Contract interpretation redux.

• Author: Schwartz, Alan

REVIEW CONTENTS INTRODUCTION I. THE INTERPRETATION PROBLEM A. The Timing and Nature of Interpretation Issues B. The Problems the State Must Solve C. An Introduction to Our Theory of Interpretation 1. The Case for Party Control 2. Parties Prefer Textualist Defaults II. ENGAGING THE CRITICS A. Risk Neutrality B. Strategic Behavior C. Accuracy, Context, and Party Preferences D. The Evidence III. INTERPRETATION AS A LITIGATION PROBLEM: HOW TEXTUALIST AND CONTEXTUALIST REGIMES WORK A. Recovering the Contract Terms: The Parol Evidence Issue B. Resolving Disputes over the Meaning of Contract Terms CONCLUSION INTRODUCTION

Interpretation issues are hard; the doctrine is difficult and the issues are complex. Courts divide over whether to retain the common law's "textualist" rules of interpretation or to apply "contextualist" interpretive principles that are reflected in the Uniform Commercial Code (UCC) and the Second Restatement. (1) States holding the former view are led by New York, while California is the most significant contextualist jurisdiction. (2) Perhaps understandably, given the doctrinal complexities and jurisdictional divisions, much of the scholarly commentary is unhelpful. This is unfortunate because contract interpretation remains the largest single source of contract litigation between business firms.(3)

In 2003, we published an article that, among other things, set out a theory of contract interpretation to govern agreements between business firms. (4) The arguments we advanced were part of a larger project arguing that the law should pursue the first order goal of maximizing contractual surplus when it chooses rules to regulate merchant-to-merchant contracts. (5) The article has generated substantial academic commentary. Of greatest interest has been our treatment of interpretation issues. In that section, we supported a formalist theory of contract interpretation. Our article has become the iconic formalist statement. As such, it has engendered a number of antiformalist responses. (6)

Recently, Professor Steven Burton has published a book on contract interpretation advancing a theory he calls "objectivism" that purports to resolve the divisions between these competing claims. (7) In the course of developing his argument, Burton also discusses and rejects our approach. (8) Instead, he purports to chart a reasonable middle course between the Scylla of contextualist theories of interpretation and the Charybdis of formalist interpretive theories. But in order to create this space, Burton mischaracterizes both formalist and antiformalist arguments. The former, he claims, reduces to a literalism that urges the interpreter to focus only on a single word or phrase; the latter is a subjectivism that seeks to recover the parties' subjective intentions rather than the objective manifestations of those intentions. (9) As we show in the analysis that follows, Burton's intermediate position is untenable. He urges courts to consider course of dealing and usage of trade evidence in addition to the contract and the parties' objective circumstances, but he would have courts exclude extrinsic evidence (such as prior negotiations) because it is too "subjective." (10) Burton's solution thus precludes the resolution of a dispute on summary judgment while it denies to parties a full trial in which all evidence that might reveal their ex ante intentions is considered. In short, his "objectivism" sacrifices both cost and accuracy-two goals, we argue, that firms prefer the courts to consider when interpreting contracts.

Professor Burton's response to our article, as well as a number of other responses, demonstrate that the interpretation debate has become both livelier and more highly contested than ever. Unfortunately, the responses to us often mistake or misconstrue our claims. To bring some clarity to the debate, therefore, we begin by restating the four arguments our article advanced.

Our first argument begins with the premise that, although accurate judicial interpretations are desirable, accurate interpretations are costly for parties and courts to obtain. (11) If contract writing were free, parties could minimize interpretive error by exhaustively detailing their intentions. And if adjudication were costless, courts could minimize interpretive error by hearing all relevant and material evidence. Contract writing and litigation are costly, however. Since no interpretive theory can justify devoting infinite resources to achieving interpretive accuracy, any socially desirable interpretive rule would trade off accuracy against contract-writing and adjudication costs. Such a rule, we argue, tells courts in some cases to exclude relevant evidence.

The second argument follows from the fact that parties to commercial contracts have preferences over the rules courts use to interpret their agreements. These preferences exist because the parties are the primary beneficiaries of accuracy and the primary bearers of contract-writing and litigation costs. Our second argument, then, rests on three premises: (i) courts that interpret commercial contracts should share the parties' goal of maximizing expected contractual surplus; (ii) parties are better informed than courts about benefits and costs, so parties commonly have a comparative advantage over courts in making the requisite tradeoffs; and (iii) different contractual relationships may make different tradeoffs-that is, party preferences over interpretive rules are heterogeneous. Together, these premises imply that the state should defer to party preferences regarding interpretation, just as it defers today to party preferences over a contract's substantive terms.

We argue, therefore, that the state should choose interpretive rules that conform to majoritarian party preferences, and courts should obey party instructions to depart from those rules in particular cases. Much of the criticism we face stems from the failure to appreciate this claim. Thus, we do not argue that the state should enact mandatory rules that require courts to make formalist interpretations. Rather, we argue that the state should create interpretative rules that instantiate party preferences; it is the business parties that commonly prefer formalist interpretations.

Our third argument urges participants in the interpretative debate to distinguish two principal interpretive questions-whether a contract term is ambiguous; and whether the term is written in the standard language or in a private language (for example, technical terms in a trade). (12) This distinction is important to draw because the categories of evidence a court should admit when making an interpretation arguably should turn on whether the issue involves ambiguity or language.

Our fourth argument, however, holds that the majoritarian party preference is textualist in both cases: business parties commonly prefer judicial interpretations to be made on a limited evidentiary base, the most important element of which is the contract itself. (13) With regard to ambiguity, we claim that parties prefer a narrow evidentiary base when a court has enough information to reach the "correct answer" to an interpretation question on average. Put more technically, the correct answer is the mean of the distribution of possible interpretations. The claim for textualism then follows because a risk neutral firm is indifferent to the magnitude of the variance around the mean; hence, this firm is unwilling to incur additional costs in order to further increase the accuracy of any particular finding. With regard to language, we consider two defaults: a plain meaning default supposes the parties to be communicating in the standard language; and a contextual default admits extrinsic evidence that the parties were communicating in a "private" (technical) language. We argue that the preferred default should aim to reduce the risk of strategic behavior. A plain meaning default that presumes the parties have written in the standard language reduces this risk by requiring parties to specify the terms that take technical meanings. (14) Our argument that parties have textualist preferences over questions of meaning supports our further claim that parties also have preferences over how a court determines the terms of a contract; that is, parties prefer courts to use a "hard" parol evidence rule, one that restricts courts to a narrow evidentiary base when identifying the contract's terms.

This Review clarifies and extends the arguments sketched here. We briefly summarize empirical data that support our theory, and we respond to our critics. With respect to the data, although much academic commentary suggests otherwise, both the available evidence and prevailing judicial practice support the claim that sophisticated parties prefer textualist interpretation. (15) Indeed, the large majority of common law courts, led by New York, continue to follow the traditional Willistonian approach to interpretation, which embodies a hard parol evidence rule, retains the plain meaning rule, gives presumptively conclusive effect to merger clauses, (16) and, in general, permits the resolution of many interpretation disputes by summary judgment. (17)

In responding to our critics, we make three preliminary remarks. Initially, though our article was the first cut at a difficult subject, and so was less clear than it could have been, the mistakes in representing our view are hard to explain as resulting only from a lack of clarity on our part. "Formalism," to many, has come to represent almost every bad thing, (18) so we as formalists are believed to commit almost every sin. Thus, we often are taken to be literalists who want to restrict an interpreting court to consider only the contract terms at issue and a dictionary. (19) But literalism is impossible. Courts necessarily see the pleadings. When these are contested, a court will and should consider briefs and evidence as to what the...