Norms, formalities, and the Statute of Frauds: a comment.

• Author: Posner, Eric A.
• Position: Symposium: Law, Economics, & Norms

INTRODUCTION

Jason Johnston's Article makes three contributions to the economics and sociology of contract law.(1) First, it provides a methodological analysis of the use of case reports to discover business norms. Second, it makes a positive argument about the extent to which businesses use writings in contractual relations. Third, it sets the stage for, and hints at, a normative defense of the Uniform Commercial Code (WCC) section 2-201. Although the first contribution is probably the most interesting and useful, I focus on the second and third, and comment only in passing on the first. I conclude with some observations about the role of formalities in contract law.

1. JOHNSTON'S POSITIVE ANALYSIS

   1. The Hypothesis

      Johnston's hypothesis is that "strangers" use writings for the purpose of ensuring legal enforcement. "Repeat players" do not use writings for this purpose because they expect that nonlegal sanctions will deter breach. Because repeat players do not use writings, their legal disputes typically involve the issue of whether their nonwritten contracts satisfy an exception to UCC section 2-201. Because strangers do use writings, their legal disputes involve the issue of whether the writings they use satisfy the section 2-201 writing requirement. In addition, because repeat players use writings to record obligations in complex contracts, the "exception" issue will arise only for repeat players involved in simple contracts.

      Despite the simplicity of the argument, there are a number of hidden complexities. In the following paragraphs I identify those that present the most serious barriers to confirmation of Johnston's hypothesis.

   2. "Strangers" and "Repeat Players"

      1. Legal Enforcement of Cooperation Between Repeat Players

         An initial ambiguity arises over the meaning of "stranger" and "repeat player." According to Johnston, two parties are strangers if they have not had prior dealings; they are repeat players if they have.

         The question is why parties that have had prior dealings with each other would necessarily rely on nonlegal sanctions. The game-theoretic analysis indicates that the threat of losing future business from the promisee deters breach only if the present value of future business with the promisee exceeds the benefit of breach to the promisor, and the likelihood that the promisee would, in fact, deny future business is significant.

         But these conditions are not necessarily implied by prior dealings. For ease of exposition, imagine that the promisor is the buyer, that the promisee is the seller, that only the buyer has an opportunity to breach (that is, seller delivers, then buyer pays or breaches), and that the cost of breach to the buyer is less than the cost of compliance, excluding the costs imposed by any sanctions. Under these circumstances, the buyer would breach unless legal or nonlegal sanctions increase the cost of breach by a sufficient amount.

         Suppose the buyer purchases goods from the seller at time 0. When the buyer and seller enter a second contract at time 1, they will be coded as repeat players. Yet the fact that the parties had a prior dealing does not mean that the threat of losing future business (at time 2 and beyond) from seller would deter a breach by the buyer at time 1. The buyer would not be deterred if he could simply obtain business from another seller. The game-theoretic analysis assumes that the buyer is locked in with the seller (for example, because of a relationship-specific investment). If market conditions do not lock the buyer and the seller into a relationship, we would expect these "repeat players" to use a writing in order to gain the protection of legal enforcement. Johnston should code for these conditions.

      2. Nonlegal Enforcement of Cooperation Between Strangers

         The converse point can also be made. Just as prior dealings between parties do not guarantee that they will rely on nonlegal sanctions to deter breach, the fact that parties are strangers does not preclude them from relying on nonlegal sanctions to deter breach. When two strangers enter an agreement that they expect to last for a long period of time--in which there are many opportunities for each player to penalize the other for breaching, and in which the rules and payoffs are clear--the game-theoretic analysis on which Johnston relies suggests that cooperation will occur. The absence of prior dealings is irrelevant, except to the extent that they would give each party useful information about the other. Therefore, if the agreement is simple enough, the parties, despite being coded as strangers, would not use a writing for the purpose of legal enforcement.

      3. Groups and Reputation

         A further difficulty with Johnston's analysis is that he does not adequately account for the effect of group membership. Two parties are coded as "strangers" if they have not had repeat dealings. Johnston's hypothesis would predict that these parties will rely on a writing to enforce their agreement. If the parties belong to a group in which reputation matters, however, then they will not rely on legal sanctions. As a result, they will not use a writing for simple contracts.

         In response to this argument, Johnston points out that in a system of group enforcement, third parties must be able to verify that a breach has occurred. Verification can (or can most easily) occur only if parties put their contracts in writing. In contrast, in two-party situations only the injured party needs to observe the breach. Because the injured party can directly observe the breach, a writing is not necessary. The conclusion, however, does not follow from the premises. When information is cheap, both (i) parties to a contract and (ii) third parties in a group can observe or obtain information about the contract and the conduct that allegedly constitutes a breach. It is possible that the parties to a contract are less likely to need to refer to a writing in case of a dispute than are third-party members of a group. But Johnston provides no reason for believing that this possibility necessarily means that group members would need writings in order to evaluate claims in a dispute. If reputation effects are sufficient and information is cheap, they would not. Indeed, Johnston's historical evidence regarding the failure to use contract formalities in general and writings in particular comes mostly from the practices of groups, not from the practices of two-person contractual relationships.

   3. Why Would Repeat Players Not Use a Writing?

      Johnston's assumption that repeat players would not use a writing is puzzling. He claims that they would not because they expect to depend on nonlegal sanctions. But surely--if they are sophisticated--they know that nonlegal sanctions will not deter breach at an endgame. Why, then, would they not supply a writing for this purpose?

      Johnston's main argument is that the endgame is too remote to justify the cost of drafting a contract. This is possible. A writing sufficient to satisfy section 2-201, however, can be extremely brief and inexpensive. Because the people who act as repeat players in some contracts are strangers in others, they must--as occasional strangers--know about section 2-201. How costly could it be for such people to supply a writing?

      Let me suggest two other reasons why repeat players might not put their contracts into writing. First, the parties might not put the contract into writing because they do not want judicial enforcement of the contract even if an endgame occurs. The parties know that each will have ex post incentives to litigate a dispute at endgame. They also know that because of information problems a court is unlikely to resolve the dispute in a way that maximizes the prospective value of the contract. Ex ante, they would prefer the arbitrary resolution of nonenforcement, if the alternative is an equally arbitrary resolution following costly litigation and judicial evaluation of the contract.(2)

      Second, repeat players might not put their contracts into writing because of a norm against writings in their business community. The parties follow the norm blindly, in a way, without regard to whether writings are or are not cost justified in their particular case. This possibility assumes plausibly that it is too costly for parties to evaluate in every case whether it makes sense to put their contract in writing, so they rationally defer to the norm. The normative implications of this explanation are quite different from those of the first explanation, but I defer comment on them to...