The Value of Silence: Optimal Disclosure Default Rules in Contract Law

This essay is a contribution to a symposium on default rules held at Florida State University College of Law. In this symposium, Eric Posner makes a compelling argument that there are no penalty default rules in contract law, a claim that no doubt comes as a surprise to many contracts scholars. In passing, he cites Bob Scott and Alan Schwartz, who argue that there are few or no default rules in contract law, and who call for a return to formalism. Although Posner's logic is at one level iron-clad - if there are no default rules, then there are no penalty default rules - I argue that he is mistaken to cite new formalists like Scott and Schwartz as fellow travelers. This is not a central point of Posner's, and therefore my essay is not meant as a critique of his main arguments. Instead, I use his part of his discussion as an occasion to examine recent calls for a return to formalism in contract law. In particular, I focus on two distinctions Posner makes: first, between default rules and legal formalities, and second, between default rules and rules of interpretation. I argue that Scott and Schwartz are implicitly committed to collapsing both of these distinctions, and in fact offer a formalistic vision of default rules of interpretation, a vision that is, ironically, more in the spirit of a penalty default. Along the way, I briefly compare their view to classical formalism, and to Lon Fuller's famous article on legal formalities. My hope is that this discussion will set the stage for a more thorough assessment of new formalism in contract law, an assessment that is, unfortunately, beyond the scope of this essay.

How does the prospect of sale affect the seller’s incentive to investigate — to acquire socially valuable information about the asset? How do the disclosure rules of contract law influence the investigation decision? Shavell (1994) showed that, if sellers and buyers are symmetrically informed, at the pre-investigation stage, then a mandatory disclosure rule leads to a first-best outcome, and a voluntary disclosure rule leads to a suboptimal outcome. But in many real-world cases owners of assets have better information about their assets, even before they investigate. In such asymmetric information settings, we show, mandatory disclosure no longer attains a first-best outcome. And, under certain conditions, voluntary disclosure is the more efficient rule. We further enrich the analysis by introducing a third rule: the mandatory post-disclosure rule, which requires disclosure of material information, but only after the contract is concluded. We show that this rule can be more efficient than both voluntary disclosure and mandatory (pre-contract) disclosure.

This collection explores the nature and justification of mandatory rules (which are non-excludable) and default rules (which can be modified or excluded by the parties) in contract and commercial law. The collection distinguishes between different kinds of mandatory and default rules that govern commercial transactions. It also explores the choice of rule in various situations. Which rules are mandatory, and are there clearly understood and convincing reasons for parties to be denied choice? In the case of default rules, on what basis is the default position selected? The collection also explores the fundamentally important relationship between default rules and interpretation, and, relatedly, between default rules and contractual risk allocation. The collection will be of interest to academics and practitioners working across the field of commercial law.

Recently, a number of commentators have questioned the validity of the use of default rules in contract law, by challenging the assumptions that lead, in the first place, to the wide use of default rules. (See e.g., the University of Chicago Law Review Symposium on Formalism Revisited, 1999). Motivated in part by this debate, this article challenges one of the most basic assumptions in employment law: that employers and employees are silent about a number of important issues concerning the employment relationship, and thus, that courts are justified in developing default rules to apply to employment law disputes. This assumption has been used to develop default rules in a number of areas, but has been particularly relevant in the development of the law regarding privacy rights and employment security (the Employment-at-Will debate). In the article I argue that the parties to employment contracts have been telling us more than what conventionally we have recognized. In particular, I argue that by carefully analyzing aspects of the employment contract which the parties normally specify (such as the form and the basis of compensation), very specific, non trivial, understandings on other important issues are made apparent. I rely on recent developments in labor economics theory to explore the exchanges employers and employees make, and to analyze how these exchanges are reflected in the compensation provisions of their employment contracts. I argue that the information embedded in the compensation provisions of employment contracts provides valuable insights for the resolution of disputes regarding privacy rights and job security. The article advances an alternative approach to the use of default rules in the employment area, similar to the attempts to advance alternative approaches to the use of default rules in commercial law.

There is a standard analysis of default rules in contract law, including those forms of contract law that fall under the label of employment law. But behavioral economics raises many complications. The default rule can create an endowment effect, making employees value certain rights more simply because they have been granted such rights in the first instance. Similarly, the default rule for savings plans, set by employers or law, seems to have a large effect on employee behavior. When the default rule affects preferences and behavior, conventional economic analysis seems indeterminate; either default rule can be efficient. In employment law, analysis of distributive consequences also suggests the difficulty of deciding which default rule to favor, because any switch in the rule is unlikely to have significant redistributive effects. Nonetheless, switching the default rule can, in certain circumstances, have desirable effects on workers' welfare. A central question is whether the stickiness of the default rule reflects a genuine change in values, or instead employee confusion or bargaining strategy.

This article considers the principles that ought to be used to determine the scope and content of contract law's «default rules», the rules that will, in the absence of express exclusion, govern parties» contractual relationships. It examines three, ostensibly competing, approaches discussed in the literature: that defaults be grounded in the subjective consent of contracting parties, in the customs and norms immanent within the parties» community, and in the value of economic efficiency. It argues that each has something of value to tell us about default rules, but that none can, in isolation, offer a wholly compelling prescription for their design. Rather, the best such prescription must be an eclectic one, drawing something from all three accounts, but varying to reflect the institution promulgating the default. Where defaults are promulgated legislatively, the case for choosing rules that will promote efficiency is a strong one, and the main criticism of efficiency analysis is shown, in this particular context, to be misguided. Where, however, defaults are promulgated adjudicatively—in the context of settling individual cases—the normative appeal of efficiency is much reduced. The article, then, criticizes efficient adjudicative defaults against their defenders, whilst defending efficient legislative defaults against their critics.

This chapter discusses privity rules. Privity rules in contract law prevented obligations created by a contract from protruding on third parties, while privity rules in tort law prevented obligations to third parties that might otherwise be imposed by tort law from “indenting” upon a contract. Contract no longer is an impregnable circle of obligation. But contract law still has a privity requirement that prevents a contract from protruding negatively on nonparties. Meanwhile, in tort law, the function of preventing negligence law from indenting upon a contract has devolved to rules that preclude a negligence claim for pure economic loss. Moreover, there are rules in property law and the law of restitution that perform the same functions as the old privity rules in contract law and negligence. These include bona fide purchaser rules in property law and rules in the law of restitution that preclude claims for indirect enrichment and that preserve the priority of contract as a mechanism for resolving problems of unjust enrichment.

How does the prospect of sale affect the seller’s incentive to investigate—to acquire socially valuable information about the asset? How do the disclosure rules of contract law influence th...

A bargaining theory approach to default provisions and disclosure rules in contract law

In an influential article, Ian Ayres and Robert Gertner introduced the concept of the default a rule that fills a gap in an incomplete contract with a term that would not be chosen by a majority of parties similarly situated to the parties to the contract in question. Ayres and Gertner argued that such a rule might be efficient in a model in which contracting parties have asymmetric information. However, Ayres and Gertner did not provide any persuasive examples of penalty default rules; their best example is the Hadley rule, but this rule is probably not a penalty default rule. It turns out that there are no plausible examples of penalty default rules that solve the information asymmetry problem identified by Ayres and Gertner. The penalty default rule is a theoretical curiosity that has no existence in contract doctrine.

The Sherman Act forbids contracts that restrain interstate commerce, and proof of significant is usually necessary to establish the existence of such a restraint. Recently, however, some have argued that courts should employ the Sherman Act to regulate opportunistic behavior by franchisors that do not possess the sort of ordinarily necessary to establish antitrust liability. Inspired by the Supreme Court's decision in Eastman Kodak v. Image Technical Services, these advocates find market power in the presence of relationship-specific investments and would impose antitrust liability on franchisors that abuse such to the detriment of their franchisees. Informational asymmetries and bargaining costs, it is said, prevent franchisees from protecting themselves in the bargaining process from unduly onerous contractual terms. This essay argues that reliance upon the Sherman Act to combat franchisor opportunism would constitute an unjustified expansion of federal regulatory authority and upset the traditional division of labor between states and the national government. To be sure, scholars have provided a plausible story of opportunism in the franchising context, where bargaining and information costs can be significant. Still, these advocates have not explained why federal regulation of such behavior is warranted. As Professor Coase has recognized, bargaining and information costs do not exist in a vacuum, but are instead a function of the institutional framework, a framework constructed by background rules of (state) contract law that lower the costs of entering and maintaining relational contracts. Any argument for federal intervention to combat opportunism, then, must explain why the background rules of contract law are not adequate to minimize information and bargaining costs and thus deter opportunistic behavior. More precisely, those who advocate Sherman Act regulation of franchiser opportunism must demonstrate that competition between the states to produce the institutional framework governing the franchisor-franchisee relationship is characterized by a to the that warrants federal intervention. Preliminary analysis suggests that such a race to the bottom is unlikely. No state can become a haven for opportunistic franchisors without the cooperation of other states, who must enforce the franchisor's choice of law clauses. Moreover, states that adopt institutional frameworks that raise the cost of transacting and thus facilitate franchisor opportunism will raise the costs of intrastate transactions and make their own citizens vulnerable to opportunism. Federalizing this body of law, then, would unnecessarily deprive businesses and consumers of the benefits of interjurisdictional competition.

This paper considers the principles that ought to be used to determine the scope and content of contract law's rules--rules that will, in the absence of express exclusion, govern parties' contractual relationships. The paper considers three, ostensibly competing, approaches discussed in the literature: that defaults be grounded in the subjective consent of contracting parties, in the customs and norms immanent within the contractors' community, and in the value of economic efficiency. The paper argues that each such approach has something of value to tell us about default rules, but that none can, in isolation, offer a wholly compelling prescription for their design. Rather, the best such prescription must remain an eclectic one, drawing something from all three accounts, but varying to reflect the institution promulgating the default. Where defaults are promulgated legislatively, the case for choosing rules that will promote efficiency is a strong one, and the main criticism of efficiency analysis is shown, in this particular context, to be misguided. Where, however, defaults are promulgated adjudicatively--in the context of settling individual cases--the normative appeal of efficiency is much reduced, and the appeal of the two competing accounts of defaults, much enhanced.

Critics of consent theorists of contract have argued that autonomy-based theories of contract law do not provide any guidance in understanding how courts do or should decide cases when an issue on which the parties have not explicitly agreed upon arises. In Risks and Wrongs, Jules Coleman takes the challenge of rescuing the consent theorist from this attack. He defends a rational bargaining approach to gap-filling and default rules in contract law. In this comment, I pose a challenge to Coleman´s argument. Against his view, I suggest that, in order to solve many of the disputes between the parties to a contract regarding contingencies for which no explicit adequate provisions have been made ex ante in the parties´ agreement, the consent theorist need not resort to the ex ante rational contract. Coleman´s argument is based on the assumption that, whenever the parties do not explicitly agree on something, the relevant issue falls into a contractual gap. My claim is that not everything should be explicit in order for the parties to a contract to be able to understand what the terms of their agreement might be. My argument relies on – what I will call - a “public” conception of consent. In light of such an account of consent, the consent of the parties covers more than what the parties actually included or mentioned in their agreement. The paper concludes by suggesting that Coleman´s argument is relevant in those cases where implied-in-fact understandings are vague and courts have no option but to stipulate terms into the contract.

Contract law doctrines can be ranged along various spectra. One of these spectra runs from the static to the dynamic. A contract law doctrine lies at the static pole of this spectrum if its application turns entirely on what occurred at the moment in time when a contract was formed. A contract law doctrine lies at the dynamic pole if its application turns in significant part on a moving stream of events that precede, follow, or constitute the formation of a contract. Another spectrum runs from the binary to the multifaceted. Contract law doctrines are binary if they organize the experience within their scope into only two categories. Contract law doctrines are multifaceted if they organize the experience within their scope into several categories, including one or more intermediate categories. Classical contract law was a rigid, rather than a supple, instrument. Its rules were often responsive to neither the actual objectives of the parties, the actual facts and circumstances of the partiesâ transaction, nor the dynamic character of contracts. Instead, the rules of classical contract law were centered on a single moment in time, the moment of contract formation. accordingly, classical contract law doctrines were almost wholly static and also tended to be binary. The twentieth century witnessed the development of a modern contract law that has largely overthrown classical contract law. This overthrow has occurred in two ways. To begin with, in many cases modern contract law has reversed or fundamentally modified the rules of classical contract law. More important than the overthrow of specific rules of classical contract law, however, has been the overthrow of the deep structure of classical contract law. Where classical contract law had an overriding preference for rules that were objective and standardized, modern contract law has been highly flexible in adopting rules that are individualized and even subjective. Where classical contract law rules were typically binary, modern contract law rules are often multifaceted. Finally, where classical contract law was largely static, modern contact law is, in large part, dynamic. So, for example, static rules of interpretation have been replaced by dynamic rules that take into account events before and after the moment of contract formation; the static legal-duty rule has withered almost completely away, to be largely replaced by a dynamic modification regime that takes into account the value of ongoing reciprocity; a static judicial review of liquidated damages provisions is giving way to a dynamic review that takes account of the actual loss; and static offer-and-acceptance rules have been replaced by dynamic rules, such as the duty to negotiate in good faith.

Default Rules in Contract Law