Contract Law: General Theories 4000 4000 CONTRACT LAW: GENERAL THEORIES of the interpretation of most other legal documents, such as wills (see Chapter 5830) or legislative enactments (see Chapter 9200). Richard Craswell As long as legal documents fall short of this level of completeness, the law Professor of Law, Stanford Law School must have some set of presumptions or default rules, in order to resolve Copyright 1999 Richard Cras well disputes that are not settled by the terms of the document itself. The law could, of course, simply refuse to enforce any contract (or any will, or any statute) that fell short of absolute completeness. But such a rule would itself be a 'default Abstract rule': it would be a legal rule defining the obligations (or lack of obligations) that result when a contract does not itself specify what rules should govern. As When contracts are incomplete, the law must rely on default rules to resolve long as actual contracts fall short of full completeness, then, the existence of any issues that have not been explicitly addressed by the parties. Some default default rules is not so much a choice as a logical necessity. The only question rules (called 'majoritarian' or "market-mimicking') are designed to be left in is what the content of those default rules ought to be. place by most parties, and thus are chosen to reflect an efficient allocation of In choosing the content of default rules for contractual relationships, it is rights and duties. Others (called "information-forcing' or 'penalty' default often useful to distinguish default rules chosen to increase efficiency if they are rules) are designed not to be left in place, but rather to encourage the parties allowed to remain in force (as discussed in Sections 2-4) from those chosen to themselves to explicitly provide some other resolution; these rules thus aim to increase efficiency if many parties contract around the default rule (discussed encourage an efficient contracting process. This chapter describes the issues in Sections 5-9). In some cases, the steps required to contract around a default raised by such rules, including their application to heterogeneous markets and rule could themselves increase efficiency, by inducing one party to reveal to separating and pooling equilibria; it also briefly discusses some non- private information (as discussed in Sections 6-8). In other cases, it may be too economic theories of default rules. Finally, this chapter also discusses economic hard for the law to identify a single rule that would increase efficiency if and non-economic theories about the general question of why contracts should allowed to remain in force, so the default rule may instead be selected purely be enforced at all. for its simplicity or ease of administration (as discussed in Section 9). The JEL classification: K 12 choice between these approaches depends in part on the ability of courts or Keywords: Contracts, Incomplete Contracts, Default Rules lawmakers to identify efficient default rules; this issue is addressed in Section 10. The possible effect of default rules on the parties' own preferences is discussed in Section 11, while Section 12 discusses some non-economic 1. Introduction theories of default rules. Finally, there is also a good deal of scholarship on the general question of This chapter describes research bearing on the general aspects of contract law. when contracts ought to be enforceable, either through informal social Most research in law and economics does not explicitly address these general sanctions or more by formal legal mechanisms. Section 16 introduces these aspects, but instead proceeds directly to analyze particular rules of contract law, issues, and discusses the choice of enforcement mechanisms. Sections 18-20 such as the remedies for breach. That body of research is described below in focus on the question of whether promises should be enforceable at all Chapters 4100 through 4800. (whatever the mechanism), with Section 18 discussing noneconomic theories There is, however, some scholarship on the general nature of contract law's of enforcement and Sections 19-20 discussing the economic theories. 'default rules', or the rules that define the parties' obligations in the absence of any explicit agreement to the contrary. The phrase, 'complete contingent contract' is sometimes used to describe an (imaginary) contract that would spell A. 'Majoritarian' or 'Market-Mimicking' Default Rules out in complete detail the exact legal rights and duties of each party under every possible state of affairs. While no real contract ever achieves this level of 2. Introduction to Majoritarian Default Rules completeness, the concept is still useful to define one endpoint of a spectrum of completeness. If any contract ever succeeded in reaching this endpoint, the One way to select a default rule is to identify the rule that would be most law's default rules would then be irrelevant, as no issue would ever arise that efficient if that rule were allowed to remain in place (for example, if the parties could not be settled by the terms of the contract itself. Indeed, the same is true4000 Contract Law: General Theories Contract Law: General Theories 4000 did not specify some other rule in their contract). For example, if the contingencies, where the expected benefits of specifying a rule in advance are expectation measure of damages were determined to be the most efficient likely to be low. In such a case, any rule the law selects as a default rule will remedy for breach of contract, this approach to selecting a default rule would inevitably be left in place by the parties, so the only way to get the benefits of argue for making expectation damages the default remedy. whatever rule is most efficient is to make that rule the default rule. The second Much of the economically-oriented research on specific topics of contract economic argument applies if it would be costly, but not prohibitively law falls into this category. For example, many analyses of the remedies for expensive, for the parties to make their contract more complete by specifying breach aim to identify the remedy that would produce the most efficient result their own rule. In such a case, selecting a default rule that matches whatever if that remedy were allowed to govern the parties' relationship (for example, if rule the parties prefer may save some parties from having to incur those the parties' contract did not stipulate that some other remedy would govern). transaction costs, thus producing all the benefits of the most efficient rule with The same is true of many analyses of implied excuses such as impracticability lower total transaction costs. and mistake, or of other terms such as implied warranties. This work is These arguments become more complicated, however, if a market- described at more length in Chapters 4500 (unforeseen contingencies), 4600 mimicking' default rule is being applied to a market that is imperfect in some (remedies), and 4700 (warranties). This section addresses only those issues respect. For example, if a remedy of expectation damages would in fact be most common to all default rules of this sort. efficient, but if imperfect information has led the parties to believe that some other remedy would be more efficient, should the law adopt as its default remedy the one that is in fact most efficient, or should it adopt the less efficient 3. Majoritarian Rules and Hypothetical Consent remedy that the (imperfectly informed) parties would choose if left to their own devices? The transaction-cost argument discussed in the preceding paragraph Default rules selected on this basis - that is, on the grounds of their efficiency could suggest that, if the cost of contracting around the default rule is if allowed to remain in force - are sometimes described as the rules that the sufficiently low that the parties are likely to do so, then the law might as well parties themselves would have chosen, if they had taken the time to agree adopt the less efficient remedy as the default rule, because that is the remedy explicitly on a rule to govern their relationship. In most cases, parties to a the parties will contract for anyway. Alternatively, if the costs of transacting contract have an interest in maximizing the efficiency of their relationship, so around the default rule are so high that the parties are likely to leave the default the rule the parties themselves would have chosen will be the same as the rule rule in place, perhaps the law should adopt the remedy that in fact is most that would be most efficient if allowed to remain in place. Thus, default rules efficient, as that will give the parties the benefit of the more efficient rule. But chosen on this basis have also been labeled "market mimicking default rules', this latter approach is complicated by the fact that the identity of the rule that or default rules based on the principle of 'hypothetical consent'. To be sure, if is most efficient (if allowed to remain in force) may itself change if the parties there are third-party effects, or if the parties to the contract are imperfectly are imperfectly informed, or if there are other market imperfections. Moreover, informed or are subject to any other market failures, the rule that would be in some cases the presence of information asymmetries or other market chosen by the actual parties might no longer coincide with the rule that would imperfections may call for an entirely different approach to the selection of in fact be most efficient. For general discussions of the relationship between default rules, in which the default rules are intentionally chosen not to be left efficient default rules and hypothetical consent, see Posner and Rosenfield in force by many parties. This approach is discussed below in Sections 5-9. (1977, p. 89), Ayres and Gertner (1989, pp. 89-93), Coleman, Heckathorn and Maser (1989), and Craswell (1992). Section 4 discusses some additional complexities that arise in heterogeneous markets, in which the same rule would 4. Majoritarian Rules in Heterogeneous Markets not be chosen by every pair of contracting parties. This basis for selecting default rules has been supported by two economic Market-mimicking or "majoritarian' default rules raise additional issues in arguments, both of which involve transaction costs. (Some noneconomic markets characterized by heterogeneity, where different rules would be efficient arguments will be discussed in Section 12 below.) The first economic argument for different contracting pairs. If a single default rule must be chosen to govern applies when it would be prohibitively expensive for the parties to make their all contracts in such a market, the rule selected will determine which contract more complete by specifying the rule they want to govern a particular contracting pairs can do best by leaving the default rule in place and which contingency. This is especially likely for extremely low-probability pairs could potentially do better by incurring the transaction costs needed to4000 Contract Law: General Theories Contract Law: General Theories 4000 specify some other rule. It is sometimes assumed that the most efficient single "information asymmetries'. While information asymmetries are often addressed default rule would be that which was most efficient for most of the contracting directly through disclosure regulations and the like (see Chapter 5110), they pairs (hence the label 'majoritarian' default rule, coined by Ayres and Gertner, can also have implications for the law's choice of default rules. Section 6 below 1989). But if transaction costs differ across heterogeneous parties, this discusses cases where the two parties are differentially informed about the conclusion actually depends on the exact levels of transaction costs that each governing legal rule. Sections 7-8 then discuss cases where the two parties are member of each contracting pair would have to incur to contract around differentially informed about some other aspect of the transaction. whatever default rule the law adopts (see Ayres and Gertner, 1989, pp. 1 12- 115). If different rules would be efficient for different contracting pairs, the law 6. Forcing Information about the Legal Rule must also to decide the extent to which its default rules should be 'tailored', or customized to match the rule that would be most efficient for each individual In some cases, the choice of default rule may help correct one party's contracting pair (see Ayres, 1993; Goetz and Scott, 1985; Baird and Weisberg, information about the legal rule itself. For example, suppose that the default 1982). If the law adopts a single, untailored default rule, that will be most remedy for breach provides for only a small monetary payment. Suppose also efficient for only some of the contracting pairs: all other pairs will have to incur that the seller (the potential breacher) knows this, but the buyer (the potential either (1 ) the transaction costs of contracting around the default rule, or (2) the nonbreacher) does not. Suppose that the buyer instead thinks, incorrectly, that efficiency loss from leaving in place a default rule that is less than efficient for the law's default rule provides for a very large payment in the event of breach. their contract. A set of default rules tailored to each individual contracting pair If left uncorrected, this information asymmetry could lead to either of two can in theory eliminate or reduce these costs, but such 'tailoring' will usually problems. First, if a larger remedy would be more efficient for this contracting introduce other costs. For instance, individually tailored rules will usually be pair, they may not alter their contract to provide for the larger and more more complex, thus increasing the drafting costs that must be incurred by the efficient remedy, because the buyer will think that he or she already has the legislature or other lawmaking body. Moreover, it is often impossible to spell benefit of a larger remedy. Second, even if the smaller remedy provided by the out a complete set of individually tailored rules in advance, so the law will default rule is in fact most efficient for this contracting pair, the buyer's instead have to rely on vague standards to be applied by courts on a case-by- ignorance about the actual rule may keep him or her from optimally adapting case basis (for example, an implied excuse in cases where performance is no his or her behavior to that rule. For example, the buyer may purchase longer commercially 'reasonable"). Vague standards such as these usually entail insufficient insurance, or take insufficient precautions to reduce the losses that higher litigation costs; they also introduce the possibility of case-by-case error would be caused by breach. (The effect of legal remedies on the incentives in the application of the standard, and may make it hard for the parties to governing decisions such as these is discussed at more length in Chapter 4600.) predict what rule will be applied to their relationship. In short, the question of By contrast, suppose now that the default rule were changed to provide for how finely to tailor a default rule - and, indeed, whether to tailor it at all - a very large payment in the event of breach. If this remedy is left in place, that raises most of the same issues that are raised whenever the law faces a choice is, if the parties do not contract around it), then both parties will optimally between specific rules and vague standards (see Chapter 9000). adapt their behavior: the buyer will adapt because this rule matches what he or she thinks the rule is, while the seller will adapt because, by hypothesis, he or she is correctly informed about whatever the default rule is. And if this default B. 'Information-Forcing' or 'Penalty' Default Rules remedy is not left in place (that is, if the parties contract around it by stipulating a smaller remedy), the act of stipulating some other remedy should 5. Introduction to Information-Forcing Default Rules serve to inform the buyer about what remedy will apply in the event of breach. Indeed, if the default rule is one that the parties will be certain to contract In many transactions, the two parties begin with differing amounts of around- for example, if it is chosen to be highly unfavorable to whichever party information. In some cases, they may be differently informed about the relevant is better informed about the law - that will virtually ensure that the other party legal rules, or about the risks involved in the transaction. They may also be will also become correctly informed about the resulting rule, by the very process differently informed about the characteristics of the other party - for example, of stipulating to some other rule in their contract. Hence, these default rules are the seller may not know how much the buyer will lose if the seller's product sometimes described as "information forcing' rules (Scott, 1990, p. 609), or as turns out to be defective. Differences such as these are often referred to as4000 Contract Law: General Theories Contract Law: General Theories 4000 'penalty defaults' slanted against the better-informed party to induce him or her would lose less may be the ones with an incentive to contract around that rule, to contract around the default rule (Ayres and Gertner, 1989, p. 97). A number by negotiating for a smaller stipulated damage to get a more favorable price). of analyses of particular topics in contract law have recommended default rules In other words, the choice of default rule will determine which set of buyers - chosen on this basis, or have suggested that actual legal rules could be buyers with little at stake, or buyers with lots at stake - have an incentive to try understood as serving this function. See, for example, Ayres and Gertner (1989, to contract around the default rule. As a result, sellers may be able to infer pp. 98-99, 104-106), Goldberg (1984, pp. 295-296), Muris (1983, p. 390), something about the amount that any given buyer has at stake by observing Verkerke (1995, pp. 885-890), Isaacharoff (1996, pp. 1793-1795). whether that buyer does or does not try to contract around the default rule. And One difficulty raised by default rules slanted against the better-informed if buyers also differ in the gains they would get from transacting around the party is that it may not be clear which party is better informed. This raises default rule, or in the costs they would face in doing so, the resulting another "tailoring' question of the sort discussed above in Section 4: should the equilibrium may depend critically on which default rule the law adopts. (The party against whom the default rule is slanted be determined in advance for a welfare consequences of these differences are discussed below in Section 8.) broad category of cases, or individually on a case-by-case basis? These differences are often analyzed using signaling models from game Another difficult issue, even in cases where it is clear which party is least theory (see generally Chapter 0550). If sellers have no information about how well-informed, concerns the comparison between the benefits and the costs of much any given buyer would lose in the event of breach, the result may be a correcting the information asymmetry. The benefit of correcting the asymmetry pooling equilibrium in which all buyers are charged an identical price. But if will vary from case to case, depending on the information involved, so it is this asymmetry can somehow be overcome, the result may be a separating difficult to generalize. The costs of correcting the asymmetry clearly include the equilibrium in which buyers who face large losses in the event of breach will direct costs of contracting around the original default rule (which will depend have a right to collect those losses, but will pay a higher price (to compensate in turn on the procedures that are required to contract around a default rule, as the seller for its greater potential liability), while buyers who face lower losses discussed in Section 14 below). The costs of correcting the asymmetry also will pay a lower price. One way to achieve this separating equilibrium is to depend on the risk that the parties will simply forget to contract around, thereby select a default rule that induces one of these classes of buyers to signal the unintentionally leaving in force a default rule that was chosen not to be efficient amount they have at stake, by their actions in trying to contract around the for these contracting parties. default rule. For formal models of this effect see, for example, Ayres and Gertner (1989, 1992), Johnston (1990), Allen and Gale (1992), Hviid (1996). 7. Forcing Information about the Other Contracting Party 8. Information-Forcing and Economic Welfare In many markets there is heterogeneity among the potential parties on a single side of a proposed transaction. For example, sellers may differ in the reliability Unfortunately, it is often difficult to assess the welfare implications of default of their products, or buyers may differ in the losses that they would suffer if the rules that produce separating equilibria. Part of the difficulty is that, while there product they purchase fails to perform. At the outset of the transaction, this will usually be efficiency gains from eliminating this information asymmetry, information is often known to one party but not to the other - for example, each that will not always be the case. Gains could arise if information about each buyer may already know how much loss he or she would suffer, but sellers may individual buyer's potential losses may let some sellers make customized have no way of knowing how much any individual buyer has at stake. This is adjustments to the reliability of their products. Gains could also arise if this another example of information asymmetry. information let sellers calculate a price that better reflected the true risk of When this asymmetry is present, contract law's default rules can again selling to that particular buyer, thus sending buyers the correct signals about create incentives for one party to take actions that will reveal information to the whether to purchase that product (see Ayres and Gertner, 1989; Quillen, 1988). other party. For example, if the default remedy for breach of contract provides In some cases, though, information about the buyer's potential losses may be for only a small monetary payment, buyers who would lose a larger amount in of no relevance to sellers - as, for instance, when sellers operate mass the event of breach may have an incentive to try to contract around that rule, businesses that cannot practicably adjust their actions or prices for individual by negotiating for a clause stipulating a larger payment in the event of breach. buyers (Danzig, 1975; Eisenberg, 1992, pp. 591-596). In such markets, there By contrast, if the default remedy is already set at a larger payment, buyers who will be no efficiency gains at all from curing the information asymmetry. In4000 Contract Law: General Theories 10 Contract Law: General Theories 4000 still other markets, there may be positive gains from curing the asymmetry but is no way to breach an obligation to deliver a quantity of zero, and hence no those gains may not outweigh the costs of communicating the necessary need to ever measure damages. Still, the essential feature of a formality is information (Bebchuk and Shavell, 1991). merely that some number be fixed in advance and be easily learnable by the Moreover, even when net efficiency gains are possible, the parties' private parties, so that they can determine whether they will have to specify some other incentives may lead them to act in a way that fails to achieve those gains. For number in their contract. The formality could even be set at the number that example, if buyers face a price-discriminating monopolist who can charge most parties would prefer (if that number were known), thus giving it one higher prices to buyers who have more at stake in a particular transaction, feature in common with a market mimicking or majoritarian default rule. The buyers may be reluctant to do anything to reveal the amount they have at stake only key is that, since formalities are chosen for their simplicity and ease of for fear of having to pay a higher price (Wolcher, 1989; Johnston, 1990; Ayres administration, they will necessarily be "untailored' in the sense defined earlier and Gertner, 1992). In other cases, some buyers may get private benefits (such in Section 4. As a result, no matter what specific rule is adopted as the default as a more favorable price) by distinguishing themselves from other buyers, thus formality, many (perhaps most) contracting pairs will find it in their interest leading to socially excessive signaling (Rea, 1984; Aghion and Hermalin, to specify some other rule in their contract. 1990). At present, it is difficult to generalize about when the signaling or Because formalities are designed to be easily administered, they will at least separating effects of a default rule will improve overall efficiency (see Hviid, have the virtue of reducing litigation costs in all cases when the parties fail to 1996). specify some other rule in their contract, so the default rule remains in effect. This same ease of administration may also minimize another component of transaction costs: the cost to the parties of becoming informed about the legal 9. 'Formalities' as Default Rules rule, and of predicting how that rule might be applied. Also, if the formality is not chosen to be deliberately unfavorable to either party, it may reduce the costs Still another approach to selecting default rules aims entirely at ease of imposed when parties forget to specify some other rule in their contract: in this administration. That is, rather than trying to identify the default rule that would way, formalities may reduce the cost of remaining uninformed about the law. (1 ) be most efficient if left in place, or would (2) induce an efficient disclosure (These two effects have offsetting influences on parties' incentives to become of information, this approach aims for default rules that are easily administered informed about the law.) by courts, and easily learned and understood by contracting parties. In an influential early article, Fuller (1941) coined the term 'formality' to refer to rules designed to induce parties to specify their intentions in a way that could C. Other Issues in Designing Default Rules easily be recognized by courts. In this respect, Fuller's rules were designed to force the parties to disclose information to the court, rather than (or in addition 10. Default Rules and Institutional Capabilities to) forcing one party to disclose information to the other contracting party. For example, if the parties to a contract fail to specify the quantity of goods The preceding sections have discussed three bases on which default rules might they intend to convey, many jurisdictions refuse to enforce any obligation be selected: market-mimicking or majoritarian defaults (Sections 2-4), whatsoever, thus implicitly filling the gap with a quantity of"zero' (see Ayres information-forcing or penalty defaults (Sections 5-8), and pure formalities and Gertner, 1989, pp. 95-96). This default rule clearly is not designed to (Section 9). The choice among these various approaches depends in part on the match what any contracting pair would have intended anyway. Instead, its competence and capabilities of legal institutions. For example, the first two purpose is to induce each pair to contract around the default rule by specifying approaches - market mimicking or majoritarian defaults, and information- the quantity they prefer, thus sparing the court from having to guess about the forcing or penalty defaults - place obvious demands on those institutions, either parties' preferred quantity. Thus, unlike majoritarian or market-mimicking to identify the rule that would in fact be most efficient (if left in place) for most default rules, formalities are not necessarily intended to be left in place by the contracting pairs, or to identify the default rule that would induce the most parties. efficient disclosure of information. These demands are only increased if either Unlike other "penalty' or "information-forcing' rules, however (see Sections of these approaches is to be adopted on a relatively 'tailored' basis, requiring 5-8), formalities need not be slanted against any particular party. For example, the legal decision makers to assess the effect on individual markets or even the default rule for contracts that fail to specify any quantity of goods could just individual contracting pairs. Thus, it is obviously an oversimplification to as easily be set at any specific number, not necessarily zero. True, a default rule of "zero' has certain administrative advantages over any other number: there1000 Contract Law: General Theories 11 12 Contract Law: General Theories 4000 analyze how either of these approaches would work if it were to be caused them to reduce the value they place on such a warranty. In that event, administered by an omniscient legal decision maker. The real question is how it would be possible for either default rule (an implied warranty, or the absence well either of these approaches will work when administered by actual courts of an implied warranty) to be left in place by the parties, if the law's adoption and legislatures. of each default rule changed the parties' preferences sufficiently. It would also Two views of this question have developed in the contracts literature. The be possible for both default rules to be perfectly efficient, at least when judged first begins by positing that certain rules - often, the rules that would have been by the preferences the parties would have once the law adopted either default efficient in a first-best world with perfect legal institutions - are simply beyond rule. the capability of real legal institutions. This assumption is often made when the The possibility that default rules might influence parties' preferences is only rule in question depends on information that, although observable by one or just beginning to be explored. Experimental tests of this possibility can be even both of the parties, cannot be demonstrated or verified publicly in court. found in Schwab (1988) and Korobkin (1998); the latter also discusses many For example, if the default remedy for breach were based on the net profits the of the potential policy implications. (Other experimental work regarding the breacher made, this would require a court to be able to measure the breacher's effect on preferences of legal rules generally is discussed in Chapter 0570). revenues and costs, which might in some cases require more accounting Brief discussions of the implications for default rules in particular can also be expertise than real courts possess. Scholars often posit that such a rule would found in Charny (1991, pp. 1835-1840); and in Schwartz (1993, pp. 413-415), be unworkable in order to focus their analysis on alternative rules: rules that, who refers to default rules with this effect as 'transformative default rules'. while they might be less efficient in a first-best world, place fewer demands on the court or other legal decisionmaker (for example, Hermalin and Katz, 1993). For a general discussion and defense of this approach, see Schwartz (1992, pp. 12. Non-Economic Theories of Default Rules 279-280, 1993, pp. 403-406). By simply positing that certain rules are "unworkable', though, these While default rules have received less attention in scholarship outside of law scholars implicitly assume an unfavorable balance between (1 ) the sum of all and economics, there are several non-economic theories that deserve mention. costs that would be imposed if courts tried to apply the unworkable rule, with For general discussions in the legal literature, see Charny (1991), Barnett the large number of errors that would entail; and (2) the sum of all costs (1992), and Burton (1993). associated with whatever rule is second-best. Other scholars have attempted a The first, and least well-developed (at least as a general theory), depends on more finely-grained analysis by explicitly modeling the costs associated with the identification of certain rules as morally superior, as a sort of 'merit good". judicial implementation of an unworkable rule. However, those costs depend That is, just as it is sometimes argued that all citizens ought to have certain in part on the nature and the probability of various errors courts might make in goods (education, health care, and so on), it is sometimes said that all citizens applying such a rule, and there is no consensus (and, regrettably, no empirical ought to have certain contract rights, such as the right to complete data) on how best to model such an error function. For two applications of this compensation in the event of a breach; or that the law should especially approach to contract issues, see Hadfield (1994), Hermalin and Katz (1991) and promote certain kinds of relationships, such as those based on long-term Allen and Gale (1992). The general discussion of legal errors and uncertain cooperation. Arguments of this sort could be particularly compelling if the rules in other bodies of law (see Chapter 0790) is also relevant here. law's choice of default rule influenced citizens' own beliefs about the value of certain relationships, as discussed above in Section 11. A second non-economic theory rests on the idea of hypothetical consent. 11. Default Rules and Preference Formation There is an entire family of non-economic theories that traces the binding force of contracts to individual autonomy, and to the fact that the contractual In some situations, the law's choice of default rules could alter contracting obligation was freely chosen by the contracting party (see Section 17 below). parties' beliefs or preferences, thereby changing the value of the costs and To be sure, these theories might seem to have little to say about the content of benefits associated with different rules. For example, if the law adopts an default rules, which (by definition) fill in the content of obligations that were implied warranty making sellers liable for all defects in their products (unless not explicitly chosen by the parties (see Craswell 1989a). However, some have explicitly disclaimed), this could conceivably lead buyers to increase the value argued that, even in the absence of explicit consent, a party should still be they place on such a warranty. At the same time, the adoption of the opposite bound to the rule that he or she would have consented to if he or she had default rule (no implied warranty) might lead buyers to the opposite view, if it explicitly negotiated an agreement on that point. Interestingly, this argument4000 Contract Law: General Theories 13 14 Contract Law: General Theories 4000 converges with the market-mimicking or majoritarian approach discussed Unfortunately, those bodies of law are themselves among the least analyzed earlier in Sections 2-4. As a result, some economically-oriented scholars have portions of contract law. Moreover, the choices made by a legal system in sought to rest their recommendations on this philosophic position, as well as selecting the rules of contract formation and interpretation can both be on more conventional economic grounds (for example, Schwartz, 1988, pp. influenced by, and exert an influence upon, the choice of the original default 357-360). In the philosophical literature, however, it is disputed whether this rule. Sections 14 and 15 briefly discuss some of the interactions between these invocation of hypothetical consent carries any of the moral force of 'real' sets of rules. consent, or whether it adds anything to standard efficiency arguments. For discussions in the legal literature of this issue, see Barnett (1992), Charny (1991), Coleman, Heckathorn and Maser (1989), Craswell (1992), and the 14. Procedural Requirements for a Valid Agreement exchanges between Coleman (1980a, 1980b) and Posner (1980, 1981). In the philosophical literature, useful discussions include Scanlon (1982), Gauthier Any attempt to displace a default rule will normally have to satisfy (at a (1986), and Brudney (1991). minimum) all the requirements of an enforceable contract. For example, A third non-economic approach suggests that default rules should be depending on the legal regime, the agreement may (or may not ) have to be in designed to mimic the norms or customs that are already observed, either in the writing, and it may (or may not) have to be supported by consideration. These community at large or in the parties' prior relationship. This approach is often requirements, and the other rules governing contract formation, are discussed employed in the "relational contract' theory usually identified with Ian Macneil at more length in Chapter 4300. (1978, 1980, 1981); see also Brown and Feinman (1991), Feinman (1993), and Should there be extra procedural requirements for parties who wish to Craswell (1993b). In addition, some scholars working from philosophical contract around a default rule? If the default rule is presumptively valid, and theories of individual autonomy and consent have seen the prevailing norms especially if it is presumptively valid for moral or other non-economic reasons, and customs as acceptable sources of default rules, at least in the absence of any it might be argued that parties who wish to choose a presumptively less valid explicit agreement to the contrary (Barnett, 1992; Burton, 1993). In particular rule should have to take extra steps, if only to ensure (and to demonstrate to a cases, this approach could of course converge with any of the economic theories court) that this is what the parties really intend. For example, it might be discussed here, depending on whether the norms or customs happened to be argued that one party should not be able to displace a default rules by means of efficient (see the general discussion in Chapter 0800). Among the issues raised a single clause buried in a 30-page document that the other party will not by this approach are questions about the manner in which the norms or customs normally bother to read. Arguments of this sort are often made in connection are to be identified (see Bernstein, 1996, pp. 1787-1795; Craswell, 1998), and with standard form contracts and the legal doctrine of unconscionablety (see about the ability of courts or other legal decisionmakers to properly carry out Chapter 4 100). Some of the links with standard default rule analysis are noted this identification (see Section 10 above). briefly in Craswell (1993a, pp. 12-14). Indeed, arguments of this sort may fit best in connection with information- forcing or penalty default rules. As discussed earlier (see Section 6), such rules D. Contracting Around Default Rules may be deliberately designed to induce the better-informed party to contract around the default rule, in the hope that the process of contracting around the 13. Displacing Default Rules by Agreement rule will itself give the other party more information about the rights that he or she now has. The efficacy of this approach, however, depends on whether the A default rule, by definition, leaves parties free to specify some other rule to process of contracting around the rule really does inform the other party - and govern their relationship if they so choose. There is, however, very little this, in turn, depends on the procedures that are required to contract around the scholarly analysis of the steps the parties must take if they wish to specify some rule. Again: if a default rule can be altered merely by inserting a clause in a 30- other rule. Most scholars implicitly assume that specifying some other rule page contract that nobody ever reads, the process of contracting around the would require a valid provision to that effect in a valid contract. This could default will not inform the other party at all. suggest that the rules governing those steps can be left to the law of contract On the other hand, extra procedural requirements will usually increase the formation and contract interpretation, two bodies of law that are addressed at transaction costs required to contract around the default rule. For example, if more length in Chapters 4300 and 4400. altering a default rule requires the clause in question to be pointed out and4000 Contract Law: General Theories 15 16 Contract Law: General Theories 4000 explained to the other party, the process of contracting around the defaultmight court's idea of what most parties would have wanted. This is the question of indeed increase the other party's information. However, this requirement may precisely how far the parties must go to contract around an otherwise applicable also be costly to satisfy, especially if a single contract alters a large number of default rule (or, in this case, around an otherwise applicable rule of default rules, and if the other party has no desire to sit through a lengthy set of interpretation). As discussed in Section 14, whatever requirements the law explanations. In that event, the cost of altering the default rules via this adopts here will have to be considered in deciding what default rule (or what procedure might turn out to be effectively prohibitive, so many parties would interpretive presumption) to adopt in the first place. end up leaving the original default rules still in force. If so, this would require reevaluation of the original decision to select a default rule that was designed not to be left in force (that is, a default rule that was chosen to be inefficient E. The Enforceability of Contracts Generally precisely in order to induce the parties to contract around it). In this way, the rules governing the process of contracting around a default rule can themselves 16. Introduction to Theories of Enforceability affect the principles on which the original default rule should be chosen. The analysis of default rules takes it as given that contracts are enforceable, and concerns itself with determining the content of the enforceable obligation. This 15. Interpreting Contractual Terms that Alter a Default Rule Section addresses the opposite issue: given a contract of (let us assume) definite content, when should that contract be legally enforceable? Contracting parties often use language which appears to address an issue that One branch of this question asks whether contracts should be enforced by would otherwise be governed by a default rule, but which is vague or a legal system, or whether non-legal enforcement mechanisms might be ambiguous, and thus requires interpretation. For example, imagine a contract superior (see, for example, Bernstein, 1992, 1996; Charny, 1991). Non-legal providing that the remedy to be paid in the event of a breach should be an enforcement mechanisms could include arbitration panels or trade association amount that would "reasonably compensate" the nonbreacher. Should the courts boards that function much like a court, except for not being backed by official treat this vague language as leaving a gap in the contract, to be filled by the state sanctions. They could also involve much less formal mechanisms, such as normal default remedy? Or should they instead apply some other set of the threat of withholding business from anyone who had broken a promise in principles? the past. In both of these respects, they are similar to the non-legal mechanisms In conventional legal terminology, default rules are said to apply only when that might be used to enforce any other obligation (see Chapters 0780 and there is an actual gap in the contract, while questions of vague contractual 0800), with which this literature has much in common. language are usually described as questions of interpretation. There is, By contrast, most of the literature on whether contracts ought to be enforced however, no consensus (and very little theory) on what should count as a 'gap' typically abstracts from the choice of the enforcement mechanism, and focuses (see Ayres and Gertner, 1989, pp. 1 19-120). Fortunately, this distinction often instead on the question of whether (and why) contracts ought to be enforced by will notmatter, because the approaches used to interpret contracts (see Chapter any mechanism whatsoever. Non-economic theories are discussed briefly in 4400) have much in common with the approaches used to select default rules. Section 17 below, followed by a discussion of the law and economics literature In many cases, for example, vague or ambiguous language is interpreted so as in Sections 18-19. to fit whatever the parties probably would have agreed to if they had discussed the matter, thus producing the same result as the majoritarian or market- mimicking default rules discussed in Sections 2-4 (see also Goetz and Scott, 17. Non-Economic Theories of Enforceability 1985). In other cases, vague or ambiguous language is interpreted against the party who drafted it, just as in the case of a penalty or information-forcing Moral philosophers have written extensively about the question of whether (or default rule designed to induce more careful and explicit communication (see why) a promise should be morally binding. Some of their theories rest on Sections 5-9). utilitarian accounts that have much in common with the economic theories; Notice, though, that some decision must still be made to determine when the these will be discussed in Sections 18-19. This section focuses instead on the parties have taken enough steps to make their language sufficiently clear to non-utilitarian or non-instrumental accounts. In the legal literature, general avoid the rule construing ambiguities against the drafter, or when their language is sufficiently clear to avoid being interpreted in accordance with the4000 Contract Law: General Theories 17 18 Contract Law: General Theories 4000 surveys of these accounts can be found in Atiyah (1981), Barnett (1986), promise ought to be given such evidentiary weight, however, it is difficult to Craswell (1989a, pp. 491-503), and Gordley (1991). avoid falling back either on autonomy-based explanations of the sort discussed One family of theories derives the obligation to keep one's promise from earlier in this section, or on utilitarian theories of the sort to be discussed in considerations of individual freedom and moral autonomy. For example, Fried Sections 18 and 19 (1981 ) argues that if the law did not allow individuals to bind themselves with respect to their future conduct, it would thereby fail to respect the individuals' status as autonomous moral agents. (For a variant account of when individual 18. Economic Theories of Free Exchange autonomy requires that promises be enforced, see Barnett, 1986.) These accounts do not imply that promises ought to be kept in every circumstance: Economic theories of why promises should be enforced can be divided into two this theory, like all of the others discussed in this section, allows for the categories. One set of theories, to be discussed in this section, focuses on the possibility of a set of implied conditions or implied excuses. Instead, the goal utility created by the eventual performance of the promise. The other set, to be of these theories is to explain why promises are prima facie binding, and this discussed in Section 19, focuses on the utility created by the ex ante incentives family of theories rests that binding force on the promise's status as the that the promise sets up. voluntary commitment of a autonomous moral agent. The first economic argument for enforcing promises rests on the utility that Another, different set of theories rests the obligation to keep a promise on will be produced when the promise is eventually performed. Since voluntary the substance of what has been promised. Perhaps the best-known theories in transactions generally increase the welfare of all parties to the transaction, this set focus on harm to others: if one's promise has led others to change their whenever a promise is voluntary it could be argued that welfare will usually be behavior in reliance on the promise, so that they would now be injured if the increased if the promise is carried out. Viewed in these terms, the economic promisor failed to perform, that promise is binding because it is wrong to harm argument for enforcing promises is very similar to the economic argument for other agents. Making a promise and then failing to keep it might also be seen free exchange and free markets generally (see Chapter 5000). as a form of lying, for such a promisor has misled others about the future. Other This argument, however, could imply that a promise should not be binding theories in this set focus on reciprocity or restitution: if one has received a if conditions have changed sufficiently that the promised transaction would not benefit and promised to pay for it, that promise is binding because it is only increase both parties' welfare. For example, if a promisor's costs have right to pay for the benefits one has received (Atiyah, 1981, pp. 34-36). Under increased to the point where it is no longer efficient for him or her to perform some theories, the fairness of the terms of the promise is also relevant to the promise, this theory could suggest that the promisor ought to be released whether the promise is binding (for example, Gordley, 1995). with no obligation to pay any damages at all, because this particular efficiency Under any of these substance-based theories, the promise's status as the rationale for enforcing promises no longer applies. Under this theory, the only voluntary commitment of a free moral agent is less significant, for the agent is way to save the prima facie obligation to keep one's promises (even after (in some sense) promising to do what he or she ought to be doing anyway. conditions have changed) is to argue for the virtues of a general rule over a Indeed, under many of these theories, if there is no independent reason for the case-by-case inquiry into the efficiency of any given transaction - in agent to perform the action - for example, if the agent has received no benefits, philosophical terms, by shifting from act-utilitarianism to rule-utilitarianism. and if no one has yet relied on the promise - the obligation to keep the promise That argument, in turn, must rest on empirical claims about the ability of courts isseen as weaker or non-existent. These theories thus have difficulty explaining to determine whether and when performance of the promise was still efficient. why the obligation should be stronger in the case of an individual who has More generally, there is an important difference between permitting free made a promise than it is in the case of an individual who has acted identically exchange and permitting (or enforcing) binding promises. An exchange can but has explicitly disclaimed any promise (for example, 'I think I'm going to take place instantaneously, but a promise necessarily involves a commitment dox, but I warn you that I'm not promising to do it, so you should rely only at to act in a certain way at some time in the future. Once this temporal element your own risk', or 'you can confer those benefits on me if you want, but I warn is recognized, it can be seen that enforcing promises does not simply transfer you now that I have no intention of paying you anything for them'). Atiyah existing goods from one owner to another. Instead, the enforcement of promises (1981, pp. 184-202) has argued that an explicit promise could serve as creates a new good: it allows people to exchange *wheat to arrive on September evidence, perhaps even conclusive evidence, that the underlying obligation I' (for example), where without a binding promise they could only exchange really is a just one that ought to be enforced. If one asks why an individual's actual bushels of wheat. Viewed in these terms, the economic case for enforcement rests on the proposition that this new good (that is, the good4000 Contract Law: General Theories 19 20 Contract Law: General Theories 4000 represented by a future commitment) is a socially useful good which people promisor's control. Generally speaking, all of the economic analysis of efficient frequently will want to exchange. To explain why such a commitment is useful remedies for breach (see Chapter 4600) is relevant here, since to make a and valuable, economists have focused more on the ex ante effects created by promise enforceable is to set a non-zero remedy for the promise's breach. The such a commitment, as discussed in Section 19 below. less-developed economic analysis of the conditions under which formation of a binding contract should be inferred (see Chapter 4300) is also relevant here. 19. Economic Theories of Advance Commitments Acknowledgments Most economic justifications for enforcing promises have focused on the ex ante effects that would be created by a general rule of enforceability. In essence, Richard Craswell is a professor of law at the Stanford Law School. Jack L. these economic theories analyze promises as effectuating a present transfer not Goldsmith, Eric A. Posner, Cass R. Sunstein, and two anonymous referees of goods and services, but of rights and duties. (For a similar view expressed provided helpful comments. Financial support was provided by the Lynde and in non-economic terms, see Barnett, 1986, pp. 291-300.) Such a transfer of Harry Bradley Foundation and the Sarah Scaife Foundation at the University rights and duties may itself produce efficiency gains, independently of whether of Chicago Law School. it is efficient to actually carry out the promise. The efficiency gain that is analyzed most often stems from the effect on the promisee's incentive to rely on the promised behavior (see Goetz and Scott, Bibliography on Contract Law: General Theories (4000) 1980). If the law denied promisees any compensation whenever a promisor could show that performance of the promise had become inefficient, this would Aghion, Philippe and Hermalin, Benjamin (1990), 'Legal Restrictions on Private Contracts can shift more of the risk of a change in conditions to the promisee, and thus would Enhance Efficiency', 6 Journal of Law, Economics, and Organization, 381-409. Allen, Franklin and Gale, Douglas (1992), 'Measurement Distortion and Missing Contingencies in reduce the promisee's incentive to rely. To be sure, if the law instead Optimal Contracts', 2 Economic Theory, 1-26. guarantees that promisees will be compensated whenever the promisor fails to Ayres, Ian (1993), 'Preliminary Thoughts on Optimal Tailoring of Contractual Rules', 3 Southern perform, this could create incentives for excessive reliance on the part of the California Interdisciplinary Law Journal, 1-18. promisee (see the discussion of reliance incentives in connection with remedies Ayres, Ian and Gertner, Robert (1989), 'Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules', 99 Yale Law Journal, 87-130. for breach in Chapter 4600). If the incentives for excessive reliance can be Ayres, Ian and Gertner, Robert (1992), "Strategic Contractual Inefficiency and the Optimal Choice of constrained by other legal doctrines, however, the net effect on the promisee's Legal Rules', 101 Yale Law Journal, 729-73. reliance incentives could still be positive. The argument that enforceability is Baird, Douglas G. and Weisberg, Robert (1982), 'Rules, Standards and the Battle of the Forms: A Reassessment of"2-207", 68 Virginia Law Review, 1217-62. needed to induce one party to take the risky step of beginning his or her own Barnes, David W. and Stout, Lynn A. (1992), Economics of Contract Law, Minneapolis, West performance (when the other party's return performance is not due until later) Publishing. is really a special case of this argument, since beginning performance is one of Barnett, Randy E. (1992), "The Sound of Silence: Default Rules and Contractual Consent', 78 Virginia the many ways in which parties may rely on a contract. Law Review, 821-911. Bebchuk, Lucien Ayre and Shavell, Steven (1991), 'Information and the Scope of Liability for Breach More generally, there are many other ex ante effects that could be produced ofContract: The Rule of Hadley v. Baxendale', 7 Journal of Law, Economics, and Organization, by a rule requiring compensation even when conditions have changed to make 284-312. performance unprofitable. If the promisor and promisee differ in their attitudes Bernstein, Lisa (1992), "Opting Out of the Legal System: Extralegal Contractual Relations in the Diamond Industry', 21 Journal of Legal Studies, 115-57. toward risk, a rule requiring compensation may achieve a better allocation of Bernstein, Lisa (1993), "Social Norms and Default Rule Analysis', 3 Southern California risk between the two parties (see, for example, Polinsky, 1983). A rule Interdisciplinary Law Journal, 59-90. requiring compensation may also increase the promisor's incentive to tell the Bernstein, Lisa (1996), "Merchant Law in a Merchant Court: Rethinking the Code's Search for Immanent Business Norms', 144 University of Pennsylvania Law Review, 1765-1821. truth about the conditions that will affect his or her performance, thus increasing the promisee's information about those conditions (see Shavell, 1991; Craswell, 1989b; Katz, 1996, pp. 1289-1291). A compensation requirement may also give the promisor an incentive to affect those conditions directly, if the probability of performance rests on factors that are within the