Incomplete Contracts: An Empirical Approach

Journal of Law, Economics, & Organization, vol. 34, pp. 650-679 (2018)

30 Pages Posted: 2 Aug 2016 Last revised: 18 Nov 2018

Date Written: May 22, 2018

Abstract

The strategic ambiguity hypothesis posits that when some aspects of performance are observable but not verifiable, the optimal contract is deliberately incomplete. I test this result for the first time. Because a direct test is infeasible, I derive an equivalent result: incompleteness is optimal when some terms are legally void. Using executive contracts from S&P 500 firms, I find that firms pay severance in discretionary installments to induce their executives to comply with noncompete agreements -- but only in California, where noncompetes are void. Outside California, noncompetes are valid and these same firms pay non-discretionary severance upfront. I conclude that firms use strategic ambiguity to circumvent legal constraints.

Keywords: Incomplete Contracts, Strategic Ambiguity, Repeated Games, Covenant Not to Compete

JEL Classification: D86, K12, J41

Suggested Citation

Sanga, Sarath, Incomplete Contracts: An Empirical Approach (May 22, 2018). Journal of Law, Economics, & Organization, vol. 34, pp. 650-679 (2018), Available at SSRN: https://ssrn.com/abstract=2816630 or http://dx.doi.org/10.2139/ssrn.2816630

Sarath Sanga (Contact Author)

Northwestern University - Pritzker School of Law ( email )

375 E. Chicago Ave
Chicago, IL 60611
United States

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