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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 fees of experts (financial advisors, lawyers, accountants) are a substantial fraction of bankruptcy costs. Scholars have considered how best to reduce these costs, but have not considered how they should be allocated among creditors. The allocation issue is important because creditors can spend redistributionally (to violate or uphold absolute priority) and productively (to increase the value of the bankrupt firm). An efficient bankruptcy cost allocation scheme should discourage redistributional and encourage productive creditor spending.

We consider the desirability of various allocation schemes in a model in which senior and junior creditors can engage in both types of spending but the bankruptcy court cannot distinguish productive from rent seeking activities. We suppose that the senior claim is at or in the money. This implies that the seniors have an incentive to spend only to defend their position while the juniors have both good and bad incentives: to spend productively on value improvement because they are residual claimants and to spend redistributionally because they are partly or totally out of the money under absolute priority. A good bankruptcy cost allocation scheme thus should induce the seniors to spend more and the juniors to spend less.

We show: (i) The current US cost allocation system is unsatisfactory because the scheme partially reimburses junior expenses on experts but does not reimburse seniors at all; (ii) Full reimbursement schemes that imposes all costs on one set of parties, such as seniors, juniors or the government, are dominated by partial reimbursement schemes, because these can be better tailored to encourage the right and discourage the wrong kind of spending; and (iii) A cost allocation scheme that approaches first best and is implementable would delegate the issue of expert cost reimbursement to the debtor in possession. The incentive of Chapter 11 debtors to survive would induce them partly to reimburse senior spending but not to reimburse junior spending.

Abstract:
The standard contract that governs friendly mergers contains a material adverse change clause (a MAC) and a material adverse effect clause (a MAE); these clauses permit a buyer costlessly to cancel the deal if such a change or effect occurs. In recent years, the application of the traditional standard-like MAC and MAE term has been restricted by a detailed set of exceptions that curtails the buyer's ability to exit. The term today engenders substantial litigation and occupies center stage in the negotiation of merger agreements. This paper asks what functions the MAC and MAE term serve, what function the exceptions serve and why the exceptions have arisen only recently. It answers that the term encourages the target to make otherwise noncontractable synergy investments that would reduce the likelihood of low value realizations, because the term permits the buyer to exit in the event the proposed corporate combination comes to have a low value. The exceptions to the MAC and MAE term impose exogenous risk on the buyer; the parties cannot affect this risk and the buyer is a relatively superior risk bearer. The exceptions have arisen recently because the changing nature of modern deals make the materialization of exogenous risk a more serious danger than it had been. The modern MAC and MAE term thus responds to the threat of moral hazard by both parties in the sometimes lengthy interim between executing a merger agreement and closing it. The paper's empirical part examines actual merger contracts and reports results that are consistent with the analysis.

Abstract:
The standard contract that governs friendly mergers contains a material adverse change clause (a "MAC") and a material adverse effect clause (a "MAE"); these clauses permit a buyer costlessly to cancel the deal if such a change or effect occurs. In recent years, the application of the traditional standard-like MAC and MAE term has been restricted by a detailed set of exceptions that curtails the buyer's ability to exit. The term today engenders substantial litigation and occupies center stage in the negotiation of merger agreements. This paper asks what functions the MAC and MAE term serve, what function the exceptions serve and why the exceptions have arisen only recently. It answers that the term encourages the target to make otherwise noncontractable synergy investments that would reduce the likelihood of low value realizations, because the term permits the buyer to exit in the event the proposed corporate combination comes to have a low value. The exceptions to the MAC and MAE term impose exogenous risk on the buyer; the parties cannot affect this risk and the buyer is a relatively superior risk bearer. The exceptions have arisen recently because the changing nature of modern deals make the materialization of exogenous risk a more serious danger than it had been. The modern MAC and MAE term thus responds to the threat of moral hazard by both parties in the sometimes lengthy interim between executing a merger agreement and closing it. The paper's empirical part examines actual merger contracts and reports preliminary results that are consistent with the analysis.

Abstract:
Karl Llewellyn was America's leading legal realist, academic law reformer, and Sales Law theorist. Though extensive analyses exist of Llewellyn's performance in the first two of Llewellyn's roles exist, no studies use his original work to evaluate his performance in the third role. Citation analysis reveals that many of the ideas in these articles retain value today, but modern scholars commonly infer his views on contract theory from more recent sources. This essay is predicated on the notion that Llewellyn's theory is best recovered from the articles that originally set it out rather then from later partial references by Llewellyn or from UCC drafts that commonly reflected both the work of the author and what it was politically acceptable to say.

Abstract:
This essay reviews a relatively neglected body of Llewellyn's work, the contract and sales articles he published between 1925 and 1940. The essay claims that Llewellyn was an important founder of the modern law and economics approach to regulating contracts. He argued, among other things, that the state should reduce contracting costs, draft default rules for parties and use economic thought to understand parties' contracting behavior. Llewellyn's recommendations for rules to govern concrete cases, however, are out dated because the economic thought of his time was too primitive to offer policy analysts much help. Analysts today draw on the economics of information, the theory of finance and transaction cost economics when devising rules to regulate contracts, but none of these bodies of thought were available to scholars of the thirties. The essay concludes with a showing that Llewellyn's contract scholarship differed substantially from the current view of what legal realist scholarship was like in general and what Llewellyn's work was like in particular. On these views, there was no law and economics in private law until modern times. This seems mistaken.

Abstract:
Under standard accounts of corporate governance, capital markets play a significant role in monitoring management performance and, where appropriate, replacing management whose performance does not measure up. Recent case law in Delaware, however, appears to have altered dramatically the mechanisms through which the market for corporate control must operate. In particular, the interaction of the poison pill and the Delaware Supreme Court's development of the legal standard governing defensive tactics in response to tender offers have resulted in a decided, but as yet unexplained, preference for control changes mediated by means of an election rather than by a market. In this paper, we begin the evaluation of the preference for elections over markets that the Delaware Supreme Court has not yet attempted. We apply to this effort both doctrinal logic and insights derived from an interesting but complex formal literature that has developed to understand how voting structures work in political contests and jury deliberations. Since these contexts differ substantially from transfers of corporate control, our analysis raises a question of fit: are voting models suitable for analyzing the question asked here? In our view, the models do shed some light on the takeover institution, but if this view is ultimately rejected, then we will have eliminated what at least superficially appears to be a useful set of tools.

Abstract:
In most of the contract theory literature, contracting costs are assumed either to be high enough to preclude certain forms of contracting or low enough to permit any contract to be written. Similarly researchers usually treat renegotiation as either costless or prohibitively costly. This article addresses the middle ground between these extremes, in which the costs of contracting and renegotiation can take intermediate values and the contracting parties can themselves influence these costs. The context for our analysis is the canonical problem of inducing efficient relation-specific investment and efficient ex post trade. Among our principle results are: (i) The efficiency and complexity of the initial contract are decreasing in the cost to create a contract. Hence the best mechanism design contracts can be too costly to write. (ii) When parties use the simpler contract forms, they require renegotiation to capture ex post surplus and to create efficient investment incentives. In some cases, parties want low renegotiation costs. More interesting is that, in other cases, parties have a strict preference for moderate renegotiation costs. (iii) The effect of contract law on contract form is significant but has been overlooked. In particular, the law's interpretive rules raise the cost of enforcing complex contracts, and thus induce parties to use simple contracts. Worse, the law also lowers renegotiation costs, which further undermines complex contracts and is also inappropriate for some of the simpler contracts.

Abstract:
In most of the contract theory literature, contracting costs are assumed either to be high enough to preclude certain forms of contracting, or low enough to permit any contract to be written. Similarly, researchers usually treat renegotiation as either costless or prohibitively costly. This paper addresses the middle ground between these extremes, in which the costs of contracting and renegotiation can take intermediate values and the contracting parties can themselves influence these costs. The context for our analysis is the canonical problem of inducing efficient relation-specific investment and efficient ex post trade. Among our principal results are: (i) The efficiency and complexity of the initial contract are decreasing in the cost to create a contract. Hence, the best mechanism design contracts can be too costly to write. (ii) When parties use the simpler contract forms, they require renegotiation to capture ex post surplus and to create efficient investment incentives. In some cases, parties have a strict preference for moderate renegotiation costs. (iii) The effect of Contract Law on contract form is significant but has been overlooked. In particular, the law's interpretative rules raise the cost of enforcing complex contracts, and thus induce parties to use simple contracts. Worse, the law also lowers renegotiation costs, which further undermines complex contracts and is also inappropriate for some of the simpler contracts.

Abstract:
In most of the contract theory literature, contracting costs are assumed either to be high enough to preclude certain forms of contracting, or low enough to permit any contract to be written. Similarly, researchers usually treat renegotiation as either costless or prohibitively costly. This paper addresses the middle ground between these extremes, in which the costs of contracting and renegotiation can take intermediate values and the contracting parties can themselves influence these costs. The context for our analysis is the canonical problem of inducing efficient relation-specific investment and efficient ex post trade. Among our principle results are: (i) The efficiency and complexity of the initial contract are decreasing in the cost to create a contract. Hence, the best mechanism design contracts can be too costly to write. (ii) When parties use the simpler contract forms, they require renegotiation to capture ex post surplus and to create efficient investment incentives. In some cases, parties want low renegotiation costs. More interesting is that, in other cases, parties have a strict preference for moderate renegotiation costs. (iii) The effect of Contract Law on contract form is significant but has been overlooked. In particular, the law's interpretive rules raise the cost of enforcing complex contracts, and thus induce parties to use simple contracts. Worse, the law also lowers renegotiation costs, which further undermines complex contracts and is also inappropriate for some of the simpler contracts.

Contracts, contracting costs, renegotiation, investment, contract law

Abstract:
It is widely agreed that capital cost reduction should be among the goals that a business bankruptcy law should pursue. This Essay argues that capital cost reduction should be the only goal, and that a bankruptcy system seriously committed to this goal would be both smaller and less centralized than the current U.S. Bankruptcy Code. In particular, a bankruptcy law that sought to reduce the cost of debt capital to firms would (a) require the trustee or debtor in possession to maximize the value of the insolvent firm rather than the payoffs of general creditors; (b) permit preferences (but continue to bar fraudulent conveyances); (c) permit suppliers and customers to contract for the right to cease dealing with a firm that has become insolvent; (d) not subsidize the use of expert professionals by junior creditors, but sometimes subsidize expert use by seniors; and (e) permit parties in the lending agreement to induce the debtor to use the bankruptcy procedure, either Chapter 7 or Chapter 11, that turns out to be optimal in the state of the world in which insolvency occurred.

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:
Contract law's liquidated damage rules prevent enforcement of contractual damage measures that require the promisor, if it breaches, to transfer to the promisee a sum that exceeds the net gain the promisee expected to make from performance; but these rules permit the promisor to transfer less than the promisee's expectation. We define a contractual damage multiplier as any number between zero and infinity by which the promisee's expected gain - its expectation interest - is multiplied. Multipliers of one or less thus comply with the liquidated damage rules while multipliers that exceed one do not; the high multipliers are unenforceable penalties. This paper shows that multipliers of any size can be efficient or inefficient, depending on the parties' purposes in creating them. For example, a multiplier that exceeds one will decrease welfare if used by a seller with market power to deter entry, but will increase welfare if used by parties to induce efficient relation specific investment. As a consequence, a court should inquire, not into the size of the multiplier, but into the purpose the multiplier serves for the parties. The practical implication of this view is that it no longer should be a sufficient defense to an action to enforce a contractual damage measure that the parties' multiplier exceeded one.

Abstract:
This paper explores how the opportunity to recontract affects investment and trade in contractual relationships when it is assumed that renegotiation is costly. In this world, recontracting retains much of the benefit that has been ascribed to it, including the realization of any surplus that is available ex post. Costly recontracting also mitigates the well-known drawback, that parties who expect to renegotiate sometimes cannot credibly commit to invest efficiently. This is because the attractiveness of renegotiation decreases in recontracting costs. We show that the optimal contracting environment often involves moderate recontracting costs, which balance the beneficial and detrimental effects of renegotiation. Our result stands in contrast to those derived in common models that assume unrealistically either that recontracting costs are zero or that they are infinite. We discuss implications for the design of legal institutions, governance systems, and contractual form.

Abstract:
This paper explores how the opportunity to recontract affects investment and trade in contractual relationships when it is assumed that renegotiation is costly. In this world, recontracting retains much of the benefit that has been ascribed to it, including the realization of any surplus that is available ex post. Costly recontracting also mitigates the well-known drawback, that parties who expect to renegotiate sometimes cannot credibly commit to invest efficiently. This is because the attractiveness of renegotiation decreases in recontracting costs. We show that the optimal contracting environment often involves moderate recontracting costs, which balance the beneficial and detrimental effects of renegotiation. Our result stands in contrast to those derived in common models that assume unrealistically either that recontracting costs are zero or that they are infinite. We discuss implications for the design of legal institutions, governance systems, and contractual form.

Abstract:
This paper uses a principal/agent framework to analyze consumer bankruptcy. The bankruptcy discharge partly insures risk averse borrowers against bad income realizations, but also reduces the borrower's incentive to avoid insolvency. Among our results are: (a) High bankruptcy exemptions increase bankruptcy insurance but at the cost of reducing the borrower's incentives to stay solvent; (b) Reaffirmations -- renegotiations -- have ambiguous efficiency effects in general, but the right to renegotiate is especially valuable for relatively poor persons; (c) Giving consumers the ex post choice regarding which bankruptcy chapter to use also provides more insurance but, by making bankruptcy softer on debtors, has poor incentive effects; (d) Serious consideration should be given to expanding the scope of consumers' ability to contract about bankruptcy because private contracts are better than regulations at making context sensitive tradeoffs between risk and incentives.

Abstract:
This short Essay analyzes two Supreme Court cases that considered valuation issues in consumer bankruptcy cases: Associates Commercial Corp. v. Rash, 520 U.S. 953 (1997), and Till v. SCS Credit Corp., 541 U.S. 465 (2004). The Bankruptcy law provides some wage insurance by permitting debtors to discharge debts in bad states of the world, and also provides incentives for borrowers to avoid those states because bankruptcy is costly to persons and discharge may not be complete. The Essay shows that these two cases reach inconsistent results from an insurance and an incentive point of view. Rash chose a valuation standard for collateral whose effect is to reduce the Code's ability to insure, but thereby to increase the borrower's incentive to avoid bankruptcy. Till chose an interest rate standard for discounting to present value the periodic payments that are supposed to equal the collateral's actual value. The effect of the Till standard is to require the individual borrower to purchase more insurance against default than theretofore, and thereby to reduce the borrower's incentive to avoid bankruptcy. The opinions in Till appear to be unaware of these inconsistencies, and the opinions in Rash seem not to understand its effect. Both cases also increased the administrative costs of bankruptcy by creating additional occasions for valuation and interest rate hearings. The Essay concludes by remarking that the Supreme Court's limited competence in the bankruptcy field and its restricted docket suggest that the task of harmonizing bankruptcy law among the circuits actually falls on the circuit courts unaided. These courts thus should be more sensitive to uniformity issues than they have been.

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:
In a common commercial pattern, the seller of a standard product contracts with one buyer and then sells to another at the contract price after the initial buyer breaches. Sellers argue, and courts largely agree, that the seller could have served the contract buyer as well as the later buyer; hence, the seller is entitled to retain a down payment to the extent of, or sue to recover, the profit - price less cost - that it would have realized on the initial sale had that sale been completed. Some courts and many scholars disagree, arguing that resale of the contract product at the contract price is fully compensatory; consequently, the seller is not entitled to damages. In this paper, we show that sellers in these "lost volume" contexts may use non-refundable down payments and later transaction prices in an attempt to practice second degree price discrimination. Sellers select among combinations of low down payment and high transaction price - which maximize the number of contracts as these serve low-value buyers, who are relatively unlikely to trade and pay the transaction price but who would be deterred by a significant down payment - and combinations of high down payment and low transaction price - which maximize the likelihood of transaction given a contract and serve high value buyers, who are relatively undeterred by a high down payment as they expect to benefit from increased trade at the low transaction price. These disparate preferences sometimes enable sellers to induce separation among the buyers by offering contracts that differ in their down payment/transaction price combinations. As a positive matter, we identify a form of price discrimination that does not require the seller to vary either the quantity or the quality of goods sold to an individual buyer. As a normative matter, we argue that a rule enforcing price discrimination contracts - i.e., restricting sellers to retention only of the down payment - is preferable to any mandatory rule on the treatment of liquidated damages as well as to the current majority default rule, which permits sellers to recover lost profits when they exceed the down payment, or the current minority default rule, which permits sellers to recover nothing.

Contracts, Damages, Remedy, Commercial Law, UCC

Abstract:
The Supreme Court is thought to use a method of statutory interpretation called "the new textualism" when construing Federal Statutes, including the Bankruptcy Code. The new textualism, in brief, ties interpreters more closely to the text than more traditional interpretative methods. This Essay inquires into the justifications for the new textualism, but its primary goal is to argue that the Court prefers an important justification of this interpretative method to the method itself. The justification holds that interpretation should advance the rule of law virtues of certainty and predictability. A court that is committed to the new textualism would construe statutory standards as standards. This Essay argues that the Court, in contrast, exhibits a strong tendency to transmute Bankruptcy Code standards into bright line rules that maximally confine the discretion of the bankruptcy courts that administer the Code, and the district courts that review them. This tendency is in the self conscious service of attempting to advance the rule of law virtues. The Essay goes on to argue that judicial attempts to restrict the discretion of administrators are likely to fail when the governing statute, like the Bankruptcy Code, is intended to confer on administrators a large discretion; and the Essay suggests the possibility that the Court may be reading other statutes as it reads the Bankruptcy Code, subject to Chrevon type constraints that do not apply to bankruptcy as a field of Federal regulation.

Bankruptcy, supreme court, statutory interpretation, textualism

Abstract:
Professor du Marais and his colleagues analyze the way CRAs condition their ratings on the effectiveness of debt collection. Three such agencies are studied: Standard and Poor, Moody's and Fitch. The method used was to conduct interviews of stakeholders, the CRAs, top managers of all kinds of issuers, and staff of the regulators. All of these interviews were conducted in France.

This paper is in the line of papers that make serious studies of private institutions that affect the law and markets. These institutions have not received sufficient scrutiny, so this paper is welcome. In my view, the paper's positive findings are valuable but its normative critique needs more work. Thus, this Comment should be taken as a request for further research. My remarks are in three categories: market responses; ratings criteria; and data issues.

Comment

Abstract:
We study the effect of legal constraints in an environment in which agents face demand shocks they would like to smooth, but the agents also have weakness of will: their long and short run preferences are misaligned. Some agents are sophisticated - they know they will make inconsistent intertemporal choices - while other agents are naive. The consequent public policy problem is complex. The state apparently should facilitate consumer borrowing, to help agents cushion the effect of shocks, but also should facilitate pre-commitment, to help agents control excessive present-based preferences. We show that naive and sophisticated agents make similar consumption/savings choices, which simplifies the policy problem. We also show that agents with relatively strong present-based preferences who face relatively mild consumption shocks will borrow to finance excessive current consumption. Other agents save appropriately. Legal constraints that severely restrict agents' access to credit thus would be overinclusive. Offering agents access to both a liquid and an illiquid savings vehicle is welfare improving relative to allowing agents complete freedom to borrow or strongly restricting their access to the credit market.

Abstract:
Section 365 of the Bankruptcy Code prohibits enforcement of the once common "ipso facto clause." The clause excuses the solvent party from performance of the contract when the other party becomes insolvent. We show that the ability of insolvent firms to continue bad projects is enhanced by the absence of ipso facto clauses. Without such a clause, the firm can exploit the inability of courts always to assess expectation damages accurately to compel a solvent party to stay in a bad deal. An ipso facto clause would preclude this outcome because the clause permits the solvent party to exit costlessly. Further, an ipso facto clause improves the managers' incentive to exert effort to avoid financial distress. These results have two broader implications. First, that the important mandatory rule regulating the ability of solvent parties to exit is inefficient suggests that the justifications for the Bankruptcy Code's other mandatory rules should be rethought. Second, our analysis suggests that stakeholders such as contract partners of bankrupt firms may have important roles to play in inducing efficient bankruptcy decisions, through their abilities to stop unproductive projects that bankrupt firms may otherwise continue.

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:
This paper asks whether market competition can ameliorate the effect of cognitive error. Competition is possible because consumers differ cognitively, some consumers being more prone to err (the "naive") than others (the "sophisticated"). The approach here is to create a search equilibrium model of a market with a large number of firms. Each firm can offer either an exploitative or a naive contract to a consumer population that differs along two dimensions: some consumers are sophisticated while others are naive; and some consumers search for their preferred contract while others visit one firm. There are two principle results. First, when consumers comparison shop, neither contract type is priced monopolistically and competitive pricing will sometimes obtain; hence, there is less redistribution from consumers to firms. Second, when a fair proportion of consumers are sophisticated and the naive have a relatively low willingness to pay for their preferred contract, competition reduces the incidence of exploitative contracts and may cause these contracts to vanish. These results suggest that while decision makers should continue to ask if consumers suffer from cognitive error, they also should ask whether the market is ameliorating the consequences of error or could be helped to do so.

Abstract:
The regulatory compliance defense holds firms liable whose products or product warnings fail to satisfy federal regulatory standards, but does not exculpate firms that comply. Rather, compliance is relevant evidence for a jury to consider in a products liability action. This article argues that the defense should exculpate compliant firms as a matter of law. A Congress that thought about the matter would prefer this judicial construction of an unclear safety statute. To defend this view, the article argues that a legislature can have intentions in a normatively meaningful sense, that claims that a Congress or its agencies are captured by special interests should be nonjusticiable, and that, when a court is in doubt as to what a legislature intended, it should adopt that construction of the relevant statute that would be easiest for the legislature to correct if the court errs. In this case, it is easier for Congress to correct a construction that it intended to exculpate compliant firms than a construction that it did not.

Abstract:
Section 365 of the Bankruptcy Code prohibits enforcement of the once common "ipso facto" clause." The clause excuses the solvent party from performance of the contract when the other party becomes insolvent. We show that the ability of insolvent firms to continue bad projects is enhanced by the absence of ipso facto clauses. Without such a clause, the firm can exploit the inability of courts always to assess expectation damages accurately to compel a solvent party to stay in a bad deal. An ipso facto clause would preclude this outcome because the clause permits the solvent party to exit costlessly. Further, an ipso facto clause improves the managers' incentive to exert effort to avoid financial distress. These results have two broader implications. First, that the important mandatory rule regulating the ability of solvent parties to exit is inefficient suggests that the justifications for the Bankruptcy Code's other mandatory rules should be rethought. Second, under free contracting, the inefficient continuance of insolvent firms would be less of a problem than it now is because the ability of contract partners to withhold future performances sometimes would stop bad projects.

Abstract:
We consider legal rules that determine the price at which minority shareholders can be excluded from the corporate enterprise after a change in control. These rules affect investment after such a change as well as the probability of the change itself. Our principal results are that minority shareholders should be given the value that their interest would have had were no later investment made; and that this rule is best implemented, in large companies, by awarding the minority the pre-investment market value of their shares. The former aspect of our proposal is consistent with much current law but is rejected by many modern law reformers; the latter aspect of our proposal is novel.

Abstract:
This essay reviews the normative implications of contractual incompleteness. It reaches two conclusions: First the state can complete contracts with efficient defaults in fewer cases than is commonly supposed. Second, making specific performance routinely available for contracts that are sufficiently complete for courts to enforce often will permit parties to achieve first best.

Abstract:
Parties to lending agreements can create priority rankings in two ways: by securing a lender or by protecting the lender's debt with financial covenants. Protected debt turns into high priority debt because the early lender will permit covenant violations only if a later lender agrees to subordinate its claim. The Bankruptcy Code sustains both forms of priority by according secured debt senior status and by enforcing subordination agreements among creditors. The latter priority is not controversial but several recent reform proposals would reduce the secured lender's priority. This article argues that creditors who lend early in a firm's life are concerned about debt dilution, which can occur even when all of the borrower's later projects have positive values. It then shows that the equilibrium financial contract for private debt has strong borrowers protecting the early debt with financial covenants, and it suggests that weak borrowers protect the early debt with security. Thus security and financial covenants may be substitutes. "Covenant equilibria" are argued to be efficient. That these equilibria closely resemble "security equilibria," and that arguments for the inefficiency of the secured lender's priority are weak, both argue that the Bankruptcy Code's current respect for both forms of priority should continue. The article also argues that financial covenants should be made binding on later lenders whose advances would cause covenant violations.

Abstract:
Creditors and the insolvent firm are required to use the state supplied bankruptcy procedure if they cannot agree on a private resolution after financial distress has occurred. While these ex post workouts are legal, parties cannot agree in the lending contracts to use a bankruptcy procedure alternative to the one the state supplies. This paper considers this legal prohibition. The paper makes three principal claims: the prohibition on contracting for preferred bankruptcy procedures exacerbates underinvestment; the prohibition should be lifted for this reason and because parties could coordinate on "bankruptcy contracts" although firms tend to have numerous creditors, who lend at different times and may have different preferences over procedures; and methodologically, that regulators should take the ability of parties to contract about bankruptcy issues into account when devising legal rules.