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
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: Suggested Citation