The function of Article V.

Author:Huq, Aziz Z.
Position:II. The Function of Article V in the Early Republic A. The Constitution as a Long-Term Relational Contract 2. The Hold-up Problem in Private Contracting through Conclusion, with footnotes, p. 1196-1236

2. The Hold-up Problem in Private Contracting

A large law and economics literature about barriers to contracting pursues Ronald Coase's famous question why contracting parties opt to internalize a transaction within a firm rather than using the market. (140) Coase's analysis identified a comparison of the marginal "costs of organizing" production inside and outside the firm as pivotal to this decision. (141) When the costs of organizing through market mechanisms are relatively high, it is worth fashioning a long-term and incomplete relational contract--that is, the firm. Coase's insight generated a range of hypotheses about how incomplete, relational contracts can be designed to address problems specific to particular industries and parties. (142) His analysis pointed toward different ways in which contracts could respond to heterogeneous barriers to contracting, (143) including adverse selection problems, information asymmetries, (144) and the need for high-powered rather than low-powered incentives to make a contract succeed. (145)

The problem of "hold-ups," (146) otherwise known as the problem of "post-contractual opportunistic behavior," (147) has special relevance for understanding the role of textual rigidity in constitutions qua contracts. Hold-up problems can arise whenever parties must make post-contractual investments in assets specific to their relationship. (148) An investment-backed asset is specific when a contracting party's next-best return from the asset is substantially less than the return from the asset within the context of the contractual relationship. (149) For example, imagine a printing press built with specifications for a particular newspaper that generates a joint annual surplus of $1.5 million, where the next-best use of the press (for a different publisher with different needs) would yield only $500,000. (150) Once the press has made its investment, the newspaper can threaten to breach in order to extort a greater share of the jointly produced surplus from the investing party. (151) Because the second-best use of the asset pays out much less to the investing party, the latter stands to realize a large loss by walking away from the contract. Accordingly, it is rational to accede to renegotiation. (152) Even when the dependency is bilateral, the possibility of hold-up can still lead to haggling that dissipates gains from trade. (153)

The potential for hold-up has both ex ante and ex post effects. Ex ante, a potential investing party will rationally anticipate the possibility of hold-up and so decline to enter into contracts where that risk exists. (154) Otherwise Pareto-superior deals will, as a result, remain unrealized. Ex post, parties that do enter deals will dissipate resources on both hold-ups and resistance to hold-ups, resulting in intracontractual disputes and haggling that expend resources without commensurate social gain. (155) Solving the hold-up problem is valuable, therefore, because it enables otherwise Pareto-superior deals to be negotiated and honored in ways that maximize their value.

The relationship-specificity of assets created by post-contractual investment and the consequent specter of a hold-up can be observed across the landscape of private contracting. (156) Consider, for example, a coal-burning power generation facility that benefits from being located at the "mouth" of a mine, but that thereby renders itself vulnerable to hold-up. (157) Or think of an automobile manufacturer that may wish for a subsidiary supplier to invest in specialized manufacturing hardware, and even to co-locate, in order to minimize production costs, only to find that the supplier baulks out of a fear of hold-up. (158) It is even possible to find hold-ups in contracts over human capital. A famous example involves the tough bargaining by actor James Gandolfini over whether he would appear in later seasons of the lucrative HBO series The Sopranos, which resulted in the actor roughly doubling his $400,000 per episode salary--the network being the object of the putative hold-up. (159) As these examples suggest, an investment's specificity can take many forms, from location to physical design or human capital allocations. (160) The hold-up problem may be also especially acute in circumstances in which a post-contract formation investment is cooperative in nature in that it "generate^] a direct benefit for the trading partner." (161) Such cooperative investments are "critically important in modern manufacturing." (162) Empirical studies confirm that the hold-up problem is not merely hypothetical, but has significant effects in observed contracting contexts. (163)

Hold-up problems arise in both incomplete and complete contracts, albeit in different ways. Hold-up can arise either when an incomplete contract does not address an unexpected exogenous event that provokes one party to seek renegotiation, or when post-contracting investments expose one party to another's opportunism. With a complete contract, changed circumstances can also lead to hold-up. (164) For instance, Gandolfini's contract was likely complete in the sense that it specified a salary. (165) The latter dispute can hence be described either in terms of an incomplete or a complete contract; it either concerned the breach of a complete contract followed by de novo deal-making (from HBO's perspective), or the modification of an incomplete contract that did not state when modifications were permitted in light of changed circumstances (from Gandolfini's perspective). The problem can accordingly be framed either as one of contractual commitment or gap-filling. For the purposes of this Article, there is little need to distinguish between these two characterizations, even if the distinction has significance in the private contracting context. (166)

There are several ways of mitigating the potential for hold-ups, not all of which translate well into the public-law context. Among the first solutions to be identified in the law and economics literature involved vertical integration. One firm would purchase the other and thereby eliminate the possibility of interfirm hold-up. (167) Arranging deals within the firm, although it mitigates the hold-up problem, is not costless. Rather, it "sacrifices the high-powered incentive advantages of market exchange and, consequently, demands greater investments in monitoring and administration." (168) Some evidence nevertheless suggests that integration "becomes more likely in the presence of relationship-specific human capital...." (169) However promising it may be as a private-law solution, vertical integration cannot be transposed easily to the public-law context. A constitution cannot by mere ipse dixit dissolve a diverse and conflictive pool of interest groups into a harmonious whole.

A second possible solution is to draft the contract to include one of the rather complex mechanisms economists have identified that dampen renegotiation. (170) For example, a leading analysis postulates that in some circumstances, mechanisms for verifiable communication between parties will enable the maintenance of efficient investment levels. (171) Like vertical integration, the specific contractual solutions proposed in this line of analysis do not translate easily into the context of constitutions as contract. (172) An exception is the possibility of "offering to the potential cheater a future 'premium,' more precisely, a price sufficiently greater than average variable (that is, avoidable) cost to assure a quasi-rent stream that will exceed the potential gain from cheating." (173) Examples of the latter mechanism include long-term implicit contracts with particular suppliers and interfirm reciprocity agreements. Both solutions create an enduring stream of benefits, the present-discounted value of which is greater than the benefits from cheating. (174) As explained below, something akin to this mechanism might be discerned in the American constitutional domain, with the public-law context providing easier ways of generating the solution.

The third solution to hold-ups explored in the private-law literature does, however, bear directly on public-law problems. Indeed, this solution may paradoxically be easier to employ in the public-law context than in the original private-law context. This is the possibility of simply declining to enforce any modifications to a contract. (175) For example, after two parties sign a contract that requires relationship-specific investments on the part of party A, the court asked to enforce a modification of the contract elicited by party B will demur. Instead, it will enforce the terms of the contract as originally drafted. A rule against modification of this kind "assures prospective contract parties that signing a contract is not stepping into a trap," and thereby enables Pareto-superior deals. (176)

In practice, the effect of no-modification clauses under American contract law is unclear. The "pre-existing duty rule" sometimes has the effect of barring certain sorts of modifications. It hence mitigates certain hold-up problems. (177) For example, in Alaska Packers' Ass'n v. Domenico, a contract law casebook staple, the Ninth Circuit Court of Appeals declined to enforce a salary-increasing modification negotiated by the crew of a fishing vessel in the midst of an Alaska salmon run, at a time at which no substitute crew could possibly be found. (178)

In other instances, however, "courts simply ignor[e] the pre-existing duty rule" or find ways to circumvent it. (179) "Freedom of contract" principles are often cited as ground for such refusals. (180) Even more problematic is the fact that "[t]hose who make a contract may unmake it.... Whenever two men contract, no limitation self-imposed can destroy their power to contract again." (181) In other words, there is a generally available mechanism for rendering no-modification clauses nugatory--by entering into a...

To continue reading