A Theory of Self-Control Problems and Incomplete Contracting: The Case of Shareholder Contracts

Abstract

Existing incomplete contracting models assume that contracting parties have perfect self-control. This Article approaches the incomplete contracting problem from a new perspective, one that brings to the foreground the potential self-control problems faced by contracting parties. In particular, the Article identifies two types of self-control sources of contractual incompleteness: serial procrastination and the projection bias. This Article shows that, under certain conditions, parties will have an incentive to repeatedly procrastinate adopting contractual provisions that they otherwise believe to be value-maximizing. Contracts may therefore be incomplete not because parties intended to leave the existing gaps, but because they procrastinated addressing contractual issues for one period too many - until conflict and litigation ensued. Additionally, at the beginning of a transaction, each party must try to predict her own and the other party's future preferences to take harmful or opportunistic actions. The projection bias - the tendency to project current preferences onto future ones - can lead contracting parties to project their initial preference - colored by feelings of trust, mutual cooperation, and optimism - onto their future preferences, thereby distorting their predictions of how their preferences may evolve during the transaction. This can lead contracting parties to systematically underappreciate the extent to which their preferences may change, as unforeseen (or unattended) contingencies give way to tempting opportunism and to discord, anger, or vengeance. As a result, at the time of contracting, parties will tend to underappreciate the need to adopt contractual provisions to curb the ability of one or both parties to take harmful or opportunistic actions during the transaction. Finally, this Article shows that the perfect self-control assumption of the current literature can lead courts to mistaken conclusions of why contractual gaps exist and mistaken policy decisions when filling those gaps. While the Article focuses on shareholder contracting, the results generalize to other contracting contexts.

Keywords: incomplete contracts, contracts, corporations, behavioral law & economics

JEL Classification: K12, K22