An Embedded Options Theory of Indefinite Contracts
50 Pages Posted: 12 Oct 2005 Last revised: 19 Aug 2009
Option theory is beginning to generate robust insights in the legal literature, and it is particularly well-suited to contract law. This Article develops an embedded options theory of indefinite contracts, focusing on the proper scope of the indefiniteness doctrine - a core principle of contract law invalidating contracts that are too vague. This approach offers answers to two puzzling questions. First, why do parties write deliberately vague contracts, especially when they can contract with precise, verifiable metrics at a low cost? Second, what should a court do when confronted with an indefinite contract? Should it throw out the entire contract, impose a popular term, or do something else? This Article shows how the use of indefinite terms plus active judicial gap-filling can create an embedded option - the valuable opportunity to take action in the future based on outcomes that are uncertain today. It then argues that these embedded options can be problematic from an economic point of view because they are unlikely to be fully appreciated by both parties to the contract. This means that embedded interpretative options will sometimes distort efficient trade and investment decisions. In short, there are under-explored costs to contractual gap-filling. Ultimately, then, courts should resist the temptation to instinctively plug gaps and recognize that the indefiniteness doctrine has a meaningful role to play in contract law.
Keywords: contract theory, law and economics, option theory, indefiniteness doctrine, incomplete contracts
JEL Classification: K12
Suggested Citation: Suggested Citation