“The Contract Production Paradox,” With Robert E. Scott

ROBERT SCOTT: So about 10 days ago, I got a call from Mitu who said that, I am assigning you the task of setting the stage for the discussion that we will have over the next two days. And as many of you have learned through Hard Knocks, you don't get to say no to Mitu. And so here I am. And we will hope that the stage is set with at least some preparatory material that is useful for you to think about for the next two days.

And indeed, I'm delighted to welcome everybody, and many old friends and a few new colleagues, to what I believe is a fair statement, is the first contracts conference that focuses exclusively on the issue of contract production. And that's a notable event. Until recently, only a very few lonely voices, most of them present in this room, have been working to correct what has been a massive neglect in contract law scholarship.

Now, we write countless law review articles and many books on the moral bases of contract. Greg has contributed at least a third of that number. We also refine insights gained from economics on the theory of incomplete contracts. And more recently, we have turned-- and here I plead guilty-- we have turned our energies to the question of optimal contract design.

But largely lost in all of that literature is the fact that commercial contracts do not emerge fully formed from the mind of Zeus. They're produced by lawyers who are charged with the task of implementing the design that, in an important sense, has already largely been agreed to by their clients. And let's start something that academics have failed to recognize. This requires a lot of skill.

Clients, for starters, don't understand-- my experience-- that the contract terms that the lawyers are asked to formulate are actually part of the product, and therefore they will affect the price, which has actually already been usually agreed upon before the lawyer even gets to work.

Now, operating under this and other constraints, the drafting lawyer must formulate terms that respond effectively to both the ex ante performance stage and the ex post enforcement stage of a contract's lifespan. So it's unsurprising that, mindful of their typical client's principal concerns, drafting lawyers generally attend more carefully to the performance stage-- what's going to happen in the present-- and devote less attention to the enforcement stage, which, after all, is only relevant in the unlikely event of a breach.

It's also unsurprising that lawyers have turned to the considerable benefits of standardization to reduce the costs of formulating these enforcement terms for the contract. We know it's costly to write a contract from scratch. Instead, drafters look to their precedents. This is well known. Everybody needs a baseline for formulating the terms they need.

And we need-- before we start criticizing these precedents, we need to acknowledge their value. Having a menu of established contract terms from which a drafter can choose greatly simplifies and reduces the cost of production. Moreover, these precedents bring to bear a collective wisdom and experience that the drafter cannot access individually.

So now when the precedents, developed by the contract drafters, coalesce and become standardized across a market, then they emerge as boilerplate, standard language that is widely used by all or almost all of the parties who trade in that market. And again, great benefits. The unique benefits of boilerplate derive from the very process by which these prior precedents mature and are then recognized by the parties to the market and by the courts as having consistent meaning.

The problem-- the problem is that boilerplate and the precedents that precede it evolve in distinctly different ways. And here's the rub-- this evolutionary process is not uniform across the market. Now, ideally, we would agree that boilerplate should evolve only as exogenous changes in the market dictate a new assignment of rights and responsibilities. But, in addition, these standardized terms evolve endogenously and evolution proceeds randomly and at different rates in different markets.

And we, as people who care about this process, are only just beginning to see how agency costs that separate the interests of the lawyers from that of their clients, asymmetries between the negotiating lawyers themselves, and differences in law firm structure and culture, all affect the nature and pace of changes to the boilerplate. And then we are also only beginning to see how parties in these heterogeneous markets are unable to readily coordinate on a market solution to the many mutations that have infected this standard form.

So our goal, as scholars and practitioners who care about this, should be to better understand these ways, the ways that these and many other factors affect the production process. Now, fortunately, we do have a starting point. Thanks to the pathbreaking work of Marcel Kahan and Michael Klausner, we've known for more than 25 years that standardized language that is boilerplate, if you will, creates inevitable trade-offs, including the willingness of parties to accept ill-fitting and suboptimal terms in order to secure the various benefits from the standard form.

Now, the questions, I'm going to argue, that this trade-off generates ought to be front and center in contract scholarship today. And hopefully if it is, those of us here today will provide some answers to those questions. Now, in reviewing the abstracts outlining your intended projects, I note, with the appreciation of one who lacks any empirical skill, that many, if not most of you, are intent on learning more about the facts of contract production in many different settings.

Several of you are investigating the production of consumer boilerplate. Others are studying the evolution of boilerplate in arbitration clauses and joint bank accounts. Others are still looking at the effects of formal and informal networks on contract production.

What is noteworthy and perfectly consistent with contemporary academic sensibilities is the emphasis in many of your abstracts on finding out about stuff. Systematically seeking to find the facts on the ground. This focus of contemporary contract scholars on empirical work reminds me of a story. I have to say some of you heard this story already. You're just going to have to bear with me. I've told it once before, but it's the only way that I can get my point across. So here it goes.

Some years ago, my very good friend and former colleague George Triantis, who just became the Dean at Stanford Law School, said to me, somewhat ruefully, that my generation of contract scholars had managed to, quote, "take all the low-hanging fruit." And my response then was that the observation might well be true, but the result was still fair because his generation had so many more skills with which to mine the fruit that was higher up on the branches of the tree.

Now, I still think that my comment was a correct one. But in the years since, I've decided that there is another metaphor that more accurately captures the relationship between my generation and yours, between the generations that have been studying and writing about contracts now for over 50 years. And this metaphor was a favorite of Charlie Whitebread, a now departed friend and former colleague here at UVA.

Charlie, as probably only a few remember-- I know Paul, maybe Rip-- was a great wit and an incredibly successful teacher of just about anything. He used to travel around the country-- I'm sure he was well compensated-- giving sage advice to first-year law students at just about every law school as they approached their first set of exams.

And there are, Charlie explained to this audience of rapt students, there are three types of law students. There's the A student. There's the B student. And there's the C student. Now, this would need to be updated in your classes today as the A-plus student, the A student, and the A-minus student.

[LAUGHTER]

Charlie then described the first-year courses as consisting of a dense forest populated by many different kinds of trees. The B student, he said, would approach the forest, find its density much too intimidating, and instead of entering the maze of the trees, would carefully walk around the perimeter and analyze its externally observable characteristics.

The C student would plunge blindly ahead into the forest without first examining the exterior and get hopelessly lost among the trees. The A student, Charlie's ideal, would first walk around the forest carefully, noting its essential characteristics and looking for clues-- clues about the best way through. Then having found a path among the various trees would successfully emerge on the other side having described both the whole and its many parts.

Now, adapting this metaphor to George's challenge, I'm going to start by admitting, quite cheerfully, that my generation of contract scholars, whose primary focus was to develop descriptive and interpretive theories of contract, were the eponymous B student in Charlie's story. The current generation of scholars, you, is equipped to do so much better than that.

But the lesson of the story is clear. Before beginning to classify the trees, we must first find a good map to guide us through the forest. Theory, then, is a necessary precondition to harnessing the now widely available array of methodological skills because it ensures us that we deploy those skills in search of the facts that matter.

So that is my parting shot for the current generation of scholars of today. Do you have a good map? A good map that points you to the facts that matter. And then can you find those facts in a systematic and rigorous way?

Now, since I believe, as strongly as I do, that theory and empirical inquiry must go hand-in-hand, I'm going to take a few minutes and trespass on your patience by summarizing some of the theoretical claims and supporting evidence that my co-authors, Mitu, Steve, and more recently Matt, have set out in a series of papers over the past decade culminating in a book project, a portion of which I believe Mitu has sent to many of you.

And the book is entitled The Contract Production Paradox because it centers on an essential trade-off-- trade-off between two contract values. So we begin with a very strong theoretical claim-- drafters of commercial contracts optimize between efficient contract design and efficient production. And the thickness of the relevant market will determine the balance between bespoke design and standardized production.

And the trade-off we see is the fact that, given agency costs, the production benefits of standardization inevitably lead to errors, mutations from the standard form that measurably increase litigation risk. We call them landmines. And we go further. We also claim that not only do these landmines exist in a number of key markets, but that in some of these markets they are pervasive and they persist across time and contracts.

Now, we do this by conceiving of the contracting space as a continuum, ranging from, at one end, very thick liquid markets-- we use as our exemplars corporate and sovereign debt-- to, at the other end, very thin markets, which at the limit you would imagine would be the fully customized, individually crafted bespoke contract. Now, the trade-off between design and production implies that we will find landmines throughout this continuum. And we do.

We spend a good deal of effort on the thick market side, taking advantage of Mitu's encyclopedic knowledge of the sovereign bond contract and of current and contemporary restructured efforts. And these thick markets have the highest degree of standardization, and thus we would predict these contracts would have the most landmines. And they do.

We are also able to identify more than a dozen landmines that have exploded over the past decade or so during restructuring negotiations. And we are then able to classify them according to the different ways that these mutations occur, given the asymmetric character of legal representation in that market.

Now, we then turn to the thin market side of the continuum. In theory, if you could find a purely bespoke, individually drafted contract, one that would be completely customized, it would have no standard terms and no landmines. But we claim that, in fact, there is no meaningful real-world case of the individually drafted, purely bespoke contract.

I've separately written the history of adaptation of contract and innovation, and you can find, in the middle of the 19th century, you can find some wonderful cases of individually crafted, bespoke contracts where there are three terms-- delivery, price, and the time for performance. They don't exist anymore.

Rather, all one-off contracts in the thin markets that do exist, when we call these quasi bespoke, will have standardized terms, and therefore they will also feature landmines. And we test that claim by analyzing a random sample of one-off commercial contracts. Now, the optimizing strategy that we have as our archetype predicts that we would find many fewer landmines here, and we do. But the important point is that those that exist are prevalent and persistent.

Now, notably, in both the thick and the thin market setting, there is evidence that the market for lawyers is divided between experts, gurus, and relative novices, lawyers who are simply not especially contract literate. This market structure, we believe, exacerbates the misaligned incentives separating the clients, whose interests are primarily, if not exclusively, on design efficiency, and the lawyers, whose interests require, necessarily, attention to the costs of production.

Landmines result, in part, because these production costs are greater for novice lawyers than for the gurus. Now, having made the first bold claim, we make a second. Contracting parties all along this continuum have insufficient incentives to remove landmines individually. As a consequence, they face a significant collective action problem. And here we directly challenge the axiom of financial contracting made famous by Smith and Warner that harmful heuristics, like harmful mutations, will inevitably die out.

And we offer several explanations for why Smith and Warner's axiom does not appear to withstand empirical inquiry. The first, as I just noted, is the critically important problem of lawyer agency costs. The second is the structure of the links between and among the lawyers in any given market. Landmines will persist, despite the axioms of efficient contracting theory, in the absence of a means by which lawyers can coordinate on ways to identify and remove them.

Now, somewhat paradoxically perhaps, coordination over these best practices for avoiding landmines is very difficult to achieve at either end of our continuum. You have to think about it for a minute. But thick liquid markets lack an institutional structure to facilitate coordination among what is necessarily widely diverse interests in those markets. In a sense, in those markets, there are too many different diverse parties to create a spider-- it's our metaphor-- for the web in the network.

Thin markets, on the other hand, consist of parties that are, again, metaphorically, all alone on an island. Here, there are no other parties with whom to form a network for sharing information about landmines.

We finally turn to the intermediate case of M&A contracting, particularly private equity deals, where we find a mixture of bespoke and standard terms. And we find, yes, there are landmines in that market. But we find also that the landmines in that market are more readily discovered and then defused than at either pole of the continuum where coordination, as we've suggested, is infeasible.

Evidence, which we continue to gather from interviews and other qualitative investigations, supports the claim that M&A lawyers, at least in the private deal setting, have formed what we would call an informal network. It's not like Lisa Bernstein's cotton or corn structures. An informal network with a spider in the web that functions to coordinate landmine removal.

Now, we're still in the process of testing these claims with data. Fortunately, as you know, I have partners who are world class at that task. And so we believe that we can ultimately find solid support for this attempt to theorize about the production problem. And importantly, if not, we can and will look for alternative theories.

In any case, we hope that our discussions together for the next two days will sharpen your own work and offer you the hope that you can provide candid, but perhaps gentle, critiques of ours.

[LAUGHTER]

And now, having indulged me, it is time for our first panel, and I turn over the mic to me because I have to moderate the first panel.

[LAUGHTER]