Relationship-Specific Investment, Asymmetric Information, and the Role of Good Faith Obligations
23 Pages Posted: 8 Feb 2019
Date Written: February 8, 2019
Some relationship-specific investments that increase the contracting surplus can also endow the investing party with private information that affects the bargaining process. The presence of private information can lead to ex post bargaining failure (ex post inefficiency) which, in turn, can dampen ex ante investment incentives. This paper explains why protecting one party’s investment with reliance damages, the conventional solution, can be insufficient in tackling both ex post and ex ante efficiency challenges. We then suggest that legal requirement of good faith (whether imposed by agreement between the parties or the background contract law) can improve efficiency by granting a remedy conditioned on a party’s private knowledge or state of mind, even if the court can verify such state of mind only imperfectly. We demonstrate this solution by using as example the investment that contracting parties make in identifying the optimal terms of trade (such as product attributes or contract terms), and the judicial enforcement of a duty to negotiate in good faith. We analyze the choice that the parties might make among three alternative negotiating agendas: (a) no binding agreement before investment; (b) a fully binding agreement before investment that can be modified thereafter; or (c) a non-binding agreement but with the duty to negotiate in good faith. Subsequently, one party invests and privately learns about the optimal terms of trade, and the parties can negotiate (or renegotiate) the agreement. The analysis demonstrates that the inefficiency in scenario (a) is exacerbated in scenario (b) because the investing party is protected from renegotiation failure, since the investing party can still perform under the original terms of the agreement. The result can explain why preliminary agreements in commercial transactions are often expressly non-binding, even though they contain all or most of the essential terms of the transaction. The paper then shows that, in many parameter spaces, agreeing only to a duty to negotiate in good faith (scenario (c)), with properly calibrated damages, can best provide the necessary investment incentive and also allow the parties to implement the most efficient terms ex post.
Keywords: Preliminary Agreement, Letter of Intent, Memorandum of Understanding, Term Sheet, Duty to Negotiate in Good Faith
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