The Law and Economics of Preliminary Agreements
56 Pages Posted: 4 Aug 2006
Contract law encourages parties to make relation-specific investments by enforcing the contracts the parties make, and by denying liability when the parties had failed to agree. For decades, the law has had difficulty with cases where parties sink costs in the pursuit of projects under agreements that are too incomplete to enforce, and where one of the parties prefers to exit rather than pursue the contemplated project. The issue whether to award the disappointed party any remedy has divided a large number of courts over many years. The judicial uncertainty arises, we claim, because the questions why parties make such incomplete contracts, then rely before uncertainty is resolved and finally disagree over cost reimbursement when both recognize that their project would be unprofitable have not been satisfactorily answered. We create a model which shows that parties create "preliminary agreements" rather than complete contracts when the project they explore could take a number of forms, and the parties are unsure at the outset which form would maximize profits. A preliminary agreement roughly allocates investment tasks between the parties, specifies investment timing and commits the parties only to pursue a profitable project. Parties sink costs in a project because investment accelerates the realization of returns and illuminates whether any of the possible project types would be profitable. A party to a preliminary agreement "breaches" when it delays its investment beyond the time the agreement specifies. Delay will save costs for this party if no project turns out to be profitable and improves this party's bargaining power in the renegotiation to a complete contract if a project would succeed. Delay often disadvantages the promisee, but the main inefficiency is ex ante: When parties anticipate such strategic behavior, the likelihood that they will make preliminary agreements is materially reduced. This is unfortunate because the performance of a preliminary agreement often is a necessary condition to the creation of a complete contract and the subsequent realization of a socially efficient opportunity. Thus, contract law should encourage relation-specific investment by awarding verifiable reliance costs to a party to a preliminary agreement if its partner has strategically delayed investment. We also study a large sample of appellate cases that deal with reliance prior to the signing of a complete contract. This study reveals that (a) parties appear to make the preliminary agreements we describe and breach for the reasons our model identifies; and (b) courts sometimes protect the disappointed party's reliance interest when they should, but the courts' imperfect understanding of the parties' behavior causes courts to make mistakes.
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