Yale law School Public Law and Legal Theory Research Paper No 52 Center for Law, Economics and Public policy Research Paper No 275 University of virginia School of Law Law and economics research Paper series Research Paper No. 03-1 Contract Theory and the limits of Contract Law Alan Schwartz and robert e. scott Yale la journal. vol 113. 2003 This paper can be downloaded without charge from Social Science Research Network Electronic Paper Collection at http://papers.ssrn.com/abstract=397000
Social Science Research Network Electronic Paper Collection at: http://papers.ssrn.com/abstract=397000 Center for Law, Economics and Public Policy Research Paper No. 275 Public Law and Legal Theory Contract Theory and the Limits of Contract Law This paper can be downloaded without charge from: Yale Law School Alan Schwartz and Robert E. Scott Research Paper No. 52 Yale Law Journal, Vol. 113, 2003 University of Virginia School of Law Law and Economics Research Paper Series Research Paper No. 03-1
CONTRACT THEORY AND THE LIMITS OF CONTRACT LAW Alan schwartz& robert e. scott LINTRODUCTION I. JUSTIFYING AN EFFICIENCY THEORY OF CONTRACTS A. What Firms maximize B Why the State Should Help Firm IIL THE ENFORCEMENT FUNCTION 1678 A Enforcement Often is Unnecessary B. Encouraging Relation-Specific Investment C Contracting to Avoid Disruption: The Case of Volatile Markets D. Enforcement and duress V THE INTERPRETATION FUNCTION A. The Relevant Interpretive Question Two Interpretive Issues: Problems of Meaning and of Language C. The Parties' Preferences Regarding Interpretive Styles 1. The Continuous Payoff Case 2. The Invariant Payoff Case D. Private Languages, Linguistic Defaults and the Parole Evidence Rule 1. The Preferred Linguistic Default 2. The parol Evidence rule 3. Course of Performance Evidence Sterling Professor of Law, Yale Law School; Professor, Yale School of Management Lewis F. Powell, Jr. Professor and William L. Matheson Robert A Morgenthau Distinguished Professor. University of Virginia School of law This paper benefitted from comments received at workshops at the Law Faculty, Cambridge, England and at the Pennsylvania, Texas, Toronto, Virginia and Yale Law Schools. We also are grateful to Bruce Ackerman, Jules Coleman, Sam Issacharoff, John Jeffries, Jason Johnston, Paul Mahoney, Tom Nachbar, Paul Stephan, William Stuntz and george Triantis for helpful comments
* Sterling Professor of Law, Yale Law School; Professor, Yale School of Management. ** Lewis F. Powell, Jr. Professor and William L. Matheson & Robert A. Morgenthau Distinguished Professor, University of Virginia School of Law. This paper benefitted from comments received at workshops at the Law Faculty, Cambridge, England and at the Pennsylvania, Texas, Toronto, Virginia and Yale Law Schools. We also are grateful to Bruce Ackerman, Jules Coleman, Sam Issacharoff, John Jeffries, Jason Johnston, Paul Mahoney, Tom Nachbar, Paul Stephan, William Stuntz and George Triantis for helpful comments. 1 CONTRACT THEORY AND THE LIMITS OF CONTRACT LAW Alan Schwartz* & Robert E. Scott** I.INTRODUCTION........................................................................................................................2 II. JUSTIFYING AN EFFICIENCY THEORY OF CONTRACTS ............................................11 A. What Firms Maximize..................................................................................................11 B. Why the State Should Help Firms.................................................................................16 III. THE ENFORCEMENT FUNCTION .................................................................................... 17 A. Enforcement Often is Unnecessary ..............................................................................18 B. Encouraging Relation-Specific Investment...................................................................20 C. Contracting to Avoid Disruption: The Case of Volatile Markets .................................25 D. Enforcement and Duress ...............................................................................................28 IV. THE INTERPRETATION FUNCTION................................................................................. 31 A. The Relevant Interpretive Question ..............................................................................31 B. Two Interpretive Issues: Problems of Meaning and of Language.................................33 C. The Parties’ Preferences Regarding Interpretive Styles ...............................................37 1. The Continuous Payoff Case .................................................................................. .38 2. The Invariant Payoff Case ........................................................................................ 42 3. Summary ....................................................................................................................47 D. Private Languages, Linguistic Defaults and the Parole Evidence Rule ........................48 1. The Preferred Linguistic Default ............................................................................. 48 2. The Parol Evidence Rule ........................................................................................ 55 3. Course of Performance Evidence ..............................................................................57
V THE LEGAL DEFAULT PROJECT A. The Case For Defaults B. The Cost concern 1. Default rules 63 2. Default Standards C. The Asymmetric Information Concern D Summary VI MANDATORY RULES 75 A. Parties Cannot Ban Modifications B. Parties Must Accept Substantial Performance C. Parties Cannot Agree to Penalties ⅤI. CONCLUSION 83 . INTRODUCTION Contract law has neither a complete descriptive theory, explaining what the law is, nor a complete normative theory, explaining what the law should be. These gaps are unsurprising given the traditional definition of contract as embracing all promises that the law will enforce. Even a theory of contract law that focuses only on the enforcement of bargains must still consider the entire continuum from standard form contracts between firms and consumers to commercial contracts between business firms. No descriptive theory has yet explained a law of contract that comprehends such a broad domain. Normative theories that are grounded in a single norm --such as autonomy or efficiency--also have foundered over the heterogeneity of contractual contexts to which the theory is to apply. Pluralist theories attempt to respond to the difficulty that unitary See michael Trebilcock, THE LIMITS OF FREEDOM OF CONTRACT(1993). Autonomy theories thus require elastic notions of consent in order to regulate the full scope of contracting behavior with one norm. Peter Benson, Abstract Right and the Possibility of a Nondistributive Conception of Contract: Hegel and Contemporary Contract Theory, 10 Cardozo L Rev. 1077(1989); Peter Benson, Contract in A Companion to Philosophy of Law and Legal Theory, ( Dennis Patterson ed, 1996); Peter Benson, The ldea ofa Public Basis of Justification for Contract, 33 Osgoode Hall L J. 273(1995); Randy Barnett, A Consent Theory of Contract, 86 Colum. Rev. 269(1986); Randy Barnett, The Sounds of silence: Default Rules and Contractual Consent, 78 Va. L
1 See Michael Trebilcock, THE LIMITS OF FREEDOM OF CONTRACT (1993). Autonomy theories thus require elastic notions of consent in order to regulate the full scope of contracting behavior with one norm. Peter Benson, Abstract Right and the Possibility of a Nondistributive Conception of Contract: Hegel and Contemporary Contract Theory, 10 Cardozo L. Rev. 1077 (1989); Peter Benson, Contract in A Companion to Philosophy of Law and Legal Theory, (Dennis Patterson ed., 1996); Peter Benson, The Idea of a Public Basis of Justification for Contract, 33 Osgoode Hall L. J. 273 (1995); Randy Barnett, A Consent Theory of Contract, 86 Colum. Rev. 269 (1986); Randy Barnett, The Sounds of Silence: Default Rules and Contractual Consent, 78 Va. L. 2 V. THE LEGAL DEFAULT PROJECT .......................................................................................59 A. The Case For Defaults ..................................................................................................61 B. The Cost Concern......................................................................................................... 63 1. Default Rules ............................................................................................................63 2. Default Standards ....................................................................................................67 C. The Asymmetric Information Concern ........................................................................70 D. Summary ......................................................................................................................73 VI. MANDATORY RULES .........................................................................................................75 A. Parties Cannot Ban Modifications.................................................................................76 B. Parties Must Accept Substantial Performance ..............................................................79 C. Parties Cannot Agree to Penalties .................................................................................81 VII. CONCLUSION ......................................................................................................................83 I. INTRODUCTION Contract law has neither a complete descriptive theory, explaining what the law is, nor a complete normative theory, explaining what the law should be. These gaps are unsurprising given the traditional definition of contract as embracing all promises that the law will enforce. Even a theory of contract law that focuses only on the enforcement of bargains must still consider the entire continuum from standard form contracts between firms and consumers to commercial contracts between business firms. No descriptive theory has yet explained a law of contract that comprehends such a broad domain. Normative theories that are grounded in a single norm -- such as autonomy or efficiency -- also have foundered over the heterogeneity of contractual contexts to which the theory is to apply.1 Pluralist theories attempt to respond to the difficulty that unitary
normative theories pose by urging courts to pursue efficiency, fairness, good faith and the protection of individual autonomy. Such theories need, but so far lack, a meta principle that tell which of these goals should be decisive when they conflict. We attempt to make progress here with a more modest approach--to set out and defend a normative theory to guide decisionmakers in the regulation of business contracts. 3 The theorys affirmative claim, in brief, is that contract law should facilitate the efforts of contracting parties to maximize the joint gains(the"contractual surplus")from transactions. The theorys negative claim is that contract law should do nothing else. Both claims follow from the premise that the state should choose the rules that regulate commercial transactions according to Rev. 821(1992). Efficiency theories tend to have a more limited scope. Positive articles analyze broad doctrinal patterns in the attempt to find fundamental consistency between these patterns and the efficiency norm, but the authors do not purport to provide a fully descriptive theory of contract law. See, e.g, Charles J. Goetz robert e Scott, Enforcing Promises: An Examination of the Basis of Contract, 89 Yale L J. 1261(1981): lan Ayres robert Gertner, Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules, 99 Yale L J 729(1989) Normative economic theories, on the other hand, typically evaluate discrete doctrines by the efficiency norm. See e.g., Charles J. Goetz and Robert E. Scott, Liquidated Damages, Penalties and the Just Compensation Principle, 77 Colum. L. Rev. 554(1977); Alan Schwartz, The Case for Specific Performance, 89 Yale. L J. 271(1979); Christine Jolls, Contracts as Bilateral Commitments: A New Perspective on Contract Modification, 26J Leg. Stud. 203 (1997); Robert E. Scott, The Case for Market Damages: Revisiting the Lost Profits Piccle, 57U Chi L Rev. 455 (1990) effort, tha he problems that pluralist theories without meta norms pose are nicely illustrated in Melvin ey ownure's purports to solve the" broad scope of contract problem "by proposing overlapping sets of norms. See Melvin A Eisenberg,, The Bargain Principle and its Limits, 95 Harv. L. Rev. 741(1982): Melvin A Eisenberg, The Theory of Contracts in THE THEORY OF CONTRACT LAW: NEW ESSAYS (Peter Benson ed 2000). For example, Eisenberg's schema restricts the domain of freedom of contract by norms of reciprocity, trust, and fairness He recognizes that this "multi-value" approach can generate conflicting social propositions. When conflicts actually occur,the lawmaker must make a legal rule that gives a proper weight and role to each of the conflicting values or goals in the context at hand. Further, when social propositions conflict, the legislature must exercise good judgment concerning the weight or role to give to each proposition in the issue at hand. Eisenberg, The Theory of Contracts at 243-44. Eisenberg recognizes that his theory lacks a metric that would tell the lawmaker just how to give the proper"weight and role " to each social proposition or value when conflicts occur. Since courts or legislatures are likely to be involved when the relevant social propositions or values arguably favor more than one party type or interest group, pluralist theories such as Eisenberg's tend to be least helpful when they are most needed 'In a thoughtful critique of autonomy and efficiency theories of contract, Michael Trebilcock concludes that both theory types are"valid in their own right, but without a"meta-theory that weights and ranks these various values", both values should be pursued in various social contexts according to the relative competency of different legal institutions to perform effectively. See Trebilcock, supra note l, at 248. This article takes up Trebilcock's invitation and proposes a normative theory that fits business contracts, the subsidiary category of contractual relationships that the law most affects
Rev. 821 (1992). Efficiency theories tend to have a more limited scope. Positive articles analyze broad doctrinal patterns in the attempt to find fundamental consistency between these patterns and the efficiency norm, but the authors do not purport to provide a fully descriptive theory of contract law. See, e.g., Charles J. Goetz & Robert E. Scott, Enforcing Promises: An Examination of the Basis of Contract, 89 Yale L. J. 1261 (1981); Ian Ayres & Robert Gertner, Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules, 99 Yale L. J. 729 (1989). Normative economic theories, on the other hand, typically evaluate discrete doctrines by the efficiency norm. See e.g., Charles J. Goetz and Robert E. Scott, Liquidated Damages, Penalties and the Just Compensation Principle, 77 Colum. L. Rev. 554 (1977); Alan Schwartz, The Case for Specific Performance, 89 Yale. L. J. 271 (1979); Christine Jolls, Contracts as Bilateral Commitments: A New Perspective on Contract Modification, 26 J. Leg. Stud. 203 (1997); Robert E. Scott, The Case for Market Damages: Revisiting the Lost Profits Puzzle, 57 U. Chi. L. Rev. 455 (1990). 2 The problems that pluralist theories without meta norms pose are nicely illustrated in Melvin Eisenberg’s effort, that purports to solve the “broad scope of contract problem” by proposing overlapping sets of norms. See Melvin A. Eisenberg,, The Bargain Principle and its Limits, 95 Harv. L. Rev. 741 (1982); Melvin A. Eisenberg, The Theory of Contracts in THE THEORY OF CONTRACT LAW: NEW ESSAYS (Peter Benson ed. 2000). For example, Eisenberg’s schema restricts the domain of freedom of contract by norms of reciprocity, trust, and fairness. He recognizes that this “multi-value” approach can generate conflicting social propositions. When conflicts actually occur, “the lawmaker must make a legal rule that gives a proper weight and role to each of the conflicting values or goals in the context at hand.” Further, “when social propositions conflict, the legislature must exercise good judgment concerning the weight or role to give to each proposition in the issue at hand.” Eisenberg, The Theory of Contracts at 243-44. Eisenberg recognizes that his theory lacks a metric that would tell the lawmaker just how to give the proper “weight and role” to each social proposition or value when conflicts occur. Since courts or legislatures are likely to be involved when the relevant social propositions or values arguably favor more than one party type or interest group, pluralist theories such as Eisenberg’s tend to be least helpful when they are most needed. 3 In a thoughtful critique of autonomy and efficiency theories of contract, Michael Trebilcock concludes that both theory types are “valid in their own right”, but without a “meta-theory that weights and ranks these various values”, both values should be pursued in various social contexts according to the relative competency of different legal institutions to perform effectively. See Trebilcock, supra note 1, at 248. This article takes up Trebilcock’s invitation and proposes a normative theory that fits business contracts, the subsidiary category of contractual relationships that the law most affects. 3 normative theories pose by urging courts to pursue efficiency, fairness, good faith and the protection of individual autonomy. Such theories need, but so far lack, a meta principle that tells which of these goals should be decisive when they conflict.2 We attempt to make progress here with a more modest approach -- to set out and defend a normative theory to guide decisionmakers in the regulation of business contracts.3 The theory’s affirmative claim, in brief, is that contract law should facilitate the efforts of contracting parties to maximize the joint gains (the “contractual surplus”) from transactions. The theory’s negative claim is that contract law should do nothing else. Both claims follow from the premise that the state should choose the rules that regulate commercial transactions according to
the criterion of welfare maximization A simple categorization of the universe of bargaining transactions will clarify the domain of our theory. a transaction involves a seller(whether of goods or services)and a buyer. Parties to transactions can be partitioned into individuals and firms. This yields four transactional categories: (1)A firm sells to another firm; (2) An individual sells to another individual; (3)A firm sells to an individual; and(4) An individual sells to a firm. Category 2 contracts, between individuals are ily regulated by family law(antenuptial agreements an settlements)and real property law(home sales and some leases). Few litigated contracts between individuals are regulated by the rules of contract law. Category 3 contracts, between a firm as seller and an individual as buyer, are primarily regulated by consumer protection law, real seller and a firm as buyer, commonly involve the sale of a persons labor, and are regulated by %o property law(most leases)and the securities laws. Category 4 contracts, between an individual laws governing the employment relation. The rules in Article 2 of the Uniform Commercial Code and the provisions of the Restatement(Second)of Contracts constitute what commonly is meant by contract law. These provisions are primarily invoked to resolve disputes arising under Category 1 contracts, between firms. Our theory applies only to these contracts, and thus has important implications for the content of the UCC and the common law of contracts Category 1 contracts, however, can be partitioned into two subcategories. Some parties obviously are sophisticated economic actors (i.e, the General Electric Corporation). Other parties function in commercial contexts but have many of the characteristics of ordinary persons(i.e,a gift shop owned and run by a retired teacher). Any effort to analyze contracts between"firms thus confronts a boundary issue -to define a firm for purposes of the theory. We draw this oundary here by defining a Category I firm as(a)an entity that is organized in the corporate form and that has five or more employees; (b)a limited partnership; and(c)a professional partnership such as a law or accounting firm. These economic entities apparently understand how to make business contracts, and the theory we develop here applies only to contracts between two such firms. The extent to which this Article's conclusions hold when one or both of the parties to a commercial contract falls on the other side of our boundary awaits further work 4
4 the criterion of welfare maximization. A simple categorization of the universe of bargaining transactions will clarify the domain of our theory. A transaction involves a seller (whether of goods or services) and a buyer. Parties to transactions can be partitioned into individuals and firms. This yields four transactional categories: (1) A firm sells to another firm; (2) An individual sells to another individual; (3) A firm sells to an individual; and (4) An individual sells to a firm. Category 2 contracts, between individuals, are primarily regulated by family law (antenuptial agreements and divorce settlements) and real property law (home sales and some leases). Few litigated contracts between individuals are regulated by the rules of contract law. Category 3 contracts, between a firm as seller and an individual as buyer, are primarily regulated by consumer protection law, real property law (most leases) and the securities laws. Category 4 contracts, between an individual as seller and a firm as buyer, commonly involve the sale of a person’s labor, and are regulated by laws governing the employment relation. The rules in Article 2 of the Uniform Commercial Code and the provisions of the Restatement (Second) of Contracts constitute what commonly is meant by contract law. These provisions are primarily invoked to resolve disputes arising under Category 1 contracts, between firms. Our theory applies only to these contracts, and thus has important implications for the content of the UCC and the common law of contracts. Category 1 contracts, however, can be partitioned into two subcategories. Some parties obviously are sophisticated economic actors (i.e., the General Electric Corporation). Other parties function in commercial contexts but have many of the characteristics of ordinary persons(i.e., a gift shop owned and run by a retired teacher). Any effort to analyze contracts between “firms” thus confronts a boundary issue – to define a firm for purposes of the theory. We draw this boundary here by defining a Category 1 firm as (a) an entity that is organized in the corporate form and that has five or more employees; (b) a limited partnership; and (c) a professional partnership such as a law or accounting firm. These economic entities apparently understand how to make business contracts, and the theory we develop here applies only to contracts between two such firms. The extent to which this Article’s conclusions hold when one or both of the parties to a commercial contract falls on the other side of our boundary awaits further work