Should Courts Always Enforce What Contracting Parties Write?

2006

The essence of a free-market economy is the ability of private parties to enter into voluntary agreements that govern the economic exchange between them. Consequently, the law that governs such agreements is critical to the functioning of such economies. While the law of property determines the configuration of entitlements that form the basis of production and exchange, and the law of torts protects those entitlements from involuntary encroachment and expropriation, it is contract law that sets the rules for exchanging individual claims to entitlements and, thus, determines the extent to which society is able to enjoy the gains from trade. Accordingly, economists interested in the welfare properties of specific institutions in particular, or the micro-foundations of exchange generally, have good reason to take account of the law of contracts. This chapter, accordingly, surveys the main issues arising in the economic analysis of contract law. We discuss both the main features of contract law as they relate to the problem of economic exchange, and how relevant legal rules and institutions can be analyzed from an economic perspective. In this introductory section, we set out the basic scope, methodology, and organization of the discussion to follow. Subsection 1.1 discusses why formal and informal contracts exist, and what economic functions they serve. Subsection 1.2 distinguishes between positive and normative issues in the economic analysis of contract law, and discusses some methodological problems associated with applying standard economic analysis to legal institutions and when engaging with legal scholarship. Subsection 1.3 identifies limits on the chapter's scope and provides bibliographic recommendations for material we don't cover; and subsection 1.4 sets out the organization of the remainder of the chapter. A caveat is in order at the outset: although it is conventional to present contract law as a discrete field, one should understand that, to a significant extent, the operation of the rules and institutions discussed below will depend on other aspects of the law, including the fields of tort, bankruptcy, procedure, and evidence. Lawyers have a cliché that describes this interdependence; they say that "the law is a seamless web." It is useful to keep in mind that many issues that economists would regard as contractual, including some important limits on contractual freedom, are governed not by contract but by tort law. Additionally, the rules relating to certain categories of exchange, such as consumer, employment, insurance, and information-licensing contracts, have developed specialized content to the point that they are often treated as distinct legal fields. Finally, the practical ability of contracting parties to assert their legal entitlements depends importantly on the procedural rules that govern courts and other enforcement institutions. Many of the specific features of contract law that we discuss below cannot be understood except as a response to the costs and other limitations of such institutions. 1.1.3 Implementing production over time Finally, contracts are valuable in promoting production in advance of exchange. Advance production typically increases the surplus available from exchange, but requires sinking resources in ways that may be unrecoverable if the contemplated exchange is not completed. For example, a clothing manufacturer can increase Enforcement costs. It is never costless to hold a party to his commitment if he is inclined to try to escape it. If the contract is being enforced through the courts, for instance, lawyers must be hired and evidence assembled, and performance or damages are likely to be awarded only after some delay. Such costs make enforcement incredible when the damages from breach are relatively 1.2.2 Positive issues While most work on the economics of contract law has sought, at least in part, normative conclusions, there is a segment of the literature devoted to predicting and explaining how different contractual rules affect private transactions, and why contracting parties might choose one contractual device rather than others. For example, a variety of authors (e.g., Joskow, 1987; Crocker and Masten, 1988; Pirrong, 1993) have investigated the connection between the use and duration of contractual agreements and the extent of relationship-specific investments.

Contract interpretation is an understudied topic in the economic analysis of contract law. This Article combines simple formal analysis of the tradeoffs involved in interpretation with applications to the principal doctrines of contract interpretation, including the 'four corners" rule, mutual mistake, contra proferentum, and what I call the (informal but very important) rule of "extrinsic nonevidence. " Gap filling is distinguished, and the relativity of interpretive doctrines to the interpretive medium-jurors, arbitrators, and judges in different kinds ofjudicial systems-is emphasized.

Case Western Reserve law review, 2005

discussing hypothetical consent as basis of bargain). 4 Scott & Triantis, supra note 1, at 187 ("[E]conomic contract theory should incorporate a more textured understanding of the process for judicial enforcement of contracts."); see also Craswell, supra note 1, at 151 ("While that literature has had a good deal to say about some decisions that contracting parties must make[,] ... it has had little or nothing to say about other decisions, including decisions about precautions that might reduce the likelihood of an accidental breach."); Katz, supra note 1, at 171 ("[l]n the language of law-and-economics, scholars should pay greater attention to considerations of private transactional efficiency as opposed to larger issues of social efficiency."). 5 Scott & Triantis, supra note 1, at 191 ("In contract theory, incompleteness is due to the fact that information is costly and sometimes unavailable to (a) the parties at the time of contracting or (b) the parties or the enforcing court at the time of enforcement."); see also Craswell, supra note 1, at 155 (focusing on the problem of setting rules with the "limitations [that] (a) courts are imperfect decision-makers and (b) parties can always renegotiate their contracts"); Katz, supra note 1, at 171 (stressing that "the parties have more information than the courts"). 6 The authors discuss the conflict between enforcing contracts to promote the security needed to foster investment and the conflicting need to promote efficiency ex post. Katz, supra note 1, at 171-72; Scott & Triantis, supra note 1, at 189. Protection of the investment might call for enforcement even when circumstances have changed so that enforcement would no longer be efficient. I Craswell, supra note 1, at 152, 155 (distinguishing the "newer 'incomplete contracts' literature" from the traditional law-and-economics analysis of contracts); Katz, supra note 1 at 173-74 (discussing the theory of "strategic renegotiation design" and the problem of "unverifiable information, or unverifiability"); Scott & Triantis, supra note 1, at 188, 192 (stating that "[a]n important concern of contract theory is the renegotiation of agreements"). 8 Scott & Triantis, supra note 1, at 191 (classifying these scholarly solutions as part of the mechanism design literature). 9 Craswell, supra note 1, at 167 (outlining the search for contracting parties as one avenue for incomplete contracting literature to pursue); Scott & Triantis, supra note 1, at 198-200 (urging scholars to investigate different choices that parties might make in the process of litigation (whether to arbitrate or settle) and how the anticipation of such choices might affect earlier choices that parties make both in crafting their initial contracts and in acting efficiently during performance of the contract). 10 Scott & Triantis, supra note 1, at 195-96. 1Id. In addition to high costs, there may be problems of judicial errors. 12 Id. 13 Id. at 196. For example, one can reduce the ex ante drafting costs by leaving certain matters for courts to decide later on, adding to back-end enforcement costs. Id. at 196-97. The overall costs may be lower under such a strategy since at the actual time of enforcement, "information may yet be superior to (less costly than) that of the parties at the time they contract." Id. at 197. '4 Katz, supra note 1, at 174-75. "5 Id. at 170-71. 16 Id. 2005] 69 Scott & Triantis, supra note 1, at 187. 70 Id. 71 Id. at 189. 72 Id. 73 Id. 74 Id. at 191 (discussing Eric Maskin's solutions to the problem). 75 Id. at 192. 76 Id. (explaining that "[o]ption contracts and other similar implementation mechanisms ... are parameter-specific").

SSRN Electronic Journal, 2010

Using a special dataset on small and medium enterprises in India, we investigate the effectiveness of informal relationships relative to courts in both ex ante prevention and ex post settlement of business disputes. We find that availability of informal channels for dispute prevention, such as intervention by a social or business contact, does not help contract enforcement. However, we also find that, following a contract violation, relationships are used widely as a substitute for courts to settle the dispute, especially by the smaller and younger firms. While fairly developed market institutions in India resulting in low search costs for alternative partners render relational contracts fragile and explain the first result, high transactions costs of using an ineffective commercial legal system explain the second. Our findings are applicable to many other emerging countries that share the two features in varying degrees. Our analysis of ex ante and ex post incentives of a firm to deal with business disputes without courts is a unique contribution to the existing literature.

The Nature and Enforcement of Choice of Court Agreements : A Comparative Study, 2017

notes that the binding effect of choice of law agreements fl ows from the universal legal principle of pacta sunt servanda. However, this does not mean that the agreement regulates or proscribes the conduct of the parties because a choice of law agreement is properly conceived of as a ' self-fulfi lling (dispositional) contract ' ; HLA Hart, when discussing the nature of international law and the possible formulation of a ' basic norm ' of international law, has discussed the principle of pacta sunt servanda as a potential candidate. However, he reasoned that the view has been abandoned by many theorists and it is incompatible with the fact that not all obligations under international law arise from ' pacta ' , however widely that term is construed. It should be noted that Hart is recognising that regulatory constraints played at least some role within an emerging international legal order. Therefore, the principle of pacta sunt servanda does not even offer a satisfactory and comprehensive justifi cation of the customary behaviour of states in public international law: see HLA Hart , The Concept of Law (Oxford , Oxford University Press , 1961) 228. For the relevance of the general principle of pacta sunt servanda in relation to the law of treaties in public international law, see the Preamble and Art 26 of English commercial private international law in general and jurisdiction agreements in particular have been characterised as private law matters, where the growing infl uence of general common law contract and commercial law principles is increasingly evident. 1 This is supported by the relative effect of an exclusive choice of court agreement in English law as giving rise to an independently enforceable inter partes contractual obligation to sue only in the elected forum, over and above their more traditional international procedural and allocative role of prorogating and derogating the jurisdiction of courts. For Briggs, the obligations contained within a comprehensive dispute resolution agreement are capable of being breached and where breached will, like any ordinary contractual breach, lead to both primary and secondary remedies. Briggs is never shy of advancing the pacta sunt servanda 2

Published in: Towards a european Civil Code (eds. A.S. Hartkamp, M.W. Hesselink, E.H. Hondius), Second revised and expanded edition, Kluwer / Ars aequi 1998, 239-254

2005

69 Scott & Triantis, supra note 1, at 187. 70 Id. 71 Id. at 189. 72 Id. 73 Id. 74 Id. at 191 (discussing Eric Maskin's solutions to the problem). 75 Id. at 192. 76 Id. (explaining that "[o]ption contracts and other similar implementation mechanisms. .. are parameter-specific"). 77 Id. at 194-95.

U Chicago Law & Economics, Olin Working Paper, 2002

Law and economics has failed to produce plausible descriptive theories of contract doctrines. This paper documents these failures and suggests that they are due to a methodological problem involving the concept of transaction costs. If transaction costs refer to writing or information costs, then rational individuals would agree to complex contracts that are not in fact observed, and contract law would, for the most part, have no other function than that of specifically enforcing contracts. If transaction costs refer to limits on foreseeability and other cognitive restrictions, then law and economics assumes implausibly both that people are rational enough to allow legal rules to influence their investment and breach decisions, but not rational enough to allow legal rules to influence contractual design. Implications for normative analysis are discussed, and non-economic approaches to contract law are surveyed and criticized.

Economics Letters, 2013

We consider how parties' formal contracts are underpinned by their ongoing relationship and how welfare changes as the legal system improves. Regardless of impatience, the parties write formal contracts they wouldn't honor-despite stipulated penalties-were interaction one shot. The change in welfare with an improvement in the legal system can be ambiguous and even non-monotonic.

Journal of Law Economics & Organization, 2007

We study a contracting model with unforeseen contingencies in which the court is an active player. Ex ante, the contracting parties cannot include the risky unforeseen contingencies in the contract they draw up. Ex post, the court observes whether an unforeseen contingency occurred and decides whether to void or uphold the contract. If the contract is voided by the court, the parties can renegotiate a new agreement ex post. There are two effects of a court that voids contracts. The parties' incentives to undertake relationship-specific investment are reduced, and the parties enjoy greater insurance against the unforeseen contingencies that the ex ante contract cannot account for. In this context, we fully characterize the optimal decision rule for the court. The behavior of the optimal court is determined by the trade-off between the need for incentives and the gains from insurance that voiding in some circumstances offers to the agents.