Simplicity and Complexity in Contracts

Standard economic models of contract imply that contracts should be highly “complex,” by which we mean (1) rich in the expected number of payoff-relevant contingencies; (2) variable in the magnitude of payoffs contracted to flow between parties; and (3) severe in the cognitive load necessary to understand the contract. Yet most realworld contracts are simple along all three of these dimensions. We argue that many factors, often neglected in the literature, account for this discrepancy. The factors are categorized as asymmetric information, monitoring dynamics, evolutionary pressures, conventions, reliance on trust and reputation, enforcement costs, bounded rationality, and renegotiation. This positive analysis has normative implications for how lawyers draft contracts, and for how courts rely on the form of a contract (specifically, its degree of complexity) in order to interpret it. Recent work in the law and economics of contracts suggests that contracts ought to be highly complex and “fine-tuned.” They should have many terms describing the obligations of parties across alternative future states of the world; these terms should provide for highly variable rewards for desired behavior and penalties for undesired behavior; and these rewards and penalties should bear a complex mathematical relationship to the value of the benefits produced by the different kinds of behavior. In practice, however, many contracts are quite simple. They divide the future into very crude partitions; they provide for constant or close to constant payments across different outcomes; and the terms are easy to understand. This divergence between theory and practice suggests that the assumptions underlying the economic models of contracts should be revised, and raises basic questions of public policy of interest to lawyers. What are the advantages and disadvantages of complexity in contracts? How should courts think about the complexity of contracts? Should courts enforce complex contracts more strictly than they enforce simple contracts? To understand why these questions are important, one might compare the idea of contractual complexity with the better developed idea of contractual completeness. Courts and contracts scholars now understand that a contract might be more or less “complete,” in the sense of describing the obligations of parties in different future states of the world. A more complete contract takes account of many future contingencies that would change the value of performance—increases in the cost of inputs, decline in demand for the product, and so on. A less complete contract might simply state the price and performance—deliver the widget on January 1, for $X—without saying what happens if the product is destroyed in transit or similar 1 Kennedy School of Government, Harvard University and Department of Economics, Tufts University; Law School, the University of Chicago; and Kennedy School of Government, Harvard University. Thanks to Ian Ayres, Virginia Coleman, Richard Craswell, Oliver Hart, Christine Jolls, Louis Kaplow, Richard Posner, Alan Schwartz, Cass Sunstein, and George Triantis, and members of audiences at the University of Chicago Law School and Harvard Law School, for valuable comments. Posner thanks the John M. Olin Fund, the Sarah Scaife Foundation Fund, and the Ameritech Fund in Law and Economics for generous financial support. Chicago Working Paper in Law and Economics 2 events occur. Courts seem to be more willing to aggressively interpret incomplete contracts than complete contracts. Thus, completeness matters. The question is whether contractual complexity matters as well. We argue that it does, and that the current tendency of scholars to focus on completeness and neglect complexity has resulted in an inadequate understanding of contracts and contract law. One of our major themes is that complexity is predicted by models that make unrealistic assumptions about human behavior and the environment. The basic point of these models is that contracts should be complex because of pervasive uncertainty about the future. Because any of an indefinitely large set of events could influence the cost or value of the performance, a desirable contract would condition performance on all of these events. As is well understood, one reason that parties would not draft such a contract is that drafting would be extremely costly. But there are many other reasons as well, which we categorize as: asymmetric information, monitoring dynamics, evolutionary pressures, conventions, reliance on trust and reputation, enforcement costs, bounded rationality, and renegotiation. To take one example, when a firm cares about its reputation, and its customers know this, they may enter a simple contract that does not describe the firm’s obligations in detail, because both sides expect the firm to act in the customer’s interests when it is time to perform. Our positive arguments about contractual complexity are in principle susceptible to empirical testing, and should be of interest to lawyers who draft contracts and are always concerned about the appropriate level of detail. Our other major theme is that the complexity of a contract is a relevant consideration for courts when they decide how to interpret a contract. We do not argue that simple contracts are good and complex contracts are bad, or vice versa; nor do we argue that courts should always interpret simple contracts and complex contracts differently. Our argument is more modest and subtle. It is that the relative complexity of a contract can tell a court something about the contractual goals of the parties, the process of negotiation, and the environment that the parties faced when they negotiated the contract. Under certain conditions, the degree of complexity reveals whether one party took advantage of the other party, or whether negotiations were hampered by asymmetric information, or whether the parties anticipated that trust or reputational concerns would resolve disputes, or other facts that are of concern. Because courts care about preventing advantage-taking, overcoming problems of asymmetric information, encouraging trust, and so on, they should take account of the complexity of the contract when deciding how to interpret the contract and whether to enforce it. A word about the background of this article. There are two economic literatures on contracting. One is “law and economics;” the other is the “economics of contracts.” Both focus 2 Some of these same factors (e.g., asymmetric information) can push toward complexity in some circumstances as well. See Part III, infra. 3 The law and economics literature is produced mainly by law professors, including some economists who teach at law schools, and appears mainly in law reviews. The economics of contracts literature is produced mainly by economists who teach in economics departments, and appears mainly in economics journals. Citations to both 3 Simplicity and Complexity in Contracts on people’s incentives to enter, invest in, breach, and renegotiate contracts, or broadly to engage in “contract-related behavior.” The two literatures share an underlying purpose: to describe the conditions under which the value of contractual exchange is maximized. However, the law and economics literature focuses on the effects of legal rules, whereas the economics of contracts literature takes legal rules as given, and examines the optimal design of contracts. Law and economics has a public orientation; it gives advice to courts and legislatures about the design of legal rules. Economics of contracts has a private orientation; it gives advice to parties entering exchange relationships about how to design their contracts. As some authors have pointed out, the distinction between these literatures is artificial; a rapprochement is needed. Although the two literatures have different focuses, their origins and methods are quite similar, and their divergence has created two problems. First, the economics of contracts literature has made a number of methodological advances that have not yet spread to the law and economics literature. Unfortunately, these advances are often quite technical, and this has hampered the transport across disciplinary boundaries. Second, there is no reason why law and economics should ignore problems of contract design, and why economics of contracts should ignore problems of legal design. Indeed, the two subjects cannot be separated: lawyers, judges, and legislatures cannot evaluate contract rules without understanding the contracts that these rules are supposed to regulate. Yet the law review literature on contracts is almost completely devoid of the positive analysis of contracts. This article uses insights from the economics of contracts literature to discuss both legal rules and contract design. The idea of contractual simplicity and complexity is used to organize the discussion. The degree of complexity of a contract is one of its central features, and it is a source of concern to those who design contracts. The positive regularity that we seek to explain is the apparent use of highly simple contracts despite the complexity of the environments in which people use contracts. This is the subject of Parts I and II, which discusses examples and terminology, and Part III, which explores reasons for contractual simplicity. We also make several normative arguments (Part IV). There is a traditional law and economics approach to contract interpretation, which holds that courts should fill gaps in contracts by either supplying terms that maximize the value of the contract (the terms that the parties themselves would have chosen if transaction costs were zero) or that provide correct incentives for parties to reveal information to each other. There are also more recent attempts, relying on the economics of contracts literature, to defend more formal or literal interpretation of contracts. Our focus on complexity reveals defects in both approaches. We argue that the proper literatures can be found below. 4 See, e.g., Ian Ayres and Robert Gertner, Strategic Contractual Inefficiency and the Optimal Choice of Legal Rules, 101 Yale L.J. 729, 730-31 (1992). 5 Avery Katz, Taking Private Ordering Seriously, 144 U. Pa. L. Rev. 1745 (1996). 6 Observers sometimes wonder whether courts strike down contracts with apparently one-sided terms because they do not understand the purpose of these terms. In such cases as Britton v. Turner, 6 N.H. 481 (1834) (employment contract that delayed pay until end of term) and Williams v. Walker-Thomas Furniture, 350 F.2d 445 (D.C. Cir. 1965) (consumer credit contract with cross-collateral clause), one might wonder whether the courts understood the economic purposes of the terms that they criticize. Chicago Working Paper in Law and Economics 4 interpretative strategy depends on the cause of the gap in the contract, and that the complexity or simplicity of the contract provides clues about what that cause is in any given case.