Scottish Law Commission (Reports)

 


PART 5

EXTENDING THE PROTECTION AGAINST UNFAIR TERMS TO SMALL BUSINESSES

INTRODUCTION

5.1      The UTCCR affect a wider range of potentially unfair clauses than UCTA.^[1] In the Consultation Paper we provisionally proposed that the controls over unfair terms in contracts between businesses should be extended. We suggested that businesses should receive protection similar to that currently enjoyed by consumers under the UTCCR. As we explained in Part 4, this proposal proved to be controversial and the Commissions have now decided not to recommend such expanded protection.^[2] However, many consultees (including some of those who opposed our proposals for contracts between larger businesses) said there was a need for greater protection for small businesses. In this Part we make specific recommendations to increase the protection afforded to small businesses.

5.2      In summary, we recommend that most of the protections currently given by the UTCCR to consumers should be extended to small businesses, defined as those with nine or fewer employees. A small business, when dealing with a larger business or another small business, should be able to challenge any standard term even if it is not an exclusion or restriction of liability clause currently covered by UCTA. The protection would not apply to certain types of contract including most of those currently exempt from UCTA and those regulated by the Financial Services Authority. Transactions over £500,000 would also be exempt, as would those that form part of a series of similar transactions likely to exceed that sum in a two-year period.

Consultation responses

Responses to our Consultation Paper

5.3      Many of those who responded to our Consultation Paper referred to the particular problems experienced by small businesses.

(1) Many of those who supported our provisional proposals for business contracts in general did so without elaborating on their reasons for thinking that expanded protection is warranted. Those who did give reasons usually stressed the need for small businesses to be protected. They explained how very harsh terms shifting risk often result from inequalities of bargaining power that are particularly persistent in industries such as construction, manufacturing and farming where small businesses are common.

(2) Those consultees who represented small businesses^[3] were unanimously in favour of increased protection for (small) businesses and greater control over business contracts.

(3) A significant number of those who did not agree with our Consultation Paper proposals for expanding controls over business contracts in general qualified their opposition by acknowledging that small businesses are more vulnerable and that additional protection may be appropriate in this area.

Further consultation on protection for small businesses

5.4      Following our analysis of the consultation responses we developed proposals specifically for small businesses alone and consulted on these new proposals. We sought views on our proposals at a seminar organised in conjunction with the Society of Advanced Legal Studies^[4] and in correspondence with interested parties. As we shall see, the response was on the whole favourable. We have decided, therefore, to adopt these proposals as our recommendations on unfair terms in contracts with small businesses.

The problems for small businesses revealed by the consultation exercises

Small businesses as customers

5.5      Because they had received complaints the DTI asked us to consider extending the UTCCR regime to businesses and, in particular, small enterprises.^[5] Most of these complaints seemed to involve contracts made by small businesses acting as customers^[6] for goods or services outside their particular field of expertise – for example, a newsagent who enters a contract to rent a photocopier.^[7] Our consultation confirmed that in this context small businesses often find themselves bound by harsh terms. Small businesses and their representatives complained about unfair terms in what appeared to be standard form contracts. In particular, problems arising from hire-purchase and leasing contracts were drawn to our attention by the Specialist Officers Group for Fair Trading of the North of England Trading Standards Group.

5.6      Consultation also confirmed our suspicion^[8] that small businesses face similar problems even when the contracts under which they obtain goods or services are in what might be called their area of expertise. The terms complained of usually appeared to be the other party's standard terms.^[9] It was suggested that small businesses can sometimes only obtain goods and services essential to their business on terms that seem to be unfair.

5.7      A particular example cited to us were terms that prevent a small retailer which has incurred liability when it resells defective goods from passing that liability "back up the chain" to its supplier. The retailer is in effect "squeezed" between consumers, on the one hand, and the supplier or manufacturer, on the other. This can happen where a relatively small number of large suppliers dominate the supply of goods to the retail sector. It can also occur in an entirely competitive retail environment: a retailer that faces a "brand-specific" demand from its consumers cannot afford not to do business with a particular supplier. So, for the benefit of the consumer, a retailer may have to replace the manufacturer's faulty goods with new goods yet be unable to obtain compensation or replacement stock from the manufacturer because of clauses allowing the manufacturer to observe lower standards in its dealings with the retailer.

5.8      Many of the complaints of this type appeared to be about exemption clauses which already fall within the controls imposed by UCTA on all business contracts. (This indicates the limited efficacy of controls which have to be triggered by an individual person, a point to which we return below.^[10]) Nonetheless, it seems that some of these contracts contain harsh terms which fall outside the existing UCTA controls: for example, terms requiring the small business to renew contracts at escalating prices;^[11] or terms giving the supplier excessive discretion over prices.^[12] A frequent cause for complaint was terms allowing the supplier to terminate the contract forthwith if the small business commits any default, while the small business cannot terminate for breach by the supplier without giving the supplier the opportunity to cure the default.

5.9      Representatives of small businesses acting as suppliers complained about clauses that imposed an unfair distribution of risk. Respondents observed that ancillary clauses are being used to offload risks such as force majeure and third party default onto the small business. Some of these clauses required the small business to indemnify a large purchaser or client against a loss caused by a third party or, indeed, the large business's own defective performance. These terms appeared in all kinds of supply contracts. Many were clearly examples of the large business's standard terms and conditions. Some were apparently "bespoke" clauses imposed on a one-off basis with the large business drafting the term in advance and refusing to negotiate on it.

5.10      Many respondents pointed out that the practice of offloading risk onto the party who can least afford to bear it is detrimental to small businesses. They thought it could discourage enterprise at this level. In all cases reported to us, the viability of the small business was significantly affected and in some cases the impact was said to be "nearly fatal".

5.11      We were told that these clauses are agreed by small businesses for a variety of reasons that reflect distortions in the market, including bargaining pressure, lack of information and failure to understand the implications of the clause. In most of the cases drawn to our attention, it was said that the objectionable clauses are reluctantly agreed by the small business because the larger business has excessively disproportionate bargaining power and simply refuses to negotiate its standard terms. In some cases, however, the clauses were apparently agreed without the small business appreciating the nature or effect of the clause.

THE CASE FOR EXTENDING THE CONTROLS TO PROTECT SMALL BUSINESSES

5.12      It is clear from the responses to our Consultation Paper and subsequent informal consultation that some of the harsh terms encountered by small businesses could be challenged by the small business under UCTA. However, there are significant numbers of clauses which are potentially unfair to the small business but are currently outside the reach of UCTA. This is particularly so in contracts in which the small business is a customer for goods and services.^[13]

5.13      When a small business contracts as a customer for goods or services which are outside its field of expertise, it is in a position that is very similar to that of a consumer. We accept, of course, that most small businesses are run by people of intelligence and skill. But outside their area of experience they may be in a poor position to look after their own interests.

5.14      It is important to bear in mind the makeup of the small business sector. Many small businesses are in fact very small: 69% of all UK enterprises have no employees at all,^[14] 20% have between one and four employees, and a further 5% have between five and nine employees.^[15] The number of enterprises with no employees (mostly sole traders) strongly points to the vulnerability and lack of sophistication of small businesses. Moreover, even businesses in the category of Small-and-Medium-sized Enterprises ("SMEs", a larger category, covering businesses with up to 250 employees) very rarely seek legal advice. Statistics published by the DTI suggest that only 3% of SMEs sought legal advice in the previous 12 months.^[16] In addition, many entrepreneurs who run small businesses are relatively young (25% are 25 or younger, 46% are 35 or younger).^[17] Furthermore, only 64% of entrepreneurs have vocational training or a degree: around 5% have no educational qualifications at all.^[18] These factors reinforce our view that many small businesses are in a similar position to consumers.

5.15      Practically speaking, small businesses are unlikely to be able to afford to seek legal advice on the terms of a proposed contract and are much less likely than a larger business to have appreciable in-house legal expertise. As such, small businesses are distinctly more vulnerable than larger businesses to unfair terms.

5.16      In particular, many small businesses are unlikely to have anything like a full understanding of standard terms put forward by the other party. As we explained in the Consultation Paper, while standard terms of business have many advantages to both sides, they carry a significant risk that the party who deals on the other's written standard terms will agree to them without understanding them or their implications. Moreover, that party will seldom have the resources to obtain legal advice on a contract of this type. As a result, it may be taken unfairly by surprise. Obviously, this can be a problem even if the small business attempts to negotiate the terms but it is most likely to be a problem with standard terms. In addition, when a small business is a customer for goods or services on a one-off basis, it is most unlikely to have the bargaining power to persuade the other business to alter its standard terms. Simply to avoid having to alter its standard terms in the instant case, the larger business may insist on terms that do not represent the best interests of either party or the best practical outcome for both: in other words, the parties contract on terms that are inefficient.^[19]

5.17      The problem is not limited to small businesses that are customers for goods and services outside their field of expertise. Responses confirmed that many small businesses do not fully understand the standard terms on which they obtain supplies regularly and certainly are not able to persuade suppliers to alter the terms in the small business's favour. This is just as true for terms that fall outside UCTA as it is for exclusions and restrictions of liability that are currently subject to the Act.

5.18      Many of our respondents were themselves, or represented, small suppliers or service providers forced to contract on the standard terms of business of a larger retailer, prime contractor or client. Where the small business is the supplier it is even more likely that the terms will be outside UCTA, since UCTA applies only to exclusion or restrictions of liability in various forms and does not affect terms that impose additional obligations on the other party (the small business).^[20]

5.19      When a small business is making a contract (whether as customer or as supplier) that is within its area of expertise, the problems associated with a lack of information are less pressing than in the context of one-off contracts. Nevertheless, in the course of our consultations, some of our respondents emphasised that unfair term controls have a role to play in upholding existing regulatory protections and in offsetting some of the market distortions created by power imbalances.

5.20      We do not think that it is appropriate for our scheme to attempt to address all the problems reported by our consultees. Some complaints were about clauses which were well-known to and understood by the small business but over which it had tried to negotiate and had failed to obtain what it wanted. This represents a different kind of problem to that outlined above. A term cannot be looked at in isolation: it is part of an overall "package". A change in one term may be balanced by a change in another so that, for example, a reduction in the risk carried by a small business supplier might be at the cost of a reduction in the price the customer is prepared to pay. Where the parties have been prepared to negotiate a term, if at the end of the day the term is left unaltered, it is probable that this is because the original term represents the most efficient balance of risk and price. Any attempt to regulate the term allocating risk will merely reduce the price the customer is willing to pay. The effect would be to reduce the price payable to the small business.^[21]

5.21      It may be that standard terms also represent a balanced package. However, when it is a standard term there is a much greater risk that the small business will not have understood it or will be met with a blanket refusal to negotiate it because of the cost of altering a standard contract for "one small customer or supplier". In these circumstances, the term will not in fact represent an efficient outcome. Thus it is the unfairness produced when small businesses deal on the other party's standard terms which we think should be addressed in any new protective regime.

5.22      In the further round of consultation mentioned earlier,^[22] we decided to address these concerns by proposing to extend a UTCCR-style regime to small business contracts. A small business would be allowed to challenge any non-core, non-negotiated term of the contract on the grounds that it was unfair or unreasonable.^[23] By restricting the controls to non-negotiated terms, we hoped primarily to cover unfair "surprise" terms. It is also important to avoid regulation where it is not needed. We therefore proposed certain exemptions for particular contracts or contracts with special categories of business.

5.23      The response to our consultation on controls over small business contracts was not unanimous. The CBI opposed the scheme on the ground that it would increase the risks of dealing with a small business and would therefore operate against their interests. The organisations which represent small businesses took a completely different view and welcomed the proposals. So did the large majority of those who attended our seminar or who wrote to us, though some consultees wished to see certain types of small business or small business contracts exempted from the scheme.

5.24      In broad terms we agree with the reservation. We have sought to devise a series of exemptions for contractual contexts in which either (i) the small business is sufficiently sophisticated or sufficiently likely to take legal advice so that the protection is not necessary or (ii) where the contract falls into a category or field which is already sufficiently regulated. These include:

(1) a "transaction value limit" according to which contracts with a value greater than £500,000 would be excluded and would not count as small business contracts no matter what the size of the businesses involved;

(2) an exemption for businesses under the control of a larger business; and

(3) an exemption for financial services contracts.

These are discussed below. ^[24]

OUR RECOMMENDATIONS

Background: controls over business contracts in general

5.25      The existing protections afforded to businesses were outlined in Part 4. We have recommended that, broadly speaking, these should continue to apply. In other words, the controls that apply to businesses in general would apply equally to protect a small business.

5.26      For example, under UCTA clauses which purport to exclude business liability for breach of any of the four implied terms of correspondence and quality are valid only if they are reasonable.^[25] We have already recommended that under the new scheme such clauses should be subject to a "fair and reasonable" test where the buyer deals on the seller's written standard terms.^[26] This would also apply in respect of small business contracts. It is not necessary to specify this result in the Draft Bill as, in relation to the replacement for the UCTA regime, small business contracts are simply a sub-category of business contracts.

The new general clause

5.27      The chief constraint on these protections is that the controls over general business contracts reproduced from UCTA are restricted to what effectively amount to exclusion and limitation clauses. Thus, under the existing legislation, a party who is acting in the course of a business is not protected against unfair terms which, say, relate to its own performance rather than that of the other party. Some protection is provided by the common law, for example in relation to penalty clauses, but this is narrow and to some degree uncertain in its scope.^[27]

5.28      Our recommendation for small business contracts is that small businesses^[28] should be able to challenge any "non-core" contract term under the "fair and reasonable" test,^[29] provided it is a standard term.

5.29      The significant difference between this regime and that which we have recommended for consumers is that a consumer will be able to challenge a "non-core" term even if it was negotiated. We have explained why we do not think that this would be appropriate for small businesses. The exact meaning of what we have referred to as a "standard" term is considered below. ^[30]

5.30      We recommend that small businesses should be given powers to challenge any "non-core", standard term of a contract under a "fair and reasonable" test.

5.31      Another difference is that small businesses, unlike consumers, must bear the burden of proving that a term is not fair and reasonable. In other respects, however, the general clause^[31] mirrors the consumer general clause.^[32] It would be repetitious to discuss in this Part the provisions which have been replicated from the consumer regime and the reader is referred to the relevant discussions in Part 3.

Definitions

"small business contract"

5.32      Under our recommended regime a small business contract is defined as a contract between a small business and another business, whether or not the second business is also a small business. If only one business is small, only the small business can take advantage of the provisions to challenge unfair terms. We decided to protect small businesses in their dealings with large businesses because we believe this is the situation in which small businesses are most vulnerable and least likely to be able to influence the "non-core" terms of the contract. However, small businesses are also to be protected in their dealings with each other because we believe (i) that a lack of sophistication and access to legal advice is still likely to disadvantage some small businesses in this situation and (ii) that doing so will lead to a regime that is simpler and more consistent overall and therefore more accessible.

5.33      We recommend that small businesses should be protected in their dealings with any other business, no matter what the size of the other business.

"small business"

5.34      Finding a suitable criterion for the size of a small business has been a difficult task. Definitions of "small business" vary enormously. Although the European Commission is promoting the adoption of harmonised definitions,^[33] there is no consistent domestic approach. The primary aspect of such definitions is always the number of employees, although it is quite common for definitions to refer to business turnover as well. We thought carefully about a range of tests (including VAT registration) and looked closely at the possibility of a turnover criterion, which found favour with some of our consultees. However, we have settled for a criterion based solely on employee numbers.

5.35      We are aiming to protect the least sophisticated businesses, which are so small that they are unlikely to have expertise in contracting or the resources to seek legal advice. We have therefore confined protection to those normally categorised as "micro" businesses, namely those with nine or fewer employees.^[34] We are conscious that many definitions of small businesses extend to those with less than 50 employees and this group may also find it difficult to access legal advice in contractual negotiations. Nevertheless, as the definition expands, the need for protection declines. We have therefore restricted the scheme to the most vulnerable businesses. As a matter of terminology, we have decided to use the term "small business" throughout this Report and in the Draft Bill, rather than the more technical phrase, "micro" business. We believe this better accords with the fundamental principle of clear and accessible drafting.

5.36      We have rejected a turnover criterion for three reasons. The first is that we do not believe turnover is, in fact, an accurate guide to the size of a business. Businesses in some sectors (for example, building, construction and farming) typically have a small profit to turnover ratio because there is considerable outlay involved in reaching the finished saleable product. These businesses may be less sophisticated than professional service providers (such as consultants or software developers) with a lower turnover but a higher profit. The many regimes which use a turnover criterion are all devised for other purposes and we do not feel that those purposes are sufficiently close to our own to justify using the same approach.

5.37      Secondly, key elements in the rules must be certainty, accessibility and predictability for persons acting in the market. Turnover is rarely accurately ascertainable on the "face" of the business. It will be easier for the other party to determine whether it is dealing with a small business if the criterion is simply one of employee numbers. A turnover criterion may be suitable for administrative regimes setting tax exemptions or subsidy levels where it would be used as a threshold criterion which, once satisfied, would entitle a business to membership of a certain class for a period of time. It is more difficult to see how it would work in regard to transactions. The fact that the size of the business must be reassessed with each transaction means that the inherent variability of a turnover criterion would be likely to cause problems for a business of marginal size. This difficulty is recognised in the European Commission's definitions, which assume that it may be appropriate to refer only to the number of employees when there are no state aid implications.^[35]

5.38      Thirdly, there is a more specific objection to a turnover criterion. Many of the representatives of small businesses who responded to our consultation papers were keen to point out that small businesses are all too often economically dependent on a small number of key contracts. For example, small farmers may be dependent on supermarket chains, small publishers on bookseller chains or sub-contractors on large construction concerns. In such circumstances, for a small business to provide details of turnover to one contracting party might be tantamount to revealing the price of its contracts with that party's competitors. This in turn could place the other party in a strong position to exact stricter terms from the small business. For this reason, small businesses would often be reluctant to reveal such market-sensitive information as turnover to their contracting partners and to require them to do so would place them in an invidious position.

5.39      In suggesting that we should define the small business category by reference only to the number of employees, we have used as a model the commencement provisions of the Late Payment of Commercial Debts regime.^[36] In defining "small business" for the purpose of these commencement provisions, a relatively simple definition was adopted, namely: a small business was one with 50 or fewer full-time employees and no financial criteria were applied.^[37] This approach has been adopted in the Draft Bill but the number of employees is reduced to nine. This number corresponds to the upper limit of the category used by the DTI to identify the smallest businesses, which the DTI calls "micro" businesses.

5.40      We recommend that only businesses with nine or fewer employees should be included in the new regime.

"employee"

5.41      In defining who should be counted as an employee, we decided to use a fairly wide definition in order to generate a figure which reflects the true size of the business in practice. Thus "employee" is defined in the Draft Bill as an individual who works "in the business" under a contract of employment or a contract for services.^[38] This is a simplified version of a provision that was used in the Late Payment of Debts regime.^[39]

the number of employees

Counting employees

5.42      There are two issues. The first is that it should not be necessary to calculate the size of a business on each day that a contract is made. Therefore Schedule 4 starts from the assumption that the relevant number of employees will be the number at the end of the last day of the preceding month. The second is that the number of employees that a business has can fluctuate, sometimes dramatically. For example, a fruit farm with a small number of year-round staff may employ a large number of seasonal pickers. We thought it desirable to follow the approach that has been taken in domestic legislation and at the EU level and provide that, in determining whether a business is a small business, the number of employees is to be assessed according to an averaging calculation. The calculation that seems to us best to combine certainty with simplicity is the average daily number of employees over the course of the preceding twelve months. For the averaging calculation we have used "a full-time equivalent basis", whereby part-time employees are counted as fractions of a full-time employee. Short-term employees are, of course, simply included in the general averaging calculation. This was the approach taken by the commencement provisions of the Late Payment of Commercial Debts regime. There are supplementary provisions for companies that have been in business for less than a year.

Relevant time

5.43      In our view, the period over which the number of employees is averaged must be the period immediately preceding the conclusion of the contract and not the period preceding the commencement of proceedings. Our reasons are twofold. First, our concern for small businesses arose from their susceptibility to outside pressure to contract on harsh terms. Any protective regime must therefore take into account the sophistication and bargaining power of the small business at the time when that pressure would be applied, that is, at the time the contract was made.

5.44      Secondly, if this were not the case, a business might contract with a large business on terms that assume maximum freedom of contract only to find that the large business had become a small business over the course of the contract. This would allow the shrinking business to challenge contract terms even though both businesses had contracted on the basis that the small business controls would not apply. This would lead to unfairness and uncertainty.

Small businesses that form part of a larger group

5.45      We see no need to protect small businesses that, by virtue of their membership of or links with a larger organisation, have access to the resources and expertise of other businesses in the group. Thus the Draft Bill provides that, in calculating the number of employees, the court is to take into account the total number of persons employed not only by the business itself but also by any associated person.^[40] Below, we discuss the need for a wide definition of "associated person" so as to exclude a range of sophisticated businesses.^[41]

5.46      We recommend that the size of a business should be calculated by averaging the number of persons employed by that business or by it and any associated business over the preceding year.

Uncertainty

5.47      There will remain areas in which the regime is likely to lead to problems of predictive uncertainty for parties entering into small business contracts. The proposed test for calculating the size of a business is necessarily complex. Employee numbers is not the straightforward concept that it might at first appear: there is the question of how to deal with short-term and part-time workers, seasonal fluctuations and natural wastage. The test that we have proposed addresses these questions and has the virtue of generating a certain, fixed figure should the issue of a business's size arise in court. However, it is impractical to expect the parties to perform the entire calculation prior to contracting. One business will have a rough idea of the number of people employed by another but in a marginal case it will be unable to perform the entire calculation with exactitude. This means that businesses approaching a contract with a business of marginal size may be uncertain whether they are dealing with a small business.

5.48      The question is whether anything needs to be or can be done to reduce these uncertainties. We looked, for instance, at whether the legislation might provide that the parties could agree on the size of the business. This would be complicated. It would be necessary to ensure that larger companies could not pressure a small business to accept a standard term under which the other party, whatever its actual size, "agreed" that it was not a small business. In other words, it would be necessary to provide that the agreement would only be effective if it was reached in good faith.

5.49      We consider that legislative provision is not necessary. The common law offers a solution which the parties could put into operation themselves without statutory intervention. When it is dealing with a small-medium sized business whose status is in doubt, the other party may require as a term of the contract a "warranty"^[42] that the small-medium business is of a particular size. Such a statement provides protection provided the other party has relied upon it when entering the contract. If the other party knew it was incorrect, there would be no protection as that party would not have entered into the contract in reliance on the statement.^[43]

sophisticated businesses with few employees

5.50      During consultation our attention was drawn to the problem of businesses which meet the employee numbers criterion but which operate in such a sophisticated environment that it would not be appropriate for them to be treated as small businesses under the Draft Bill. These include City businesses set up to act as vehicles for tax-driven financial arrangements ("special purpose vehicles" or "SPVs") or to be responsible for specific projects ("project companies"). We have been told that it is quite common for such companies to have only a handful of employees but to operate in extremely sophisticated ways and do business worth millions of pounds.

5.51      We have developed three ways of excluding these businesses from small business protection. We are excluding small businesses that are quasi-subsidiaries of larger organisations; contracts with a value of more than £500,000; and contracts for regulated financial business.

Excluding quasi-subsidiaries

5.52      As already discussed, our scheme defines the number of employees by reference to the total number of persons employed not only by the business itself but also by any "associated person".^[44] We looked in some detail at the requirements of the "associated person" test to ensure that it will cover sophisticated SPVs and project companies.

5.53      SPVs and project companies are often set up as "orphan" companies which are not directly owned by another business. They would not therefore fall within the traditional test that two persons are associated when one controls the other as its owner or majority shareholder. SPVs are sometimes referred to as quasi-subsidiaries because, although they are not owned by another business, they are in fact run in accordance with the wishes of the business that created them. In order to cover these quasi-subsidiaries, we recommend that an associated person should include those who have the de facto ability to dictate how the business is run as well as those who have the ability to control a business through a majority shareholding.^[45]

5.54      We recommend that widely-defined group exemptions should be put in place so as to exempt from the small business regime those businesses that are associated with larger businesses.

Contracts of value higher than £500,000

5.55      After some deliberation and consultation, we decided to recommend that transactions above a certain value should not qualify as small business contracts. Thus the Draft Bill provides that a business will not be treated as a small business in respect of a particular contract if the anticipated value of the transaction exceeds a certain pre-set limit.^[46] The limit has been set at £500,000 for three reasons.

5.56      First, the figure needs to be reasonably high as it is not intended to exclude the contracts of ordinary small businesses but rather to exclude finance businesses that deal with very high value transactions but happen to have very few employees. We have been given to understand that we are not in danger of including the typical business transaction of an SPV within our limit so long as it is below £1 million.

5.57      Secondly, during consultation it came to our attention that some of the most vulnerable small businesses were those dependent for their entire trade on one, or perhaps two, commercial relationships. Examples of this were diverse and included small suppliers supplying to one or two large retail chains (for example, chains of bookstores, department stores or supermarkets) as well as small retailers buying from one or two suppliers (for example, mobile phone companies). We wanted to include these contracts within our recommended regime of protection for small businesses. We therefore sought to identify the average turnover of a small business in the expectation that, in acute cases, this sum might reflect outlay on a single contract with a large business. Our (admittedly limited) research suggested that the average annual turnover of a small business is in the order of £500,000.^[47] This is therefore the sum on which we settled as our transaction limit.

5.58      Finally, the justification for our small business regime is that we wish to protect unsophisticated businesses from the rigours of contract terms that they do not understand or expect. We anticipate that any business entering into a contract of a certain value would be ill-advised not to take legal advice on the contract and as such will not require the protections of the small business regime. We feel that the majority of small businesses would seek legal advice before entering into a contract of more than £500,000 and have therefore set that figure as our transaction value limit.

5.59      We recommend that contracts with a value of more than £500,000 should not be controlled under the small business regime.^[48]

5.60      In order to prevent small businesses circumventing the transaction value limits by splitting contracts into distinct parts we are proposing to aggregate the sums contained in contracts that form part of a series of contracts or a larger transaction. We also think that a small business that is about to establish a series of contracts which have a high aggregate value is as likely to take legal advice as one that is about to enter a single contract of high value. Clause 29 of the Draft Bill provides for contracts which form part of a larger transaction (or series of transactions) to be aggregated with other contracts in the series over a two year period to determine whether the value-threshold for small business contracts has been surpassed.

5.61      We recommend that where a contract is one of a series, the transactions should be aggregated so that if the aggregated value of the contracts is greater than £500,000 the whole series or arrangement should be exempt from the small business controls.^[49]

5.62      This transaction limit proposal is likely to present the parties with problems of ascertainability and predictability similar to those presented by the employee numbers test for business size. No matter how sophisticated the test, it will not be able to deal in a straightforward way with contracts where the contract price, although ultimately certain, cannot be calculated by the parties in advance when the contract is made. Examples might be contracts for services on an emergency call out basis when the number of emergencies that will occur is not known in advance, or contracts for building work where the cost of materials and labour cannot be ascertained in detail in advance. There are other contracts where the contract price is intended to vary during the performance of the contract or where it is difficult to talk about a contract price at all. This means that a business entering such a contract with a small business will be uncertain whether it is agreeing to a small business contract or not.

5.63      Once again, we believe there may be common law solutions to the difficulty of determining whether a transaction will fall within the financial limit. These can be instituted by the parties themselves. For example, the parties could make a statement in the contract that the value of the agreement exceeds the transaction value limit. Such a statement would, we believe, be effective unless the party seeking to rely on it knows that it is incorrect since it cannot then be said to have entered into the contract in reliance on the statement.^[50]

Financial services contracts

5.64      It was pointed out that protections are largely unnecessary in areas where businesses dealing with small businesses are already regulated. To extend protection to small businesses in these situations could result in over-regulation of the market.

5.65      The most obvious example is contracts for the provision of financial services. Most contracts of this kind are already subject to regulation by the FSA. Therefore we decided to explore the possibility of creating an exemption for such contracts. The response to our further consultation on this point was favourable. We therefore recommend that any contracts made by an "authorised person"^[51] pursuant to a "regulated activity"^[52] should be excluded from the small business regime. Thus small businesses buying banking, insurance and financial advice services from a body regulated by the FSA will not be able to challenge the terms of the contract under our proposed legislation.

5.66      The exemption extends only to regulated activities and not to the provision of financial services more generally.

5.67      We recommend that there should be an exemption from the controls over small business contracts for contracts entered into in pursuance of regulated financial services business.^[53]

Terms not individually negotiated

5.68      The scheme is intended to protect small businesses from unfair standard terms which were not negotiated. The question, then, is how the concept of non-negotiated terms should be defined. In particular, should the "written standard terms of business" formula in UCTA section 3 be retained, or should the UTCCR's "not individually negotiated" formula be used, or should some other formula be devised?

a term-by-term approach

5.69      A small business faced with a set of terms may well attempt to amend some terms they understand and regard as important but may also overlook others entirely, even if those terms are very harsh. From this point of view, the UCTA test – which focuses on a set of standard terms – does not include all the situations that we believed to be problematic. Under the UCTA test, significant changes to only a few terms may prevent the whole set (including the unchanged terms) from amounting to written standard terms. Thus we prefer a term-by-term approach. This means that the status of each term in the set would be assessed independently to see whether it had been altered in favour of the small business from the version put forward by the other party as a result of negotiations.

only "standard" terms

5.70      The UTCCR's "not individually negotiated" formulation is wider than this. Because there is no reference to standard terms, it would allow a small business to challenge any term that was drawn up in advance by the other party and not subsequently negotiated. This applies even if all the terms of the contract were tailor-made for the particular transaction in question. We do not think that this would be appropriate. As we explained earlier,^[54] if the term has been drawn up for the particular contract, by definition the other party will not refuse to negotiate it simply because it is one of a set of standard terms. If the other party refuses to negotiate the term, that is probably because the business finds the overall balance of the contract appropriate to its needs.

5.71      In the light of these concerns, we think that the starting point for identifying a non-negotiated term should be that it has been put forward by the other party as one of its written standard terms of business.^[55] The reference to written standard terms of business is intended to target standard terms and to leave bespoke contracts unregulated. However, by referring to individual terms put forward by the other party (as part of a set of written standard terms) the definition is intended to engender a term-by-term approach to the question of challengeability, avoiding the risk of the all-or-nothing approach that was outlined in paragraph 5.69.

not altered in favour of the small business

5.72      The purpose of taking a term-by-term approach is to discriminate between those terms which, although originally part of a set of written standard terms, have subsequently been changed as a result of negotiation and those which have not. If the small business asked for and obtained some change during negotiation – even a change less than it sought – this shows that the other party was not unwilling to alter its terms just because they are standard. The reason we have given for allowing a challenge falls away.

5.73      To achieve this result, we have added a second limb to our definition of challengeable terms which specifies that the substance of the term must not have been altered in favour of the small business as a result of negotiation.

5.74      The reason that a term in the other party's standard terms was not altered in favour of the small business may not have been that the other party did not want to alter its standard terms as such but that the term reflects the best balance of risk and price.^[56] This might suggest that a term should not be subject to review if there was negotiation over it even though the negotiation led to no change. The difficulty is that there is no criterion by which to distinguish such a case from one in which the party refused to alter its term for other reasons. Thus the criterion for the control to apply must simply be whether the standard term was altered in favour of the small business. Arguments that it was left unaltered because it reflected the best balance of risk and price will have to be taken into account when the court assesses whether the term was fair and reasonable.

5.75      We recommend that only certain terms in small business contracts should be open to challenge: those terms which have been put forward by the other party as one of its standard terms of business and which have not been subsequently changed in favour of the small business as a result of negotiation.^[57]

Expressly excluded categories of contract

business contracts in general

5.76      In Part 4 we recommended that certain categories of contract should be excluded from the proposed controls over business contracts.^[58] We now recommend that all these categories of contract also be excluded from the small business regime. Contracts relating to land, intellectual property, company constitutions and securities involve specialised categories of activity in which either certainty is usually highly-prized in the market or where it is customary for parties to seek legal advice so that harsh terms are not usually agreed to unwittingly (or both). Insurance contracts are also exempted; many would in any event be covered by the larger exemption we have recommended for financial services contracts.^[59] Contracts in category (6) were exempted from UCTA to maintain existing arrangements in the commercial maritime field – arrangements which had, at that time, developed over the course of a century and were thought to achieve a valuable level of certainty. We see no reason to disrupt these tried and tested arrangements in relation to small business contracts any more than in relation to business contracts generally.

5.77      We recommend that the same categories of contract should be exempt from the small business controls as are expressly exempt from the business controls.^[60]

international contracts

5.78      This is discussed in Part 7.

choice of law

5.79      This is discussed in Part 7.

The "fair and reasonable" test

5.80      In Part 3, we proposed that the basic test in the new legislation for consumer contracts should be whether, judged by reference to the time the contract was made, the term was fair and reasonable.^[61] In Part 4 we recommended using the same test for the controls on general business contracts.^[62] We now recommend adopting the same test in respect of small business contracts. Having one test for all the various controls we recommend will lend coherence to the new legislation and, more importantly, make its provisions easier to understand and apply.

5.81      We recommend that the same "fair and reasonable" test should apply to the new general clause for small business contracts as to other contracts under the new legislation.

Indicative List

5.82      For consumer contracts the legislation must include a list of terms which may be unfair. In Part 3 we recommended that the Indicative List be reformulated to make it easier to understand and apply in the UK.^[63] We also recommended that the Secretary of State should be given powers to add to the list.^[64] In the Consultation Paper, we proposed that there should be an indicative list of business contracts to assist businesses in knowing what terms were likely to be unfair.^[65] We proposed, however, that such a list should be limited to clauses excluding and restricting liability for breach of contract or negligence.^[66]

5.83      Now that our proposed extension of controls is only to small business contracts, the question arises whether it is desirable to have an Indicative List as part of the small business regime. The list would indicate what terms are likely to be regarded as unfair and unreasonable and would provide businesses with useful guidance. We believe that the same terms which are likely to be objectionable in a consumer contract are likely to be unfair and unreasonable in relation to a small business. We therefore recommend that the reformulated Indicative List should also apply to small business contracts.

5.84      We recommend that the Indicative List of terms that may be regarded as unfair should apply to small business contracts as well as consumer contracts.^[67]

The burden of showing unfairness

5.85      We recommend that a small business should have the burden of proving that any term which it challenges is unfair. This is the current position under the UTCCR in relation to consumers and we see no reason to change it for small businesses. The imperative of protection for the inexperienced which underlies our recommendations on consumer contracts does not apply with such force to small business contracts.

5.86      We recommend in relation to small business contracts that the small business should bear the burden of showing unfairness.^[68]

The effect of an invalid term

5.87      The issues over the effect of a term being invalid because it is not fair and reasonable are the same for small business contracts as they are for consumer contracts. Again we refer readers to the earlier discussion.^[69]

5.88      We recommend that, where a term of a small business contract is found to be unfair, the contract should continue in existence in all other respects insofar as possible.

Attempted evasion

by secondary contract

5.89      As in the case of consumer contracts, it should not be possible to evade the controls over small business contracts by means of a secondary contract, whether between the same parties or different parties. The issues are the same as they are for consumer contracts and we refer readers to the discussion in Part 3.^[70]

5.90      We recommend that controls should be put in place to prevent businesses evading the small business controls by means of secondary contracts.

by choice of law

5.91      This is discussed in Part 7.

Prevention

5.92      It is clear from the responses that the right of individuals to challenge unreasonable exclusion clauses has not eliminated their use from small business contracts any more than it did from consumer contracts.^[71] Nor is there likely to be an effective distribution of information among small businesses. A case can be made for a body having power to prevent the use of unfair terms by businesses in their contracts with small businesses. Such controls are found in some continental countries.^[72]

5.93      In the Consultation Paper^[73] we said that the decision whether to recommend the extension of the preventive powers of the UTCCR to business contracts depended on the answers to at least two questions. The first is whether it is desirable in principle to extend the controls. The second is whether there is some body which is suitable to take on the task. We observed that to operate a scheme effectively would be expensive and that we did not know whether any organisation would be prepared to meet the necessary expenditure.

5.94      We have now concluded that, in principle, it would be desirable to extend the preventive regime to small business contracts. Allowing parties to challenge individual terms has a limited impact on general contracting practice when compared to the general powers of an authorised body.^[74] While respondents did not support the idea of extending UTCCR-style preventive controls into the business sector in general, a substantial number indicated that such protections might be justifiable for small businesses only. We note that the Late Payment of Commercial Debts Regulations 2002^[75] grant preventive powers to certain representative bodies.

5.95      We accept these submissions and we would like to recommend this extension. However, our enquiries into the practical implementation of such a scheme have led to doubts over whether there are suitable enforcement bodies capable of meeting the cost and willing to do so. In particular, the Office of Fair Trading has indicated that it would not be willing to take on the role of policing small business contracts. In short, there appear to be no bodies which currently have the resources effectively to carry out this role. We have not, therefore, made provision in the Draft Bill for a preventive powers regime in respect of terms in small business contracts.

Note 1    See para 2.31.    [Back]

Note 2    See paras 4.4 and 4.8 – 4.12, above.    [Back]

Note 3    A variety of representatives of small business interests responded to the Law Commissions’ Consultation Paper on unfair terms. These included: small companies, self-employed professionals, industry-sector representatives and bodies such as the Federation of Small Businesses (FSB) and the Small Business Service at the Department of Trade and Industry (SBS), representing small businesses as a whole.    [Back]

Note 4    In July 2003, a background paper setting out our thinking in this area was circulated to interested parties.     [Back]

Note 5    See our Terms of Reference, set out in Consultation Paper, para 1.1.    [Back]

Note 6    The word “customer” is used here to refer to a party who buys goods or services – usually on a rare or one-off basis – in a situation where it can be expected to have much less knowledge and experience than the supplier. While a small business may act as a “customer” in the course of its business, it will not be acting as a “customer” in any contract for the goods or services that represent its core business. For example, a small pub will probably be acting as a “customer” when it buys a television to display sporting events in the bar area but not when it buys supplies of beer.    [Back]

Note 7    See Consultation Paper, para 2.30, especially at n 39.    [Back]

Note 8    See Consultation Paper, para 5.7, especially at n 7.    [Back]

Note 9    The responses did not always specify this.    [Back]

Note 10    See paras 5.92 – 5.95, below.    [Back]

Note 11    See Consultation Paper, para 2.30, n 39.    [Back]

Note 12    Ibid.    [Back]

Note 13    See para 5.8, above.     [Back]

Note 14    They are sole proprietorships and partnerships comprising only the self-employed owner-manager(s) and companies comprising only an employee director.     [Back]

Note 15    Statistics are taken from the report, UK 2003 issued by National Statistics, and relate to the reference year beginning 2001.    [Back]

Note 16    Small Business Service, Omnibus Survey (November 2001) p 22.    [Back]

Note 17    Small Business Service, Small Firms: Big Business, chapter 3 (Characteristics of Entrepreneurs).    [Back]

Note 18    5.5% have no educational qualifications, 30.4% have not gone beyond secondary school, 32.6% have had some vocational training, 16.5% have a first degree and 15% have a postgraduate degree: Small Business Service Small Firms: Big Business, chapter 3 (Characteristics of Entrepreneurs).    [Back]

Note 19    See Consultation Paper, paras 2.4 – 2.7.    [Back]

Note 20    See para 2.6(1), above.    [Back]

Note 21    Assuming the small business is the supplier.    [Back]

Note 22    See para 5.4, above.    [Back]

Note 23    See para 5.30, below.    [Back]

Note 24    See paras 5.50 – 5.67. See also Excluded Contracts at paras 5.76 – 5.78, below.    [Back]

Note 25    See para 4.1, above.    [Back]

Note 26    See paras 4.25 – 4.29.    [Back]

Note 27    See Consultation Paper, paras 2.1 and 4.141.    [Back]

Note 28    We consider that there are instances where some small businesses do not warrant this protection. We recommend certain exceptions to the small business regime in paras 5.50 – 5.67 and 5.76 – 5.78, below.     [Back]

Note 29    The details of the test are discussed in Parts 3 and 4 above.    [Back]

Note 30    See paras 5.68 – 5.75.    [Back]

Note 31    See Draft Bill, clause 11.    [Back]

Note 32    See Draft Bill, clause 4. Note that: Subsection (1) of clause 4 (relating to terms that are detrimental) is replicated in subsection (2) of clause 11; Subsection (4) of clause 4 (excluding a term that is transparent and is not substantially different from what would apply as a matter of law in the absence of the term) is replicated in clause 11 as subsection (5). The exemptions for the definition of the subject matter and price (the core terms exceptions) in subsections (2) and (3) of clause 4 are replicated (with the same definition of transparency applying) in clause 11 at subsections (3) and (4).    [Back]

Note 33    See the Commission Recommendation of 6 May 2003 concerning the definition of micro, small and medium-sized enterprises (Official Journal L 124, 20/05/2003 P 0036 – 0041). Also the Commission Recommendation of 3 April 1996 concerning the definition of small and medium-sized enterprises (Official Journal L 107, 30/04/1996 P 0004 – 0009).    [Back]

Note 34    Annex 1, Art 1.5, Commission Recommendation of 3 April 1996 concerning the definition of small and medium sized enterprises (1996/280/EC).    [Back]

Note 35    Art 2 of the Commission Recommendation of 6 May 2003 concerning the definition of micro, small and medium-sized enterprises (Official Journal L 124, 20/05/2003 P. 0036 – 0041). Also Art 2 of the Commission Recommendation of 3 April 1996 concerning the definition of small and medium-sized enterprises (Official Journal L 107, 30/04/1996 P. 0004 – 0009).    [Back]

Note 36    Late Payment of Commercial Debts (Interest) Act 1998 (Commencement No 1) Order 1998 SI 1998 No 2479.    [Back]

Note 37    Late Payment of Commercial Debts (Interest) Act 1998 (Commencement No 1) Order 1998 SI 1998 No 2479, Art 2(2). (This commencement order was followed by three subsequent commencement orders which all defined “small business” in the same way. The Late Payment of Commercial Debts (Interest) Act 1998 (Commencement No 5) Order 2002 SI 2002 No 1673 ultimately extended the regime to all commercial debts, regardless of the sizes of the businesses involved.)    [Back]

Note 38    Ours is a wide definition because it includes those employed under a contract for services. A contrasting example is provided by the Employment Rights Act 1996, s 230, which draws a distinction between “employee” and “worker”. The former includes only those persons employed under an employment contract. The latter includes those employed under a contract for services. Our definition would cover both.    [Back]

Note 39    See Late Payment of Commercial Debts (Interest) Act 1998 (Commencement No 1) Order 1998 SI 1998 No 2479, Sch 2, para 2.    [Back]

Note 40    See Draft Bill, clause 27. According to Sch 2 (para 6(3)) to the Late Payment of Commercial Debts (Interest) Act 1998 (Commencement No 1) Order 1998 SI 1998/2479, two employers will be treated as associated if, either, one is a body of which the other employer (directly or indirectly) has control, or both are bodies of which a third person (directly or indirectly) has control. Sch 2, para 6(4) goes on to provide that “‘body’ means a body of persons corporate or unincorporate” and that “‘control’, ‘directly’, ‘indirectly’ and ‘third person’ have the same meaning as in section 231 of the Employment Rights Act 1996”.    [Back]

Note 41    See paras 5.52 – 53, below.    [Back]

Note 42    Scots law does not recognise “warranties” as such. A similar result could be achieved by a different route. Where in the course of negotiating the contract a party asks what the size of the “small” business is, this could be noted in the contract. If it turned out to be untrue the party relying on the statement could sue in delict [tort] for misrepresentation.    [Back]

Note 43    In Watford Electronics v Sanderson CFL Ltd [2001] EWCA Civ 317; [2001] 1 All ER (Comm) 696, Chadwick LJ, citing Lowe v Lombank Ltd [1960] 1 WLR 196, suggested that where a party seeks to set up a contractual representation as an evidential estoppel, the clause in question may not be able to achieve its purpose if that party cannot satisfy the court that he entered into the contract in the belief that the contractual statement was true: [2001] 1 All ER (Comm) 696, at 711.    [Back]

Note 44    See para 5.45, above.    [Back]

Note 45    See Draft Bill, clause 28.    [Back]

Note 46    See Draft Bill, clause 29.    [Back]

Note 47    £500,000 is a median figure drawn from data on micro business turnovers, published by the DTI’s Small Business Service on its website.    [Back]

Note 48    See Draft Bill clause 29(2) – (3).    [Back]

Note 49    See Draft Bill clause 29(5) – (8).    [Back]

Note 50    See Watford Electronics v Sanderson CFL Ltd [2001] EWCA Civ 317 [2001] 1 All ER (Comm) 696, discussed in n 43, above.    [Back]

Note 51    As defined under the Financial Services and Markets Act 2000.    [Back]

Note 52    Ibid.    [Back]

Note 53    See Draft Bill, clause 29(4) and (10).    [Back]

Note 54    See para 5.20, above.    [Back]

Note 55    This approach is encapsulated in clause 11(1)(a) of the Draft Bill.    [Back]

Note 56    See above, para 5.20.    [Back]

Note 57    See Draft Bill, clause 11(1).    [Back]

Note 58    See paras 4.81 – 4.84. The categories of contract (1 – 6) are listed in para 4.81.    [Back]

Note 59    Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI 2001/544), Art 10 specifies effecting or carrying out a contract of insurance as principal as a regulated activity for the purposes of the Financial Services and Markets Act 2000.    [Back]

Note 60    See Draft Bill, Sch 3, paras 3 – 7 and 9 – 10.    [Back]

Note 61    See paras 3.84 – 3.105, above.    [Back]

Note 62    See para 4.70, above    [Back]

Note 63    See paras 3.108 – 3.116, above.    [Back]

Note 64    See para 3.112, above.    [Back]

Note 65    See Consultation Paper, paras 5.84 – 5.88.     [Back]

Note 66    In the Consultation Paper we proposed that, as under UCTA s 11(5) [s 24(4)], where a business seeks to rely on an exclusion or limitation of liability clause it should bear the burden of showing that the clause is fair and reasonable. We proposed to achieve this by including such terms in the Indicative List for the purposes of business to business contracts. As we have explained in Part 3, we are no longer proposing that the burden of proof should vary according to whether or not a term is on the Indicative List. There is instead an express provision on the burden of proof: see Draft Bill, clause 17(1).    [Back]

Note 67    See Draft Bill, clause 14(6).    [Back]

Note 68    See Draft Bill, clause 17(2).    [Back]

Note 69    See paras 3.131 – 3.140, above.    [Back]

Note 70    See paras 3.141 – 3.142, above.    [Back]

Note 71    See Consultation Paper, para 5.99.    [Back]

Note 72    In Sweden it appears that the powers have seldom resulted in reported cases, but there may have been informal settlements resulting in unfair terms being withdrawn and the existence of the powers may have had influence.    [Back]

Note 73    See Consultation Paper, para 5.110.    [Back]

Note 74    See Consultation Paper, paras 5.99 – 5.100.    [Back]

Note 75    SI 2002 No 1674, reg 3.    [Back]