Principles of Contract Design
Abstract
Economic contract theory postulates two obstacles to complete contracts: high transaction costs and high enforcement (or verification) costs. The literature has proposed how parties might solve these problems under a stylized litigation system, but it does not address the question of how parties design contracts under the existing adversarial system, that relies on the parties to establish relevant facts indirectly by the use of evidentiary proxies. We advance a theory of contract design in a world of costly litigation. We examine the efficiency of investment at the front-end and back-end of the contracting process, where we focus on litigation as the back-end stage. In deciding whether to express their obligations in specific or vague terms, contracting parties implicitly choose their allocation of costs between the front- and back-end. When the parties agree to vague terms (or standards), such as best efforts or commercial reasonableness, they delegate to the back-end the task of selecting proxies: e.g., the court selects market indicators that serve as benchmarks for performance. When the parties agree to specific terms(or rules), they invest more at the front-end to specify proxies in their contract and thereby leaving a smaller task for the enforcing court. In this Article, we explore the choice between rules and standards in terms of this tradeoff, and offer an explanation for why contracts in practice have a mix of vague and specific provisions. We then suggest that parties can achieve further contracting gains by varying procedural rules governing the prospective enforcement of their disputes. We illustrate by examining provisions in commercial contracts that allocate burdens and standards of proof. If the parties can improve the cost-effectiveness of litigation in this manner, they can reduce back-end costs. They thereby create opportunities to further lower contracting costs (or to improve the incentive gains from contracting) by shifting more investment to the back-end by increasing their use of vague terms. Vague terms have fallen into disfavor with contract theorists and this Article offers a justification for why they are nevertheless commonplace in commercial practice. Our analysis highlights the general and valuable lesson that the anticipated path of litigation is relevant to contract design.