Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules, 99 Yale Law Journal 87 (1989) (with Robert Gertner)

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The legal rules of contracts and corporations can be divided into two distinct classes. The larger class consists of "default" rules that parties can contract around by prior agreement, while the smaller, but important, class consists of "immutable" rules that parties cannot change by contractual agreement. Default rules fill the gaps in incomplete contracts; they govern unless the parties contract around them. Immutable rules cannot be contracted around; they govern even if the parties attempt to contract around them. For example, under the Uniform Commercial Code (U.C.C.) the duty to act in good faith is an immutable part of any contract, while the warranty of merchantability is simply a default rule that parties can waive by agreement. Similarly, most corporate statutes require that stockholders elect directors annually but allow the articles of incorporation to contract around the default rule of straight voting. Statutory language such as "[u]nless otherwise provided in the certificate of incorporation" or "[u]nless otherwise unambiguously indicated" makes it easy to identify statutory default, but common-law precedents can also be divided into the default and immutable camps. For example, the common- law holding of Peevyhouse v. Garland Coal & Mining Co., which limited damages to diminution in value, could be contractually reversed by prospective parties. In contrast, the common law prerequisite of consideration is largely an immutable rule that parties cannot contractually abrogate.

There is surprising consensus among academics at an abstract level on two normative bases for immutability. Put most simply, immutable rules are justifiable if society wants to protect (1) parties within the contract, or (2) parties outside the contract. The former justification turns on parentalism; the latter on externalities. Immutable rules displace freedom of contract. Immutability is justified only if unregulated contracting would be socially deleterious because parties internal or external to the contract cannot adequately protect themselves. With regard to immutable rules, the disagreement among academics is not over this abstract theory, but whether in particular contexts parentalistic concerns or externalities are sufficiently great to justify the use of immutable rules.

When the preconditions for immutability are not present, the normative legal analysis devolves to the choice of a default rule. Yet academics have paid little attention about how to choose among possible default rules. The law-and-economics movement has fought long and hard to convince courts to restrict the use of immutable rules, but has lost most of its normative energy in constructing a theory of default choice. Economists seem to believe that, even if lawmakers choose the wrong default, at worst there will be increased transaction costs of a second order of magnitude.

Few academics have gone beyond one-sentence theories stipulating that default terms should be set at what the parties would have wanted. Frank Easterbrook and Daniel Fischel have championed the "would have wanted" theory in a number of articles suggesting that "corporate law should contain the [defaults] people would have negotiated, were the costs of negotiating at arms'-length for every contingency sufficiently low."

Similarly, Richard Posner has argued that default rules should "economize on transaction costs by supplying standard contract terms that the parties would otherwise have to adopt by express agreement." Douglas Baird and Thomas Jackson have argued that the default rules governing the debtor-creditor relationship "should provide all the parties with the type of contract that they would have agreed to if they had had the time and money to bargain over all aspects of their deal." While this literature has vigorously examined what particular parties would have contracted for in particular contractual settings, it has failed to question whether the "would have wanted" standard is conceptually sound.

Thus, although the academy recognizes the analytic difference between default and immutable rules, a detailed theory of how defaults should be set has yet to be proposed. Indeed, the lack of agreement over even what to call the "default" concept is evidence of the underdeveloped state of default theory. Default rules have alternatively been termed background, backstop, enabling, fallback, gap-filling, off-the-rack, opt-in, opt-out, preformulated, preset, presumptive, standby, standard-form and suppletory rules.

This Article provides a theory of how courts and legislatures should set default rules. We suggest that efficient defaults would take a variety of forms that at times would diverge from the "what the parties would have contracted for" principle. To this end, we introduce the concept of "penalty defaults." Penalty defaults are designed to give at least one party to the contract an incentive to contract around the default rule and therefore to choose affirmatively the contract provision they prefer. In contrast to the received wisdom, penalty defaults are purposefully set at what the parties would not want-in order to encourage the parties to reveal information to each other or to third parties (especially the courts).

This Article also distinguishes between tailored and untailored defaults. A "tailored default" attempts to provide a contract's parties with precisely "what they would have contracted for." An "untailored default," true to its etymology, provides the parties to all contracts with a single, off-the-rack standard that in some sense represents what the majority of contracting parties would want. The Restatement (Second) of Contracts' approach to filling gaps, for example, provides tailored defaults that are "reasonable in the circumstances." "Reasonable" defaults usually entail a tailored determination of what the individual contracting parties would have wanted because courts evaluate reasonableness in relation to the "circumstances" of the individual contracting parties. In contrast, Charles Goetz and Robert Scott have proposed that courts should set untailored default rules by asking "what arrangements would most bargainers prefer?"

This Article provides a general theory of when efficiency-minded courts or legislatures should set penalty defaults and how they should choose between tailored and untailored default rules. Some common-law and statutory defaults are flatly at odds with the "would have wanted" principle. Although this Article does not make the full-blown positivist claim that current default rules are efficient, it does offer a more complete explanation of the current diversity of defaults.

An essential component of our theory of default rules is our explicit consideration of the sources of contractual incompleteness. We distinguish between two basic reasons for incompleteness. Scholars have primarily attributed incompleteness to the costs of contracting. Contracts may be incomplete because the transaction costs of explicitly contracting for a given contingency are greater than the benefits. These transaction costs may include legal fees, negotiation costs, drafting and printing costs, the costs of researching the effects and probability of a contingency, and the costs to the parties and the courts of verifying whether a contingency occurred. Rational parties will weigh these costs against the benefits of contractually addressing a particular contingency. If either the magnitude or the probability of a contingency is sufficiently low, a contract may be insensitive to that contingency even if transaction costs are quite low.

The "would have wanted" approach to gap filling is a natural outgrowth of the transaction cost explanation of contractual incompleteness. Lawmakers can minimize the costs of contracting by choosing the default that most parties would have wanted. If there are transaction costs of explicitly contracting on a contingency, the parties may prefer to leave the contract incomplete.

Indeed, as transaction costs increase, so does the parties' willingness to accept a default that is not exactly what they would have contracted for. Scholars who attribute contractual incompleteness to transaction costs are naturally drawn toward choosing defaults that the majority of contracting parties "would have wanted" because these majoritarian defaults seem to minimize the costs of contracting.

We show, however, that this majoritarian "would have wanted" approach to default selection is, for several reasons, incomplete. First, the majoritarian approach fails to account for the possibly disparate costs of contracting and of failing to contract around different defaults. For example, if the majority is more likely to contract around the minority's preferred default rule (than the minority is to contract around the majority's rule), then choosing the minority's default may lead to a larger set of efficient contracts. Second, the received wisdom provides little guidance about how tailored or particularized the "would have wanted" analysis should be.

Finally, the very costs of ex ante bargaining may encourage parties to inefficiently shift the process of gap filling to ex post court determination. If it is costly for the courts to determine what the parties would have wanted, it may be efficient to choose a default rule that induces the parties to contract explicitly. In other words, penalty defaults are appropriate when it is cheaper for the parties to negotiate a term ex ante than for the courts to estimate ex post what the parties would have wanted. Courts, which are publicly subsidized, should give parties incentives to negotiate ex ante by penalizing them for inefficient gaps.

This Article also proposes a second source of contractual incompleteness that is the focus of much of our analysis. We refer to this source of incompleteness as strategic. One party might strategically withhold information that would increase the total gains from contracting (the "size of the pie") in order to increase her private share of the gains from contracting (her "share of the pie"). By attempting to contract around a certain default, one party might reveal information to the other party that affects how the contractual pie is split. Thus, for example, the more informed party may prefer to have inefficient precaution rather than pay a higher price for the good. While analysts have previously explained incomplete contracting solely in terms of the costs of writing additional provisions, we argue that contractual gaps can also result from strategic behavior by relatively informed parties. By changing the default rules of the game, lawmakers can importantly reduce the opportunities for this rent-seeking, strategic behavior. In particular, the possibility of strategic incompleteness leads us to suggest that efficiency-minded lawmakers should sometimes choose penalty defaults that induce knowledgeable parties to reveal information by contracting around the default penalty. The strategic behavior of the parties in forming the contract can justify strategic contractual interpretations by courts.

Our analysis therefore moves beyond the received wisdom that default rules should simply be what the majority of contracting parties would have wanted. In choosing among default rules, lawmakers should be sensitive to the costs of contracting around, and the costs of failing to contract around, particular defaults. We show that different defaults may lead to different degrees of "separating" and "pooling." In "separating" equilibria, the different types of contracting parties, by bearing the costs of contracting around unwanted defaults, separate themselves into distinct contractual relationships. In "pooling" equilibria, different types of contracting parties fail to contract around defaults, thus avoiding transaction costs but bearing the inefficiencies of the substantive default provisions.

In contrast to the majoritarian analysis, our analysis shows that it may be efficient to choose a rule that a majority of people actually disfavor. To set defaults efficiently, lawmakers must not only know what contracting parties want, but how many are likely to get it and at what cost. We recommend a greater and more explicit legal sensitivity toward the ways in which different defaults will affect the resulting contractual "equilibrium."

Finally, before deciding how to fill gaps, courts must decide whether the contract even has a gap. In other words, courts must decide whether the contract already allocates a particular risk or duty. We show that this issue of whether a gap exists is identical to the issue of what is sufficient to contract around a particular default. While the received wisdom is that lawmakers should minimize the costs of contracting around default rules, we suggest that efficiency-minded courts and legislatures may want to intentionally increase these transaction costs to discourage parties from contracting around certain defaults.

The Article has three sections. Section I discusses the possible efficiency of penalty defaults. Section II embeds penalty defaults in a more general model of default choice, a model which suggests when penalty, tailored, or untailored defaults will be efficient. Section III then develops a theory of gap definition that determines what should be sufficient to contract around a given default.

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