The no-reading problem in consumer contract law.

Author:Ayres, Ian
Position::II. Analyzing Consumer Expectations G. An Application to the Warning Box through Conclusion, with appendix and footnotes, p. 576-609

G. An Application to the Warning Box

The goal is to rank terms by the welfare losses that consumer mistakes cause. (80) Welfare losses are decreasing in a, the portion of informed consumers, and increasing in [lambda], the portion of uninformed optimists that contract. Hence, if a survey revealed, say, that consumers commonly believe the warranty is broader than it actually is (an optimistic belief), but many consumers understand the financing terms and the rest make pessimistic mistakes (they think sellers are tougher on defaulters than they actually are), then the warning box should highlight warranty terms but not financing terms.

To generalize, the empirical researcher should consider three variables: the frequency of mistakes; the direction of mistakes; and the cost of mistakes. Evidence could uncover frequency and direction more conveniently than cost. Some mistakes seem monetizable, however. An example may be the cost difference between a narrower and a broader warranty. In any event, the general idea is clear: to rank mistakes by their welfare cost, for which we proxy in our proposal by requiring sellers to inquire about the relative importance of particular terms.

To introduce how such a scheme would work, consider the following 1989 Roper study of 1484 adults regarding the coverage of a homeowner's insurance policy. (81) Figure 1 below shows that a substantial majority could correctly answer that their policy covered theft, liability for bodily injury, storms, and vandalism. A slight majority (54%), however, incorrectly believed that damage from riots was not covered.

The policies' riot coverage illustrates pessimism: a majority of consumers believed that the contract was less favorable to them, with regard to riot coverage, than it actually was. We show above that pessimism is not a cause for concern. These pessimists would have continued to contract were their expectations corrected, so there is no need to correct them.

The same study, however, also produced substantial evidence of optimism--the unexpected and unfavorable term. Figure 2 reports respondent answers concerning five possible losses that the standard homeowner's policy excludes.

A majority of respondents correctly understood that losses from nuclear accidents and normal wear and tear are not recoverable. But a majority of respondents failed to recognize that damages from floods, earthquakes, and mudslides are also excluded. In particular, respondents held unexpectedly favorable beliefs about flood coverage. If we put aside the 15% who reported not knowing whether flood damage is covered, Figure 2 shows that a majority of the remaining respondents thought they were protected against flood damage. And even those who reported not knowing might have mistakenly attributed some value to the possibility of such coverage. A positive fraction of these term optimists may not have been in the market under correct expectations, so their mistakes should be corrected. The term-substantiation part of our proposal would require insurers to inform themselves about such mistakenly favorable beliefs; the disclosure part would require the informed insurers to warn consumers about the unexpected terms.

More recently, a 2008 study by Brian Bucks and Karen Pence provided evidence that mortgage borrowers hold systematically optimistic beliefs about the terms of their adjustable-rate mortgages. (82) As discussed by Christine Jolls:

The Bucks and Pence study produced clear evidence of borrower misunderstanding--in an optimistic direction--of permissible interest rate adjustments in adjustable-rate mortgages.... 40 percent [of adjustable-rate borrowers] believed that interest rates on their adjustable-rate mortgages could increase at most one percentage point per period, while [lenders reported that] less than two percent of adjustable-rate mortgages had caps this low. Rather, 47 percent had caps of two percentage points per period, and 46 percent had caps higher than two percentage points. Likewise, with respect to the lifetime cap on interest rate adjustment, 63 percent of adjustable-rate mortgage borrowers ... believed the cap to be five percent or less, whereas only 31 percent of adjustable-rate mortgages had caps this low.... (83) As with our insurance example, optimistic consumer expectations about mortgage terms probably caused inefficiency. Optimistic consumers attributed greater utility to the payment term than they would have attributed to that term were they informed. As a consequence, mortgage contract quality probably was inefficiently low. Accordingly, evidence that consumer borrowers make this or similar mistakes about actual mortgage content could, if sufficiently substantial, trigger a heightened lender duty to warn.


    We use the incentive of more certain enforcement to induce mass-market sellers to become better informed about likely consumer mistakes. In essence, we would require a "know thy customer" duty that is already in place with regard to brokers and other financial intermediaries. (84) But while brokers need to learn of the substantive investment goals of their clients, we only require sellers to learn what their customers believe about the contractual attributes of the product or service being purchased. Indeed, in the current era of Big Data, our "know thy customer" proposal comes at a time when many sellers are independently scoring their customers' beliefs and behaviors. (85)

    Once sellers acquire actual knowledge of consumer beliefs, the sellers could not enforce disadvantageous, unknown terms. (86) A consequence would be to increase the incentive of sellers to make better disclosures. For the reasons in Part I, however, the standard efforts to increase disclosure efficacy are unlikely to work. Our approach is an advance because it (i) encourages the burying of expected terms, and (ii) mandates a standardized form, the "unexpected term box," to alert consumers to unexpectedly unfavorable terms. By reducing the salience of expected terms and increasing the salience of unexpected terms (with the help of an easily identifiable box), our enhanced disclosures have an increased chance of promoting informed consumer consent in a cost-effective manner.

    A. Institutional Implications and Warning Principles

    Our proposal is directed to both federal and state actors. At the federal level, we propose that the FTC promulgate a term-substantiation policy that would require mass-market sellers to become informed about unexpected, unfavorable terms and to provide warnings about such terms in a cautionary standardized box. At the state level, state courts should reinforce the term-substantiation project by refusing to enforce unexpected terms both as a matter of common law--as a violation of section 211 of the Restatement--and as a matter of state "Little-FTC Acts" (88)--as an unfair and deceptive trade practice. Our proposal thus represents a handoff from federal to state enforcement. Although either federal or state consumer protection officials might enforce "substantiate and warn" duties, more often the federal duty to substantiate would trigger private state enforcement actions (in contract or under the Little-FTC Acts). (89) In the shadow of a federal substantiation policy, state common law courts should presumptively void invisible terms when a mass-market seller fails to adequately substantiate or warn.

    We limit the duty of term substantiation to mass-market sellers because there are nontrivial fixed costs to substantiation surveys that would impose undue burdens on smaller sellers that are likely to outweigh any benefit in consumer welfare. The law and the marketplace already draw distinctions between small and large businesses in many contexts. The Uniform Computer Information Transactions Act, for example, provides special legal rules for "[m]ass-market transaction[s]," which are flexibly defined as transactions aimed at a broad market and governed by a standard form. (90) The Small Business Administration generally defines a business as "small" if it has 500 or fewer employees and $7 million or less in average annual receipts. (91) For concreteness, we propose defining a "mass-market" seller as one with more than 500 employees or more than $20 million in annual retail sales.

    We propose a regime for mass-market contractors under which unexpected, unfavorable terms would be presumptively unenforceable unless the seller adequately disclosed and secured separate assent to them. A seller who satisfied this requirement would predictably win a summary judgment motion challenging its standard form. (92) The next Subpart discusses in more detail what the process of term substantiation would entail and how it might identify unexpected, unfavorable terms. Here we describe what the seller should do when it learns of terms that are unexpectedly unfavorable.

    Before reaching the details, we note a common objection. If consumers do not read current contracts, then a reform that relies on consumers reading is misguided. This objection overlooks the role that search costs play in the consumer's search strategy. When search costs are introduced, it becomes apparent that a form that reduces those costs can increase the amount that consumers learn. (93) To see how this insight applies in the warning box context, first let the consumer's cost of learning the content of a term from reading it be [r.sub.r] and the cost of learning term content from informal channels be [r.sub.c]. Revealed preference reasoning implies that [r.sub.c]

    The warning box proposal reduces the consumer's learning cost. Denoting the cost of learning by reading the box as [r.sub.b], we claim that [r.sub.b] [r.sub.b] is possible: the consumer will read--that is, learn the content of--the t - (s + 1) term because he expects to derive more utility from knowing the content of the term than the cost of finding out. The warning box proposal, however...

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