• Selected
• Entire List

Abstract:
This article sets out a normative theory to guide decisionmakers in the regulation of contracts between firms. Commercial law for centuries has drawn a distinction between mercantile contracts and others, but modern scholars have not systematically pursued the normative implications of this distinction. We attempt to cure this neglect by setting out the theoretical foundations of a law merchant for our time. Firms contract to maximize expected surplus and the state permits markets to function because markets maximize social welfare. Thus, there is a correspondence of interest between firms and the state, which implies that, when externalities are absent, the state should implement the preferences of firms regarding the rules that regulate their contracting behavior.

A contract law for firms would differ in three major respects from current contract law. First, such a law would have far fewer default rules and standards than current contract law contains. The high level of generality on which much contract law is written (e.g., a party must behave "reasonably") creates unacceptable moral hazard for parties subject to it. Thus, firms in theory should, and in practice commonly do, contract out of much of the law most of the time. The primary effect of today's law, that is, is to raise transaction costs without altering substantive behavior. Second, the default theory of interpretation in a contract law for firms would require courts to base interpretations primarily on the written texts of agreements. The risks of incorrect interpretations that such a theory creates, we argue, would be more acceptable to firms than the costs that the courts' current interpretative practices create. Third, the law would contain almost no mandatory rules. To summarize, a modern law merchant would be much smaller than current contract law; would truncate broad judicial searches for parties' true intentions when interpreting their agreements; and would accord parties much more freedom to write efficient contracts than now exists.

Abstract:
The law influences the behavior of its citizens in various ways. Well understood are the direct effects of legal rules. By imposing sanctions or granting subsidies, the law either expands or contracts the horizon of opportunities within which individuals can satisfy their preferences. In this way, society can give incentives for desirable behavior. In recent years, the social norms literature has shown that law can also have indirect effects on incentives. By empowering neighbors and other citizens to use public ridicule as an enforcement technique, these laws can influence behavior by imposing informal sanctions, such as shaming. Similarly, these laws can have self-sanctioning effects to the extent that citizens internalize the legal rule and are deterred by the prospect of guilt. These latter effects require that legal rules be mediated through social phenomena-social norms and human emotions-that are highly complex and only imperfectly understood. In the case of a shaming sanction, the law must rely on existing normative structures to influence in predictable ways the "expression" or social meaning of the disfavored (or favored) action. In the case of self-sanctions, the law must rely on the even more complex phenomenon of internalization of normative behavior.

Legal scholars and economists continue to explore the internal mechanisms of social norms and of human emotions and to suggest predictive tools that may be capable of accounting for the influences of legal rules on social norms and individual values. In this essay, I ask the evaluative question: How far have we come? Clearly, as a descriptive matter, we have come a long way. But when it comes to using this more textured understanding of human experience to improve our ability to predict the effects of legal rules, the verdict is far less clear. The danger in such an environment is that the analyst will be guided more by the strength of her a priori beliefs in the relative efficacy of government intervention than in the analytical tools that are deployed. In short, the dilemma remains no different from when it was first identified by Arthur Leff a generation ago. Law and economics, Leff said, "is a desert," and law and society (read: sociology and psychology) "is a swamp." For twenty-five years legal scholars have searched for the holy grail, the fertile middle ground between economics and the other behavioral sciences. The search may be noble and important, but the end of the journey is not yet in sight.

The Essay proceeds as follows. In Part I, I set out a contextual case study as an archetypal environment for analyzing the interactions of law and norms. Part II evaluates both the direct and indirect effects of law within this contextual framework using the techniques of rational choice theory. In Part III, I relax the assumption that preferences are exogenous in order to examine, in the same context, the explanatory power of the emerging expressive and internalization theories of law. I conclude, in Part IV, that a preference-shaping analysis provides a richer explanation for commonly observed interactions among legal rules, norms and values, but at a considerable price. The introduction of non-falsifiable hypotheses produces an analysis that is rich in content but also speculative and context-dependent.

Abstract:
The central task in developing a plausible normative theory of contract law is to specify the appropriate role of the state in regulating incomplete or relational contracts. Complete contracts (to the extent that they exist in the real world) are rarely, if ever, breached since by definition the pay-offs for every relevant action and the corresponding sanctions for non performance are prescribed in the contract. In the case of incomplete (or relational) contracts, however, parties have incentives to breach by exploiting gaps in the contract. Making the verifiable terms of the contract legally enforceable and regulating incompleteness in a consistent manner reduces, but does not eliminate, these incentives to breach. There still remains the fundamental question: Should the law seek to complete the contract for the parties? And, if so, from what vantage point should the contractual gaps be filled? Determining the answers to these questions has preoccupied contract law scholars for the past fifteen years.

In this paper, I review the academic debate and outline the core arguments for (and difficulties with) three alternative strategies for interpreting relational contracts. Thereafter, I evaluate each strategy in terms of the lessons that are available to us from theory and experience. In particular, I examine the insights from the recent theoretical literature on the economics of incomplete contracting and test those insights against the results of an analysis of the cases interpreting disputed contracts under the significantly different regimes of the Uniform Commercial Code and the common law over the past thirty years.

As the title of the paper implies, the case for formalism in interpreting relational contracts emerges out of this analysis. The contract theory literature suggests that the activist role courts traditionally have been asked to assume in specifying default rules ex ante and/or adjusting contractual risks ex post may be far less useful in a complex, heterogeneous economy. Moreover, the invitation to courts to create broadly useful default rules or to undertake equitable adjustment of apparently harsh contract terms threatens a parallel goal of predictable, transparent interpretation of explicit contract terms. If, as theory suggests, the state is simply incapable of supplying parties in a complex economy with useful defaults ex ante or imposing fair outcomes ex post, the better instrumental strategy is for courts to accept the limits imposed by legal formalism and interpret the facially unambiguous verifiable terms of disputed contracts literalistically. Not only would a rigorous application of the common law plain meaning and parol evidence rules preserve the value of predictable interpretation, but the analysis suggests as well that common law formalism has an heretofore unrecognized role in expanding the menu of legally blessed standard form terms and clauses that further reduce contracting costs for most parties.

At bottom, the merits of these theoretical speculations turn on the empirical realities. While much of the available evidence is anecdotal, it does point unambiguously to a contrast between the functionalist interpretation of the Uniform Commercial Code and the formalist interpretation that is retained by many common law courts and by the private arbitral regimes of trade associations and other intermediaries. The formalist approach seems to have created a more hospitable environment; one that appears to support both reliable interpretation of contract language and the evolutionary production of standardized and appropriately tailored contract terms. Evidence that commercial parties, whose contracts nominally fall under the jurisdiction of the Code, opt instead for private regimes that employ formalist modes of interpretation further challenges the unquestioned assumption of most contemporary scholars that functionalism is a priori superior to formalism. While the case for formalism is a tentative one, the evidence is sufficient to shift the intellectual burden of proof to those who would defend the activist strategies unleashed by the Uniform Commercial Code.

Abstract:
All contracts are incomplete. But incomplete contracts differ along several key dimensions. Many contracts are incomplete because parties decline to condition performance on future states that they cannot observe or verify to courts. In these cases, the incompleteness is exogenous to the contract. Other agreements, however, appear to be "deliberately" incomplete in the sense that parties decline to condition performance on available, verifiable measures that could be specified in the contract at relatively low cost. Thus, incompleteness is endogenous to these agreements suggesting that the parties had other reasons for leaving the terms in question unspecified.

Traditional contract law doctrine appears to track this distinction. One of the core principles of contact law is the requirement of definiteness. An agreement will not be enforced as a contract if it is uncertain and indefinite in its material terms. It is widely believed, however, that the indefiniteness doctrine is largely ignored by contemporary courts. But a study of the contemporary case law on indefinite contracts reveals some striking facts. In literally dozens of cases, American courts dismiss claims for breach of contract on the grounds of indefiniteness, often without granting any relief to the disappointed promisee. This evidence raises a fundamental question: Why do parties write deliberately incomplete agreements in the shadow of a robust indefiniteness doctrine?

One hypothesis is that these agreements may be self-enforcing. But most of the recently litigated cases do not appear to be self-enforcing in the traditional sense. Rather, most are isolated transactions between strangers trading at arms length. Recent work in experimental economics suggests, however, that the domain of self-enforcing contracts may be considerably larger than has been conventionally understood. A robust result of these experiments is that a significant fraction of individuals behave as if reciprocity were an important motivation (even in isolated interactions with strangers) while a comparable fraction react as if motivated entirely by self interest. These experiments support a theory that predicts that deliberately incomplete contracts that rely on self-enforcement through reciprocal fairness are more efficient than the alternative of more complete, legally enforceable agreements. The potency of reciprocal fairness as a method of self-enforcement explains (and justifies) the resiliency of the common law indefiniteness doctrine in the face of a contemporary academic consensus in favor of expanding the scope of legal regulation.

Abstract:
Contract law encourages parties to make relation-specific investments by enforcing the contracts the parties make, and by denying liability when the parties had failed to agree. For decades, the law has had difficulty with cases where parties sink costs in the pursuit of projects under agreements that are too incomplete to enforce, and where one of the parties prefers to exit rather than pursue the contemplated project. The issue whether to award the disappointed party any remedy has divided a large number of courts over many years. The judicial uncertainty arises, we claim, because the questions why parties make such incomplete contracts, then rely before uncertainty is resolved and finally disagree over cost reimbursement when both recognize that their project would be unprofitable have not been satisfactorily answered. We create a model which shows that parties create "preliminary agreements" rather than complete contracts when the project they explore could take a number of forms, and the parties are unsure at the outset which form would maximize profits. A preliminary agreement roughly allocates investment tasks between the parties, specifies investment timing and commits the parties only to pursue a profitable project. Parties sink costs in a project because investment accelerates the realization of returns and illuminates whether any of the possible project types would be profitable. A party to a preliminary agreement "breaches" when it delays its investment beyond the time the agreement specifies. Delay will save costs for this party if no project turns out to be profitable and improves this party's bargaining power in the renegotiation to a complete contract if a project would succeed. Delay often disadvantages the promisee, but the main inefficiency is ex ante: When parties anticipate such strategic behavior, the likelihood that they will make preliminary agreements is materially reduced. This is unfortunate because the performance of a preliminary agreement often is a necessary condition to the creation of a complete contract and the subsequent realization of a socially efficient opportunity. Thus, contract law should encourage relation-specific investment by awarding verifiable reliance costs to a party to a preliminary agreement if its partner has strategically delayed investment. We also study a large sample of appellate cases that deal with reliance prior to the signing of a complete contract. This study reveals that (a) parties appear to make the preliminary agreements we describe and breach for the reasons our model identifies; and (b) courts sometimes protect the disappointed party's reliance interest when they should, but the courts' imperfect understanding of the parties' behavior causes courts to make mistakes.

Abstract:
Economic contract theory postulates two obstacles to complete contracts: high transaction costs and high enforcement (or verification) costs. The literature has proposed how parties might solve these problems under a stylized litigation system, but it does not address the question of how parties design contracts under the existing adversarial system, that relies on the parties to establish relevant facts indirectly by the use of evidentiary proxies. We advance a theory of contract design in a world of costly litigation. We examine the efficiency of investment at the front-end and back-end of the contracting process, where we focus on litigation as the back-end stage. In deciding whether to express their obligations in specific or vague terms, contracting parties implicitly choose their allocation of costs between the front- and back-end. When the parties agree to vague terms (or standards), such as best efforts or commercial reasonableness, they delegate to the back-end the task of selecting proxies: e.g., the court selects market indicators that serve as benchmarks for performance. When the parties agree to specific terms(or rules), they invest more at the front-end to specify proxies in their contract and thereby leaving a smaller task for the enforcing court. In this Article, we explore the choice between rules and standards in terms of this tradeoff, and offer an explanation for why contracts in practice have a mix of vague and specific provisions. We then suggest that parties can achieve further contracting gains by varying procedural rules governing the prospective enforcement of their disputes. We illustrate by examining provisions in commercial contracts that allocate burdens and standards of proof. If the parties can improve the cost-effectiveness of litigation in this manner, they can reduce back-end costs. They thereby create opportunities to further lower contracting costs (or to improve the incentive gains from contracting) by shifting more investment to the back-end by increasing their use of vague terms. Vague terms have fallen into disfavor with contract theorists and this Article offers a justification for why they are nevertheless commonplace in commercial practice. Our analysis highlights the general and valuable lesson that the anticipated path of litigation is relevant to contract design.

Contract design, litigation, verifiability, rules/standards, burdens of proof

Abstract:
This paper begins with the claim that the state's primary role in uniformly enforcing commercial contracts is to regulate incomplete contracts efficiently. This role requires the state to perform two interdependent but conceptually distinct functions. The first is an interpretive function -- the task of correctly (and uniformly) interpreting the meaning of the contract terms chosen by parties to allocate contract risk. The second is a standardizing function -- the task of creating broadly suitable default rules or assigning standard meanings to widely used contract terms. Correct interpretation argues for a "textualist" or plain meaning interpretation of the express terms used in incomplete contracts. The task of generating useful defaults argues, on the other hand, for contextualizing incomplete contracts so that courts can find out about commercial practice. Thus, the first goal seems to require keeping context out whenever possible, and the second goal seems to require incorporating context as often as possible. As a consequence, the law is apparently forced to trade off one goal against the other.

The UCC has quite clearly chosen the strategy of incorporation; it adopts a pervasive standard of commercial reasonableness that requires context to supply meaning to many of its generic default rules. But curiously, the Code fails even at the one task it was explicitly designed to do. Under the Code there has been very little production of standardized defaults. Moreover, the Code, intent on incorporation, fails at the first enterprise -- reliable and predictable interpretation of contractual text. Surprisingly, the development of standardized defaults has been much more successful under the common law, in those areas of contract law such as commercial services to which the Code does not extend. And these courts have also retained more traditional plain meaning and parol evidence rules and thus have reinforced their textualist interpretive strategy. The result is that both kinds of efficiency gains -- the creation of a fairly uniform menu of standardized defaults, with regular additions of new terms to the menu and stable (i.e., uniform) interpretation of express terms, are seen much more in the common law than under the Code.

I argue that the inefficiencies of the Code are a product of the codification enterprise itself -- of trying to introduce a civil-law approach into a largely successful common law system. Because gaps are filled with reference to the internal norms of the Code rather than the external contractual context, interpretation is both contextual and self-referential--the worst of both worlds.

Abstract:
The United Nations Convention on Contracts for the International Sale of Goods, or CISG, has been adopted by more than 60 countries in an effort to harmonize the law that applies to international sales contracts. In this paper, we argue that the effort to create uniform international sales law (ISL) fails to supply contracting parties with the default terms they prefer, thus violating the normative criterion that justifies the law-making process for commercial actors in the first instance. Our argument rests on three claims. First, we contend that the process by which uniform ISL is drafted will dictate the form that many provisions take. Second, we contend that the legal form dictated by the drafting process has significant substantive consequences, particularly for the policy objectives of uniform ISL. That leads to our third claim. We predict that in order to achieve uniform ISL that is widely adopted, those involved in the drafting process will systematically promulgate many vague standards that contracting parties would not choose for themselves. These defaults cannot be justified as the inevitable cost of achieving an optimal level of uniformity. If the products of a uniform ISL are default terms that parties do not want, then the underlying justification for the law-making function - reduction of contracting costs - vanishes.

We find significant correspondence between our predictions about the drafting of uniform international sales law and the CISG. The CISG was drafted by parties whose objectives did not necessarily coincide with those of the commercial actors whose conduct the treaty was intended to regulate. The result is a variety of vague standards and compromises that appear inconsistent with commercial interests. We also illustrate the ways in which the CISG avoided potential correctives to these problems. We conclude by suggesting that commercial actors involved in international sales would prefer to choose governing law from among legal regimes that compete to supply parties with more desirable substantive terms.

Abstract:
International law provides an ideal context for studying the effects of freedom from coercion on cooperative behavior. Framers of international agreements, no less than the authors of private contracts, can choose between self enforcement and coercive third-party mechanisms to induce compliance with the commitments they make. Studies of individual contracting provide some evidence that coercive sanctions may crowd out self enforcement, implying that too great a propensity by external actors to intervene in the contractual relationship may produce welfare losses. We explore the possibility that too much coercive third-party enforcement similarly can reduce the value of international agreements.

We argue that, in spite of the obvious differences between state and individual decisionmaking, enough similarities exist to make the inquiry worthwhile. Using analytic moves worked out in the context of private contracts, we make two general claims about international agreements, one conventional and one controversial. First, we maintain that one usefully can evaluate efforts to frame and implement international agreements in terms of optimal enforcement structure. Choosing from a broad range of normative criteria, one still can distinguish between better and worse enforcement strategies. Second, we argue that the optimal enforcement structure for any particular international agreement will depend on both the goals of the agreement and the context in which it designed and implemented. Because these goals and contexts are diverse, the set of optimal enforcement structures is heterogenous. Some optimal enforcement structures will depend largely on self enforcement, while others will not.

Central to our claim is an appreciation of the interaction of self enforcement and third-party coercion including binding arbitration, use of international courts, and enforcement by domestic actors. We maintain that in a far from trivial number of instances subject to international agreement, self enforcement and coercive enforcement may be rivalrous and the optimal enforcement structure would preclude or limit coercive enforcement. In particular, we argue that good theoretical arguments buttress the general tendency of domestic courts not to extend their coercive powers to implement an international agreement without a clear signal from the framers of the agreement that this coercion is desired.

Contracts, law and economics, international law, international trade

Abstract:
Hoffman v. Red Owl Stores is one of the storied cases in modern contract law. The conventional wisdom is that Hoffman represents the emergence of a new legal rule imposing promissory estoppel liability for representations made during preliminary negotiations. Yet a review of contemporary case law shows that, in fact, courts require some form of agreement before they will grant recovery for early reliance. Hoffman's main legacy, therefore, has been as a trap for the unwary lawyer (and unhappy client) who unsuccessfully seek recovery for reliance on preliminary negotiations. This article asks how the court in Hoffman was able to find liability where other courts have not. A careful examination of the trial record shows that the conventional understanding of the facts in Hoffman is simply wrong. The true facts show that the breakdown in the negotiations between Hoffman and Red Owl officials was a product of a misunderstanding as to the nature of his financial contribution to the enterprise, a misunderstanding as attributable to Hoffman's carelessness as to any representations made by Red Owl's agents. The article then uses a large sample of decided cases to recover the law in action that governs precontractual liability. This sample highlights the emergence of a new default rule that imposes liability for a failure to bargain in good faith following a binding preliminary commitment. This new legal duty has been largely unexplored in the casebooks or the secondary literature, in part because of the misplaced attention paid to the unfortunate controversy between Mr. Hoffman and Red Owl Stores.

Contracts, Promissory Estoppel, Preliminary Agreements, Hoffman v. Red Owl

Abstract:
Rapidly innovating industries are just not behaving the way theory expected. Conventional industrial organization theory predicts that when parties in the supply chain have to make transaction-specific investments, the risk of opportunism will drive them away from contracts and toward vertical integration. Despite the conventional theory, contemporary practice is moving in the other direction. Instead of vertical integration, we observe vertical disintegration in a significant number of industries, as producers recognize that they cannot themselves maintain cutting-edge technology in every field required for the success of their product. In doing this, the parties are developing forms of contracting beyond the reach of contract theory models. In this Article, we connect the emerging contract practice to theory, learning from what has happened in the real world to frame a theoretical explanation of this cross-organizational innovation and to reconceptualize the boundaries of the firm accordingly. We argue that the vertical disintegration of the supply chain in many industries is mediated neither by fully specified technical interfaces that allow suppliers to produce a modular piece of the ultimate product, nor by entirely implicit relational contracts supported only by norms of reciprocity and the expectation of future dealings. Rather, we suggest that the change in the boundary of the firm has given rise to a new form of contracting between firms - what we call contracting for innovation. This pattern braids explicit and implicit contracting to support iterative collaborative innovation by raising switching costs. These costs, represented by the parties' parallel investment in transaction specific investment in knowledge about their collaborators' capacities, deter opportunism under circumstances when explicit contracting, renegotiation and the anticipation of future dealings cannot.

vertical integration, contracting, switching costs, innovation

Abstract:
Rapidly innovating industries are just not behaving the way theory expected. Conventional industrial organization theory predicts that when parties in the supply chain have to make transaction-specific investments, the risk of opportunism will drive them away from contracts and toward vertical integration. Despite the conventional theory, contemporary practice is moving in the other direction. Instead of vertical integration, we observe vertical disintegration in a significant number of industries, as producers recognize that they cannot themselves maintain cutting-edge technology in every field required for the success of their product. In doing this, the parties are developing forms of contracting beyond the reach of contract theory models. In this Article, we connect the emerging contract practice to theory, learning from what has happened in the real world to frame a theoretical explanation of this cross-organizational innovation and to reconceptualize the boundaries of the firm accordingly. We argue that the vertical disintegration of the supply chain in many industries is mediated neither by fully specified technical interfaces that allow suppliers to produce a modular piece of the ultimate product, nor by entirely implicit relational contracts supported only by norms of reciprocity and the expectation of future dealings. Rather, we suggest that the change in the boundary of the firm has given rise to a new form of contracting between firms - what we call contracting for innovation. This pattern braids explicit and implicit contracting to support iterative collaborative innovation by raising switching costs. These costs, represented by the parties' parallel investment in transaction specific investment in knowledge about their collaborators' capacities, deter opportunism under circumstances when explicit contracting, renegotiation and the anticipation of future dealings cannot.

Abstract:
Market damages - the difference between the market price for goods or services at the time of breach and the contract price - are the best default rule whenever parties trade in thick markets: they induce parties to contract efficiently and to trade if and only if trade is efficient, and they do not create ex ante inefficiencies. Courts commonly overlook these virtues, however, when promisors offer a set of services some of which are not separately priced. For example, a promisor may agree to pay royalties on a mining lease and later to restore the promisee's property. In these cases, courts compare the cost to the promisor of providing the service that was not supplied to the increase in the market value of the promisee/buyer's property had the promisor/seller performed. When the cost of completion is large relative to the market delta - the increase in market value - courts concerned to avoid economic waste limit the buyer to the market value increase. This concern is misguided. Since the buyer commonly prepays for the service at the ex ante market price, a cost of completion award actually has a restitution element - the prepaid price - and an expectation interest element - the market damages. The failure to recognize the joint nature of cost of completion damages causes courts to deny these damages more frequently than they should. In this paper, we argue that the unappreciated virtues of market based damages justify removing the courts' discretion to deny them no matter how high they appear to be. The rule that denies buyers market damages induces excessive entry into these service markets. Moreover, buyers are under-compensated when they prepay and cannot recover the price paid for the breached services but instead are restricted to the market delta. As a result, too few buyers contract ex ante for the relevant service and surplus maximizing contracts are forgone. Finally, sellers often can take actions in the interim between making the contract and the time for performance of the service that would reduce the service cost to manageable proportions. Sellers are less likely to take these precautions if they are required to pay buyers only the market delta rather than the full performance cost that their actions could have avoided.

Abstract:
Market damages - the difference between the market price for goods or services at the time of breach and the contract price - are the best default rule whenever parties trade in thick markets: they induce parties to contract efficiently and to trade if and only if trade is efficient, and they do not create ex ante inefficiencies. Courts commonly overlook these virtues, however, when promisors offer a set of services some of which are not separately priced. For example, a promisor may agree to pay royalties on a mining lease and later to restore the promisee's property. In these cases, courts compare the cost to the promisor of providing the service that was not supplied to the increase in the market value of the promisee/buyer's property had the promisor/seller performed. When the cost of completion is large relative to the "market delta" - the increase in market value - courts concerned to avoid "economic waste" limit the buyer to the market value increase. This concern is misguided. Since the buyer commonly prepays for the service at the ex ante market price, a cost of completion award actually has a restitution element - the prepaid price - and an expectation interest element - the market damages. The failure to recognize the joint nature of cost of completion damages causes courts to deny these damages more frequently than they should. In this paper, we argue that the unappreciated virtues of market based damages justify removing the courts' discretion to deny them no matter how high they appear to be. The rule that denies buyers market damages induces excessive entry into these service markets. Moreover, buyers are under-compensated when they prepay and cannot recover the price paid for the breached services but instead are restricted to the market delta. As a result, too few buyers contract ex ante for the relevant service and surplus maximizing contracts are forgone. Finally, sellers often can take actions in the interim between making the contract and the time for performance of the service that would reduce the service cost to manageable proportions. Sellers are less likely to take these precautions if they are required to pay buyers only the market delta rather than the full performance cost that their actions could have avoided.

Abstract:
On August 13, 2001 the National Conference of Commissioners on Uniform State Laws voted 89 to 53 to reject the 2001 Amendments to Article 2 of the Uniform Commercial Code that had just been approved in May by the American Law Institute. While negotiations continue, this public split between the two bodies that have together shepherded the UCC project for over fifty years represents the likely end of the fourteen year effort to revise the law of sales as embodied in Article 2.

In this Essay, I examine the political economy of the Article 2 project from its origins to the present. I begin by analyzing the drafting and enactment process of the original Article 2 and evaluate the success of the new sales law it introduced, a success attributable in no small measure to the replacement of archaic vestiges of property law with efficient contract default rules. I then I consider the effects of the compromises Karl Llewellyn made to secure the enactment of the Code. Of particular significance is how the vague terms that invoke the commercial context (originally intended by Llewellyn as a means of incorporating ex ante default rules) have been used to challenge the objective meaning of disputed contracts. For many commercial contractors, exit may have been a cheaper option than lobbying for clearer and more predictable default rules. But the parties to mass-market sales transactions remain subject to Article 2, and their representatives have sought to influence the revision process. Thus, the focus has shifted from Llewellyn's original goal of prescribing optimal default rules for commercial contracts to the current debate over proscribing freedom of contract in mass-market transactions. The resulting divergence between the interests of producers and those of consumer buyers, computer information licensees and their representatives has produced deadlock.

I conclude that the flaws in the Article 2 project were present from its inception. Given the limits of legal regulation, it is unlikely that any set of "uniform" rules that are promulgated for adoption in every state can both efficiently complete the gaps in commercial contracts as well as optimally police consumer transactions. In sum, the uniform laws process works when there is distributional symmetry (when today's buyer might be tomorrow's seller). On the other hand, the process deadlocks when it seeks to produce uniform rules for transaction-types in which the distributional effects are asymmetric and prices do not adjust efficiently to compensate for the victory of one group in the legislative process.

Abstract:
Many scholars believe that notions of fault should and do pervade contract doctrine. Notwithstanding the normative and positive arguments in favor of a fault-based analysis of particular contract doctrines, I argue that contract liability is strict liability at its core. This core regime is based on two key prongs: (1) the promisor is liable to the promisee for breach, and that liability is unaffected by the promisor's exercise of due care or failure to take efficient precautions; and (2) the promisor's liability is unaffected by the fact that the promisee, prior to the breach, has failed to take cost-effective precautions to reduce the consequences of non-performance. I offer two complementary normative justifications for contract law's stubborn resistance to consider fault in either of these instances. First, I argue that there are unappreciated ways in which courts' adherence to strict liability doctrine at the core of contract reduces contracting costs. In addition, I argue that a strict liability core best supports parties' efforts to access informal or relational modes of contracting, especially where key information is unverifiable.

Abstract:
Modern contract law is governed by a two-stage adjudicative regime - an inheritance of the centuries-old conflict between law and equity. Under this regime, formal contract terms are treated as prima facie provisions that courts can override by invoking equitable doctrines so as to substantially “correct” the parties’ contract by realigning it with their contractual intent. This ex post judicial determination of the contractual obligation serves as a fallback mechanism for vindicating the parties’ contractual intent whenever the formal contract terms fall short of achieving the parties’ purposes. Honoring the contractual intent of the parties is thus the central objective of contract law. Yet little scholarly attention has been given to the structure of contractual intent. Courts naturally identify contractual intent with the parties’ contractual objectives, which we call the “contractual ends” of their collaboration. But reaching agreement on a shared objective is only the first step to designing an enforceable contract. Thereafter, the parties must create the particular rights and duties that will serve as their “contractual means” for achieving their shared ends. The thesis of this Article is that the current regime of contract adjudication conflates the parties’ contractual means with their contractual ends. In so doing, it reduces the range of contractual arrangements to which contract law gives effect, thereby potentially depriving commercially sophisticated parties of essential tools for contract design. Sophisticated actors engage in ex ante determinations of their means of enforcement, choosing whether enforcement is to be either legal or relational and whether legal enforcement should rely on either rules or standards. Both theory and available evidence suggest, therefore, that such parties would prefer a default rule that strictly enforces formal contract doctrine unless they have expressly indicated their intent to delegate hindsight authority to a court. By eliminating the risk that courts will erroneously infer the parties’ preference for ex post judicial intervention, such a regime increases the reliability of formal contract terms and enhances the parties’ control over the content of their contract.

Abstract:
According to the overwhelming majority view, promissory estoppel is not an appropriate ground for legally enforcing statements made during preliminary negotiations unless there is a “clear and unambiguous promise” on which the counterparty reasonably and foreseeably relies. Bill Whitford and Stewart Macaulay were among the first scholars to note the apparent absence of such a promise in the case of Hoffman v. Red Owl Stores. Several years ago, after studying the trial record, I concluded that the best explanation for the breakdown in negotiations was the fundamental misunderstanding between the parties as to the amount and nature of Hoffmann’s equity contribution to the franchise. After locating and interviewing Hoffmann, Whitford and Macaulay tell a different story. They view as insignificant the misunderstanding about the nature of Hoffmann’s equity contribution. Rather, they focus attention on additional statements urging Hoffmann to sell his bakery business and store. In these later statements, ignored by the Wisconsin Supreme Court, they find the “missing promise” that they challenged all of us to look for years ago. While I credit their account, I remain as unconvinced by their story as they are of mine. Thus, the important question is how scholars could draw such different inferences from the same basic facts. In this Essay, I speculate that the different stories are a product of our respective methodological commitments: their commitment to a law and society approach to legal issues and mine to law and economics modes of analysis. Those diverse approaches illustrate the tension between “context” and “theory” and the inherent paradox of legal analysis: without context no legal rule can be applied, but with nothing but context no legal rule can be found. For this reason, I conclude, it is important for legal academics of every stripe to appreciate the biases inherent in their methodology of choice and work to correct for them

Abstract:
Contract interpretation remains the largest single source of contract litigation between business firms. In part this is because contract interpretation issues are difficult, but it also reflects a deep divide between textualist and contextualist theories of interpretation. While a strong majority of U.S. courts continue to follow the traditional, "formalist" approach to contract interpretation, some courts and most commentators prefer the "contextualist" interpretive principles as exemplified by the Uniform Commercial Code and the Second Restatement. In 2003, we published an article that set out a theory of contract interpretation to govern agreements between business firms. In that article, we support a formalist theory of contract interpretation. Our article has prompted a number of anti-formalist responses. In our article we argued that, although accurate judicial interpretations are desirable, accurate interpretations are costly for parties and courts to obtain. Thus, any socially desirable interpretive rule would trade accuracy off against contract writing and adjudication cost. This trade-off implies that risk neutral business parties will commonly prefer judicial interpretations to be made on a limited evidentiary base the most important element of which is the contract itself. But importantly, we also argued that commercial parties’ preferences along this dimension will be heterogeneous. Thus, any interpretation rules the state adopts should be defaults and the state should defer to the expressed preferences of particular parties regarding interpretation. This Review Essay clarifies and extends these arguments. We briefly summarize empirical data that support our theory, and respond to our critics. Although much academic commentary suggests otherwise, both the available evidence and prevailing judicial practice support the claim that sophisticated parties prefer textualist interpretation. Sophisticated commercial parties incur costs to cast obligations expressly in written and unconditional forms to permit a party to stand on its rights under the written contract, to improve party incentives to invest in the deal, and to reduce litigation costs. Contextualist courts and commentators prefer to withdraw from parties the ability to use these instruments for contract design. The contextualists, however, cannot justify rules that so significantly restrict contractual freedom in the name of contractual freedom.

Abstract:
Individual actors want to make their promises enforceable in order to motivate mutually profitable investments. But parties cannot easily design contracts that maximize beneficial investments and also respond appropriately to changing conditions. Although economists have designed theoretical models that maximize joint welfare both ex ante and ex post, these mechanisms depend on a perfectly functioning and costless system of enforcement. In the real world, parties must expend substantial resources to enforce commitments legally, and, in many cases, courts lack information to assess the parties' actions. This review examines one of the main insights of the theory of incomplete contracts: that legal enforcement alone cannot ensure the full realization of jointly beneficial cooperative ventures. Legal enforcement, supported by the coercive power of the state, is only one mechanism for inducing cooperation, and in many relationships it typically has only a limited role to play. Complex contracts do lend themselves to effective formal enforcement. But parties often choose to write simple contracts that look to renegotiation once the future is known. Simple contracts require enforcement by informal mechanisms, such as reputation, repeated dealings, and norms of reciprocity in order to motivate both beneficial investment ex ante and adjustment ex post.

contract theory, commercial law

Abstract:
Despite the fact that compensation is the governing principle in contract law remedies, it has tenuous historical, economic and empirical support. A promisor's right to breach and pay damages (which is subject to the compensation principle) is only a subset of a larger family of termination rights that do not purport to compensate the promisee for losses suffered when the promisor walks away from the contemplated exchange. These termination rights can be characterized as embedded options that serve important risk management functions. We show that sellers often sell insurance to their buyers in the form of these embedded options. We explain why compensation is of little relevance to the option price agreed to by the parties, which is a function of the value of the option to the buyer, its cost to the seller and the market in which they transact. We thus propose a novel justification for why penalty liquidated damages may be higher than seller's costs: they are option prices that reflect the value of the options to the buyer. The regulation of liquidated damages is thus tantamount to price regulation, which is outside the realm of contract law. Moreover, in light of the heterogeneity among optimal option prices, we also make the case against having an expectation damages default rule to begin with. In thick markets, we argue for enforcing the parties ex ante risk allocation with market damages. In thin markets, we propose that parties be induced to agree explicitly with respect to all termination rights, including breach damages, by the threat of specific performance of their contemplated exchange or, in the case of consumers, by a default rule that provides them a termination option at no cost.

Contracts, options, risk management, expectation damages, liquidated damages

Abstract:
The debate over the social value of secured credit (and the appropriate priority for secured claims in bankruptcy) is entering its nineteenth year. Yet the continuing publication of succeeding generations of papers exploring the topic have yielded precious little in the way of an emerging scholarly consensus about the nature and function of secured credit. In this paper, I build upon the existing scholarship and seek to answer three questions. First, what are the right (and the wrong) questions to ask if we are to advance our understanding of secured credit and its appropriate priority. Second, what do we know (and do not know) about the answers to these questions? Third, what normative stance is justified in a world of uncertainty in which many of the key questions will likely not be answered for some time (if ever)?

I conclude that the best theoretical explanation for secured credit that survives observation centers on the unique advantages of leverage over the debtor provided by the foreclosure options given to secured creditors in Article 9. The leverage of secured credit is used to solve several different contracting problems for certain classes of debtors and creditors. These solutions carry both social and private benefits as well as offsetting costs. The social benefits derived from the ability of security-created leverage to control vexing problems of overinvestment and underinvestment that are ubiquitous in financial contracting. The private benefits derive from the use of leverage to improve repayment probabilities vis-a-vis other creditors.

Unhappily, the costs of security are high, and thus, security is observed in the world only where the social benefits and private benefits work in combination. This combination of social and private benefits means that the answer to the question whether secured credit does (or does not) promote social welfare is both currently unknown and unknowable. In a world of uncertainty, therefore, I argue that the intellectual burden of proof should turn on an analysis of the political economy of both the Article 9 and bankruptcy law making process.