2007): “Courts of law and unforeseen contingencies

Abstract. We study a contracting model with unforeseen contingencies in which the court is an active player. Ex-ante, the contracting parties can-not include the risky unforeseen contingencies in the contract they draw up. Ex-post the court observes whether an unforeseen contingency occurred, and decides whether to void or uphold the contract. If the contract is voided by the court, the parties can renegotiate a new agreement ex-post. There are two effects of a court that voids contracts. The parties ’ incentives to undertake relationship-specific investment are reduced, and the parties enjoy greater insurance against the unforeseen contingencies that the ex-ante contract cannot account for. In this context, we fully characterize the optimal decision rule for the court. The behavior of the optimal court is determined by the tradeoff between the need for incentives and the gains from insurance that voiding in some circum-stances offers to the agents