IMPLIED TERMS AND INTERPRETATION IN CONTRACT LAW
George M. Cohen
Edward F. Howrey Research Professor of Law
University of Virginia School of Law
© Copyright 1998 George M. Cohen
This entry examines the economic arguments for textualism and contextualism, the two primarymethodologies used by courts to determine the intentions of contracting parties with respect to theirperformance obligations. Textualism, which is rooted in the idea of complete contracting, calls for amore restrictive approach to implied terms and interpretation than contextualism, which is rooted in theidea of incomplete contracts. The primary conclusions are that, as in other areas of contract law, thechoice between the two interpretive methodologies depends on the transaction costs of drafting, therelative likelihood of court error, and the risks of opportunistic behavior. Neither methodologydominates so much that it should be uniformly employed, which is consistent with how courts actuallybehave.
JEL classification: K12
Keywords: Contracts, completeness, interpretation, implied terms, opportunism, contextualism,textualism
Questions of how courts interpret, and should interpret, contract terms and when courts imply, andshould imply, terms to which the contracting parties have not explicitly agreed loom large in contractdisputes and in the legal literature on contract law. Law and economics scholars, however, have writtenfar more extensively on other topics in contract law than on these questions. For example, JudgePosner's treatise has no section specifically discussing interpretation or implied terms, and discussescontractual good faith in only two paragraphs. Richard Posner (1998, p. 103, 126). Other leadingtextbooks also have no discussion of interpretation or implied terms. One possible explanation for thisdiscrepancy is that there is little need for research specifically on interpretation and implied termsbecause much of the economic analysis of other areas of contract law carries over straightforwardlyto these questions. An alternative explanation is that economic analysis has less to say aboutinterpretation methods than it does about other questions in contract law. This article, which willsummarize and expand on the literature that does exist, aims to demonstrate that economic analysis hasa good deal to say about interpretation questions, but the issues are complex and there are many fruitfulavenues for further research.
The argument that there is no real need for a separate economic analysis of interpretation andimplied terms stems from the fact that the delineation of the topic is based on legal rather than economicconsiderations. In contract law, interpretation usually refers to problems arising from express contractterms that are reasonably susceptible of more than one meaning. Implied terms are those that are addedto, or place limits on, expressly stated terms. The two are closely related, yet not identical. Forexample, if a contract contains a "best efforts" clause, determining what that clause requires is a questionof interpretation; if the contract contains no such clause, courts may have to decide whether to implya best efforts obligation and if they do, they have to determine the content of that obligation. On theother hand, some questions of interpretation do not involve questions of implication, for example, adispute over the meaning of the word "chicken."
In some sense, all contract disputes involve questions of interpretation and implied terms. Forexample, force majeure clauses--usually discussed in the context of the (implied) impossibilitydefense--present questions of interpretation, and most contract formation, excuse, and damage rulesare "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 ormore parties have performed as the contract requires, or have breached. Thus, I will assume forpurposes of this discussion that the parties have made an enforceable contract, there are no changedcircumstances or "mistakes" sufficient to give rise to an excuse claim, the applicable remedies in theevent of breach are accepted, and there are no third-party effects. How do courts decide--and howshould they decide--what the performance obligations are and whether the parties have met them?
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, acomplete contract has referred to one that provides a complete description of a set of possiblecontingencies and explicit contract terms dictating a performance response for each of thesecontingencies. 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 refugefrom 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 acourt 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 ofcompleteness does not get us very far. The concept can be rescued in one of three ways. One way isto view completeness as a useful benchmark, similar to perfect competition. Just as some markets areclose enough to being perfectly competitive that the perfect competition model is a useful predictor, sosome contracts may be complete enough that no reasonable interpretation or implied term questionsarise. The law refers to these contracts as "integrated." But tying completeness to integration simplyreduces to a tautology the statement that a complete contract obviates the need for interpretation orimplied 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 wayto rescue completeness is to recognize that contracting parties can make a contract complete by usinggeneral "catchall" clauses that state what happens in all unspecified states of the world. Hermalin andKatz (1993, p. 236); Hadfield (1994, p. 160, n.5). For example, a catchall clause might state: "Theprice term will be x, and will apply regardless of any change in circumstances or conduct by eitherparty." Alternatively, the parties could state their general desire not to have courts interpret or implyterms. But although contracting parties often use general clauses such as merger clauses, which directa court to apply a particular interpretive methodology (i.e., do not look beyond the writing), they donot seem to use catchall clauses that are broad enough to make contracts complete. Of course, clausesthat are not stated as catchalls could be--and sometimes are--interpreted that way, but, to lawyers atleast, 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, asopposed to completeness. Hadfield (1994, p. 163).
A third way to rescue completeness, more common in formal economic modeling, is to tie theconcept of completeness to the efficient use of available information. A complete contract is one thatmakes 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 notexpressly 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 theyhave in fact written one. And the ability of private parties to write economically complete contracts inthe real world is unclear. We do not seem to see, for example, contracts of the type described byHermalin and Katz, in which the contract leaves the quantity and price unspecified, then after someperiod one party names the price and the other names the quantity. Perhaps the costs of writing thesecontracts (including the costs of strategic circumvention) are too high. Perhaps the current enforcementregime 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 thequestion of their completeness is itself a legitimate question for judicial interpretation. Theincompleteness may be intended by both parties, which creates so-called "relational contracts," Goetzand Scott (1981), or "fiduciary contracts," Easterbrook and Fischel (1983, p. 438). It may result fromunintended "formulation error," which occurs when, as a result of defective contractual instructions, theoccurrence 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 mayresult from court error. Whether a contract that the parties think is complete, but is misinterpreted bya 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 mustassume that completeness means that a contract's terms are "unambiguous," that is, the contract termsrepresent a confluence of the parties' intentions and the court's ability to interpret those intentionscorrectly (unless the contract is somehow self-enforcing).
Incomplete contracts may be efficient contracts, even if the incompleteness is unintended. Thecosts of contractual completeness would often exceed the benefits, just as the costs of reducing crimeor pollution or accidents to zero would exceed the benefits. Incomplete contracts will tend to beefficient when contracts are relatively complex, that is, when there are a large number of low-probabilitycontingencies that could affect the value of contractual performance, and the efficient responses to thosecontingencies 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 completecontract are high.
More generally, in the language of institutional economics, a complete contract is only one formof "governance mechanism" for guiding the behavior of contracting parties. Al-Najjar (1995).Alternative governance mechanisms include the courts and extralegal enforcement, such as socialsanctions and reputation. In this approach, incomplete contracts will tend to be efficient whenevergovernance mechanisms superior to a detailed contract exist, that is, whenever the opportunity costsof completeness are high. In fact, contrary to the usual economic approach, the actual historicaldevelopment of contracts is probably best described as starting as incomplete as possible, thenbecoming more complete and formal as governance mechanisms other than the written contract provedto be inadequate.
The question of contract interpretation and implied terms is really a question of when the courtsare a superior governance mechanism. Courts may be able through interpretation and implied terms toprovide necessary flexibility--efficient adjustments to contingencies--that an incomplete contractotherwise lacks. Courts may also be superior to nonlegal institutions such as reputation becausereputation effects may be weak due to such things as cognitive dissonance, optimism about the abilityof a party with a poor reputation to change, the difficulty of knowing when a contracting partner hasbehaved badly, and the last period problem. In general, the role for courts in interpreting contracts andimplying terms increases as contracts become more efficiently incomplete.
Now suppose the contract is incomplete, as are most contracts that are the subject of litigation. Whatshould a court do? The economists' (and courts') usual assumption is that courts should follow theintentions of the parties, but to admit incompleteness is to admit that the intention of the parties isuncertain, or at least disputed (some would say nonexistent). The next best solution is to adopt theterm--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 (1994,p. 161); Hadfield (1992). First, courts might presume that complete contracting is both feasible anddesirable. This presumption has both a positive and a negative component. On the positive side, theexpress terms of the contract are presumed to be the best approximations of the parties' intentions anddeemed to create a complete contract. This strategy is usually referred to as textualism. On the negativeside, 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 andencourage complete contracting. This strategy is a variant of what has come to be known as penaltydefaults, Ayres and Gertner (1989), which is itself a variant of an old idea in the Austrian School ofeconomics that individuals should bear the consequences of their actions so that they become morerational over time. E.g., Wonnell (1986, p. 520).
The second general approach involves a presumption that contractual incompleteness isunavoidable 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 withreference to some standard external to the written contract. Courts might presume parties contractedwith reference to their current (course of performance) or prior (course of dealing) conduct, or to theconduct 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 UniformCommercial Code, are usually referred to as contextualist. Alternatively, courts might presume theparties contracted with the expectation that courts would fill in any gaps with a joint maximizing termthat would have been written by rational parties under conditions of low transaction costs. Goetz andScott (1981). In practice, the joint maximization strategy will often dissolve into contextualism, as courtslack the data necessary to do pure joint maximization.
It is important to remember that all of these strategies involve presumptions. It is all too easyfor courts or proponents of a particular strategy to criticize the alternatives as failing to hew closelyenough to the parties' intentions, when in fact the parties' intentions in incomplete contracts are at leastuncertain, and the question is which strategy is more likely to be successful at approximating theseintentions. For example, suppose a buyer rejects goods delivered late after the market price dropsbelow the contract price. A court might be called upon to decide whether to imply a good faithlimitation on the buyer's ability to reject. A textualist might argue no on the ground that such implicationwould 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 impliedrather than that the time of delivery term should be interpreted as absolute. A proposition thattextualism, contextualism, penalty defaults, or joint maximization best represents the parties' intentionsneeds to be defended. Economic analysis can help to identify the conditions under which the variousinterpretive strategies are more likely to approximate the parties' intentions, and whether courts arebetter off pursuing a pure interpretive strategy or a mixed one.
The recognition of incomplete contracting and the uncertainty of contractual intent renders problematicanother distinction that has played an important role in economic discussions of contracts, namelydefault 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 tospecify some contract term, the court will fill in the gap and supply one; and (3) if the parties fail tospecify 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 ofa 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 thecourt knowingly: (1) imposes a term that contradicts a term the parties specified; (2) refuses to fill ina gap that the parties left when the parties wanted the court to fill the gap; and (3) fills in a gap that theparties did not want the court to fill in.
When economists refer to mandatory terms, they usually mean the first sense, that is the courtrejecting a term the parties specified. An example would be a liquidated damage clause deemed to bea penalty, or a term deemed to be unconscionable. The usual critique of mandatory terms is thatbecause they disregard the intentions of the parties, the parties who prefer these terms will be madeworse off. For example, if a court imposes a stronger performance obligation on an obligor than theparties intended, then future obligors will extract a higher price, which is more than the obligee wantedto pay (else he would have paid for it originally). E.g., Easterbrook and Fischel (1993, p. 431). Thiscritique makes sense if contracts are assumed to be complete.
But once we allow for the possibility of efficiently incomplete contracts and unclear intent, it becomesmuch more difficult to distinguish mandatory rules from default rules. Take, for example, the impliedduty 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 believesthat parties may write incomplete contracts for which they expect courts to fill in the gaps, the duty ofgood faith or the duty of loyalty might easily be viewed as a default. If the parties want a particularobligation that conflicts with what courts ordinarily view as good faith or loyalty, and they specify thatobligation, 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 loyaltyto fill in gaps that the parties did not want to be filled, or to reject obligations the parties thought theyhad 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 maysometimes decline to fill gaps the parties have left in contracts. The doctrine could be viewed as adefault 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 fillingin the terms themselves. Alternatively, the doctrine could be viewed as a mandatory rule if one assumesthat 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 theassumptions being made about contractual completeness and intent, and so do not by themselvesresolve the questions of implied terms and interpretation.
If the contracting parties wanted to write a complete contract but failed in some way, the failure can beviewed as analogous to an accident in tort law. The accident may occur because one or both partiesfailed to take cost-effective "contract-based precautions." Cohen (1992, p. 949). Alternatively, oneof the parties might make a contract incomplete to serve his strategic bargaining interests by withholdinginformation. In either case, courts can use the doctrines of interpretation and implied terms to encouragethe parties to "facilitate improvements in contractual formulation." Goetz and Scott (1985, p. 264). Oneway to encourage better contracting is to encourage more complete contracts, that is, the greater useof express written terms. If a court is willing to "insure" parties through flexible interpretations andimplied terms it creates a classic moral hazard problem: the parties have less incentive to write goodcontracts themselves, for example contracts with more precise language. Doctrines such as the parolevidence rule encourage parties to write more complete contracts by giving more weight to the writtendocument and limiting the extrinsic evidence courts can consider. Strict application of these doctrinesmay thereby increase the accuracy of contract enforcement (reduce contractual accidents) by reducingthe 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 theprecautions are cost-effective. That will be the case if one or both of the contracting parties face lowex ante transaction costs of drafting and monitoring express contract terms that successfully specifyperformance obligations in response to different regret contingencies, as well as if the expected lossesfrom interpretive accidents are high. Eric Posner (1998, p. 543-547). Moreover, courts must be ableto identify accurately situations in which precautions are cost-effective. Usually, the best courts can dois 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 disputeto other litigated contracts. Eric Posner (1998, p. 553-561).
In comparing contracting parties, courts might conclude that one contracting party is the "leastcost avoider," or in this case the "cheaper contract drafter," namely the party in a better position toclarify a term or to identify what should happen in the event of some contingency. This approachexplains such interpretive rules such as contra proferentum, which encourage the party in the betterposition to draft a more complete contract to do so. Similarly, if one of the parties is a repeat contractoror is assisted by legal counsel and the other is not (as in many consumer contracts), imposing liabilityon the repeat and represented contractor in cases of contractual ambiguity or incompleteness willencourage that party to improve the terms of its contracts. In addition, if one of the parties has aninformational advantage, imposing liability on that party could encourage similarly situated parties in thefuture to reveal the information. But there may not always be a "cheaper contract drafter," or if thereis, the necessary precautions might not be cost-effective. Such might be the case, for example, with aparty who commits a "scrivener's error" in a written contract, especially if the error is one that the otherparty could reasonably have noticed.
The alternative of comparing similar contracts rather than contracting parties can also yieldsome useful guidelines. For example, one piece of relevant evidence about ex ante transaction costswould be how common a particular term is in similar contracts. The more common a term, the morelikely the costs of contracting over that term are low. Courts can then presume that most parties whowanted such a term would have contracted expressly for it and those who have not can be deemednegligent 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 identifysimple contracts or common or crucial terms, there is a further difficulty: ease of contracting may notbe a sufficient justification for imposing liability.
The reason is that encouraging better contracting does not necessarily mean encouraging greatercontractual completeness; it may mean encouraging greater contractual incompleteness through relianceon implied terms. Under a majoritarian default approach to implied terms, courts would minimizetransaction costs by choosing the mix of express and implied terms that most contracting parties wouldwant. The majority of contracting parties might want courts to use implied terms, especially inwell-developed markets, because they believe that will save on the costs of contracting, even if thetransaction costs of contracting are relatively low. Alternatively, the majority of contracting parties mightbelieve that relying solely on express terms--even those that simply try to mimic implied terms--mightbe less reliable than relying on well-established implied terms either in conjunction with or instead ofexpress terms; that is, they might fear court misinterpretation more than court misimplication. The onlycontracting parties who should be encouraged to contract more explicitly under this approach are thosewho have "idiosyncratic" preferences. Thus, the fact that parties fail to contract expressly (orunambiguously) for a given term--even a common or crucial one--may simply be an expression of intentto 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 ina trade to develop such usages (which are majoritarian understandings) and to familiarize themselvesrapidly 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 acceptor 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 elaboratedefinition 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 areoften ill-equipped to make, though to the extent that there is a recognized trade usage, or a course ofdealing or course of performance, this problem is mitigated. Verkerke (1995) attempts to remedy thisproblem in the context of employment contracts by surveying employers about the discharge termscontained in their employment documents. He found that 52% of employers reported that theiremployment documents specified an "at will" provision (the prevailing default), 15% reported that theirdocuments contain a "just cause" provision, and 33% reported that they do not have documents thataddress the issue explicitly. Verkerke (1995, p. 867). He also found that larger firms and firms frommore "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 wouldbe that a broadly defined just cause provision is not a majoritarian default, but given the limitationsmany 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 willdoctrine 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 whenthe parties have contracted around the default. Goetz and Scott (1985) argue that it is often difficult forcourts to tell whether parties are using express terms to trump (opt out of) implied terms or merely tosupplement them. That is, it may be difficult for courts to tell in a particular case whether the partiesintended to incorporate implied terms by writing an incomplete contract, or whether they intended theexpress terms they used to create a complete contract; thus, the contractual "accident" results from theparties' unintended failure to resolve the tension between the express terms and implied terms. Themore courts favor and encourage implied terms and common usages, the more costly it becomes forthe parties who want to contract out of those terms to do so. As discussed above, ostensible defaultrules begin to look more like mandatory rules. The courts' choice of interpretive strategy, therefore, mayaffect not only the parties' incentives to contract more expressly, but also their ability to contract aroundthe implied default rule.
Goetz and Scott argue that the more likely it is that contracting parties will be unhappy with thecourt's implied terms and interpretations--the more heterogeneous contracting parties are likely tobe--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--thatis, where the transactional variance is low--the more likely a contextual approach will be efficientbecause it will foster the development of more standardized terms by trade groups, lawyers, and theparties 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, p. 553, 556). Implementingthis notion is often more difficult than stating it, however.
For example, Goetz and Scott suggest that in well-developed markets courts should generallyallow context evidence to supplement express terms, but should generally not allow context evidenceto override the plain meaning of express terms. Goetz and Scott (1985, p. 313-315). Eric Posner hasrecently criticized this argument on the ground that there is no theoretical justification for having aflexible approach with respect to incompleteness (implied terms) but a strict approach with respect toambiguity (interpretation of express terms). Eric Posner (1998, p. 559-560). On the one hand, it shouldnot matter whether the parties use, for example, a best efforts clause or leave one out and let the courtimply it; if the courts consider extrinsic evidence in one case, they should do so in the other. On theother hand, the "plain meaning" of a best efforts clause requires a kind of context evidence, namely thegeneral understanding of the clause. Thus, there may be no inconsistency in having a flexible approachto incompleteness and a plain meaning approach to ambiguity: both favor allowing a certain type ofcontextual evidence, namely general contextual evidence. The problem arises when the contextualevidence being considered is not general but specific to the contracting parties, such as course ofdealing, course of performance, or prior negotiations. Here a flexible approach to incompletenesswould allow the specific context evidence to trump the general, but the plain meaning rule would havethe general context evidence trumping the specific. At this level of generality, Posner's argument seemscorrect. Although one could imagine cases in which a court might want to use a flexible approach toincompleteness and a strict approach to ambiguity, it is difficult to make any general statements aboutsuch cases; in fact, one could just as easily imagine cases in which a strict approach to implied termsand a flexible approach to ambiguity would be appropriate. Goetz and Scott's argument about the plainmeaning rule perhaps should be read as limited to express terms that are commonly understood asgeneral trumping terms that override implied terms, such as merger clauses, disclaimers, or clausesgranting one party broad discretion. If the parties go to the trouble of using such a general trumpingterm, then arguably that should be a sufficient signal of their idiosyncracy. But even this interpretationis unsatisfactory because, as with the at will term discussed above, it may not be clear whether theparties simply intended to use the trumping clause to reject an overly broad implied term or whetherthey also meant it to convey the full measure of the parties' obligations to the exclusion of all extrinsicevidence.
The discussion in this section so far has assumed that ex ante transaction costs are low. Thehigher the ex ante transaction costs of drafting and monitoring become, the less likely it will be efficientfor a court to adopt restrictive rules of interpretation and implied terms that encourage parties tocontract more explicitly, because it will not be cost-effective for the parties to do so. Reliance on thetypes of contextual evidence discussed above now becomes relatively more cost-effective as theaccuracy of the written contract declines. If courts take too restrictive a view of interpretation andimplied terms, the development of cost-saving interpretive devices might be discouraged in favor ofmore complete, but costlier, writings. Burton (1980, p. 373). Alternatively, too few contracts might beformed ex ante, as the promisor's costs rise to cover an anticipated remedy that the promisee does notvalue at this cost. And too much performance might occur ex post, as the promisor performs even whenthe 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 ofhigh-transaction costs contracts are principal-agent contracts usually referred to as "fiduciary." Thesecontracts typically involve complex tasks for which the principal cannot easily measure the agent's effortor outcome, thus making express contracting difficult. Easterbrook and Fischel (1993, p. 426); Cooterand Freedman (1991a, p. 1051). Other examples include contracts between unsophisticated partiesor long-term contracts. Even in high-transaction cost contracts, however, a more restrictive approachto interpretation and implied terms might be appropriate if the contracting parties' preferences withrespect to certain obligations are likely to be idiosyncratic, or equivalently if the relevant contextevidence is less reliable. Eric Posner (1998, p. 557-558). By the same token, the same concerns raisedby high-transaction cost contracts might exist even in ordinary sales contracts. For example, if acontract allows for a 10% variation in the quantity for the (unstated) purpose of avoiding liability overloss during transportation, a question might arise whether the seller could take advantage of thisprovision to deliberately increase or decrease the quantity as the market price drops or rises. Althoughone could say that the buyer could contract to prevent such behavior by, say, limiting the applicationof the quantity variation provision to losses suffered in transit, Gillette (1981, p. 655), it may be quitedifficult to draft such a clause. What should happen, for example, if both a market price change anddamage to the goods occur? What about damage to the goods before and after transit? Is it alwaysdesirable to have the parties provide explicitly for all these contingencies? The point is that a givencontract may be viewed as low-transaction cost for some purposes and high-transaction cost for others.
Getting the mix of express and implied contracting terms right--that is, encouraging the optimallycomplete written contract--is only one consideration (and perhaps not the most important) that courtsdo or should face when deciding questions of interpretation or implied terms. A second approach tothe question of how courts should interpret contracts and when they should imply terms focuses not onencouraging efficient contracting, but on deterring opportunistic contractual behavior (thoughobviously the two overlap). Opportunism can be broadly defined as deliberate contractual conduct byone 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 anattempted redistribution of an already allocated contractual pie, that is a mere wealth transfer. Muris(1981); cf. Burton (1980, p. 378). For example, a contract may require B to paint A's portrait "to A'ssatisfaction." Richard Posner (1998, p. 103-104). This provision allows A to reject the portrait evenif others like it if it does not suit A's taste. But if A rejects the portrait for reasons other than unhappinesswith the painting's quality--say because A remarries a spouse who doesn't want A's portrait in thehouse--A acts opportunistically.
The problem of opportunistic behavior is perhaps the key justification for court intervention incontracts. In general, "the threat of opportunism increases transaction costs because potentialopportunists and victims expend resources perpetrating and protecting against opportunism," which "donot 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. Evenif contracting parties could anticipate all of the possible changes in economic variables, they would havea much harder time anticipating and protecting against opportunistic behavior by the other party. At theextreme, the more one contracting party is willing to contemplate the possible opportunistic behaviorof his contracting partner, the less likely he will be to want to contract with that partner at all. Somedegree of trust is necessary for contracting to occur. More important, many seemingly airtight contractterms can seem awfully leaky once a clever lawyer and a highly motivated client get through analyzingthem. Just as cartel members can often find ways to cheat on cartels involving the most standardizedproducts, so disappointed contractors can often find a way to act opportunistically in the moststandardized contracts. Because contracting parties cannot solve all problems of opportunism on theirown, 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 isoften "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. Thisunhappiness 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 otherparty had breached or to allow the contested behavior, even though the term was intended to handleanother situation. Alternatively, the disappointed party might be able to exaggerate or misrepresent theextent 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 agentwhen that agent has a conflict of interest, engages in self-dealing, or withholds information from theprincipal. Cooter and Freedman (1991a, p. 1054). More broadly, opportunism may be more possiblewhenever one party has a significant information advantage over the other. In other contexts, courts canfind "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, andthat risk materializes, the court should be skeptical of attempts by that party to escape his obligationsvia a different contract
term. The classic example is a change in market price. If a buyer in a requirements contract suddenlyexperiences 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 courtshould suspect opportunism, or in legal terms, a violation of the implied obligation of good faith. On theother hand, whereas a change in market price suggests opportunism, a change in economiccircumstances either not contemplated by the contract or whose risk the contract places on the partyseeking strict enforcement, suggests a lack of opportunism. To return to the requirements contractexample, if the buyer's requirements decrease or increase because of a change in costs or technologysubsequent to the contract, the buyer's behavior is likely not opportunistic (is in good faith) because thevery purpose of the requirements contract is to assign some risk of variation in the buyer's needs to theseller.
Another example of objectively verifiable circumstances on which courts can focus is ex posttransaction costs. If the market for substitute performance is thick, opportunism is less likely. Goetz andScott (1983). Opportunism can occur only when it is costly to switch to a new contracting partner, thatis, when at least one party has made sunk, specific investments. Although this test may be useful inestablishing general presumptions, it is of limited help in deciding specific cases. Litigated cases tendto be precisely those in which ex post transaction costs are likely to be high; otherwise, the cases wouldbe settled.
Although opportunism is often discussed as an ex post problem, opportunism can occur ex anteas well. For example, under a strict parol evidence rule, a party might intentionally make oral statementsthat the other party understands and relies on as part of the contract, then leave the provision out of (orput a contradictory provision in) the writing. One common situation is where a party tells the other toignore the terms on the back of the first party's forms, then later tries to enforce those terms. On theother hand, under a more flexible parol evidence rule, a party might intentionally "pad" the negotiationrecord 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 ofthe contract (a common practice in legislative history). Eric Posner (1998, p. 564-565). This latter formof opportunism helps explain why courts tend to be much more skeptical of evidence that the partiescan easily manipulate--especially prior negotiations--than evidence over which the parties have lesscontrol--especially common usages. It may also explain the motivation behind the use of merger clausesas well as one reason why they should not be interpreted too broadly. It is difficult for a party to predictin advance which negotiation tidbit the other side might seize on later, Eric Posner (1998, p. 572), soit is necessary to write a broad clause that excludes them all. The same is not true for less manipulableevidence, 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 ondetermining contractual intent, which is often uncertain. Stating that courts do and should deteropportunism does not by itself explain how courts do and should resolve the question of how todetermine contractual intent; it simply opens the question up. Professor Muris, who first articulated theopportunism 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] ofopportunism." Muris (1981, p. 561-62, n.110). Nevertheless the opportunism approach may havesomething to say about how courts should go about determining intent. First, courts should hesitate tointerpret a contract in such a way as to permit conduct that would ordinarily be understood asopportunistic. Second, courts should hesitate to attribute to contracting parties an intention not to havecourts police against opportunistic behavior. Cf. Muris (1981, p. 573, n.138). Because contextualismand textualism are both useful for deterring different types of opportunism, we should thereforeexpect--and we find--that courts are never completely committed to one or the other.
In many contractual disputes, there are often precautionary steps that both parties could have taken tohave avoided or mitigated the contractual loss. We have already considered one suchprecaution--drafting a better contract. Quite separate from the costs of drafting better terms are thecosts 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 arisk that the contract assigned to them or to extricate themselves from a vulnerable position of their ownmaking, which they could have avoided at low cost.
In these cases, courts may have to make judgments about the relative fault of both parties todecide whose behavior it is more important to deter in a particular case. In particular, if one party is theleast cost avoider of some contingency while the other party regrets the contract for other reasons andis opportunistically seeking to avoid its obligations, courts face a "negligence-opportunism tradeoff."Cohen (1992, p. 983-990). To take a classic example, suppose a builder promises to use a particularbrand of pipe in building a house but inadvertently substitutes a different, but functionally equivalentbrand, a fact not discovered by the owner until the house is nearly completed. The owner refuses tomake the final payment on the house. The court must choose between placing liability on the negligentbuilder or the potentially opportunistic owner. There is an economic case to be made thatopportunism--if sufficiently proved--is more costly behavior and deterrence of that behavior should takepriority. Cohen (1992). On the other hand, the more likely it is that the builder "built first and askedquestions later," Goldberg (1985, p. 71), the more willing courts should be to find for the owner byimplying a condition.
To take another example of the negligence-opportunism tradeoff, suppose that a buyer rejectsgoods 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 thelate delivery to the seller. Textualism will not resolve this dispute: either the price term or the time ofdelivery 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 doanything about the price drop and the buyer did not cause the delay in delivery. If the buyer's rejectionis 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 implyinga good faith "limitation" on the buyer's ability to escape its obligations.
One of the main criticisms of courts' taking too contextualist an approach to interpreting and implyingcontractual terms is the problem of court error and incompetence. At one extreme, if courts make noerrors in importing contextualist evidence, then such evidence should always be allowed, at least if thecost of producing such evidence is not too high. At the other extreme, if courts make too many mistakesin interpreting or implying terms, then textualism becomes superior if the transaction costs of contractingare lower than the expected savings resulting from fewer court errors. Eric Posner (1998, p. 542-544).If courts make the methodological error of choosing contextualism in situations of high court error, thenthe parties will respond by attempting to contract around the court's rules through detailed language orbroad merger clauses, by avoiding courts (e.g., arbitration) or contracts (e.g., vertical integration), orby 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, asHadfield (1994) has argued, the feared inefficient responses to court error may not occur. Developinga formal model of good faith clauses in intentionally incomplete contracts in the presence of probabilisticcourt error, Hadfield concludes that the possibility of court error does not always caution against courtintervention. If courts are of such low competence that the parties cannot reduce their marginal liabilityby improving their contractual efforts in a cost-justified way (i.e., liability is essentially strict), then theparties will not change their behavior under the contract and will adjust to the anticipated court errorby adjusting the price of the contract rather than by declining to contract. On the other hand, if courtsare of higher, but still limited, competence, then enforcement of good faith clauses may lead to greaterjoint profits for the parties than nonenforcement. This will occur if the court error does not have toosevere an adverse effect on the parties' incentives, and if the private mechanisms for inducing optimaleffort without court enforcement are relatively weak.
In addition, Hadfield argues that courts of low competence should not follow bright line rulesor precedent, but instead should use standards. By bright line rules she means rules requiring a certainlevel of conduct that is independent of changing economic conditions; for example, a bright line rulemight say to a supplier in an output contract that to act in good faith it cannot reduce its output to zerounless continued production puts the firm on the verge of bankruptcy. By standards she means requiredactions that vary depending on the economic circumstances, such as a rule that says an agent subjectto a best efforts clause must adopt reasonable sales methods. Bright line rules thus correspond totextualism, whereas standards correspond to contextualism. Bright line rules may compound rather thanameliorate court error by a court of limited competence, because a bright line rule setting forth arequired action will so often be "wrong." Thus, parties will respond to a bright line rule either by ignoringit or by conforming their behavior to the inefficient safe harbor established by the rule. Standards, bycontrast, are more likely to encompass the "efficient" response because courts using standards will setthe minimum required action low and set the safe harbor high. Thus, contracting parties are likely torealize that their marginal liability can be reduced through increases in cooperative effort (because courtsare likely to notice and take those efforts into account), and so the parties will be encouraged to takesteps in the direction of optimal behavior. The point is that the presence of court error does notpreclude the desirability of court flexibility.
A similar argument might apply even outside the relational contract context. The argument fortextualism here is that if transaction costs are low, court error will be minimized because the parties willbe encouraged to put more terms in the writing. Textualist courts will interpret this writing moreaccurately than contextualist courts, which will sometimes erroneously rely on contextual evidence inaddition to the writing. Eric Posner (1998, p. 545-546). The argument assumes that transaction costsinclude, as has been suggested above, not merely the cost of drafting, but the cost of drafting in sucha way that courts make fewer interpretive mistakes. But low drafting costs may not be sufficient toensure that court error is reduced under textualism. If, for example, drafting costs decrease (as theyprobably have due to technological progress) so that it is relatively easy for parties to add more termsto their writings, court error could in fact increase if more detailed contracts are more likely to haveconflicting terms or courts are more likely to misinterpret a term to cover a particular contingency theparties did not intend to cover.
Another aspect of court error that some argue supports textualism is error in interpretivemethodology, namely the choice between textualism and contextualism itself. The contracting partiesmay prefer textualism and express that preference through, for example, merger clauses. But if courtsmake 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,p. 547-548, 570-571). But once again, this conclusion depends on the assumption that if courts usetextualism (this time to decide the parties' methodological preference) they will err less often becausethe costs to the parties of accurately expressing their methodological intentions are low. One wouldthink, however, that the costs to the parties of drafting a particularized methodological term are quitehigh. Methodological preference is only a second-order concern for the parties. It is difficult for theparties to predict how court error will likely impact the wide variety of possible disputes they mighthave, 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 expectinterpretation x of some term. There are actually three ways the court could err. The court could takea contextual approach but reach interpretation x. Or the court could take a textual approach and reachinterpretation y. Or the court could take a contextual approach and reach interpretation y. Although theparties prefer the textualist approach, it might be more important to them that the court gets the termright, however the court does it. If courts are more likely to choose the desired interpretation x usinga contextual approach and interpretation y using a textual approach--either because the partiesunderestimate the courts' competence with respect to that term or because their expressed preferencefor textualism inaccurately conveys the parties' correct estimate of the courts' competence in thisinstance--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 orcontextualist methodology. If it chooses textualism, the likelihood of interpreting the term the way theparties want is .4; if it chooses contextualism, the likelihood of interpreting the term the way the partieswant is .6. Suppose further that ex ante the parties would value the court's using textualism andchoosing x at 100; would value the court's using contextualism and choosing x at 80; would value thecourt's using textualism and choosing y at 50; and would value the court's using contextualism andchoosing y at 10. Thus, the parties prefer textualism to contextualism, but prefer the right outcomemore. The expected value if the court uses a textualist approach is (.4 x 100) + (.6 x 50) = 40 + 30= 70. The expected value if the court uses a contextualist approach is (.6 x 80) + (.4 x 10) = 48 + 40= 88 > 70.
The point is that the possibility of court error does not always argue in favor of textualism. Bothtextualist and contextualist methodologies lead to court error. The real question is which methodologyhas the lowest error rate and at what cost. It is hard to answer this question in the abstract. This mayhelp to explain why courts do not--and never will--use pure interpretive methodologies, but tend toswitch back and forth depending on the circumstances.
To a large degree, the economic approach to interpretation and applied terms parallels the approachin other areas of contract law. Court intervention is most justifiable when transaction costs are high andthe likelihood of court error is low. Transaction costs include not only the ex ante costs of drafting insuch a way as to reduce court error, but the ex post costs associated with sunk specific investmentsthat make possible opportunistic behavior, as well as the costs of alternative governance institutionssuch as extralegal sanctions. Most of the economic arguments that suggest a restrictive court approachto interpretation and implied terms have counterarguments. Therefore the institutional and contractualcontext matters greatly in deciding what approach efficiency-minded courts should take. The literatureto date has mapped out the broad contours. Future work will have to do the hard digging. That meanspaying more attention to why people write the contracts they do and the circumstances that motivatenonperformance.
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© Copyright 1998 George M. Cohen