Contract theory and the limits of contract law.

• Author: Schwartz, Alan

1. INTRODUCTION II. JUSTIFYING AN EFFICIENCY THEORY OF CONTRACT A. What Firms Maximize B. Why the State Should Help Firms III. THE ENFORCEMENT FUNCTION A. Enforcement Often Is Unnecessary B. Encouraging Relation-Specific Investment C. Contracting To Avoid Disruption: The Case of Volatile Markets D. Enforcement And Duress IV. THE INTERPRETATION FUNCTION A. The Relevant Interpretive Question B. Two Interpretive Issues: Problems of Meaning and of Language C. The Parties' Preferences Regarding Interpretive Styles 1. The Continuous-Payoff Case 2. The Discontinuous-Payoff Case 3. Summary D. Private Languages, Linguistic Defaults, and the Parol Evidence Rule 1. The Preferred Linguistic Default 2. The Parol Evidence Rule 3. Course-of-Performance Evidence V. THE LEGAL DEFAULT PROJECT A. The Case for Defaults B. The Cost Concern and Default Rules C. The Moral Hazard Concern and Default Standards D. The Asymmetric Information Concern E. Summary VI. MANDATORY RULES A. Parties Cannot Ban Modifications B. Parties Must Accept Substantial Performance C. Parties Cannot Agree to Penalties VII. CONCLUSION I. INTRODUCTION

   Contract law has neither a complete descriptive theory, explaining what the law is, nor a complete normative theory, explaining what the law should be. These gaps are unsurprising given the traditional definition of contract as embracing all promises that the law will enforce. Even a theory of contract law that focuses only on the enforcement of bargains must still consider the entire continuum from standard form contracts between firms and consumers to commercial contracts among businesses. No descriptive theory has yet explained a law of contract that comprehends such a broad domain. Normative theories that are grounded in a single norm--such as autonomy or efficiency--also have foundered over the heterogeneity of contractual contexts to which the theory is to apply. (1) Pluralist theories attempt to respond to the difficulty that unitary normative theories pose by urging courts to pursue efficiency, fairness, good faith, and the protection of individual autonomy. Such theories need, but so far lack, a meta-principle that tells which of these goals should be decisive when they conflict. (2)

   We attempt to make progress here with a more modest approach--to set out and defend a normative theory to guide decisionmakers in the regulation of business contracts. (3)

   The theory's affirmative claim, in brief, is that contract law should facilitate the efforts of contracting parties to maximize the joint gains (the "contractual surplus") from transactions. The theory's negative claim is that contract law should do nothing else. Both claims follow from the premise that the state should choose the rules that regulate commercial transactions according to the criterion of welfare maximization.

   A simple categorization of the universe of bargaining transactions will clarify the domain of our theory. A transaction involves a seller (whether of goods or services) and a buyer. Parties to transactions can be partitioned into individuals and firms. This yields four transactional categories: (1) A firm sells to another firm, (2) an individual sells to another individual, (3) a firm sells to an individual, and (4) an individual sells to a firm. Category 2 contracts, between individuals, are primarily regulated by family law (antenuptial agreements and divorce settlements) and real property law (home sales and some leases). Few litigated contracts between individuals are regulated by the rules of contract law. Category 3 contracts, between a firm as seller and an individual as buyer, are primarily regulated by consumer protection law, real property law (most leases), and the securities laws. Category 4 contracts, between an individual as seller and a firm as buyer, commonly involve the sale of a person's labor, and are regulated by laws governing the employment relation. That leaves Category 1 contracts (those between firms) as the main subject of what is commonly called contract law--namely, the rules in Article 2 of the Uniform Commercial Code (UCC) and the provisions of the Restatement (Second) of Contracts. Such provisions are primarily invoked to resolve disputes arising under Category 1 contracts. Our theory applies only to these contracts, and thus has important implications for the content of the UCC and the common law of contracts.

   Category 1 contracts, however, can be partitioned into two subcategories. Some parties obviously are sophisticated economic actors (e.g., the General Electric Company). Other parties function in commercial contexts but have many of the characteristics of ordinary persons (e.g., a gift shop owned and run by a retired teacher). Any effort to analyze contracts between "firms" thus confronts a boundary issue--how to define a firm for purposes of the analysis. We draw this boundary here by defining a Category 1 firm as (1) an entity that is organized in the corporate form and that has five or more employees, (2) a limited partnership, or (3) a professional partnership such as a law or accounting firm. These economic entities can be expected to understand how to make business contracts, and the theory we develop applies only to contracts between two such firms. We do not address the extent to which our conclusions hold when one or both of the parties to a commercial contract fall on the other side of our boundary.

   Firms that maximize profits face the canonical "contracting problem" of ensuring both efficient ex post trade and efficient ex ante investment in the subject matter of the contract. (4) Parties trade efficiently when, and only when, the value of the exchanged performance to the buyer exceeds the cost of performance to the seller. Parties invest efficiently when their actions maximize a deal's expected surplus. Many observers would agree that contract law should attempt to facilitate efficient trade and investment. The novelty of our theory lies in its systematic development of the implications of this goal and in its claim that contract law should restrict itself to the pursuit of efficiency alone (for Category 1 contracts).

   Four objections may be made to the claim that contract law should restrict itself to encouraging efficient trade and investment. First, one could argue that firms sometimes do not maximize profits and, owing to the systematic cognitive errors made by the people who run them, are incapable of doing so should they try. A law that presupposes profit maximization would then be misguided. Second, one might claim that firms that maximize profits sometimes do bad things--pollute the environment, for example--that the law should attempt to deter. Third, one could contend that the state should promote fairness in contracting in addition to efficiency. And, finally, one might maintain that the state should pursue distributional goals, even if they may sometimes conflict with efficiency.

   These objections would be troublesome for an efficiency approach that covered all contract types. We will argue, however, that they have little force when Category 1 contracts alone are considered. Firms and markets are structured so as to minimize the likelihood of systematic cognitive error by important decisionmakers within the firm. Cognitive error, then, is more likely to afflict Category 2, 3, and 4 contracts than Category 1 contracts. Further, the bad things that firms do commonly entail imposing costs on third parties, such as creating environmental harms or erecting barriers to entry. These behaviors the creation of negative externalities--are regulated by the environmental and antitrust laws. An analysis of contract law as such therefore can assume the absence of externalities. Finally, it usually is futile to pursue either distributional goals or contractual fairness when firms are permitted a large measure of contractual freedom. This is because firms will contract away from redistributive or fair legal rules that do not maximize joint surplus. In sum, efficiency is the only institutionally feasible and normatively attractive goal for a contract law that regulates deals between firms. (5)

   An efficiency theory restricted to contracts between firms (as firms are defined above) has four major implications for contract law. The first implication follows from an important fact: Many contracts would be performed even if there were no legal sanction for breach. Contracts will be "self-enforcing" when parties contemplate making a series of contracts and the gains from breach are lower than the expected profit stream from future contracts that breach would cause to vanish. Moreover, neither party would breach if the gains from breach were less than the reputational sanction the market would exact. When contracts fall outside the self-enforcing range, however, legal enforcement is necessary to ensure performance in two principal cases: in volatile markets, when a party's failure to perform could threaten its contract partner's survival; and when contractual surplus would be maximized if one or both parties made relation-specific investments. (6) "Enforcement" includes more than simply requiring parties to perform, however. It also entails the prevention of fraud and duress, as well as rules to encourage or facilitate performance, such as damages rules. Perhaps a third of the sections in UCC Article 2 are enforcement rules under the definition here. The initial implication of our theory is that enforcement, when needed, is by far the most important thing the state does. Put more starkly, a modern commercial economy can function well with little more than honest courts and a set of enforcement rules. The rest is of second-order importance.

   A court cannot enforce contracts, however, without a theory of interpretation that "maps" from the semantic content of the parties' writing to the writing's legal implications. Our second implication thus holds, in contrast to the UCC and much...