Facilitating incomplete contracts.

• Author: Epstein, Wendy Netter

ABSTRACT

Contract law abhors incompleteness. Although no contract can be entirely complete, the idea of a purposefully incomplete or underspecified contract is antithetical to lawyers' ideals of certainty for the parties and for the law. Indeed, contract law is designed to incentivize parties to specifically articulate their intentions. Yet there is a growing body of interdisciplinary work in economics and cognitive psychology demonstrating that highly specified contracts tend to stifle intrinsic motivation and innovation, whereas less-specified contracts--particularly in public-private contracting, IP, and contracting for innovation--can induce higher effort levels and a more cooperative principal-agent relationship than the traditional approach. Nevertheless, there remain both entrenched doctrinal and sociolegal deterrents to drafting less-specified contracts.

This Article argues that the existing doctrinal roadblocks to incomplete contracts are out of step with the normative goals of commercial contracting--promoting efficiency and incentivizing commercial activity. The indefiniteness doctrine and current approaches to contract interpretation, for instance, over-deter the use of incomplete contracting even when it would be efficient. Ultimately, this Article suggests a new doctrinal approach for those contracts where the law should incentivize incomplete contracting, borrowing from principles of constitutional interpretation: dynamic contextualist interpretation. Courts should look not only to party intent at the moment when the contract was formed but should consider how intentions developed during contract performance. Rather than punishing incompleteness, flexibility should guide determinations of validity and questions of interpretation.

CONTENTS INTRODUCTION I. FLEXIBLE CONTRACTING CAN BE EFFICIENT A. Economic Approach to Incomplete Contracts B. Behavioral Evidence Touting Incompleteness 1. Experimental and Observational Work 2. Contexts Ripe for Flexible Contracting a. Contracting for Innovation b. Intellectual Property Licenses c. Public-Private Contracting C. Types of Contracts Where Implicit Rather Than Explicit Drafting May Engender More Efficient Results II. DETERRENTS TO DRAFTING LESS-SPECIFIED CONTRACTS A. Doctrinal Deterrents 1. Indefiniteness Doctrine 2. Rules of Interpretation B. Sociolegal Deterrents III. CONTRACT DOCTRINE SHOULD, BUT FAILS TO, SUPPORT INTENTIONALLY INCOMPLETE DRAFTING A. Doctrine Has Incentive Effects on Drafting B. Doctrine Should Be Tolerant of Incompleteness IV. CONTRACT DOCTRINE SHOULD BE BOTH CONTEXTUAL AND DYNAMIC A. Formalist Interpretation B. Dynamic Contextualist Interpretation C. Limitations CONCLUSION INTRODUCTION

Legal certainty is a central principle for the rule of law. Contract doctrine illustrates the centrality of that principle perhaps more than any other legal field. (1) In the ideal depiction of contracting, two parties negotiate an agreement prior to undertaking performance obligations. Once both parties have consented to the terms of an agreement and have entered into a contract, then the parties perform their obligations because it is in their rational self-interest to do so; otherwise, no contract would have been signed in the first place. If one party absconds and does not meet his contractual obligation, a court can easily determine breach and damages because the terms of the parties' deal were clear and certain.

In this contracting ideal, compliance is the goal. Parties want to be certain that they will get what they contracted for, or at least that they will be otherwise compensated for a breach. Certainty is the reason parties formally contract rather than informally agree. And it is easy to understand why "[o]ne of the core principles of contract law is the requirement of definiteness." (2) In this model, incomplete contracts that fail to give adequate guidance to the parties about their duties and obligations are more likely to result in opportunistic behavior and litigation and make litigation more time consuming and costly if it does result. Thus, lawyers are taught to avoid these drafting pitfalls. (3)

Even more importantly, courts punish parties who either carelessly or purposefully draft incomplete contracts. (4) These parties cause systemic costs in litigation that, in the traditional view, could have and should have been easily avoided by better drafting. (5) A simple sales contract illustrates. Consider a buyer who agrees to purchase one hundred widgets for five dollars per widget in a one-time transaction. The parties negotiate these terms before any obligations accrue and detail the terms in a written contract. If the buyer receives the widgets but does not pay the seller $500, the questions of breach and damages are entirely straightforward.

But now consider a second contract. Here, one firm partners with another to co-develop new technology, utilizing the strengths of both entities to build a product that is not yet fully conceived. After development, the parties intend for the product to be jointly marketed and sold worldwide. In this second contract, compliance still matters--a party that makes a relationship-specific investment does not want the other pulling out of the deal--but so do coordination, collaboration, and innovation. By contracting, the parties need to mitigate risk and facilitate coordination, all against a backdrop of complexity and uncertainty.

Perhaps the parties could accomplish these goals by drafting a highly detailed contract with extensive control provisions to try to prevent opportunistic behavior. (6) This is the strategy the law prefers. (7) But it is not only difficult and costly to accomplish, it may also not be the best or most efficient strategy in certain contexts. Recent interdisciplinary scholarship in economics, psychology, and the law has found that specificity, financial incentives, and control provisions, in general, can signal mistrust and crowd out parties' intrinsic motivation to perform. (8) Control-based contracting can give the impression that the principal is trying to constrain the agent and does not trust the agent to implicitly deliver skillful or consummate performance. (9) Agents respond reciprocally to this sort of treatment. An agent who perceives being treated unfairly will in turn react negatively.

In addition, contracts that are highly specified can create cognitive problems. Agents will often adhere to the strict requirements specified in the contract at the sacrifice of furthering the main objective of the deal. (10) Agents do not think for themselves; they merely do what is required.

On the flip side, more flexible contracting has been shown to mitigate these problems. Less-complete contracts that rely on trust and reciprocity rather than control can induce higher effort levels and a more cooperative principal-agent relationship than the traditional approach. They also mitigate the cognitive problems identified in highly detailed contracts. For both behavioral and cognitive reasons, detailed, highly certain contracts may actually lead to greater inefficiency and an increased likelihood of litigation than more incomplete ones. (11)

Despite much scholarship now suggesting a more flexible contracting approach, however, lengthy and complicated contracts filled with boilerplate and specific financial incentives continue to be commonplace in commercial transactions. This Article explores why incomplete contracting has not taken hold more widely despite its promise. It suggests that the theory is sound. But the law does not embrace the theory. Contract law assumes that incomplete contracts are always undesirable and should always be deterred. Contract doctrine actively disincentivizes parties from writing incomplete, flexible contracts, even when they might be efficiently employed.

This is most obvious in contract law's (renewed) preference for formalist interpretation in contracts between sophisticated entities. Formalist courts prioritize the four corners of the written agreement when confronted with interpretation questions, incentivizing parties to draft more complete contracts ex ante. Even contextualist interpretation is somewhat unfriendly to incomplete contracts. Contextualist courts look to evidence outside the contract in an attempt to discern the intent of the parties at contract execution. For the most part, though, they ignore the evolution of the relationship post signing--an integral aspect to the success of flexible contracting. (12)

If the normative goal of contract doctrine is to incentivize commercial activity and efficient dealmaking, the doctrinal approach deriding incompleteness is out of step with the goal. This Article suggests instead an approach to contract interpretation that borrows from principles of constitutional interpretation: dynamic contextualist interpretation. Given that less-specified contracts may be efficient, particularly in a variety of commercial contexts, courts reviewing such contracts should treat them more flexibly and liberally. Courts should account for the nature of flexible contracting--that not all decisions will be made before contract execution. Deals may evolve over time. Indeed, this may be the most efficient approach. The law assumes that contracts are static and focuses on the agreement between the parties at execution. But many contracts are not static. They are dynamic, and their meaning evolves as the parties' relationship evolves. Contract doctrine should match this reality. This Article begins to explore how and when that could be accomplished.

The Article proceeds in four parts. Part I rejects the traditional assumption that "good" contracts are necessarily detailed and specific. It reviews the growing interdisciplinary body of work suggesting that for both economic and behavioral reasons, commercial parties writing less-specified contracts ex ante might engender better contracting results ex post...