• 04 November 2009

Contract Design and the Structure of Contractual Intent

Jody S. Kraus & Robert E. Scott

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Modern contract law is governed by a two-stage adjudicative regime—an inheritance of the centuries-old conflict between law and equity.  Under this regime, formal contract terms are treated as prima facie provisions that courts can override by invoking equitable doctrines if they believe that doing so is necessary to “correct” the contract by realigning it with the parties’ contractual intent.  For example, if two parties intended to provide the seller a three percent profit, they might specify a term that required the buyer to pay the seller a price equal to three percent above a published industry price index.  If the seller later claimed it was entitled to more than three percent above the published price index, a court would first apply formal contract doctrine to determine the price term of the agreement.  However, if a court believed that the published price index severely underrepresented the seller’s actual costs, it would then invoke an equitable doctrine to override the formal contract price term and substitute one that it believed more accurately represented the seller’s true costs.

This ex post judicial determination of the contractual obligation serves as a fallback mechanism for vindicating the parties’ intent whenever a court determines that the formal contract terms fall seriously short of effectuating that intent.  In short, under the current adjudicative regime, every contract by default comes with a judicial insurance policy against any formal contract term that, in the court’s view, turns out to have ill-served the parties’ intentions.

 
I.
Contractual Ends v. Contractual Means

Honoring the contractual intent of the parties is thus the central objective of contract law.  Yet despite its theoretical and doctrinal centrality, little scholarly attention has been given to the structure of contractual intent.  Courts naturally equate contractual intent with the parties’ contractual objectives, which we call the contractual ends of the parties’ collaboration.  But reaching agreement on shared objectives is only the first step to designing an enforceable contract.  Thereafter, the parties must create the particular rights and duties that will serve as their contractual means for achieving those contemplated ends.

Our thesis is that the current regime of contract adjudication conflates the parties’ contractual means with their contractual ends.  In so doing, it reduces the range of contractual arrangements to which contract law gives effect, thereby potentially depriving commercially sophisticated parties of essential tools for contract design.  Sophisticated actors engage in ex ante determinations of their means of enforcement, choosing whether enforcement is to be legal or relational and whether legal enforcement should rely on rules or standards.  We argue, therefore, that commercially sophisticated parties would prefer a regime in which courts apply formal doctrine exclusively, unless at the time of formation the parties expressly indicate their desire to have courts apply equitable doctrine as well.

Our claim that sophisticated parties would prefer courts to honor their formal contract terms even when doing so will frustrate their contractual ends may appear to be unsupportable either in theory or in practice.  After all, the contemporary two-stage regime for contract adjudication rests on the natural and powerful intuition that most parties, including commercially sophisticated ones, prefer courts to take advantage of their hindsight to assist in achieving the parties’ contractual ends.1 Indeed, had the parties known at the time of formation what the court knows at the time of adjudication, the parties themselves would have crafted different terms.

It appears to follow that the parties would prefer courts to do for them in the course of adjudication what the parties would have done for themselves at the time of contract formation had they known then what the court has since learned.  It would seem perverse for a court to insist on holding parties to terms that it knows the parties themselves would have rejected.  Holding parties to their formal contract terms when those terms no longer (or never did) constitute reasonable means of achieving the parties’ intended contractual ends would be exalting formal doctrine over substance.

As compelling as it seems, however, this justification of the two-stage regime of contract adjudication rests on the unsupported premise that contract law should equate the parties’ contractual intent with their intended ends rather than their intended means.  Sometimes the only way to maintain fidelity to the parties’ contractual intent is to enforce the formal contract terms to which they agreed, even when doing so defeats their contractual ends.  To return to the example above, by specifying an industry index to determine the seller’s costs, the parties might have intended to reject recourse to judicial hindsight in order to increase the certainty of their contract price.  The parties might have believed that the benefits of judicial hindsight are outweighed by gains in the reliability of the deal and a decrease in expected litigation costs.  When one party unilaterally claimed that the index had not functioned as expected, it invited a court to second-guess the contract’s formal price term.

But what if the parties here specified an objective price index precisely to avoid the costs of a judicial inquiry into its accuracy?  To entertain such an inquiry would perversely defeat the parties’ intent by undermining the very means they chose to achieve their contractual ends.  Judicial intervention to “correct” this contract by realigning the price term with the seller’s actual costs thus would vindicate the parties’ contractual ends at the expense of undermining their chosen means.  A regime that embraces such intervention impairs the ability of parties to rely on relatively cheap and reliable proxies, such as a price index, in lieu of relatively expensive and unpredictable ex post judicial inquiry into actual costs.

 
II.
A New Theory of Contract Design

The two-stage regime thus ultimately destroys the distinction between the parties’ contractual means and ends.  It presumes that all parties want courts to advert directly to the parties’ contractual ends to determine the parties’ rights and duties.  But there is good reason to doubt that commercially sophisticated parties typically, let alone always, prefer this method of vindicating their contractual intent.  Both theory and available evidence suggest that parties would prefer a regime that strictly enforces formal contract doctrine unless they have expressly chosen to delegate hindsight authority to a court.  By eliminating the risk that courts will erroneously infer the parties’ preference for ex post judicial intervention, such a regime increases the reliability of formal contract terms and enhances the parties’ control over the content of their contract.  That control, in turn, permits sophisticated commercial parties to implement the most efficient contract design strategies available to them.

We propose a theory of contract design that explains why commercially sophisticated parties would prefer a regime that delegates to them complete discretion over the methods for determining the specific content of their contractual obligations.  We begin with the premise that, in the absence of contracting costs, commercial parties would choose to specify unambiguously each party’s performance obligations in all possible future states of the world.  However, parties face two obstacles to writing such “complete contingent contracts”:  front-end transaction costs and back-end enforcement costs.  The first axiom of our theory of contract design is that contracting parties are motivated to select those contracting mechanisms that will best achieve their objectives at the least cost.  Parties economize on contracting costs in two distinct ways:  first, by choosing between legal and relational means of enforcement, and second, by shifting costs between the front end and the back end of the contracting process when drafting legally enforceable agreements.

 
A.     Relational v. Legal Enforcement

Consider first the tradeoff between legal and relational enforcement.  In experimental settings, legal enforcement has been shown to undermine relational norms based on reputation, repeated dealings, and reciprocity.  This research has demonstrated that, in many instances, legal enforcement operates to displace rather than complement relational enforcement mechanisms.  Moreover, the relational mechanisms that may be displaced by a system of legal enforcement are often less costly and more effective than the legal alternative.  In particular, relational mechanisms for motivating performance of contractual obligations are likely to be optimal whenever key information is observable but not easily verifiable:  The parties themselves can obtain the information at reasonable cost, but the costs of proving the information to a third-party adjudicator exceed the gains from legal enforcement.2

To be sure, in some circumstances, legal enforcement may be preferable even though it undermines relational norms.  The complexity of a particular transaction may make it difficult for either the parties or casual observers to determine confidently whether a party has departed from the agreed course of conduct, but the information necessary to make that decision may subsequently be provable to a court at reasonable cost.  In such cases, the threat of a legally enforceable sanction might best deter opportunistic behavior.  This calculus of relative costs and benefits often motivates parties to partition their agreements into legally enforceable and unenforceable components.  A court that breaches this partition in order to vindicate the parties’ contractual ends undermines the efficacy of their choice of contractual means.

 
B.     Vague v. Precise Contract Terms

When parties decide to make some or all of their agreement legally enforceable, they face a second choice of contractual means:  By choosing between vague or precise contract terms, the parties can shift costs between the back and front ends of the contracting process.  When the parties agree to vague terms, such as the obligation to use their best efforts, the subsequent adjudication of contractual disputes concerning best efforts will require a court to give concrete and specific meaning to the vague phrase as part of the process of interpretation.  By framing their agreement in vague terms, the parties embed their legal obligations in broad standards that delegate discretion to courts and thereby increase back-end enforcement costs.  However, this strategy saves the parties the costs of specifying precise performance obligations at the time of formation.  Moreover, because the court will have information that was not available to the parties at the time of formation, it potentially allows the parties to benefit from more efficient performance standards than they could have specified at the time of formation.

Alternatively, when the parties agree to precise terms, such as the obligation to pay for a fixed quantity of goods at a price determined by a specified index, the parties reduce the need for a court to interpret the terms of the contract.  Precise terms reduce legal obligations to bright-line rules that specify the content of the obligation ex ante.  Rules withdraw authority from courts to determine particular performance obligations and instead direct them to enforce the formal obligations that the parties have explicitly specified in advance.  Parties might do this because they are better informed than the courts are about their contractual purposes and have better incentives to pursue them efficiently.

This strategy, however, does require the parties to rely on estimates of the likelihood of various future events rather than the actual knowledge of those events that would be available to a court at a later date.  If those estimates turn out to be erroneous, a court may be tempted to realign the contract terms with the parties’ original contractual ends.  But only if courts faithfully enforce the precise terms, notwithstanding subsequent frustration, will parties be able to retain the choice between using precise or vague terms as the best means of achieving their particular contractual ends.3

 
III.
Advantages of Judicial Fidelity to Contract Terms

Our theory of contract design thus explains why commercial parties need to anticipate and control which portions of their agreements will be legally enforceable and the extent to which their agreements will be governed by precise rules or vague standards.  When faithfully applied, formal contract doctrine provides parties with just this control.  There are many examples where courts apply formal doctrine in a nonstandard fashion or invoke historically equitable doctrines to override formal doctrine when they perceive that enforcing the parties’ formal contract terms would defeat the parties’ contractual ends.  In particular, courts often use the parol evidence and integration doctrines, the mistake and excuse doctrines, and the law of conditions and waiver in order to avoid outcomes that they perceive to be misaligned with the parties’ contractual ends.

We do not claim that the court in any of these cases necessarily reached an improper result.  After all, these contracts were formed against the backdrop of the current two-stage regime of contract adjudication.  The parties in these situations may have designed their contracts on the assumption that a court might advert to equitable doctrine and reasoning.  We claim only that, contrary to the courts’ reasoning, the formal terms of these contracts cannot be dismissed on the ground that they are at odds with any rational or reasonable understanding of the parties’ contractual intent.  Therefore, our principal objective is to explain why sophisticated commercial parties, such as the parties to these contracts, might prefer their future contracts to be adjudicated under a regime that applied formal doctrine exclusively unless the contract expressly invited the courts to exercise equitable power in the event of a subsequent dispute.

The root cause of the problem we identify is the historical English practice of subordinating law to equity.  This historical practice has deeply ingrained the equitable mindset into the current practice of adjudication in American contract law.  The dilemma for sophisticated parties is that the ubiquity of equitable reasoning undermines the instruments they might wish to use in designing their contracts.  For example, formal contract doctrines that govern the interpretation of agreements enable parties to partition their agreement into legally enforceable and legally unenforceable components.  The faithful application of formal contract doctrine thus permits parties to choose the optimal mix of legal and relational commitments, while ex post equitable intervention impairs this choice.

A similar conflict exists over the choice between precise and vague contract terms.  The desire to preserve the basic tools of contract design explains why parties might reasonably choose to forswear the equitable doctrines of mistake and excuse even where strict enforcement of formal contract terms may subject them to the risk of serious hardship.

Overall, there is a deep rift within the common law between the formal doctrines requiring strict enforcement of formal terms and the equitable doctrines permitting abrogation of those terms when strict enforcement appears to frustrate the parties’ contractual ends.4 The logic of equity invites courts to distort formal doctrine and interpret express conditions in ways that better align with the parties’ contractual ends, even at the expense of dramatically undermining the parties’ contractual means.

 
Conclusion

We conclude, therefore, that the challenges of contract design argue for permitting sophisticated parties to exercise the freedom to use a combination of legal and relational norms, as well as contractual rules and standards, to optimize their contract in light of uncertainty about the future and the difficulties of proof.  Since design choices are best made by the parties, both theory and the available empirical evidence suggest that sophisticated commercial parties would prefer a regime in which equitable override of formal contract doctrine is invoked only if specifically requested.dingbat

 

Acknowledgments:

Copyright © 2009 New York University Law Review.

Jody S. Kraus is the Robert E. Scott Distinguished Professor of Law and Professor of Philosophy at the University of Virginia School of Law.

Robert E. Scott is the Alfred McCormack Professor of Law and Director of the Center for Contract and Economic Organization at Columbia University.

This Legal Workshop Editorial is based on the following Article: Jody S. Kraus & Robert E. Scott, Contract Design and the Structure of Contractual Intent, 84 N.Y.U. L. REV. 1023 (2009).

  1. In deciding on their particular contractual obligations, parties make assumptions about their present and future circumstances. Yet they also know that subsequent information may show that their initial assumptions were erroneous. The justification for the two-stage regime thus rests on the premise that, by delegating to courts the historically equitable authority to modify their formal contract terms, the parties can both rely on their formal contract terms but rest safe in the assurance that, if their assumptions turn out to be false, a court will set aside their formal terms and craft substitute terms that better serve their contractual ends.
  2. There is no sharp dichotomy between verifiable and nonverifiable conditions. The question is whether the benefits of using informal norms to enforce a difficult-to-prove condition (such as the level of effort needed to comply with a contractual commitment) are greater than the alternative of verifying compliance with a less accurate but more easily established proxy for the condition in question. The important point is that informal enforcement mechanisms can take into account conditions that are hard to verify even where legal enforcement cannot. Where this is true, exclusive reliance on legal enforcement can deprive parties of relational mechanisms that can promote better compliance at a lower cost.
  3. The parties’ objective is to select that combination of precise rules and vague standards that optimizes their total costs of contracting. Note that the parties’ goal is not simply to minimize contracting costs. Parties will incur additional contracting costs so long as those costs result in improvements in the parties’ incentives to maximize the expected surplus from the contract.
  4. This tension between equity and the instruments of contract design is most vividly illustrated in the law of conditions.

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