Interpreting contracts: the purposive approach and non-comprehensive incentive contracts
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Interpreting contracts: the purposive approach and non‑comprehensive incentive contracts Benjamin Bental1,2 · Bruno Deffains3 · Dominique Demougin3,4 Published online: 18 September 2020 © Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract Real world contracts often contain incentive clauses that fail to fully specify conditions triggering payments, giving rise to legal disputes. When complete contract generate Pareto efficient allocations the L&E literature advocates that courts should fill in the missing clauses. This logic does not directly extend to environments with moral hazard, where complete contracts result in constrained efficient allocations. Despite this inefficiency we find that when agency and marginal agency costs are congruent, the legal system can do no better than guide its courts to complete contracts according to the parties’ intentions. Keywords Asymmetric information · Balance of probabilities · Incomplete contracts · Judicial system · Courts JEL Classification D82 · D86 · K40
1 Introduction Real world contracts are usually designed to align incentives. That purpose is partially thwarted by contract incompleteness which may trigger opportunistic behavior and lead to conflicts. In a court of law resolving such conflicts will require an ex-post interpretation of contractual clauses. This juridical issue is embedded in a fundamental debate among legal scholars and practitioners concerning the interpretation of documents where some advocate a “literal approach” and others favor a “purposive interpretation”. For contracting disputes, the law and economics literature * Bruno Deffains bruno.deffains@u‑paris2.fr 1
Department of Economics, University of Haifa, Haifa, Israel
2
European Business School, EBS University, Wiesbaden, Germany
3
Paris Center for Law and Economics, University Paris 2, Pantheon Assas, Paris, France
4
Department of Business and Economics, Technical University, Kaiserslautern, Germany
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Vol.:(0123456789)
242
European Journal of Law and Economics (2020) 50:241–265
usually supports the latter approach based on the intuition that completing contracts should generate a Pareto efficient allocation.1 In this paper, we focus on a subclass of contracting problems where this rationale does not apply. In our analysis, contract incompleteness arises from a non-comprehensive description of the conditions triggering payment in a moral hazard environment.2 The presence of informational frictions implies that guiding courts to resolve payment disputes by completing contracts according to the parties’ initial purpose would enforce Pareto inefficient allocations. Clearly, this invalidates the aforestated justification underlying the purposive approach. For this context, we find a condition which nevertheless ensures that courts can do no better than apply that approach. To fix ideas, consider two recent UK court cases. In Rainy Sky S.A. and others (Appellants) v Kookmin Bank (Respondent) [2011], the dispute centered around the repayment of a bond in a m
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