Loopholes in Complex Contracts

Abstract

In 2016, J. Crew exploited a loophole in a complex debt contract, allowing it to remove $250 million of collateral from its lenders’ reach to refinance other debt. Why would an important and unanticipated flaw like this arise in a contract between sophisticated commercial actors? Answering this question requires a model where contracts can be imperfect and evolving. We create such a model in a principal-agent setting using genetic algorithms, a tool from the complexity science literature. As in real-world practice, contracts in a genetic algorithm evolve from prior contracts, combining terms from the “parent” generation based on their past performance.

Our main result is that loopholes arise as an inherent by-product of evolutionary learning. Through experience, contracting parties gradually allow the agent’s activity level to increase as they learn how to permit more activity without increasing agency costs. But, as activity rises, contracts become more complex in two ways. First, more value-relevant states of the world arise. This increases the number of potential mistaken terms that the agent can exploit. Second, the interdependence of terms increases, making loopholes more severe. In particular, when a flaw arises in a term that identifies and blocks bad activity, the flaw does more damage when a greater activity level is permissible. As contracts evolve, then, they can achieve greater performance but also become less robust to mistakes.

Keywords: loopholes, complexity, contract theory, contract evolution, bounded rationality, genetic algorithms