Our initial model considers the set of cases in which the parties payoffs under their contract are monotonic and continuous in the space of possible judicial interpretations. Those rules bar enforcement to contract terms that efficiently cope with problems of hidden information and hidden action. The buyer cannot later claim that it was coerced to accept a price increase because, ex ante, this buyer would have wanted the court to enforce a modification that would leave it better off than performance under the original contract would have done. But as the discussion in the text has shown, parties can cheaply opt into a private language by agreeing in their contract to have evidence admitted regarding that language should a dispute arise. To see why, consider the quality level illustration in the preceding paragraph. 87 (1989). There, we claimed that permitting the seller to sue for the price would deter the buyer threat to renegotiate after the seller had invested. The Three Theories of Contract Law Equity Theory Will Theory Formalist Theory In the past, courts asked whether the parties to a contract exchanged thing of equal value. Since the buyers gross valuation is $120, one third of the time a purchase of the goods would contribute nothing toward the buyers fixed obligations. He believed that customs govern ordinary cases but seldom are relevant to the unusual cases that cause parties to litigate. The structure of the payoff invariant case creates the possibility that a party will incur a large loss because of a small judicial error. Home | 5 0 obj A business partys patience is a function of its ability to finance its projects. This argument assumes that parties can only opt out of the plain meaning linguistic default with costly translations. It is a function of business education to teach people to make optimizing (rather than cognitively erroneous) decisions. It is inefficient to draft for one case. Firms that this set of cases describes have. We assume that values are unverifiable. A default that supposes parties to be writing majority talk unless their contract recited otherwise would eliminate this move. Our analysis thus identifies a reason for parties to use arbitration, but it cannot support the inference that parties use courts because they prefer the interpretive styles in current use. 107Recall that a rule specifies the relevant conduct in advance not to drive above fifty five miles per hour. A default rule also could specify the illustrative sellers quality obligation, but recall that the product was assumed to be specialized to the buyers use. Notwithstanding the costs involved, in an effort to meet the difficulty many contractors have undertaken fairly detailed contractual risk allocations. Force Majeure And Frustration of Contract v-vi (2d Ed. A common example states: This contract contains the final understanding between the parties, and represents the final agreement on all terms. The buyer again rejects on quality grounds. In response to this difficulty, parties commonly ignore the, standards in 2-615 and 2-609 in favor of writing force majeure and insecurity clauses that specify precisely the exogenous causes that will excuse the sellers performance obligation, and specify the permissible responses that the buyer can take when insecure about the sellers performance. Hence, permitting parties to introduce additional evidence as to intent would generate costs in excess of gains, We illustrate this case by recalling the specialized product example in Part IIIA. The buyers expected gain as of t0 if the buyer did not contract, however, would be the larger sum z, or $20. Parties choose the contract terms jointly so as to maximize the surplus that the price may then divide unequally.23, We noted at the outset that there are four main objections to a single minded state pursuit of welfare maximization for commercial contract law. Standards thus are useful only when parties can predict accurately the behaviors that courts will find sufficient to satisfy a vague descriptor. 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. Research 1 (2001) and Alan Schwartz, Incomplete Contracts in 2 The New Palgrave Dictionary of Economics and the Law 277-83 (1998). As a consequence, the states power is limited to reducing contracting costs, which it best does by enacting popular defaults. A contract price of $60 achieves this split.32, The price at which the parties will ultimately contract, however, would not be $60 because the buyers incentive to cooperate vanishes after the seller invests s in the subject matter of the deal. 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. This suggests that there is a third, largely unremarked, ground for mandatory contract law rules such as the rules that govern contract interpretation. See Ronald Gilson and Alan Schwartz, Understanding MACs, Mimeo (2003). To fill nonexistent gaps is to do for parties what parties do not want done. Knowing this, the parties would write the contract to produce the specialized product and trade it for $60. 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. 2022-05-16T13:58:38-07:00 The formalists argued that the study of literature should be exclusively about form, technique, and literary devices within a work of literature. Suggested Citation, Subscribe to this fee journal for more curated articles on this topic, Microeconomics: Asymmetric & Private Information eJournal, Law & Society: Private Law - Contracts eJournal, We use cookies to help provide and enhance our service and tailor content. 12. 17In addition, many corporate executives have attended business school and also attend business school executive programs for working managers. A standard nevertheless is efficient here because the buyer will exit only if the sellers value has fallen materially. 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. In short, parties can have good reasons for banning modifications.136. It is often seen as a naive and unsophisticated approach to the adjudication of legal disputes. Let the buyer instead take delivery of the goods but claim that they do not conform to the quality the seller promised to deliver. A supplementary set of enforcement rules apparently also is needed. Section 2-615(a) of the UCC provides that a sellers failure to perform is not a breach if performance as agreed has been made impractical by the occurrence of a contingency the non-occurrence of which was a basic assumption on which the, contract was made.110 Courts decide after the fact whether a performance would have been. In the example above, if the machines were crucial to a start-up venture and the buyer had little cash, the buyer ex ante would want the evidentiary base in a later suit to be sufficiently broad so that the memorandum would be admitted into evidence. 106See Alan Schwartz and Robert E. Scott, The Political Economy of Private Legislatures, 143 Pa. L. Rev. however, was not whether the parties had or lacked good reasons to permit forfeitures. The sellers threat would be credible only if it had, or had convenient access to, the capital needed to sustain it until the buyers performance could be replaced. The seller would anticipate being compensated for its investment, and the buyer would prefer to have the specialized product and, 33Recalling note 32, pr = vs (x + (dr)) = $80 ($10 + $35) = $35. It believed both that forfeiture of the entire last payment would have been unfair, and that the parties could not have intended this result. A Formalist Theory of Contract Law Adjudication Felipe Jimnez Published 29 July 2019 Economics Formalism has a bad name. For example, a contract written in majority talk may require the seller to deliver red sweaters. One prominent application of it is the design of optimal schemes of managerial compensation. See Ian Ayres, Making a Diference: The Contractual Contributions of Easterbrook and Fischel, 59 U. Chi. The project of creating publicly supplied default standards is difficult to defend. 97Parties tend to omit low probability states. A contract law for firms, we answer, would be smaller and more deferential to contracting parties than the contract law we now have. To see why, it is helpful to begin with an information taxonomy from the contract theory literature. Sellers who have easier access to cash in the long run than in the short run, or who could sell their legal claim, will use the duress doctrine to recover their original expectation. Disagreements as to what the contract directs raise interpretation issues that are discussed in Part IV below. Statutory drafters and courts, we will argue, often adopt default rules and standards that fail to satisfy these stringent conditions. The existence of asymmetric information sometimes will cause parties to make constrained efficient contracts. movement can have spillover effects.40 In the first case, in the absence of legal enforcement the non-investing party has an incentive to renegotiate the contract price downward rather than to perform under the original contract. Our analysis thus supports the conclusion that courts should interpret business contracts on minimal evidentiary bases whether the issue is what the contract language means or what language the contract was written in, unless parties explicitly instruct the court otherwise.82. A contract has an intertemporal aspect: parties agree today to do something tomorrow.25 State enforcement of these agreements is unnecessary when the agreements fall within the self, 24For excellent analyses of the strengths and limitations of the various autonomy-based theories of contract law, see Richard Craswell, Contract Law, Default Rules, and the Philosophy of Promising, 88 Mich. L. Rev. rather than rules, when it regulates at all. 8 See, e.g. 120Ian Ayres has suggested that standards may be good defaults because precedent can crystalize around them, thereby providing parties with guidance. Firms that this set of cases describes prefer courts to make interpretations on the minimum evidentiary base Bmin except in unusual circumstances. The parties then could write a liquidated damage clause that would award the buyer the difference between the value the goods would have had were the buyer to invest optimally and the price. & S. 826, 122 Eng. formalist theory of contract law. Second, freedom of contract. No one would claim that the Statute of Frauds interferes with party autonomy in a normatively serious way, though the Statute sometimes requires parties to cast their agreements in written form. A default standard should be written when parties do not. In some states of the world, the sellers cost to produce the specialized product will be lower than the buyers valuation, as in the original example, well known overinvestment problem.122 The buyers damages if the seller breaches will be the difference between its realized valuation and the price. 1 The last payment, which is sizable, is due when construction is completed. Given renegotiation, the sellers expected gain if it invests is .8($20) + .2($10) $12 = $6. ~7inE}_hrW5A?9N!J i~EFa0aZy2=7?EYf ,71N .7ier)\'%uI+=v!%(QzC4v>>9rR?moWzmk1QwY#Dp?N6u k2ZzObIR>WL;N2Th,LXe-ZG]fE-!rE*kh|?: The argument of this Article starts from the assumption that contract law is not morally justified because of its enforcement of promissory rights or some other dimension of interpersonal morality. This surplus is the value of the specialized product (vs) less the anticipated cost of producing it (s) less the sum of the parties disagreement points (x = vg g for the buyer, and zero for the seller). 21A partys discount rate measures his patience: the higher is a partys discount rate, the more highly the party values current dollars than future dollars. The unreliability of renegotiation promises coerced by duress reduces the incentive to extract them (that is, to behave as did the buyer in our example). 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. to pursue contractual fairness when firms are permitted a large measure of contractual freedom. Even in this case, however, litigation cost considerations will cause a majority of parties to prefer courts to use a narrow evidentiary base. For example, let a contract use the word red, and let a party persuade the court, wrongly, that the parties used a private language in which the word red meant green. 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. We now suppose, as in the invariant payoff case of Part IV(C)2, that if the court uses a contextualist interpretive style, it will find the correct answer (so that the seller will realize $10) with a probability of .7. In Part III, we argued that firms need state enforcement in order to permit them to make credible commitments when their promises are not self-enforcing. Econ. The sellers disagreement point is largely a function of how redeployable is its investment. It is often seen as a nave and unsophisticated approach to the adjudication of legal disputes. Since the paying party would know this, neither party would think that the contract required the equivalent of a forfeiture for a slight nonconformity, in spite of what the written words appear to say. > But Judge Easterbrook has penned his share, for example in Empro Mfg. These rules, that regulate various aspects of the contracting relationship, commonly are defaults, controlling only when parties do not contract out. at 60-61. 1988). The UCC also adopts standards in order to avoid resolving controversial issues. The lesson is that the state cannot help when asymmetric information prevents parties from writing the efficient contract. Intention, however, is determined objectively and prospectively: a party is taken to mean what its contract partner could plausibly believe it meant when the parties contracted. If the parties agree to produce the specialized version, they will bargain over how to divide the expected surplus. 1986) (An integration clause is only some evidence of the parties intentions. See, e.g., Austin v. Loral, supra note 42, and Wolf v. Marlton Corp., 57 N.J. Super. The interpretation dispute matters a great deal, however, when the interpretive issue concerns the language in which the parties wrote. When parties compare possible interpretive regimes, they will not only consider ex post enforcement costs and gains, The analysis here permits further us to clarify the debate between contextualists and textualists and also suggests a new understanding of the function of merger clauses. Formalities work when parties intend their legal effects, that is, when they perform juristic acts. But then the owner will know that the contracts penultimate performance will be the final one, and it will cheat then. (25) Here, it is intended to refer to a theory of contract law that, above all else, elevates the content of the parties' written contract (its form) over any concerns for normative values or societal notions of fairness. endobj See Hunt Foods & Industries v. Doliner, 26 A.D.2d 41, 270 N.Y.S.2d 937, afirmed 272 N.Y.S.2d 686 (1966) (permitting the grantors testimony). A normative theory of contract law that takes party sovereignty seriously shows that much of the expansion of contract law over the last fifty years has been ill advised. To be sure, some such buyers could guard against disruption by maintaining sufficient cash reserves, but this strategy is difficult for all businesses to follow. 89This proposed interpretation of 2-202 actually was made in Southern Concrete Services v. Mableton Contractors, Inc., 407 F. Supp. See, e.g., Ian Ayres & Robert Gertner, Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules, 99 Yale L. J. CONTRACT LAW AND THEORY,supra note __, at 718-21. The members of each set in P may write contracts in their own party talk or write them in majority talk. Textualists dispute this claim. For example, parties may attribute a private meaning to the phrase two by four (wood supports so described in construction contracts are meant to state dimensions of 17/8 x 33/4), but such parties seldom would use a private language to describe the delivery date, the place of delivery, the price and so forth. First, we let the sellers costs be stochastic. We begin by clarifying two interpretive issues that commonly are commingled: What does the language of the contract mean? Moreover, although many contracts have an insurance component (i.e., commodities contracts, currency hedging, etc. If a party can introduce extrinsic evidence explaining that the contract actually had the meaning mp, then extrinsic evidence never could contradict the writing. 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, No one doubts that managers sometimes successfully sabotage owners, but for two reasons we will assume here that managers obey shareholder instructions. 1960) (does chicken include all types of chicken or only a subset? The contract theory literature has developed a number of contracts that, in theory anyway, sometimes would induce the parties to invest when they should.123 These contracts, however, are parameter specific, 122See Steven Shavell, Damage Measures for Breach of Contract, 11 Bell J. Econ. The seller also can produce a specialized version of the product for buyers who are willing to pay the extra cost. The parties solution follows from the contextual nature of verifiability. Any liquidated damage clause that incorporates observable but nonverifiable values thus will be vulnerable to a penalty claim even when the clause accurately measures the promisees lost expectation.141 Moreover, courts sometimes find compensatory, 140See UCC 2-718(1) (Damages for breach by either party may be liquidated in the agreement but only at an amount which is reasonable in the light of anticipated or actual harm caused by the breach . Part II(A) argued that the cognitive objection is weak, and Part V(A) will argue against the fairness objection. Firms would prefer the state not to create inefficient defaults because firms will contract out of them, Commercial parties commonly will want to condition their obligations on the nature of their contract partners or on the state of the world that will materialize after the contract is written. Thus, 2-302(1) of the UCC authorizes a court to strike any clause of the contract if the clause is unconscionable, and it is common to hear apparently one-sided terms described as the product of unequal bargaining power. However, when bargaining power is determined prior to contract formation, as is common in business contexts, these views are incorrect. This page was processed by aws-apollo-5dc in. When the variance in the error term is large, parties will think that the answer a court will later give can deviate widely from the correct answer. 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. Here, an unfavorable interpretation that is close to the correct answer will have negative consequences for a firm that are as severe as interpretations that are far from the correct answer. The dispute between these camps, we have shown above, is irrelevant when the issue is what the contract says: business firms are content with interpretations of their language that are correct on average, not always correct, and so prefer narrow evidentiary bases to broad ones. To understand the first implication, realize that contracts often would be performed even if there were no legal sanction for breach. 847, 853-56 (2000) 2. It follows that courts should encourage parties to use majority talk. Ex ante duress occurs when a party is wrongfully coerced to make a contract.41 Ex post duress occurs when a party is wrongfully coerced to modify an existing contract.42 Contract law applies the same legal standard in both cases: a contract or a modification is unenforceable if a partys consent thereto was obtained by an improper threat that left the party no reasonable alternative but to submit .43 Our focus here is on ex post duress, and we suggest that courts should ask a different question in this case than is appropriate for ex ante duress cases. As an illustration, suppose that a seller sold the goods to a third party instead of delivering them to the contract buyer. 278, 154 A.2d 625 (1959). 799 (2002), 69See Comment 1 to UCC 1-205: This Act rejects both the lay-dictionary and the conveyancers reading of a commercial agreement. 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.
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