75 Pages Posted: 13 Jan 2010 Last revised: 3 Mar 2010
Date Written: January 11, 2010
This article studies the relationship between formal contract enforcement, where performance is encouraged by the prospect of judicial intervention, and informal enforcement, where performance is motivated by the threat of lost reputation and expected future dealings or a taste for reciprocity. The incomplete contracting literature treats the two strategies as separate phenomena. By contrast, a rich experimental literature considers whether the introduction of formal contracting and state enforcement “crowds out” or degrades the operation of informal contracting. Both literatures, however, focus too narrowly on formal contracts as a system of incentives for inducing parties to perform substantive actions, while assuming that the effectiveness of informal enforcement depends on pre-existing levels of trust. As a result, current scholarship misses the relationship between formal and informal contract mechanisms characteristic of contemporary contracting in practice. Parties are responding to rising uncertainty by writing contracts that intertwine formal and informal mechanisms – what we call “braiding” – in a way that allows each to assess the disposition and capacity of the other to respond cooperatively and effectively to unforeseen circumstances. These parties agree on formal contracts for exchanging information about the progress and prospects of their joint activities, and it is this information sharing regime that “braids” the formal and informal elements of the contract and endogenizes trust. We argue that the low-powered enforcement associated with the formal governance structure in these braided contracts complements rather than crowds out the informal mechanisms that rely on increasing levels of trust. We examine the braiding phenomenon in a variety of contexts characterized by rising uncertainty. These range from the uncertainties of technological innovation to commercial ventures and corporate acquisitions where the uncertainty centers on the importance of the search for new partners. In each instance, courts appear to have harnessed the braiding phenomenon by using low-powered sanctions to protect formal contractual “preliminaries” without creating potential liability that will crowd out informal contracting. This technique allows potential collaborators to explore and develop their relations but it does not impose mutually enforceable obligations to pursue a particular project. But despite the wisdom of temperate enforcement of braided contracts, courts that emphasize the contemporary duty to negotiate in good faith are often tempted to expand the legal sanction and thereby unwittingly undermine the very informal arrangements that braided obligations are designed to support. We conclude, therefore, by explaining how courts can best support the braiding strategies that are critical to the success of an integrated regime of formal and informal contracting.
Keywords: Contract theory, experimental economics, crowding out, formal contracting, informal contracting, preliminary agreements, letters of intent
JEL Classification: C9, K12, K22, l22, O3
Suggested Citation: Suggested Citation
Gilson, Ronald J. and Sabel, Charles F. and Scott, Robert E., Braiding: The Interaction of Formal and Informal Contracting in Theory, Practice and Doctrine (January 11, 2010). Stanford Law and Economics Olin Working Paper No. 389; Columbia Law and Economics Working Paper No. 367. Available at SSRN: https://ssrn.com/abstract=1535575 or http://dx.doi.org/10.2139/ssrn.1535575