Document Type

Article

Publication Date

1981

Center/Program

Center for Contract and Economic Organization

Center/Program

Program in the Law and Economics of Capital Markets

Abstract

Recent scholarship has demonstrated that a significant proportion of private contracts do not easily fit the presuppositions of classical legal analysis." One reason for this is the pivotal role played in conventional legal theory by the concept of the complete contingent contract. Parties in a bargaining situation are presumed able, at minimal cost, to allocate explicitly the risks that future contingencies may cause one or the other to regret having entered into an executory agreement.2 Under these conditions, the role of legal regulation can be defined quite precisely. Once the underlying rules policing the bargaining process have been specified, contract rules serve as standard or common risk allocations that can be varied by the individual agreement of particular parties. These rules serve the important purpose of saving most bargainers the cost of negotiating a tailor-made arrangement. If the basic risk allocation provided by a legal rule fails to suit the purposes of particular parties, then bargainers are free to negotiate an alternative allocation of risks.3 All relevant risks thus can be assigned optimally-either by legal rule or through individualized agreement-because future contingencies are not only known and understood at the time the bargain is struck, but can also be addressed by efficacious contractual responses.

In a complex society, however, many contractual arrangements diverge so markedly from the classical model that they require separate treatment. Parties frequently enter into continuing, highly interactive contractual arrangements. For these parties, a complete contingent contract may not be a feasible contracting mechanism. Where the future contingencies are peculiarly intricate or uncertain, practical difficulties arise that impede the contracting parties' efforts to allocate optimally all risks at the time of contracting.4 Not surprisingly, parties who find it advantageous to enter into such cooperative exchange relationships seek specially adapted contractual devices. The resulting "relational contracts"5 encompass most generic agency relationships, including distributorships, franchises, joint ventures, and employment contracts.

Although a certain ambiguity has always existed, there has been a tendency to equate the term "relational contract" with long-term contractual involvements. We here adopt a very specific construction of the term that is based more precisely on a contrast with the classical contingent contract. A contract is relational to the extent that the parties are incapable of reducing important terms of the arrangement to well-defined obligations. Such definitive obligations may be impractical because of inability to identify uncertain future conditions or because of inability to characterize complex adaptations adequately even when the contingencies themselves can be identified in advance. As the discussion below illustrates, long-term contracts are more likely than short-term agreements to fit this conceptualization, but temporal extension per se is not the defining characteristic. The contracts that we actually observe are, of course, neither perfectly contingent nor entirely relational. Legal theory has merely tended to concentrate on agreements that fall close to the one polar extreme, while our focus in this article is directed toward the other end of the continuum.

Conventional doctrine has failed to explain adequately the nature and function of these relational contracts and how they differ from more standard contracts. The resulting incomplete understanding is a prime source of costly litigation over the meaning and enforceability of key provisions of such agreements. Much of the litigation has centered on two doctrinal linchpins of relational contracts: the obligation of one party (the "agent") to use its "best efforts" to carry on an activity beneficial to the other (the "principal"), and the concomitant right of the principal to terminate the relationship.6 Part I of this article describes how these core provisions of relational contracts represent an optimizing response to peculiar environmental constraints of complexity and uncertainty. Appreciating the difficulty of ex ante regulation by contracting parties provides the basis, in Part II, for attaching a more precise legal meaning to those contractual provisions that establish the standard of future performance. Finally, Part III explores the relationship between these performance standards and other contractual provisions, particularly termination clauses. We conclude that current uncertainty over the legal treatment of these provisions impedes the ability of contracting parties to adjust to the special conditions that induce relational contracting.

Comments

Copyright is owned by the Virginia Law Review Association. The article is used with the permission of the Virginia Law Review Association.

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