Contract law, party sophistication and the new formalism.

Author:Miller, Meredith R.

    An ever growing body of case law (1) and scholarship (2) has fashioned a rigid dichotomy between sophisticated and unsophisticated parties in a wide array of contract inquiries. Courts mention party sophistication in determining whether the parties intended to form a contract (3) and what they meant by the terms they used. (4) They determine the enforceability of reliance disclaimers, (5) exculpatory clauses (6) and liquidated damages provisions (7) based, at least in part, on party sophistication. Courts also reference sophistication in determining whether a party can avoid a contract on the grounds of mistake or fraud. (8) While consumers are commonly contrasted with sophisticated parties, (9) the relevance of party sophistication is not limited to consumer transactions. Its relevance transcends any one area of substantive law--arising in commercial, business, employment, franchise, insurance, family and property disputes, among others.

    For its ubiquity, party sophistication remains an unstudied and largely unaddressed question in contract law. Although they often mention sophistication, the extensive contract treatises of Williston, Corbin and Farnsworth do not dedicate a section to clarifying what is meant by the terminology. (10) This Article begins the discussion.

    It is not certain why the dichotomy between sophisticated and unsophisticated parties has grown in significance. To be sure, courts often use "sophistication" as code for socio-economic status--wealth and education are common attributes of individuals that are deemed sophisticated. (11) "Sophisticated" parties, whether individuals or business entities, are presumed to have access to information, resources to allocate risk and experience or predisposition to counteract cognitive bias. (12) Often, a court's indication that a party is "sophisticated" is used to signal that, even though the result may seem harsh, it should be interpreted as fair. But none of these descriptions elucidates the trend of increased reference to sophistication. The trend appears to be best explained by examining what is happening in contract law on a theoretical level.

    Scholars have observed that contract law is experiencing a period of renewed formalism--which has been variably described as "neoformalism" and "anti-anti-formalism." (13) However, this new formalism, which values the literal content of a contract and the autonomy of the parties, has not completely abandoned the normative concerns characteristic of the realist period. At least nominally, through the dichotomy based on party sophistication, the law has attempted to preserve concern about the context of a transaction.

    In the new formalism, sophisticated parties are held to a different set of rules, (14) grounded in freedom of contract. It is presumed ex post that a sophisticated party was aware of what to bargain for (15) and read (or should have read) and understood (or should have understood) the terms of a written agreement. (16) Sophisticated parties are expected to negotiate ably and order contract risks sensibly. It is, therefore, now an accepted tenet of contract law that "[freedom of contract prevails in an arm's-length transaction between sophisticated parties ... and in the absence of countervailing public policy concerns there is no reason to relieve them of the consequences of their bargain." (17) Courts frequently state that it is not their role to interfere with or "rewrite" the terms of a deal for sophisticated parties. (18)

    This Article does not advocate abandoning this status-based dichotomy; rather, it argues that courts need to define sophistication, which cannot be done with ready, bright lines. As currently used, "sophistication" is a slippery word. Courts have not established clear, meaningful criteria for sophistication and often presume without analysis that parties to a commercial transaction are sophisticated. (19) In this regard, party sophistication has served as a pretense of concern for context that allows courts to avoid more difficult questions about the relative positions of the contracting parties. often, labeling the parties "sophisticated" allows the court to avoid further discussion of any disparities in the parties' bargaining positions. However, the label should not lead; rather, the court should apply a rigorous fact-driven analysis to determine whether assignment of the sophistication label is appropriate.

    Absent evidence of a deliberative approach to assessing sophistication, and for want of the guidance a definition would provide, some cases have been wrongly decided. It is evident that, in at least some instances, courts have erroneously deemed parties sophisticated and, in so doing, denied those parties the benefits of certain defenses or arguments. (20) For example, where a party is not sophisticated, she will more likely be able to a establish mistake of fact or fraud in the inducement. Similarly, for unsophisticated parties, a relaxed parol evidence rule is often applied.

    Of course, the meaning of party sophistication is of significance to the contracting parties when they find themselves litigating a dispute; it is important to them that the case is appropriately and fairly decided. Further, to the extent that sophistication is treated as a question of fact, (21) the issue is conclusively decided in the trial court and is reversible only if "clearly erroneous." (22) But the importance of defining sophistication is not limited to the handful of questionable cases where a trial court may have erred in rashly deeming a party sophisticated.

    Party sophistication has even broader significance for contracting parties and for the goals of formalism--certainty and predictability in the law. A deliberative approach to sophistication would enable courts to reach fair decisions for just and identifiable reasons, which would develop the law in a way that enables parties to contract with more certainty about their obligations and better ability to predict whether their deals will be enforced as written.

    Part II of this Article positions the discussion in a theoretical context and describes the significance of party sophistication as a compromise between formalist and realist concerns. Part III collects examples of settings in which courts have used party sophistication as a tool to organize the world of contracting parties and, with that, the applicable legal principles. For sophisticated parties, in answering a wide array of contract questions, courts employ a formalist approach. Part IV begins descriptively and addresses the general lack of meaningful assessment of party sophistication. Drawing upon the review of hundreds of cases, Part IV identifies what appears to be germane to courts as they apply the label of sophistication and details the attributes common among parties that courts have deemed sophisticated.

    Finally, Part V presents the central normative claim of this Article: courts should undertake a more exacting, fact-driven approach in addressing party sophistication. Drawing upon the extensive review of case law, Part V provides a definition of sophistication that assesses information and resource asymmetries among the contracting parties. The proposed standard assesses whether a party, relative to the other parties to the contract, has sufficient experience and access to information and resources that the person or entity understands or should understand the intricacies, risks and consequences of the transaction. This standard takes into account the theoretical underpinnings of applying the sophistication label: for knowledgeable and experienced parties dealing in familiar industries, private autonomy should prevail over normative concerns. However, where a party lacks relative knowledge and experience, normative concerns may outbalance the literalism and private autonomy championed by formalism.

    In the absence of a meaningful definition of sophistication, however, courts are not actually addressing the context of the deal. Rather, they are simply reciting well-worn cliches about "sophisticated parties dealing at arms' length."


    In The Death of Contract, Grant Gilmore eloquently describes how literature and the arts have endured "alternating rhythms of classicism and romanticism." (23) Gilmore contemplated the "possibility of such alternating rhythms in the process of the law." (24) Contract law's rhythms appear to alternate between the poles of formalism and realism (or "anti-formalism").

    The term "formalism" escapes exact definition. (25) Here, it is intended to refer to a theory of contract law that, above all else, elevates the content of the parties' written contract (its form) over any concerns for normative values or societal notions of fairness. It is an acontextual and rules-driven approach dedicated to literalism. With these priorities, formalism is ideologically justified by freedom of contract. (26) It is committed to the ideal of voluntary, private actors creating their own legally binding obligations, free from judicial interference. As a rules-based approach, (27) formalism permits certainty and predictability in the marketplace but leaves little room for case-by-case inquiries that consider the context of the deal, the behavior of the parties and their relative bargaining positions.

    By the conventional account, formalism reigned in United States contract law until the mid-twentieth century. (28) At this time, the realist trend in contract law began a shift away from formalism's "context insensitivity." (29) Realism demonstrated concern for the particular circumstances of the parties; (30) standards-based approaches emerged, with reasonableness and fairness as guiding principles. The realist movement was met with the criticism that adherence to fairness norms curtailed the certainty and predictability that contract law allows in the marketplace. (31)

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