Firms that maximize profits face the canonical"contracting problem"of ensuring both efficient ex post trade and efficient ex ante investment in the subject matter of the contract Parties trade efficiently when, and only when, the value of the exchanged performance to the buyer exceeds the cost of performance to the seller. Parties invest efficiently when their actions maximize a deals expected surplus. Many observers would agree that contract law should attempt to facilitate efficient trade and investment. The novelty of our theory lies in its systematic development of the implications of this goal and in its claim that contract law should restrict itself to the pursuit of efficiency alone(for Category I contracts Four objections may be made to the claim that contract law should restrict itself to encouraging efficient trade and investment. First, one can argue that firms sometimes do not maximize profits and, owing to the systematic cognitive errors made by the people who run them, are incapable of doing so should they try. Thus, a law that presupposes profit maximization will be misguided. Second, firms that maximize profits sometimes do bad things- pollute the environment, for example -- that the law should attempt to deter. Third, the state should promote fairness in contracting in addition to efficiency. And, finally, the state should pursue distributional goals although they sometimes conflict with efficiency These objections should trouble a unitary efficiency approach to the regulation of all contract types, but we will argue that the objections have little force when Category I contracts alone are considered. Thus we will argue. firms and markets are structured so as to minimize the likelihood of systematic cognitive error by important decisionmakers within the firm. Cognitive error, that is, is more likely to afflict Category 2 and 3 contracts than Category 1 contracts Further, the bad things that firms do commonly entail imposing costs on third parties, such as creating environmental harms or erecting barriers to entry. These behaviors-the creation of negative externalities-are regulated by the environmental and antitrust laws. A contract law as such therefore can assume the absence of externalities. Finally, it usually is futile Legal scholars commonly refer to investment in the contracts subject matter as "reliance". We use reliance and the economists term"investment" interchangeably
4 Legal scholars commonly refer to investment in the contract’s subject matter as “reliance”. We use reliance and the economist’s term “investment” interchangeably. 5 Firms that maximize profits face the canonical “contracting problem” of ensuring both efficient ex post trade and efficient ex ante investment in the subject matter of the contract.4 Parties trade efficiently when, and only when, the value of the exchanged performance to the buyer exceeds the cost of performance to the seller. Parties invest efficiently when their actions maximize a deal’s expected surplus. Many observers would agree that contract law should attempt to facilitate efficient trade and investment. The novelty of our theory lies in its systematic development of the implications of this goal and in its claim that contract law should restrict itself to the pursuit of efficiency alone (for Category 1 contracts). Four objections may be made to the claim that contract law should restrict itself to encouraging efficient trade and investment. First, one can argue that firms sometimes do not maximize profits and, owing to the systematic cognitive errors made by the people who run them, are incapable of doing so should they try. Thus, a law that presupposes profit maximization will be misguided. Second, firms that maximize profits sometimes do bad things – pollute the environment , for example -- that the law should attempt to deter. Third, the state should promote fairness in contracting in addition to efficiency. And, finally, the state should pursue distributional goals although they sometimes conflict with efficiency. These objections should trouble a unitary efficiency approach to the regulation of all contract types, but we will argue that the objections have little force when Category 1 contracts alone are considered. Thus, we will argue, firms and markets are structured so as to minimize the likelihood of systematic cognitive error by important decisionmakers within the firm. Cognitive error, that is, is more likely to afflict Category 2 and 3 contracts than Category 1 contracts. Further, the bad things that firms do commonly entail imposing costs on third parties, such as creating environmental harms or erecting barriers to entry. These behaviors – the creation of negative externalities – are regulated by the environmental and antitrust laws. An analysis of contract law as such therefore can assume the absence of externalities. Finally, it usually is futile
pursue contractual fairness when firms are permitted a large measure of contractual freede This is because firms will contract away from fair legal rules that do not maximize joint surplu In sum, efficiency is the only institutionally feasible and normatively attractive goal for a contract law that regulates deals between firms .S An efficiency theory restricted to contracts between firms(as firms are defined above)has four major implications for contract law. To understand the first implication, realize that contracts often would be performed even if there were no legal sanction for breach. These contracts are"self-enforcing"in two senses. First, when parties contemplate making a series of contracts, neither party would breach an early contract if the gains from one breach are lower than the expected profit stream from future contracts that breach would cause to vanish. Second neither party will breach if the gains are exceeded by the reputational sanction the market will exact. When contracts fall outside the self-enforcing range, legal enforcement is necessary to erformance in two principal cases: in volatile markets, when a partys failure to perform could threaten its contract partners survival; and when contractual surplus would be maximized if one or both parties made relation-specific investments. Enforcement"includes more than simply requiring parties to perform, however. The enforcement function comprises policing contracts for fraud and duress, and the congeries of rules that encourage or facilitate performance such as the damage rules. Perhaps a third of the sections in UCC Article 2 are enforcement rules under the definition here. The initial implication of our theory is that enforcement, when needed, is much the most important thing the state does. Put more starkly, a modern commercial economy As another example of the criticism that we sidestep here, Professor Melvin Eisenberg has criticized theories holding that contract law should maximize welfare alone on the ground that"these theories are impoverished. because they exclude other important policy values, such as the value of keeping intimate and affective relationships free from the intrusion of state power". Melvin A. Eisenberg, The Theory of Contracts, in THE THEORY OF CONTRACT LAW: NEW ESSAYS 206, 238( Peter Benson, Ed 2000). This objection may have force as applied to Category 2 contracts, between persons, but seems irrelevant to the Category I contracts we analyze. Thus, contracts between General Electric and General Motors seem not to involve"intimate and affective A relation-specific investment is not fully"redeployable". As an example, assume that a seller purchases standard steel tubes to make a machine for the buyer. The seller's investment would be"general"if breach occurred before the seller began work on the tubes because the tubes could be resold on the market. The investment would become"relation specific"if breach occurred after the tubes had been fabricated into shapes that only the buy could use, for then the transmuted tubes could only be resold as scrap, probably for less than their cost 6
5 As another example of the criticism that we sidestep here, Professor Melvin Eisenberg has criticized theories holding that contract law should maximize welfare alone on the ground that “these theories are impoverished ... because they exclude other important policy values, such as the value of keeping intimate and affective relationships free from the intrusion of state power”. Melvin A. Eisenberg,The Theory of Contracts, in THE THEORY OF CONTRACT LAW: NEW ESSAYS 206, 238 (Peter Benson, Ed. 2000). This objection may have force as applied to Category 2 contracts, between persons, but seems irrelevant to the Category 1 contracts we analyze. Thus, contracts between General Electric and General Motors seem not to involve “intimate and affective relationships.” 6 A relation-specific investment is not fully “redeployable”. As an example, assume that a seller purchases standard steel tubes to make a machine for the buyer. The seller’s investment would be “general” if breach occurred before the seller began work on the tubes because the tubes could be resold on the market. The investment would become “relation specific” if breach occurred after the tubes had been fabricated into shapes that only the buyer could use; for then the transmuted tubes could only be resold as scrap, probably for less than their cost. 6 to pursue contractual fairness when firms are permitted a large measure of contractual freedom. This is because firms will contract away from fair legal rules that do not maximize joint surplus. In sum, efficiency is the only institutionally feasible and normatively attractive goal for a contract law that regulates deals between firms.5 An efficiency theory restricted to contracts between firms (as firms are defined above) has four major implications for contract law. To understand the first implication, realize that contracts often would be performed even if there were no legal sanction for breach. These contracts are “self-enforcing” in two senses. First, when parties contemplate making a series of contracts, neither party would breach an early contract if the gains from one breach are lower than the expected profit stream from future contracts that breach would cause to vanish. Second, neither party will breach if the gains are exceeded by the reputational sanction the market will exact. When contracts fall outside the self-enforcing range, legal enforcement is necessary to ensure performance in two principal cases: in volatile markets, when a party’s failure to perform could threaten its contract partner’s survival; and when contractual surplus would be maximized if one or both parties made relation-specific investments.6 “Enforcement” includes more than simply requiring parties to perform, however. The enforcement function comprises policing contracts for fraud and duress, and the congeries of rules that encourage or facilitate performance, such as the damage rules. Perhaps a third of the sections in UCC Article 2 are enforcement rules under the definition here. The initial implication of our theory is that enforcement, when needed, is much the most important thing the state does. Put more starkly, a modern commercial economy
can function well with little more than honest courts and a set of enforcement rules The rest is of second-order importance A court cannot enforce contracts, however, without a theory of interpretation that"maps from the syntactic content of the parties' writing to the writings legal implications. An interpretive theory that is grounded in efficiency holds, in contrast to the UCC and much modern scholarship, that textualist interpretations best suit parties to Category 1 contracts. Business firms, that is, prefer courts to adhere as closely as is possible to the ordinary meanings of the words the parties used, apply a hard parol evidence rule, and honor merger clauses" reciting that the parties intended their writing to be interpreted as if it were complete. a textualist theory of interpretation, however, will not suit all parties all of the time. Therefore, our second implication actually holds that textualist interpretation should be the default theory for Category 1 contracts. Courts should use narrow evidentiary bases when interpreting agreements between firms, but also should comply with party requests to broaden the base that is applicable to them This implication is at variance with current law, which holds that interpretation is an issue for courts to decide and is conducted according to rules that parties cannot vary Contract law has more rules than are needed to perform the enforcement and interpretation functions. These rules, that regulate various aspects of the contracting relationship, commonly are defaults, controlling only when parties do not contract out. Creating good defaults is widely believed to be the principal function of a law of contracts. This belief is misguided because the state could create defaults that business firms would want only under quite stringent conditions a good default rule must apply in very few possible states of the world, be relatively simple in courts cannot conveniently recover. a default standard should be written when parties do ny E form, be efficient in a highly heterogenous set of circumstances, and not rely on information that See TA?A"hard" parol evidence rule treats writings that appear to be complete contracts as complete contracts SThe decisionmaker specifies the content of a rule in advance. Thus, drivers cannot exceed a 55 mile per hour speed limit. The decisionmaker specifies the content of a standard ex post. Thus, parties must drive reasonably"in the circumstances
7 A “hard” parol evidence rule treats writings that appear to be complete contracts as complete contracts. See TAN 81-89, infra. 8 The decisionmaker specifies the content of a rule in advance. Thus, drivers cannot exceed a 55 mile per hour speed limit. The decisionmaker specifies the content of a standard ex post. Thus, parties must drive “reasonably” in the circumstances. 7 can function well with little more than honest courts and a set of enforcement rules. The rest is of second-order importance. A court cannot enforce contracts, however, without a theory of interpretation that “maps” from the syntactic content of the parties’ writing to the writing’s legal implications. An interpretive theory that is grounded in efficiency holds, in contrast to the UCC and much modern scholarship, that textualist interpretations best suit parties to Category 1 contracts. Business firms, that is, prefer courts to adhere as closely as is possible to the ordinary meanings of the words the parties used, apply a “hard” parol evidence rule,7 and honor “merger clauses” reciting that the parties intended their writing to be interpreted as if it were complete. A textualist theory of interpretation, however, will not suit all parties all of the time. Therefore, our second implication actually holds that textualist interpretation should be the default theory for Category 1 contracts. Courts should use narrow evidentiary bases when interpreting agreements between firms, but also should comply with party requests to broaden the base that is applicable to them. This implication is at variance with current law, which holds that interpretation is an issue for courts to decide and is conducted according to rules that parties cannot vary. Contract law has more rules than are needed to perform the enforcement and interpretation functions. These rules, that regulate various aspects of the contracting relationship, commonly are defaults, controlling only when parties do not contract out. Creating good defaults is widely believed to be the principal function of a law of contracts. This belief is misguided because the state could create defaults that business firms would want only under quite stringent conditions. A good default rule8 must apply in very few possible states of the world, be relatively simple in form, be efficient in a highly heterogenous set of circumstances, and not rely on information that courts cannot conveniently recover. A default standard should be written when parties do not
need, or it is too costly to provide them with, concrete guidance regarding the perfor bligation. Because standards permit parties much latitude(the seller must deliver in a reasonable" time), a good standard will confer discretion only when a party's likely actions under it will maximize joint rather than individual gains. Statutory drafters and courts, we will argue, often adopt default rules and standards that fail to satisfy these stringent conditions. This is itself inefficient because parties respond to bad rules or standards by contracting out of them. The creation of inefficient defaults thus raises business parties' contracting costs but does not otherwise affect their behavior. Our theory s third implication holds, in consequence, that the effective domain of business contract law is much smaller than is commonly thought. Another way to put this point is that the difficulty of creating good defaults makes much of what today is called contract law irrelevant to commercial lif In addition to the many defaults, contract law contains a number of mandatory rules that are applied to contracts between firms as well as to contracts between firms and persons. The fourth implication of our efficiency theory is that many of the rules regulating business contracts should not be mandatory. We discuss a number of mandatory rules, including the interpretation rules, the modification rules and the rules relating to liquidated damage clauses. The justification for these rules apparently is a form of paternalism. The contract terms the rules override do not create externalities and are not unconscionable. Rather, contract law overrides terms that appear to decision makers to conflict with the parties true substantive intentions. We argue, to the contrary, that business firms have good reasons to adopt the terms that today are prohibited, and that a commitment to party sovereignty requires those reasons to be respected There are several reasons why an attempt to develop a general efficiency theory of business contracts is particularly salient now. First, the specification of a good contract law has become an important priority in many countries as they have made a commitment to markets. It is a consensus that a good contract law is a necessary condition for a modern commercial economy. It is less well understood just how such a law is supposed to function. Our article thus attempts to address concerns that have global implications
8 need, or it is too costly to provide them with, concrete guidance regarding the performance obligation. Because standards permit parties much latitude (the seller must deliver in a “reasonable” time), a good standard will confer discretion only when a party’s likely actions under it will maximize joint rather than individual gains. Statutory drafters and courts, we will argue, often adopt default rules and standards that fail to satisfy these stringent conditions. This is itself inefficient because parties respond to bad rules or standards by contracting out of them. The creation of inefficient defaults thus raises business parties’ contracting costs but does not otherwise affect their behavior. Our theory’s third implication holds, in consequence, that the effective domain of business contract law is much smaller than is commonly thought. Another way to put this point is that the difficulty of creating good defaults makes much of what today is called contract law irrelevant to commercial life. In addition to the many defaults, contract law contains a number of mandatory rules that are applied to contracts between firms as well as to contracts between firms and persons. The fourth implication of our efficiency theory is that many of the rules regulating business contracts should not be mandatory. We discuss a number of mandatory rules, including the interpretation rules, the modification rules and the rules relating to liquidated damage clauses. The justification for these rules apparently is a form of paternalism. The contract terms the rules override do not create externalities and are not unconscionable. Rather, contract law overrides terms that appear to decision makers to conflict with the parties true substantive intentions. We argue, to the contrary, that business firms have good reasons to adopt the terms that today are prohibited, and that a commitment to party sovereignty requires those reasons to be respected. There are several reasons why an attempt to develop a general efficiency theory of business contracts is particularly salient now. First, the specification of a good contract law has become an important priority in many countries as they have made a commitment to markets. It is a consensus that a good contract law is a necessary condition for a modern commercial economy. It is less well understood just how such a law is supposed to function. Our article thus attempts to address concerns that have global implications
A further reason motivating our decision to develop a theory of business contracts is that the building blocks for such a theory are only now becoming available. Contract theory has become one of the most significant fields in modern micro and industrial organization economics Three recent Nobel prizes, to George Akerloff, Michael Spence and Joseph Stiglitz, were awarded argely for work in contract theory, but the field itself is less than thirty years old. Moreover, much of the work in the field takes a mathematical form, and thus has not been easily accessible to nonspecialists. We draw heavily on contract theory to construct our normative theory of contracts. o Finally, as we suggested earlier, the current state of contract law scholarship suffers from the absence of a successful theory of contract. Thirty years ago, Grant Gilmore described what he called the classic willistonian model of contract law, a model grounded in formalist notions of the centrality of written agreements voluntarily exchanged between contracting parties, and that emphasized the limited role of the law in enforcing and interpreting these agreements According to Gilmore, this classical model owed more to Holmes imagination than to a careful reading of the case law. 2 But whether this was so or not, Gilmore believed that the modern case law repudiated the model. The disjunction between the dominant scholarly view and the lived 9The work of these scholars is concisely summarized in Karl-Gustaf Lofgren, Torsten Perssons and Jorgen Weibull, Markets with Asymmetric Information: The Contributions of George Akerlof, Michael Spence and Joseph Stiglitz, 104 Scan. J. Econ. 195(2002) Law and economics scholars such as Aaron Edlin, lan Ayres and Jason Johnston have used contract theory in illuminating fashion when discussing particular legal rules. See, e.g., lan Ayres robert Gertner, Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules, 99 Yale L J 729(1989);Jason Johnston, Strategic Bargaining and the Economic Theory of Contract Default Rules, 100 Yale L.J. 615(1990). Aaron Edlin, Cadillac Contracts and Upfront Payments: Efficient Investment Under Expectation Damages, 12 J. L Econ. Org 98(1996). The genre of model that we and these scholars use has performed well in empirical tests. See P.A. Chiappori and B. Salanie, Testing Contract Theory: A Survey of some Recent Empirical Work, Working Pap #2002-11, Institut National De La Statistique Et Des Etudes Economiques(2002) IGRANT GILMORE, THE DEATH OF CONTRACT(1974) 12 The theory of contract, as formulated by Holmes and Williston, seems to have gone into its protracted period of breakdown almost from the moment of its birth"Id at 57. But see, Richard E. Speidel, An Essay on the Reported Death and Continued vitality of Contract, 27 Stan. L. Rev. 1161(1975)
9 The work of these scholars is concisely summarized in Karl-Gustaf Lofgren, Torsten Perssons and Jorgen Weibull, Markets with Asymmetric Information: The Contributions of George Akerlof, Michael Spence and Joseph Stiglitz, 104 Scan. J. Econ. 195 (2002). 10Law and economics scholars such as Aaron Edlin, Ian Ayres and Jason Johnston have used contract theory in illuminating fashion when discussing particular legal rules. See, e.g., Ian Ayres & Robert Gertner, Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules, 99 Yale L. J. 729 (1989); Jason Johnston, Strategic Bargaining and the Economic Theory of Contract Default Rules, 100 Yale L. J. 615 (1990). Aaron Edlin, Cadillac Contracts and Upfront Payments: Efficient Investment Under Expectation Damages, 12 J. L. Econ. & Org. 98 (1996). The genre of model that we and these scholars use has performed well in empirical tests. See P. A. Chiappori and B. Salanie, Testing Contract Theory: A Survey of Some Recent Empirical Work, Working Paper #2002-11, Institut National De La Statistique Et Des Etudes Economiques (2002). 11GRANT GILMORE, THE DEATH OF CONTRACT (1974). 12“The theory of contract, as formulated by Holmes and Williston, seems to have gone into its protracted period of breakdown almost from the moment of its birth” Id. at 57. But see, Richard E. Speidel, An Essay on the Reported Death and Continued Vitality of Contract, 27 Stan. L. Rev. 1161 (1975). 9 A further reason motivating our decision to develop a theory of business contracts is that the building blocks for such a theory are only now becoming available. Contract theory has become one of the most significant fields in modern micro and industrial organization economics. Three recent Nobel prizes, to George Akerloff, Michael Spence and Joseph Stiglitz, were awarded largely for work in contract theory, but the field itself is less than thirty years old.9 Moreover, much of the work in the field takes a mathematical form, and thus has not been easily accessible to nonspecialists. We draw heavily on contract theory to construct our normative theory of contracts.10 Finally, as we suggested earlier, the current state of contract law scholarship suffers from the absence of a successful theory of contract. Thirty years ago, Grant Gilmore described what he called the classic Willistonian model of contract law, a model grounded in formalist notions of the centrality of written agreements voluntarily exchanged between contracting parties, and that emphasized the limited role of the law in enforcing and interpreting these agreements.11 According to Gilmore, this classical model owed more to Holmes’ imagination than to a careful reading of the case law.12 But whether this was so or not, Gilmore believed that the modern case law repudiated the model. The disjunction between the dominant scholarly view and the lived