Schwartz and Watson, ‘Conceptualizing Contractual Interpretation’

Contract interpretation is an important subject for lawyers but there are few rigorous economic analyses. We use a formal model to derive the interpretive rule that an “ideal” legal enforcer would adopt. Commercial parties make contracts to maximize gains from trade. Our enforcer is ideal, in the sense that he interprets contracts to maximize welfare over the set of contracting relationships. We then compare how actual interpretation matches the ideal. We derive the following results, among others: (a) An optimal interpretive rule induces parties to make efficient tradeoffs between the gain from accurate interpretation and the costs of (i) writing contracts; (ii) investing in the deal, which also conveys intent; and (iii) trials; (b) The optimal rule induces inefficient relationships not to form and permits the enforcer sometimes to exclude trial evidence and decide on reduced evidentiary bases; (c) Expertise in interpretation comes in several forms, including the ability to infer party intent from a performance and from the written words; (d) Parties choose between arbitrators and courts on the bases of their respective competencies and the cost of writing a contract meant for a court and the cost of writing a contract meant for an arbitrator; (e) Courts maximize accuracy in interpretation rather than welfare, which creates a number of inefficiencies; (f) Party attempts to constrain the evidence courts use would cause courts to act more as the ideal enforcer acts, so courts should obey party interpretive instructions. We also test several of the model’s predictions on a data set of almost 43,000 actual contracts. The data appear to be consistent with the theory.

Schwartz, Alan and Watson, Joel, Conceptualizing Contractual Interpretation (April 20, 2012). Yale Law & Economics Research Paper.

First posted 2012-04-21 09:32:19

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