Early Contract Termination, Performance-Contingent Control Rights, and Specific Investment

Abstract:     
Many early-termination provisions in multi-shipment contracts (in the form of explicit contract clauses or legal default rules) are performance-contingent and limit the right to termination (and cancellation of future deliveries) to cases of sufficiently poor performance at earlier stages of the contract. Analyzing an environment of court-enforced incomplete contracts with relationship-specific investment, I show that the right to early termination facilitates first-best implementation by solving a standard holdup problem. A necessary condition for this outcome is the performance-contingency of said termination provisions, rendering the contract nondivisible by introducing memory. I further illustrate when this right to early termination is optimally limited to cases of sufficiently poor performance.

Number of Pages in PDF File: 30

Keywords: contingent control rights; early termination; expectation damages; holdup; incomplete contracts; material breach of contract; nondivisible contracts.

JEL Classification: D23, D86, K12, L42

working papers series