The Desert and the Jungle:
The Desert and the Jungle: Alan Schwartz and Robert Scott on Contract Theory
- Introduction
Alan Schwartz (Yale) and Robert Scott (Virginia) have uploaded Contract Theory and the Limits of Contract Law, forthcoming in the Yale Law Journal. Here is the abstract:
- This article sets out a normative theory to guide decisionmakers in the regulation of contracts between firms. Commercial law for centuries has drawn a distinction between mercantile contracts and others, but modern scholars have not systematically pursued the normative implications of this distinction. We attempt to cure this neglect by setting out the theoretical foundations of a law merchant for our time. Firms contract to maximize expected surplus and the state permits markets to function because markets maximize social welfare. Thus, there is a correspondence of interest between firms and the state, which implies that, when externalities are absent, the state should implement the preferences of firms regarding the rules that regulate their contracting behavior.
A contract law for firms would differ in three major respects from current contract law. First, such a law would have far fewer default rules and standards than current contract law contains. The high level of generality on which much contract law is written (e.g., a party must behave "reasonably") creates unacceptable moral hazard for parties subject to it. Thus, firms in theory should, and in practice commonly do, contract out of much of the law most of the time. The primary effect of today's law, that is, is to raise transaction costs without altering substantive behavior. Second, the default theory of interpretation that a contract law for firms would require courts to base interpretations primarily on the written texts of agreements. The risks of incorrect interpretations that such a theory creates, we argue, would be more acceptable to firms than the costs that the courts' current interpretative practices create. Third, the law would contain almost no mandatory rules. To summarize, a modern law merchant would be much smaller than current contract law; would truncate broad judicial searches for parties' true intentions when interpreting their agreements; and would accord parties much more freedom to write efficient contracts than now exists.
But What Is Going On Here I find most of Schwartz and Scott's story to be compelling. In particular, their argument for the plain meaning approach to the interpretation of commercial contracts was very persuasive. But stepping back for a moment, I find large portions of their argument puzzling or confusing--although I think I agree with their core normative positions. Let me start with their basic theoretical notions--the idea of complete contract and a default rule. Before I start my analysis, it is probably useful to lay out some of Schwartz and Scott's basic ideas and arguments. Here goes:
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A Complete Contract
The first idea is that of a complete contract. The intuitive notion is that a complete contract would set out the obligations of the parties in all possible future states of the world. Schwartz & Scott rely on this idea in a number of places. Here are some examples:
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--"We now consider the case in which the parties have written a complete contract in some language." (p. 47)
--"Incomplete contracts sometimes produce law suits because parties will not always agree ex post regarding the treatment of omitted contingencies." (p. 60)
--"The commonly held view is that but for the cost parties would write complete contracts." (p. 62)
Default Rules and Mandatory Rules From this picture, it follows that the law of contracts contains default rules and mandatory rules. A default rule is a rule of law that fills a gap in an incomplete contract; default rules can be overriden by the terms of a contract, and hence, if a contract is complete, it completely excludes the operation of default rules. A mandatory rule is like a default rule, except that it trumps the terms of a contract. For example, a contract that with a liquidated damages clause that called for the breaching party to forfit a pound of flesh in the event of breach would be uneforceable because it would violate a mandatory rule.
Schwartz and Scott's Argument for Minimizing the Number of Default Rules Schwartz and Scott argue that contract law should contain very few default rules and standards. Let me quote three key paragraphs. The first sets out criteria for a good default rule. The second argues that because default rules would be too expensive, contract law relies on default standards instead. The third paragraph :
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Paragraph One, Criteria. A good default rule will condition on few possible states of the world, be relatively simple in form, and be efficient for a wide variety of contract parties. The first of these criteria is necessary because there can be an infinite number of possible future states of the world, but thestate’s drafting costs also are finite. Thus, it likely would not be cost justified to create a publically supplied rule if the rule had to contain directions for parties in many possible future states. The criterion of simplicity is a function of institutional competence. While legal rules can be complex, contract law rules are created by courts and drafters. Courts cannot conduct investigations into the efficiency properties of possible rules and rule combinations. Drafters also have limited resources.
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Paragraph Two, Costs Lead to Default Standards. Contract and commercial law thus contain very few default rules because parties are heterogeneous in modern economies, good rules sometimes must be complex, and the efficient rule may have to take many possible future states of the world or party types into account. Rather, the Restatement of Contracts and Article 2 of the UCC primarily contain standards; these texts are replete with provisions requiring parties to behave “reasonably”, “conscionably”, “fairly”, “in good faith”, and the like.
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Paragraph Three, Default Standards Are Inefficient The project of creating publicly supplied default standards is difficult to defend. A publicly supplied contract law is justified as solving problems for parties that contracting costs prevent parties from solving on their own. It is relatively costless for parties to write standards in their contracts, however. Thus, for parties to provide that the seller should deliver a “reasonable” quality level, deliver within a “reasonable” time, but be excused if its performance has become “impractical”, would exhaust few drafting resources. When a court observes the absence from a contract of a standard that would have resolved the issue at bar, then, the court should not infer that the contract has a gap that typical parties would want the court to fill. Instead, given how easy it is for parties to create standards, the best inference commonly will be that a standard is not “missing” from the contract, but rather its use has been rejected. The court therefore should not imply a standard to decide the case. And for the same reason drafters should be reluctant to enact sets of seemingly missing standards into statutes or restatements. To fill nonexistent gaps is to do for parties what parties do not want done.
Desert Landscapes How might we capture the core intuition behind Schwartz and Scott's theory of contracts between firms? Let us analogize current contract law to a lush jungle, populated by a dense undergrowth of default standards and a forest of default and mandatory rules. For firms to build a contract in this jungle, they must hack their way through the undergrowth--cutting down default standards willy nilly and building their agreement around the many awkwardly placed mandatory rules of contract. Schwartz and Scott might be said to long for contract law that is like a desert landscape. Surveying this sparse Schwartzscottian Desert, we would see a few scattered but attractive default rules along with the rare but prickly mandatory rule, usually spied only atop a distant dune. Building a contract in the desert is cheap by jungle standards. Because the mandatory rules are few and easily avoided, it is a simple task for firms to find a suitable plot upon which they can build their agreement. The default rules that might impinge on one’s contract can be incorporated in the structure or cleared away without undue expense. The desert floor is bare and solid—already a suitable foundation for building an agreement. It is no wonder that firms would prefer to build their contracts in desert landscapes.
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Complete Contract? Incoherent Idea!
Let's start with the first building block of Schwartz and Scott's analytic framework--the idea of a complete or fully specified contract. Will that dog hunt? Let's try to make the notion of a completely specified contract more precise. The method for specification will be the employment of possible-world semantics to cash out the idea of a "possible future state of the world." Once we have a clear understanding of this idea, we can move to the fully specified contract itself.
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Possible Worlds Semantics
Begin with the notion of a possible world. If X is possible, we say that X occurs in some possible world. We add the notion of the "actual world"—where actual is an indexical term that picks out this world from all possible worlds. A completely specified contract need not deal with all possible worlds--only with the possible future states of the actual world. This limitation is expressed in possible world semantics via what is called an "accessibility" relation. Those possible worlds that share the history of the actual world up to now are called "historically accessible." Of course, it is logically possible that the future states of the actual world could be just about anything you can imagine; there is no logical contradiction in a possible world that shares the history of the world up until now, but that is completely empty the very next moment. We should restrict the domain of possible worlds to those that share the basic laws of nature (physics, etc.) with the actual world; these worlds are called "nomologically accessible." The historically and nomologically accessible worlds, then, are those that share the history of the actual world up to now and that share our laws of nature.
"States of the World" and "Obligations of the Parties" We also need to define two more elements that enter into the notion of a completely specified contract: state of the world and obligations of the parties. First, stipulate that a state of a possible world is a unique time slice of that world: thus, world Wz at time Tq is at state S[WzTq]. Second, stipulate that obligations of the parties to a contract for a given state of the world will be a set of descriptions O that contains for each party, p1, p2, . . . pN, the obligation descriptions o1, o2, . . . oK that pick out the action types the occurrence of which is required by the contract. Thus, party p1's discrete obligation o1 would be p1o1. Given these definitions, a completely specified contract will take the form of a list of ordered pairs. One member of each pair will be a state of some historically and nomologically accessible possible world and the other will be a specification of the obligations of the parties for that event type. Let the equal symbol (=) represent the relationship between the two members of the ordered pair. A completely specified contract for n parties with k obligations in q time slices of z possible worlds would need to spell out all obligations of all parties for all time slices of all nomologically and historically accessible possible worlds. For just one time slice of one possible world and some number of parties N, we have
- S[WzTq]={(p1o1 & p1o2 & . . . & p1oK) & (p2o1 & p2o2 & . . . & p2oK) & . . . (pNo1 & pNo2 & . . . & pNoK).
Default Rules? Conceptual Default! A complete set of default rules simply is a complete contract minus the particular provisions that identify the parties and their core obligations. If contract law is to provide default rules for all situations in which an actual contract falls short of the ideal of a fully specified contract, then contract law must either contain an infinite number of rules or a finite number of rules or standards that predetermine outcomes in an infinite number of cases. A core assumption of Schwart and Scott's argument is that a complete set of default rules or standards that provide determinate guidance for the resolution of cases is impossible. And they are right. The dream of a completely specified contract has taken on a nightmarish quality. It is not clear that the idea of a contract that specifies the obligations of the parties for all possible futures states of the world makes sense.
Reconceputalizing Default Rules We need to rebuild the idea of a default rule on foundations firmer than the incoherent idea of a fully specified contract. Once we severe that tie, we can develop a workable albeit less ambitious concept. The key move is to figure out what default rules really do. My suggestion is that default rules perform three functions, or putting it a bit differently, default rules fill three kinds of gaps:
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Gap Type One. Failure to Specify Background Assumptions. The first cause for a gap might be the termed failure to specify contingent but highly probable background assumptions. For example, the contract requires payment of $10,000,000.00 on a certain date, and the obligee makes her payment by tendering 1,000,000,000 pennies. One might say that this situation exposes a "gap." The contract does not specify what will happen in the event of payment in pennies. The gap is created by a background assumption—that payment will be made by check or perhaps by $100 bill, but certainly not by pennies. The ability to contract against a background of unstated background assumptions is an absolute necessity for the enterprise of contracting to get off the ground. Without background assumptions, contracts would have no meaning. Courts must fill in the background assumptions, or they could not interpret contracts. And this leads to a very important point. Modes of contract interpretation are themselves default rules. Thus, a plaining meaning approach to contract interpretation is simply a default rule--or to be more precise a "default standard" in Schwartz and Scott's terminology.
Gap Type Two. Contractual Generality and the Variability of Experience. Consider a second and related reason for so-called "gaps." Contracts are written in relatively general language, but human experience is enormously variable. Recall Aristotle's classic discussion of equity in Chapter Ten of Book Five of the Nicomachean Ethics:
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[A]ll law is universal but about some things it is not possible to make a universal statement which will be correct. In those cases, then, in which it is necessary to speak universally, but not possible to do so correctly, the law takes the usual case, though it is not ignorant of the possibility of error. And it is none the less correct; for the error is not in the law nor in the legislator but in the nature of the thing, since the matter of practical affairs is of this kind from the start. When the law speaks universally, then, and a case arises on it which is not covered by the universal statement, then it is right, when the legislator fails us and has erred by over-simplicity to correct the omission--to say what the legislator himself would have said had he been present, and would have put into his law if he had known.
Gap Type Three. Recurring Omissions of Anticipatable Contingencies. Consider a third source of contractual gaps, the omission by the parties of an anticipatable contingency. Of course, such examples are familiar from contracts casebook. These are the garden-variety gaps with which we are all familiar. And of course the law does provide default rules for such recurring gaps. In a common law system, such gap filling by default rules is almost inevitable. The fact patters recur, opinions are published and particular rules governing omission types begin to form. One important default rule that applies to most contracts is law of contract damages--the expectation measure fills a gap in contracts without liquidated damage clauses (or other damage provisions). Even more ubiquitious is the set of rules that define the rights and obligations of the parties in the event that the contract is invalidated. Once again, the law provides a default for an anticipatable contingency--the invalidation of the contract itself. Of course, this default rule is an absolute nececessity. Although the parties could attempt to enter into a second order contract that established the consequences for invalidation of their first order contract, you have already seen that there is an infinite regress looming. What if the second order contract was not properly formed or is invalidated for some other reason? Well, the parties could form a third order contract, but . . .
I Have Good News and Bad News The good news first. Sure, complete and utter incoherence is not a good-making feature of theories, but in this case, there is a fix available. What Schwartz and Scott really mean is that of necessity default rules must be formulated so as to be contingent on only a few properties of the world. The problem isn't that there are an infinity of possible worlds. Rather, the problem is that each possible world can be described in an infiinite number of ways and contains a vast (but not infinite) number of entities, events, and actions. A default rule cannot be formulated as a complete description of the world. Default rules must be sparing in their formulation. When compared to the complexities of the world, legal rules are very sparse indeed. This is true even of the Internal Revenue Code--which despite its enormous complexity is vanishingly simple in comparison to the vastly complex world of human conduct it attempts to regulate in exquisitely fine-grained detail. So Schwartz and Scott are not in trouble. We might say that the surface structure of their point is incoherent but the deep structure is sound.
And Now for the Bad New But now that we understand the nature of default rules, it turns out that that one of Schwartz and Scott's claims is self-refuting. Schwartz and Scott claim that default standards are not so hot, because the parties will try to contract around them. But there is no escaping default standards. Contracting without default standards is inconcievable, and trying to concieve of contract law without pervasive default standards is an enterprise fraught with incoherence and confusion. And so it turns out that what Schwartz and Scott are advocating is not fewer default rules or default rules that condition on fewer states of the world. What Schwartz and Scott are advocating is different default rules. So, for example, they offer an argument for a method of contract interpretation, i.e., a "textualist interpretive style, one that restricts the evidentiary base to not much more than the written." And this just is a default standard. Default because Schwartz and Scott's own arguments against mandatory rules tell us that this interpretative method should give way if the parties so stipulate. Standard because the applicability of "textualist interpretation" to particular situations is defined ex post and not ex ante (and that is how Schwartz and Scott define standards as opposed to rules).
And One Thing More . . . One more piece of bad news. If you have gottent this far, you are probably wondering about the following question. If Schwartz and Scott advocate fewer default rules, then what will they do about the gaps? There must be some rule of law to deal with such situations--unless Schwartz and Scott would relegate the parties to self help. Here is what they say:
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What then is the proper role of courts in resolving disputes over incomplete contracts? If a contract contains a gap, a court sometimes must decide whether to create a standard or to declare the contract incomplete and thus void for indefiniteness. It would be appropriate to create a standard if the standard could satisfy the criteria set out above. If such a standard does not exist but the contract has been partly performed, so that declaring it void would create hardship, courts understandably attempt to read the contract to reach a reasonable result. It does not follow from these understandable efforts that drafters should infer default standards from the courts’ holdings. Rather, our argument holds that UCC or Restatement drafters commonly should do nothing, and that courts should be hospitable to attempts by later parties to alter or avoid earlier rules of the case.
