretation by parties or through judicial intervention. But in the developments that Cafaggi observes, “the entire regulatory regime contained in a code of conduct or in a technical standard is incorporated and given binding force between parties or … all along the supply chain.” Unlike most provisions in commercial sales contracts, these regulatory provisions now increasingly focus on the production process. Moreover, remedies are not just directed at redressing parties injured by contract breach, but also towards pursuing certain regulatory objectives.

According to Cafaggi’s research, examples of such standards include provisions requiring suppliers to respect a certain minimum wage or child labor laws or to commit to certain environmental practices. Most of the provisions arise from “soft-law,” or unenforceable developments of organizations such as the Organization for Economic Co-operation and Development. When integrated into contracts, these soft-law standards become enforceable.  In addition, enforcement of such provisions is often linked to requirements for external certification of compliance.

Cafaggi’s paper notes that implementation of soft-law measures via transnational commercial contracts “influences legitimacy and effectiveness of these regimes” by making the soft-law regimes binding between particular private parties. Such contracts may increase the importance of and “expand the effects of international public regulation.” Due to this impact, he argues that the use of contracts in transnational regulation has effects “well beyond the signatories of individual bilateral contracts.”

Cafaggi’s research explores why transnational commercial contracts are increasingly used as “vehicles” of transnational regulation. He cites both endogenous and exogenous drivers of this phenomenon, including compliance with both human rights policies and technical standards. For example, in the area of corporate social responsibility, the International Standards Organization (ISO) approach is that companies are required to adopt internal compliance programs and ensure compliance along supply chains.

There are a number of tensions between traditional regulatory regimes and contract-based regulation. For instance, Cafaggi identifies tension “between the bilateral structure of commercial contracts and the multilateral architecture of regulatory regimes.” Unlike traditional regulatory regimes, which are based on hierarchal authority structures, in the contract setting both parties consensually determine the applicable regulations. Nonetheless, the author warns, this shift towards consent should not be overstated because the eventual “allocation of regulatory power depends on the relative contractual bargaining power of the various enterprises along the chain.” In bilateral contracts, the retailer or buyer generally controls participants’ conduct by contracting through sequential bilateral contracts where the buyer may impose contractual obligations, including regulatory standards, on subsequent parties along the supply chain. A party contracting directly with a retailer may assume obligations which affect contracting parties located further up the global supply chain.

The remedies available in a contract-based regulation regime also differ from those sometimes available in regulatory regimes. Domestic or international contract laws do not generally permit a retailer’s direct action against upstream sellers. Furthermore, the beneficiaries of these regulations, such as the employees benefiting from labor standards, do not generally have access to remedies against breaching parties via contract laws. Therefore, beneficiaries must rely on other areas of law, such as tort and competition law, for legal protection.

Within this supply-chain regulatory regime, the role of a regulator may change from time to time, from the various contractual players to third-parties. A retailer may delegate regulatory monitoring power to various contacting parties or to a third-party such as a certifier or regulator. Monitoring authority involves observation, as well as sanctioning authority, such as decertification or contract termination.

The effect of incorporation is not easily measured. Cafaggi states that the total quantity of litigation concerning these regulatory provisions is not a good measure of these provisions’ effectiveness because enforcement of contract-based regulations occurs through non-legal means common in contract law, such as suspension of performance or contract termination of non-complying buyers. Evaluating the consequences of such contracts, Cafgaggi writes, is not just a matter of analyzing the individual bilateral contracts between buyers and sellers in a supply chain, but also the effects of such contracts on the whole supply chain because incorporation may affect power dynamics along the supply chain.

Cafaggi also emphasizes the interaction of the contract regulatory regime with public and private regulatory and certification regimes. He points out that one instance of non-complying behavior may potentially subject a party to sanctions under certification, regulatory, and contract laws, “triggering simultaneous or sequential remedial systems.”

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PPR seminar focuses on transnational private regulation

According to Cafaggi, certification, regulatory, and contract law are all needed to monitor compliance with transnational private regulation. Nonetheless, Cafaggi suggests that multiple and simultaneously operating regulatory schemes may result in over-enforcement of breaching behavior regulated by such contract provisions. As a result, Cafaggi asserts that domestic and international contract laws must adopt to the power shifts created by incorporation. Moreover, certification and regulatory laws need to consider the effects of incorporation and rethink the “conventional divide” between regulation and “contract law as a tool aimed at facilitating exchanges.” Cafaggi warns that while “transnational regulatory bodies and human rights organizations should be fully aware both of the potential advantages and shortcomings of using contracts as vehicles for the implementation of regulatory standards.”

At the recent PPR seminar, Penn Law Professor Charles W. Mooney, suggested that firms may incorporate regulatory contract provisions because they have realized that these provisions are good for business. Wharton Professor of Legal Studies and Business Ethics, David Zaring, suggested that Professor Cafaggi’s research sets up an interesting solution to the issue of weak enforcement of international law in areas where governments have been either unwilling or unable to regulate. Associate Dean for International Affairs at Penn Law, Dr. Amy Gadsden, noted that incorporation may have important implications in the area of human rights where the absence of the rule of law has proved problematic.

Cafaggi’s paper was written as part of a larger project focusing on the emergence of public-private regulatory regimes in transnational governance, hosted at the European University Institute and funded by the Hague Institute for the Internationalisation of Law (HiiL). The subject is also the focus of Fabrizio Cafaggi’s recent book, Enforcement of Transnational Private Regulation.