Anticipating litigation in contract design.

• Author: Scott, Robert E.

INTRODUCTION

In recent years, spurred by theoretical developments in the economics of contract, scholars have focused attention on the problems of incomplete contracting: What prevents parties from writing complete contracts that achieve the dual objectives of efficient reliance and efficient trade? (1) Contract theorists have identified two primary reasons for why parties may agree to contracts that fail to provide for the optimal obligations in each contingency (or state of the world) that might materialize during the term of the contract. (2) First, the front-end transaction costs of anticipating all future states of the world, calculating the efficient outcome in each state, and providing specifically for low-probability states may exceed the resulting gains in contractual surplus. (3) Second, the back-end costs of enforcing contracts may exceed all gains, owing to the difficulty of observing and then verifying to a court private information known only to the parties. (4) Unfortunately, this focus on problems of incompleteness has led scholars to neglect a related, and equally important, question: How do parties manage the costs of creating and enforcing the incomplete contracts that they write ?

Despite its theoretical advances, therefore, the theory of incomplete contracts has yet to yield predictions that are borne out by the realities of commercial practice. This gap between theory and practice is due to a number of limitations in the literature. First, scholars often neglect to weigh contracting costs, at either the front or back end, against the incentive gains that they produce--what we refer to as the incentive bang for the contracting-cost buck.

Second, scholars tend to focus on either front-end or back-end obstacles to complete contracts and assume the absence of friction at the other end. (5) For example, theorists concerned about back-end verification or uncertainty costs assert that parties will tend to avoid vague contract terms such as "best efforts" or "commercial reasonableness." (6) Yet these provisions are commonplace in commercial contracting because they reduce front-end transaction costs. Indeed, the mix of precise and vague terms that characterize the typical commercial contract can be framed as the product of a tradeoff that the parties have made in investing in the front end or back end of the contracting process, based on their particular circumstances. By reaching the optimal combination of front-end and back-end costs, parties can minimize the aggregate contracting costs of achieving a particular gain in contractual incentives. Conversely, for any given expenditure of contracting costs, the parties can reach the highest possible incentive gains by optimizing the allocation of their investment between the front and back ends.

Third, contract theorists assume a highly stylized enforcement mechanism in which the court verifies information and then orders the parties to execute the trade or not to execute it. As noted above, these scholars postulate that some contract provisions are too costly to verify and yield excessively uncertain enforcement outcomes. Their analysis adopts a binary approach in which these terms are labeled nonverifiable, while the remaining provisions can be verified without error at no cost. When parties enter into a legally binding contract, however, they invoke an adversarial enforcement mechanism that is governed by an elaborate set of procedural rules. The parties bear their own evidentiary costs, and a wide range of institutional features constrains the cost of litigation so that the back-end costs are lower than the verification costs envisaged by contract theorists. Moreover, when parties settle or renegotiate rather than litigate, they avoid verification costs entirely. Accordingly, parties may well find it desirable to accept these back-end costs in order to reap savings at the front end. Although the uncertainty in judicial factfinding might undermine contract incentives, the effect is context-dependent, and it is simply one factor to be taken into account in resolving the tradeoff.

Finally, contract theorists focus on substantive contract terms and not on attempts by the parties to regulate the enforcement process. Yet some of the rules governing litigation are default rules that the parties can vary or manipulate in their ex ante contract. By doing so, the parties can further reduce the cost of litigation and improve the ex ante incentive gains from enforcement. This has repercussions on the choice between precise and vague terms. A reduction in back-end enforcement costs should lead the parties to substitute more back-end for front-end investment by replacing precise provisions with vague terms. (7)

In this Article, we explore how the choice between precise and vague terms shifts investment between the front and back end of the contracting process and thereby improves efficiency. In designing their contract, parties choose contract terms based on the expected mechanism of enforcement. We offer a theory of contract design that anticipates the enforcement of contracts by adversarial litigation. Courts do not verify facts by direct investigation, but rather rely on the self-interested evidence presented by the parties. The enforcement of vague terms entails additional layers of evidence production. For example, a promisor would first propose to the court the activities that constitute "reasonable care" and then provide evidence that she performed them. We refer to the intermediate determination as the selection of "proxies" for reasonable care. (8) The choice between precise terms and vague terms thus reduces to who chooses the relevant evidentiary proxies and when they are chosen: the parties at the time of contracting or the court at trial. To illustrate this distinction, we might compare an obligation to deliver a widget weighing ten pounds and an obligation to deliver a widget of merchantable quality.

There are various bits of evidence that can establish the weight of the delivered widget in the first case. For example, compare the testimony of the seller's agent as to the widget's weight immediately before delivery against the testimony of the buyer's agent as to its weight the day after delivery. By specifying the proxy ex ante (a widget weighing ten pounds), the parties delegate to the court the relatively simple task of choosing between these evidentiary bits before deciding whether to find a breach. When the contract requires instead a merchantable widget, the weight of the widget competes with other proxies in establishing merchantability. In this case, the litigation process determines which proxies are relevant and the weight to be assigned to each. The back-end cost is borne only with respect to the contingency that actually materializes, and it might be avoided entirely if the parties settle or renegotiate.

The parties choose between front- and back-end proxy determination by comparing the informational advantage the parties may have at the time of contracting against the hindsight advantage of determining proxies in later litigation. Damages for contract breach provide a familiar illustration of this choice. Suppose that contracting parties wish to set damages so that the breacher internalizes the expectation loss inflicted on the promisee. The parties have a choice between a liquidated damages term and a broad standard of expectation damages (which also happens to be the legal default). The parties might choose liquidated damages that are fixed or otherwise based on fairly specific pieces of evidence, such as market prices. If the parties adopt instead the default of expectation damages, the court will invite the parties to propose proxies for the value of the promisee's lost expectation. Courts regularly require the parties to present market evidence of costs and values, which they then use to measure damages. (9) The court thus chooses among more or less efficient proxies for the promisee's expected losses from breach, in light of the information it enjoys ex post. Efficient proxies are those that maximize the gains in contractual incentives net of expected litigation costs. The parties may agree to liquidated damages, therefore, because they determine that their private information at the time of contracting is superior even to the court's market information ex post.

Our analysis of the tradeoff between front-end transaction costs and back-end enforcement costs owes an intellectual debt to the work of legal scholars who have analyzed the choice between rules and standards in legislation and administrative regulation. (10) They frame the choice between rules and standards to focus on the stage at which content is given to regulation: Either a rule is promulgated before the regulated behavior occurs, or a standard is enforced after the behavior occurs. (11) In a similar manner, we frame the choice between precise terms (rules) and vague terms (standards) as the decision to give content to legal obligations either on the front end or back end of the contracting process.

We build on this analysis in several important respects, however. First, we unpack the enforcement process to represent more accurately how content is injected at the back end. In particular, we treat the back end as an evidentiary process in which the court chooses proxies with which to judge whether the promisor has complied with a vague contract obligation.

Second, in public lawmaking, promulgators are typically legislatures or administrative bodies, whose lawmaking process is complicated by problems of collective decisionmaking and agency relationships. These problems impede the efficient choice between rules and standards, as promulgators may be more or less willing to delegate to a future court. (12) The front-end agency and bargaining relationships in a commercial contract are far more straightforward. Each lawyer represents a single party and...