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合同法中的隐含条款及解释
文/George M. Cohen

 IMPLIED TERMS AND INTERPRETATION IN CONTRACT LAW

Abstract

 

This chapter examines the economic arguments for textualism and

contextualism, the two primary methodologies used by courts to determine the

intentions of contracting parties with respect to their performance obligations.

Textualism, which is rooted in the idea of complete contracting, calls for a

more restrictive approach to implied terms and interpretation than

contextualism, which is rooted in the idea of incomplete contracts. The primary

conclusions are that, as in other areas of contract law, the choice between the

two interpretive methodologies depends on the transaction costs of drafting, the

relative likelihood of court error, and the risks of opportunistic behavior.

Neither methodology dominates so much that it should be uniformly employed,

which is consistent with how courts actually behave.

JEL classification: K12

Keywords: Contracts, Completeness, Interpretation, Implied Terms,

Opportunism, Contextualism, Textualism

 

1. Introduction

 

Questions of how courts interpret, and should interpret, contract terms and

when courts imply, and should imply, terms to which the contracting parties

have not explicitly agreed, loom large in contract disputes and in the legal

literature on contract law. Law and economics scholars, however, have written

far more extensively on other topics in contract law than on these questions.

For example, Judge Posner’s treatise has no section specifically discussing

interpretation or implied terms, and discusses contractual good faith in only

two paragraphs (Richard Posner, 1998, pp. 103, 126). Other leading textbooks

also have no discussion of interpretation or implied terms. One possible

explanation for this discrepancy is that there is little need for research

specifically on interpretation and implied terms because much of the economic

analysis of other areas of contract law carries over straightforwardly to these

questions. An alternative explanation is that economic analysis has less to say

about interpretation methods than it does about other questions in contract law.

This article, which will summarize and expand on the literature that does exist,

aims to demonstrate that economic analysis has a good deal to say about

interpretation questions, but the issues are complex and there are many fruitful

avenues for further research.

 

The argument that there is no real need for a separate economic analysis of

interpretation and implied terms stems from the fact that the delineation of the

topic is based on legal rather than economic considerations. In contract law,

interpretation usually refers to problems arising from express contract terms

that are reasonably susceptible of more than one meaning. Implied terms are

those that are added to, or place limits on, expressly stated terms. The two are

closely related, yet not identical. For example, if a contract contains a ‘best

efforts’ clause, determining what that clause requires is a question of

interpretation; if the contract contains no such clause, courts may have to

decide whether to imply a best efforts obligation, and if they do, they have to

determine the content of that obligation. On the other hand, some questions of

interpretation do not involve questions of implication, for example, a dispute

over the meaning of the word ‘chicken’.

 

In some sense, all contract disputes involve questions of interpretation and

implied terms. For example, force majeure clauses - usually discussed in the

context of the (implied) impossibility defense - present questions of

interpretation, and most contract formation, excuse, and damage rules are

‘implied terms’. But contract law has generally used the labels ‘interpretation’

and ‘implied terms’ more narrowly, to refer to questions of contract

performance, rather than questions of formation, excuse, defense, or remedy.

That is, the legal issue addressed by these doctrines is whether one or more

parties have performed as the contract requires, or have breached. Thus, I will

assume for purposes of this discussion that the parties have made an

enforceable contract, there are no changed circumstances or ‘mistakes’

sufficient to give rise to an excuse claim, the applicable remedies in the event

of breach are accepted, and there are no third-party effects. How do courts

decide - and how should they decide - what the performance obligations are and

whether the parties have met them?

 

2. Complete or Incomplete Contracts

 

Economic analyses of contract law have tended to start with the idealized

concept of a ‘complete’ contract, though this term has perhaps engendered

more confusion than clarity. Traditionally, a complete contract has referred to

one that provides a complete description of a set of possible contingencies and

explicit contract terms dictating a performance response for each of these

contingencies (Al-Najjar, 1995; Hart and Moore, 1988). Contingencies include

changes in ‘exogenous’ economic variables, such as a production cost increase.

But they also include ‘endogenous’ behavioral responses, such as falsely

claiming a cost increase or seeking refuge from a now-disadvantageous bargain

behind a contract term intended to serve a different purpose. Economic analyses

generally conclude that if a contract is complete, there is no beneficial role for

a court other than to enforce the contract according to its terms; that is,

incompleteness is a necessary, though not sufficient, condition for an active

court role in interpretation and implied terms.

 

But because no real-world contracts are fully complete in this sense, the

concept of completeness does not get us very far. The concept can be rescued

in one of three ways. One way is to view completeness as a useful benchmark,

similar to perfect competition. Just as some markets are close enough to being

perfectly competitive that the perfect competition model is a useful predictor,

so some contracts may be complete enough that no reasonable interpretation or

implied term questions arise. The law refers to these contracts as ‘integrated’.

But tying completeness to integration simply reduces to a tautology the

statement that a complete contract obviates the need for interpretation or

implied terms. The question is how do courts know when a contract is complete

in this sense.

 

One way courts can know a contract is complete is if the parties tell them.

Thus, a second way to rescue completeness is to recognize that contracting

parties can make a contract complete by using general ‘catchall’ clauses that

state what happens in all unspecified states of the world (Hermalin and Katz,

1993, p. 236; Hadfield, 1994, p. 160, n.5). For example, a catchall clause might

state: ‘The price term will be x, and will apply regardless of any change in

circumstances or conduct by either party’. Alternatively, the parties could state

their general desire not to have courts interpret or imply terms. But although

contracting parties often use general clauses such as merger clauses, which

direct a court to apply a particular interpretive methodology (that is, do not look

beyond the writing), they do not seem to use catchall clauses that are broad

enough to make contracts complete. Of course, clauses that are not stated as

catchalls could be - and sometimes are - interpreted that way, but, to lawyers

at least, if not economists, that act of interpretation then requires justification

(Hadfield, 1994, p. 160). Even clauses that are stated as catchalls might require

interpretation (Charny, 1991). Moreover, contracting parties often use

contracting clauses that are the exact opposites of completeness catchalls:

general clauses such as ‘good faith’ or ‘best efforts’ clauses signal contracting

incompleteness, as opposed to completeness (Hadfield, 1994, p. 163).

 

A third way to rescue completeness, more common in formal economic

modeling, is to tie the concept of completeness to the efficient use of available

information. A complete contract is one that makes full use of the private

information available to the contracting parties (Hermalin and Katz, 1993, p.

235). The point of this definition is to make clear that parties can write efficient

contracts that do not expressly specify the response to every contingency, yet

obviate the need for court intervention (Hermalin and Katz, 1993, p. 242). But

the fact that parties may in a simplified model be able to write ‘economically

complete’ contracts does not answer the question of whether in a given legal

dispute they have in fact written one. And the ability of private parties to write

economically complete contracts in the real world is unclear. We do not seem

to see, for example, contracts of the type described by Hermalin and Katz, in

which the contract leaves the quantity and price unspecified, then after some

period one party names the price and the other names the quantity. Perhaps the

costs of writing these contracts (including the costs of strategic circumvention)

are too high. Perhaps the current enforcement regime interferes with, or

discourages, the parties, writing of such contracts, though this seems unlikely.

 

It seems fair to say, however, that many if not most contracts are

incomplete, or at least the question of their completeness is itself a legitimate

question for judicial interpretation. The incompleteness may be intended by

both parties, which creates so-called ‘relational contracts’ (Goetz and Scott,

1981), or ‘fiduciary contracts’ (Easterbrook and Fischel, 1983, p. 438). It may

result from unintended ‘formulation error’ which occurs when, as a result of

defective contractual instructions, the occurrence of some contingency produces

surprising consequences (Goetz and Scott, 1985, p. 267, n. 11). It may result

from strategic withholding of information by one party. Or incompleteness may

result from court error. Whether a contract that the parties think is complete,

but is misinterpreted by a court, should in fact be viewed as an ‘incomplete’

contract depends on how completeness is defined. If completeness is defined

with reference to the obviation of interpretive questions, the definition must

assume that completeness means that a contract’s terms are ‘unambiguous’,

that is, the contract terms represent a confluence of the parties’ intentions and

the court’s ability to interpret those intentions correctly (unless the contract is

somehow self-enforcing).

 

Incomplete contracts may be efficient contracts, even if the incompleteness

is unintended. The costs of contractual completeness would often exceed the

benefits, just as the costs of reducing crime or pollution or accidents to zero

would exceed the benefits. Incomplete contracts will tend to be efficient when

contracts are relatively complex, that is, when there are a large number of

low-probability contingencies that could affect the value of contractual

performance, and the efficient responses to those contingencies vary greatly and

so cannot easily be specified in advance (Hadfield, 1994, p. 165, n.15). In these

cases the transaction costs of negotiating, drafting, monitoring, and enforcing

a complete contract are high.

 

More generally, in the language of institutional economics, a complete

contract is only one form of ‘governance mechanism’ for guiding the behavior

of contracting parties (Al-Najjar, 1995). Alternative governance mechanisms

include the courts and extralegal enforcement, such as social sanctions and

reputation. In this approach, incomplete contracts will tend to be efficient

whenever governance mechanisms superior to a detailed contract exist, that is,

whenever the opportunity costs of completeness are high. In fact, contrary to

the usual economic approach, the actual historical development of contracts is

probably best described as starting as incomplete as possible, then becoming

more complete and formal as governance mechanisms other than the written

contract proved to be inadequate.

 

The question of contract interpretation and implied terms is really a

question of when the courts are a superior governance mechanism. Courts may

be able through interpretation and implied terms to provide necessary flexibility

- efficient adjustments to contingencies - that an incomplete contract otherwise

lacks. Courts may also be superior to nonlegal institutions such as reputation

because reputation effects may be weak due to such things as cognitive

dissonance, optimism about the ability of a party with a poor reputation to

change, the difficulty of knowing when a contracting partner has behaved

badly, and the last period problem. In general, the role for courts in interpreting

contracts and implying terms increases as contracts become more efficiently

incomplete.

 

3. Incomplete Contracts and Contractual Intent

 

Now suppose the contract is incomplete, as are most contracts that are the

subject of litigation. What should a court do? The economists’ (and courts’)

usual assumption is that courts should follow the intentions of the parties, but

to admit incompleteness is to admit that the intention of the parties is

uncertain, or at least disputed (some would say nonexistent). The next best

solution is to adopt the term - or interpretive methodology - the parties would

have chosen had they bargained over the matter, that is, presumed or

hypothetical intent. But how is presumed intent determined?

 

There are two general possibilities on which economic analyses have

focused (Hadfield, 1992, 1994, p. 161). First, courts might presume that

complete contracting is both feasible and desirable. This presumption has both

a positive and a negative component. On the positive side, the express terms of

the contract are presumed to be the best approximations of the parties’

intentions and deemed to create a complete contract. This strategy is usually

referred to as textualism. On the negative side, if parties fail to write a complete

contract, the incompleteness is presumed to be inefficient, whether unintended

or strategic, and the court’s approach should be to deter this behavior and

encourage complete contracting. This strategy is a variant of what has come to

be known as penalty defaults (Ayres and Gertner, 1989), which is itself a

variant of an old idea in the Austrian School of economics that individuals

should bear the consequences of their actions so that they become more rational

over time (for example, Wonnell, 1986, p. 520).

 

The second general approach involves a presumption that contractual

incompleteness is unavoidable and/or desirable, due to limitations of money,

time, comprehension and foresight (Hadfield, 1992, p. 259). The courts then

fill in the gaps by presuming the parties intended to contract with reference to

some standard external to the written contract. Courts might presume parties

contracted with reference to their current (course of performance) or prior

(course of dealing) conduct, or to the conduct and understandings of similarly

situated parties (trade usage or custom or business mores). Strategies that focus

on these presumptions, which are featured predominantly in the Uniform

Commercial Code, are usually referred to as contextualist. Alternatively, courts

might presume the parties contracted with the expectation that courts would fill

in any gaps with a joint maximizing term that would have been written by

rational parties under conditions of low transaction costs (Goetz and Scott,

1981). In practice, the joint maximization strategy will often dissolve into

contextualism, as courts lack the data necessary to do pure joint maximization.

 

It is important to remember that all of these strategies involve presumptions.

It is all too easy for courts or proponents of a particular strategy to criticize the

alternatives as failing to hew closely enough to the parties’ intentions, when in

fact the parties’ intentions in incomplete contracts are at least uncertain, and

the question is which strategy is more likely to be successful at approximating

these intentions. For example, suppose a buyer rejects goods delivered late after

the market price drops below the contract price. A court might be called upon

to decide whether to imply a good faith limitation on the buyer’s ability to

reject. A textualist might argue no on the ground that such an implication

would be contrary to the parties’ intentions as expressed in the time of delivery

term. But the parties’ intentions - whether actual or hypothetical - may well be

that a good faith obligation should be implied rather than that the time of

delivery term should be interpreted as absolute. A proposition that textualism,

contextualism, penalty defaults, or joint maximization best represents the

parties’ intentions needs to be defended. Economic analysis can help to identify

the conditions under which the various interpretive strategies are more likely

to approximate the parties’ intentions, and whether courts are better off

pursuing a pure interpretive strategy or a mixed one.

 

4. Default versus Mandatory Rules and Contractual Intent

 

The recognition of incomplete contracting and the uncertainty of contractual

intent renders problematic another distinction that has played an important role

in economic discussions of contracts, namely default rules versus mandatory

rules. The term ‘default rule’ refers to several different characteristics: (1) if the

parties specify some contract term, the court will enforce that term; (2) if the

parties fail to specify some contract term, the court will fill in the gap and

supply one; and (3) if the parties fail to specify some contract term but do not

want the court to fill in the gap, the court will honor that intent (that is, the

gap-filling rule itself is a default). UCC § 2-305 on open price terms is a good

example of a rule that satisfies all three characteristics. Default rules are usually

contrasted with mandatory rules, which term can also refer to three

characteristics. Mandatory rules can refer to situations in which the court

knowingly: (1) imposes a term that contradicts a term the parties specified; (2)

refuses to fill in a gap that the parties left when the parties wanted the court to

fill the gap; and (3) fills in a gap that the parties did not want the court to fill

in.

 

When economists refer to mandatory terms, they usually mean the first

sense, that is the court rejecting a term the parties specified. An example would

be a liquidated damage clause deemed to be a penalty, or a term deemed to be

unconscionable. The usual critique of mandatory terms is that because they

disregard the intentions of the parties, the parties who prefer these terms will

be made worse off. For example, if a court imposes a stronger performance

obligation on an obligor than the parties intended, then future obligors will

extract a higher price, which is more than the obligee wanted to pay (else he

would have paid for it originally) (for example, Easterbrook and Fischel, 1993,

p. 431). This critique makes sense if contracts are assumed to be complete.

 

But once we allow for the possibility of efficiently incomplete contracts and

unclear intent, it becomes much more difficult to distinguish mandatory rules

from default rules. Take, for example, the implied duty of good faith, or the

duty of loyalty in fiduciary contracts. Are these defaults or mandatory rules?

That depends on how well one thinks the duty of good faith tracks contractual

intent. If one believes that parties may write incomplete contracts for which

they expect courts to fill in the gaps, the duty of good faith or the duty of loyalty

might easily be viewed as a default. If the parties want a particular obligation

that conflicts with what courts ordinarily view as good faith or loyalty, and they

specify that obligation, courts will generally enforce it. This is the view

espoused by Easterbrook and Fischel (1993). On the other hand, if one believes

that courts use the duty of good faith or the duty of loyalty to fill in gaps that

the parties did not want to be filled, or to reject obligations the parties thought

they had fully specified, then the duty of good faith looks more like a

mandatory term. UCC § 1-102(3) evidences this ambivalence about the good

faith obligation.

 

The mirror image issue is presented by the doctrine of certainty, which says

that courts may sometimes decline to fill gaps the parties have left in contracts.

The doctrine could be viewed as a default if one is willing to presume that when

the parties have left ‘too many’ gaps for the courts to fill, they do not have

contractual intent, and if they do have such intent they will override the default

by filling in the terms themselves. Alternatively, the doctrine could be viewed

as a mandatory rule if one assumes that the courts use it to refuse to fill in gaps

when the parties wanted them to.

 

The point is that the labels ‘default’ and ‘mandatory’ are conclusions that

can mask the assumptions being made about contractual completeness and

intent, and so do not by themselves resolve the questions of implied terms and

interpretation.

 

5. Unintended or Strategic Incompleteness: Encouraging Better

Contracting

 

If the contracting parties wanted to write a complete contract but failed in some

way, the failure can be viewed as analogous to an accident in tort law. The

accident may occur because one or both parties failed to take cost-effective

‘contract-based precautions’ (Cohen, 1992, p. 949). Alternatively, one of the

parties might make a contract incomplete to serve his strategic bargaining

interests by withholding information. In either case, courts can use the

doctrines of interpretation and implied terms to encourage the parties to

‘facilitate improvements in contractual formulation’ (Goetz and Scott, 1985,

p. 264). One way to encourage better contracting is to encourage more complete

contracts, that is, the greater use of express written terms. If a court is willing

to ‘insure’ parties through flexible interpretations and implied terms it creates

a classic moral hazard problem: the parties have less incentive to write good

contracts themselves, for example contracts with more precise language.

Doctrines such as the parol evidence rule encourage parties to write more

complete contracts by giving more weight to the written document and limiting

the extrinsic evidence courts can consider. Strict application of these doctrines

may thereby increase the accuracy of contract enforcement (reduce contractual

accidents) by reducing the interpretive risks of relying on extrinsic evidence

(Eric Posner, 1998, p. 546).

 

As in tort law, the goal of encouraging better contracting makes economic

sense if the precautions are cost-effective. That will be the case if one or both

of the contracting parties face low ex ante transaction costs of drafting and

monitoring express contract terms that successfully specify performance

obligations in response to different regret contingencies, as well as if the

expected losses from interpretive accidents are high (Eric Posner, 1998, pp.

543-547). Moreover, courts must be able to identify accurately situations in

which precautions are cost-effective. Usually, the best courts can do is to use

proxies to make reasonable comparative judgments. In particular, in

investigating precautions, courts can compare the capabilities of contracting

parties and they can compare the contract in dispute to other litigated contracts

(Eric Posner, 1998, pp. 553-561).

 

In comparing contracting parties, courts might conclude that one

contracting party is the ‘least cost avoider’, or in this case the ‘cheaper contract

drafter’, namely the party in a better position to clarify a term or to identify

what should happen in the event of some contingency. This approach explains

such interpretive rules such as contra proferentum, which encourage the party

in the better position to draft a more complete contract to do so. Similarly, if

one of the parties is a repeat contractor or is assisted by legal counsel and the

other is not (as in many consumer contracts), imposing liability on the repeat

and represented contractor in cases of contractual ambiguity or incompleteness

will encourage that party to improve the terms of its contracts. In addition, if

one of the parties has an informational advantage, imposing liability on that

party could encourage similarly situated parties in the future to reveal the

information. But there may not always be a ‘cheaper contract drafter’, or if

there is, the necessary precautions might not be cost-effective. Such might be

the case, for example, with a party who commits a ‘scrivener’s error’ in a

written contract, especially if the error is one that the other party could

reasonably have noticed.

 

The alternative of comparing similar contracts rather than contracting

parties can also yield some useful guidelines. For example, one piece of

relevant evidence about ex ante transaction costs would be how common a

particular term is in similar contracts. The more common a term, the more

likely the costs of contracting over that term are low. Courts can then presume

that most parties who wanted such a term would have contracted expressly for

it and those who have not can be deemed negligent or strategic. Alternatively,

one might argue that transaction costs are low for relatively ‘simple’ contracts

or for ‘crucial’ terms. But even if courts are able through comparative analysis

to identify simple contracts or common or crucial terms, there is a further

difficulty: ease of contracting may not be a sufficient justification for imposing

liability.

 

The reason is that encouraging better contracting does not necessarily mean

encouraging greater contractual completeness; it may mean encouraging

greater contractual incompleteness through reliance on implied terms. Under

a majoritarian default approach to implied terms, courts would minimize

transaction costs by choosing the mix of express and implied terms that most

contracting parties would want. The majority of contracting parties might want

courts to use implied terms, especially in well-developed markets, because they

believe that will save on the costs of contracting, even if the transaction costs

of contracting are relatively low. Alternatively, the majority of contracting

parties might believe that relying solely on express terms - even those that

simply try to mimic implied terms - might be less reliable than relying on

well-established implied terms either in conjunction with or instead of express

terms; that is, they might fear court misinterpretation more than court

misimplication. The only contracting parties who should be encouraged to

contract more explicitly under this approach are those who have ‘idiosyncratic’

preferences. Thus, the fact that parties fail to contract expressly (or

unambiguously) for a given term - even a common or crucial one - may simply

be an expression of intent to be bound by the majoritarian understanding of that

obligation.

 

An example of the majoritarian default approach is the rule that contracting

parties ‘in the trade’ are bound by trade usages, even if they did not know about

them. This rule encourages the parties in a trade to develop such usages (which

are majoritarian understandings) and to familiarize themselves rapidly with

these usages, hence reducing the need for heavily lawyered documents (Warren,

1981). Thus, implied terms serve as a public good, a standard set of contract

terms that parties either accept or reject. The same majoritarian approach could

also apply to the interpretation of express terms. The ‘plain meaning rule’

could be viewed as a way of encouraging contracting parties to learn the

common (one might even say implied) meaning of words, thus reducing the

need for and costs of elaborate definition and explanation.

 

Of course, the majoritarian approach to encouraging better contracting itself

presents problems. For example, identifying the majoritarian default seems to

call for an empirical inquiry, which courts are often ill-equipped to make,

though to the extent that there is a recognized trade usage, or a course of

dealing or course of performance, this problem is mitigated. Verkerke (1995)

attempts to remedy this problem in the context of employment contracts by

surveying employers about the discharge terms contained in their employment

documents. He found that 52 percent of employers reported that their

employment documents specified an ‘at will’ provision (the prevailing default),

15 percent reported that their documents contain a ‘just cause’ provision, and

33 percent reported that they do not have documents that address the issue

explicitly (Verkerke, 1995, p. 867). He also found that larger firms and firms

from more ‘liberal’ jurisdictions are more likely to contract explicitly for the at

will rule. From these data, Verkerke concludes that the at will default is the

majoritarian default. A more cautious conclusion would be that a broadly

defined just cause provision is not a majoritarian default, but given the

limitations many states have put on the at will doctrine and the possibility of

unwritten (or written, but narrow) qualifications on the right to discharge,

whether the majoritarian default is the strong form of the at will doctrine

expressed in many employer documents or a more limited form is less clear.

 

An additional problem with the majoritarian default approach is the need

to determine when the parties have contracted around the default. Goetz and

Scott (1985) argue that it is often difficult for courts to tell whether parties are

using express terms to trump (opt out of) implied terms or merely to

supplement them. That is, it may be difficult for courts to tell in a particular

case whether the parties intended to incorporate implied terms by writing an

incomplete contract, or whether they intended the express terms they used to

create a complete contract; thus, the contractual ‘accident’ results from the

parties’ unintended failure to resolve the tension between the express terms and

implied terms. The more courts favor and encourage implied terms and

common usages, the more costly it becomes for the parties who want to contract

out of those terms to do so. As discussed above, ostensible default rules begin

to look more like mandatory rules. The courts’ choice of interpretive strategy,

therefore, may affect not only the parties’ incentives to contract more expressly,

but also their ability to contract around the implied default rule.

 

Goetz and Scott argue that the more likely it is that contracting parties will

be unhappy with the court’s implied terms and interpretations - the more

heterogeneous contracting parties are likely to be - the more inefficient an

expansive approach to implied terms and interpretation will be. In contrast,

where contracting parties are more likely to engage in homogeneous and

repetitive transactions - that is, where the transactional variance is low - the

more likely a contextual approach will be efficient because it will foster the

development of more standardized terms by trade groups, lawyers, and the

parties themselves. One could also justify the contextual approach in such cases

on the ground that in ‘conventional’ contracts, court error is likely to be low

(Eric Posner, 1998, pp. 553, 556). Implementing this notion is often more

difficult than stating it, however.

 

For example, Goetz and Scott suggest that in well-developed markets courts

should generally allow context evidence to supplement express terms, but

should generally not allow context evidence to override the plain meaning of

express terms (Goetz and Scott, 1985, pp. 313-315). Eric Posner has recently

criticized this argument on the ground that there is no theoretical justification

for having a flexible approach with respect to incompleteness (implied terms)

but a strict approach with respect to ambiguity (interpretation of express terms)

(Eric Posner, 1998, pp. 559-560). On the one hand, it should not matter

whether the parties use, for example, a best efforts clause or leave one out and

let the court imply it; if the courts consider extrinsic evidence in one case, they

should do so in the other. On the other hand, the ‘plain meaning’ of a best

efforts clause requires a kind of context evidence, namely the general

understanding of the clause. Thus, there may be no inconsistency in having a

flexible approach to incompleteness and a plain meaning approach to

ambiguity: both favor allowing a certain type of contextual evidence, namely

general contextual evidence. The problem arises when the contextual evidence

being considered is not general but specific to the contracting parties, such as

course of dealing, course of performance, or prior negotiations. Here a flexible

approach to incompleteness would allow the specific context evidence to trump

the general, but the plain meaning rule would have the general context

evidence trumping the specific. At this level of generality, Posner’s argument

seems correct. Although one could imagine cases in which a court might want

to use a flexible approach to incompleteness and a strict approach to ambiguity,

it is difficult to make any general statements about such cases; in fact, one

could just as easily imagine cases in which a strict approach to implied terms

and a flexible approach to ambiguity would be appropriate. Goetz and Scott’s

argument about the plain meaning rule perhaps should be read as limited to

express terms that are commonly understood as general trumping terms that

override implied terms, such as merger clauses, disclaimers, or clauses granting

one party broad discretion. If the parties go to the trouble of using such a

general trumping term, then arguably that should be a sufficient signal of their

idiosyncracy. But even this interpretation is unsatisfactory because, as with the

at will term discussed above, it may not be clear whether the parties simply

intended to use the trumping clause to reject an overly broad implied term or

whether they also meant it to convey the full measure of the parties’ obligations

to the exclusion of all extrinsic evidence.

 

The discussion in this section so far has assumed that ex ante transaction

costs are low. The higher the ex ante transaction costs of drafting and

monitoring become, the less likely it will be efficient for a court to adopt

restrictive rules of interpretation and implied terms that encourage parties to

contract more explicitly, because it will not be cost-effective for the parties to

do so. Reliance on the types of contextual evidence discussed above now

becomes relatively more cost-effective as the accuracy of the written contract

declines. If courts take too restrictive a view of interpretation and implied

terms, the development of cost-saving interpretive devices might be

discouraged in favor of more complete, but costlier, writings (Burton, 1980, p.

373). Alternatively, too few contracts might be formed ex ante, as the

promisor’s costs rise to cover an anticipated remedy that the promisee does not

value at this cost. And too much performance might occur ex post, as the

promisor performs even when the cost of doing so exceeds the value of

performance (Easterbrook and Fischel, 1993, p. 445).

 

Once again, stating the general principle may be easier than applying it.

Classic examples of high-transaction costs contracts are principal-agent

contracts usually referred to as ‘fiduciary’. These contracts typically involve

complex tasks for which the principal cannot easily measure the agent’s effort

or outcome, thus making express contracting difficult (Cooter and Freedman,

1991a, p. 1051; Easterbrook and Fischel, 1993, p. 426). Other examples

include contracts between unsophisticated parties or long-term contracts. Even

in high-transaction cost contracts, however, a more restrictive approach to

interpretation and implied terms might be appropriate if the contracting parties’

preferences with respect to certain obligations are likely to be idiosyncratic, or

equivalently if the relevant context evidence is less reliable (Eric Posner, 1998,

pp. 557-558). By the same token, the same concerns raised by high-transaction

cost contracts might exist even in ordinary sales contracts. For example, if a

contract allows for a 10 percent variation in the quantity for the (unstated)

purpose of avoiding liability over loss during transportation, a question might

arise whether the seller could take advantage of this provision to deliberately

increase or decrease the quantity as the market price drops or rises. Although

one could say that the buyer could contract to prevent such behavior by, say,

limiting the application of the quantity variation provision to losses suffered in

transit (Gillette, 1981, p. 655), it may be quite difficult to draft such a clause.

What should happen, for example, if both a market price change and damage

to the goods occur? What about damage to the goods before and after transit?

Is it always desirable to have the parties provide explicitly for all these

contingencies? The point is that a given contract may be viewed as

low-transaction cost for some purposes and high-transaction cost for others.

 

6. Deterring Opportunistic Behavior

 

Getting the mix of express and implied contracting terms right - that is,

encouraging the optimally complete written contract - is only one consideration

(and perhaps not the most important) that courts do or should face when

deciding questions of interpretation or implied terms. A second approach to the

question of how courts should interpret contracts and when they should imply

terms focuses not on encouraging efficient contracting, but on deterring

opportunistic contractual behavior (though obviously the two overlap).

Opportunism can be broadly defined as deliberate contractual conduct by one

party contrary to the other party’s reasonable expectations based on the parties’

agreement, contractual norms, or conventional morality (Cohen, 1992, p. 957).

Alternatively, opportunism is an attempted redistribution of an already

allocated contractual pie, that is a mere wealth transfer (Muris, 1981; compare

Burton, 1980, p. 378). For example, a contract may require B to paint A’s

portrait ‘to A’s satisfaction’ (Richard Posner, 1998, pp. 103-104). This

provision allows A to reject the portrait even if others like it if it does not suit

A’s taste. But if A rejects the portrait for reasons other than unhappiness with

the painting’s quality - say because A remarries a spouse who does not want

A’s portrait in the house - A acts opportunistically.

 

The problem of opportunistic behavior is perhaps the key justification for

court intervention in contracts. In general, ‘the threat of opportunism increases

transaction costs because potential opportunists and victims expend resources

perpetrating and protecting against opportunism’, which ‘do not help produce

a commodity or service that the contracting parties mutually value’ (Muris,

1981, p. 524). More specifically, opportunistic behavior makes complete

contracting extremely difficult. Even if contracting parties could anticipate all

of the possible changes in economic variables, they would have a much harder

time anticipating and protecting against opportunistic behavior by the other

party. At the extreme, the more one contracting party is willing to contemplate

the possible opportunistic behavior of his contracting partner, the less likely he

will be to want to contract with that partner at all. Some degree of trust is

necessary for contracting to occur. More important, many seemingly airtight

contract terms can seem awfully leaky once a clever lawyer and a highly

motivated client get through analyzing them. Just as cartel members can often

find ways to cheat on cartels involving the most standardized products, so

disappointed contractors can often find a way to act opportunistically in the

most standardized contracts. Because contracting parties cannot solve all

problems of opportunism on their own, courts can reduce transaction costs by

imposing liability on the ‘most likely opportunist’.

 

But there are difficulties with using courts to deter opportunism. In

particular, opportunism is often ‘subtle’, that is, difficult to detect or easily

masked as legitimate conduct (Muris, 1981, p. 525). Contract performance

disputes arise when one party becomes unhappy with the contract. This

unhappiness may stem from the occurrence of a risk that party had

contractually agreed to bear. However, the disappointed party might be able to

exploit some contract term to claim that the other party had breached or to

allow the contested behavior, even though the term was intended to handle

another situation. Alternatively, the disappointed party might be able to

exaggerate or misrepresent the extent of a contingency that might excuse his

performance, and so escape his contractual obligations.

 

The problem that subtle opportunism poses for courts is often surmountable.

In the fiduciary context, courts adopt, via the duty of loyalty, a strong

presumption of wrongful misappropriation by an agent when that agent has a

conflict of interest, engages in self-dealing, or withholds information from the

principal (Cooter and Freedman, 1991a, p. 1054). More broadly, opportunism

may be more possible whenever one party has a significant information

advantage over the other. In other contexts, courts can find ‘objectively

verifiable circumstances that act as surrogates for the existence of opportunism’

(Muris, 1981, p. 530). On the one hand, when the contract assigns a particular

risk to one of the parties, and that risk materializes, the court should be

skeptical of attempts by that party to escape his obligations via a different

contract term. The classic example is a change in market price. If a buyer in a

requirements contract suddenly experiences a large drop in ‘requirements’ after

the market price has fallen below the contract price, or a large increase in

requirements after the market price has risen above the contract price, the court

should suspect opportunism or, in legal terms, a violation of the implied

obligation of good faith. On the other hand, whereas a change in market price

suggests opportunism, a change in economic circumstances either not

contemplated by the contract or whose risk the contract places on the party

seeking strict enforcement, suggests a lack of opportunism. To return to the

requirements contract example, if the buyer’s requirements decrease or increase

because of a change in costs or technology subsequent to the contract, the

buyer’s behavior is likely not opportunistic (is in good faith) because the very

purpose of the requirements contract is to assign some risk of variation in the

buyer’s needs to the seller.

 

Another example of objectively verifiable circumstances on which courts

can focus is ex post transaction costs. If the market for substitute performance

is thick, opportunism is less likely (Goetz and Scott, 1983). Opportunism can

occur only when it is costly to switch to a new contracting partner, that is, when

at least one party has made sunk, specific investments. Although this test may

be useful in establishing general presumptions, it is of limited help in deciding

specific cases. Litigated cases tend to be precisely those in which ex post

transaction costs are likely to be high; otherwise, the cases would be settled.

 

Although opportunism is often discussed as an ex post problem,

opportunism can occur ex ante as well. For example, under a strict parol

evidence rule, a party might intentionally make oral statements that the other

party understands and relies on as part of the contract, then leave the provision

out of (or put a contradictory provision in) the writing. One common situation

is where a party tells the other to ignore the terms on the back of the first

party’s forms, then later tries to enforce those terms. On the other hand, under

a more flexible parol evidence rule, a party might intentionally ‘pad’ the

negotiation record with statements that party knows will be rejected by the

other party both orally and in writing, in the hopes that the first party can later

convince the court that these statements were in fact part of the contract (a

common practice in legislative history) (Eric Posner, 1998, pp. 564-565). This

latter form of opportunism helps explain why courts tend to be much more

skeptical of evidence that the parties can easily manipulate - especially prior

negotiations - than evidence over which the parties have less control -

especially common usages. It may also explain the motivation behind the use

of merger clauses as well as one reason why they should not be interpreted too

broadly. It is difficult for a party to predict in advance which negotiation tidbit

the other side might seize on later (Eric Posner, 1998, p. 572), so it is necessary

to write a broad clause that excludes them all. The same is not true for less

manipulable evidence, but it might be difficult to specify all such evidence in

writing in advance, especially in a single ‘anti-merger’ clause.

 

It is important to recognize once again that the opportunism approach is

dependent on determining contractual intent, which is often uncertain. Stating

that courts do and should deter opportunism does not by itself explain how

courts do and should resolve the question of how to determine contractual

intent; it simply opens the question up. Professor Muris, who first articulated

the opportunism approach to good faith, recognized that to apply the approach

courts need to consider ‘risk allocation’, which is a question of ‘interpretation’

that is ‘analytically prior to [the question] of opportunism’ (Muris, 1981, pp.

561-562, n.110). Nevertheless the opportunism approach may have something

to say about how courts should go about determining intent. First, courts should

hesitate to interpret a contract in such a way as to permit conduct that would

ordinarily be understood as opportunistic. Second, courts should hesitate to

attribute to contracting parties an intention not to have courts police against

opportunistic behavior (compare Muris, 1981, p. 573, n.138). Because

contextualism and textualism are both useful for deterring different types of

opportunism, we should therefore expect - and we find - that courts are never

completely committed to one or the other.

 

7. The Problem of Joint Fault or Multiple Contingencies

 

In many contractual disputes, there are often precautionary steps that both

parties could have taken to have avoided or mitigated the contractual loss. We

have already considered one such precaution - drafting a better contract. Quite

separate from the costs of drafting better terms are the costs of reducing the

likelihood of, or harm from, some risk ex ante, and of mitigating losses ex post.

Parties seeking to have the court imply or interpret a term in their favor may

be attempting to avoid a risk that the contract assigned to them or to extricate

themselves from a vulnerable position of their own making, which they could

have avoided at low cost.

 

In these cases, courts may have to make judgments about the relative fault

of both parties to decide whose behavior it is more important to deter in a

particular case. In particular, if one party is the least cost avoider of some

contingency while the other party regrets the contract for other reasons and is

opportunistically seeking to avoid its obligations, courts face a

‘negligence-opportunism tradeoff’ (Cohen, 1992, pp. 983-990). To take a

classic example, suppose a builder promises to use a particular brand of pipe

in building a house but inadvertently substitutes a different, but functionally

equivalent brand, a fact not discovered by the owner until the house is nearly

completed. The owner refuses to make the final payment on the house. The

court must choose between placing liability on the negligent builder or the

potentially opportunistic owner. There is an economic case to be made that

opportunism - if sufficiently proved - is more costly behavior and deterrence of

that behavior should take priority (Cohen, 1992). On the other hand, the more

likely it is that the builder ‘built first and asked questions later’ (Goldberg,

1985, p. 71), the more willing courts should be to find for the owner by

implying a condition.

 

To take another example of the negligence-opportunism tradeoff, suppose

that a buyer rejects goods delivered late after a market price drop and the seller

sues. There are two contingencies here: the price drop and the late delivery.

The contract assigns the risk of the price drop to the buyer and the late delivery

to the seller. Textualism will not resolve this dispute: either the price term or

the time of delivery term cannot be read absolutely. It is not sufficient to say

that only the seller has breached, because what constitutes a breach and the

consequences of that breach are precisely what is at issue. Nor can it be said

that only the seller could take precautions here because neither party could do

anything about the price drop and the buyer did not cause the delay in delivery.

If the buyer’s rejection is viewed as opportunistic behavior, then refraining

from such behavior could be viewed as a ‘precaution’. Depending on the

circumstances, there is an economic argument to be made for implying a good

faith ‘limitation’ on the buyer’s ability to escape its obligations.

 

8. Court Error

 

One of the main criticisms of courts’ taking too contextualist an approach to

interpreting and implying contractual terms is the problem of court error and

incompetence. At one extreme, if courts make no errors in importing

contextualist evidence, then such evidence should always be allowed, at least

if the cost of producing such evidence is not too high. At the other extreme, if

courts make too many mistakes in interpreting or implying terms, then

textualism becomes superior if the transaction costs of contracting are lower

than the expected savings resulting from fewer court errors (Eric Posner, 1998,

pp. 542-544). If courts make the methodological error of choosing

contextualism in situations of high court error, then the parties will respond by

attempting to contract around the court’s rules through detailed language or

broad merger clauses, by avoiding courts (for example, arbitration) or contracts

(for example, vertical integration), or by engaging in inefficient contractual

behavior to adjust to the court’s erroneous legal standard.

 

But the problem of court error does not necessarily favor textualism. In the

first place, as Hadfield (1994) has argued, the feared inefficient responses to

court error may not occur. Developing a formal model of good faith clauses in

intentionally incomplete contracts in the presence of probabilistic court error,

Hadfield concludes that the possibility of court error does not always caution

against court intervention. If courts are of such low competence that the parties

cannot reduce their marginal liability by improving their contractual efforts in

a cost-justified way (that is, liability is essentially strict), then the parties will

not change their behavior under the contract and will adjust to the anticipated

court error by adjusting the price of the contract rather than by declining to

contract. On the other hand, if courts are of higher, but still limited,

competence, then enforcement of good faith clauses may lead to greater joint

profits for the parties than nonenforcement. This will occur if the court error

does not have too severe an adverse effect on the parties’ incentives, and if the

private mechanisms for inducing optimal effort without court enforcement are

relatively weak.

 

In addition, Hadfield argues that courts of low competence should not

follow bright line rules or precedent, but instead should use standards. By

bright line rules she means rules requiring a certain level of conduct that is

independent of changing economic conditions; for example, a bright line rule

might say to a supplier in an output contract that to act in good faith it cannot

reduce its output to zero unless continued production puts the firm on the verge

of bankruptcy. By standards she means required actions that vary depending on

the economic circumstances, such as a rule that says an agent subject to a best

efforts clause must adopt reasonable sales methods. Bright line rules thus

correspond to textualism, whereas standards correspond to contextualism.

Bright line rules may compound rather than ameliorate court error by a court

of limited competence, because a bright line rule setting forth a required action

will so often be ‘wrong’. Thus, parties will respond to a bright line rule either

by ignoring it or by conforming their behavior to the inefficient safe harbor

established by the rule. Standards, by contrast, are more likely to encompass the

‘efficient’ response because courts using standards will set the minimum

required action low and set the safe harbor high. Thus, contracting parties are

likely to realize that their marginal liability can be reduced through increases

in cooperative effort (because courts are likely to notice and take those efforts

into account), and so the parties will be encouraged to take steps in the

direction of optimal behavior. The point is that the presence of court error does

not preclude the desirability of court flexibility.

 

A similar argument might apply even outside the relational contract

context. The argument for textualism here is that if transaction costs are low,

court error will be minimized because the parties will be encouraged to put

more terms in the writing. Textualist courts will interpret this writing more

accurately than contextualist courts, which will sometimes erroneously rely on

contextual evidence in addition to the writing (Eric Posner, 1998, pp. 545-546).

The argument assumes that transaction costs include, as has been suggested

above, not merely the cost of drafting, but the cost of drafting in such a way that

courts make fewer interpretive mistakes. But low drafting costs may not be

sufficient to ensure that court error is reduced under textualism. If, for example,

drafting costs decrease (as they probably have due to technological progress) so

that it is relatively easy for parties to add more terms to their writings, court

error could in fact increase if more detailed contracts are more likely to have

conflicting terms or courts are more likely to misinterpret a term to cover a

particular contingency the parties did not intend to cover.

 

Another aspect of court error that some argue supports textualism is error

in interpretive methodology, namely the choice between textualism and

contextualism itself. The contracting parties may prefer textualism and express

that preference through, for example, merger clauses. But if courts make errors

in determining the parties’ intentions generally, they will also err in

determining the parties’ methodological preference. Courts may therefore

choose contextualism too often (Eric Posner, 1998, pp. 547-548, 570-571). But

once again, this conclusion depends on the assumption that if courts use

textualism (this time to decide the parties’ methodological preference) they will

err less often because the costs to the parties of accurately expressing their

methodological intentions are low. One would think, however, that the costs to

the parties of drafting a particularized methodological term are quite high.

Methodological preference is only a second-order concern for the parties. It is

difficult for the parties to predict how court error will likely impact the wide

variety of possible disputes they might have, and methodological preference

terms have no contractual use to the parties outside of litigation. As a result, it

is not obvious a priori that choosing a textualist approach minimizes court

error.

 

Suppose, for example, that the parties generally prefer a textualist approach

and expect interpretation x of some term. There are actually three ways the

court could err. The court could take a contextual approach but reach

interpretation x. Or the court could take a textual approach and reach

interpretation y. Or the court could take a contextual approach and reach

interpretation y. Although the parties prefer the textualist approach, it might

be more important to them that the court gets the term right, however the court

does it. If courts are more likely to choose the desired interpretation x using a

contextual approach and interpretation y using a textual approach - either

because the parties underestimate the courts’ competence with respect to that

term or because their expressed preference for textualism inaccurately conveys

the parties’ correct estimate of the courts’ competence in this instance - then

error costs could be reduced if the court ‘mistakenly’ used a contextual

approach.

 

To give a simple numerical example, suppose the court can choose either

a textualist or contextualist methodology. If it chooses textualism, the

likelihood of interpreting the term the way the parties want is 0.4; if it chooses

contextualism, the likelihood of interpreting the term the way the parties want

is 0.6. Suppose further that ex ante the parties would value the court’s using

textualism and choosing x at 100; would value the court’s using contextualism

and choosing x at 80; would value the court’s using textualism and choosing

y at 50; and would value the court’s using contextualism and choosing y at 10.

Thus, the parties prefer textualism to contextualism, but prefer the right

outcome more. The expected value if the court uses a textualist approach is (0.4

@ 100) + (0.6 @ 50) = 40 + 30 = 70. The expected value if the court uses a

contextualist approach is (0.6 @ 80) + (0.4 @ 10) = 48 + 40 = 88 > 70.

The point is that the possibility of court error does not always argue in favor

of textualism. Both textualist and contextualist methodologies lead to court

error. The real question is which methodology has the lowest error rate and at

what cost. It is hard to answer this question in the abstract. This may help to

explain why courts do not - and never will - use pure interpretive

methodologies, but tend to switch back and forth depending on the

circumstances.

 

9. Summary and Future Research

 

To a large degree, the economic approach to interpretation and applied terms

parallels the approach in other areas of contract law. Court intervention is most

justifiable when transaction costs are high and the likelihood of court error is

low. Transaction costs include not only the ex ante costs of drafting in such a

way as to reduce court error, but the ex post costs associated with sunk specific

investments that make possible opportunistic behavior, as well as the costs of

alternative governance institutions such as extralegal sanctions. Most of the

economic arguments that suggest a restrictive court approach to interpretation

and implied terms have counterarguments. Therefore the institutional and

contractual context matters greatly in deciding what approach

efficiency-minded courts should take. The literature to date has mapped out the

broad contours. Future work will have to do the hard digging. That means

paying more attention to why people write the contracts they do and the

circumstances that motivate nonperformance.

 


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