Developing an Analytical Framework for Contract Theory

Contract Theory: Contract Theory: Are Contracts Required for an Efficient Marketplace?

Contract Theory: Are Contracts Required for an Efficient Marketplace?

The primary business document that is used in the United States and most other countries of the world today is the contract. Contract law generally attempts to consider questions such as whether an enforceable contract actually exists, what the true meaning of that document is, whether a contract has been broken, and what compensation is due the injured party. This research paper is about theory of contract and provides a review of contemporary legal contract theories to answer the questions, “Why do we have contract law, anyway?,” and, “Is contract law justified because people require a moral framework in which they are bound by what they agree to, or is contract law a fundamental necessity for a functioning market? How does that inflect on the freedom of contract principle as courts started to restrain the freedom of contractors to promote welfare and to protect certain sectors of society such as consumers and employees?” To this end, this study provides a timely discussion concerning the relation between contract law and trust. A description of various analytical approaches to understanding contract theory is followed by a discussion concerning how important lawyers are in contract law for promoting trust in commerce will be provided. In this regard, some lawyers view contract law as a major factor in promoting trust in the market; other lawyers think that many other factors contribute to trust and they think that indeed contract law would undermine trust if it was the dominating factor.

Review and Discussion

Developing an Analytical Framework for Contract Theory.

Given its importance to the efficient functioning of an open market economy, it is not surprising that there has been much attention given to contract theory and its implications for consumers and businesses. In his book, Binding Promises: The Late 20th Century Reformation of Contract Law, Slawson (1996) reports that, “Contract law remained in its classical state until late in the 20th century, when the courts of the United States began reforms” (p. 3). Such classical contract had three distinguishing characteristics:

Virtually unlimited freedom of contract. Freedom of contract is the freedom to choose the contents of a contract. For example, a law that requires employers to maintain safe working conditions limits freedom of contract by preventing employers from contracting with their employees to accept unsafe working conditions;

Nearly unlimited contracting power. Contracting power is the power to make contracts; for instance, the Statute of Frauds constrains contracting power by preventing people from making contracts without writing and signing them; and, clear separation from tort. Tort is the category of laws that hold people liable for their harmful conduct; for example, tort laws require careless drivers to pay compensation to the victims of their actions and these characteristics have traditionally allowed people to make the contracts they chose, practically without limitation as to kind or extent (Slawson, 1996).

Such classical contracting was based on two fundamental precepts: (a) that people can serve their private interests by contracts, and (b) that contracts can serve the public interest well enough to enable governments to limit their functions to law enforcement and national defense; while these premises were unrealistic even under the relatively simple societal conditions of the nineteenth century, they were rationale and supportable in terms of the social context in which they emerged (Slawson, 1996). Today, though, in an era of increasingly globalized marketplaces, these expectations and guidelines have become unrealistic and the courts responded by making laws that increased consumers’ bargaining powers and placed public responsibilities on producers (Slawson, 1996).

Before examining any regulation of contracts, though, Collins (1999) suggests that it is important to gain some concept of a typical contractual relation itself: “This relation plainly differs from other types of human association, such as those found between friends, neighbors, members of a club, and between members of a family. Such an investigation of the social institution of contract presents a considerable problem, because the idea of contract possesses a confusing surplus of meanings” (p. 13). On the one hand, Black’s Law Dictionary (1990) defines a contract as “An agreement between two or more parties which creates an obligation to do or not to do a particular thing. As defined in Restatement, Second, Contracts, Section 3, ‘A contract is a promise or a set of promises for the breach of which the law gives a remedy, or the performance of which the law in some way recognizes as a duty’” (p. 322). In addition, contracts “contain the agreement of parties with the terms and conditions, and which serve as a proof of the obligation” (Black’s, 1990, p. 322).

On the other hand, though, Collins (1999) points out that in spite of the standard legal definition, contracts are viewed differently by different professionals depending on their respective roles in the contractual administration:

practicing lawyer identifies the key function of contracts as the planning of an economic relation;

The legal scholar views the rules of contract law as a particular source of private law obligations;

The socio-legal scholar perhaps considers contract law as a tool for the regulation of economic and social transactions; and, judge may treat contracts as creating binding rules of law between the parties, breach of which provides a justification for the imposition of state sanctions (Collins, 1999, p. 13).

The foregoing interpretations suggest that the multiplicity of contexts and meanings clearly indicates that the concept of contract is used not only to describe a key economic institution in a market economy, but to express more generally a central form of human association in modern society today (Collins, 1999). At its core, contract law therefore governs transactions that involving one or more promises. According to Mather (1999), “A promise is a commitment or assurance that something will (or will not) be done in the future. This commitment or assurance invites reliance by the promisee. When a person makes a promise, he in effect tells the promisee, ‘You can count on me, you can trust me, you can rely on me.’ As one commentator puts it, ‘promises are given to induce people to act upon them’” (p. 1).

Much of the research to date has been focused on some of the more nebulous aspects of contract theory, such as the legal codification of a moral commitment in the form of making a promise. According to Craswell (1989), “Among the topics addressed by moral philosophy is the obligation to keep one’s promises. To many philosophers, there is something strange (or, at least, something calling for explanation) in the idea that moral obligations can be created simply by an individual’s saying so — yet this is what seems to happen when a person makes a promise. Consequently, there is by now a large body of literature attempting to identify the exact source and nature of this moral obligation” (p. 489). Such moral obligations are in fact as old as mankind itself: “Since Roman times, the law of contract has been located as a part of the private law of obligations. The body of rules, principles, and concepts that comprise the private law of contract have their immediate source in authoritative legal materials such as Codes, statutes, and precedents. These positive statements of the law express interpretations and decisions about fundamental normative standards appropriate for the law of contract. Legal rules invariably rest on interpretations of other normative standards (Collins, 1999).

One such standard, for instance, might be the moral idea that promises should be kept which would subsequently be translated into a positive legal rule; however, more commonly, the transition from normative standard to a particular legal rule does not allow a simple transposition, and in fact, no legal system has ever simply adopted a legal rule requiring that all promises should be kept (Collins, 1999). Rather, the content of the law must be drawn from the robust dialogue that contains a variety of normative standards drawn from politics, morality, economics, public policy, conventions, and values internal to the legal system (Collins, 1999). These normative standards frequently compete and contain mutually exclusive or inconsistent values; therefore, the process of translation of these issues is accomplished through legal doctrinal writers, judges, and legislators, that may be viewed as being engaged in a dialogue both with the background normative standards and the legal system itself (Collins, 1999). According to Mather (1999), the promises codified in contracts take place in an overwhelmingly social context:

Promising takes place within the context of a social practice and derives its significance from that practice. A social practice is established whenever people engage in a regular pattern of conduct because they agree that this is the right way to act. The behavioral regularity that we observe in a social practice is the result of people internalizing the rules of the practice and judging each other’s conduct by these rules. In the social practice of promising, we have one important rule: “Keep your promises!” Most members of our society adhere to this rule most of the time, because they believe this is the right way to act. Because promises are usually kept, it is usually reasonable to rely on a promise, and promises are usually relied upon. (p. 1)

Despite its centrality to the human condition, the social practice of promising remains primitive and incomplete in comparison to other disciplines such as mathematics and linguistics (Mather, 1999). When it comes to the promises contained in contracts of any type, there are some general guidelines but these do not embrace all of the issues involved by any means. For example, “We have our basic rule, ‘Keep your promises!,’” Mather advises, “But the practice of promising does not determine, in any precise way, what counts as a promise. It is generally agreed that one need not say “I promise” in order to make a promise, but we have no agreed-upon test specifying which kinds of words or actions constitute a promise and which do not. Nor does our promising practice include a set of rules determining what counts as an excuse or justification for breaking a promise” (pp. 1-2). With regard to the private law of contract, three crucial sources of normative standards should be emphasized to help understand why promises are made and contracts are created: (a) theories of political obligation, (b) doctrinal integrity, and – market conventions, which are described further in Table 1 below.

Table 1.

Three Normative Standards of the Law of Contract.



Political obligation

Because the application of sanctions by the state comprises the practical outcome of the application of legal doctrine, private law responds to the governing political theories about the appropriate occasions for the use of state power and the type of sanctions which can be employed; since the law of contract transforms a social arrangement into a potential instrument for the application of sanctions backed by the force of the state, the legal system must ensure that this application of state power conforms to appropriate principles of justice, including due respect for liberty, equality, and solidarity. The relationship codified by legal doctrine can therefore be understood in part as a specialized branch of theories of justice and political obligation relating to the formation of binding associations between citizens.

Doctrinal integrity

The authority of law in modern societies depends in part on the perception that it achieves a system of governance that conforms to the ideal of the Rule of Law. This ideal is generally interpreted to require consistency in the application of law and the ability to justify the content of the law through rational evidence. These considerations exert a force on the development of legal doctrine because they require that its elaboration of the law of contract be presented as a coherent system of rules, based upon principle, without arbitrary distinctions. Legal scholarship perceives its central task to provide the rational elaboration of a coherent doctrinal system of law. Because of the economic importance of contractual relations in a market society, scholarship in the law of contract has been robust and profound.

Market convention

Private law cannot develop in complete isolation from one crucial normative dimension of social practice in markets; the law could not ignore conventional understandings of when binding commitments have been made, when they have been broken, and where unfair market practices have been deployed. These differ from country to country and region to region, but the parties themselves through their contractual agreement specify many of their reciprocal undertakings; however, these specifications will only incompletely describe their expectations. These expectations will also be discovered in the norms derived from the embeddedness of their relation, both in the sense of their personal relationship and their implicit reference to market convention. When pursuing the task of providing support for market transactions, in its application of state sanctions, legal regulation cannot ignore these conventional understandings because they may differ substantially.

Source: Collins, 1999, pp. 35-6.

According to Cheffins (1997), “Clearly, legal rules do matter sometimes. Nevertheless, they are certainly not always of fundamental importance. Often, company participants pay little attention to the state of the law. Furthermore, when they do, they are just as likely to be contracting around legal rules as complying with the applicable doctrines” (p. 31). Consequently, it is unrealistic and inappropriate to assume that the law will always control how companies are operated because the law is only one factor which influences corporate activities, and in many circumstances it is not the key one (Cheffins, 1997). This point is also made by Deakins and his colleagues (1994) who report that:

Empirical studies have consistently demonstrated a low level of awareness of contract law and legal sanctions on the part of business contractors themselves…. Trade customs, ‘unwritten laws,’ and repeat trading were found to provide an important mechanism for fostering trust, while contract law provides a residual form of security should all other things fail, and a basis for systematic planning over risk in certain agreements, particularly where firms deal overseas or with firms outside the industry where the normal trade customs do not apply. (p. 337).

Despite the growing body of research into contract theory and its interpretation, though, there remains a need for a comprehensive approach to analyzing the fundamental trust and obligatory issues involved. In their essay, “Contract Theory and the Limits of Contract Law,” Schwartz and Scott (2003) report that, “Contract law has neither a complete descriptive theory, explaining what the law is, nor a complete normative theory, explaining what the law should be. These gaps are unsurprising given the traditional definition of contract as embracing all promises that the law will enforce” (p. 541). There are also inherent problems involved with the method concerning issues of justification. In this regard, Charney asks, “Why are we bound by obligations to which we did not assent explicitly, but only hypothetically? It is by no means clear that individuals should be bound to hypothetical — as contrasted to actual — contracts, or even that it is appropriate to call such hypothetical contracts ‘contracts’ at all” (1991, p. 1817). The autonomy- or rights-based arguments for promissory obligation do not readily extend to merely hypothetical agreements; further, it is unclear from a consequentialist perspective that a rule implying obligations to which transactors “would have assented” generally will reduce, rather than increase, the costs of transacting (Charny, 1991, p. 1817).

Given the wide range of issues that can be embraced by contract theory, then, identifying an appropriate analytical approach has therefore assumed increasing importance in recent years but the authorities largely agree that no such technique has been forthcoming. For instance, Craswell (2003) maintains that economic analysis has failed to provide such a mechanism in two respects, both as a descriptive theory and as a normative one. “Descriptively,” he advises, “economics fails to predict existing doctrine: Either existing doctrine differs from the rules that economics identifies as efficient, or economics is too indeterminate to identify the most efficient rules. And normatively, this same indeterminacy also prevents economics from making any suggestions for the reform of contract law” (p. 903). Despite these constraints, Posner (2003) suggests that the economic analytical approach to understanding contract theory represents the most effective approach:

Modern economic analysis of contract law began about thirty years ago and, many scholars would agree, has become the dominant academic style of contract theory. Traditional doctrinal analysis exerts less influence than it did prior to 1970 and enjoys little prestige. Philosophical work on the nature of promising has captured some attention, but petered out in the 1980s, with little to show for the effort other than arid generalizations about the nature of promising. Academic critiques from the left no longer stir up excitement as they did twenty years ago. Scholarship influenced by cognitive psychology has so far produced few insights. Only economic analysis seems to be on solid footing. (Posner, 2003, p. 829)

This point is echoed by Deakin, Lane and Wilkinson (1994), who report that, “The possibility that the parties to a contract can independently enforce their agreement without recourse to law is addressed by the economic theory of repeated games. It is assumed that the parties will act in their own self-interest but that they will be able, through interaction, to develop cooperative strategies which will minimize the possibility of breach” (pp. 334-5). Such an economic analysis of contract law carries with it some fundamental assumptions. For example, a commonality involved in almost all types of economic analyses is the precept that individuals have preferences over outcomes, that these preferences tend to follow basic consistency conditions, and that individuals satisfy these preferences subject to an exogenous budget constraint (Posner, 2003). Contracts scholars typically assume that individuals do not have preferences regarding the consumption or well-being of other individuals, nor regarding contract doctrine itself; in fact, there is no preference for expectation damages, for instance (Posner, 2003).

The standard economic analytical approach to contract theory also assumes that the parties enter a contract in order to secure investment in a jointly beneficial project. The project could be as simple as the sale of a good from Seller to Buyer — with one party (or both) enhancing the gains by an investment that reduces the cost of production for Seller or increases the value of the good for Buyer — or as complex as the construction of a skyscraper. If Buyer can increase the value of the good by making investments prior to delivery, Buyer will want a guarantee that Seller will not increase the price after Seller has observed Buyer’s reliance. A contract can sometimes prevent Seller from holding up the Buyer in this way, and thus permit Buyer to invest with knowledge that he will enjoy the full return of his investment (Posner, 2003).

In their contracts, parties include terms describing performance and governing the main contingencies that affect the value of performance. Terms might describe the goods to be delivered, the date of delivery, or the identity of the party that bears the risk of an accident during the shipment. The terms might also release the seller from its obligation if a strike or similar event occurs. A theoretically complete contract would describe all the possible contingencies, but transaction costs — including the cost of negotiating and writing down the terms — and foreseeing low-probability events, render all contracts incomplete. In addition, parties might elect to use some terms or avoid others for strategic reasons in order to exploit superior bargaining power or information asymmetries; as a result, contracts are usually incomplete to some extent when they are executed and parties rely on custom, trade usage, and, in the end, the courts to complete the terms of the contract (Posner, 2003).

The terms that actually do appear in contracts, then, depend on what the parties are trying to accomplish, shared understandings about the relevant industry, transaction costs, general characteristics of their interaction such as asymmetric information and unequal bargaining power, and the background legal regime. The last factor, the legal regime, is the focus of the economic analysis of contract law. The question is, broadly speaking, what rules of contract law would best serve the interests of the parties. This question is asked in two different ways, depending on whether the scholar takes a descriptive or a normative approach (Posner, 2003).

A descriptive analysis of contract theory provides a “prediction” of contract doctrine. Built into this approach is the assumption that judges decide cases (and/or choose doctrine) in a manner that will serve to maximize efficiency of the system. The question why judges would decide cases in this way, or whether it is necessary for them to do so in order to generate efficient law, is bracketed. The author constructs a model in which parties would maximize their utility if they could enter an optimal contract. They cannot enter such a contract in the absence of legal enforcement, so the question becomes what legal rule enables the parties to enter the optimal contract. This hypothetical legal rule is then compared to actual legal rules, and, if they are the same, the descriptive hypothesis is vindicated (Posner, 2003).

The normative position assumes that contract law should be efficient. As before, the author constructs a model in which parties can increase their welfare through a contract that is legally enforceable. The author first shows the optimal outcome — where, for example, performance occurs only when the buyer’s valuation exceeds the seller’s cost, and buyer and seller make efficient investments — and then the equilibrium outcomes under alternative legal rules. Typically, the author recommends one rule as efficient, or shows that different rules are efficient under different assumptions, or else criticizes various existing rules because they do not enable the parties to achieve the optimal outcome (Posner, 2003).

In fact, even a theory of contract law that concentrates specifically on, say, the enforcement of agreements (as discussed further below) must still consider the entire spectrum of the issues ranging from standard form contracts between commercial enterprises and consumers to commercial contracts among and between businesses themselves (Schwartz & Scott, 2003). To date, there has not been a descriptive theory advanced that can explain a law of contract that takes into account the entire continuum of factors that can affect the formulation and enforcement of contracts.

On the one hand, normative theories grounded in a single norm (e.g., autonomy or efficiency) have been unable to adequately address the heterogeneity of contractual contexts to which the theory is to apply; on the other hand, pluralist theories that seek to address the inherent difficulty involved in unitary normative theories typically urge courts to pursue efficiency, fairness, good faith, and the protection of individual autonomy. In sum, the authors note that, “Such theories need, but so far lack, a meta-principle that tells which of these goals should be decisive when they conflict” (Schwartz & Scott, 2003, p. 542). In this regard, Schwartz (1998) suggests that contract theory applies when either of two market imperfections obtains: (a) hidden information or (b) hidden action. According to Schwartz (1998), “There is hidden information when a party does not know the “types” of its potential contract partners. For example, a seller who is considering whether to make a warranty does not know whether any particular buyer will be an intense user, and thus likely to make warranty claims, or a less intense user” (p. 1807).

The task of contract theory, then, is to identify the contract that the parties will make when one side of the market does not know the types — in this example, the different buyers’ use patterns — of the other side (Schwartz, 1998). According to Adams and Brownsword (1995), though, contractual rights that rely on information that can only be verified only at a prohibitively high cost are inefficient because they typically involve inordinately expensive litigation costs that are burdensome ex-post and, even more significantly, create an ex-ante uncertainty that commercial parties try to avoid. Likewise, Johnston and Zimmermann (2002) report that, “An instrumental conception of contract that understands the contractual relationship in the classical, adversarial model of self-interested exchange would yield to this preference for maximising the material surplus of the contract. Thus, as argued above, it would resist any attempt to apply a profits remedy to breaches of contract” (p. 358). An alternative view of modern contract law considers the contractual relationship (even in commercial settings) as a locus of competition or an instrument for the allocation of risks and the production of wealth, as well as being a potential area requiring mutual cooperation and confidence, dependence and vulnerability (Johnston & Zimmermann, 2002). According to these authors, “This conception of the contractual relationship requires the parties to protect one another and care for each other. To be sure, the contractual parties are not required to prioritize the interests of the other side. But the pursuit of their self-interest must be constrained; they must respect the legitimate interests of their fellow contractors; their obligations to their contractual partners may deviate from those to which they explicitly committed themselves” (Johnston & Zimmermann, 2002, p. 358).

Clearly, then, there are some differences of opinion concerning how best to interpret contract theory and what factors are the most important for understanding why people and businesses act the way they do when it comes to contract negotiations and fulfillment. Adding to the problem is the requirement for professional assistance in formulating contract instruments that may have profound implications for the actors, with different views being advanced on the importance of lawyers in the process, and these issues are discussed further below.

Importance of Lawyers to the Interpretation of Contracts.

In a day and age where virtually anyone can use standardized “boiler-plate” contracts to accomplish the routine requirements of their commercial transactions, are lawyers an obsolete addition to the interpretation of contracts today? The research makes it clear that while every situation is unique, of course, the exigencies of contract theory seem to call for the involvement of such legal professionals as part and parcel of their efficient administration. For instance, in his essay, “Hypothetical Bargains: The Normative Structure of Contract Interpretation,” Charny (1991) advises that, “To interpret contracts, lawyers ask: what would the parties have agreed to had they explicitly adverted to the issue? That is, the interpreter constructs a “hypothetical bargain”: he determines how the parties would have bargained to treat the situation that has arisen had it been directly presented to them at the time they were forming the contract. In particular, the hypothetical bargain framework is invoked to resolve two types of issues:

Courts use it to interpret “ambiguous” language; that is, to apply the language of a contract to a particular contingency which subsequently arises, “the court [] construe[s] the language… so as to give effect to what would have been the intention and agreement of the parties had their attention been drawn to events as they actually were to occur”; and,

Courts use the rule as one of “construction”: to supply “implied duties” in the face of a contingency that no language in the contract addresses. For example, in construing the scope of the implied duty of good faith, courts ask whether the parties ‘would have agreed to proscribe the act later complained of as a breach of the implied covenant of good faith — had they thought to negotiate with respect to that matter.’ Likewisey, ‘when supplying terms of an effective but incomplete contract a court properly picks those for which the parties probably would have bargained, had they anticipated the problem’ (Charny, 1991, p. 1816).

The duty of good faith reflects some important institutional values in the law of contracts. According to Clarke (1997), “In some legal systems there is a general contractual duty to (re)negotiate in good faith but this is not even current general contract law in England” (p. 151). Furthermore, despite having been made the determining factor in a number of recent contract law decisions, the precise meaning of good faith remains unclear today; none of the cases assigning a distinct doctrinal role to good faith in fiduciary duty analyses to date has been able to fully articulate the steps of that analysis and none has filled in the content of the emerging doctrine (Griffith, 2005).

At its most elemental level, good faith is based on the precept that the law should protect the fundamental expectations of good faith and reasonable conduct in the performance of contractual relations without requiring a corresponding express agreement of the parties; however, in recent years, the increasing trend towards textualism has threatened to completely negate the importance of this essential duty of good faith (Van Alstine, 1999). According to this author, “Under this view, we are left with a mere snapshot of the surface of contractual relationships, unable to examine the complexity of life below. The sum of the argument advanced here is that this new restrictive trend in interpretation is founded on fundamentally flawed premises about the proper function of good faith and fair dealing in the law of contracts” (Van Alstine, 1999, p. 1223).

There are other important issues of method and justification that remain unresolved as well. For instance, there is disagreement concerning the manner in which the hypothetical bargain test should be applied. A simple example illustrates the range of issues. Consider the question whether to imply a good faith term in an employment contract. The adjudicator can construct the “hypothetical bargain” in many different ways. He could ask: would this particular worker and firm have bargained for this term? Or he could ask: would workers and firms of this “type,” however defined, generally bargain for such a term? The adjudicator then would have to decide how general or widespread the purported outcome must be before it is taken as authoritative: all transactions, most transactions, a preponderance of transactions? Likewise, an adjudicator must determine what characteristics to ascribe to hypothetical bargainers. For example, should the potential outcome for workers and firms as currently informed be taken into account, or for workers and firms with all information that is now available to the adjudicator, even if the transactors do not have that information when they actually bargain? Should contract theory assume that workers and firms will apply their existing preferences and modes of thinking, or should analysts advance some “ideally rational” worker or firm? Clearly, such questions make contract interpretation problematic and potentially flawed for even legal professionals, so laypersons might be at a distinct disadvantage if they lack such guidance in the administration of a given contract (Charny, 1991).

According to Craswell (1989), contract law is inextricably related to promises, and philosophers of law (and philosophically minded lawyers) frequently draw on philosophical theories about promising when writing about contract law. This author cites as an example a book by Charles Fried, Contract as Promise, purports “to show how a complex legal institution, contract, can be traced to and is determined by a small number of basic moral principles….” From Fried’s perspective, a recognition of the proper philosophical basis of contract law leads to conclusions profoundly different from those that would result from any attempt to rest contract law on other social policies, such as economic efficiency or the redistribution of wealth. By contrast, Craswell maintains that such claims on behalf of philosophical theories of promising are greatly exaggerated: “In particular, analyses such as Fried’s have little or no relevance to those parts of contract law that govern the proper remedies for breach, the conditions under which the promisor is excused from her duty to perform, or the additional obligations (such as implied warranties) imputed to the promisor as an implicit part of her promise” (p. 489). These doctrines have traditional provided the framework in which to define the precise extent of contractual obligations, are frequently referred to as “background rules” or “default rules”; however, the term “default rules” more commonly refers only to those rules which the parties are free to vary by appropriate language in their contract (Craswell, 1989).

Because not all contract rules can be varied in this way, Craswell uses the term “background rules” to refer to both waivable and nonwaivable rules. The author does not maintain that philosophical theories about promising can have no implications for any part of contract law. Such theories may well have implications for questions about the proper scope of freedom of contract — that is, questions about whether any given rule ought to be merely a default rule, or whether it ought to be mandatory for all parties. In addition, certain philosophical theories may have implications for the proper content of contract law’s background rules. For example, theories that justify the enforceability of promises on grounds of economic efficiency, or on the special value of certain kinds of relationships, may imply that the law should adopt those background rules that are most efficient or that best promote the most highly valued kinds of relationships (Craswell, 1989).

Other philosophical theories, however — including the one endorsed by Fried — have no such implications for the content of the law’s background rules. These theories base the enforceability of promises on considerations of individual freedom and autonomy, or on the principle of fidelity to one’s prior statements or commitments. “In a nutshell,” Craswell advises, “the fidelity principle is consistent with any set of background rules because those rules merely fill out the details of what it is a person has to remain faithful to, or what a person’s prior commitment is deemed to be” (1989, p. 490). Therefore, although fidelity may determine that a promisor must in fact fulfill the obligations described by any set of background rules the law has adopted, it cannot guide the legal system in determining which set of background rules should be used for the purpose (Craswell, 1989). Furthermore, the principle of individual freedom is likewise unhelpful because it suggests that only that private individuals should be left free to change whatever default rule the law adopts as a starting point. Here again, some other value must be invoked to determine why one starting point should be selected by the law in preference to another: “If I am right, this means that it is not enough to reject notions such as economic efficiency, or theories that value certain kinds of relationships more highly than others, as insufficient or incorrect justifications for the basic proposition that promises ought to be enforced” (Craswell, 1989, p. 490).

Even when the parties to a contract strongly desire to be bound by an agreement, though, the law does not automatically assign effect to such mutual assent. According to Beatson and Friedman, “Each system may impose additional conditions for the validity of a contract, e.g., the requirement of consideration or that of a formal document. These rules impose a limitation on the positive notion of freedom of contract. If such requirements are not complied with, the contract does not exist or is unenforceable” (p. 27).

Because a contract is an agreement that sets forth specific enforceable legal relationships between the parties thereto, it is essential that the instrument be free of mistakes, but mistakes – which are inevitable in some cases — in contracts can usually be fixed after the instrument has been executed with or without the assistance of a lawyer. The parties to such a contract can mutually agree, for example, that a mistake has been made and appropriate revisions made to the contract. Of course, an arbiter or judge could also enforce a contract that contains a mistake, even if the party making such mistake objects depending on the circumstances; for example, “Where an action is brought on a written agreement which is signed by the defendant, the agreement is proved by proving his signature, and, in the absence of fraud it is wholly immaterial that he has not read the agreement and does not know its contents” (Waddams, 1993).

According to DiMatteo (1998), “The common law has long espoused the belief that the proper focus of the judge is to look backward to the genesis of the contract. Contractual intent as it existed at the formation of the contract is the only true guide to defining the contractual obligation. This narrow, backward-looking objectivity was the major justificatory force existing at the time of Williston’s First Restatement. Judicial decision making anchored in the bedrock of contractual intent has since passed. The Willistonian expectation that the judicial decision maker must affix blinders so as not to see the consequences of enforcing the parties’ private law does not reflect the reality of modern contract law. Fairness concerns have become an overriding force in the implication of contractual terms. The immutable rules of good faith, fair dealing, and unconscionability are far removed from the specific contractual intent of the parties” (p. 30).

While many observers might believe that the contract laws as applied throughout the United States and England are common elsewhere, the fact is that many other countries approach contracts in a very different manner based on cultural values and social practices. In their essay, “Trust or Law?,” Deakin and his colleagues (1994), ask, “Does the law have a role to play in fostering trust or is trust, on the contrary, an independent cultural phenomenon resting upon country or industry-specific factors which cannot readily be reproduced in different contexts” (pp. 329-30). In this regard, DiMatteo (1988) reports that, “French law approaches the issue of contractual intent in a direct, commonsensical way. The creation in the commercial world of a meaningless instrument is unthinkable. Why would two commercial entities create unenforceable instruments? Anglo-American contract theory would hold that such instruments are unenforceable because they lack clear contractual intent. French jurisprudence renders a contrary presumption that the objective person would presume that such commercial instruments possess an implied intent to be binding obligations de faire” (p. 30).

Likewise, the German contract law approach represents more than a difference in the degree of formalism or scope compared to other systems. For instance, DiMatteo notes that the objective effect of the judicial interpretation plays a major role in the implication of intent in German contract law. “The objectivity of result is intimately connected to the objectivity of intent,” he advises. “One goal of contractual interpretation and construction is to give effect to the purpose of the instrument. This teleological or purpose-oriented approach is less focused on the literal, objective meaning of the language of contract” (DiMatteo, 1998, p. 30). Instead of restricting themselves to a “literal interpretation of the wording of a contractual term,” Germans tend to consider the purpose of the contract and to interpret it in the way best suited to meet that purpose (Dimatteo, 1998).

To determine why the state plays an essential role in encouraging investment, Schwartz and Scott (2003) developed a simple model to explain why contracts are not legally enforceable. The sellers in this vignette can function in two distinct markets; sellers can produce a generic version of a particular product and sell the generic in a competitive market at a price that equals cost (including a return on the sellers’ investment). In addition, sellers can also produce a specialized version of the product for buyers that are willing to pay the extra expense. The authors advise that, “To be precise, a buyer’s valuation for the generic product is denoted [v.sub.g] and the cost of the product is simply g. Thus, the generic product will sell at the price g (because price equals cost in competitive markets) and generate a contractual surplus of [v.sub.g] – g. Suppose a particular buyer values the specialized version of the product at [v.sub.s] and that the product costs s to produce where’d > g)” (Schwartz & Scott, 2003, p. 542).

The authors emphasize that they have assumed that the seller’s investment to make the specialized product would not be redeployable; if the seller were to spend s but the deal were to break up, the seller would lose all of s. The parties prefer to produce the specialized product when that would maximize the contractual surplus. This leads to the efficient decision rule: Produce the specialized version when [v.sub.s] – s > [v.sub.g] – g. To make their example more concrete, the authors suppose the buyer values the specialized product at $80 ([v.sub.s] = $80); its cost is $50 (s = $50); the buyer values the generic version at $50 ([V.sub.g] = $50); and its cost is $40 (g = $40). On these values, the parties’ efficient decision rule requires the seller to produce the specialized product: It would generate a surplus of $30 while the generic would generate a surplus of $10 (Schwartz & Scott, 2003).

Should the parties contract as the efficient decision rule requires them to, they will tend to bargain over how to divide the expected $30 surplus. The division of the surplus will be determined by the bargaining game the parties play, and we assume for the reasons given above that they engage in deal-me-out bargaining. Deal-me-out bargaining will generate an equal split if the parties are equally patient bargainers because each party’s disagreement payoff ($10 for the buyer and $0 for the seller) is less than one-half the $30 surplus from producing the specialized product. “We suppose that the parties are equally patient, because firms commonly have similar costs of capital, so that a contract to produce the specialized product would split the bargaining surplus equally. An equal split is achieved by a $65 price” (Schwartz & Scott, 2003, p. 542).

The price at which the parties will ultimately transact, however, would not be $65, because the buyer’s incentive to cooperate vanishes after the seller invests s in the subject matter of the deal: To see why, assume that the contract was made as described. After the seller had made its investment, the buyer would have an incentive to demand renegotiation of the price. At that point, the investment cost s would have been sunk and so would be ignored in the new bargain: The only issue for the parties would be whether to trade the specialized product at some price or not to trade. Trading would produce a gross gain of $80, the buyer’s valuation, while not trading would produce no value. The parties thus would trade, dividing the $80 gain equally. If the price were reduced to $40, the buyer would receive a $40 payoff and the seller would lose $10 ($40 less its cost of $50). Because the seller would lose its entire $50 investment if the parties failed to trade, it would be compelled to agree to the new price (Schwartz & Scott, 2003).

The lesson that this example illustrates is not that the parties’ ultimate transaction prices would differ from their initial contract prices; the point, rather, is that when contracts are unenforceable a sophisticated seller will refuse to produce the specialized product, even though producing it would maximize expected surplus. The seller would anticipate losing $10 under a renegotiated contract to produce the product rather than earning $15 under the initial contract. Therefore, the seller would produce the generic product, an outcome that is fundamentally inefficient. “The generic product generates a social surplus of $10, while the specialized product would have generated a surplus of $30” (Schwartz & Scott, 2003, p. 543).

By contrast, the parties would cooperate to produce the specialized product, however, if the buyer’s promise to pay the contract price were legally enforceable. Under the Uniform Commercial Code (UCC) (and the common law of contracts as well), the seller could treat the buyer’s demand to renegotiate rather than perform as an anticipatory breach. In this case, the seller then would be entitled to recover the price if the goods contracted for could not be resold at a reasonable price (Schwartz & Scott, 2003). Furthermore, because the seller could not resell the specialized product for a positive price (its investment, recall, is assumed not to be redeployable), it could therefore recover the original $65 price from the buyer. Recognizing this, the parties would write the contract to produce the specialized product and trade it for $65 because the seller would anticipate being compensated for its investment, and the buyer would prefer to have the specialized product and realize a $15 payoff rather than have the generic product and realize a $10 payoff (Schwartz & Scott, 2003).

The foregoing analysis suggests two important conclusions:

Contract remedies are thought to protect injured promisees — the seller here — by awarding the expectation interest. This view is true but shallow. If contracts were not enforceable, sophisticated commercial parties seldom would put themselves in positions where they needed the law’s aid. They would instead act as would the seller here, who would produce the generic product and sell it on the market rather than subject itself to exploitation. Enforcement actually empowers promisors by enabling them to make credible promises to perform or to pay. The buyer in our example, when a contract is contemplated, thus wants the power to make a legally enforceable — that is, a credible — promise to pay the seller the $65 contract price. Enforcement, in sum, permits parties to make believable promises to each other when reputational or self-enforcement sanctions will not avail.

The example also serves to explain the very small amount of foreign direct investment that private parties have made in the former Soviet states and in many Third World countries. Much of this investment would have been relation-specific (e.g., building a factory far from the home country, developing a mine or an oil field). Potential investors would not deal unless the host country or local firm could make credible promises to adhere to the terms originally agreed upon rather than renegotiate those terms after investments had been made. The lack of enforcement rules and honest courts in many of these countries, however, prevents the local parties from making promises that are more believable than was the buyer’s promise in the example above. In response, foreign parties reduce investment. “The ability of a firm to make a credible promise, which lawyers in developed countries take for granted, is a regrettably rare power in many parts of the world” (emphasis added) (Schwartz & Scott, 2003, p. 543).


When consumers and commercial enterprises enter into virtually any type of agreement, promises are usually made that may become legally enforceable. The research showed that the contracts are the primary business instrument used to transact commercial exchanges in the United States and abroad today. The research also showed that the basic provisions of classic contracting have been replaced by increasingly active judicial oversight, particularly in the developed nations of the world, where reliance on the promises contained in contracts remains an essential element in the efficient functioning of the marketplace. In this environment, it is reasonable to conclude the past elemental definitions of trust must be reevaluated in terms of more sophisticated, but alas also more negative, views of how and why people and commercial enterprises behave the way they do. In the final analysis, contract law serves as a bastion of last resort because people will tend to behave in ways that maximize their self-interest at the expense of others and will try to get away with whatever they can absent some external constraint.


Adams, J., & Brownsword, R. (1995). Key issues in contract. In D. Johnston & R. Zimmerman (Eds). Unjustified enrichment: Key issues in comparative perspective. Cambridge, UK: Cambridge University Press.

Beatson, J.E., & Friedmann, D.E. (eds.). 1997. Good faith and fault in contract law. Oxford: Clarendon Press.

Black’s law dictionary. 1990. St. Paul, MN: West Publishing Co.

Buckley, F.H. (ed.). (1999). The fall and rise of freedom of contract. Durham, NC: Duke University Press.

Charny, D. (1991). Hypothetical bargains: The normative structure of contract interpretation. Michigan Law Review, 89(7), 1817.

Clarke, M.A. (1997). Policies and perceptions of insurance: An introduction to insurance law. Oxford: Clarendon Press.

Craswell, R. (1989). Contract law, default rules and the philosophy of promising. Michigan Law Review, 88(3), 490.

2003). In that case, what is the question? Economics and the demands of contract theory. Yale Law Journal, 112(4), 903.

Collins, H. (1999). Regulating contracts. Oxford: Oxford University Press.

Deakin, S., Lane, C., & Wilkinson, F. (1994, September). ‘Trust’ or law? Towards an integrated theory of contractual relations between firms. Journal of Law and Society, 21(3), 253- 323.

DiMatteo, L.A. (1998). Contract theory: The evolution of contractual intent. East Lansing, MI: Michigan State University Press.

Fried, C. (1981). Contract as promise. Cambridge, MA: Harvard University Press.

Griffith, S.J. (2005). Good faith business judgment: A theory of rhetoric in corporate law jurisprudence. Duke Law Journal, 55(1), 1.

Johnston, D., & Zimmermann. R. (2002). Unjustified enrichment: Key issues in comparative perspective. Cambridge, UK: Cambridge University Press.

Mather, H. (1999). Contract law and morality. Westport, CT: Greenwood Press.

Posner, E.A. (2003). Economic analysis of contract law after three decades: Success or failure? Yale Law Journal, 112(4), 829.

Schwartz, A. (1998). A contract theory approach to business bankruptcy. Yale Law Journal, 107(6), 1807-51.

Schwartz, A., & Scott, R.E. (2003). Contract theory and the limits of contract law. Yale Law Journal, 113(3), 541.

Slawson, W.D. (1996). Binding promises: The late 20th century reformation of contract law. Princeton, NJ: Princeton University Press.

Van Alstine, M.P. (1999). Of textualism, party autonomy and good faith. William and Mary Law Review, 40(4), 1223.

Waddams, S.M. (1993). The law of contracts 209 (3d ed.) in Buckley, 1999 at p. 83.

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