Contract Law Imperfection Cause and Rulings

Abstract：Contract is one of the foundations of modern society. With the development of contract law， the art of crafting contracts has evolved from a crude bargaining game to systematic economic theories. A common phenomenon is that contracts will have incomplete terms， or insensible terms. The reason is usually a mixture of two causes. Behind each imperfection， there are costs and gains in both negotiating and enforcing. When ruling cases about these contracts， the court will have to keep in mind such costs and gains， and process such imperfections accordingly. Sometimes， both parties even intentionally leave gaps in the contract， to minimize transaction costs. What cause this？ I will explain it in the following essay， accompanying some ways that court might follow.

Key Words：Imperfect contract；Allocating risk；Saving transaction costs；Ways to solve the imperfection

Contract is one of the foundations of modern society. With the development of contract law， the art of crafting contracts has evolved from a crude bargaining game to systematic economic theories. A common phenomenon is that contracts will have incomplete terms， or insensible terms. The reason is usually a mixture of two causes： parties often do not have a comprehensive prediction of the future， and sometimes it is less expensive to leave a gap than to measure transaction costs at drafting time. Behind each imperfection， there are costs and gains in both negotiating and enforcing. When ruling cases about these contracts， the court will have to keep in mind such costs and gains， and process such imperfections accordingly.

As the first factor to cause an imperfect contract， imperfect expectation of future risk is not rare in the real life. In fact， real contracts often allocate risks imperfectly although they have explained some risks in the content. No matter how rational the contracting parties are， there are still several small probability events that people wouldn’t have expected before the signing of a contract. For instance， hijacking incidence， a sudden outbreak of the war， even any unknown infectious disease and so on， all these items are able to affect the actual implementation of the contract. Therefore， some inevitable gaps are left， the contracts are always lack of full specific.

In addition， there is also another possibility to lead an imperfect contract. Sometimes， contracting parties are able to anticipate almost every case before the signing， but several cases among them is nearly impossible to occur. Under such a situation， both contracting parties would not spend more time and more resources to consider how to deal with it in the contract， since each party seeks for the minimization of transaction costs. Therefore， some small probability events would be intentionally ignored in the contract. In a word， the expectations of risks held in people’s minds do not always include everything which could happen in the actual life.

Sometimes， parties intentionally leave gaps in the contract， to minimize transaction costs. The contracts explicitly explain parts of specific attributes of the transaction costs. However， they do not explain other attributes that though are parts of the transaction costs are costly to measure， hence， the contracts are imperfect. Transaction costs， considered as the second point of the former question， could not be ignored by people. Moreover， as transaction costs increase， gaps would be left in the contract. Thus， with the existence of the transaction costs， the contract is seldom fully specified. Sometimes transaction costs could also cause several externalities， misinformation， or monopolies and so on. All the people want to do is to minimize transaction costs for approaching perfection.

To minimize the transaction costs， we need to analyze if allocation of Ex ante risks is better than allocation of Ex post losses. Contracting parties aim at saving transaction costs by leaving gaps in the contract， when the expected cost of filling a gap is smaller than the actual cost of negotiating about every specific item. Therefrom， we get the final cost of allocating losses through using the cost of allocating Ex post losses multiples their probability， it is not difficult for us to find that it is always smaller than the costs of allocating Ex ante risks. In this way， contracting parties would be able to minimize the transaction costs.

These factors demonstrate how and why contracts are usually not perfect. When such imperfections are presented in court， what choices does the court have？ There are three major ways the court may follow： enforcing explicit terms disregarding the imperfection， applying default rules to fill in gaps， and regulating the contract by enforcing mandatory rules instead of contract terms.

Contracts are almost always flawed somewhere， so sometimes the court may decide to just enforce the explicit terms of the contract as if the contract is perfect， disregarding the imperfections. Such tolerance is always necessary， because in real life， contracts are produced with certain time and cost limitations， and thus improbable to be fully exhaustive and complete. In most occasions of private transaction， not every imperfection can be sensibly fixed by filling gaps or replacing terms； in this case， the court is supposed to make judgements only based on the contract as written. Therefore， the court will consider the imperfect contraction as a perfect one， and then enforce every explicit term.

To fill a gap， the court will use an instrument named default rules. As discussed above， when gaps are left intentionally， the parties are aimed to minimize transaction costs. In this case， the critical element is the bargain between both sides. From the perspective of the court， the major mission is to assist contracting parties in pursuing an efficient bargain instead of an inefficient one. Both parties will benefit from an efficient bargain from filling the gap， or even reach the maximum gain in the end. For instance， if the court imputes the terms which meet both preferences of contracting parties through only one bargain， the transaction cost will be minimum， which means the gain will reach the maximum. The court will evaluate efficiency of default rules by hypothetical bargain， finding out the terms that would be reached if the missing terms were negotiated when the contract was drafted. Essentially， the court will undertake the cost of performing the bargaining procedure， and thus the resulting bargain is more efficient than parties actually negotiating.

When there are imperfections within the explicit terms， rather than having gaps， the court may decide to avoid the terms， and regulate the contract. To replace the explicit terms， the court will use an instrument named mandatory rules. In this case， the court will make a regulation to against imperfection. In other words， the court will distribute an ideal contract which is perfect， then using mandatory rules to describe the imperfect contract.

Today， leaving imperfections and dealing with imperfections are all part of the economic theory of contract， and thus the parties of contracts and the court both tend to minimize costs and maximize gains. Through such model， production and enforcement of contracts are more efficient and realistic than a crude bargaining model.

Reference：

Law and Economics （6th Edition）， Robert Cooter and Thomas Ulen， 2012

Contract Theory and the Limits of Contract Law， Alan Schwartz and Robert E. Scott， 2003