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Posted June 1, 2010

Choi Wins Faculty Prize for Scholarship in Contract Law

Albert Choi

Contract law expert Albert Choi recently won the Law School’s Professor Carl McFarland Prize, a biennial award given to a junior faculty member for outstanding research.

“When I received the news, I was not only surprised, I was honored and humbled,” Choi said.

Choi has been exploring the connections between economic contract theory and contract law since he was a doctoral student in economics at the Massachusetts Institute of Technology.

“As a student of economics, I was very much interested in the various implications of contract theory,” Choi said. “It was natural for me to try to tie my interest in economic contract theory with what actually happens in real-world contracts and in contract law.”

As a law professor at Virginia since 2005, he has dug deeper into an economic analysis of the law, with recent works focusing on two themes: the effects on third parties when two parties enter into a contract and the effects of the balance of vague and verifiable terms that contracting parties regularly use.

“His early work built on an insight from the economics literature that principals and agents often design contracts with the purpose of extracting value from third parties,” Dean Paul G. Mahoney said of Choi’s work. 

For example, in one article published in the Journal of Law, Economics and Organization, Choi showed that a golden parachute — a large severance payment made to top executives when their companies are merged or taken over — could actually benefit shareholders if the contract is structured to make the third-party buyer bear more of the costs of the parachute.

Choi’s insights “help to explain why we see these contractual terms and, importantly, show that the usual legal assumption that these terms have no third-party effects is oversimplified,” Mahoney said.

Choi offers a “potentially path-breaking insight” into contract law theory, Mahoney said, in a recent Journal of Legal Studies article co-authored with former Virginia Law professor George Triantis, now at Harvard.

In that paper they explored verifiable and vague contract terms.

“In economic contract theory, it used to be the case that the parties would contract on things that are easily verifiable, but will not contract on things that are very difficult to verify,” Choi said. “For instance, if I’m contracting you to write a book of fiction, it’s very difficult to stipulate on the quality of the book.”

To work through that issue in a contract, parties will use proxies as a way to verify success or quality, such as whether or not the book receives awards or how many copies the book sells.

“But if you look at the real-world contracts — for instance, M&A, franchise, employment, sales or corporate financing agreements — they often rely not only measures that are very easy to verify, such as sales or stock price, but also contain terms that are very vague and difficult to verify.”

For example, an employment contract might not only tie a CEO’s compensation on stock performance to provide incentive to the CEO, but might also stipulate that the CEO has to put in her “best efforts” in executing her job.

Choi said it was puzzling that parties were not following the traditional economic contract theory, which points to reliance on verifiable, rather than on vague, terms.

“In reality, people tend to use both,” he said. “Our attempt was to explain why the reliance on both is necessary and can actually be beneficial. We show sometimes it’s better to rely only on vague terms such as the best efforts and material adverse change rather than anything specific such as stock price or sales.”

Including a material adverse change in an M&A contract enables the buyer to refuse to complete the acquisition, merger or financing with the party being acquired if the target suffers such a change.

Choi said the recent financial crisis, in which many merger and acquisition deals fell apart, showed why understanding vague terms in contractual obligations is important.

“They’re relying heavily on these kinds of vague terms to mitigate the incentive and informational issues.”

Although some scholars and practitioners have suggested that the parties were over-relying on vague terms and need to use more precise proxies for those terms, Choi said he and Triantis argue that such a substitution is “not a slam-dunk.”

“Vague terms can play an important screening role in ex post litigation by allowing only the stronger cases to proceed,” Choi said. “This will not only prevent the contracting parties from making false claims ex post, but can also produce a stronger incentive effect ex ante.”