Document Type

Working Paper

Publication Date

2000

Center/Program

Center for Contract and Economic Organization

Center/Program

Program in the Law and Economics of Capital Markets

Abstract

The central task in developing a plausible normative theory of contract law is to specify the appropriate role of the state in regulating incomplete or relational contracts. Complete contracts (to the extent that they exist in the real world) are rarely, if ever, breached since by definition the pay-offs for every relevant action and the corresponding sanctions for non performance are prescribed in the contract. In the case of incomplete (or relational) contracts, however, parties have incentives to breach by exploiting gaps in the contract. Making the verifiable terms of the contract legally enforceable and regulating incompleteness in a consistent manner reduces, but does not eliminate, these incentives to breach. There still remains the fundamental question: Should the law seek to complete the contract for the parties? And, if so, from what vantage point should the contractual gaps be filled? Determining the answers to these questions has preoccupied contract law scholars for the past fifteen years. In this paper, I review the academic debate and outline the core arguments for (and difficulties with) three alternative strategies for interpreting relational contracts. Thereafter, I evaluate each strategy in terms of the lessons that are available to us from theory and experience. In particular, I examine the insights from the recent theoretical literature on the economics of incomplete contracting and test those insights against the results of an analysis of the cases interpreting disputed contracts under the significantly different regimes of the Uniform Commercial Code and the common law over the past thirty years. As the title of the paper implies, the case for formalism in interpreting relational contracts emerges out of this analysis. The contract theory literature suggests that the activist role courts traditionally have been asked to assume in specifying default rules ex ante and/or adjusting contractual risks ex post may be far less useful in a complex, heterogeneous economy. Moreover, the invitation to courts to create broadly useful default rules or to undertake equitable adjustment of apparently harsh contract terms threatens a parallel goal of predictable, transparent interpretation of explicit contract terms. If, as theory suggests, the state is simply incapable of supplying parties in a complex economy with useful defaults ex ante or imposing fair outcomes ex post, the better instrumental strategy is for courts to accept the limits imposed by legal formalism and interpret the facially unambiguous verifiable terms of disputed contracts literalistically. Not only would a rigorous application of the common law plain meaning and parol evidence rules preserve the value of predictable interpretation, but the analysis suggests as well that common law formalism has an heretofore unrecognized role in expanding the menu of legally blessed standard form terms and clauses that further reduce contracting costs for most parties. At bottom, the merits of these theoretical speculations turn on the empirical realities. While much of the available evidence is anecdotal, it does point unambiguously to a contrast between the functionalist interpretation of the Uniform Commercial Code and the formalist interpretation that is retained by many common law courts and by the private arbitral regimes of trade associations and other intermediaries. The formalist approach seems to have created a more hospitable environment; one that appears to support both reliable interpretation of contract language and the evolutionary production of standardized and appropriately tailored contract terms. Evidence that commercial parties, whose contracts nominally fall under the jurisdiction of the Code, opt instead for private regimes that employ formalist modes of interpretation further challenges the unquestioned assumption of most contemporary scholars that functionalism is a priori superior to formalism. While the case for formalism is a tentative one, the evidence is sufficient to shift the intellectual burden of proof to those who would defend the activist strategies unleashed by the Uniform Commercial Code.

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