April 07, 2005
Contracts and Corporations
Posted by Gordon Smith

One of the most important recent developments in contracts scholarship has been the emergence of neo-formalism, led by Robert Scott, Eric Posner, and Alan Schwartz. In 2003 Schwartz and Scott published a provocative article entitled, Contract Theory and the Limits of Contract Law, in which they offer a simple theory of the role of contract law in disputes between firms: "contract law should facilitate the efforts of contracting parties to maximize the joint gains (the 'contractual surplus') from transactions, [and] contract law should do nothing else."

One important implication of this view relates to the manner of judicial interpretation of contracts:

[I]n contrast to the UCC and much modern scholarship, ... textualist interpretation should be the default theory for [these] contracts. Business firms, that is, commonly prefer courts to adhere as closely as possible to the ordinary meanings of words, to apply a "hard" parol evidence rule, and to honor "merger clauses" (which state that the parties intended their writing to be interpreted as if it were complete). A textualist theory of interpretation, however, will not suit all parties all of the time. Therefore, courts should use narrow evidentiary bases when interpreting agreements between firms, but also should comply with party requests to broaden the base that is applicable to them. This implication is at variance with current law, which holds that interpretation is an issue for courts to decide and should be conducted according to rules that parties cannot vary.

While I have some sympathy for this position, there is no denying that it has the potential to produce erroneous results (i.e., results that do not accurately reflect the parties' intentions) in a substantial number of cases. Schwartz and Scott rebuff this objection, arguing among other things that judicial error will not be systematically biased. This lack of bias means that firms that enter many contracts can expect to be the beneficiaries of some errors and the victims of others, but in the long run the errors should balance out. Clever ... but my co-blogger at Times & Seasons Nate Oman isn't buying.

Nate has written a paper entitled, Corporations and Autonomy Theories of Contract: A Critique of the New Lex Mercatoria, which rejects the foundational assumption of Schwartz and Scott that autonomy is not a relevant consideration when enforcing contracts in the corporate context. According to Schwartz and Scott, "business firms that make commercial contracts are artificial persons whose autonomy the state need not respect on moral grounds and whose morality is ordinarily required by positive law."

Nate contends that the "Artificial Personality Argument" invoked by Schwartz and Scott is an attempt to push autonomy theories of contract to the side, but Nate claims that the attempt is fundamentally flawed. He does not try to refute the Artificial Personality Argument -- indeed, he is not at all interested in whether this is an accurate description of corporations -- but instead argues that the Artificial Personality Argument is inconsistent with an efficiency theory of contract, such as that endorsed by Schwartz and Scott.

Nate's main claim is that the Artificial Personality Argument relies on a conception of the corporation that is "essentially individualistic." The nexus-of-contracts theory is such a conception, and it "denies that a firm is fundamentally different from any other contractual endeavor." As a result, contracts between corporations are just as susceptible to autonomy theories as other contracts.

In my view, Nate does more to indict the nexus-of-contracts theory of corporations than the neo-formalism of Schwartz and Scott. If the firm itself is a nexus of contracts, how do we make sense of contracts between firms? If the contractual corporation is "essentially individualistic," how does the corporation act vis-a-vis other corporations? Although the nexus of contracts has been a useful metaphor, it does not offer a realistic account of corporations.

Indeed, I think Nate could have done Schwartz and Scott some more lasting damage by challenging the Artificial Personality Argument more directly. Organizational theory certainly has a lot of support for the notion that corporations really are something more than the sum of their parts.

But Nate's main quarry here is not a single article. He is after something more substantial: nothing less than a unified theory of contract. You can perceive that in his conclusion, where he writes:

While the injection of the corporation into contract theory throws up new examples of old problems, it does not pose any fundamentally new or unique issues for autonomy theories. A new lex mercatoria may indeed hold the promise of reconciling the competing approaches to contract, but the promise does not lie in the fact that autonomy theories can be summarily banished from its domain. Rather, the meta‑theoretical advantage of a new lex mercatoria must lie in its ability to make the principled integration of autonomy and welfare theories into a single approach more tractable.

Like a cliffhander novel, that "single approach" does not appear in this paper. For more on that, read Nate's forthcoming article in the Michigan Law Review, Unity and Pluralism in Contract Law.

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