doctrine, he thought, produced incoherence. Modern scholars commonly share Gilmores rejection of williston but have yet to disprove his incoherence thesis. 4+ We, too, lack a theory of everything. Rather, the theory we develop here is Willistonian in spirit, but applies in a limited domain - to contracts between firms that do not create externalities This limited scope permits our normative thesis to develop according to a particular logic The markets social function is to maximize welfare, subject to distributional and fairness constraints. Firms, we show below, have incentives to choose the contracts and contracting trategies that will maximize the surplus their deals can create. Further, firms are more able than courts or statutory drafters at choosing efficient terms and strategies. It follows that, when externalities are absent. a contract law that regulates firms should be the contract law that firms prefer. The state, that is, should let the preferences of firms control because firms can pursue the objective that both the state and firms share. The central organizing question this Article asks thus is: What contract law would commercial parties want the state to provide? We proceed as follows. Part ii defends the welfare maximization norm as applied to the contracts of sophisticated actors. In Part Ill, we describe commercial parties' first order preference: To have the state enforce contracts in order to protect relation-specific investments or to guard against especially disruptive market movements. Part IV argues that firms want the state to supply a theory of interpretation, but not the theory currently advanced by the UCc and the Restatement of Contracts. Rather, we defend a textualist theory of interpretation as the optimal default approach for business contracts. In Part V, we develop the restrictive conditions under which the state can create defaults terms that satisfy typical party preferences. Part Vi analyzes a set of unjustifiable mandatory rules--rules that rest on a misplaced view of the parties'interests We conclude, in Part VIl, that today s contract law is a series of category mistakes. Rules that are Consider the Restatements definition of consideration [in $75] taken in connection with its most celebrated section, $ 90(promissory estoppel). One thing that is clear is that these two contradictory proposition cannot live comfortably together: in the end one must swallow the other up. Id at 60-61 Eric A. Posner, Economic Analysis of contract Law after Three Decades: Success or Failure? Yale LJ(2002)
13“Consider the Restatement’s definition of consideration [in §75] taken in connection with its most celebrated section, § 90 (promissory estoppel)...One thing that is clear is that these two contradictory propositions cannot live comfortably together: in the end one must swallow the other up.” Id. at 60-61. 14Eric A. Posner, Economic Analysis of Contract Law after Three Decades: Success or Failure? Yale L.J.(2002). 10 doctrine, he thought, produced incoherence.13 Modern scholars commonly share Gilmore’s rejection of Williston but have yet to disprove his incoherence thesis.14 We, too, lack a theory of everything. Rather, the theory we develop here is Willistonian in spirit, but applies in a limited domain -- to contracts between firms that do not create externalities. This limited scope permits our normative thesis to develop according to a particular logic. The market’s social function is to maximize welfare, subject to distributional and fairness constraints. Firms, we show below, have incentives to choose the contracts and contracting strategies that will maximize the surplus their deals can create. Further, firms are more able than courts or statutory drafters at choosing efficient terms and strategies. It follows that, when externalities are absent, a contract law that regulates firms should be the contract law that firms prefer. The state, that is, should let the preferences of firms control because firms can better pursue the objective that both the state and firms share. The central organizing question this Article asks thus is: What contract law would commercial parties want the state to provide? We proceed as follows. Part II defends the welfare maximization norm as applied to the contracts of sophisticated actors. In Part III, we describe commercial parties’ first order preference: To have the state enforce contracts in order to protect relation-specific investments or to guard against especially disruptive market movements. Part IV argues that firms want the state to supply a theory of interpretation, but not the theory currently advanced by the UCC and the Restatement of Contracts. Rather, we defend a textualist theory of interpretation as the optimal default approach for business contracts. In Part V, we develop the restrictive conditions under which the state can create defaults terms that satisfy typical party preferences. Part VI analyzes a set of unjustifiable mandatory rules -- rules that rest on a misplaced view of the parties’ interests. We conclude, in Part VII, that today’s contract law is a series of category mistakes. Rules that are
appropriate for contracts involving individuals( Categories 2 through 4 above)are too frequently applied today within the domain in which sophisticated parties function. Another way to put this conclusion is to remark that commercial law for centuries has drawn a distinction between mercantile contracts and others. Modern scholars have not systematically pursued the normative implications of this ancient distinction, however. We attempt to cure this neglect by setting out the theoretical foundations of a law merchant for our time IL. JUSTIFYING AN EFFICIENCY THEORY OF CONTRACT A. What Firms maximize It had been traditional to assume that firms attempt to maximize expected profits. The accuracy of this assumption recently has been challenged. An economic actor may not maximize wealth for two reasons: (a)She is maximizing something other than her own wealth, perhaps because she is concerned with fairness; (b) She cannot maximize wealth in the context under study, perhaps because she is prone to cognitive error. These reasons apply much less to firms than to persons. A firm is directed by its owners, who often are shareholders. Shareholders prefer their firms to maximize profits that the shareholders then can consume or save. Firms thus will choose to maximize profits unless the managers who run them cannot be controlled by the shareholders who own them. In these cases, the managers may be maximizing their own earnings or perks at the expense of profit maximization No one doubts that managers sometimes successfully sabotage owners, but for two reasons we will assume here that managers obey shareholder instructions. First, managers Vestiges of this distinction exist in the few Uniform Commercial Code sections that regulate deals between merchants" differently than deals between a merchant and a person. See, e.g., UCC $$ 2-104(3), 2-201(2) 2-207(2),2-209(2),2-603,and2-609(2) IIndividuals are assumed to be risk averse while firms are assumed to be risk neutral. The utility function of a risk neutral party is linear in money: that is, the party values each additional dollar of wealth it may receive as much as it valued all previous dollars. Because monetary gains are coextensive with utility gains for risk neutra arties,we assume that firms maximize profits, a monetary measure 11
15Vestiges of this distinction exist in the few Uniform Commercial Code sections that regulate deals “between merchants” differently than deals between a merchant and a person. See, e.g., UCC §§ 2-104(3), 2-201(2), 2-207(2), 2-209(2), 2-603, and 2-609(2). 16Individuals are assumed to be risk averse while firms are assumed to be risk neutral. The utility function of a risk neutral party is linear in money: that is, the party values each additional dollar of wealth it may receive as much as it valued all previous dollars. Because monetary gains are coextensive with utility gains for risk neutral parties, we assume that firms maximize profits, a monetary measure. 11 appropriate for contracts involving individuals (Categories 2 through 4 above) are too frequently applied today within the domain in which sophisticated parties function. Another way to put this conclusion is to remark that commercial law for centuries has drawn a distinction between mercantile contracts and others.15 Modern scholars have not systematically pursued the normative implications of this ancient distinction, however. We attempt to cure this neglect by setting out the theoretical foundations of a law merchant for our time II. JUSTIFYING AN EFFICIENCY THEORY OF CONTRACT A. What Firms Maximize It had been traditional to assume that firms attempt to maximize expected profits. The accuracy of this assumption recently has been challenged. An economic actor may not maximize wealth16 for two reasons: (a) She is maximizing something other than her own wealth, perhaps because she is concerned with fairness; (b) She cannot maximize wealth in the context under study, perhaps because she is prone to cognitive error. These reasons apply much less to firms than to persons. A firm is directed by its owners, who often are shareholders. Shareholders prefer their firms to maximize profits that the shareholders then can consume or save. Firms thus will choose to maximize profits unless the managers who run them cannot be controlled by the shareholders who own them. In these cases, the managers may be maximizing their own earnings or perks at the expense of profit maximization. No one doubts that managers sometimes successfully sabotage owners, but for two reasons we will assume here that managers obey shareholder instructions. First, managers
sabotage shareholders either by diverting corporate wealth to themselves or by failing to take appropriate risks on behalf of the firm. Managers, however, have no incentive to degrade the quality of the contracts that they do write, after all, these contracts create the wealth that the managers later can divert. Second, the legal rules that attempt to deter bad manager behavior fall in the domains of the criminal, corporate and securities laws. Contract law should exploit this pecialization by assuming that the agreements it regulates reflect the parties' maximizing choices Firms that attempt to maximize expected profits commonly do as well as their circumstances permit. This is because survivorship pressures tend to induce competence. These pressures take two forms: (i) Firms that systematically make bad economic decisions lose out in competition with profit maximizing firms. Hence, surviving firms generally can do what they set out to do; (ii Employees who systematically make bad economic decisions are unlikely to be promoted to positions of responsibility. Hence, senior managers generally can do what they set out to do. This is not to say that all firms all the time pursue profit maximizing strategies. But it is to say that owners and the market put systematic pressure on firms to behave optimally, hence, it is a plausible working assumption that firms rationally pursue the objective of maximizing profits 18 In addition, many corporate executives have attended business school and also attend business school executive programs for working managers. It is a function of business education to teach people to make optimizing rather than cognitively erroneous)decisions experi.Psychologists and economists have shown that persons make systematic cognitive mistakes in laboratory experiments when asked to solve specified individual decision problems. These experiments do not test a general theory of how people make decisions, and thus they raise an issue of extemal validity: it is an open question whether, or when, real world parties will behave as did the experimental subjects. Two scholars recently noted a consequence of this"lack of theoretical foundations":"the policy implications of BE [behavioral economics] are limited by its inability to predict circumstances in which anomalous behavior will arise(other than in those sorts of circumstances in which it has been observed before)or how it will respond to policy changes". Jessica L. Cohen and William T. Dickens, A Foundation for Behavioral Economics 92 Amer. Econ. Rev. 335 (2002). For recent, exhaustive analyses of the psychological literature and a skeptical view of its relevance for the law see Gregory Mitchell, Taking Behavioralism Too Serious/y? The Warranted Pessimism of the New Behavorial Analysis of law, 43 William and Mary L Rev. 1907(2002), Gregory Mitchell, Why Law and Economics'Perfect Rationality Should Not be Traded for Behavioral Law and Economics Equal Incompetency, 91 Geo. L J.(2002) First,as we are in a world of speculation, we speculate that individuals in laboratories maypera ct for three reasons We provisionally view the individual decision experiments as not relevant to our proje officers of firms because the experimental subjects had not been trained to make good decisions and were not subject
17In addition, many corporate executives have attended business school and also attend business school executive programs for working managers. It is a function of business education to teach people to make optimizing (rather than cognitively erroneous) decisions. 18Psychologists and economists have shown that persons make systematic cognitive mistakes in laboratory experiments when asked to solve specified individual decision problems. These experiments do not test a general theory of how people make decisions, and thus they raise an issue of external validity: it is an open question whether, or when, real world parties will behave as did the experimental subjects. Two scholars recently noted a consequence of this “lack of theoretical foundations”: “the policy implications of BE [behavioral economics] are limited by its inability to predict circumstances in which anomalous behavior will arise (other than in those sorts of circumstances in which it has been observed before) or how it will respond to policy changes”. Jessica L. Cohen and William T. Dickens, A Foundation for Behavioral Economics 92 Amer. Econ. Rev. 335 (2002). For recent, exhaustive analyses of the psychological literature and a skeptical view of its relevance for the law see Gregory Mitchell, Taking Behavioralism Too Seriously? The Unwarranted Pessimism of the New Behavorial Analysis of Law, 43 William and Mary L. Rev. 1907 (2002); Gregory Mitchell, Why Law and Economics’ Perfect Rationality Should Not be Traded for Behavioral Law and Economics Equal Incompetency, 91 Geo. L. J. ___ (2002). We provisionally view the individual decision experiments as not relevant to our project for three reasons. First, as we are in a world of speculation, we speculate that individuals in laboratories may perform worse than officers of firms because the experimental subjects had not been trained to make good decisions and were not subject 12 sabotage shareholders either by diverting corporate wealth to themselves or by failing to take appropriate risks on behalf of the firm. Managers, however, have no incentive to degrade the quality of the contracts that they do write; after all, these contracts create the wealth that the managers later can divert. Second, the legal rules that attempt to deter bad manager behavior fall in the domains of the criminal, corporate and securities laws. Contract law should exploit this specialization by assuming that the agreements it regulates reflect the parties’ maximizing choices. Firms that attempt to maximize expected profits commonly do as well as their circumstances permit. This is because survivorship pressures tend to induce competence. These pressures take two forms: (i) Firms that systematically make bad economic decisions lose out in competition with profit maximizing firms. Hence, surviving firms generally can do what they set out to do; (ii) Employees who systematically make bad economic decisions are unlikely to be promoted to positions of responsibility. Hence, senior managers generally can do what they set out to do.17 This is not to say that all firms all the time pursue profit maximizing strategies. But it is to say that owners and the market put systematic pressure on firms to behave optimally; hence, it is a plausible working assumption that firms rationally pursue the objective of maximizing profits.18
The assumption that each party to a contract wants to maximize its own profit does not itself imply that parties also want to maximize joint gains. Rather, a party may prefer a larger share of a smaller pie. Thus, parties appear sometimes to have an incentive to behave strategically at the expense of joint welfare maximization. On a deeper view, however, parties at the negotiation stage prefer to write contracts that maximize total benefits. To see why, assume that each partys share of the contractual surplus is set exogenously. This assumption holds that a party cannot affect the size of its share of the parties' bargain by the(nonfraudulent)actions it takes during a negotiation. On this assumption, the parties will want only to maximize the total surplus. To put this point in a contracting context, let parties contemplate making a simple sales contract for goods that the buyer values at $100 and that would cost the seller $80 to produce Now assume that each party's share in the contracting surplus($100-$80)is fixed in advance at one half each. Then the price will be $90, and each party's profit would be $10. Of more mportance, assume that the seller could make a $2 investment in the subject matter of the contract that would lower its production cost to $70. The seller would want to make this investment because then its share of the new $28 contractual surplus($100-$2-$70)would be $14, a share that would be realized by a price reduction to $86. Similarly, the buyer has an incentive to make cost justified value increasing investments can be substantially mitigated or made to disappear when individuals are asked to perform as actors in firms--See Jennifer Arlen, Matthew Spitzer and Eric Talley, Endownment Effects Within Corporate Agency Relationships, 31J egal Stud. 1(2002)-, or when the applicable institutions permit communication within a group of actors and require competition between groups-see Do institutions promote rationality? An Experimental Study of the Three Door Problem, Discussion Paper #2002-21(University of St. Gallen, Sept. 2002). The last finding is consistent with experiments showing that when persons are required to function in markets rather than to perform individual tasks the persons reach equilibria that are consistent with individually optimizing behavior. See Vincent P. Crawford Introduction to Experimental Game Theory, 104 J. Econ. Theory 1, note 8 at 3 (2002)(.repeated play of the same game often converges to equilibrium no matter what subjects are thinking. ) Dhananjay K. Gode and Shyam Sunder, What Makes Markets Allocationally Eficient?, 112 Q. J. Econ. 603(1997); Same authors, Allocative Efficiency of Markets with Zero Intelligence Traders: Markets as a Partial Substitute for Individual Rationality, 101 J. Pol. Econ. 119(1993): Vernon L. Smith, Rational Choice: The Contrast Between Economics and Psychology, 99 J. Pol. Econ. 877(1991). Individuals acting on behalf of firms make contracts in markets Part Ill, infra, shows that parties need the law's help to deal with post-contractual opportunism 2put simply, if a party is to receive a fixed 20% of a joint gain, it would ahvays prefer the joint gain to be S200 rather than $100
to the pressures to maximize that are described above. Second, recent evidence suggests that behavioral anomalies can be substantially mitigated or made to disappear when individuals are asked to perform as actors in firms -- See Jennifer Arlen, Matthew Spitzer and Eric Talley, Endownment Effects Within Corporate Agency Relationships, 31 J. Legal Stud. 1 (2002) –, or when the applicable institutions permit communication within a group of actors and require competition between groups -- see Do institutions promote rationality? An Experimental Study of the ThreeDoor Problem, Discussion Paper #2002-21 (University of St. Gallen, Sept. 2002). The last finding is consistent with experiments showing that when persons are required to function in markets rather than to perform individual tasks, the persons reach equilibria that are consistent with individually optimizing behavior. See Vincent P. Crawford, Introduction to Experimental Game Theory, 104 J. Econ. Theory 1, note 8 at 3 (2002) (“... repeated play of the same game often converges to equilibrium no matter what subjects are thinking.”); Dhananjay K. Gode and Shyam Sunder, What Makes Markets Allocationally Efficient?, 112 Q. J. Econ. 603 (1997); Same authors, Allocative Efficiency of Markets with Zero Intelligence Traders: Markets as a Partial Substitute for Individual Rationality, 101 J. Pol. Econ. 119 (1993); Vernon L. Smith, Rational Choice: The Contrast Between Economics and Psychology, 99 J. Pol. Econ. 877 (1991). Individuals acting on behalf of firms make contracts in markets. 19Part III, infra, shows that parties need the law’s help to deal with post-contractual opportunism. 20Put simply, if a party is to receive a fixed 20% of a joint gain, it would always prefer the joint gain to be $200 rather than $100. 13 The assumption that each party to a contract wants to maximize its own profit does not itself imply that parties also want to maximize joint gains. Rather, a party may prefer a larger share of a smaller pie. Thus, parties appear sometimes to have an incentive to behave strategically at the expense of joint welfare maximization. On a deeper view, however, parties at the negotiation stage prefer to write contracts that maximize total benefits.19 To see why, assume that each party’s share of the contractual surplus is set exogenously. This assumption holds that a party cannot affect the size of its share of the parties’ bargain by the (nonfraudulent) actions it takes during a negotiation. On this assumption, the parties will want only to maximize the total surplus.20 To put this point in a contracting context, let parties contemplate making a simple sales contract for goods that the buyer values at $100 and that would cost the seller $80 to produce. Now assume that each party’s share in the contracting surplus ($100 - $80) is fixed in advance at one half each. Then the price will be $90, and each party’s profit would be $10. Of more importance, assume that the seller could make a $2 investment in the subject matter of the contract that would lower its production cost to $70. The seller would want to make this investment because then its share of the new $28 contractual surplus ($100 - $2 - $70) would be $14, a share that would be realized by a price reduction to $86. Similarly, the buyer has an incentive to make cost justified value increasing investments
It remains for us to show that parties'bargaining shares actually are set exogenously Bargaining power is a function of two factors. The first factor is the parties'relative patience The more patient bargainer will reject offers it dislikes to wait for more favorable offers, while the less patient bargainer will accept relatively unfavorable offers just to get a deal. The second factor is each party's disagreement point. In order for parties to agree at all, each party must do at least as well in the deal at hand as it could do elsewhere. Therefore, if party a has many good opportunities should it fail to agree with party B, then party b will have to give party aa good deal in order for the parties to contract. On the other hand if party b is party a's only hope, a will accept a less favorable offer. 22 a business party's patience is a function of its ability to finance its projects. Firms that have capital or convenient access to capital can be more patient than firms that need revenue immediately to survive. Parties ordinarily cannot affect the access of prospective contract partners to the capital market. Moreover, one party to a possible contract ordinarily cannot affect the other party's alternative business opportunities (its disagreement point). Thus, each potential contract partner will realize that its share of the maximum surplus the parties could generate jointly has already been fixed before any contract is signed. And this implies a preference by each party to contract so as to maximize the size of the pie partys discount rate measures his patience: the higher is a party's discount rate, the more highly the party values current dollars than future dollars. Parties with high discount rates thus are impatient bargainers: they want their share of the surplus now. A party for whom current dollars are relatively less important-a party with a low discount rate -- suffers less from delay and, as a result, is more willing to reject low current offers. Hence, patient parties do well when bargaining with impatient parties, who will reduce their demands in order to reach agreement quickly This paragraph summarizes the Nash bargaining game with disagreement points that function as threat points. In this game, each party receives a payoff that equals the payoff she would receive in her next best alternative plus an exogenously determined share of the surplus from concluding the bargain. The game is widely used in the contract theory literature. See,e.g, OLIVER HART, FIRMS, CONTRACTS, AND FINANCIAL STRUCTURE(1995)and Oliver Hart and John Moore, Property Rights and the Nature of the Firm, 98J Pol Econ 119(1990). Predictions of bargaining outcomes using this game have received substantial support in the experimental literature. See, e.g., Joep Sonnemans, Hessel Oosterbeek and Randolph Sloof, The Relation Betveen John Sutton, An Outside Option Experiment, 104 Q. J. Econ. 753(1989). An accessible treatment of Nash bargaining with threat points is in JOEL WATSON, STRATEGY: AN INTRODUCTION TO GAME THEORY 172-78(2002). We use this bargaining game here and in the analyses below
21A party’s discount rate measures his patience: the higher is a party’s discount rate, the more highly the party values current dollars than future dollars. Parties with high discount rates thus are impatient bargainers: they want their share of the surplus now. A party for whom current dollars are relatively less important -- a party with a low discount rate -- suffers less from delay and, as a result, is more willing to reject low current offers. Hence, patient parties do well when bargaining with impatient parties, who will reduce their demands in order to reach agreement quickly. 22This paragraph summarizes the Nash bargaining game with disagreement points that function as threat points. In this game, each party receives a payoff that equals the payoff she would receive in her next best alternative plus an exogenously determined share of the surplus from concluding the bargain. The game is widely used in the contract theory literature. See, e.g., OLIVER HART, FIRMS, CONTRACTS, AND FINANCIAL STRUCTURE (1995) and Oliver Hart and John Moore, Property Rights and the Nature of the Firm, 98 J. Pol. Econ. 119 (1990). Predictions of bargaining outcomes using this game have received substantial support in the experimental literature. See, e.g., Joep Sonnemans, Hessel Oosterbeek and Randolph Sloof, The Relation Between Asset Ownership and Specific Investments, 111 The Econ. J. 791 (2001); Kenneth Binmore, Alexander Shaked and John Sutton, An Outside Option Experiment, 104 Q. J. Econ. 753 (1989). An accessible treatment of Nash bargaining with threat points is in JOEL WATSON, STRATEGY: AN INTRODUCTION TO GAME THEORY 172-78 (2002). We use this bargaining game here and in the analyses below. 14 It remains for us to show that parties’ bargaining shares actually are set exogenously. Bargaining power is a function of two factors. The first factor is the parties’ relative patience. The more patient bargainer will reject offers it dislikes to wait for more favorable offers, while the less patient bargainer will accept relatively unfavorable offers just to get a deal.21 The second factor is each party’s disagreement point. In order for parties to agree at all, each party must do at least as well in the deal at hand as it could do elsewhere. Therefore, if party A has many good opportunities should it fail to agree with party B, then party B will have to give party A a good deal in order for the parties to contract. On the other hand, if party B is party A’s only hope, A will accept a less favorable offer.22 A business party’s patience is a function of its ability to finance its projects. Firms that have capital or convenient access to capital can be more patient than firms that need revenue immediately to survive. Parties ordinarily cannot affect the access of prospective contract partners to the capital market. Moreover, one party to a possible contract ordinarily cannot affect the other party’s alternative business opportunities (its disagreement point). Thus, each potential contract partner will realize that its share of the maximum surplus the parties could generate jointly has already been fixed before any contract is signed. And this implies a preference by each party to contract so as to maximize the size of the pie