Caught on our radar

Congrats to the
Nobel Prize winners
in economics

The 2016 Nobel prize winners in economics, Professors Oliver Hart and Bengt Holmström, both of whom worked on the so called contract theory. Their research is our daily reality as it points to the significance of contracts in modern society and how contracts can be used to manage conflicts of interest. The two laureates wanted to create tools to analyse problems that arise in contract signing.

From a theoretical point of view, they’ve thought a lot about what business lawyers have to solve practically on a daily basis; namely how a contract for a specific business event can and should be designed. Contract theory may be theoretical, but it affects highly practical issues such as how the contract may affect future behaviour, how risks are allocated and managed, and how you build trust and facilitate cooperation between the parties.

Create understanding

The purpose of contract theory is partly to explain why different contracts have such different designs and partly to create understanding of how contracts can be best written in order to avoid pitfalls. The law often distinguishes different “types of contracts” in which problematization of known areas of conflicts occur. Typical solutions to common issues can sometimes be found in optional legislation and sometimes in the various model contracts and standard agreements that abound in different fields. Major business events often require tailored contracts where an individualised assessment is done regarding both risks and success factors.

How to design an optimal contract is specified in Hart’s contribution in contract theory about so called incomplete contracts. He says that with such an unpredictable future, it’s impossible to formulate a complete contract, specifying any and all eventualities that may arise during the contract period and predict which obligations must be included. We usually say that the idea of the complete contract remains just that – an idea. Not even the most extravagant contracts, with their “included but not limited to”, cover every possible situation that may arise. Complicated contracts therefore often have “organisational elements” where the parties agree on an order for managing open questions that come up. In its most developed form, the contract then begins to take the form of an imaginary company, even if the parties, for the sake of good order, usually state that no company is formed.

Who gets the right of decision?

In situations where you can’t write an optimal contract that regulates the actions of all parties in every possible scenario, Hart says that the contract should regulate which of the parties gets the right of decision in cases where the parties can’t agree. It should also regulate under which circumstances decisions can be made. As this strengthens the negotiating position of the party that gets the right of decision when the unforeseen or non-contractual occurs, it might be easier to accept in theory than in practice. There is some help to be had though. Swedish case-law includes examples on how the courts put extra responsibility on the party entrusted to administer a particular contractual rule. It must be done with the interests of the other party taken into account. If, for example, adjustments can be made by a party to an interest or a fee, the party must adjust not only when an increase is justified but also when a decrease is justified (see NJA (Swedish law archive) p. 142 no 21, The Leasing Case).

According to Holmström, an optimal contract is demonstrated by his so called information principle. The principle states, among other things, that the contract should weigh uncertainty against financial incentives, such as when employees are motivated by reward systems. The information principle also specifies how a principle (e.g. an employer) can design an optimal contract for a risk-averse agent (e.g. an employee) whose actions can’t be directly observed by the principle. The principle is then able to monitor the company’s results and thus get an imperfect measure of the agent’s performance. A company’s result, however, can be affected by factors other than the actions of one agent. There is therefore a risk that an agent whose compensation is tied to the company’s results is rewarded by sheer luck, and penalised for bad luck. Holmström says that the harder it is to observe the connection between the agent’s actions and the company’s results, the smaller should the compensation based on company results be. The practical difficulties of this are known to all those involved with compensation systems of different types, such as those in a CEO contract.

Optimal contracts

Hart’s and Holmström’s research has shed new light on the issues of optimal contracts. Admittedly, their research provides no definite answer as to what the optimal contract looks like, since, as is common in law, it “depends on” the specific circumstances of the individual case. But their contract theory has yielded new theoretical tools that can be useful in future contract writing.

As always in commercial contract law, the negotiating parties face a choice; to think the business event and its contractual provisions through in advance and negotiate a contract more or less tailored to the deal in question; or, to move faster and leave a number of issues to be resolved at a later stage. Either option takes time and costs money. Both options generally require the involvement of lawyers as well as people with understanding of the deal. If the lawyers drawing up the contract don’t understood the deal to begin with, the resulting contract will be accordingly. And chances are that the businessman won’t understand the law in the disputes that are sure to follow in the wake of an unsuitable contract.


Contract theory Contract law Optimal Contracts

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