The strategy structure of contract law

Contract Law rules should be crafted as to create the incentives for the behaviour of the contracting partners that would maximize the welfare of the parties affected by the contract or,

The Strategic Structure of Contract Law

Book Draft

Juanjo Ganuza Fernando Gomez Pomar Universitat Pompeu Fabra, Barcelona (Spain)

I) T HE B ASIC E CONOMICS OF C OOPERATION AND C ONTRACT

II) T HE S OCIAL G OALS OF C ONTRACT L AW : E FFICIENCY AND D ISTRIBUTION

III) T HE B ASIC L AW AND E CONOMICS N OTIONS OF C ONTRACT L AW

IV) T HE L AW AND E CONOMICS OF C ONTRACT F ORMATION

1) Existence and Formalities in Consent

2) Tacit Consent and Timing of Consent

3) Illegal Contracts and Contracts Against Public Policy and Public Morals

4) Defects in Contractual Consent

5) Standard Terms in Contracts

6) Complex Contract Negotiations: Pre-contractual Liability

7) Complex Contract Negotiations: Representations and Warranties

V) C OMPLETING THE C ONTRACT : T HE L AW AND E CONOMICS OF C ONTRACT B REACH

1)What is a Breach and Remedies for Breach

2) Legal Remedies for Breach and their Strategic Effects

3) Impossibility and Frustration of Contract

Chapter 1 The Basic Economics of Cooperation and Contract

One of the basic questions in modern Economic Theory is how to sustain cooperation in economic exchange When modern economists use the expression “economic exchange” they are not referring primarily to markets The reason basically lies in the (at least among economists) success of neoclassical general equilibrium theory The first fundamental theorem of welfare economics confirms that if markets are competitive, all individuals are informed, and all commodities are allocated by means of markets, then individual interaction through a complete set of markets produces Pareto efficiency (a social situation in which no improvement is possible without someone being worse-off) Of course, economists know that the conditions for the theorem to hold are very strong, and that market imperfections abound

Modern economists think that the most interesting economic exchanges do not take place in perfect markets, but in imperfect markets, or in situations in which markets are only of little relevance Contrary to intuition, this is the case, for instance, in the relationship between an employer and an employee, or a wholesaler and a retailer, or a seller of a good of uncertain quality and the buyer In fact, many modern economists tend to focus attention on human interactions outside perfect markets Given that most legal contracts deal with interactions in this kind of settings, it is almost natural that analysing Contract Law from an economic perspective becomes an important dimension in understanding human cooperation

The broad question that we could ask ourselves could be formulated as follows: What are the means to induce the adoption of cooperative actions in human relations, countering the impulse present in individuals to behave opportunistically and to pursue self-interest at the expense of the common welfare of all interacting parties1?

Despite its generality, and the apparent lack of a "legal" or "institutional" component, the truth is that the set of issues behind this question, and the set of responses to it, are also of particular interest to Law, and Contract Law more specifically Contract Law is the most ostensible area of the Law directed

to promote and protect cooperation and exchange between individuals and firms This interest should

be particularly acute when the task is precisely to design legal rules and institutions that promote cooperative behavior and, in the end, social welfare through desirable interactions by and between members of society

2 Basic instruments to achieve cooperation

Economists and social scientists more generally have identified several major mechanisms to achieve cooperation among humans.2 It has to be noted, however, that some of them are not exclusive to humans, but to a large extent are shared by humans and animals In presenting them we will also briefly comment on the role -if any- that the Law and, more specifically, Contract Law, may possess in the working of the different mechanisms

Biological selection favors genes with higher survival and reproductive payoffs, and reproductive success involves not just selfish behavior, but also cooperative, disinterested behavior, if this benefits other individuals sharing a part of the relevant genes This explains why in the animal and the human world, cooperation between family members appears to be prevalent In other words, genetic self-interest promotes cooperation among biologically closely connected individuals This has a downside too, since nepotism and similar ills may be more difficult to eradicate than one may optimistically think It is not clear that the Law may contribute to reinforce this cooperative driver On the other side, the Law may be used, albeit with uneven success, to curtail some of the negative consequences of cooperation among kin Rules against nepotism or corruption in favor of family members exist in many legal systems, though their level of enforcement, and the degree of deterrence that they achieve are probably far from perfect, even in societies in which open social norms and public opinion outwardly condemns nepotism

b) Selfish cooperation

Although the idea of selfish cooperation may look like an oxymoron, in fact it is not One can think of human interactions in which it is in the best individual interest of the parties involved to choose to cooperate with the rest, and thus, maximize the joint welfare of the group That is, the interaction is characterized by a structure of payoffs to participating parties by which it is in the self-interest of each participating party to take the action that is jointly preferable (i e conducive to the common good) if and only if the rest of the interacting parties do likewise In the terminology of game theory, these interactions are called (for reasons unknown to us) as assurance games Here is an example of an assurance game:

2Avinash Dixit, Lawlessness and Economics: Alternative Modes of Governance, Princeton University Press (2007).

As you can observe, in assurance games there is more than a single Nash equilibrium Although (Cooperate, Cooperate) is the pareto-optimal (i e., preferred by both players) outcome, it is not the only equilibrium (Defect, Defect) is also a Nash equilibrium, because no player has an incentive to deviate if the other does not deviate

There are several ways to select a specific equilibrium, in particular, to select the pareto-optimal equilibrium A formal and legally enforceable contract imposing legal obligations on both parties to execute the actions corresponding to the desired equilibrium (Cooperate, Cooperate) is one option, though it may not be workable in many settings of human interaction Creating common expectations

on the resulting equilibrium might do the trick, with less expense, and less institutional apparatus, than formal contracting: If each player is convinced that the other will cooperate, and each is convinced that the other is equally convinced of it, they will both choose to cooperate, and thus the pareto-optimal equilibrium will be achieved There are several mechanisms to coordinate expectations to obtain cooperation in this sense

Typically, long-term relationships, especially when they present an open-ended time horizon, can serve

to effectively coordinate expectations of behavior by all involved parties, and therefore, to induce the desired cooperation for the common good, or maximization of overall social welfare: if one expects the interaction to go on in the future, one would expect that the other party will choose cooperation

The Law, in an expressive function, can also serve to coordinate expectations around a focal point The fact that a given conduct (defect, in our example) is labelled as illegal, or as less desirable by the legal system, makes the other option the focal point to coordinate the expectations on behavior by the parties3 This explains why unenforced or weakly enforced legal rules may produce positive effects in terms on increasing the level of cooperative behavior by individuals and firms It the legal rule, disregarding sanctions and enforcement, affects the beliefs of the parties as to the actions of other players, the cooperative equilibrium may ensue

3 Richard McAdams, “A Focal Point Theory of Expressive Law”, 86 Va L Rev (2000).

This coordination effect of the Law is not restricted to Contract Law For instance, smoking bans, laws against littering or vandalism, in addition to creating enforcement dynamics through social reactions and sanctions, are often mentioned as expressive rules fostering selfish cooperation But this may, be achieved through Contract Law rules as well The fact that a given action can be described as a breach

of contract -although non-enforceable-, or an admissible behavior under some acceptable, though selective, contract interpretation, seems to affect the way in which people judge those actions, and their intentions to voluntarily act one way or the other.4

c) Altruism (or fairness)

Interacting agents might not only have self-regarding preferences, but other-regarding preferences as well, based on altruism or similar notions (preference for cooperativeness, or for achieving the common good) Although the educational function of the Law, or of Contract Law more specifically, cannot be completely disregarded in fostering this kind of preferences, it is arguable that it is not a forceful factor

in the promotion of collective altruism or cooperativeness as a preference

d) Reciprocity in long-term relationships

Probably the most famous application of game theory outside economics is the prisoners’ dilemma The

prisoners’ dilemma is a strategic structure (albeit not the only one) that characterizes many interactions involving cooperation among two parties

In a one shot interaction, the prisoners’ dilemma structure cannot sustain cooperation by the players, to the detriment of the interests of each and both of them: Each player has a dominant strategy of defecting from cooperation

4Yuval Feldman and Doron Teichman, "Are All Contractual Obligations Created Equal?", Geo L J (forthcoming, 2012)

If the interaction is a unique, or one-shot interaction, the unique strictly dominant strategy equilibrium

is (Defect, Defect), producing pay-offs for the parties of (1, 1), which are strictly dominated in the Pareto sense by (4, 4)

This dismal result is not a feature of the fact that both players choose their actions simultaneously Even

if one acts after the other and is thus able to observe the other party’s move, the non-cooperation outcome still holds This is the case of the one-shot dynamic interaction, such as the so-called trust game5: Here, not trust and betray are non-cooperative actions, whereas trust and honor are the cooperative actions

The game begins with a decision node for Player 1, who can choose either to Trust or Not Trust Player

2 If player 1 chooses Trust, then the game reaches a stage in which Player 2 can choose either to Honor

or Betray Player 1’s Trust If Player 1 chooses Not Trust, then the game ends (in fact, Player 1 chooses not to initiate a relationship)

If Player 1 chooses not to establish a relationship, both players’ payoffs are zero If Player 1 chooses to trust Player 2, however, then both players’ payoffs are one if Player 2 honors 1’s trust, but Player 1 receives -1 and Player 2 receives a pay-off of two if Player 2 betrays Player 1’s trust

The Trust Game can be easily solved by backwards induction or rollback—that is, by working backwards through the game tree, one node at a time:

If player 2 gets to move (i.e., if Player 1 has chosen Trust) then Player 2 can receive either a payoff of

one by honoring Player 1’s trust, or a payoff of two by betraying Player 1’s trust Since two exceeds one, Player 2 will betray Player 1’s trust if given the opportunity to do so Knowing this, Player 1’s initial choice amounts to either not initiating the relationship (and so receiving a payoff of zero) or trusting Player 2 (and so receiving a payoff of -1, after Player 2 betrays Player 1’s trust) Since zero exceeds -1, Player 1 rationally prefers not to create the relationship, contractual or of other kind Therefore, in a

5David Kreps, “Corporate Culture and Economic Theory”, in Alt/Shepsle (Eds.), Perspectives in Positive Political Economy,

Cambridge University Press (1990).

dynamic setting, cooperation in exchange cannot be sustained, even if both parties would be better-off

by trusting and honoring trust, by establishing and respecting the relationship

Things may be different in repeated interactions, however, and hence the great importance of long term relationships to sustain cooperation in economic exchange But simple repetition of the game is not enough The economic idea of a long-term relationship goes beyond the mere repetition of a one-shot game The argument is as follows:

Assume that the trust game is played in exactly the same terms as shown above, with the difference that it is played a very large number of periods, T Let’s think first, using again the perspective of backwards induction, of the last period In the Tth period, Player 2 has no reason to honor the relationship, because he can obtain a higher pay-off by betraying than by honoring, given there is no future to care about in this last period Anticipating this, Player 1 will not enter the relationship in the last period, T Then, the last possible effective period of the relationship is the T-1th period Here, Player 2 knows it is the last period, and therefore he would behave accordingly, betraying Player’s 1 trust Anticipating this, Player 1 will not play the T-1th round, making the T-2th the last plausible period And so the dismal logic of the trust game unravels down to period 1, and both players find themselves exactly in the same position as in the one-shot interaction Finite repetition does not improve cooperation in economic exchange Cooperation remains unachievable when the parties know their relationship will last for a fixed and known length of time6

But the trust game (or other games involving cooperation, such as the prisoners’ dilemma) can be repeated an infinite number of periods or, more realistically, that it can be played an unknown –by the parties- number of periods, so the interaction can end at any round, with a given probability which the parties are unable to control

In such a scenario, it is possible to show that if the parties care enough about the future (i e., the discount factor at which they discount pay-offs ahead in the future is not too large), reciprocity strategies7in the repeated interaction can lead to cooperative outcomes8 The two reciprocity strategies most used in the game-theoretic literature are the following:

1 The grim trigger strategy, that states for each player:

 Choose a cooperative action until the other players deviates from cooperation

 Once the other player has defected, play defect forever after

2 The Tit-for-tat strategy, that states for each player:

 Choose a cooperative action if the other player cooperated in the previous period

8 See Joel W ATSON (2002), Introduction to Game Theory, Norton; Robert Gibbons (2001), “Trust in Social Structure: Coase

and Hobbes Meet Repeated Games”, in C OOK(Ed.), Trust in Society, Russell Sage Foundation.

 Defect if the other player defected the previous player

This powerful result that reciprocity can achieve cooperation has been crucial to the relevance of term contracts in economic theory Even in the absence of other external mechanisms to achieve cooperation in economic exchange, most notably, even in the absence of complete, formal, and legally enforceable contracts, in long-term relationships the parties themselves can attain satisfactory cooperative outcomes

long-If (i) parties can write complete contracts specifying the pareto-optimal actions for each of the parties and each of the potential or imaginable contingencies that may arise, and (ii) Courts can costlessly enforce them, of course, the short or long nature of the relationship, and the use or not of reciprocity strategies, is of no importance: Contract Law is able to force cooperation through the use of the appropriate legal sanction This is why economists, when approaching long-term relationships, have routinely assumed that contracts between the parties are incomplete, that is, they do not specify the complete set of optimal actions by the contractual parties This makes a contractual relationship governed by Contract Law what is often known in the economics literature a relational contract: Many

of the relevant actions cannot be foreseen and specified when the contract is signed, and it is in the course of the on-going relationship that the parties will adopt those actions, based upon the set of incentives arising from factors (personal, institutional) different from the formal contract and the legal rules in contract Law The relational contract can be based on information that cannot be verified by a Court of Law, or controlled by formal legal rules and procedures The relational contract can be based

on information only at the disposal of the parties as it becomes available, maybe only as a result of a change of circumstances

Of course, a relational contract in this sense cannot be simply and mechanically enforced by a Court or

an arbiter In front of relational contracts, the quest is then the design of self-enforcing agreements or relational contracts, those in which the parties are induced to adopt the best available actions for the joint welfare of the parties following their own strategies, which are checked by reciprocity, reputation,

or other intrinsic motivators, but not by the direct threat of external -to the relationship- enforcement and external sanctions

e) External enforcement mechanisms (notably legal)

It is clear that society as a whole benefits from the fact that its members interact mostly in a cooperative way This explains why societies have developed systems to enforce cooperative commitments by individuals

These enforcement systems may show a variable degree of formalization and State intervention For instance, take the trust game in figure 3 If we change from 2 to -1 the pay-off of Player 2 in case of betrayal, to reflect social disapproval by third parties of the non-cooperative behavior of that Player, then (Trust, Honor) becomes the only Nash equilibrium of the game Social disapproval may be expressed by a social sanction in the form of ostracism, negative gossip, etc Many economic exchanges have taken place historically (and even nowadays) within relatively closed social groups defined by

ethnic origin, religious affiliation, or philosophical creed, and in those contexts social sanctions are particularly powerful motivators towards cooperation9.

It cannot be denied that in large and open societies the most powerful external mechanism to promote cooperation in economic exchange is the legal system To operate as an enforcement instrument, legal systems require a set of rules determining cooperative behavior in a given context, an external (to the parties involved) authority to enforce the rules, and a system to produce the relevant information in order to apply the rule of cooperation in a given situation

A crucial issue remains thus open concerning the role of Law and formal, enforceable contracts, in term relationships Does the use of contract Law promote or undermine cooperation in long-term contracts? The response from economic theorists is surprisingly mixed and cautious Although the Law, and Contract Law in particular, is a powerful instrument to create incentives for cooperative behavior

long-in economic exchange, it is not certalong-in whether contract Law generally improve or weaken the enforcing nature of relational contracts Two factors weigh opposite directions First, in a positive way, contract Law reduces the likelihood of breaching a relational contract, by making non-cooperative behavior more costly and/or the gains from opportunistic behavior less important In the latter, unwelcome direction, it can be said that contract Law may reduce the effectiveness of the other self-enforcing mechanisms in relational contracts, thus reducing the costs of non-cooperative behavior

self-As a conclusion, it has to be acknowledged that the big questions concerning the actual effects of Contract Law on many issues of contracting remain largely unanswered by economic theory in a fully convincing way It is also true, though, that from an economist perspective, the role of Contract Law cannot be often properly understood without a joint contemplation of (at least) the legal factors, and of the “internal” or self-enforcing dimensions, especially in long-term relationships Legal rules and institutions in isolation do not capture the full picture of cooperation in contracts An exclusive focus on the legal dimensions might induce a design of rules and legal instruments that interfere with the latter, with the undesired result of reducing, rather than increasing, the level of cooperation in economic exchange

9 See for historical examples, Avner Greif, “Cultural Beliefs and the Organization of Society: An Historical and

Theoretical Reflection on Collectivist and Individualist Societies”, 102 Journal of Political Economy (1994); Lisa Bernstein,

"Opting Out of the Legal System: Extralegal Contractual Relations in the Diamond Industry," 21 Journal of Legal Studies

(1992).

Chapter 2

The Social Goals of Contract Law: Efficiency and Distribution

The long discussion in the preceding section has led the way to the design of substantive rules of Contract Law in order to induce cooperation in those instances of interaction among economic agents (individuals and firms) that take place outside well-performing and structured markets – in perfect markets The recipe from Economic Theory is simple at the abstract level, corresponding to the abstract goal of Contract Law as seen economically Contract Law rules should be crafted as to create the incentives for the behaviour of the contracting partners that would maximize the welfare of the parties affected by the contract or, in more precise economic jargon, to maximize the joint surplus from the contractual relationship

From the perspective of normative reasoning, Economics (and Law and Economics, which essentially is applied welfare Economics in the fields touched upon by, or that concern, the Law), as a social science,

is consequentialist and welfarist in its approach to societal problems Welfarism in this regard allows degrees, and some may advocate a strict version of welfarism, which condemns, in social decision-making, any consideration that is not embodied in the well-being or welfare of individuals.10 Others adopt a milder or weaker version of welfarism, which notwithstanding a strong weight attached to the individual welfare, does not rule out other social values, which may not demonstrably have entered the well-being of an identifiable individual.11 Although the differences between strict and mild welfarism are significant from a theoretical viewpoint, I don’t think that the issue can be resolved inside economic analysis (or Law and Economics) by itself, and, more importantly, my view is that those differences have little bearing on issues of Contract Law (they are more relevant in Criminal or Constitutional Law), so I will not pursue this distinction much further

Both versions of welfarism in economic analysis (including economic analysis of Law) coincide in their individualistic (or autonomy-based, or libertarian, if one prefers) approach to individual welfare Preferences held by an individual are taken essentially as given, and a matter of individual choice, genetic predisposition or determination, or cultural influence, or peer pressure, but mainly outside the bounds of the judgment of the analyst It is true that economists are devoting increasing attention to the process of preference formation (in which the Law may play a role, undoubtedly) In fact, social norms have received in recent years a substantial degree of curiosity and analysis by economists and

10 Louis K APLOW / Steven S HAVELL (2002), Fairness versus Welfare, Harvard University Press, cap 1 A strict welfarist

would not allow restrictions on what individuals consider as welfare-enhancing, based on moral or other factors external

to the individual himself A strict welfarist would not accord any value at all to those other factors in a social welfare function.

11 Matthew A DLER / Eric P OSNER (2006), New Foundations of Cost-Benefit Analysis, Harvard University Press, cap 1 A mild

welfarist may allow restrictions on what individuals judge as their welfare or well-being, based on ethical or other criteria, as well as credit some weight to those other factors in the social welfare function.

economically-oriented lawyers.12But still the core of this literature has remained positive in analytical terms, and the results have not entered the mainstream of economic normative reasoning

Contrary to commonly accepted wisdom among philosophers and legal scholars critical of the economic approach to social and legal decision-making, welfarism, either in the strict or in the milder form, does not entail a rejection of distributive goals Distribution might enter the welfarist picture dominant in Economics and in Law and Economics through three different avenues

First, individuals in society may have preferences concerning fair or just distribution of resources, and therefore their well-being will be affected by how different options in social decision influence these distributive issues The impact of distribution is, however, indirect, through particular – how idiosyncratic will they be, is a different, and solvable only through empirical inquiry, matter – tastes or preferences actually present in the individual utility functions composing the social welfare aggregate

Second, well-being depends on the level of wealth (meaning all material resources available to the individual), and thus the distribution of wealth affects individual and, consequently, overall social welfare It seems a very plausible generalization about individual human welfare that wealth increases the utility (the traditional term in economics to name individual well-being) of the individual, albeit at

a diminishing rate, that is, that each additional unit of wealth adds less utility to the total than the preceding units This generalization is commonly known as decreasing marginal utility of wealth For some, it may have important – both at a theoretical and at a policy level – distributive consequences If one thinks that interpersonal comparisons of welfare are possible,13 decreasing marginal utility of wealth implies that if we compare two social situations that add an additional unit of wealth, one to a rich individual and the second to a poor one, the second is preferable in terms of aggregate social welfare, because it adds more welfare than the first It can, thus, justify, extensive redistribution from the better-off in favour of the worse-off

Moreover, this redistributive bent is increased under most (non-additive) systems of aggregating the welfare of each and every individual into a social welfare function For instance, if individual well-beings of the members of the relevant population are aggregated not through mere summation, but by other operators (multiplicative, exponential, etc) distribution of welfare within the population is relevant for overall social welfare

Third, levels of wealth of an individual can directly affect incentives to behave in different areas subject

to legal rules One of the clearest instances refers to the assets of the agents engaging in activities that can cause harm to others If an individual or a firm has limited assets, so that he may be unable to pay for all resulting harm arising from his activity, his incentives to take care under alternative liability

12 Eric P OSNER (2001), Law and Social Norms, Harvard University Press.

13 At the theoretical level, interpersonal comparisons of utility were taboo for neoclassical economic analysis [Lionel

R OBBINS (1932), An Essay on the Nature and Significance of Economic Science, MacMillan] is the canonical exposition of such

negative attitude), but nowadays some ways to circumvent the taboo have successfully been explored in the literature: Matthew A DLER / Eric P OSNER (2006), New Foundations of Cost-Benefit Analysis, Harvard University Press, cap 3, for an

excellent reference to these issues, with an eye towards legal applications.

rules are distorted, and he will take less precaution than that required by social optimality.14It can be shown that adapting (lowering) safety standards to the levels of assets of the potential injurer, actually improves the incentives to take safety measures, and in fact, with an adequately chosen more adaptive and softer standard, the legal system can maximize the precautionary effort of potential injurers, thus attaining a second-best situation.15 This means that in the presence of exogenously given and limited levels of assets,16poorer potential injurers should optimally be subject to lower standards of behaviour than richer individuals, and this result does not depend neither on a taste for redistribution, nor on interpersonal comparisons of well-being It is based on a pure incentive (or efficiency, if one prefers to word it this way) effect, which is nevertheless dependent on the level and the distribution of wealth In fact, when determining optimal standards for an entire population, the level of wealth, but also its distribution, are crucial factors for determining the desirable safety standards, and it can be shown that under certain regularity conditions of the distribution of assets, the wealthier a given society becomes, the higher the relevant standards should be.17

The initial economic position on the guiding principle for the design of the substantive content of Contract Law rules is that the Law should create (taking in due regard the non-legal sources or incentives for cooperation within the relationship) the incentives for the behaviour of the contracting partners that would maximize their welfare of the parties affected by the contract or, in more precise economic jargon, to maximize the joint surplus from the contractual relationship Of course, this assumes that the contract does not affect third-parties, because when this assumption is not satisfied, a pure welfarist treatment of the contract should include also the impact of the contract on the welfare of the non-contracting but affected parties Thus, even if two firms are made better-off by a collusive agreement that restricts competition, there are good reasons for the Law – and for Contract Law – not

to enforce such an agreement and, on the contrary, not to give effect to the parties’ intentions and to subject it to sanctions, even criminal ones The same happens to an agreement that intends or helps to perform an intrinsically illegal action, such as murder, theft, or kidnapping In fact, Contract Law rules consider those agreements void, and, from an economic perspective, rightfully so, due to the important negative external effects arising from them

Contract Law of different Member States, moreover, sometimes contain rules ancillary to the nullity principle that try to create negative contract incentives (ie disincentives) to engage in such

17 And this result does not depend on the dependence of the level of harm on the level of assets in the population, that is,

it applies as well to a wealth-independent (environmental, for instance) external harm: Juanjo G ANUZA / Fernando

G OMEZ (2006), “Realistic Standards: Optimal Negligence under Limited Liability”, Journal of Legal Studies.

agreements.18In fact, such rules typically try to erode the incentives for cooperation within those agreements, and to create incentives for opportunistic behaviour, thus discouraging the potential contracting parties from entering into them.

The bulk of Contract Law rules, and also in present European Contract Law, do not respond to the external effects from the contractual relationship, but are concerned with the internal – to the parties –behaviours and effects To what extent is in this context the goal of maximizing the joint welfare –contract surplus – of the parties affected by the issues of distribution of wealth that economists tend to recognise as relevant for normative reasoning?

My view is that it is mostly the third dimension of the relevance of distributive issues, which will be effective and important for substantive Contract Law rules, also, eventually, for European Contract Law rules The level of wealth of an individual may, under a wide variety of circumstances, affect the incentives to act in one way or the other, and this influence has to be recognised by legal rules striving for social optimality Thus, if A has to contract with B, on the one side, and with C, on the other, in order to obtain certain desired – entirely unsubstitutable, let’s assume – results, it is likely that if C has assets much lower than B, the standard of performance may – optimally – be lower for C than for B The reason for this is not a desire to give C more wealth than to B at the expense of A (who may be wealthier than both of them), but simply to maximize contractual effort by C and by B, given their exogenously given levels of assets In fact, an optimal contract fully specified, between A and C would contain such a lower standard, compared with the complete, fully specified contract between A and B The Law, as a default, when parties may be unable to draft a complete contract may well include this differentiated standard based on the relative level of assets of the contracting parties.19 But the relevance of wealth and distribution in these circumstances does not respond to a redistributive policy

or desire, simply to an improvement of behavioural incentives of the parties, as it happens, influenced here by those issues of distribution In essence, we remain here in the safe terrain of efficiency, of providing the incentives that the parties themselves would have provided in a fully contingent and complete contract

More problematic, at least with our current level of knowledge, is the first dimension, the one based on the presence of a specific taste for distributive concerns in the utility functions of the contracting parties Although there seems to be evidence in experimental settings of behaviour consistent with a strong taste not to be treated in an obviously unequal fashion,20 it seems very problematic to translate this taste into substantive obligational content in abstract Contract Law rules, or even in factors that may be fruitfully employed in such kind of legal rules At the level of European Law, which would

18 For instance, Art 1305, 1306, Spanish Civil Code and § 817, German Civil Code On such a disincentive vision of these rules, Juanjo G ANUZA / Fernando G OMEZ (2002), “Civil and Criminal Sanctions Against Blackmail: An Economic

Analysis”, 21 International Review of Law and Economics, p 475; Gerhard WAGNER (2006), “Prävention und

Verhaltenssteuerung durch Privatrecht- Anmassung oder legitime Aufgabe?”, 206 Archiv für die civilistische Praxis, p 365.

19 This logic does not necessarily apply in all circumstances and contracts and, in fact, a default rule based on levels of wealth may be counterproductive under many other circumstances.

20 See, for a theory of inequality aversion based on this evidence, Ernst F EHR / Klaus S CHMIDT (1999), “A Theory of

Fairness, Competition and Cooperation”, 114 Quarterly Journal of Economics, p 817 Some think a reciprocity preference

more explanatory: Matthew R ABIN , (1993) “Incorporating Notions of Fairness in Game Theory and Economics”, 83

American Economic Review, p 1281.

apply to a more diverse set of individuals and groups than a national legal system, this note of caution

is particularly required, given that the available evidence points at large differences among cultures and societies in the experimental results.21

Also problematic, though for different reasons, would be to pursue through general Contract Law rules

a policy of consistently redistributing welfare, or wealth more narrowly, from one contracting party in favour of the other, even if one thinks that the gains from trade and interaction between parties are unequally distributed (for instance, are systematically biased towards sellers and against buyers) and that the legal system should attempt to correct the imbalance in this distribution

The problem with the use of substantive Contract Law rules to achieve this redistributionist policy, even accepting the premise of its overall desirability,22 is that contracting parties, sellers and buyers, firms and consumers, affected by those rules are, by definition, in a contractual relationship And this allows the parties to alter the terms of trade or the exchange An increase in duties or rights that is not efficient or welfare-increasing, in the sense of augmenting the surplus of the interaction, will imply a readjustment of the terms to the detriment of buyers that cannot be compensated by the increased welfare of buyers due to a higher level of sellers’ legal duties or buyers’ legal rights Thus, a purely redistributive legal intervention – one that does not increase joint welfare apart from how this welfare

is shared among the parties to the interaction – is very likely to become moot due to the readjustment in price and/or other terms of the transaction, when the affected parties find themselves in a contractual situation.23As has been noticed already,24 redistributive policies can be largely undone when the party benefiting – from redistribution – party and the losing party are not into a contractual relationship Thus, it is easier to redistribute with tort law rules than with contract rules, and among the latter, it is easier to redistribute through rules that allow one party not to enter into the contract, or alter the

“Why the Legal System is Less Efficient Than the Income Tax in Redistributing Income”, 23 Journal of Legal Studies, p

667; Louis K APLOW / Steven S HAVELL (2000), “Should Legal Rules Favor the Poor? Clarifying the Role of Legal Rules and

the Income Tax in Redistributing Income”, 29 Journal of Legal Studies, p 821 The core of the argument is as follows: The

use of taxes and transfers as redistributive mechanisms just creates one distortion, namely in the work-leisure trade-off Substantive legal rules generate a double distortion: One, the same we have just described for taxes, the other, the inefficiency generated by a legal rule chosen not on its efficiency merits, but on its redistributive effectiveness Again, some within the Law and Economics literature disagree with this gloomy view of legal rules as redistributive instruments: Christine J OLLS (2000), “Behavioral Analysis of Redistributive Legal Rules”, in Cass S UNSTEIN (ed.) (2000),

Behavioral Law and Economics, Cambridge University Press, Cambridge, p 288; Chris William S ANCHIRICO (2000), “Taxes

versus Legal Rules as Instruments for Equity: A More Equitable View”, 29 Journal of Legal Studies, p 797; Chris William

S ANCHIRICO (2001), “Deconstructing the New Efficiency Rationale”, 86 Cornell Law Review, p 1003 I do not take sides in

this debate, because my topic here is narrower, as it refers solely to substantive Contract Law rules, and my view is that one can confidently answer the narrower question without attempting to answer the broader one.

23 The argument is by no means a new one: Harold D EMSETZ (1972), “Wealth Distribution and the Ownership of Rights”,

1 Journal of Legal Studies, p 223; Koichi HAMADA (1976), “Liability Rules and Income Distribution in Product Liability”, 66

American Economic Review, p 228; Lucian B EBCHUK (1980), “The Pursuit of a Bigger Pie: Can Everyone Expect a Bigger

Slice?”, 8 Hofstra Law Review, p 671.

24 C RASWELL (1991), “Passsing-On the Costs of Legal Rules: Efficiency and Distribution in Buyer-Seller Relationships” 43

Stanford Law Review, p 387 Emphasizing the difference in redistributive effectiveness between rules on bargaining starting points as opposed to rules on bargaining outcomes – ie substantive rights and duties in the contract –, Chris William S ANCHIRICO (2001), “Deconstructing the New Efficiency Rationale”, 86 Cornell Law Review, p 1047.

negotiation process, than through rules that govern, as mandatory or default provisions, the content of the relationship.

We will develop the argument with the help of figure 4 and figure 5, which provide an illustration of redistributive legal intervention favouring buyers.25In both, demand and supply for a given product or service is depicted A mandatory contract legal right for the buyer (think of a non-waivable warranty

on accompanying the product) is imposed That the measure is pro-buyer is shown by the increase in demand following the introduction of the warranty: D2 > D1

Figure 4 represents a legal right favouring buyers that does not increase contract surplus, because it costs the seller (as shown by the segment a-b, the distance between supply curve, S1, before the legal warranty is imposed, and supply curve, S2, after its imposition) more than it benefits the buyer (as shown by the segment c-d, the smaller distance from D1 to D2)

Figure 5, in turn, represents a legal right favouring buyers that does increase contract surplus, because

it costs the seller (as shown by the segment c-d, the distance between supply curve, S1, before the legal warranty is imposed, and supply curve, S2, after its imposition) less than it benefits the buyer (as shown by the segment a-b, the larger distance from D1 to D2)

25 To represent a redistributive policy pro-seller (of services, say, like the mandatory termination compensation in favor

of the agent provided by Art 17-19 of the Commercial Agency Directive) one would only need to reverse figure 4 and figure 5 (the inefficient legal intervention pro-buyer, as shown now in figure 4 would be an efficient legal intervention pro-seller, and vice- versa in figure 5).

c d

D1 Q2

Thus, if a pro-buyer legal rule is not joint welfare-enhancing, the readjustment of price and quantity terms will in the end reduce the well-being of the intended beneficiaries of the distributive policy If the rule, on the contrary, increases contract surplus, even if sellers are benefiting, in net terms, from it, may

as well have valuable distributive consequences favouring buyers This implies, at least presumptively,

a good case for Contract Law rules that create incentives for the behaviour of the contracting partners that maximizes the welfare of the parties affected by the contract

The preceding analysis summarizes the outcome of distributive legal rules when buyers are homogeneous When they differ in terms of the valuation of the increased duties or rights, the analysis

is more complicated, and the result ambiguous, because there may be winners and losers among the group of buyers, thus raising distributive issues inside them In fact, it is true, that under certain conditions, a pro-buyer legal rule that does not increase contract surplus may overall benefit the class of buyers If the reduction in contracted quantity (Q1-Q2) is sufficiently small, and the valuation of the increased duties or rights by the marginal buyer is sufficiently smaller than the corresponding valuations of the infra-marginal buyers,26 it is the case that even if the imposed rule is inefficient – it reduces joint surplus – buyers as a group – albeit not all of them – will be better-off at the expense of

26 The marginal buyer is the one located along the demand curve at the equilibrium price Infra-marginal consumers are those located up the demand curve Marginal buyer’s valuation is the one that determines the equilibrium price, which will be paid, however, in the same amount by all buyers – absent price discrimination.

sellers, who would not be able to recover through the increase in price the entire impact on production

or distribution costs of the pro-buyer rule.27

The qualitative implication, namely that inefficient legal intervention is not likely to be an attractive redistributive policy, however, still holds First, because pro-buyer rules that reduce joint welfare of the contracting parties tend to burden more heavily the marginal buyers, and these are typically those who are more worthy of redistribution in their favour, and in turn, tend to favour more intensely the infra-marginal buyers, who are the ones that even before the legal change already enjoyed a higher share of the contract surplus In other words, inefficient legal interventions are more likely to produce regressive internal redistribution among buyers Second, because the requirements for effective redistribution through non-welfare enhancing rules are restrictive and exacting This makes hard for the legal decision-maker in Contract Law (legislator or Court) to be in possession of the necessary information to make the right redistributive choice If the required information is not available, the likelihood that with an inefficient rule we end up also with an undesirable distributive outcome is relatively high

All the preceding reasons cast substantial doubts on the ability of Contract Law Rules, and not the least those in European Law, to ambitiously pursue distributive objectives Particularly when these seem to overtly conflict with maximizing the size of the welfare pie produced by the contract, the redistributive bent should be considered very cautiously, as it is likely that they will be will not be distributively appealing, in addition to being inefficient This does not mean that wealth and its distribution should

be entirely disregarded in the design and implementation of Contract Law rules, but essentially their role should be important when these dimensions improve the behavioural incentives that lead to greater total contract surplus, or joint economic welfare of the contracting parties

27 Richard C RASWELL (1991), “Passing-On the Costs of Legal Rules: Efficiency and Distribution in Buyer-Seller

Relationships’ 43 Stanford Law Review, p 377 and following Even those who are more sympathetic to redistributive

policies among the economic analysts of the Law acknowledge the existence of these restrictive assumptions for an effective redistribution pro-buyer in the contractual context: Chris William S ANCHIRICO (2001), “Deconstructing the New

Efficiency Rationale”, 86 Cornell Law Review, p 1046.

Chapter 3 The Basic Law and Economic Notions of Contract Law

In this chapter we will present some essential notions and concepts to start looking at contracts and Contract Law rules from an economic and strategic perspective The conceptual starting point to analyze Contract Law is the notion of a complete contract (or completely contingent contract) When individuals can write a contract:

(i) specifying each and every contractual action of the parties involved;

(ii) specifying the best action for the joint welfare of the parties involved;

(iii) for the full set of possible circumstances or contingencies that may possibly take place;

(iv) the factual basis and the agreed consequence for each and all contractual determinations can be verified by the legal enforcer, typically, a Court of Law

then we have a complete contract

We do not find complete contracts, in this sense, in the real world Contracts in reality do not fit this exacting notion We should bear in mind, however, that the economic notion of a complete contract is essentially a conceptual tool to understand contractual behavior and contracting institutions (including the legal institutions surrounding contracts) but it is by no means not a description of the real world of contracting, not to speak of the legal rules and doctrines

Let's start, however, one step back and consider the notion of contract in itself The economic and legal notions of a contract do not exactly coincide The existence of an agreement by the parties is the basis of

a contract, from both the economic and the legal view point The most foundational element in a contract is that it consists of a voluntary28 agreement, together with the idea of set of future actions which are enforceable through an external mechanism Contrary to common belief, from an economic perspective, the idea of exchange, of price paid in exchange of something plays a secondary role compared to the idea of specification of future behavior

Here are some notes of the concept of contract from an economic point of view:

 The economic concept of contract is characterized by voluntariness29: parties to the contract take part in it voluntarily, presumably because their preferences are satisfied better by the contract than by any of the other mutually exclusive alternatives of conduct

 The contract establishes the future behavior of the contracting parties

28 The Principles of European Contract Law (hereinafter, PECL), Article 1:102: Freedom of contract, proclaim the basic freedom of contracting and determining contractual content Art 2:101 PECL foresees sufficient agreement as the basis of contract formation Similar provisions may be found in most Civil Codes.

29 Free and spontaneous determination of the will to enter into a contract, as is traditionally defined.

 The aforementioned is based on an explicit or implicit characterization of circumstances or future states of the world that can affect such behavior by contracting parties, or the outcomes from such behavior.

In Law, typically any (or almost any) voluntary or consensual agreement with legal consequences will

be deemed a contract It is obvious that the economic concept of contract is related to its legal concept, but both differ along several dimensions:

 The economic concept of contract is more exacting than the legal notion It involves less phenomena, less economic and social situations than the common legal concept: Spot market interactions (buy the daily bread, in exchange for its market price, or buy shares in a stock exchange for the spot market price) are only nominally contracts, but do not pose the problems that the conceptual tools of the economic view of contracts are designed to resolve

 The economic concept of the contract stresses aspects such as future actions and circumstances

connected with the contract

For example, most legal systems contain definitions of what is a sales contract or Purchase Agreement

A sale of a newspaper in a news stand is a sales contract from the legal point of view However, it is not a contract from the economic view point, since it has no relevance for the future On the contrary, this temporal dimension exists, for example, if a purchaser pays with false currency, or when the a purchaser finds a defect in the goods and thus may claim against seller for said defect.

For reasons mentioned above, contracts are economically relevant if either there are nothick markets,

or if markets work imperfectly Thus, it is for the parties to decide, and not to the markets, what will happen in the future, and on what terms The transactions in organized and quasi-perfect markets (e.g., stock exchange) tend not to fall within this notion.

How does the notion of the complete contract fits into this The beauty and usefulness of such notion lies in the interesting property that a contract satisfying the tough requirements of a complete contract defines a Pareto-optimal situation for the parties A contract in which both parties agree to a complete and welfare-maximizing specification of all contractual behavior by the parties in all possible and imaginable states of the world and future circumstances, is Pareto-optimal by definition (otherwise parties would not agree to it) A complete contract cannot be improved upon from the point of view of the joint welfare of the contracting parties This makes it an excellent benchmark for analysing and evaluating policy and legal options affecting contracting and the situation of contracting partners

In the real world, as already pointed out, contracts are not complete in this sense Incomplete contracts are the rule in the real world, given the extremely exacting requirements that pareto-optimality, completeness of coverage, and verifiability of information pose on complete contracts A number of reasons have been identified by economic theorists supporting the proposition that contractual incompleteness is the rule and not the exception:

 The prevalence of non-verifiable information concerning many relevant contractual behaviors; the inevitability of imperfect specification of actions that will take place in the future, and in all possible states of the world in the future,

 The difficulties in measuring and evaluating the cooperativeness of contractual behaviors, given the multidimensionality of complexity of many of them;

 The advantage, under certain circumstances, of internal (including reciprocity-based) motivators for cooperation over external mechanisms such as formal and legally enforceable contracts30;

 The parties may not foresee all the circumstances which shall occur in the future and which may in a way affect the contract;

 Even when the parties could have foreseen all future circumstances influencing, however slightly, the transaction, there exist several obstacles which may prevent them from reaching an agreement: these are called transaction costs

Therefore, the notion of complete contract is not descriptive, but heuristic: It is a very useful conceptual benchmark, being, as it is, optimal for the parties It allows us to evaluate and compare the real world mechanisms to achieve a given contractual outcome, including legal rules and principles The closer a given contractual mechanism (legal or non-legal) brings us to the outcome under the complete contract, the more desirable that mechanism is (remember that the complete contract, being Pareto-optimal, cannot be improved for both parties simultaneously, and unbeatable contractual situation)

Legal theorists have long recognized the existence of loopholes, of incompleteness in legally enforceable contracts Many basic legal rules (artt 1:102, 1:105 PECL, many provisions in Civil Codes) intend to provide instruments to deal with those loopholes, basically through default rules, usages and practices in trade or in a given area of economic or contracting activity, and good faith and fair dealing requirements, at least in Civil Law countries

However, an incomplete contract in the economic sense may appear as not having gaps in a legal sense

If the essential obligations of the parties are defined, as well as the timing of their performance, it may

be the case -even often- that no surprising or unexpected event happens, so the contract appears to be legally complete or gap-free, and the adjudicator thinks it is easy and straightforward to enforce as written, if voluntary compliance with the terms of the contract does not occur But such a contract is surely economically incomplete, since the timing and actions of the parties have not been foreseen as depending upon relevant factors: how costly it is for the parties, when the time comes, to perform, how demand in the market may affect the valuation of performance by the buyer, and so on A completely contingent contract would dictate the best solution to each imaginable contingency that may affect performance, but the incomplete contract -yet, from a legal viewpoint, gap-free contract- fails to have fine grained and tailored determinations for each scenario, and mandates uniformly performance in the same terms for every possible situation in the future state of the world

30 See, Martin Brown / Armin Falk / Ernest Fehr, “Contractual Incompleteness and the Nature of Market Interactions”, CEPR Discussion Paper (2002), for experiments showing how explicit and enforceable contractual clauses may crowd out reciprocity and altruism in contracting On these general issues, Colin C AMERER, Behavioral Game Theory Experimental

Studies of Strategic Interaction, Princeton University Press (2003).

It is then clear that the economic point of view should be distinguished from the legal one: from the former view point, the contracts are classified in complete and incomplete, whereas from the latter one, the Law typically thinks in terms of contracts with and without obligational gaps in them.

We will try to show this idea with a very simple numerical example involving a contract for the production and delivery of a good between Seller and Buyer

S and B are thinking of entering into a contract The cost of performance for S is uncertain: it could be 50, with 60% of probability, 70, with 20% probability, and 150, with 20% probability The value of performance by S to B

is 100 In such a way, pursuant to the “complete contract”:

 With a cost of the contract for S of 50, S shall perform since the purchaser values it in 100, and so a surplus

of 50 (joint interest) shall be produced (100 – 50) In this case, the contract produces an increase of the value

"breach of contract" if the parties, as is usually the case, had simply written a contract stipulating that S, at

a given time, should perform and B at that time should pay the price 31

In the example it should be noted -a point of general validity- how the role of the contract price is essentially distribute between the parties the surplus or increase in value produced by the actions contemplated in the contract The higher the price, the bigger the seller’s share of the surplus At a lower price, it is the purchaser who benefits from most of the value.

The price also is the inducement to contract, that is, it may not be inferior to the one which makes S or P enter into the Contract within said interval (minimum price in order that S enter into the contract and maximum price

in order to B to do the same) In our case, many prices within a range could be part of a complete contract since,

in any case, the complete contract shall be performed whenever it is desirable for both ex ante that it is performed Of course, B could obviously prefer the lowest possible price, and S the highest possible one S shall not accept a price of 30 as he will prefer not to enter into the contract (since the cost of production of the good is,

at least, 50).

From the economic point of view, what is crucial is that value is created, not the fact that any party may obtain more or less from the contractual surplus, the cooperation pie (typically that issue depends on the negotiation abilities of each contracting party, and therefore, usually outside the boundaries of Law and Economics).

What is a conclusive issue in order that a complete contract exists is that a surplus is created (a situation that cannot be improved upon for both parties at the same time) If, e.g a price of 60 is agreed (within the contracting interval), which places the parties in a better position than one not to enter into the contract (If for any reason whatsoever, the cost of production is 70, according to the concept of complete contract, S shall enter into the contract although he will only obtain a price of 60 since 70 is lower than 100 (70 < 100) (100 = estimation

31A critique of this notion in Daniel Markovits and Alan Schwartz, "The Myth of Efficient Breach: New Defenses of

the Expectation Interest", 97 Virginia Law Review (2011), p 1939.

of the consideration for B): the concept of complete contract looks at the joint interest and not the interest of only one of the parties: the optimal thing is that contract is entered into because a value of 30 is created , notwithstanding the fact that, later on, S looses 10 (price - cost of production = 60 – 70 = -10).

With this example we can observe the relevance of informational problems for the actual existence of complete contracts: There exist certain circumstances which, even though they could be contractually foreseen and solved

by both parties in an optimal way, they may not be verified by a third party who shall have to find a solution in respect of said contract.

E g a Court or an arbitrator may not be able to determine, in the prior example, when the cost of production is actually 150 or a lower amount Let’s think that the actual cost, ex post, is 60 We know that when cost is 150, the optimal solution would be not to perform Thus, if in a contract which provides for the non-performance of S in case the cost is 150, S does not comply with it being the actual cost of 60, it may try to cheat the arbitrator or Court by saying that the cost has been of 150 In that case, S may benefit from a more complete contract, in order

to manipulate the lack of verifiability by the external enforcer For said reason, it may be better to use a more coarser information set, a contract with lees fine information, but which may be verified by an external observer and not subject to manipulation by the parties according to their ex post private interest (e.g., audited figures, instead of demand conditions) In that case, although the contract is not complete, the circumstance shall be more secure and less subject to interested modifications and strategic use by the parties before an arbitrator or a Court.

Let's now turn to another foundational issue, namely the roles and tasks that Contract Law can be entrusted with in this framework, beyond the simple one of enforcing the terms of a contract in a sort of purely mechanistic way These tasks indeed result from the basic notions of contract and complete contract that we have previously examined

We emphasized above the importance of voluntariness, of consent -a more common and dear legal concept Voluntariness ensures, at least presumptively, that the interaction improves the lot of the parties compared to the situation prior to the contract Contracts are indeed enforced -and encouraged-legally, because the social effects of contracting are judged to be positive and praiseworthy A key requirement for this attitude in legal systems is the existence of consent Without consent, nothing typically guarantees that the contract makes both parties better-off Thus, it makes sense for the legal system to devote energy and resources to try to make sure that consent is indeed genuine, not merely cosmetic Genuine consent, of course, depends on the knowledge and information that parties have over a long range of relevant variables, at the time of entering into the contract Moreover, the social desirability of contract not only depends on the interaction being consensual, but also on the outcome -

or perhaps the mere existence- of the contract not affecting negatively non-contracting parties Think of

a price fixing agreement among competitors and the negative effects over consumers Thus, the legal system is also concerned with the third-party dimension of how and what contracts are entered into

These tasks form the first pillar of Contract Law rules, namely those related to contract formation Here, issues of voluntariness and information loom large, as will become apparent in the following chapters The legal rules on contract formation affect a wide variety of decisions by potential contract parties, and not just narrowly those that take place in the contract negotiation and agreement phase (how to negotiate, how to respond to offers by the other side, whether and how much to invest prior to the contract) but also previous actions, such as acquiring information about the future contract, or how to look for adequate contract partners We also find rules -not always inside Contract Law as it is

traditionally understood- that police the contract in order to reduce or eliminate negative externalities

or third-party effects It is in the area of contract formation where we tend to find mandatory rules, that

is, legal propositions whose application does not depend on the intention of the people involved, so that they will be forced onto the parties even if they do not like them or prefer to be free from them, or governed by other rules

The second fundamental role is directly linked to the idea of completing the incomplete agreement made by the parties Many factors explain why contracting parties fail to make complete contracts in the economic sense of the term, and thus fail to realize the full gains from the interaction by setting the best action rules for every possible contingency But the parties, although not having signed a complete contract, have signed a contract nonetheless, and thus circumstances will take place where their failure

to specifically provide for an optimal response will become relevant, and often, this will even lead to a dispute Contract Law rules will be then used to determine which actions parties will need to take in those contingencies not explicitly provided for by the contract agreed by the parties or, less frequently,

to override the actions that the parties themselves had foreseen This is a task of completion of the contract

Completing the contract may involve different legal tasks Interpreting and construing the agreement is one of them, since they imply the determination of a contractual outcome when the text of the contract

is not sufficiently clear and unambiguous It also includes the fundamental function of providing remedies for breach, that is, for situations where one of the parties feels aggrieved because the other has failed to act according to what the terms of the contract provided for as obligations Interpretive rules and default rules on breach of contract, applied by external adjudicators such as Courts or arbiters constitute the bulk of the tools through which Contract Law discharges this function As already mentioned, the complete contract notion is very useful to think of this completion endeavor, since it provides the optimal benchmark against which to assess how well or how badly the different alternative solutions offered by interpretive or breach rules fare with respect to the pareto-optimal allocation Also it is importance to notice that these legal rules will affect a wide range of actions by the parties, from drafting behaviour, to performance and breach decisions, to decisions of whether to invest,, how much to invest, and what type of investments linked to the contract to make, to risk allocation of the consequences of probabilistic developments and contingencies

It is important to notice, however, that the task of completion is not the sole responsibility of these rules for the entire realm of contracting The Law often relies on other mechanisms different from default rules designed and/or enforced by Courts For certain types of important areas of contracting, the legal system, although not fully renouncing to use default rules, prefers to entrust completion to other means, of a diverse nature Sometimes, the incomplete contract has to be completed by subsequentnegotiation by the parties (renegotiation is term usually chosen by economists) in order to determine how parties will act in the contingencies that arise after the formation of the contract The Law substantially does not provide default rules to cover future contingencies and outcomes, besides very broad and undetailed provisions, and simply is concerned about the break-up of the contractual relationship and its aftermath Thus, if parties fail to satisfactorily renegotiate their agreement along the way to respond to every contingency, the only option is to bring the contract to an end, under the rules about break-up set up by the legal system Many contracts are handled according essentially to this model Paramount among those is marriage, but also in the business context this model is easy to find:

joint ventures and other similar types of business agreements are completed essentially relying on a continuous process of renegotiation in the shadow of the legal rules about break-up.

For other relationships, the legal system provides that a permanent or stable organization will be created by the parties, and the organization will be entrusted with completing the contract The legal system does not have a hands-off approach, since it contains default rules for some specially important

or frequent contingencies, and also provides safeguards against malfunctioning of the organization set

up by the parties through the contract But the detailed and daily completion is left to the organization governing the contract This is what we observe in companies and corporations, where the company and corporate relevant bodies take the decisions about course of action and contract completion along the way -and often it is a long way, since the contracts are in principle of indefinite duration- within the boundaries set by mandatory company law rules

Default rules of Contract Law, renegotiation and organization do not exhaust the contract completion mechanisms that legal systems actually use An important one is authority: one of the parties is entrusted with the power to complete the contract and provide rules of action for the contingencies affecting the life of the contract This authority is not without bounds or limits, often strict ones In fact, the Law gives especial weight to such constraints, in order to reduce arbitrariness, and even discretion,

in the exercise of the authority to complete the contract The employment contract is probably the clearest example of this completion model, where the employer is empowered to determine most of the content of the contract, albeit subject to important constraints imposed by employment laws and collective agreements, setting limits to working conditions and often establishing as well compensation schemes following termination of the relationship Also outside the labor contract one may observe this completion mechanism at work In distribution contracts (franchise, selective distribution, etc.) the franchisor or supplier enjoys significant authority to complete the contract, again subject to certain limits on the exercise of authority, and sometimes under the shadow of compensation provisions for termination Again, it is no surprise than in most legal systems, legal density and emphasis concerning those contracts, both quantitatively and qualitatively, is concentrated on limiting discretion and regulating the consequences of termination

In the following chapters we will not deal with this set of alternative contract completion mechanisms Not because we believe they are, theoretically or practically, unimportant It is merely that our focus is

on the core of Contract Law, or if one prefers, the traditional area of this field of the Law Thus, the discussion in the remainder of this book will be organized around the two main tasks of Contract Law

in the narrow sense of the word: rules on contract formation and rules on contract completion Again, the division is not intended as metaphysically essential, since it is clear that both are mutually dependent Parties would obviously decide to enter into a contract having regard of how the Law will complete their agreements: contracting parties weigh the legal remedies in case of breach by the other party before they jump into the agreement And the contract formation process will influence how a contract will be interpreted, gaps will be filled, and remedies will be enforced For expositional purposes, we will deal with the issues arising from the two fundamental tasks of Contract Law in a separate fashion

Activities and Readings

1 S and P are considering entering into a contract The cost of production of the consideration for S

is uncertain: it could be 30, with 60% probability (1), 70 with a probability of 20% (2) and 150 with a probability of 20% (3) The value estimation of the consideration on the part of P is of 100, and the price would be paid on completion and delivery of the consideration.

a) Let us suppose that the parties enter into a contract which will be called A1, whereby S will perform the consideration for P at any case and that the latter shall pay the price of 75 Which is the surplus of this contract for P and for S? Show why both will prefer another contract to be called A2, pursuant to which S will perform the consideration only when the cost is 30 or 70, and calculate a satisfactory price for both to prefer entering the A1 contract to A2

b) Let us suppose that the initial contract (called A3) provides for compliance solely when the cost

of compliance is 30, establishing a price of 50 Show why both contracting parties prefer contract A2 to contract A3

A3) The cost of the consideration for the Seller (S) is 30 in 60% of the cases, so:

Vs = 60% (50 – 30) = 12

Vp = 60% (100 – 50) = 30

32 V = estimation of the contract for (S) and (P) respectively.

33 Pursuant to contract A2, S shall only perform his consideration when the cost is of 30 or of 70 (that is to say, in 80% of the cases), so in the other 20% of the cases he shall not enter into the contract.

S and P prefer A2 to A3 as both maximize their benefits under this contract: under A2, S obtained 16 y P obtained 32.

Conclusion: If we initially consider a situation which differs from the best possible contract for the benefit of both parties (the complete contract) it will be possible to find a case in which if the price is modified conveniently, the benefit of all contracting parties shall improve

2 STS, 1ª, 11.2.1999 (RJ 1999\652) MP: Alfonso Barcalá y Trillo- Figueroa

FUNDAMENTOS DE DERECHO

PRIMERO.- Doña María del Carmen H P y doña Estrella A A promovieron juicio declarativo de menor cuantía contra doña Encarnación P G., en reclamación de pago de la cantidad de 16.666.666 pesetas, importe de su participación en el premio correspondiente al boleto propiedad de las tres, así como los intereses legales hasta el total pago de la suma reclamada, y, subsidiariamente, para el supuesto de que no se estime procedente la pretensión deducida, que se determine por el Juzgador cual

es la participación personal de las demandantes en el premio obtenido, declarando la obligación de la demandada al pago a las actoras de la cantidad procedente Las pretensiones así ejercitadas fueron desestimadas por el Juzgado de Primera Instancia Número Dos de Leganés en Sentencia de 16 de marzo de 1993, pero fue revocada por la dictada, en 21 de junio de 1994, por la Sección Vigésimo Primera de la Ilma Audiencia Provincial de Madrid, y en su lugar, estimando totalmente la demanda, condenó a doña Encarnación P G a pagar a favor de doña María del Carmen H P y de doña Estrella

A A la cantidad de 16.666.666 pesetas, importe de su participación en el premio correspondiente al boleto propiedad de las tres, así como a abonarles el interés anual de 16.666.666 pesetas, incrementado

en dos puntos, desde la fecha de esta sentencia hasta el completo pago de la suma de 16.666.666 pesetas Y en esta sentencia se relatan una serie de hechos, que atendiendo al modo y forma en que figuran redactados, bien pueden ser conceptuados como probados, y que concuerdan, substancialmente, con los estimados acreditados en la recaída en primera instancia, así: «A doña María del Carmen H P (demandante), doña María Estrella A (demandante) y doña Encarnación P G (demandada), les unía una fuerte amistad, y, durante el año 1989, acordaron jugar, conjunta y de forma continua y habitual, a la Lotería Primitiva, para lo cual se realizaba una aportación semanal de 235 pesetas cada una, que, en un principio, era recogida por la señora H., y, posteriormente, por la señora P

la cual se encargaba de presentar el boleto de siete apuestas para ser visado, previo pago de su importe, quedándose con el resguardo, con el compromiso que, de obtener un premio, se partiría su importe entre las tres por partes iguales Y así lo vinieron haciendo, hasta el día 8 de enero de 1992 Tras recibir las aportaciones dinerarias de las señoras H y A., la señora P visó el boleto múltiple de 7 apuestas, número 365-07420810-076 (con la siguiente combinación: 2-7-12-27-32-34-41 y reintegro el 2) para participar en el primer sorteo del año 1992 de la Lotería Primitiva, a celebrar el día 2 de enero de 1992, quedándose con el resguardo del boleto, el cual no resultó premiado Existía en esas fechas un concurso denominado "Primi-Juego II" que se regía por unas normas publicadas por el Organismo Nacional de Loterías y Apuestas del Estado (Ministerio de Economía y Hacienda), figurando un extracto de las

mismas en los establecimientos autorizados Siendo una de las formas en las que se puede participar, atendiendo a las llamadas telefónicas que se efectúen en directo desde el programa de televisión en el que previamente se retransmite el sorteo de la Lotería Primitiva Para lo cual se tiene en cuenta la Guía Telefónica, con todos los números de teléfono existentes en la misma, y, por sorteo, se elige uno de entre ellos, al que se le llama desde el programa de televisión El concurso consiste en la existencia de

un panel en el que figuran 41 números (del 1 al 41) detrás de los cuales, sin estar a la vista de los espectadores, figura un premio en dinero o en especie, siendo el más elevado el de 25.000.000 de pesetas, teniendo el concursante que elegir un número de los del panel obteniendo el premio que figura detrás del mismo (en ocasiones puede elegir varios números correspondiéndole el premio más alto de entre los diversos obtenidos) De la reglamentación del "Primi Juego II" conviene destacar las siguientes normas, la 24: "Durante la retransmisión por TVE del concurso se marcará el primer teléfono sorteado

En el caso de no conseguir comunicación, o la persona que lo atiende manifiesta que no desea participar en el Concurso, se marcará el siguiente teléfono, y así hasta efectuar las tres llamadas telefónicas"; la 26ª: "Serán requisitos indispensables para obtener algún tipo de premio con las llamadas telefónicas, que se conteste al teléfono antes de que el timbre suene seis veces y que la persona que atiende el teléfono manifieste clara y rápidamente su deseo de participar en el Concurso"; la 28ª en su número 1: "Concursante que desea participar, pero no conoce la combinación ganadora del sorteo de Lotería Primitiva celebrado minutos antes, ni juega a la Lotería Primitiva de esa semana ni al Bono-Loto que ha finalizado el miércoles anterior o empieza el próximo domingo Este concursante obtendrá como premio un número completo de Lotería Nacional, y se efectuará la siguiente llamada telefónica, si la hubiese Cuando los tres concursantes de un mismo programa fueran de esta modalidad, se actuará tal como se indica en la Norma 25, acumulándose la cifra más alta para las llamadas telefónicas de los siguientes concursos", y en su número 3: "concursante que desea participar, no conoce la combinación ganadora del sorteo de la Lotería Primitiva celebrado minutos antes, pero juega a la Lotería Primitiva

de esa semana o al Bono-Loto que ha finalizado el miércoles anterior o empieza el próximo domingo

En el caso que posea varios resguardos podrá participar con el que tenga mayor número de apuestas Este concursante deberá indicar el número de apuestas de su resguardo y si es de Lotería Primitiva o Bono-Loto antes de que transcurran treinta segundos, contabilizados con un cronómetro que se verá en pantalla, pues de lo contrario se pasará al siguiente teléfono, si lo hubiera Este concursante podrá iluminar tantos números del Panel del concurso como la mitad, redondeada por exceso, de las apuestas que tenga en su resguardo, es decir, si tiene una apuesta encenderá un número, si tiene dos igualmente

un número, si tiene tres dos números, etc , obteniendo como premio la cifra más alta aparecida Obtiene también como premio un número completo de Lotería Nacional Los números que obligatoriamente ha de decir el concursante para que se iluminen en el Panel han de ser los que tenga el primer bloque del resguardo, por el orden que desee En el caso de apuestas múltiples, podrá añadir los números que quiera hasta completar los que tenga derecho a iluminar"; y la 29ª: "Los concursantes de las Normas 28ª.3 y 28ª.4, inmediatamente después que finalice la llamada telefónica del concurso, deberán identificar telefónicamente el resguardo con el que han participado mediante el número de sello, número de validación mecánica o número de control, según el tipo de resguardo, quedando supeditada la obtención de los premios, incluidos los números de Lotería Nacional, a la comprobación posterior de la veracidad de los datos facilitados durante y después del concurso" En el programa de televisión del día 2 de enero de 1992, en el que se emitía el concurso denominado "Primi-Juego II", después de transmitirse el sorteo de la Lotería Primitiva, se llama por teléfono al número , del que figura como titular en la guía telefónica don José M G., esposo de doña Encarnación P G (demandada), el cual descuelga el auricular y a la pregunta de si desea participar en el concurso del

"Primi-Juego II" contesta afirmativamente, después de lo cual es su esposa, la señora P., la que se apodera del auricular y continúa la conversación telefónica, contestando que no conoce la combinación ganadora del sorteo de la Lotería Primitiva celebrado unos minutos antes, pero, añadiendo, que ha jugado a la Lotería Primitiva de esa semana y que era siete el número de apuestas de su resguardo, y, ante la invitación para que designe varios números de los que figuran en el panel, elige, entre otros, el número 12, detrás del cual figura un premio de 25.000.000 de pesetas Inmediatamente después de finalizar la llamada telefónica del concurso no fue capaz de identificar telefónicamente el resguardo de

su boleto, pero se comprometió a hacerlo al día siguiente Y, en efecto, el día 3 de enero de 1992, le comunica al Organismo Nacional de Loterías y Apuestas del Estado, que su resguardo es el del boleto múltiple de 7 apuestas número 365-07420810-076, y, este mismo día, procede a depositar en el "Banco

de Santander", el resguardo, de donde no lo retirará hasta el día 27 de enero de 1992 El Organismo Nacional de Loterías y Apuestas del Estado procede a comprobar, a través de sus servicios técnicos, si los datos facilitados por la señora P corresponden a un boleto que hubiera participado en el sorteo de esa semana, y, dado que la comprobación resultó positiva, el día 23 de enero de 1992 le pagan a la señora P la suma de 25.000.000 de pesetas, importe del premio obtenido en el concurso del "Primi-Juego II"»

SEGUNDO.-(…)

TERCERO.- La pormenorizada relación de hechos acreditados a la que se hizo referencia permite extraer como consecuencias fácticas indiscutibles que el previo acuerdo de tipo asociativo tenido lugar entre las tres amigas litigantes tuvo como exclusiva finalidad la de jugar a la «lotería primitiva», con la aportación semanal igualitaria que aportaba cada una de ellas al respecto, a cuyo convenio inicial no es posible atribuirle ninguna otra finalidad, relacionada en mayor o menor medida con el resguardo del boleto o boletos que no hubieran obtenido premio en el sorteo indicado, a no ser que dejara de tenerse a

la vista la disposición restrictiva del artículo 1283 del Código Civil, pues ello representaría la total desnaturalización de los términos convenidos y dejaría vacía de contenido la específica «afectio societatis» que movió la concordada voluntad de las partes Y estas consecuencias fácticas se imponen fuese cual fuese la calificación a asignar al «negocio jurídico atípico» así convenido, esto es, la semejante

a una sociedad civil irregular o a una comunidad de bienes, o cualquier otra figura jurídica de análogas características

CUARTO.- Las consideraciones que anteceden unidas al hecho incuestionable de que el «boleto» no premiado en la «lotería primitiva» agotó como tal su consideración jurídica a los fines del convenio existente entre las participantes, no permiten entender, de modo alguno, que el premio obtenido en el concurso de «Primi-Juego» pudiera ser interpretado como fruto de las consecuencias que, como derivadas de lo convenido, figuran prevenidas en el artículo 1258 del Código Civil, pues ello supondría atribuir al acuerdo inicial un alcance, extensión y finalidad totalmente distinta y desnaturalizadora de los términos de aquél, y de aquí, que, sin necesidad de mayores reflexiones, proceda concluir que el Tribunal «a quo» vino a efectuar una indebida aplicación de los artículos relacionados en el primer motivo del recurso y a infringir los 1258 y 1283 del Código Civil, lo que conlleva, necesariamente, a la declaración acogida en el riturario artículo 1715.2: haber lugar al recurso de casación (…)

3 STS, 1ª, 24.7.1989 (RJ 1989\5776) MP: Eduardo Fernández-Cid de Temes

FUNDAMENTOS DE DERECHO

PRIMERO.-Por demanda presentada ante el Juzgado de Primera Instancia de Guadalajara, don Carlos

R G reclamó de don Manuel S G el pago del premio de una participación de lotería de 1.000 ptas en

el n.º 55.793 comprada al mismo con anterioridad, que resultó agraciado en el sorteo de 21 de diciembre

de 1984, quedando el décimo en poder de dicho demandado, que no discute la cuantía correspondiente

de 4.805.000 ptas., pero niega la venta de tal participación y su firma en el documento privado que acompaña el actor para acreditarlo, aunque reconoce que estuvo bebiendo en un bar y después en su casa, sita en la calle Almodóvar, donde «el señor R estuvo enseñando al señor S una serie de papeletas con comics y chistes, algunos de los cuales simulaban recibos de lotería, rifas inexistentes y otros documentos al mismo tiempo que rellenaban y firmaban algunos de manera alegre pero sin intención alguna de que tuviera alguna validez aquellas bromas que se gastaban mutuamente» «por

lo que pudo suceder que durante aquel rato el señor R se quedara con alguno de los que habían escrito en tono jocoso » y «aun en el supuesto, que tampoco admite el señor S porque no lo recuerda, de que hubiera firmado y rellenado la papeleta absurda que presenta el demandante se trataría en ese supuesto de una declaración "iocandi causa" » La tan aludida participación dice así:

«n.º 55.793 LOTERIA NACIONAL.-EL GACHO QUE EXIBE EL PRESENTE AFORO LA CANTIDAD

DE MIL LEGAÑAS PA QUE SE ENDINE LA «TOSTA» U SEASE UNA PASTA MU GANSA PA EN EL CASO DE QUE LOS GUARISMOS INDICAOS AL FRONTIS SEAN AGRACIADOS EN EL SORTE DE

LA LOTE DEL DIA 21 DE DICIEMBRE DE 1984 SON MIL CHULAS.» y al final «AUTOGRAFO» con

la firma debajo El Juzgado, por Sentencia de 3 de octubre de 1985, desestimó la demanda, con base en

la negativa del demandado y el resultado de la prueba pericial caligráfica, para la que se señalaron con indubitados la firma que estampase el demandado al prestar confesión y el cuerpo de escritura que formase, por no aclararse debidamente que fuese la misma firma, «aunque parece existir mayor similitud entre la firma de la participación y la firma puesta por el demandado al ser emplazado» La Audiencia Territorial revocó la sentencia recurrida y estimó la pretensión de la actora-apelante, al recoger la estancia en el dominio de la C/ Almodóvar, que el demandado confesó, respecto al documento de la participación, «que las palabras obrantes en el mismo "se parecen un poco a su letra", parecido este que se traduce en identidad si se compara la firma del citado documento estampado bajo

la palabra "autógrafo" y la firma de don Manuel S G obrante en la diligencia de emplazamiento -folio 17-»

SEGUNDO.-Contra esta última Sentencia, de 17 de julio de 1987, se interpuso recurso de casación, con base en un único motivo, al amparo del n.º 5 del art 1692 de la L.E.C., por entender el recurrente que al concederse fuerza probatoria al documento presentado para fundamentar la reclamación se contradicen los preceptos del ordenamiento jurídico establecedores de los principios dispositivos y de aportación de parte, «lo que constituye un error de derecho» que ha de denunciarse por tal vía, infringiéndose el art

1214 del C Civil, cuya cita «puede viabilizar el recurso cuando se alegue y se demuestre que el Juzgador de instancia ha desconocido las reglas del mismo sobre atribución a cada parte de la carga de

la prueba invirtiendo el «onus probandi», pues, sigue diciendo, no se ataca la valoración de la prueba utilizando el conjunto global de los medios aportados, sino, en contradicción con ellos, basarse en el emplazamiento, que no figura en la pieza de prueba, supliendo la Sala la iniciativa de la parte actora El motivo tiene que ser desestimado porque; a) el viejo principio de que lo que no está en los autos no está

en el mundo implica, a sensu contrario, que todo lo que obra en autos puede y debe ser valorado por el Juzgador, figure o no en los ramos de prueba cuando no hay duda sobre su realidad; b) aunque se

afirma que no se ataca la valoración conjunta de la prueba, es precisamente eso lo que se está haciendo

y lo que tuvo en cuenta el Tribunal de Instancia, sin que se cite una norma de hermenéutica jurídica infringida, dado que no lo es el art 1214 del C Civil, precepto no apto, por su carácter genérico, para amparar un recurso de casación, al no referirse a un medio concreto de prueba, ni regular su eficacia, por lo que sólo es operante cuando el Tribunal «a quo» ha desconocido la correcta distribución de la carga demostrativa (…)-; c) el art 1214, con su redacción simplista y aparente acierto, no resuelve el problema de la prueba y hubo de ser completado con la doctrina del «onus probandi», en su recto sentido de que las consecuencias perjudiciales de la falta de prueba han de parar en quien tenía la carga

de la misma, si bien la carga probatoria que impone se torna innecesaria respecto de los hechos que aparecen acreditados y para ellos no importa ya discriminar si los ha aportado el actor o el demandado (…) pudiendo incluso completar la prueba los órganos jurisdiccionales (diligencias para mejor proveer)

o valorar la existente, cual se ha dicho, tomando en cuenta para ello cuantos datos obren en autos, de forma que lo pretendido por el recurrente es imponer su propio criterio sobre el del Juzgador, sin respetar la potestad de éste en la determinación de los hechos; y d) tanto el art 609 de la L.E.C., que, respecto al cotejo de letras, faculta al juez para hacer por sí mismo la comprobación, después de oír a los Peritos revisores, como el 632 del propio texto legal, establecen que los Tribunales apreciarán esta prueba conforme a las reglas de la sana crítica, no definidas en el ordenamiento jurídico, por lo que, siendo racionales y lógicas las consecuencias a que llega la Audiencia, no siendo necesario para ello

«poseer conocimientos científicos ni prácticos dadas las notorias identidades que se pueden observar a simple vista entre ambas firmas» y la espontaneidad con la que hubo de plasmarse la estampada en la diligencia de emplazamiento (las actuaciones judiciales se equiparan a escrituras públicas y solemnes S

de 5 de julio de 1911), es claro que -como sigue afirmando- no infringió precepto formal alguno, cosa que hace en cambio el recurrente al citar dentro del mismo motivo los arts 1091, 1261 y 1790 del C Civil, que no pueden resultar vulnerados si se parte de la base fáctica sentada por la Sala de instancia, pues: La entrega de una participación de lotería implica un contrato de cesión de derechos realizada en

el caso que nos ocupa por precio; en nuestra legislación, a partir del Ordenamiento de Alcalá, que inspira el vigente C Civil, los contratos se perfeccionan y son obligatorios cualquiera que sea la forma

en que se hayan celebrado, siempre que en ellos concurran las condiciones esenciales para su validez (art 1278); la existencia o inexistencia del consentimiento, objeto y causa y, en definitiva, la del contrato, constituyen cuestiones de hecho que ha de apreciar el Juzgador de instancia y su criterio sólo puede combatirse al amparo del n.º 4.º del art 1692 de la L.E.C., al menos en cuanto a los hechos que le sirvieron como soporte; no cabe sostener que el consentimiento se dio por motivos distintos de los que aparecen claramente expresados en el contrato, pues si existieran otros se habrían también consignado;

el consentimiento manifestado en forma jocosa no vicia su existencia, ni la del objeto y la causa, cuando éstos resultan claros de aquella expresión y no cabe dudar de su validez, es decir, que el consentimiento

«iocandi causa» sólo revela la inexistencia del contrato cuando de él se desprenden la falta de objeto cierto que sea materia del mismo o la falta de causa de la obligación que se establezca, nada de lo cual

se da en el presente caso, en el que el buen humor en la forma, como muestra de alegría y complacencia

e incluso de la duda o esperanza sobre la buena suerte que haya de acompañar a los contratantes en el juego de la lotería, en nada empece a la seriedad del contrato (…)

4 BGH, 16 May 1974 (NJW 1974.1705) Source: Hugh B EALEet alii (2010), Contract Law, 2nd ed.,

Hart Publishing Oxford and Portland.

Chapter 4 Formation of Contract (I): Existence and Formalities in Consent

One of the most relevant dimensions issues in Contract Law is the determination of the conditions for legally enforceable contracts to be formed In this sphere, several aspects raise concern, and are subject

to scrutiny, by Contract Law sets of rules, such as the DCFR, Civil Codes around the world or doctrines

in the Common Law of contracts Sometimes, economists, and even lawyers, think of these rules and doctrines as purely technical, obscure, slightly more than residual products of the Law's legendary path-dependence As explained before, contract formation issues are crucially connected with the social desirability of the binding effect and the legal enforceability of contracts, and thus their economic importance cannot be underestimated Some of these issues are linked to the existence of consent (formalities in expressing consent, offer and acceptance and the timing of consent, the meaning of omissions in consent, etc.) Others are related to the genuineness of consent, and the levels of information at the disposal of the parties for having a legally binding contract (defects in consent and rules on information disclosure, contract negotiations and their legal consequences)

In this chapter we will explore the first of these two fields of contract formation

The first are of contract formation rules that we will analyze is that of contractual formalities As a general rule, Contract Law adopts a form-less approach to contract formation That is, as a broad or overarching rule, consent may be expressed -and yet the contract be binding- however the contract parties themselves see fit The Law does not impose, at a general level, requirements on what form consent must be expressed through, contained or evidenced in for having a valid, binding contract To provide a recent European example, Art II-1:106 DCFR says that “a contract or other juridical act need not be concluded, made or evidenced in writing nor is it subject to any other requirement as to form” Civil codes tend to (generally) do the same For example, Art 1278 of the Spanish Civil Code proclaims that “contracts shall be binding no matter the way in which the contract was formalized, provided that the essential conditions for its validity are met” As we will explore below, there are numerous and important exceptions to this general principle of "informality" in contractual consent, but the Civil Law tradition remains strongly committed to the general principle

The Common Law tradition is slightly different, since the Statute of Frauds (originally stemming from 1677) contains a list of contracts with an ample scope requiring written expression for them to become enforceable Additionally, in the US the UCC has included Statute of Frauds provisions covering also broad categories of contracts Still, of course, there is much left to freedom of form in the universe of contracts It is true, however, that the kind of firm, abstract position favoring the free choice of the form expressing contractual consent that is so solemn in Civil Law countries seems to be lacking in the Common Law

Freedom from formality seems to be a sensible general starting point from an economic perspective: If a contract is mutually agreed, it is because it increases welfare by existing parties, and thus social welfare Therefore, the Law should not erect barriers, except when justified on other grounds, to prevent these welfare-enhancing interactions from taking place.

However, in most legal systems a non-trivial set of contracts require certain formalities Some contracts, given their subject matter, require a public deed, so without this form of declaration of the consent, there is no contract (prenuptial agreements, donative contracts of real property; in many jurisdictions, the sale of real property) Similarly, mortgages, (some) suretyships, corporations and limited liability companies usually also require public deeds Other agreements have to be made in writing And in jurisdictions where no public deeds are requested, written memorandums are necessary for those kinds of agreements

All these are "traditional" formalities, that have been part of the Law often for centuries, and whose imposition does not depend on the quality and condition in which the contractual party acts However,

in modern Contract Law, many formalities are required only when one of the contracting parties is a consumer:

 The requirement that the contract is made in writing with one copy for the consumer (door to door sale contracts, time sharing contracts)

 The requirement of a minimum content, informative of contractual rights of consumer (consumer credit, distance sales)

 The right of withdrawal, thereby the consumer can walk away from the contract within a legally specified time from signing the contract (door to door sale contracts, time sharing contracts, distance sales)34

Some traditional formalities, on reflection, may be functionally not so different from the modern consumerist formalities: They tend to provide opportunities for the less informed party to increase its level of information, and also grant her with a kind of right of withdrawal: since in order to donate real property, or signing a pre-nup, a public deed is required, there must be some time lag from the moment

in which the internal decision to donate or sign the agreement is taken, to the moment in which the contract becomes binding through the signature of the public deed This time lag gives the parties whose interests may be more at risk -the donator, the poorer spouse who is waiving economic rights of compensation- to re-evaluate their first impulse and choice, and reflect whether the contract fully satisfies their long-term preferences Thus, the function of such formality requirements seems to be close of that of a cooling-off period In the case of an explicit right of withdrawal legally mandated, we face the conscious legal creation of transaction costs -since the contract does not become binding until the withdrawal period has lapsed- in order to ensure the correspondence between the expressed contractual consent and the real and long-term preferences of the contracting party

Other contractual formalities have different economic rationales Some try to prevent external effects to the legal and judicial systems as a whole: Formalities are required to provide evidence as to the existence and true intent of the parties, reducing in such way, the costs later litigation on the existence

34 It should be noted that not all consumer contracts include a right of regret.

and content of contractual consent, and thus reducing the both the costs for the justice system, and the costs deriving from uncertainty about what the Courts would say about the existence and content of what has been agreed In other cases, the formality requirements seem to be subordinate conditions to providing information to third parties (creditors of one of the parties, potential future contracting parties) who are, or at least may be, interested in the existence and terms of the contract This seems to

be the case concerning mortgages -a contract that reduces the possibility of recovery for creditors other than the mortgagee-, or company contracts -whose tems are of interest for future trading partners of the company

2 Right of withdrawal and cooling-off periods in the consumer rights directive

One of the most striking especial rules about contract formation is the mandatory grant to certain contract parties, consumers, of the right to withdraw from the contract if they choose to do so within a specified period of time Typically, moreover, the other party has to provide detailed information about the existence and conditions to exercise this right, and even provide a written form so as to ease such exercise European Consumer Law has made use of this regulatory strategy in the past, and now, the most general regime of the right of withdrawal is contained in Directive 2011/83/EU on consumer rights This Cirective foresees in favour of consumers a right to withdraw (or, almost equivalently, a cooling-off period) in distance and off-premises contracts In other Consumer Directives (timeshare, life insurance, consumer credit) a similar right is granted to the consumer

The right implies that the consumer shall have a period of fourteen days to withdraw from the contract, without giving any reason The consumer rights Directive does not allow Member States from having more or less stringent provisions, departing from the level of protection set out in the Directive, unless expressly authorised by the Directive itself In other words, it is a full harmonization Directive

a model withdrawal form, 12 months from the date in which it would have otherwise started,

or 14 days after the information is granted, if it is provided within the 12 months period

 The deadline is met if the communication concerning the exercise of the right of withdrawal is sent by the consumer before the end of that deadline

b) Exercise of right of withdrawal

 A statement in his own words or a form prepared and given to him No extra formalities will be required

 The seller may, additionally, give the option to the consumer to electronically fill in and submit the standard withdrawal form on the trader's website.

c) Effects of withdrawal

 Seller shall reimburse any payment received from the consumer within 14 days from the date in which he receives the communication of withdrawal Reimbursement should be made through same means of payment as used by consumer, unless otherwise agreed by the latter

 For sales contracts, the trader may withhold the reimbursement until he has received or collected the goods back, or the consumer has supplied evidence of having sent them

 When the consumer is in material possession of the goods, the consumer shall send back the goods or hand them over to the seller or to a person authorised by the seller within fourteen days from the day on which he communicates his withdrawal unless the seller has offered to collect the goods himself

 The consumer shall only be charged for the direct cost of returning the goods unless the seller agreed to bear that cost

 The consumer shall only be liable for any diminished value of the goods resulting from the handling other than what is necessary to ascertain the nature and functioning of the goods If the consumer was not informed of right of withdrawal, he will not be liable for any such costs For service contracts subject to a right of withdrawal, the consumer shall bear no cost for services performed, in full or in part, during the withdrawal period where the consumer was not informed of his rights, or he did not expressly request performance to begin during the withdrawal period

 Any ancillary contracts shall be automatically terminated, without any costs for the consumer

d) Exceptions to the grant of right of withdrawal

In distance and off-premises contracts, the right of withdrawal shall not apply as regards the following:

 services where performance has begun, with the consumer's prior express consent, before the end of the fourteen day period

 the supply of goods or services for which the price is dependent on fluctuations in the financial market which cannot be controlled by seller

 the supply of goods made to the consumer's specifications or clearly personalized or which are liable to deteriorate or expire rapidly

 the supply of goods that given their nature are to be inseparably mixed with other goods after delivery

 the supply of sealed audio or video recordings or computer software which were unsealed by the consumer;

 the supply of newspapers, periodicals and magazines

 not suitable for return due to health or hygienic reasons

 accommodation except for residential purposes, transport of goods, car rental, catering and leisure when the contract sets a specific date or period of performance

 digital content without tangible medium when performance has started with the consumer’s express consent and knowledge of losing right to withdraw from the contract

 contracts for the supply of foodstuffs, beverages or other goods intended for current consumption in the household, selected in advance by the consumer by means of distance communication and physically supplied to the consumer's home, residence or workplace

 contracts for which the consumer, in order to respond to an immediate emergency, has requested the immediate performance of the contract

 contracts for which the consumer has specifically requested a visit to his home

e) Excluded contracts

The right of withdrawal does not exist in contracts that the Directive itself leaves out of its scope of application Thus, the right of withdrawal shall not apply in certain distance and off-premises contracts:

a) for the sale of immovable property or relating to other immovable property rights, except for rental and works relating to immovable property;

b) concluded by means of automatic vending machines or automated commercial premises;

c) concluded with telecommunications operators through public payphones for their use;

d) for the supply of foodstuffs or beverages on frequent and regular rounds in the neighbourhood

of his business premises

e) for social services;

f) for healthcare;

g) for gambling;

h) financial services;

i) construction or renovation of buildings or rental of accommodation:

j) where other withdrawal righs are provided, such as timeshare

k) auctions

l) contracts in which a notary intervenes;

m) package travel;

n) automatic vending machines;

o) telecommunications through public payphones

2 The right of withdrawal may be excluded by Member States for contracts < € 50

3 Economic rationales for the right of withdrawal

From an economic perspective, plausible rationales for a right of withdrawal lie in typical failures in the contracting process, as well as an increase in the informational opportunities of the consumer after the transaction is concluded

Correcting failures in the contracting process: In certain settings of interaction between consumers

and professional marketers and sellers, consumers may make suboptimal or irrational decisions due

to:35

35Pamaria Rekaiti and Roger van den Bergh, “Cooling-Off Periods in the Consumer Laws of the EC Member States: A

Comparative Law & Economics Approach”, 23 Journal of Consumer Policy (2000), p 371.

 Unstable and peak preferences affecting consumers when making decisions

 Important impact of emotional factors upon consumer choices

 Inter-temporal choice inconsistencies

 Pressing marketing tactics used by sellers and against which consumers have difficulty in reacting

 Limited cognitive abilities of consumers in certain decision contexts

Also, certain marketing strategies or decisional environments created by firms may produce situational

monopoliesin which sellers may extract higher portions of surplus from consumers

4 Information acquisition post-transaction

Sometimes consumers cannot easily evaluate goods and services prior or at the time of buying The value of the goods for the consumer may depend on how they look together with other goods (furniture, clothes), or the consumer may need to try their functioning for some time (equipment) In other cases (timeshare, insurance, credit, mortgages) the complexity of the contract may require extra time to fully understand and may get advice about the desirability of the contract.36

5 Strategic use of right of withdrawal (moral hazard)

The problem is that a generous and ample right of withdrawal may be strategically abused by the consumer, who uses the good at will during the cooling-off period, and then withdraws from the contract leaving a much depreciated good to the seller If sellers can anticipate this strategic use, and given they cannot screen consumers through contract terms given the mandatory nature of the right to withdraw, the prices will go up, and some valuable consumer transactions will be lost

Of course, this inefficiency will disappear if consumers had to pay for depreciation costs in case of the exercise of the right of withdrawal, because then the negative externality on sellers will be internalized The problem is that calculating the depreciation cost of the good in each case may be difficult (goods are very different in this respect, some depreciate quickly, others do not; some depreciate only with use, others simply with the passing of time, etc.), and/or excessively costly with respect to the value of the goods

Thus, it probably would make sense to set a limit to the right to withdraw, even a short one, giving the high degree of depreciation of most goods It need not be the same for all goods and services, however,

so more diversity may be welcome Sometimes, the exclusion makes sense, given the immediate depreciation of some goods (food products, drugs, sealed IP protected items) It also makes sense to condition right of withdrawal on lack of use, if this is the triggering factor of depreciation (clothes only with label), and to make consumers bear the particularly high transportation and return costs of some goods (heavy products, for example)

36Omri Ben-Shahar and Eric Posner, "The Right to Withdraw in Contract Law", 40 (1) Journal of Legal Studies (2011),

p 115

Chapter 5 Formation of Contract (II): Tacit Consent and Timing of Consent

In addition to formalities, the existence of contractual consent is subject to other rules of contract formation In this chapter we will analyse a few of them and show their economic and strategic dimensions, without being exhaustive on the issue of what are the conditions for the existence of proper offer and acceptance of a contract, a favorite topic in traditional, black-letter, Contract Law

The first issue to deal with is whether contractual consent needs some positive action on the part of the parties, or passivity may suffice to produce the binding effects of consent Although this would seem at first glance a very narrow, obscure, and overtly technical point in the Law of contract formation, we will show that the significance of the rule is, both in theoretical and practical terms, much larger than it appears

In the DCFR the rule is that, for a valid contract to be formed, the positive expression of the contractual will is necessary (by means of a public or private document, orally, or by means of conclusive acts by

which the contractual will may be deduced) Art II-4:204 (2) DCFR states that “silence or inactivity does

not in itself amount to acceptance” The same rule prevails in the Vienna Convention of 1980 of international sale of goods (CISG), and also in the US The Restatement (Second) of Contracts, § 69 states:

"§ 69 Acceptance by Silence or Exercise of Dominion

(1) Where an offeree fails to reply to an offer, his silence and inaction operate as an acceptance in the following cases only:

(a) Where an offeree takes the benefit of offered services with reasonable opportunity to reject them and reason to know that they were offered with the expectation of compensation.

(b) Where the offeror has stated or given the offeree reason to understand that assent may be manifested

by silence or inaction, and the offeree in remaining silent and inactive intends to accept the offer.

(c) Where because of previous dealings or otherwise, it is reasonable that the offeree should notify the offeror if he does not intend to accept."

The mere omission of conduct is not construed as an acceptance of the contract However, in certain circumstances mainly case law creatures silence may be deemed relevant to indicate contractual consent The rule, in fact, importantly affects the costs of making contracts and also the incentives to make offers, and on which terms.37

A simple game-theoretic model will show the economic logic behind this rule Assume that an offeror (O) faces two actions, either send a contractual offer to an offeree (D) or do nothing Sending the

37Avery Katz, "Transaction Costs and the Legal Mechanics of Exchange: When Should Silence in the Face of an Offer

be Construed as Acceptance?", 9 Journal of Law, Economics and Organization (1993), p 77.

contractual offer to the offeree entails some cost to the offeror (drafting and posting the offer), whereas doing nothing is costless If the offer is sent, D, given the value she expects to obtain from the contract offered, and the price contained in the offer, decides whether she wants to enter the contractual relationship or not She may express her contractual assent or her refusal to contract through three different actions: positive acceptance, silence, or rejection The legal significance of positive acceptance and rejection is straightforward and undisputed, but that of silence depends on the legal rule attributing or not consensual value to failure to respond The following figures represent the game in extensive form depending on what legal regime is in place concerning the legal significance of silence

by the offeree First, when silence is considered assent, or expression of contractual will, and thus the a binding contract is formed, second when silence is not considered as such, and thus no binding contract comes into existence

Let's look first, at the second figure, the one under the regime in which the general rule requires an

actual declaration of acceptance for contractual consent (silence has no value as declaration of will) Since sending a explicit response has a cost, then D (addressee of the offer) will never explicitly reject the offer since this is costly and she will obtain the same result by remaining silent and saving the cost

of responding D will thus choose between remaining silent (which implies no binding contract) and accepting the proposal of O (offering party) and getting the contract She will opt for the latter if:

V – R – P ≥ 0

V = D's valuation of the goods or subject matter of the contract

R = cost of sending back a response to V

P = contract price

The above implies as follows:

P ≤ V - R

If this weak inequality is satisfied, D will accept the offer, since it will lead him to a weak increase in welfare The maximum price that D would accept in this situation is the one that satisfies the above expression as an equality, that is, leaves D indifferent between accepting the offer or rejecting it by remaining silent:

P = V – RNotice that this maximum acceptable price to the offeree is less than her valuation of the good

Let's now turn to the alternative regime, in which the general rule is the positive value of silence (who

remains silent in front of an offer, is deemed to have tacitly consented): Since remaining silent is tantamount to acceptance, D shall not waste the costs of responding, and thus D shall never take the option of expressly accepting She will only consider explicitly rejecting and remaining silent, the latter entailing tacit consent On the other hand, it shall remain silent if:

by remaining passive in front of the offer, since to reject it would be more costly than accept it, but accepting it may imply paying above the maximum amount she was willing to pay for the contract (V <

V + R), thus letting D in a worse situation The addressee (D) is placed in the situation of entering into undesired contracts And the offering party, then, has the incentive to send undesired -but barely acceptable due to the costs of responding- and to seek as contractual partners those people with high costs of rejection, and to seek expensive means of communication (and inefficient ones), with the purpose of increasing the value of R for the addressees, and thus the price that O can extract from them

Thus, it seems clear that given such undesirable consequences stemming from a general regime of tacit consent, it is economically superior to stick to a general rule denying silence value as tacit expression of contractual assent It is true, though, that avoiding the above mentioned evils comes at a cost, namely that of forcing people who receive welcome offers -those that make them better-off from the perspective of not entering into the contract- to incur costs of drafting and sending responses

Legally speaking, the Law is somewhat more complex, since in addition to the general rule, in some legal contexts, a given value to silence is specifically granted or denied:

 In the field of distance consumer sales, for instance, in Spanish Law, art 99 of RDL 1/2007, November 16th, on consumer protection, establishes that in distance sales, under no circumstances,

will silence be interpreted as assent: “in any case shall the lack of response to the distant sale offer be

considered an acceptance to it” In this area, the risk of exploiting vulnerable addressees and using inefficient means of communication is very high, so a clear specific rule establishing that silence and passivity never have value as tacit consent seems to be appropriate

 On the other hand, the Law sometimes grant positive value to silence as tacit consent We find this ,

in Case Law of different jurisdictions, and also in the Restatement of Contracts (Second)§ 69:

"(b) Where the offeror has stated or given the offeree reason to understand that assent may be manifested

by silence or inaction, and the offeree in remaining silent and inactive intends to accept the offer.

(c) Where because of previous dealings or otherwise, it is reasonable that the offeree should notify the offeror if he does not intend to accept."

This happens typically when the contract is entered into by firms having regular business dealings, since it can be assumed reasonably safely that: (i) parties have incentives to use efficient means of communication, not existing in such case risk of choosing an inefficient means of communication; (ii) offers are typically welcome, since when two parties hold long-term or frequent contractual relationship, the probability that the contract has positive value for both parties is substantially high Here, binding a party to its passive attitude as tacit consent may be economically efficient as a means to save communication costs in these settings of continuous, or repeated, trading