The Efficiency of Vague Contract Terms: A Response To The Schwartz-Scott Theory Of U.C.C. Article 2

• Author: George G. Triantis
• Position: Perre Bowen Professor and Horace W. Goldsmith Research Professor of Law

Perre Bowen Professor and Horace W. Goldsmith Research Professor of Law, University of Virginia. I am indebted to Chris Sanchirico for insights generated during several discussions and I thank Eric Posner, Saul Levmore, Alan Schwartz and Robert Scott for their helpful comments on an earlier draft. This essay also benefitted from the discussion at the Louisiana Law Review Conference held in honor of William D. Hawkland.

I Introduction

In The Rise and Fall of Article 2,¹ Robert Scott presents several positive theses concerning the effect of the political economy of the drafting and revision of Article 2 of the Uniform Commercial Code on (a) the nature of the default provisions in the statute, (b) the judicial interpretation of express contract terms, and (c) private contracting behavior. A core thesis was developed with Alan Schwartz in an earlier article.² It suggests that the original drafting of Article 2 occurred in an environment in which no interest group dominated and the drafters were predominantly academics with policy goals that diverged from the more conservative views of the median member of the private legislature, the ALI-NCCUSL. The drafters were inclined to propose vague standards instead of clear rules in order to increase the likelihood of adoption of their draft statute. Standards obtain much of their content from their subsequent application by courts to specific facts. Schwartz and Scott argue that their prediction is borne out by the vague provisions in Article 2- indeed, quite clearly so.³ The adoption of these vague provisions resulted, therefore, not from their intrinsic merits, but from the political conditions the authors identify.⁴ In The Rise and Fall, Scott reiterates this thesis and argues that private parties often prefer bright- line legal rules over the vague terms in the Code.⁵ These parties find it cheaper to simply contract out of the defaults in Article 2 than to lobby for clearer and more predictable default rules.⁶ Scott observes that the deficiencies of overly vague standards in Article 2 "may have contributed to the decision by many commercial parties to abandon Article 2 and its open-ended default rules in favor of more concrete, privately devised alternatives."⁷

The Schwartz/Scott thesis concerning Article 2 asserts that political economy, rather than intrinsic policy merits, determined the vagueness of the provisions. As persuasive as their theory may be, it is unfortunately difficult to test.⁸ The theory of optimal vagueness, or the optimal choice between rules and standards, has not evolved to the point of producing a clear normative benchmark against which Article 2 provisions may be evaluated. Contract scholars and lawyers undoubtedly have different views as to whether Article 2 provisions are indeed more vague than optimal. To some, good faith and commercial reasonableness are means to implement the intentions of the parties to rely on ex post judicial determinations. To others, these terms invite judges to rewrite contracts and create costly uncertainty in commercial transactions.

An alternative test, suggested by Scott's analysis, compares the degree of vagueness in Article 2 to the terms that sophisticated commercial parties include in their contracts.⁹ Yet, vague terms are also ubiquitous in commercial contracts. Although these contracts tend more than Article 2 to leave terms to the discretion of one party (for example, requirements or output contracts), vague expressions such as "reasonableness," "good faith" and "best efforts" are very common in commercial agreements. Indeed, in the foundational article on relational contracts, Scott and Charles Goetz observe that "best efforts" clauses are frequently used in a variety of contracts and the authors prescribe the efficient judicial interpretation of this term.¹⁰ Given that sophisticated and self-interested parties voluntarily agree to such vague terms in their agreements, the preference of Article 2 reformers for standards may simply reflect commercial practice in this regard.¹¹

The apparent willingness of commercial parties to agree to vague terms is puzzling. The conventional view is that business entities avoid the cost and risk of litigation. In this light, one would expect that parties strive to reduce the uncertainty and cost of judicial interpretation of their bargain-as well as the imposition of external judicial values-by agreeing to the precise, bright-line rules that Scott advocates. Several explanations of vague contract terms are consistent with this view in that they attribute the vagueness we see in practice to bounded rationality or agency problems in bargaining. For example, when parties bargain through agents, the agents may shirk and thereby leave obligations unspecified. Agents may also have higher discount rates than their principals, preferring to avoid the risk of a deal-breaking negotiation over a specific contingency and to accept instead the risk of a protracted and uncertain litigation.

This comment begins a search for efficiency justifications for vague terms in private contracts by examining the effect of anticipated litigation activity on the drafting of substantive contract terms. Legal scholars have explored the impact of enforcement constraints on the design of regulation: including, the choice between rules and standards¹² and the value of accuracy in adjudication.¹³ The corresponding analysis is regrettably much more limited in contract theory, where the focus has been on a simple conception of verifiability: the simple idea that contracting parties reject terms that are costly to enforce, but seek to address specifically as many future contingencies as may be feasiblely distinguished by a future court.

Part II relates vagueness to verifiability by identifying three features of vague terms: (a) the failure to fully exploit all verifiable factors, (b) the inclusion of terms whose enforcement invokes non- verifiable factors and (c) uncertainty as to the judicial weight assigned to each among a set of bundled factors. Conventional wisdom suggests that contracting parties should wish to avoid each of these features. In contrast, Part III reviews some existing explanations for the fact that contracts are often less incomplete than verifiability would allow. Part IV advances a richer conception of verifiability based on a signaling theory of litigation,¹⁴ that suggests reasons why parties would contract over terms that appear nonverifiable. Part V offers a justification for the uncertainty in vague terms: they deter overinvestment in evidence production or destruction.

II Three Features Of Vagueness

In the economic analysis of contracts, the benchmark for contract design (the first-best) is the complete contingent contract that specifies the obligations of the parties in each possible future state of the world. This contract ensures that each party makes the optimal decision in each state. If a contract partitions future states less finely by specifying the same obligations in more than one state, the contract may fall short of providing optimal incentives in each state, and it is called an incomplete contract.

Contract theory predicts that parties will avoid conditioning legal obligations on actions or states that are not verifiable to a court and a contract may be incomplete for this reason.¹⁵ Yet, the theory also expects contracting parties to complete their contract to the extent allowed by this verification constraint.

The conception of verifiability in this literature is, however, underdeveloped. Oliver Hart describes "verifiability" as follows:

The contract, 'I will pay you 1 million if you make the investment i' is not enforceable, since no outsider knows whether it has been fulfilled. Similarly, the parties' revenues and costs cannot be made part of a profit-or cost-sharing agreement. The quality of [my] book is observable, in the sense that anybody can read it. . . . However, it would have been difficult for Oxford University Press and me to have written a contract making my royalties a function of quality, since if a dispute arose it would be hard for either of us to prove that the book did or did not meet some pre-specified standard. (For this reason my royalties are made to depend on some (more or less) verifiable consequences of quality, e.g. sales.) In other words, quality is not verifiable."¹⁶

For convenience, Hart and other economists treat verifiability as exogenous, binary and static: their models assume each category of relevant fact to be either verifiable or not. However, the link between verifiability and the difficulty or cost of proving a fact is at best incomplete. After all, even a high enforcement cost might be justified by a larger benefit in resulting efficiency of ex ante performance incentives. Moreover, there are several reasons why verification costs may not be incurred: the parties may settle their disputes or one party may choose to capitulate rather than litigate. Finally, it is more accurate to think about adjudication as an exercise in persuasion rather than verification in the sense of proving truth. A fact need only be proven on balance of probabilities and courts are in fact often misled by false evidence. Before elaborating these factors in Parts III and IV to produce a richer conception of verifiability, I connect the economic concept of verifiability to the vague contract terms with which this comment is concerned. Vagueness may be defined by three distinct features. First, a vague term partitions the future into fewer states of the world than the relevant verifiable information would allow, and thus yields a less complete contract. Second, a vague term permits parties...