The Inverted Hierarchy of Contract Interpretation and Supplementation

Abstract

Contract interpretation and supplementation is conventionally conceived of as a multistage process, in which various sources, including express terms, course of performance, course of dealing, trade usages, default rules, and general standards of reasonableness, are sequentially resorted to. The decision maker should not turn to any particular source before exhausting the previous ones, and in case of inconsistency, each source trumps the following ones. A competing theory, inspired by Karl Llewellyn, maintains that the decision maker should be free to consider all the elements of the "bargain in fact" (the first four sources in the above list). Yet, it accepts that in case of inconsistency each source governs the following ones, and disregards the role of default rules and principles of contract law in the interpretive process. This Article argues that to some extent there is indeed a hierarchy among the sources, but it is an inverted one. The inverted hierarchy emphasizes the primacy of standards of reasonableness and good faith, legal default rules, and trade usages.

The argument is made on three levels. First, close examination of legal doctrines and courts' practice reveals that they better conform to the inverted hierarchy than to the conventional one. Second, based on empirical findings and on economic, sociological, and psychological insights, it is argued that the actual behavior of contracting parties largely falls into line with the inverted hierarchy. Finally, it is claimed that the inverted model is ethically superior to the conventional one. It is justified not only on the basis of social conceptions of contract law (fairness in exchange, re-distributive justice, and paternalism), but also as a means for realizing the parties' actual intentions and enhancing economic efficiency.

Keywords: contract interpretation, default rules, trade usuage, course of performance, paternalism, bounded rationality, contract law, unconscionability, parol evidence rule, plain meaning rule, endowment effect

JEL Classification: K12