Spring 2013 Workshop
Andrew Verstein (Yale Law School)
Ex Tempore Contracting
Leading contracts scholarship explicitly assumes that contractual responsibilities are determined in the following way: parties determine many of their duties ex ante, by specifying terms at the time of contract formation, and the rest of the terms are left vague, for a court to specify ex post if it should prove important. This ex ante / ex post dichotomy, implicit in contract scholarship for some time, is used to explain attempts to model the optimal contracting and contract interpretation process. For example, parties use terms like "merchantable" quality when the cost of being more specific up front is higher than the cost of relying on court to later elaborate its meaning. Yet this dichotomy obscures a third, "real-time" approach to contracting: parties frequently leave terms unspecified, while delegating ongoing determination to someone other than a court. This Article identifies this phenomenon, which can be called—as opposed to ex ante and ex post—"ex tempore" contracting.
This Article evaluates ex tempore contracting through three case studies. Using a unique cache of data only recently made available, it explores a novel dispute management system now prevalent in the construction industry that calls for the use of "dispute boards." These expert panels radically reduce the cost and frequency of litigation by determining the parties’ responsibilities whenever the parties wish, including in the course of performance. Yet ex tempore contracting is not merely a dispute resolution system for the construction industry. Ex tempore contracting is also essential to the massive financial derivatives market, subprime mortgages, industrial supply contracts and countless other transactions.
The pervasiveness of ex tempore contracting has profound implications for judicial interpretation of contracts. Realizing that the parties may have wished to allocate determination to an agent, rather than themselves ex ante or the court ex post, casts doubt on the use of penalty defaults, problematizes the debate about interpretative formalism, and urges judges to accept, rather than hinder, parties’ choice to rely on ex tempore contracting.
Gillian Hadfield (USC Gould School of Law)
Scaffolding: Using Formal Contracts to Build Informal Relations to Support Innovation
In a study that follows in Macaulay’s (1963) footsteps, we asked businesses what role formal contract law plays in managing their external relationships. We heard similar answers to the ones Macaulay obtained fifty years ago from companies who described important but non-innovation-oriented external relationships. But we also uncovered an important phenomenon: companies that described innovationoriented external relationships reported making extensive use of formal contracts to plan and manage these relationships. They do not, however, generate these formal contracts in order to secure the benefits of a credible threat of formal contract enforcement; instead, like Macaulay’s original respondents, they largely relied on relational tools such as termination and reputation to induce compliance. In this paper we first present examples of this phenomenon from our interview respondents, and then consider how conventional models of relational contracting can be enriched to take account of a very different role for formal contracting, independent of formal enforcement. In particular, we propose that formal contracting—meaning the use of formal documents together with the services of an institution of formal contract reasoning—serves to coordinate beliefs about what constitutes a breach of a highly ambiguous set of obligations. This coordination supports
implementation of strategies that induce compliance—despite the presence of substantial ambiguity ex ante at the time of contracting—with what is fundamentally still a relational contract.
Jonathan Barnett (USC Gould School of Law)
Hollywood Deals: Soft Contracts for Hard Markets
Hollywood film studios, talent and other deal participants regularly commit to big-budget film projects on the basis of unsigned “deal memos” or draft agreements whose legal enforceability is uncertain. These “soft contracts” constitute a hybrid instrument that addresses a challenging transactional environment where neither formal contract nor reputation effects adequately protect parties against the holdup risk and project risk inherent to a film project. Uncertainly enforceable contracts supply an implicit termination and renegotiation option that provides some protection against project risk while maintaining a threat of legal liability that provides some protection against holdup risk. Historical evidence suggests that soft contracts substitute for the vertically integrated structures that allocated these risks in the “studio system” era. The prevalence of soft contracting in Hollywood and other markets suggests an efficiency rationale for the historical relaxation of formation requirements in contract law.
John C. Coates (Harvard Law School)
Allocating Risk Through Contract: Evidence from M&A and Policy Implications
In a hand-coded sample of M&A contracts from 2007-08, risk allocation provisions exhibit wide variation. Earn-outs are the least common means to allocate risk, indemnities are most common, followed by price adjustment clauses. Techniques for mitigating enforcement costs – escrows, holdbacks, and seller financing – are common. Target SEC registration and ownership dispersion correlate negatively with the use and extent of risk sharing. Target-owners retain risk more frequently, but not universally or exclusively, in industries in which current liabilities vary more, and when buyers and targets are in different industries. Bidder and target law firm agents match on bid value and prior deal experience, but law firm mismatches are common, and both law firm experience and experienced-based mismatches correlate with the use, variance, and design of risk allocation provisions. While asymmetric information and incentives are important, so are transaction and agency costs, implying roles for lawyers to serve as transaction-cost engineers and for policy-makers to set binding default rules of property, tort and contract law. Specific policy implications include: contract statutes of limitations should be shorter; default law should require minimum amounts in controversy and caps on post-closing contract liability; and lawyers should disclose to clients their M&A experience and typical outcomes of specific risk-allocation provisions.
Jonathan Parker (Northwestern Kellogg School of Management)
Valuation, Adverse Selection, and Market Collapses (with Michael Fishman)
Valuation has an externality: it creates information on which adverse selection can occur. We study a market in which investors (or lenders) buy uncertain future cash flows that are ex ante identical but ex post heterogeneous across assets from sellers (or borrowers) with reservation values. There exists a limited amount of a costly technology that can be purchased before the market opens that allows an investor to value an asset—to get a private signal of the future payoff of that asset. Because sellers of assets that are valued and are rejected can sell to other investors, there are strategic complementarities in the choice of the capacity to do valuation, the private benefits to valuation exceed its social benefits, the market can exhibit multiple equilibria, and the market can deliver a unique valuation equilibrium when it is more efficient to transact without valuation. In the region of multiplicity, the move from a pooling equilibrium to a valuation equilibrium is always socially inefficient and has many features of a financial crisis: interest rate spreads rise, trade declines, unsophisticated investors leave the market, and sophisticated investors make profits. The efficient equilibrium in the region of multiplicity can be ensured by a large investor with the ability to commit to a price. We characterize several policies that can improve on market outcomes.
Mitu Gulati (Duke Law School)
The Evolution of Eurozone Sovereign Debt Contracts (with Frank Smets)
A widely-held assumption about the ongoing euro area sovereign debt crisis is that the weaker members of the European Monetary Union, upon entry to the union, took advantage of the fact that the likelihood of a bailout was going to be higher in the EMU and over borrowed, engaging in what one might call debtor moral hazard. The decision to include Collective Action Clauses (CACs) in every euro area sovereign bond after January 1, 2013 can be seen as a mechanism to counteract this moral hazard problem. It makes debt restructuring less costly, private sector bail-in (PSI) more likely and therefore strengthens market discipline. In this paper, we test the assumption of debtor moral hazard by examining whether and, if so, how euro area sovereigns altered their contract terms in response to EMU entry. If they were trying to take advantage of the higher likelihood of bailouts in a monetary union, we would expect a shift toward contract provisions that make it tougher to restructure debt. If, however, debtors and creditors believed in the Lisbon Treaty’s “no bailout” clause, the prediction would be a shift in contract terms in the opposite direction (towards being easier to restructure). Examining detailed contract provisions since the 1990s, we find the latter: a shift towards easier-to-restructure contract provisions. Contrary to accepted wisdom, euro area sovereign borrowers and their creditors might in fact have taken the “no bailout” clause seriously at the time of their entry to the monetary union.
April 29 - CANCELED
Michael Roberts (Wharton)
The Role of Dynamic Renegotiation and Asymmetric Information in Financial Contracting
Using hand-collected data from SEC filings, we show that bank loans are repeatedly renegotiated in order to modify contractual constraints designed to mitigate information related problems. The typical loan is renegotiated every eight months, or four times during the life of the contract. The financial health of the contracting parties, the uncertainty of the borrower’s credit quality, and the purpose of the renegotiation govern the timing of these renegotiations. However, the relative importance of these factors depends critically on when in the relationship the renegotiation occurs. This temporal dependence reflects a decline in information asymmetry during the lending relationship such that lenders can write more efficient contracts and rely more heavily on observable signals of borrower credit quality when amending the contracts.
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Please note that the linked papers may not be the most current version, as these were the papers used during the workshop.