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13 Eur. J.L. & Econ. 5 (2002)

handle is hein.journals/eurjlwec13 and id is 1 raw text is: kLA European Journal of Law and Economics, 13: 5-26, 2002 W © 2002 Kluwer Academic Publishers. Manufactured in The Netherlands. Ex Ante and Ex Post Allocation of Risk of Illegality: Regulatory Sources of Contractual Failure and Issues of Corrective and Distributive Justice MAHMOOD BAGHERI m.bagheri@city.ac.uk Centre for Financial Regulation, City University Business School, London EC2Y 8HB, UK CHIZU NAKAJIMA c.nakajima@city.ac.uk Centre for Financial Regulation, City University Business School, London EC2Y 8HB, UK Abstract The pursuit of welfare objectives through contract law rules could be exemplified in the case of illegality and subsequent nullity sanctions attached to a contract that violates certain regulatory rules. The effectiveness of contractual allocation of risk of illegality (regulatory prohibitions), therefore, varies, depending on which contract theory prevails. Maintaining the validity of a prohibited and failed contract, and allocation of the relevant risks, is crucially dependent on whether we adhere to a welfare or rights-based theory of contract. In this paper we argue that impossibility of ex ante and ex post allocation of risk of illegality is the logical outcome of the adherence to a welfare theory of contract law, as maintaining even a minimum validity of the failed contract would result in some welfare losses. According to this approach unjust enrichment could not be rectified because it would diminish the optimal enforcement of welfare objectives. On the other hand, and despite such prohibition and illegality, a rights-based theory would resist opportunistic and rent-seeking behaviour and would ensure the validity of the contract and just allocation of losses and gains, which arise from the failure of the prohibited contract. Keywords: risk, regulation, illegality, contractual railure, rights, efficiency, distributive and corrective justice JEL Classification: D6, D7, D8, KI, K12 1. Introduction Whilst a contract is primarily a device for allocation of the risks unfolding in future, there are contingencies, which contracting parties may not be able to plan for. They have to either rely on contract law default rules or design some broad and general terms for allocating unknown risks. However, in certain circumstances even the parties' anticipation and contractual risk management plan may not be effective. A contractual risk allocation clause could be rendered invalid if it is related to the allocation of risks of illegality as often the effect of illegality nullifies the entire contract and, for social reasons such as deterrence, any relief under such a contract is denied. Such treatment of contractual obligations is reflecting a normative orientation of contract law under which

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