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
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
