The Law and Economics of Contract Interpretation Discussion I have to turn in a 2-3 page paper containing points of agreement and disagreement with Richard

The Law and Economics of Contract Interpretation Discussion I have to turn in a 2-3 page paper containing points of agreement and disagreement with Richard A Posner on https://pdfs.semanticscholar.org/06e6/7942c8fb7a43d1b48908f3b727bf9228a8b4.pdf University of Chicago Law School
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The Law and Economics of Contract Interpretation
Richard A. Posner
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CHICAGO
JOHN M. OLIN LAW & ECONOMICS WORKING PAPER NO. 229
(2D SERIES)
The Law and Economics of Contract Interpretation
Richard A. Posner
THE LAW SCHOOL
THE UNIVERSITY OF CHICAGO
November 2004
This paper can be downloaded without charge at:
The Chicago Working Paper Series Index: http://www.law.uchicago.edu/Lawecon/index.html
and at the Social Science Research Network Electronic Paper Collection:
http://ssrn.com/abstract_id=615185
October 23, 2004
THE LAW AND ECONOMICS OF
CONTRACT INTERPRETATION
RICHARD A. POSNER1
Abstract
Contract interpretation is an understudied topic in the economic analysis of
contract law. This paper combines simple formal analysis of the tradeoffs involved in
interpretation with applications to the principal doctrines of contract interpretation,
including the “four corners” rule, mutual mistake, contra proferentum, and what I
call the (informal but very important) rule of “extrinsic nonevidence.” Gap filling is
distinguished, and the relativity of interpretive doctrine to the interpretive
medium—jurors, arbitrators, and judges in different kinds of judicial system—is
emphasized.
I. INTRODUCTION
There is now a large economic literature on contracts and contract law,
but the interpretation of contracts, as distinct from issues involving
formation, defenses, validity, and remedies, has been rather neglected. Not
entirely so;2 but the economic literature on contract interpretation has an
abstract cast, evincing only limited interest in the relevant legal doctrines.3
1
Judge, U.S. Court of Appeals for the Seventh Circuit, and senior lecturer, the University of
Chicago Law School. I thank Lindsey Briggs, Rob Kenedy, and Paul Ma for their excellent
research assistance and Douglas Baird, Lucian Bebchuk, Elizabeth Chorvat, Mitu Gulati,
Claire Hill, William Landes, John Langbein, Jeffrey Lipshaw, Richard Porter, Eric Posner,
Alan Schwartz, and participants in the Georgetown and Harvard law and economics
workshops for very stimulating comments.
2 See, for notable recent examples with many references to the previous literature, Steven
Shavell, “On the Writing and Interpretation of Contracts” (National Bureau of Economic
Resarch working Paper 10094, http://www.nberg.org/papers/10094, Nov. 2003); Pierpaolo
Battigalli and Giovanni Maggi, “Rigidity, Discretion, and the Costs of Writing Contracts,” 92
American Economic Review 798 (2002).
3 Among the principal exceptions are Avery Wiener Katz, “Form and Substantive in Contract
Interpretation,” 104 Columbia Law Review 496 (2004); Alan Schwartz and Robert E. Scott,
“Contract Theory and the Limits of Contract Law,” 113 Yale Law Journal 541, 568–594
(2003); George M. Cohen, “Implied Terms and Interpretation in Contract Law,” Encyclopedia
of Law and Economics, vol. 3, p. 78 (Boudewijn Bouckaert and Gerrit de Geest eds. 2000);
Omri Ben-Shahar, “The Tentative Case against Flexibility in Commercial Law,” 66
University of Chicago Law Review 781 (1999); Eric Posner, “The Parol Evidence Rule, the
Plain Meaning Rule, and the Principles of Contractual Interpretation,” 146 University of
Pennsylvania Law Review 533 (1998); Gillian K. Hadfield, “Judicial Competence and the
Interpretation of Incomplete Contracts,” 23 Journal of Legal Studies 159 (1994); Charles J.
Goetz and Robert E. Scott, “Principles of Relational Contracts,” 67 Virginia Law Review 1089
(1981).
Contract Interpretation
2
Interpretation might seem an activity remote from economics—might
seem a subject for cognitive psychologists, epistemologists, students of
linguistics, legal doctrinalists, perhaps even literary critics—but I shall try to
show that economics can be of considerable help in understanding the
problems involved in interpreting contracts.
Contract interpretation is the undertaking by a judge or jury (or an
arbitrator—more on arbitration later) to figure out what the terms of a
contract are, or should be understood to be.4 Interpretation should be
distinguished from (simple) enforcement. The most important function of
contract law is to provide a legal remedy for breach in order to enhance the
utility of contracting as a method of organizing economic activity,5 and that
function is independent of whether there is any uncertainty about the terms.
The defendant may challenge the plaintiff’s interpretation of the contract
rather than acknowledge the breach, but unless there is a real uncertainty
about the meaning of the contract no interesting question of interpretation is
presented.
Still, significant interpretive questions often arise in contract litigation.
The obvious although not only reason, besides clumsiness in the use of words,
against which the legal linguists warn us,6 is that contractual performance
generally occurs over time rather than being complete the instant the
contract is signed. This is a central rather than accidental feature of the
institution of contract (as of property). If exchange were simultaneous and
limited to goods the quality of which was obvious on inspection (so that there
was no danger of unwanted surprises down the road), there would be little
4
The standard treatise discussion is E. Allan Farnsworth, Farnsworth on Contracts, vol. 2,
ch. 7 (3d ed. 2004).
5 See, for example, Thomas Cooley, Ramon Marimon, and Vincenzo Quadrini, “Aggregate
Consequences of Limited Contract Enforceability,” 112 Journal of Political Economy 817
(2004). This is not to deny the importance of reputation, reciprocity, and other factors in
inducing compliance with contractual undertakings. I discuss the significance of reputation
for interpretation later in the paper.
6 See, for example, Carl Felsenfeld and Alan Siegel, Writing Contracts in Plain English
(1981).
Contract Interpretation
3
need either for contracts or for legal remedies for breach of contracts. The
main purpose of contracts is to enable performance to unfold over time
without placing either party at the mercy of the other, as would be the case if
for example a buyer could refuse to pay for a custom-built house for which
there were no alternative buyers at the agreed price. So contracts regulate
the future and interpretive problems are bound to arise simply because the
future is inherently unpredictable.7 Stated otherwise, perfect foresight is
infinitely costly, and, therefore, as the economic literature on contractual
interpretation emphasizes, the costs of foreseeing and providing for every
possible contingency that may affect the costs of performance to either party
over the life of the contract are prohibitive.8
Even in a setting of perfect foresight an interpretive problem may arise.
Parties may rationally decide not to provide for a contingency, preferring to
economize on negotiation costs by delegating completion of the contract,
should the contingency materialize, to the courts. This is especially likely if
they think that the likelihood that the contingency will materialize is slight.
But even if they think the likelihood is significant they may prefer to leave
the contingency unprovided for. Deliberate ambiguity may be a necessary
condition of making the contract; the parties may be unable to agree on
certain points yet be content to take their chances on being able to resolve
them, with or without judicial intervention, should the need arise. It is a form
of compromise, like “agreeing to disagree.”
The goal of a system, methodology, or doctrine for contractual
interpretation is to minimize contractual transaction costs, broadly
understood as obstacles to efforts voluntarily to shift resources to their most
valuable use. Those costs can be very great when by inducing parties not to
7
Hence contracts tend to be more detailed the longer their duration. Karen Eggleston, Eric
A. Posner, and Richard Zeckhauser, “The Design and Interpretation of Contracts: Why
Complexity Matters,” 95 Northwestern University Law Review 91, 126 n. 101 (2000).
8 See, for example, Richard A. Posner, Economic Analysis of Law 96 (6th ed. 2003); Jean
Tirole, “Incomplete Contracts: Where Do We Stand?” 67 Econometrica 741, 772 (1999).
Contract Interpretation
4
contract they prevent resources from being allocated efficiently. Because
methods of reducing contractual transaction costs, such as litigation, are
themselves costly, careful tradeoffs are required. But it would be a serious
mistake for courts to take the position that any ambiguity in a contract must
be the product of a culpable mistake by one or both of the parties; that the
judicial function in contract law is to punish parties who do not make their
agreement clear. Sometimes it is (I’ll give an example later), but more often it
is not.
Contract interpretation is, of course, a judicial staple, so I have a
professional as well as an academic interest in the subject. I want the paper
to be helpful to judges and practicing lawyers as well as to academics, so I
postpone most of my formal analysis to the last part of the paper. But the
following very simple equation may help to set the stage for some readers. If
C is the transaction cost (broadly defined) of a contract, then
C = x + p(x)[y + z + e(x, y, z)],
(1)
where x is negotiation and drafting cost, p the probability of litigation, y the
the parties’ litigation costs, z the cost of litigation to the judiciary, and e error
costs. The first term on the right-hand side, x, represents the first stage in
determining the meaning of the contract, the stage at which the parties
decide what the contract shall say. The second term represents the second
stage, where in the event of a legal dispute over meaning the matter is
submitted to adjudication. The costs thereby incurred include expenditures
by the parties and the courts, plus an expected cost resulting from the
possibility that the court will misinterpret the contract. This possibility is
influenced by the parties’ and the court’s investment in the litigation but also
by the parties’ investment in making the contract as clear as possible, thus
facilitating an accurate decision should a dispute over the contract’s meaning
arise and be brought to court. All the costs in the second stage must be
Contract Interpretation
5
discounted by the probability of a legal dispute, which lower the more the
parties invested at the first stage in making the contract as clear as possible.
The equation thus identifies the essential tradeoffs in analyzing the
interpretation problem: the more the parties invest at the first stage, the
lower the expected costs at the second stage. The object of the legal
enforcement of contracts is to minimize the sum of these costs—rather than,
for example, as might seem tempting, to insist that parties do whatever is
necessary at the first stage to minimize the likelihood of litigation. The “do
whatever is necessary” position is the effect and perhaps purpose of formalist
interpretation, the tendency of which is to increase x by reducing p without
understanding that an increase in x is a real cost and one that may outweigh
the savings in expected litigation costs from the reduction in the probability
of litigation.
II. GAP FILLING VERSUS DISAMBIGUATING
Persons contemplating a transaction can reduce the potential error costs
arising from imperfect foresight by shortening the duration of their contract
(consider employment at will, or spot markets), since the near future is more
predictable than the distant future. Another alternative (“agreeing to agree”),
which is similar, is to agree on just a few things and reserve the rest for a
future negotiation. Still another is the substitution of vertical integration for
contracting—a producer might choose for example to make rather than buy
an input. (Actually, this is the substitution of one type of contract for
another—a contract of employment for a contract to purchase a good.) All are
actually or potentially costly methods of avoiding contractual transaction
costs.
A fourth alternative, which will often be cheaper and which brings us
close to the central concerns of this paper, is to have a court or an arbitrator
fill any gap in the contract when and if it emerges in the course of a dispute
between the parties. For example, a contract that gives the dealer an
Contract Interpretation
6
exclusive right to distribute the supplier’s product (as by granting him an
exclusive territory) is presumed to require the dealer to devote his “best
efforts” to promoting the supplier’s product,9 on the theory that otherwise the
supplier would have delivered itself into the dealer’s power. So if a dispute
arises as to the dealer’s obligations under the contract, the court will
interpolate a best-efforts clause unless the parties specified in the contract
that the dealer would not have a best-efforts obligation. Similarly, although it
is common for contracts to contain a force majeure clause, a court will in any
event, in the name of impossibility, impracticability, or frustration, read into
a contract an implied excuse based on these common law doctrines, which the
parties however can agree to negate: a promise to perform even if
performance proves impossible for reasons wholly beyond the promisor’s
control is not a contradiction in terms, but merely an undertaking that
contains an insurance component.
Judicial or arbitral gap filling is similar to the use of form contracts to
economize on contracting costs. The forms contain standard clauses designed
to resolve contingencies that may arise in the course of performance. The
difference is that form contracts used in transactions with consumers tend to
be one-sided because they are drafted by firms, trade associations, or
professional associations, which naturally want their contracts to be slanted
in their favor (though this is not a problem for disputes between members of
the association). Standard clauses that evolve in litigation or arbitration, and
thus are created or approved by an impartial third party, are more likely to
be neutral.
To my suggestion that form contracts used in consumer transactions tend
to be one-sided it may be objected that competition can be relied upon to yield
the optimal form. But that is doubtful. Hidden traps in the language of a
contract are sprung only on the rare occasion in which there is a legal
dispute. The expected benefit of a “good” form to the consumer is therefore
9
Wood v. Lucy, Lady Duff-Gordon, 118 N.E. 214 (N.Y. 1917).
Contract Interpretation
7
slight and so is unlikely to figure in his decision to buy the seller’s product,
while the seller, having much better knowledge of the likelihood and
consequences of such a dispute, will anticipate a small gain from imposing a
“bad” form on his customers. In principle, other sellers could outcompete him
by offering better forms to consumers, but it will be difficult to profit by this
route. The benefits to the consumer are unlikely to be great enough to make
the “good” form a selling point. More important, being reminded of the
possibility of litigation is a downer for the prospective consumer. (“Don’t
worry; if I sue you, the contract will protect you.”) The seller who reminds
consumers of possible legal grief down the road is fouling his own nest.
There is a further point.10 So far as holding a contract party to his
contractual undertaking is concerned, there is an asymmetry between seller
and buyer in cases in which the latter is a consumer rather than another
business. The seller is constrained from breaking the contract both by
considerations of reputation and by the threat of being sued; the consumer is
subject, as a practical matter, to neither constraint, since he does not have a
commercial reputation to lose and is unlikely to be able to pay a damages
judgment. Slanting the terms of the contract in favor of the seller is a way of
redressing the balance. In addition, it is possible that one reason sellers will
not negotiate with consumers over changes to a form contract, besides the
cost of the negotiation relative to the small stakes in an individual consumer
sale, is that the consumer who asks to negotiate signals to the seller that he
may be litigious, or otherwise a troublemaker.
Form contracts, for example in the insurance industry, are common even
between businesses, as distinct from consumer transactions. This may reflect
in part simply a reluctance to alter terms that may have acquired a settled
meaning through litigation. More on this point later when I discuss issues of
interpretation, as opposed to gap filling.
10
Which I owe to Lucien Bebchuk.
Contract Interpretation
8
Another method of gap filling, found in “code” nations such as Germany
and other nations of Continental Europe, is for the legislature to enact a
detailed code of contractual obligations, constituting implied terms that the
parties can, however, negate. Contracts are shorter and interpretive issues
lessened because the code provisions presumably will have been clearly
drafted and received a uniform interpretation.11
Filling potential gaps in contracts, whether by means of form contracts or
otherwise, should be distinguished from disambiguating specific terms, which
is the heart of the problem of contract interpretation. A contract might
contain an explicit best-efforts clause, yet the wording of the clause might
leave a doubt as to what exactly the clause required of the dealer. Gap filling
and disambiguating are both, however, “interpretive” in the sense that they
are efforts to determine how the parties would have resolved the issue that
has arisen had they foreseen it when they negotiated their contract.
I noted in reference to “code” nations that gap filling reduces interpretive
uncertainty to the extent that the interpolated clauses will have acquired a
settled, uniform meaning as a result of having been interpreted in cases. This
is one reason for insurance companies’ well-known reluctance to alter policy
language once it has been interpreted by a court. But the other side of this
coin is that the incorporation of “boilerplate” from earlier contracts in a new
one may generate its own interpretive problems. A clause transposed to a
new context may make an imperfect fit with the other clauses in the contract,
generating ambiguity. (So litigation over the meaning of insurance contracts
is quite common.) The fit can be improved by modifying the clause, but then
the benefit of using language that has been given a settled meaning by
judicial interpretation is lost.
The tradeoff between “off the rack” and “custom-designed” contractual
language resembles that between legal rules and standards. A rule is clear by
11
For evidence, see Claire A. Hill and Christopher King, “How Do German Contracts Do as
Much with Fewer Words?” 69 Chicago-Kent Law Review 889, 912–915 (2004).
Contract Interpretation
9
virtue of being exact. But its very exactness makes it maladapted to
unforeseen situations, creating pressure for recognizing exceptions, which
will often reduce clarity. A standard is flexible and …
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